Having a mortgage balance is something you get used to. You signed up for 15 or 30 years of payments, after all. If you stick the defined payment plan you will eventually pay off the mortgage balance, but through the process you will normally pay enough in interest to buy your house again. So using a long term mortgage means you essentially buy your house twice.

The last time I checked most people spent well into the six figure range on their home, so buying it twice is even more costly.

Thankfully you do not have to be stuck sending in just your monthly payment to the lender each month. You can make additional payments along the way to pay down the balance faster.

On the other hand some argue that the extra money you send to your mortgage company would be better invested elsewhere. When you pay extra on the principal balance of your mortgage you are making an investment decision to take a stated rate of return versus an unknown return investing it elsewhere.

Which is better?

Should I Invest or Pay Off My Mortgage?

Whether or not you should pay down your mortgage faster or using that money for other investment purposes depends on how risk-averse you are and what assumptions you make on the return you would get from investing the cash elsewhere.

Investment Return Assumptions

There are two investment return calculations you must know before deciding to pay down your mortgage of investment the money elsewhere.

First, you must know how much return you will get from paying off your mortgage. Thankfully this one is easy; just look at the interest rate on your mortgage loan. If your interest rate is 3.50% over 30 years, then every dollar you pay off on the mortgage will generate a 3.50% return for you today.

The second assumption is more tricky. If you decide to invest the money elsewhere, what kind of return can you expect? Obviously for it to be worthwhile it would need to be above your current mortgage rate and then some to justify not paying off your mortgage.

So what kind of investment return assumptions can we make? Let’s look at some data.

  • The S&P 500 (and S&P 90 that came before the 500) has averaged about 9.7% annual returns from 1926 to 2011. (Source)
  • However, the annual return each year for the last 10 years has been volatile and historically low:
    • 2002: -22.10%
    • 2003: 28.69%
    • 2004: 10.88%
    • 2005: 4.91%
    • 2006: 15.79%
    • 2007: 5.49%
    • 2008: -37.00%
    • 2009: 26.46%
    • 2010: 15.06%
    • 2011: 2.05%
    • If you put the money in for investment just for one year, then 7 of the last 10 years would have been winners for you. Yet we rarely invest just for one year, and then even if you did there is a 20% chance you got crushed in the market and a 10% chance you had a positive return that was less than your mortgage amount.
  • The 5 year annualized return from 2007 to 2011 was a whopping -0.25%.
  • Bond investments don’t generate as much return, but also don’t normally take 25% negative swings either. In fact from 2002 – 2011 the 10 year Treasury Bond averaged an arithmetic average of 6.85%, much higher than the 4.93% return of stocks.

As you can see it is not easy making a return assumption for investments. Over a long period of time you can expect the returns to be positive and higher than a low mortgage rate, but it really depends on your investment timeline as to whether it is a smart move to invest or pay off your mortgage.

Being Mortgage-Free

How risk-averse are you? Do you enjoy taking on great risks or would you rather play it safe? How you feel about these types of questions can help answer what you are going to be most comfortable doing with your money.

If you prefer to play it safe then paying off your mortgage, even if it ends up being a slightly poorer return on your investment, might be the best move. You have to have the confidence to continue with the plan you choose. If you are severely risk-averse and decide to invest the money, the first drop in the markets will tear you up psychologically and you might stop investing. That’s okay — but not if you don’t then turn around and pay down the mortgage instead. (The opposite can be true if you love risk, too. If you decide to pay off your mortgage and see the markets returning 10% each year, you might kick yourself for not investing the money instead.)

There is a lot of comfort in being mortgage-free, too. No one can really fault you for not chasing stock market returns when you no longer have a mortgage payment. For the average person the mortgage is by far the largest monthly expense. When you eliminate that expense you free yourself up for new opportunities that you might not get from having the money in an investment portfolio.

Why Not Do Both?

When I am asked about my thoughts on using a Roth IRA or Traditional IRA, I lean more toward the Roth IRA. I think income tax rates will be higher in my retirement decades from now than they are today.

But I know I could be wrong, so I usually recommend doing a little bit of both. Put half your money into a Roth IRA and half into a Traditional IRA. If tax rates are higher in retirement, then only 50% of your savings will pay the higher tax. If they are lower, then only 50% of your savings paid too much tax on the front end. You end up being 50% wrong either way, but it is better than putting all of your eggs into one basket and being 100% wrong.

The same is true of the mortgage versus investment decision. You can earn higher returns through investing the funds elsewhere. But will you? The markets and the investments you choose will determine that. You get a guaranteed return by paying down your mortgage. Even if the return is low, it is still a guaranteed positive return.

Instead of deciding which path to take, why not split the extra money you have and do both? You will accelerate your mortgage payoff and still be able to get higher returns with the other half of the money you invest.

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