Consumers often find themselves asking an age-old question in finance. Should they pay off their mortgage first or start investing their money? If they pay off their mortgage, they’ll own their homes outright and build equity in their name. On the other hand, if they invest the money, they could potentially earn a great return on investment… or lose money.
This question doesn’t have a simple answer. What works for one person might not work for someone else, so it is important to look at this question from multiple angles.
First, let’s look at the types of returns available with the two options.
Guaranteed or Potential Returns
Paying off a mortgage early provides a guaranteed return, while making an investment offers a potential return. When you put money into a house, there is a tangible end value that you are working towards building in your name. There’s a bit more certainty with a mortgage despite changing property values.
On the other hand, when someone makes an investment they hope to get a return, but it is impossible to tell how much that return will be. That is the potential return, which can be far greater than the guaranteed return, but it can also be less. It depends on the circumstances.
For instance, let’s say Joe has a 4.15 percent APR on his mortgage. He pays it off, so he no longer pays interest. That means he has a guaranteed return of 4.15 percent. He is essentially making 4.15 percent on an annual basis because he is not spending it on interest.
Now, let’s say Julie also has a mortgage with an APR of 4.15 percent. She keeps her mortgage but makes an investment that nets her a return of 5.15 percent. That means she’s doing better than she would if she paid off her mortgage by a full percentage point.
Chris decides he wants in on the action as well, so he also holds onto his mortgage and makes an investment. However, he only nets a return of 2.15 percent on the investment. He comes out worse off than if he would have paid off his mortgage instead.
These variables make it impossible to give a general answer when people ask if they should pay off their mortgage or invest their money.
Home Appreciation – Another Return
People also receive a return when their home appreciates, or increases, in value. While property can also depreciate, it usually appreciates depending on the area. Here’s an example. It’s entirely possible to buy a house for $100,000 and have it appreciate over time to a value greater than $100,000. This could be viewed as an investment on its own.
On the other hand, investments can also grow. Sometimes a typical investment can return way more than an investment in property. One must consider the growth of the investment versus the appreciation of the real estate. This further complicates the matter.
Fortunately, analyzing some variables can make it easier to see the picture more clearly.
The Variables to Consider
Homeowners have six variables to consider when comparing paying off a mortgage and investing. These variables are:
- Market value of the home
- Income tax rate
- Home appreciation
- Potential inflation
- Expected rate of return on the investment
Let’s look at an example that illustrates the importance of these variables:
Let’s say a home is worth $250,000, and the homeowner pays an interest rate of 4 percent on their mortgage. The home appreciation rate also sits at 4 percent.
The person has a tax rate of 20 percent, and inflation sits at 3 percent. That takes care of all the variables related to the property.
There is one variable left, and it is related to the investment. For this example, let’s say the person expects to make a market return of 8 percent on his or her investment.
The home will be worth around $810,000 in 30 years, based on these numbers. It will be worth that amount even if the homeowner has a mortgage on it. However, if the homeowner has a mortgage on it, he or she won’t have access to all $810,000.
If the person chooses to invest the $250,000 instead of using it to pay off the mortgage, he or she will end up with $2,525,664 at the end of the same period. That’s because investment brings a return of 8 percent, while the home only appreciates at 4 percent.
In this case, it makes more sense to invest the money instead of paying it off.
When to Pay off a Mortgage
As illustrated in the example above, paying off a mortgage essentially provides people with a guaranteed return. This is an attractive option for those who have a high interest rate mortgage. The return is greater when they pay the mortgage off. It also keeps them from losing lots of money in interest.
Conservative investors in low tax brackets also benefit from this technique. Conservative investors are less likely to win the game of potential returns. They do better putting their excess money into their homes.
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When to Invest
There are also times when investing is the obvious choice. Aggressive investors with lower interest rate mortgages often benefit from investing. They are in the position to bring in higher returns with their investments, but the low interest mortgage market helps them with this.
Age is also a factor. People who are younger than 50 are better off investing. They can build a nest egg for retirement with higher paying, and riskier, investments. However, as they get to be 50 and over, it’s a good idea for them to pay off their mortgage and move to safer investments.
The Bottom Line
From a strictly monetary standpoint, holding onto a mortgage and investing the money is the smart choice. However, it is important that people look beyond finances and determine what is best for their needs.
They also need to ask themselves how much they will invest if they pay off the home. Will they put all their excess money into investments, or will they get sidetracked and spend it on other things instead?