Should You Pay Extra on Your Mortgage or Invest?

Many homeowners often reach a point where they have extra income, either as part of their monthly budget or from a windfall like a bonus. Having this surplus leads most people down the path of figuring out what to do with that money.

While there are all kinds of ways to utilize that money, from the lens of long-term financial planning, it can come down to a making a hard decision: investing it vs. paying off your mortgage. It’s important to know that there’s no right or wrong choice, as both avenues comes with pros and cons. At the end of the day, it’s about what’s going to work best for your circumstances and goals.

When Paying Off Your Mortgage Makes Sense

There are several benefits of paying off your home loan early. First is the amount of interest you could save over the long haul. Here’s how.

When you make extra payments, you’ll pay off your loan sooner and as a result, you could pay less interest overall. This can up add up to tens of thousands of dollars over the life of the loan. Since it can be a substantial amount, it’s not something to overlook. In the following hypothetical example, a homeowner saves approximately $62,000 over the life of the loan and pays off their mortgage six years early.

Prepayments especially help with mortgages that have higher interest rates. On the other hand, the lower the rate on your mortgage, the greater the potential to receive a better return through investments.

Beyond the guaranteed interest you could save, the emotional benefits of being debt-free can’t be overlooked. Paying off your mortgage early brings peace of mind, a sense of psychological security — particularly if retirement isn’t too far off or if you’re on a fixed income. In that same vein, there’s quite a lot of financial flexibility that comes with not having to make a mortgage payment every month, which is a tremendous benefit.

When Investing May Be the Better Option

Clearly there are advantages to a mortgage payoff strategy. Before you opt to prepay your mortgage, you still need to consider what you’d be giving up by doing so or opportunity cost. And there are benefits of investing you want to consider.

First is the potential for higher long-term returns. Historically, market returns have often exceeded mortgage interest rates. For example, if your mortgage rate is 3.5% and your investment generates 6% returns, you're benefiting by 2.5% by investing. Plus, investing could build more wealth over time through compound interest — essentially where your interest earns interest.

Next, investing provides flexibility and preserves liquidity, since you have access to cash. Investments can be accessed or rebalanced as needed, while equity is tied up in your home. This flexibility is crucial – working to your benefit when unexpected expenses arise or even when your financial goals change. After all, when you make an extra payment on your mortgage, that money is gone, and not available if you need it.

Investing also positions you to benefit from dollar cost averaging, which simply is investing a fixed amount of money at regular intervals, regardless of the investment's price. Investing this way helps reduce the impact of market volatility because you buy more shares when prices are low and fewer when prices are high, potentially lowering the average cost per share over time. Keep in mind, it's important to factor in your ability to purchase when price levels are fluctuating. Dollar cost averaging doesn't assure a profit and does not protect against loss when markets are declining.

Factors to Weigh Before Making a Decision

1. Mortgage interest rate vs. expected investment return. Compare your mortgage rate with potential investment returns. If the after-tax mortgage rate is lower than expected long-term investment returns, investing might be more efficient.
2. Tax implications. Consider the tax benefits of mortgage interest deductions and potential capital gains or retirement account taxes on investments.
3. Liquidity needs. Evaluate how much cash you need for other goals — things like saving for college tuition or retirement or building an emergency fund.
4. Time horizon and risk tolerance. Your investment timeline and comfort with market volatility should factor into your decision. The longer your time horizon, the more time you have to potentially grow your money by investing. It’s still important to note though, if paying off your mortgage will make you feel more secure, you should include it into your decision.

Can you do both? Absolutely. You don't have to choose between paying off your mortgage and investing. Many investors use blended strategies, splitting funds between extra mortgage payments and investment accounts. This approach balances risk reduction with potential growth. Automation can simplify things on your end and help you stay on track.

Next Steps: Revisit Your Plan with This in Mind

1. Reevaluate your financial goals, risk tolerance, and current mortgage terms.
2. Consider running projections or consulting with a financial advisor to model different scenarios.
3. Choose an approach that supports both your financial growth and peace of mind.

By carefully weighing these factors and considering your personal priorities, you can make a confident decision that stays true to your long-term financial plan.