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Should you pay down your mortgage beyond the minimum or invest instead?
If you’re among the 85 million American individuals or families who own a home, you may ask yourself this question.
In a vacuum, it feels better when we don’t owe anyone money. But mortgage rates have been extremely low for years now.
According to Freddie Mac, the average American mortgage rate hovers between 3 and 4% interest. They’ve climbed a smidge recently, but they’re still near all-time historic lows.
The S&P 500 has produced an average return of 10.7% since moving to the 500-company format in 1957. There’s a good chance your mortgage rate is considerably lower than that figure.
The difference between paying 4% interest and earning a 10% return is enormous, especially compounded over decades. So you probably already realize that in many cases, paying the minimum on your mortgage and investing your excess money is a better choice.
But why is that? What factors should you consider? And are there any reasons to pay off your mortgage instead?
The further you are from retirement — in age and dollars — the easier the decision becomes.
You have to consider the interest rate on your mortgage. But if you’re the average American, you’re paying less than 4%.
Even being conservative, a total stock market or S&P 500 index fund is going to earn more than 4% annually over a decade or more.
For most people, using your extra cash to service debt at a manageable interest rate comes with a major opportunity cost.
The shorter the time frame, the bigger the risk when it comes to the U.S. stock market as a whole. Money expert Clark Howard says that truly investing means five years at a minimum — preferably 10 years or more.
You may underperform the current average U.S. mortgage rate over a week, a month or even a few years. But over a decade or longer, it’s extremely unlikely.
Compound interest is one of the most powerful forces in finance. Take a relatively small amount of money — say, $50,000 and compound it at, say, 7% interest for 20 years. Add $5,000 per year into your investment. You’ll have nearly $225,000 after 20 years.
Start with $100,000 instead with the same interest rate. Add $10,000 per year for five years. You’ll have less than $200,000.
Funding your retirement is an important priority: one that takes discipline and time.
Perhaps you got stuck with a higher-interest mortgage and don’t have the credit to refinance. Maybe you’ve got a loaded 401(k) account but you’re concerned about paying a mortgage on a fixed income when you retire. You may need to sell the house in the not-too-distant future and need to make sure you don’t owe more than it’s worth.
At any rate, there are some legitimate reasons to consider putting your extra money toward your mortgage rather than investing it.
It’s important to tackle the basics before you get too advanced.
First, if you have high-interest debt of any kind — credit card debt, for example — that’s the first thing you should put your money toward. Investing your money and hoping for an 8% annual return while paying the minimum on $10,000 of credit card debt with 18% interest makes no sense.
You should also avoid stretching yourself so thin that you deplete your emergency fund. Don’t go all out to pay down your mortgage or invest to the point that you have nothing in your savings account. Financial “oops” happen, Clark likes to say. It’s a matter of when, not if, you’ll face unexpected expenses.
You don’t want to have to turn to credit cards to pay for your day-to-day life because all your money is tied into your mortgage or locked into investments with huge tax penalties if you sell early.
For most people, investing versus paying off your mortgage is a fairly simple decision. The further you are from retirement, the easier the decision usually is, especially if you got a good interest rate on your mortgage.
Here are some questions you should ask yourself to clarify where you should be putting your extra money.
This post was last modified on February 28, 2022 8:20 am
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