Deciding on whether or not to pay off your mortgage early is tricky.
On one hand, reducing your monthly mortgage expense can create a huge amount of margin in your budget. However, paying extra towards your mortgage means these funds are harder to access and you eliminate the potential for that money to grow in the market.
Depending on your specific situation, you could decide to go either way. However, for most people, the added risk of not paying off your mortgage has more chances of increasing your overall net-worth over periods of at least 10-years.
Defining Terms in the Pay off Mortgage Early vs. Investing
When most people talk about paying off their mortgage early, they are usually deciding on whether or not they should make extra payments towards their mortgage principal every month. Or if they should dump that money into the stock market.
Where it gets confusing is when you don’t make regular extra monthly payments towards your mortgage, that doesn’t mean you still can’t decide to pay off your mortgage early.
You could avoid making extra monthly mortgage payments, and use the funds in the stock market to pay off your mortgage early, once your balance grows to be able to pay off your mortgage in full. Or you could still hold on to the mortgage and let your stock market funds grow further over time.
As you will see below, deciding not to pay off your mortgage opens your options.
Dissecting the Numbers
The longer you are in the stock market, the more you increase your chances of hitting the overall stock market historical average yearly return. The inflation-adjusted historical return for the S&P 500 is around 8% annually.
If you make extra monthly payments towards your mortgage principal, you are guaranteed to save the interest rate on your mortgage. In our case that would be 3.625%. We were able to get this rate four years ago because of our high credit score.
Looking at these numbers, it might not seem like a 4.375% difference in returns is a big deal. But if you look at what $1,500/mo does over 10-years, the numbers start to drift apart over time.
At the end of 10-years, investing $1,500/mo at 3.625% APR would end up with $218,705. At 8%, the balance would be $277,749.
That’s almost a $60,000 difference! In other words, getting 4.375% more per year means you increase your net worth by 27% over 10-years (assuming these numbers hold true).
As your balance increases over longer periods of time, that difference will continue to expand, and it makes it more likely that you will earn more money not paying extra towards your mortgage.
Risk Profile and Timing
The stock market will fluctuate from year-to-year. And given that we are currently at the top of a bull market, the chance of us entering a bear market increases.
That’s why if you do decide to put these funds into the stock market, the longer you can let that money sit, the more you increase your chances of not having to pull that money out when the market goes down.
If you can let that money sit in the stock market for 10-15 years, you increase your chances of getting closer to the 8% historical average of the S&P 500. If you want to use that money in less than 10-years, you might end up finding your balance lower than what you are hoping for.
In my case, since I work from home, and it is unlikely that I will lose my job any time soon, I’m fine with not touching these funds for at least 10 years (or longer).
But your situation might be different. If you are close to retirement, or if your job situation is unstable, you might want to go with the lower risk option. Which is to make extra monthly payments towards your mortgage principal.
Paying off Your Mortgage Guarantees a Return
The benefit of paying off your mortgage every month is that you are guaranteeing to save the amount of money you pay on mortgage interest.
And this might be what you are looking for. If you already have a substantial amount invested in the stock market (like in your 401k or other funds), you might use this as a way to balance things out and limit your exposure to risk.
You could also decide to do both at the same time. Pay extra towards your mortgage and dump some money into an index fund. You might lower your overall return from this money, but you also reduce your risk.
If you do decide to invest in the stock market, there are no guarantees in how much you will earn. We could end up encountering a stock market crash, or an extended bear market that reduces your return. This is why the length of time you are in the market is vital, as you reduce the chances of returning less than what you would save on your mortgage interest.
In my case, my 3.625% mortgage interest is a very low rate. But if I had a mortgage that was closer to 6%, this would make the decision harder because I would be risking these funds for only a few percentage points (based on the historical S&P 500 average).
Whether you decide to make extra monthly payments towards your mortgage principal or put those funds into the stock market, is not usually going to make or break your financial future in most cases.
By investing in the stock market, you increase your chances of making more money over long periods of time. But you also open yourself up to more risk.
The key is that you decide what you want to do and stick to a plan. If you constantly switch things around and go back and forth, you have a good chance of missing gains in the stock market. And once you put this money towards your mortgage, it becomes harder to extract these funds.
Chris Roane is a financial blogger who loves to be transparent about money-related issues. He’s paid off massive amounts of credit card debt and is the blog author of Money Stir. His main focus on Money Stir is talking about how money relates to our relationships, personal development, and how to plan for the future we want. He’s been quoted on Market Watch, The Ladders, and other publications.