When you come into a substantial sum of money, like a windfall, the decision on what to do with it can be important. One option to consider is investing the money, especially if the potential return on investment is higher than the interest rate on your mortgage. However, the choice between paying off your mortgage early or investing the money involves various factors that need to be carefully weighed. Factors such as your financial situation, the interest rate on your loan, and your proximity to retirement can all influence this decision.
To make an informed choice, it’s crucial to calculate the interest savings from paying off your mortgage ahead of time compared to potential investment returns from putting that money in the market.
How Paying off a Home Affects Your Finances
Understanding how your mortgage payments function is key. Each monthly payment is divided into two parts: interest and principal. For example, if you pay $1,500 monthly, $500 might go toward interest while the remaining $1,000 reduces your loan balance. The interest rate on your mortgage can change based on economic conditions and your creditworthiness.
Over a 30-year term, your mortgage payment schedule follows an amortization pattern. Initially, most of your payment covers interest, but as years go by, a larger share goes toward lowering your loan balance.
For example, with a 30-year $200,000 mortgage at a fixed 3.5% interest rate, the payment allocation changes over time:
| Payment Number | Monthly Payment | Principal | Interest | Remaining Balance |
| — | — | — | — | — |
| 1 | $898.09 | $314.76 | $583.33 | $199,685.24 |
| 109 (10 years) | $898.09 | $431.10 | $499.99 | $159,679.65 |
| 229 (20 years) | $898.09 | $611.45 | $286.64 | $97,665.59 |
| 301 (25 years) | $898.09 | $754.10 | $143.99 | $48,613.86 |
| 360 (last payment) | $898.09 | $895.48 | $2.61 | 0.00 |
As time passes, more of your payment goes toward reducing the principal balance rather than interest. This shift is particularly noticeable after 20 years, with a considerable portion allocated to principal repayment.
Since the loan balance decreases over time, the portion of your payment attributed to interest also decreases. Early on, you’re paying interest on a larger balance, which reduces as you make monthly payments.
How Investing Affects Your Finances
Deciding whether to invest your money instead of paying off your mortgage requires considering potential returns from your investments. Depending on the rate of return, investment income might surpass what you’d save on mortgage interest in the final years of the loan.
There’s an opportunity cost in choosing to invest, as you forgo potential market earnings that could outweigh mortgage interest. It’s essential to assess the expected returns and the associated investment risks.
Investment gains from different average rates of return over a 10-year period:
| Invested Amount | Years | Rate of Return | Investment Gain |
| — | — | — | — |
| $100,000 | 10 | 2% | $22,019 |
| $100,000 | 10 | 5% | $62,889 |
| $100,000 | 10 | 7% | $96,715 |
| $100,000 | 10 | 10% | $159,374 |
The returns on your investments are impacted by compounding interest, where earnings generate additional interest. Assess how investment gains may compare to the interest savings from paying off your mortgage early.
Notably, a 5% average rate of return could yield higher returns compared to the interest savings from earlier loan scenarios with rates of 3.5%, 4.5%, or 5.5%, doubling the interest saved on paying off the loan early.
The potential investment returns surpass the interest saved from early loan repayment, especially with higher rates of return.
What the Experts Have to Say
Mark Struthers, CFA, CFP®
Sona Financial, LLC, Minneapolis, MN
When deciding between paying off your mortgage early or investing, consider factors like the interest rate on your loan and your financial portfolio. If your mortgage carries a high interest rate and you have sufficient liquid assets, paying it off may be a wise choice. However, if the interest rate is low and you are disciplined with budgeting, maintaining the mortgage while investing could be more beneficial. Striking a balance between paying off debt and retaining enough liquidity for emergencies is crucial.
Frequently Asked Questions
What is compounding interest?
Compounding interest refers to the phenomenon where your initial investment earns additional interest over time. By reinvesting your gains, you can maximize your returns, compared to simple interest. Evaluate how compounding interest influences your choices between early mortgage repayment and potential investment returns.
How does the tax deduction for mortgage interest work?
The interest you pay on mortgage loans up to $750,000 is tax deductible, subject to specific criteria. Depending on your filing status and use of the loan proceeds, you might be eligible for this tax benefit. Weigh the implications of claiming this deduction against standard deductions for optimal tax savings.
What are some options other than paying off my mortgage or investing?
Consider establishing an emergency fund or directing funds towards retirement savings such as IRAs and 401(k)s. Prioritize paying off higher-interest debts, like credit card balances, over your mortgage if it aligns with your financial goals.
The Bottom Line
Before deciding whether to pay off your mortgage early or invest the money, assess the remaining balance, interest savings, and potential returns. Utilize mortgage calculators to analyze your loan amortization. Additionally, remember that mortgage interest can often be tax-deductible, impacting your year-end taxable income.
Seek guidance from financial and tax professionals to tailor this decision to your unique circumstances and goals. Their expertise can help you navigate the complexities of mortgage repayment and investment strategies effectively.