Making Extra Payments on Your Mortgage? Experts Say You May Want to Do This Instead

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Thirty years is a long time. The typical first home buyer is 33 years oldaccording to the National Association of Realtors (NAR), meaning if they get a 30-year mortgage, the end of that loan seems to last about a lifetime.

Thirty years is also a career, the difference between starting a job and starting to think about retirement.

So, if you’ve recovered financially from saving for the down payment and have some cash set aside for when the furnace ends, you might want to start thinking about paying a little extra principal so you can get out of the bank’s clutches sooner. .’ retired again.

But is paying off that mortgage to become debt free the best thing you can do with your extra cash? Experts say there may be a better option, especially if you’ve taken advantage of historically low mortgage and refinancing rates in recent years.

“The reality is that not all debt is created equal,” says Alexander Spencer, Chief Investment Officer of Bogart Wealth, a financial planning firm based in Virginia and Texas. “Some, such as mortgages, can provide significant economic benefits depending on certain factors.”

Pro tip

Paying off your mortgage faster shouldn’t be at the top of your financial priority list. Try to pay off a higher interest debt and build an emergency fund first.

By investing that money in the stock market, despite the volatility in today’s financial markets, you can earn better returns, saving you more money in the long run than if you paid off the mortgage faster, experts say. It’s basic arbitrage: borrowing money at one interest rate and investing at a higher rate in return.

“With a 30-year fixed mortgage, you have 30 years to outperform the bank,” says Bruce Hyde, partner, chief compliance officer and wealth advisor at Round Table Wealth Management, a financial advisory firm. “It’s quite a long time and I would suggest that most people can generate returns that are higher than interest rates.”

So should you put more money on that mortgage principal or invest instead? Here’s what some experts have to say.

How mortgage loans work

A mortgage is a loan where a bank or financial institution provides the borrower with the money to buy real estate, using the real estate itself as collateral. They are generally long-term loans – 30 and 15 year mortgages are the most common.

As for the interest on the loan, it can either be fixed, where it does not change over the life of the loan, or adjustable, changing after a certain period of time and fluctuating with the market. Mortgage rates are generally lower than many other types of consumer debt, especially credit cards.

Pay off your mortgage early to save interest

Your 30-year mortgage does not have to last 30 years. You can pay more than the minimum of your payment and reduce principal faster than your amortization schedule says — which tracks how much of your payment goes from the loan to interest and principal each month.

There are a few ways to do this.

You can change your payment schedule from monthly to biweekly, paying half of your monthly payment every two weeks. Since there are 52 weeks in a year, for 26 biweekly payments, you make the equivalent of 13 monthly payments per year instead of 12. You can also schedule an additional amount of principal to be paid automatically each month with your regular payment. Or you can make one-time payments on the principal.

You should also check whether your mortgage is subject to a prepayment penalty. Those aren’t as common as they once were, but your loan may still have one. Talk to your loan manager first to make sure those extra payments go toward principal and you don’t get a headache.

At the beginning of the term of your loan, you pay more interest than principal. “If you want to spend money on your mortgage principal balance, it usually makes sense to do so early, as you will have a greater impact by making additional principal payments earlier in the life of the loan,” says Cassandra KirbyCOO and private wealth advisor at Braun-Bostich & Associates, a Pennsylvania financial planning firm.

Investing in the stock market

If you have some extra cash every month, there are other things you can do with it. You could invest it with the expectation of getting that money back. That return can be quite good depending on what you invest in, but it can also be risky.

The returns can be significant. Consider the S&P 500, an index that tracks the performance of about 500 of the largest publicly traded US companies. It has averaged returns of more than 10% since its inception in 1926. Other investment options, such as bonds, offer lower returns but also less risk, Spencer says. With a balanced portfolio of diversified low-cost index funds, you can expect average returns of about 6% or more per year.

Choosing to invest rather than pay more for your mortgage means taking risks as the markets move up and down. Experts say see it as a long-term deal and focus on the 30-year return expectation. “I balance risk and return to make sure I have positive arbitrage, but don’t put too much of the portfolio at risk,” Hyde says.

Compare investment gains to interest saved on a loan

As with most things money related, your arbitrage can vary.

Consider these numbers, for a $300,000, 30-year fixed-rate mortgage with an interest rate of 4%.

Additional Principal Per Month Total Interest PaidTime to Pay Off Loan$0$215,60930 Years$100$186,86226 Years, 6 Months$500$123,19418 Years, 4 Months*Try your numbers with NextAdvisor’s amortization calculator.

Consider instead if you $100 or $500 invested a month for 30 years and got a return of 7% every year:

Amount invested per monthTotal after 30 years$100$117,606$500$588.032

That difference — a $30,000 savings versus a potential $117,000 return, or a $92,000 savings versus a potential $588,000 return — is big, but it could be even bigger in practice, Hyde says. Mortgage interest payments are tax-deductible up to a certain amount, while if you invest in a tax-advantaged retirement account such as a Roth IRA, there can be tax savings on the investments.

It is of course possible that your return is not 7% ​​and your mortgage interest is lower or higher than 4%. Experts say the higher your mortgage interest rate, the harder it is for your investments to beat the interest savings. Whereas if your mortgage interest rate is lower, even safer assets such as bonds can provide good returns. “Choosing which way to go really depends on what your mortgage rate is and what the threshold you need to reach, and your risk tolerance,” Spencer says. If your mortgage interest rate is much higher than the current prevailing interest rate, you should of course keep in mind that refinancing to a lower interest rate can save you significantly in the long run and can change the calculation whether you have to invest or pay off faster.

Do you need to pay off or invest in your mortgage?

Before you make a decision, experts say you need to be clear where this choice lies on your financial priorities. When extra money comes in and you decide what to do with it, a number of other things should take precedence.

First, those credit card bills. “Higher interest debt, that’s the top priority before you touch your mortgage,” Kirby says. That has a higher interest rate, probably one that you probably won’t beat in the market. Second, make sure you have an emergency fund or other form of cash reserves that you can access quickly. Third, Kirby says you should prioritize putting money aside for retirement by contributing at least the maximum amount to your 401(k) that your employer will match, if you have one.

The prospect of higher returns means in the long run that investing will most likely make you more money, possibly significantly more, than paying off your mortgage faster, experts say. “As a rule of thumb, if your mortgage [rate] below 5%, it makes sense to explore some of these other options, as you’re just taking more risk incrementally,” Spencer says.

In addition to the higher return on your investment, Spencer says one advantage of investing is that your money is in a more liquid asset than paying off the mortgage. It’s easier and faster to sell some of your investments, especially if they’re in stocks or funds, than it is to take equity out of your home through an equity loan or an equity line of credit, which can be longer and longer . complicated process that involves a new interest rate.

Paying off your mortgage early can provide a number of benefits, including the psychological benefit of being debt-free. It’s also a much lower risk than investing, especially if your mortgage interest rate is quite high. “If you think you can earn more from investing than the interest you have on your mortgage, you should probably invest,” Kirby says. “That’s hard. That’s kind of market timing. It’s really hard to say what the market will do at any given time.”

It also depends on how long you plan to stay in your home, Kirby says. If you’ve only been there for a few years, it makes more sense to invest. Paying off the loan early is a better idea if you’re going to be there for a long time, she says.

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