If you find yourself with some extra money – let’s say you got a big tax refund, or received a nice inheritance – then you’ll need to decide what to do with it. If you have a mortgage worth hundreds of thousands of dollars, it may be tempting to put your windfall toward making extra payments, so you can eliminate interest-earning debt. On the other hand, it may be wise to invest it; any financial advisor will tell you that investing is arguably the best way to build wealth over the long term. If you’re faced with this decision, we’ll walk you through making the best decision for your money.
3 Things to Do Before Paying Down Your Mortgage or Investing
There are arguments for both paying down your mortgage and investing more. Before you do either, though, there are a few other moves you should make first.
1. Pay Down High-Interest Debt
For most people, high interest debt means credit card debt. Other revolving lines of credit may also have high interest rates. If you have any short-term loans, such as payday loans, pay down those balances as soon as possible.
The interest rate on these debts makes the math simple. You will almost certainly save more in the long run by paying these high-interest debts before making extra payments on a mortgage. Consider that the average interest rate on a mortgage is about 5%. The average return from the stock market is about 7%. Meanwhile, the average interest rate for a credit card is between 15% and 20%. Because your credit card interest will increase much faster than either your mortgage interest or your stock market gains, your money will go farthest if you take care of that first.
If you have a lot of credit card debt to pay off, consider a balance transfer card (especially if you have interest on multiple cards). Balance transfer cards often come with an introductory period of 0% interest. That effectively puts a temporary pause on the growth of your credit-card debt.
2. Build emergency savings.
According to a 2017 survey by CareerBuilder, 78% of Americans live paycheck to paycheck. Even 9% of people with incomes of $100,000 or more live paycheck to paycheck. If you don’t have any savings, you can find yourself in a very difficult position should something unexpected happen. That’s why it’s a good idea to build some emergency savings. Most experts will recommend a liquid, safe emergency fund covering 3-6 months of living expenses. The best savings accounts can even give you some decent interest on your fund without exposing it to market risk.
After you’ve paid down any high-interest debt, you should start an emergency fund (or make sure any existing fund is properly funded). If that still doesn’t get you to 3-6 months of expenses, set up a plan to start contributing regularly. Our simple guide to making a budget can help you find room in your budget for these regular contributions.
As you start investing more or making extra mortgage payments, remember to maintain this savings fund. If you don’t always have a liquid fund that you can access at any time, you’re exposing yourself to risk. And as your situation changes, you will need to adjust your savings. For example, you should increase how much savings you have on hand as you have kids (or even pets). So if you don’t have enough in savings, forgo investing and extra payments in favor of growing your savings.
3. Max Out Your 401(k)s Employer Match
Many employers offer some degree of matching on their 401(k) plans. This matching is effectively free money, you should contribute at least enough to meet that employer match. If you’re currently falling short of getting the maximum possible matching amount – perhaps because money has been too tight to defer too much of your paycheck – then it’s time to make it happen. See if you can take advantage of your extra wealth in a way that allows you to up your contribution and get that free money.
Once you’ve taken care of these three priorities, you can address either your mortgage or your investments. Here’s when each option makes the most sense.
Deciding Between Your Mortgage and the Market
There are two big things to think about when making the decision to pay your mortgage early:
- Your mortgage interest rate
- The returns you expect from investing
Which of these two rates is higher is the main factor in your decision. You’re trying to decide between canceling debt that’s costing you interest, or investing money that will earn you interest. In the former case, you’re saving money; in the latter, you’re earning money. But if the amount you would put toward the two options is the same, then the interest rate on the respective choices determines how much money you would save/earn. You should, then, choose the option with the higher rate.
In an average year, that will be the stock market, which generally returns around 7%. By contrast, the average 30-year mortgage rate is around 4.5%. If you’ve got $5,000 at your disposal, that would earn about $350 in the market, while $5,000 in mortgage debt will cost you around $225.
But of course, the market is very difficult to predict. That 7% figure is likely to be the average over a long period of time, but in a given year it can be much higher or lower. For instance, in 2017 the S&P 500 rose about 22%. But the next year the market actually fell, ending the year down 4%. If you invested $5,000 at the beginning of 2017, you ended the year $1,100 richer. If you made the same investment at the beginning of 2018 you actually lost $200.
To help you better understand where the stock market is going and how certain investments may perform, consider talking to an investment expert, like a financial advisor.
When to Choose Your Mortgage
The best argument for paying down your mortgage, then, is predictability. You know exactly how much you’ll save, whereas investing in the market is not a sure money-maker.
There’s also an incentive to pay down your mortgage if your rate is particularly high. The further above that 4.5% average your mortgage is, the better the case for paying it down. And if you have an adjustable rate mortgage, then paying down your mortgage helps blunt the impact of future rate increases.
Some investors also have more conservative investment portfolios than others. Let’s say you’re approaching retirement and you’ve adjusted your asset allocation accordingly to put more of your investments into bonds instead of stocks. Even if the stock market goes up significantly, your own returns will be significantly lower – perhaps lower than your mortgage rate. In this case, it’s probably best for you to pay down your mortgage instead of investing more.
If you’re nearing retirement and you still have quite a bit of your mortgage to pay, consider paying down your mortgage. That applies to people who are in their 50s or older.
Reasons to Invest First
In many cases, investing is the better option. As mentioned, the stock market sees average returns of around 7%. This is over the long term, but that’s not an issue if you have time on your side. So if you’re young, and you sign a 30-year mortgage, you have plenty of time to pay it off. Unless you have a high interest rate, think about investing. This is especially true if you have a fixed mortgage rate and know that your rate won’t increase over time.
If you are already investing with an aggressive asset allocation, you should favor investing more. Aggressive portfolios are often built to help you get gains of 10% or more. Even if you fall a bit below that, your rate of return may be markedly higher than your mortgage rate if the market is doing well. That means you have more to gain by investing your money. Of course, an aggressive portfolio also has greater risk of loss. But if this is the path you’ve chosen – perhaps because you have decades to go until retirement – then you hopefully understand that risk.
Investors with a high income value should also consider investing. When you hold an investment for one year or more, you can pay the dividend tax rate on it. This rate is lower than most of the federal income tax rates. That means taxpayers with a high regular tax rate (22% or more) can ultimately save on taxes by building more wealth through investments instead by increasing their regular earnings.
Another thing to think about is inflation. As you get older, inflation combined with that fact that your income will likely increase means that mortgage payments will be easier later in the life of your mortgage. And as the payments get easier over the life of your mortgage, it also becomes easier to to invest while still making your regular mortgage payments. On the other hand, if inflation is expected to decrease in the coming years, you may want to make extra mortgage payments now and favor investing as inflation decreases.
One More Consideration: Taxes
When you file your taxes, you can deduct the interest you paid on your mortgage. To do that, you need to itemize and claim the mortgage interest deduction. Previously, there was little incentive to make extra payments early in the life of a mortgage. Your payments are mostly interest in that period and the deduction lessened the sting of that interest. But the new tax law changed the calculus because fewer people could itemize after 2017. The result is that a new mortgage is more costly for some people. So if you’re paying a new mortgage and you aren’t itemizing, you may want to make extra payments to decrease your interest more quickly. As mentioned above, inflation will make payments easier later in your mortgage. So after a few years, consider diverting extra money to investing instead of extra payments.
Also keep in mind that the new tax law limited SALT deductions to $10,000. The lower limit could leave you paying more in property taxes for a home. This won’t directly affect your mortgage payments but it increases the overall cost of owning a home. If you were already on the edge of affordability, refinancing or even moving may make sense. Residents in the high-tax states of California, New Jersey, New York, Illinois, Texas and Pennsylvania will feel the new limit the most. Make sure you factor in SALT if you’re still in the planning phase of buying a home.
On the flip side, you have to pay taxes on investment earnings. As mentioned, those tax rates are beneficial if you have a high income and hold your investments for the long term. If you can itemize and deduct interest via the mortgage interest deduction, then you may end up spending more by investing. The big exception is that you don’t need to pay tax on earnings from a retirement account. So if you plan to invest through an IRA or employer-sponsored plan like a 401(k), then investing will save you money.
Paying down your debt can give you peace of mind and the freedom to chase other financial dreams. That makes it tempting to try paying off your mortgage early. This isn’t always the best option though. For starters, make sure you pay down high-interest credit card debt first. Then make sure you have some emergency savings to protect yourself from the unexpected. Investing for retirement is also a priority before you make other kinds of investments. If you’ve done all that and you have money left after making your regular mortgage payment, then you can consider making extra payments versus investing.
Consider making extra mortgage payments if…
- You have a high interest rate – anything around 4.5% of higher.
- You’re nearing retirement – 50s and older.
- You’re a conservative investor.
Consider investing if…
- You have a low mortgage rate.
- You’re an aggressive investor.
- You’re younger than 50.
- Your income tax bracket is 22% or higher.
Tips to Help You Invest Wisely
- Are you investing to build retirement savings? You should invest differently if you’re planning to retire in 30 years versus five years. As you get closer to your goals, you may want to invest more conservatively. That helps protect all the money you’ve already earned from investing. Our asset allocation calculator can help you get your portfolio just right.
- When it comes to savings, you can always help yourself by starting early. Compound interest in savings accounts can help you earn by constantly building off of your savings. It’s also a good idea to choose an account with a high interest rate. Most traditional savings accounts have rates of 0.05% or less. That won’t earn you much. One of these high-yield savings accounts, on the other hand, can earn you up to 2.5% in interest.
- Work with an expert. A financial advisor can sit down with you to explain what your investing options are and how different decisions will impact you. They can also answer specific questions. Has your tax situation changed drastically from last year to this year? Are you planning an estate? Are you going through a divorce? An advisor can help you through these situations and more. Our financial advisor matching tool will consider your financial needs and goals and match you with advisors in your area.
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