Americans have a lot of debt.
According to the New York Fed, outstanding mortgage balances are the largest component of household debt.
That should come as no surprise given the fact that buying a home is most likely the most expensive purchase you make.
If you’ve ever wondered if it’s worthwhile to make extra payments towards your mortgage, you’re not alone.
There’s been a long ongoing debate whether or not it makes financial sense to pay down your mortgage.
Or, whether it makes more sense to invest that money.
The answer depends on a number of factors and is ultimately based on your individual financial situation.
First Things First
Before you consider paying down your mortgage or investing the money, you should look at your overall financial health.
Consider taking these first steps before using that extra money.
Pay off other debt
It doesn’t make sense to put extra money towards your mortgage if you’re carrying high-interest debt, such as credit cards, auto loans or student loans.
You want to put any extra money towards paying off the debt that accrues the highest interest rate first.
Build an emergency fund
Just like it sounds, an emergency fund is money set aside in an account to cover unexpected emergency costs.
Dealing with an emergency, such as high medical expenses or a leaky roof, is costly and extremely stressful.
Having a “rainy day fund” to cover these unexpected expenses keeps an emergency from ruining your financial goals.
A good rule of thumb is to have enough money in an emergency fund to cover at least three to six months of living expenses.
Ideal Size of an Emergency Fund
|To start...||Ideal goal...||Super safe...|
|$1,000||3-6 months of essential expenses||12 months of expenses|
Contribute to your retirement plan
If you work for an employer who matches some or all of your contributions to a 401(k) program, there’s no question that you should participate.
If you don’t contribute at all, you’re walking away from free money.
At minimum, contribute enough to get the full amount of your employer’s contribution.
What's Included in a Monthly Mortgage Payment?
Before you decide whether or not to make extra payments towards your mortgage or to invest the money, it’s important to understand what you’re paying for on a monthly basis.
There are four key components included in the calculation of a monthly mortgage payment:
This is the amount of money you borrowed from the bank or lender to purchase the home.
The principal balance is the amount of money you still owe after making a mortgage payment each month.
It is the rate charged by the bank or lender for borrowing money.
This is the amount you pay in real estate and property tax governmental agencies.
Lenders require borrowers to have homeowner’s insurance to protect the property against damages.
In addition, if you did not put at least a 20 percent down payment when you purchase the home, you will most likely have to pay for private mortgage insurance (PMI).
The amortization schedule
Although there a variety of home loans, a 30-year fixed rate mortgage is the most popular type of mortgage for U.S. homebuyers.
A 30-year fix rate mortgage amortization schedule shows what portion of each loan payment goes towards the principal balance and how much goes towards interest.
Most of the initial payments, out of the total 360 payments over the life of the loan, are used to pay for interest.
As the principal balance decreases, the amount of interest decreases.
However, the total monthly mortgage payment stays the same. The only difference is that more money will go towards paying off the principal balance.
If you do decide to pay off your mortgage early, you’ll still pay taxes and insurance. As a homeowner, that will never go away.
Why Focus on Paying Down Your Mortgage
Here are four reasons why it’s a smart idea to consider paying down your mortgage.
1. Get rid of PMI
PMI is a type of mortgage insurance required by lenders for buyers who cannot afford to put a 20 percent down payment on their home.
PMI protects the lender in case you default on the loan. It is a percentage of the entire loan amount per year, paid on a monthly basis.
One way to remove PMI is to pay down the mortgage balance to 80 percent of the home’s original appraised value.
If you’re still paying a monthly PMI fee, make additional payments towards the principal balance of your loan before you consider investing.
2. Save on interest costs
Paying off your mortgage early can save you thousands of dollars in interest.
Most borrowers don’t look at the total amount of interest they have to pay.
If you take out a typical 30-year mortgage loan for $150,000 at an interest rate per year of 4.5 percent, you’ll end up paying a staggering $123,610.00 in interest. That’s in addition to the original loan amount of $150,000.
If you have 15 years left on that 30-year mortgage loan of $150,000 and decide to pay $100 extra per month, you’ll pay off your mortgage 2 years and 4 months early, saving a total of $6,352.00 in interest.
3. Debt free = financial freedom
Financial stress and anxiety can have a very negative impact on your physical and mental health. The more money you owe, and bills you have to pay, the more money you have to make.
Individuals who are completely debt free say there’s a sense of freedom that is hard to explain unless you’ve experienced it yourself.
4. Increase cash flow
Your mortgage payment is probably one of the largest reoccurring bills you pay on a monthly basis. Once it’s paid off, you’ll be able to use that money to invest in the market or save for the future.
Over a third of homeowners ages 65 to 74 are still burdened with monthly mortgage payments, with an average balance of $118,000, according to the Federal Reserve Board.
It’s likely that many of these seniors don’t have the same income coming in each month as they did in previous years.
It’s important to seek professional financial advice as you near retirement to ensure that if you do have a mortgage payment, you’re able to afford it.
Why Consider Investing Your Extra Cash
When you invest, you put money aside with the intent to make a profit or additional income on that money.
There are a number of common ways to invest your money in, such as:
- Mutual funds
- Exchange-traded funds (ETFs)
- Real estate
- 529 college savings plan
- Certificate of deposit (CD)
- Treasury securities
Here are four reasons why it’s a smart idea to consider investing your money.
1. Help you reach financial goals
Setting financial goals is essential to financial success. Consider setting both short-term goals and long-term goals.
Once you set those goals, you can start working to reach your objectives.
Investing allows you to reach those financial goals, such as buying a car or sending your children to college.
2. Potential higher returns
What rate should you expect on your investments? In general, the longer you park your money in an investment, the more money you’ll make.
The age-old saying, “Don’t put all your eggs in one basket” applies to your finances as well. You don’t want to lock up all your money in one place.
It’s important not only to diversify your investment portfolio but also your money and investment types.
The best way to do this depends on your financial goals, but some options in addition to home ownership are:
- Retirement account
- Brokerage account
- Saving account
- Emergency fund
4. Compounding interest
Some investment accounts earn compound interest. Compounding is when your initial principal investment makes money, and then that money makes money.
The more frequent compounding occurs, the quicker your balance grows.
Imagine that you invest $25,000 in a CD account that yields 2.75% APY, compounded on a daily basis.
In five years, you’ll earn an estimated $3,631.00.
Here are some cons to consider when investing your money.
No guaranteed return
There is absolutely no guarantee that you will make money on your investments.
Worst case scenario, you lose money
The more risks you take, the higher chance you have of losing money. The upside is that you also have a chance of making more money on higher risk investments compared to less risky investments.
Because there is no guarantee that your investments will make money, the risk that you might lose the money if you invest it is much higher compared to using that same amount of money to pay off your mortgage early.
You have to pay taxes
Whenever you make money, whether it’s from a job or through investments, you have to pay income tax.
For taxable investment accounts, when you pay taxes depends on the investment type.
Some taxes you won’t pay until you make a profit on the sale of that investment. Other taxes are due when you receive a distribution.
Deciding for Yourself
Every person’s financial situation is different. There’s good reason to take either side of the debate.
If you do decide to throw a small amount of money towards your mortgage or write one big check, make sure any additional money you pay towards your mortgage is applied to the principal balance.
If you don’t, the lender might use that money towards your next payment, which does you no good in the long run.
If you’re looking to set up an investment portfolio but don’t have a large initial investment, consider using a robo-advisor like SigFig or Wealthfront.
There are plenty of reasons to pay off your mortgage early or invest that money.
The good news is that if you’re in a position to do either, you’re doing well.