Pay Off Your Mortgage Or Invest? What Does The Math Say?

25 Aug Pay Off Your Mortgage Or Invest? What Does The Math Say?

The question of whether to pay off a mortgage or invest extra funds is a longstanding debate. When considering the current mortgage rate of 5.95%, the calculation becomes particularly relevant. The decision essentially boils down to a comparison between the guaranteed return of paying down a mortgage and the potential return from an investment. Let’s dive deep into the math to help you make an informed decision.

1. Understanding the Guaranteed Return of Paying Off the Mortgage

When you pay off or pay down your mortgage, you essentially earn a return equivalent to your mortgage interest rate. This is because every dollar you put towards your mortgage saves you from having to pay future interest on that dollar.

If your current mortgage rate is 5.95%, by paying off your mortgage early, you’re effectively getting a guaranteed, risk-free return of 5.95%. It’s hard to find a risk-free investment with that kind of return in the current financial landscape.

2. Expected Rate of Return from Investing

Now, let’s compare the guaranteed return from paying off your mortgage to the potential returns from investing.

Historically, the stock market has provided an average annual return of 7-10%, before inflation. However, it’s essential to note that this is an average, and the stock market can be very volatile. Some years you might earn 20%, and others you might lose 10%. So, while the average might be higher than the mortgage rate, there’s no guarantee.

Let’s assume a conservative expected rate of return of 7% from the stock market. This is slightly higher than the current mortgage rate of 5.95%. If you invest and consistently get this return, over the long run, you’d come out ahead compared to paying off your mortgage early.

However, don’t forget about taxes. Investment returns are typically subject to capital gains taxes, which can reduce your net return. Depending on your tax bracket and specific situation, this can make the net return from investing much closer to (or even less than) the return from paying off the mortgage.

3. Other Factors to Consider

While the numbers play a significant role in this decision, other factors might sway your decision:

• Risk Tolerance: Investing in the stock market involves more risk than paying off a mortgage. Some individuals might prefer the guaranteed return of mortgage repayment over the potential, but uncertain, higher returns from investing.
• Cash Flow: Paying off your mortgage early can free up significant monthly cash flow, which can provide peace of mind and flexibility in your budget.
• Psychological Factors: For some, the peace of mind that comes from being debt-free is invaluable and worth more than potential extra returns from investing.

From a purely mathematical standpoint, if you can achieve a consistent return higher than your mortgage rate (after accounting for taxes and fees), it would make sense to invest. In our example, a conservative stock market return of 7% does suggest a slight edge for investing over paying off a 5.95% mortgage.

However, real life isn’t just about math. Your personal risk tolerance, financial goals, and emotional factors play a significant role in this decision. Some people are more comfortable being debt-free, while others are fine carrying some debt to potentially earn higher returns. Whatever you choose, ensure it aligns with your broader financial plan and comfort level.

Paying Off Your Mortgage Early

Pros:

1. Guaranteed Return: Paying down your mortgage guarantees a return equal to your mortgage interest rate. If your rate is 5.95%, you’re essentially saving that amount in interest expenses for every extra dollar you pay.
2. Peace of Mind: Many people feel a strong sense of relief and accomplishment when they no longer have a mortgage. It can also alleviate financial stress knowing you own your home outright.
3. Improved Cash Flow: Once the mortgage is paid off, you eliminate one of the largest monthly expenses, freeing up cash for other purposes.
4. Less Total Interest Paid: By paying off your mortgage early, you’ll reduce the total amount of interest you pay over the life of the loan.

Cons:

1. Opportunity Cost: By allocating extra funds to your mortgage, you might miss out on potentially higher returns from other investments.
2. Reduced Liquidity: Money that goes into your home isn’t easily accessible. If you suddenly need funds, it’s generally easier to sell stocks or pull money from an investment account than to sell your home or refinance.

Investing Instead of Paying Off Mortgage

Pros:

1. Potential for Higher Returns: Historically, the stock market has provided returns that outpace many mortgage rates. By investing, you might achieve a higher return over the long term.
2. Liquidity: Investment accounts, especially those in liquid assets like stocks or bonds, offer better liquidity than home equity. You can quickly sell assets if you need cash.
3. Compounding: The longer your money is invested, the more you can benefit from compounding returns. Starting earlier can yield better results in the long run.
4. Diversification: Investing allows you to diversify your assets across various investments, reducing the risk associated with having all your wealth tied to your home.

Cons:

1. Volatility: The stock market can be unpredictable in the short term. It’s possible to experience years of negative returns, which could be particularly stressful if your investment timeline is short.
2. No Guaranteed Return: Unlike paying off your mortgage, investing doesn’t guarantee a return. You might end up with less than you started with.
3. Taxes and Fees: Investment returns can be subject to capital gains taxes, and you might also pay fees for managing your investments. These costs can eat into your returns.
4. Emotional Stress: Watching market fluctuations and worrying about your investments can be stressful for some people.

As you can see both paying off a mortgage early and investing have their benefits and drawbacks. Your decision should be based on a combination of financial logic, your personal risk tolerance, and your long-term goals.

Combining the Best of Both

If the decision is challenging, consider a dual approach: refinancing your mortgage while also investing. Given how competitive lenders are at the present moment, now could be an ideal time to refinance, especially if your original mortgage was signed at a higher rate. By refinancing, you might be able to reduce your interest expenses and then use the savings to make investments.

In Conclusion

When mortgage rates are comparatively low, the potential investment returns can be substantially more than the interest saved on accelerated mortgage payments. Liquid investments like managed funds or ETFs offer flexibility compared to equity tied up in a home.

Nevertheless, if having a debt-free home is your priority, or if your mortgage rate closely matches potential investment returns, prioritising the mortgage might be your best bet, especially if your investment options are more taxable than tax-advantaged accounts.

Important information and disclaimer

The information provided in this document is general information only and does not constitute personal advice. It has been prepared without taking into account any of your individual objectives, financial solutions or needs. Before acting on this information you should consider its appropriateness, having regard to your own objectives, financial situation and needs. You should read the relevant Product Disclosure Statements and seek personal advice from a qualified financial adviser. From time to time we may send you informative updates and details of the range of services we can provide.

FinPeak Advisers ABN 20 412 206 738 is a Corporate Authorised Representative No. 1249766 of Spark Advisers Australia Pty Ltd ABN 34 122 486 935 AFSL No. 458254 (a subsidiary of Spark FG ABN 15 621 553 786)