Should I Pay Off My Mortgage Early or Invest?
What is the smarter strategy - paying off your mortgage early or investing that money instead? This is a such a common question I hear from people so I decided to write this blog and attempt to answer it as best as I can.
Who Are You and What is Your Situation?
This is the number one question I would ask you before anything else. Here are the list of questions you need to ask yourself:
* How much money is remaining on your mortgage and what is the interest rate? (The higher the interest rate, the more likely I am to tell you to just pay it off!)
* How much in savings do you currently have?
* Do you have any credit card debt or other debt that is over 8 percent in interest rate? Do you have any student loan debt and at what rate?
* Do you already have other investments?
* How much income do you have from you job each year? Do you have any other sources of income?
* What is your investment strategy? Do you seek small but steady gains (think 6-10 percent a year) or do you want to take more risks?
*Finally, how old are you?
Okay, now to explain why I just ask you these questions! (In order of importance).
* First, and perhaps most importantly it obviously depends on how high of an interest rate you are paying on your mortgage.
The average rate currently for a 30-year mortgage is 4.5 percent or so. If you are paying upwards of 7 percent, I would recommend you try to refinance your mortgage to a lower rate (before interest rates go higher!). If you have a small balance remaining on your mortgage (say, less than $20,000) and you have a rate higher than 7 percent, I would tell you to just pay it off!
* Next, what other debt do you have? Do you have credit card debt? If you have ANY debt that is higher than 10 percent, just pay that off first! You are basically banking a 10 percent return on your money just by paying it off early!
* How much in savings do you have? It is important to have at least 6 months in emergency savings to cover your expenses in case you lost your job or for whatever reason. If you don't have at least 6 months in emergency savings, make that your priority first. Some experts will even recommend 12 months of emergency savings.
* Next up... what is your investment goal? What is your time horizon? Are you seeking a steady, reliable source of income or do you want to take some risks and try to double your money? The younger you are, the more risks you should take, in general.
So let's say that you are currently paying just 4.5 percent in interest on your 30-year mortgage. It definitely might make sense for you to invest your extra money instead of paying off your mortgage early.
Over the past 20 years, the S&P 500 has returned an average of 8.21 percent each year, according to Forbes.com. Much, much better than the 4.5 percent you would net from paying off your mortgage early.
* When would you need the money by? Knowing your time horizon is very important. If you would need the money within 1-3 years, I would not recommend investing in stocks because you just don't know what will happen in the market. While the S&P 500 has returned 8.21 percent on average, it's important to understand that investing still holds some risk. The market could tank next year and you could lose 20 percent on your investment. It's very, very possible.
However, if you are a long term investor, you should not care because you will make this money back. You should actually be happy that the market is down and buy even more shares of stocks! If you have a time horizon of 5 years or greater, I absolutely recommend you start buying some blue-chip stocks or low-cost ETFs.
If your investments drop in value, buy more. Make sure you have them enrolled in a DRIP Dividend Re-investment plan, which will automatically dollar cost average your investments!
I go further into details in this article - Dividends as Income: Getting Paid Just by Owning Stocks.
Learn How to Invest!
Invest vs. Payoff - Calculate the Exact Amounts!
Want to see just how much money you could make invested versus paying off your mortgage?
I love to use this free calculator by Yahoo! Finance which shows you how much the difference will be. I've used this hypothetical example:
DEBT: 5 percent interest on debt, with interest deductible on taxes.
INVEST: 8 percent before-tax return on investment, in the 25 percent tax bracket.
Paying off your mortgage early will result in a gain of 3.75%, while your after-tax return on investments is 6.00%.
Here is another way to look at this from an exact number standpoint.
You have $100,000 left on your mortgage at 6 percent interest and 15 years remaining on your mortgage. How much will you pay in interest total? $90,000.
So let's say you hypothetically had $100,000 to either pay off this balance and save the $90K, or invest it instead. You get 8 percent annual compounded returns, which is about the average return of the S&P. How much will you have made? Congratulations, your $100,000 is now worth $239,385!
Paying off the mortgage results in a net gain of $90,000, but investing the money results in a net gain of $139,385.
(I used the Return on Investment calculator from BankRate to figure this out)
What is the Best Investment to Make?
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Real Estate - Another Great Investment
Stocks are not the only option you have to invest your hard earned cash - you can also consider buying another piece of real estate and renting it out.
Here is an example of how you can make money investing in real estate:
*Say you have $40,000 in cash, and you decide you want to invest instead of paying down your mortgage. Great! So what type of returns can you expect in real estate and how do you invest?
While flipping homes has become popular (that means you buy a property for cheap, fix it up then sell for a profit), I HIGHLY recommend you invest for cash flow instead. What this means is that you'll find a property you like and rent it out. Then when all the expenses on the property are made (taxes, maintenance, etc.) the money left over is yours. This is your cash flow.
* What types of returns can you expect in real estate? You should try to get a cash-on-cash return of 12 percent or greater. Cash-on-cash means that for every single dollar you put down - down payments on house, closing costs, etc. - you should make back at least 12 percent of that each year. So if you put $40,000 down on a property that's worth $180,000, you should really try to make back at least $6,000 or so a year in cash flow.
* It gets better, though, because there's is another way you make money investing in real estate - equity buildup! Since you are renting this house out, your tenants are paying your mortgage for you. Each year, your mortgage becomes less and less, and your equity increases. There is also the possibility that your home will increase in value on its own (though I think in today's market, you really can't rely on this to happen!)
As you can tell, I think real estate is still a fantastic way to invest, even after the 2008 housing collapse. The people who lost money then were the people who speculated and flipped houses - not the long-term investors who invest for cash flow! Buy a home, find great tenants, get cash flow and equity each month... that is the way to do it.
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