Weighing Your Options: Paying Off Your Mortgage Early vs. Investing for Retirement
One of the most frequently asked questions we get as advisors is, “should I pay off my mortgage early or invest for retirement?”. This question often comes up when someone has a sound financial foundation and extra cash, whether they receive a bonus or inheritance, or they simply have excess savings at the end of each month. This dilemma requires careful consideration, as both options have their advantages and drawbacks. Below we will explore the factors you should consider in making an informed decision that aligns with your financial goals.
The Case for Paying Off Your Mortgage Early
Interest Savings: One of the primary benefits of paying off your mortgage early is the potential savings on interest payments. By reducing the life of your loan, you can significantly cut down the total interest paid over the loan term.
Peace of Mind and Financial Security: Being debt free can provide a sense of financial security and peace of mind. Without the burden of monthly mortgage payments, you may feel more confident in your overall financial stability, especially during economic downturns. This can be especially important behaviorally for people who are retired or close to retiring.
The Case for Investing
Compound Growth: Investing for retirement allows your money to grow through compound interest over time. The earlier you start, the more time your investments accumulate wealth, potentially resulting in a more substantial retirement nest egg.
Tax Advantages: Retirement accounts, such as 401(k)s or IRAs, offer tax advantages that can boost your savings. Contributions to these accounts are often tax-deductible, and the earnings may grow tax-deferred until withdrawal during retirement.
Diversification: Investing provides an opportunity for portfolio diversification. A well-diversified investment strategy can help spread risk and potentially yield higher returns compared to putting all your financial resources towards one payment.
Finding the Balance
Assess Your Financial Situation: Consider your overall financial health, including emergency savings, other debts, and potential future expenses. Ensure you have built a strong financial foundation before deciding.
Evaluate Interest Rates: Compare the interest rate on your mortgage to the potential returns from your investments. If your mortgage interest rate is low, investing may offer better returns in the long run.
Time Horizon: Assess your time horizon for both paying off your mortgage and retiring. Investing in Stocks and Bonds can be volatile in the short term (1-5 years). The longer the timeline, the more investing makes sense.
A few examples
Below we will go through some common scenarios to illustrate the points above:
Example #1: Steve and Megan are both 30 years old and just purchased their first home in 2021 for $400,000 with a 2.9% mortgage over the next 30 years. They have $300 left over every month, and they want to know whether they should invest these savings or put them towards their mortgage.
Let’s say they would be investing in the S&P 500, which has historically returned 9% per year.
If they were to put the $300 every month towards their mortgage for the life of the loan, they would end up saving approximately $48,000 in interest and pay the loan off 6 years and 7 months earlier.
Instead, let’s say they invested the $300 every month, at the end of 24 years (similar length of time that the mortgage would have been paid off), they would have a balance of just over $275,000 and only invested $86,400. That’s almost 6 times more than the interest savings!
In this instance, Steve and Megan are young, have a long-time horizon, and can take on the risk of investing. It makes more analytical sense for them to invest for retirement.
Example #2: Meet Bob and Jane, they are both 62 years old and plan to retire in the next 4 years. They also only have 4 years remaining on their mortgage. They currently have $100,000 left on the same $400,000 mortgage but with a 6% interest rate. They are invested in a 50/50 stock/bond portfolio based on their risk tolerance that typically returns 5% every year.
If they took the $300 they have left over every month and put it towards their mortgage, they would save approximately $1,600 in interest and pay their loan off 5 months earlier.
If they instead invested $300 over the next 4 years, they would have an account balance of approximately $15,500 with $14,400 invested. In this instance they only earned approximately $1,100.
Since Bob and Jane have a higher interest rate, shorter timeline, and a lower risk tolerance, it would make more sense to pay the loan off sooner. This would also most likely align with their behavior as well.
In Conclusion
Deciding whether to pay off your mortgage early or invest for retirement is a decision that depends on your financial goals, risk tolerance, and individual circumstances. It's important to carefully evaluate the pros and cons of each option and, when possible, consult with a financial advisor to create a strategy that aligns with your long-term objectives. Ultimately, finding the right balance between debt reduction and wealth accumulation is key to achieving financial success and peace of mind.
If you want to discuss your options with your financial advisor schedule a time to meet here.
