BLUF: The decision to prepay your mortgage or invest will end up varying based on each individuals mortgage parameters, risk tolerance and goals. 2-4% mortgage rates make stock investing a better historical performer than prepaying your mortgage. However, you need to run the numbers AND consider other intangible benefits to arrive at what’s best for you.
Prepay Mortgage or Invest: A Common Quandary
I see this question posed all over personal finance forums and social media platforms. How the question is phrased depends on the person but usually goes something like this: “My mortgage is less than 4% and the market historically returns 7-8% on average. Isn’t it better to invest instead of pre-paying my mortgage?”
Alternatively, I’ll sometimes see hardcore investors bashing those that are paying off their mortgage early because they’re “making a poor choice” or are “leaving money on the table.” The conversation revolves around borrowed money being cheap and those long term investments outperforming the mortgage on average.
It’s very normal to want to want to make the “best” decision and I realized that I had never seriously considered this question in my situation. I always do the math as a part of my decision making process so this article will show my numbers, my process for evaluating the options and give you my thoughts on other considerations if you are faced with this decision.
Our situation:
Mrs. MFI and I have a cute little 1,500 sq/ft split level house here in NY (image above) that only cost me around $130k to buy near the peak of the housing boom. With a low purchase price, a refinance in the middle after my divorce and some overpayments along the way we only have $45,529 left to pay on my 30 year mortgage at 3.625% Before you hate us for that mortgage only costing $456 a month, consider that our property and school taxes are more than $456/mo. Sigh, thanks NY – the tax state.
Aside from my mortgage we’re debt free! Having crushed my old debts and consumer ways there is a part of me that would love to pay off the mortgage and have no debts. However, we’re also saving hard to reach financial independence and that includes after tax savings in a brokerage account as we’ve used our tax advantaged options. As such, we have about $1,000 a month that could either be used to make additional principle only mortgage payments, invest in our brokerage account or some blend of the two. What should we do?
The Comparison Approach:
If the 30 year mortgage is taken to term with no additional payments it will be paid off in March 2031, just under 10 years from today. With that being the baseline case of do nothing extra and stay the course I came up with a variety of options that I could do between now and 3/1/2031 which is the end of the time period for the study.
Comparison options:
- Option #1 – Pay the normal mortgage payment ($456). Invest $1,000/mo into a brokerage account until the end of the study (3/1/2031).
- Option #2 – Pay the normal mortgage payment ($456) plus a $250/mo principle only payment. Invest $750/mo in a brokerage until the mortgage is paid off (4/1/2027). At that point invest the full $1456 ($456+$250+$750) into the brokerage until the end of the study (3/1/2031).
- Option #3 – Pay the normal mortgage payment ($456) plus a $500/mo principle only payment. Invest $500/mo in a brokerage until the mortgage is paid off (8/1/2025). At that point invest the full $1456 ($456+$500+$500) into the brokerage until the end of the study (3/1/2031).
- Option #4 – Pay the normal mortgage payment ($456) plus a $1,000/mo principle only payment. Invest $0/mo in a brokerage until the mortgage is paid off (1/1/2024). At that point invest the full $1456 ($456+$1,000) into the brokerage until the end of the study (3/1/2031).
In all of these cases I have the $456 monthly mortgage payment and $1,000 extra to use to either pre-pay the mortgage or invest in stock based index funds in a brokerage account. In cases where the mortgage pays off earlier than 3/1/2031 (the end of the study) I apply the extra money to the investment account.
The great unknown in all of this is the investment return of the stock market over the next 10 years. I took three different average returns over the 10 year period and used that to calculate the brokerage returns. The four values used were -3.8% (worst 10 year period in S&P history since 1928[1]), 0% (a lost decade), 7% (long range historical average), 13% (a continued raging bull market).
Resultant Data:
What information did I want at the end to help with my decision of which option was better? There were a few things:
- Mortgage Payoff Date – I wanted to see where in time this would fall so I could see if I might be at FI before the mortgage was gone.
- Mortgage Net Worth Change – This would be important if we were calculating a timeframe where the mortgage wouldn’t be payed off such as 5 years. In my case, all cases pay off the mortgage so it’s $45,529 for each.
- Brokerage Account Net Worth Change – How much would that brokerage account balance change for each method? The account is already in use so I’m looking at the change in value not the absolute value.
The Process:
How did I do this? I use two main spreadsheets. First I used a loan amortization schedule spreadsheet (widely available for free on the internet) that let me include monthly principle only payment amounts. I made a sheet for each option. That sheet provided me with certain pieces of information that I cared about including number of remaining payments, remaining interest paid for each option and the date of the mortgage payoff. Well, it at least gave me the data to calculate remaining payments and interest paid.
The second spreadsheet I used is a compound interest sheet that included an option for regular deposits. I created one of these sheets for each option and varied the investment timeline. I had to take the mortgage payoff date calculated from the amortization spreadsheet to then input into this sheet the right time for the investment per month to flip to the full $1456.
The Results:
I’m honestly surprised by the results. What surprised me the most was that there really wasn’t a massive financial difference to the brokerage account balance between any of the options due to my small mortgage remaining and my short time horizon studied.
My small mortgage balance and 3.625% APR only results in a $6,372 difference in interest paid between option #1 and option #4. The biggest delta was between option #1 and option #2 dropping by $3,555.
Take the “average” 7% market return situation. There’s a $9,500 difference over a 10 year period between the extremes of option #1 and option #4 or $950 a year. Not exactly an amount of money that would keep me up at night with a fear of missing out (FOMO).
Option #1 puts the most into the brokerage account so it’s most susceptible to market gains (and losses) based on average annual return variation. Pre-paying a mortgage is locking in a guaranteed return on your money at a rate equal to your mortgage interest rate. For that reason option #4 fluctuates the least with returns.
The easy way to think about this is that if the average annual return of the stock market is greater than your mortgage APR then investing more will always result in a financially better outcome over mortgage pre-payment.
The surprising thing that I learned in calculating the numbers and thinking through this is that mortgage interest doesn’t really matter. In my case no matter what I’ll spend $1,456 a month. What matters if I want the best financial outcome is what makes my net worth grow the most over time for that $1,456. That means house value – mortgage remaining + change investing account balance over the investing timeframe. In my case all options decreased my mortgage by the full loan amount remaining of $45,529 so I didn’t show it.
Loan amortization calculators can lead you to focus on this as well showing you large interest numbers over the life of a loan. It’s easy to add a $500 extra payments and see that interest drop dramatically. What you don’t see is what your brokerage account value would do over time if you chose to invest that $500 for comparison.
My Decision:
Drum roll…I’m going to pursue option #2. This option keeps my brokerage contributions high while accelerating my mortgage payoff by 4 years. While it’s not important to have this house paid off by FI I am interested in the psychological impact and would like to accelerate that some.
The $4,250 brokerage account difference between option #1 & #2 is trivial to me so it’s a good balance between investing and accelerated paydown. Coincidentally, 80/20 (stock/bond) allocation is our investment plan so option #2 is very similar. Option #2 is $750 (stock) / $250 (mortgage) and mortgage pre-payment is almost bond like with a 3.625% return on my loan.
Things to Consider for Your Decision:
We all have our own unique situations to consider so my decision might not be the right one for you. Here are some things to keep in mind when contemplating this decision for you.
- If your mortgage APR is less than 7% and you have a 20+ year investing time horizon then investing in the S&P500 has historically always done better, on average, than prepaying your mortgage. The S&P500 returned 7.3% on average over all 20 year periods from 1928 to 2018[1].If the market returns 7% on average and your mortgage APR is 3% then you’ll make 4% more on average, compounding, over your investing life on any money that you invest in the S&P500 index instead of pre-paying your mortgage. Is it possible for the market to underperform your 3% mortgage over 20 years? Absolutely. But on average it won’t and since none of us has a crystal ball that’s the best that we’ve got.
- Try not to fixate on mortgage interest saved when projecting what prepaying a mortgage will do for you financially. Look at overall net worth and factor in how your money would grow if you invested the money instead of paying down the mortgage.
- Keep your big picture goals in mind. Eliminating a mortgage payment will drop your monthly expenses so it’s advantageous to have that happen before FI / retirement if you plan on staying in the house. It will influence your FI date so see when you want that mortgage gone and the impact of the reduced expenses on your FI number.
- There’s a freeing feeling to being mortgage free (or so I’m told). Remember how good it felt when you paid off your car loans or when you were free of credit card debt? It’s hard to put a price on the feeling of not having a debt hanging over your head. Or the pride felt in knowing you own that house outright.
- Pre-paying your mortgage is choosing a guaranteed return on your money of your mortgage APR assuming your house value is stable. If you are more conservative when it comes to risk tolerance then mortgage pre-payment will likely be a more attractive option.
- You don’t have to choose the mathematically superior (most rational) choice that nets you the most money in the end. There are many reasonable choices on the spectrum between invest everything and don’t prepay any mortgage and invest nothing while aggressively paying off the mortgage.
- It’s much harder to get at wealth that’s tied up in your mortgage. You can refinance it out or take out a HELOC but there are costs involved. If it’s sitting in your brokerage account it can serve as an emergency fund and is far more liquid.
Action Steps:
- Make sure you understand your mortgage APR. How does that compare with 7%?
- Download a mortgage amortization calculator and compare a mortgage prepay option to an investment option. Consider in between options like invest half and prepay half.
- Make a decision and implement it into your budget.
- Automate the investments and pre-payments to make it easy to stick with your plan.
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Have you done this analysis before? What did you choose and why? Comment below!
Sources:
- FourPillarFreedom.com. Here’s How the S&P 500 Has Performed Since 1928. https://fourpillarfreedom.com/heres-how-the-sp-500-has-performed-since-1928/. Accessed 4/11/2021.
- FreddieMac.com. 30-Year Fixed-Rate Mortgages Since 1971. http://www.freddiemac.com/pmms/pmms30.html. Accessed 4/11/2021.
