Upped Your Income? Decide Whether to Pay Off Home or Invest

DISCLAIMER: This article is meant for educational purposes only and is not intended to be construed as financial, tax, or legal advice. HomeLight always encourages you to reach out to a licensed financial advisor regarding your own situation.

You just landed a big promotion, along with a healthy pay raise. There’s a glass of bubbly in your hand, and the lyrics to “Mo Money Mo Problems” are running through your head as you debate where to channel your extra disposable income. Should you pay down your mortgage to live debt free, or invest to harness the power of compound interest?

In this hotly-debated dilemma, one side argues that freedom from mortgage debt should be the priority. Paying off your loan significantly reduces your living expenses, providing stability in the event of a job loss or retirement. Plus, if you prepay your mortgage (i.e., make extra payments on the principal loan balance), you could save thousands of dollars in interest over time.

The other side disagrees, believing that investing is the best way to get ahead financially. If you earn compound interest on your investments, eventually, your investment earnings will outweigh your mortgage interest; in other words, you’ll make significantly more money from interest on your investments than you’d save by paying off your mortgage early. This latter group follows Einstein’s adage about interest: “He who understands it, earns it; he who doesn’t, pays it.”

To discuss what factors homeowners should weigh before allocating their extra cash, we asked Drew Kavanaugh, Certified Financial Planner (CFP®) and vice president of Odyssey Group Wealth Advisors, for his insight. Kavanaugh stresses that the answer lies in more than a numbers-based calculation. Both your financial situation and personal sentiments can factor into your decision.

Here’s what you should take into account when weighing up if you should pay off your home or invest:

1. Your mortgage interest rate vs. the rate of return on investments

To compare your options, start by weighing your mortgage interest rate (interest you’re paying) against the projected interest rate on your investments (interest you’d earn).

If your investments could earn more interest than you would save in interest on your mortgage over the loan period, then investing may seem like a good option that helps you gain wealth.

Historically, the stock market averages 10% returns annually (closer to 6% or 7% of “real returns” when accounting for inflation). Comparatively, the average 15-year and 30-year mortgage interest rates have ranged from 2.16% to 4.94% in the past 10 years, according to Freddie Mac.

If you take these numbers at face value, investing may seem like a no-brainer. However, the reality is more complicated. Register these concepts when strategizing:

The stock market can be lucrative but it’s also unstable

The stock market’s average return of 10% doesn’t equate to you earning a 10% return on your investments every year. Market conditions sway dramatically and unpredictably.

To borrow a visual from historian Niall Ferguson’s The Ascent of Money: A Financial History of the World, if you plotted movements in stock market indices on a graph, you wouldn’t see a neat bell curve with most points clustered at the peak around 10%. There would be many more extreme high and low points on either side of 10%, forming a trend that statisticians like to call “fat tails.”

Market dips are inevitable and can be extreme in nature. There have been nine market crashes of 20% or more in the past century. It can take the market years to recover after a tumble and even a decade or longer to recover after a major crash like The Great Recession.

As an investor, you gain or lose money depending on what’s happening in the market at a set moment in time. So while your mortgage rate remains more or less stable (depending on if you have a fixed- or variable rate), your annual interest on your investments peaks and valleys over the years. This variation means that the interest on your investments won’t always net you gains — you may even lose money on your investments from time to time.

Bottom line: If you plan to invest your extra earnings, you’ll need to strap in for the long game to truly reap the market’s 10% average return.

There are tax perks to keeping your mortgage

Don’t throw in the towel on investing and commit to paying off your home faster just yet. People who advocate for prioritizing investing point out that tax deductions effectively reduce the impact of the interest you pay over the course of your mortgage.

With the home interest mortgage deduction (HIMD), homeowners have the opportunity to deduct the amount of mortgage interest paid throughout the year from their taxable income, which reduces the amount of tax they will owe. You may be able to deduct 100% of your mortgage interest paid in the previous year, or only a portion of it, depending on your mortgage size and when you acquired the debt due to the way tax rules have changed.

If this tax deduction means you won’t save significant interest by paying off your mortgage early, it could be a better bet to invest your extra earnings.

2. Your tolerance for risk

There’s a chance that investing in the stock market could get you further ahead financially than paying off your mortgage early would. But the market can be volatile, and stock market investments aren’t guaranteed. If you’re in a tough financial spot and need to liquidate your stocks during a market dip or correction, they could be worth less than you paid for them.

Many people see their home as a less risky type of investment. As you pay down your mortgage principal, you build equity in your home. If you’re in a crunch, you can withdraw equity from your home in the form of cash with a Home Equity Line of Credit (HELOC), a home equity loan, or a cash-out refinance. There’s also always the option to sell your home and walk away with your equity, minus whatever closing costs you owe at the end of the sale.

So to wrap up, if market ups and downs don’t deter you, and the thought of potential investment returns puts a spring in your step, investing your extra cash could be the right choice. If the opposite is true, paying down your mortgage may be a better fit.

3. Your current financial standing

You need to look at your whole financial picture when deciding to pay off your home or invest. Speak with a financial advisor to understand how the following factors impact which option will help you get further ahead.

Overall debt balance

Does your debt vastly overshadow your savings and investments? Using excess income to lower your mortgage principal reduces the debt balance faster than making minimum payments. For many, carrying a large loan balance with a high monthly payment can feel burdensome. If you’re in this camp, it could be a huge relief to tackle your mortgage debt aggressively.

But before you start prepaying your mortgage, compare the interest rates across your loans and credit lines. Kavanaugh recommends paying off high-interest debt, such as credit cards, before paying off your mortgage.

Income tax status

If you itemize deductions, you may want to think twice about paying off your mortgage and losing the mortgage interest tax deduction. This is particularly important if your taxable income is borderline with a higher tax bracket. Losing the deduction could increase your taxable income, bumping you into the next tax bracket and increasing your income tax bill. Consult with a tax professional about potential tax implications before you pay down your mortgage.

Diversification of current assets

Consider how your assets are currently diversified. If you have ample home equity and no investments, or vice versa, you could have a risky imbalance. According to the U.S. Securities and Exchange, you can reduce risk by putting your money into different asset categories.

Putting all of your extra funds into your home while ignoring other investment opportunities, for example, puts most of your assets in one place. In a dire real estate market where property values dip — as we experienced during the Great Recession — you could lose some or all of the equity you’ve built up in your home. A joint report by The Russell Sage Foundation and The Stanford Center on Poverty and Inequality notes that U.S. households lost more than $7 trillion in home equity during the Great Recession.

4. Your short-term, medium-term, and long-term financial goals

Consider your financial goals for the next year, the next five years, and beyond. Are you planning to start a business? Send a child to school? Buy a new car? Your future plans can affect how you choose to allocate your extra income.

For example, a younger couple with a child may consider accelerating their mortgage payments to pay off the debt by the time their child enrolls in college. Without the monthly mortgage payment, “they will have additional resources to help with college funding,” Kavanaugh says. But that doesn’t mean every penny should go toward the house. “It’s just one budgeting silo in the comprehensive financial picture,” he adds.

5. Your retirement timeline

If you’re closing in on retirement, putting extra payments toward your mortgage balance brings you closer to owning your home outright. While paying off a mortgage doesn’t make sense for every retiree, eliminating this large monthly payment can significantly increase your monthly budget and improve your lifestyle.

The further you are from retirement, the stronger the case is for investing your extra earnings. You have more time to recover from market fluctuations and take advantage of compound interest, which maximizes its benefit over time. By the rule of 72, a shortcut for calculating compound interest, if the stock market returned 10% annually your investment would double after 7.2 years. The power of compound interest could net you major returns.

If you were to invest a $10,000 bonus at a 10% annual rate, you’d walk away with nearly $175,000 (before taxes) in 30 years — without ever adding another penny. You don’t even need a large lump sum to leverage compound interest. Want to be a millionaire? A $550 monthly investment earning 10% annually gets you there in 30 years.

6. Your moving plans — or lack thereof

If you’re planning to move in the next few years, Kavanaugh says it’s probably best not to pay down your mortgage debt with your extra income. Keeping the funds liquid gives you flexibility to increase your down payment for your new home, he notes. And if you’re staying in your home for the foreseeable future? Kavanaugh says to consider all the other factors listed to weigh up if you should pay off your home or invest.

Let’s recap the deciding factors

One factor alone probably won’t sway your decision toward paying down your mortgage or investing the funds. Consider each option holistically, looking at the benefits and drawbacks of each to help clarify your choice.

Think about investing if…

• You’re confident you’ll earn a higher returns investing than you’ll save in mortgage interest
• You aren’t anxious when the stock market fluctuates
• You don’t plan on retiring for many years

Consider prepaying the mortgage if…

• You’re uneasy about your mortgage debt balance
• You’re nearing retirement
• You don’t need the mortgage interest tax write-off

Meet with a financial advisor for tailored advice

Ultimately, there isn’t a simple answer to whether paying off your home or investing money in the market is better. When it comes to personal finance, everyone’s situation is unique. If you’re overwhelmed about making a decision or are unsure about your next step, reach out to a financial advisor for guidance.

Search for a local professional through the National Association of Personal Financial Advisors or the Certified Financial Planner (CFP®) Board. By partnering with an experienced advisor, you’ll spend less time worrying about financial missteps and more time celebrating your financial success.

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