I am often asked a great question from homeowners: ‘if I have extra money from savings, should I invest it, or pay down my mortgage?’.
While there isn’t a right or wrong answer here, there is a way to determine which option would give you the best bang for your bucks.
The two most obvious factors in weighing this decision are: mortgage rates (how much are you paying in interest each month for the mortgage on your home?), and investment rates of return (how much money back would you get on a monthly basis from your investment?). There are certainly more factors to consider beyond these two, but let’s start to break down the question with interest rates and rates of return in mind.
If you’ve been following the housing market even roughly for the past decade, you know that interest rates have increased faster than they had in history. Ten years ago, you could find a mortgage with a 2.5% interest rate. It was certainly not difficult to beat a rate of return of 2.5% for an investment. This made the answer a lot more obvious when wondering “should I pay down my mortgage or invest my money?”. That’s because homeowners with a 2.5% mortgage rate were paying pretty low interest each month. If they were lucky enough to invest savings in addition to own a home, they were making a lot more cash as a return on their investment than they would have saved by paying down their mortgage to avoid their 2.5% interest rate. To see how the question of “pay down my mortgage, or invest my savings?” could have been answered back then, let’s use the following example:
I purchased a home for $500,000 with a 30yr mortgage at a 2.5% interest rate (lucky me!!). My monthly payment on this mortgage is $1,580. The amount of interest I’m paying each month, for 30 years, averages out to $470, or $5600/year. If I decided to use $100K of my savings to pay down my mortgage, my interest payment per month would instead be $352. So, I would be decreasing my interest amount each month by about $117 (a savings of $42,244 over 30 years, or $1408/year).
But what if I decided to invest that $100K instead?
Let’s say I found an investment that would give me a 7% cash on cash return. This means that over the life of the investment, it should return back to me, on average, $7K/year. Already I can see that I’m making more on this investment per year than what I would be saving in interest if I had used this money to pay down the principal on my mortgage. And that’s not all! There are so many more factors of an investment to consider before investing. So beyond the cash on cash value, we need to understand how long the investment will be, and the total amount of money we should expect back at the end of the investment period. So, let’s say our $100K investment is going into a 5 year project and it is expecting an equity multiple of 1.7x. This means that including the cashflow I’ve received throughout this investment, at the end of the five years, I should get back 1.7 x my initial investment (so, 1.7 x $100K, which is $170K). For this investment, five years after I gave them $100K, I have received a total $170K back in my pocket.
So, what was the better decision? 1) Pay my mortgage down by $100K to save a total of $42K in interest over 30 years, or 2) Invest 100K and receive $170K in five years?
I think we’d all agree that option 2 gives me more money in the end.
But, it’s time to wake up from our 2013 dreamworld. Here we are in the age of 7% interest rates. Is the more lucrative scenario still as obvious?
The interest amount on the same purchase price and a 30 year loan are substantially higher now than they were ten years ago. But let’s test our theory against today’s numbers to see which scenario gives me a better outlook.
Today on a $500K home with 7% interest rates, I’m paying $558K in interest over 30 years. This comes out to $1550 each month on average, or $18,600/year. That’s a lot, and the amount I save beats the cashflow I’d be getting if I had invested that $100K instead (remember: we’d get an average of $7K in cashflow each year from our investment). But, also remember that there’s more to the story. Cashflow should be the smallest return in our five-year investment. At the end of the five years, our total return (including cashflow) is $170K. At the end of our mortgage, if we fast-forward 30 years, our $100K injection to principal will have saved us a total of $140K in interest. Take our $170K payout over five years, and compare it to a $140K savings over 30 years, and I’d choose the higher payout. Not to mention that I could make this same investment six times over before I see my 30-yr mortgage savings realized…
We can apply this same calculation to only the first five years of a 30 year mortgage and still come out on top. The first five years of the mortgage will have higher interest numbers, so you might think: what if I reduce my interest payments up front in my mortgage, ease my leverage, and breathe better at night? The first five years of my loan would require a total of $136K in interest payments. If I put $100K into principal, that number changes to $102K, so I’m saving $34K in five years. I’m already making this up in total cashflow of my investment.
At the end of the day (or, five years or 30 years), this comes down to a decision based on the numbers, but also based on risk tolerance and personal situations. It could be that a homeowner is wanting to reduce their monthly expenses above all else, and therefore it wouldn’t matter how their returns compare in five years, as long as they could increase their equity, and pay off their mortgage sooner.
Making the decision about whether to deploy savings into an investment or into a mortgage payoff depends on your situation… and how you compare the numbers!
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