Let’s be honest about money. You’ve got it, you need more of it, and you’re damn sure you don’t want to waste it. In the high-stakes poker game of life, every financial decision can feel like a gamble, especially when it comes to your largest debt: the mortgage.
You’re bombarded with advice:
“Pay off your home early!”
“No, invest your extra cash for the best return!”
Or my personal favorite,
“Just chill and let your money sit.”
But here’s the thing: personal finance is just that—personal. What works for your mom, brother, or the random Instagram guru – who takes their vacation pictures in front of a green screen – won’t necessarily work for you.
So, back to the question at hand. You’ve got some extra dough at the end of the month. Now what?
Do you slam that cash against your mortgage, invest it in the latest trendy stock, or shove it under your mattress and call it a day?
The answer isn’t one-size-fits-all.
In this post, I’ll break down the when, why, and how of deciding whether to overpay your mortgage, invest, or simply kicking back and enjoying the financial stability you’ve got.
Whether you’re looking to grow your net worth, save on interest, or just sleep better at night knowing you’re debt-free, I’ve got you covered.
Let’s figure out together the best way to make your money work for you.
Understanding the Basics
First things first: the cornerstone of any sound financial plan is an emergency fund. This is your financial airbag, designed to cushion you from the unexpected expenses that life can throw your way.
It’s essential to have around three to six months’ worth of living expenses saved up before you start thinking about overpaying your mortgage or investing.
Without this safety net, you could be one car repair or medical bill away from financial stress.
Once your emergency fund is taken care of, we can start the more nuanced discussion of if it makes sense to focus on your mortgage. Lets tackle the three decisions at hand…
#1: Overpay a Mortgage
Overpaying your mortgage means making additional payments towards your loan’s principal. This can shorten the life of your loan and reduce the total interest you’ll pay.
The benefit is clear: the sooner you pay off your mortgage, the less interest you’ll pay over time, which can result in substantial savings.
However, it also means tying up your cash in home equity, which can reduce your financial flexibility, especially if you don’t have a solid emergency fund in place.
#2 Investing
Investing your extra cash can come in various forms, including stocks, bonds, or real estate. The main benefit is the potential for higher returns compared to the interest saved on an overpaid mortgage. Over time, this can significantly increase your net worth.
However, investing comes with risks, and returns are never guaranteed. It’s crucial to assess your risk tolerance, risk capacity, and investment timeline before diving in.
#3 Doing Nothing
Sometimes, doing nothing is a choice in itself. Keeping your extra cash in savings or checking accounts means you’re prioritizing liquidity and ease of access to your funds. This could be a prudent choice if you anticipate large expenses in the near future or if the market is particularly volatile.
However, it’s important to be aware that inflation can erode the purchasing power of your cash over time, potentially diminishing its value.
Opportunity cost is also a fundamental concept to grasp here—it represents the potential benefits an individual, investor, or business misses out on when choosing one alternative over another.
By choosing to overpay your mortgage, for example, you may miss out on the higher returns of the stock market. Conversely, by investing, you forgo the guaranteed ‘return’ and the peace of mind of that comes with reducing overall mortgage interest paid.
When to Overpay Your Mortgage
It can be tempting to throw every spare dime at your mortgage, but it’s not always the optimal choice. Overpaying makes the most sense when the interest rate on your mortgage overshadows potential investment returns.
Say your mortgage interest rate hovers around 5%, and investment avenues are projecting a modest 3-4% return. In this case, the math tips in favor of reducing your mortgage balance. You’re essentially guaranteeing a 5% ‘return’ by avoiding future interest, outpacing what you’d likely earn from conservative investments.
The psychological win of being debt-free is another compelling reason to overpay.
There’s an undeniable satisfaction in watching that balance dwindle, and for some, this peace of mind is worth more than potential investment gains.
This is particularly relevant if you’re risk-averse or nearing retirement and prioritizing financial stability over growth. Just ensure you are paying down your principle balance and not simply paying off all the interest first (thus helping the bank get their capital back faster).
When Investing is the Better Choice
Conversely, investing is more attractive when the mortgage rates are low and investment returns are robust. Imagine your mortgage interest rate is a low 3%, and the stock market – or other investment vehicles – are returning a healthy 6-7%.
Over time, the compound growth from these investments could far exceed the interest you’d save by paying off your mortgage early.
Investing is also in tune with long-term financial objectives.
For retirement planning, the extended time horizon allows your investments to ride out market volatility and benefit from the compounding effect, which can be a significant wealth builder.
The Case for Doing Nothing
Then there’s the argument for keeping your cash liquid. If your mortgage interest rate is already low, the urgency to pay it down diminishes. Having cash available means you’re ready for whatever life throws at you, without the need to take on more debt.
In terms of investing your surplus into a money market account, this can be a savvy move.
These accounts typically offer higher interest rates compared to a basic savings account and remain relatively accessible. The strategy here would be to use the interest earned from your money market account to overpay your mortgage.
For example:
By placing $20,000 in a money market account with a 5.25% annual yield, you’re set to earn approximately $87.50 each month in interest. This strategy allows you to use the interest earned as your extra mortgage payment, effectively employing the bank’s money to pay down your own debt.
It’s a hands-off approach that doesn’t impact your day-to-day cash flow.
For instance, over the course of a year, you’ll have used $1,050 of low risk returns to reduce your mortgage principal. This not only saves you money on future interest accrued on the mortgage but does so without tapping into your $20,000 principal or your regular income.
However, it’s crucial to evaluate if the interest you’ll earn will be substantial enough to impact your mortgage balance meaningfully and whether this approach aligns with your financial goals and risk tolerance.
Personal Factors to Consider
When it’s time to decide where your extra money should go, there’s no substitute for a good, hard look at your personal circumstances. Here’s what should be on your radar:
Risk Tolerance and Capacity:
Risk tolerance is about how much market volatility you can stomach before you start losing sleep. But risk capacity is different—it’s how much financial risk you can actually afford to take on.
If you’re young with years to recoup potential losses, your capacity might be higher than someone eyeing retirement.
If lean hard into having a money script of vigilance, you can have all the disposable income in the world and still lack the risk tolerance to employ any of it.
Financial Goals and Timelines:
Your financial dreams—whether it’s retiring to a beachfront property or ensuring your kids graduate college debt-free—will influence your strategy. Short-term objectives might lean towards accessible, lower-risk options, while long-term goals could justify more exposure to the market’s ups and downs.
Current Financial Health and Emergency Funds:
Assess your financial vitals. If an emergency fund isn’t part of your portfolio yet, that’s your first mission. After that’s established, you can think about allocating extra funds to your mortgage or investments, depending on interest rates, rates of return, your risk tolerance, and risk capacity.
Conclusion
To wrap it up, the choice between paying down your mortgage or investing isn’t just about numbers; it’s deeply personal. It hinges on your risk tolerance and capacity, financial goals, and where you stand today financially.
Always remember, while paying off your mortgage is a surefire way to save on interest, investing has the potential to generate higher returns. The right path for you depends on a balanced assessment of your personal and financial situation.
If you’re navigating these waters, consulting with a financial advisor can be invaluable. They can tailor a strategy that fits not only your financial profile but also your life’s ambitions and peace of mind.