Have you received an inheritance or have extra money coming in? What’s your best next step: paying off a mortgage or investing? Putting it toward your mortgage to relieve some of the weight caused by interest-earning debt may sound appealing. On the flip side, investing the money elsewhere and capitalizing on compounding may be wiser. To help you determine the best path, let’s examine some ways you could put that money to work for you.
Pay Off Mortgage or Invest in Retirement?
When it comes to financial planning this is a common question. However, choosing to hold off on saving for retirement in order to pay off your mortgage may come with huge financial consequences.
Reasons to Invest in Retirement Before Paying Off Mortgage
Maxing out your retirement contributions should be at the top of your financial planning priorities checklist. Lets examine why.
1. 401(k) Employer Match
If the organization you work for offers a 401(k) employer match, make sure you are contributing at least that much. Otherwise, you are missing out on free money. Dave Ramsey recommends investing 15 percent of your income to retirement first and then working to pay off your mortgage afterward.
2. Start Investing for Retirement Early
The longer you invest, the more your money can grow. Waiting to invest in retirement until your mortgage is paid off will cause you to lose time you won’t get back. Even if you bump up your retirement contributions after paying off your mortgage, you can never make up for lost time. Because investments tend to gain value exponentially, every year you put off putting money toward retirement will set you back tremendously.
3. Make Compound Interest Work For You
Unlike simple interest, compound interest, or earning interest on interest, applies to loans and money deposited. Because compounding is calculated using your entire account balance, not just the original deposited amount, you make more and more money from your investments. That’s the beauty of compound interest.
4. No Taxes on Money Earned
This is the big differentiator when it comes to deciding where to invest your money. The reason is because you don’t have to pay taxes on the money earned from some retirement accounts. So if you plan to max out your IRA or 401(k), then investing will definitely save you money.
Invest in the Stock Market or Pay Off Mortgage?
After you have maxed out your retirement account contributions, the next question might be where to invest your money now. Whether you decide to invest in the stock market or start paying down your mortgage, there are several factors to consider before moving forward.
Reasons to Invest in the Stock Market Before Paying Off Mortgage
In the following sections, I will explain the main reasons to invest in the stock market before paying off a mortgage.
1. Building a Liquid Asset
Many investors choose to invest in the stock market rather than pay off a mortgage to build liquid assets. Having liquid assets or cash available with a click of a button can put you in a better overall financial position. If you decide to pay down your mortgage instead of investing, be aware that your liquid assets will be tied up in real estate and inaccessible until you sell or refinance.
2. Potential for Greater Returns
While there are no guarantees to secure a better return on your investment through the stock market, historical data paints a pretty clear picture. That is, returns from the stock market have exceeded most guaranteed returns.
There are several resources out there to see the past performance of the S&P 500, for instance. Tracking stock market performance over the long term will give you a better idea of your expected return. S&P has historically produced around a 10 percent return, with a 7 percent real return and 3 percent from inflation.
Keep in mind that investing in the stock market should be a long-term strategy, as the market fluctuates up and down. It’s important to allow enough time for the market to recover from downturns.
3. If You are Already Investing in an Aggressive Asset Allocation
Let’s say your investment strategy is more on the aggressive side. You should continue to invest more. Aggressive portfolios are customized to produce grains of 10 percent or more. Chances are, the guaranteed return on investment from your home will almost certainly be less than 10 percent. Aggressive portfolios have more to gain but also more to lose. Based on the direction you are headed, understand the risks associated.
4. You Have High-Income Value
You should also look into investing in the stock market if you make a large income. Smarasset.com explains, “When you hold an investment for one year or more, you can pay the dividend tax rate on it. This rate is lower than most of the federal income tax rates. That means taxpayers with a high regular tax rate (22% or more) can save on taxes by building more wealth through investments instead of increasing their regular earnings.”
5. Use Inflation to Your Benefit
Inflation increases prices and decreases the value of money over time. That said, you should earn a higher salary as you age. Combine your higher wage with inflation and make a mortgage payment easier. You may also find that you can make regular mortgage payments and invest simultaneously.
Reasons to Not Invest in the Stock Market Before Paying Off Mortgage
Now that we have covered the reasons for investing in the stock market, let’s move on to why you should not invest before paying off your mortgage.
1. No Guarantees on Return of Investment
One benefit to paying off your mortgage rather than investing in the stock market is earning a guaranteed return based on your interest rate. While the stock market has the potential to produce much higher returns, it offers no guarantees. If you don’t feel confident about getting a higher ROI by investing elsewhere, your best bet may be a lower, guaranteed return.
2. You Must Pay Taxes on Investment Profits
The IRS requires taxes to be paid on investment earnings. These tax rates may be beneficial, but only if you make a lot of money and hold investments long-term. If you are able to itemize and deduct interest using the mortgage interest deduction, there may be a good possibility that investing may cost you more money.
Invest in Real Estate or Pay Off Mortgage
There is no blueprint for guaranteed success when it comes to real estate investing. However, considering the benefits of all your options should make the decision easier.
Reasons to Invest in Real Estate Before Paying Off Mortgage
In the following sections, I will review some of the best reasons to invest in real estate instead of paying off your mortgage.
1. Higher Return Potential
Investing in real estate can bring in much higher returns than paying off a mortgage. Additionally, you won’t be clearing out all your savings to pay off your mortgage. You’ll be investing less of your money into a rental property and potentially setting yourself up for higher returns.
2. Tax Benefits
There are several possible tax breaks for owning more than one property. You may find additional tax benefits in real estate through an LLC or mortgage interest tax deductions. No matter what you do, it is always a good idea to consult a real estate tax professional to determine the tax breaks you qualify for.
3. Cash Flow
Investing in real estate can produce monthly cash flow, a massive draw for many investors. Rental properties may be an excellent source of passive income, especially with a long-term, buy-and-hold investment strategy.
4. Appreciation
Buying a rental property gives your asset the opportunity to appreciate in value. Meanwhile, you may be able to sit back and watch your property gain value.
5. Diversify Your Portfolio
A possible argument against investing in real estate is that you may be subjecting yourself to more risk. While that may be true in some cases, investing in real estate is a great way to diversify your portfolio, lowering your overall risk.
Reasons Not to Invest in Real Estate Before Paying Off Mortgage
1. Low Risk Tolerance
When considering any investment, it’s essential to determine and understand how much risk you are willing and able to take on. Real estate may seem too risky for some investors to want to venture into, which may be a good enough reason to choose to pay down or pay off their mortgage.
2. Stage of Life
Depending on your age, career, and financial situation, some investments may be more or less risky than others. For instance, if you are approaching retirement and want your mortgage paid off beforehand, using your extra cash would make sense.
3. Get Rid of Private Mortgage Insurance
Paying off your mortgage will eliminate interest payments and PMI. Once you’ve paid off 20 percent of your property’s original purchase price, your lender must drop PMI. Each scenario could save you a lot of money in the long run.
When to Pay Down Your Mortgage Before Investing
There are a few instances where you should pay down your mortgage before investing. If your circumstances put you into one of the following, it is recommended that you do so first. Whatever you decide to do, run the numbers to ensure this strategy is the best for your financial health.
1. If Your Mortgage Interest Rate is Unusually High
Paying off a mortgage guarantees a return on your investment equal to your mortgage interest rate. So, if you have a higher interest rate, say around six or seven percent, it may be better to pay down your mortgage. This will guarantee a return on your investment rather than playing the stock market.
On the other hand, you may want to consider refinancing a home to lower the interest rate. Refinancing your mortgage allows you to take money out of your home, use equity, and invest that money elsewhere. This is called leveraging, and many successful real estate investors use this strategy to purchase multiple investment properties.
2. If You Are Approaching Retirement
Are you approaching retirement and still have a lot of your mortgage to pay off? Now would be the time to consider paying down your mortgage as much as possible. This rule of thumb applies to individuals 50 and older.
Consider a Blended Approach
Creating a diversified portfolio is a fundamental rule of investing. Individuals who put much of their liquid assets into one or two investments add extra risk. Consider using a blended approach by spreading your investments to minimize risk and maximize potential returns.
Questions to Ask Before Deciding Where to Invest
Lastly, because everyone has a unique situation, there is no definitive correct answer to whether you should pay off your mortgage or invest. However, taking a few minutes to answer the following five questions will be critical in determining your best investment strategy.
- Can you get a better return?
- Do you need access to your money?
- Do you need a guaranteed return?
- Will you get any tax breaks from your mortgage interest?
- Do you pay private mortgage insurance?
Final Thoughts
Investors should consider whether to pay off a mortgage or invest very carefully. For some, the peace of mind that comes with paying down debt may be reason enough. Others may want peace of mind and security through investing in retirement. Others will have maxed out their yearly retirement contributions and want to invest in the stock market for a potentially higher return.
RealWealth has several experienced investment counselors who are ready and willing to offer advice on the best real estate investing strategies for you and your financial situation. To schedule a complimentary meeting, Join RealWealth today! Membership is 100% free and can help you understand how to build wealth for your future.
