Pay off your mortgage first or invest? Which nets the better return

An excellent article about one of the most common yet least understood aspects of investing and mortgages. Source: Businessinsider.com and thanks to Brian Fry Certified financial planner at Safe Landing Financial)

Whether to pay off your mortgage early or invest that money instead is a hotly debated topic among US homeowners.
Brian Fry, a certified financial planner who founded Safe Landing Financial ran a simulation for a homeowner with a 30-year mortgage who has some extra income to spend on paying off mortgage early or invest.
So the scenario is to find out what will net the greatest return: putting their additional income in a taxable investment account, or using it to pay down their mortgage sooner and then invest once their mortgage is paid off.
Fry also considered whether the homeowner refinances their mortgage to secure a lower interest rate.
Several assumptions were made to illustrate this scenario, so it’s important to consider your own unique financial goals and situation if you’re weighing a similar decision.
Debt can often negatively affect your path to building wealth, but it’s not all bad.
Still, if you’re a homeowner with a mortgage, you’ve likely weighed the decision to pay it off early, if you can afford to. It’s a worthy goal to be free and clear of all debt, but is it the right choice if you’re trying to optimize your every dollar?
That’s a common question financial advisors get from their clients. The answer however, really depends on the specifics of the situation. Generally, the biggest factor in deciding whether to pay off a mortgage early or invest your extra cash from a windfall, salary raise, or some other source is the interest rate.
“If you project a higher rate of return for your investments than your mortgage’s interest rate, then you should invest the savings,” Fry said. “If you project your mortgage’s interest rate to outperform your investments, then you should pay the mortgage off aggressively.”
Still, if you determine that the interest rate on your mortgage is higher than what you’d earn on investments, you may want to consider refinancing to secure a lower rate. In fact, refinancing can be a good option whether or not you ultimately decide to pay your mortgage aggressively.
But Fry said it’s also crucial to consider how far you are from retirement, how long you plan to stay in the home, whether you have other high-interest debt, the possibility of tax deductions, and the status of your emergency fund and retirement savings. There are non-financial factors to think about as well.
“It’s really important to have a good understanding of what you’re trying to accomplish before determining the best course of action,” he said. “A fee-only certified financial planner can help you plan for your unique financial situation and reach your financial goals.”
To help illustrate the debate between paying off your mortgage early versus investing, we asked Fry to run a simulation.

Pay off the mortgage early or invest?
The hypothetical
A homeowner just got a raise that will net them an additional $24,000 a year after taxes. They plan to stay at this job, and it’s unlikely they’ll get any more raises or cost-of-living adjustments. (This figure was used for the purposes of this calculation; a smaller raise or windfall would yield similar results.)

They have an established emergency fund and no other debt, and they’re already maxing out their 401(k) and IRA. They plan to stay in their home forever and retire in 15 years, at 65.

Their initial mortgage balance was $400,000 on a 30-year fixed-rate loan with an interest rate of 5.84%. They are 15 years into their mortgage and have a remaining balance of $282,221.

If they refinance to a 15-year fixed mortgage, their interest rate would be 3.19%. Refinancing costs are estimated to be $6,000, for simplicity. Generally, refinancing costs are 1.5% to 4% of the remaining mortgage balance.

Their nest egg is diversified, and they are looking to make the best financial decision about how to use the extra income to maximize their wealth. Do they use this extra money to pay off their mortgage more aggressively, or invest more aggressively?

The calculation
Fry used Right Capital, a financial-planning software, to calculate how much the homeowner would have in a taxable investment account in 15 years using a straight-line analysis.

The variables are whether they refinance their mortgage, and whether they put their additional income (and savings from refinancing, if available) into an investment fund or put it toward their loan balance.

Fry used the Vanguard Total Stock Market Index Fund, which has a long-term annual return of 5.38%, according to JPMorgan estimates. He said it’s important to remember that the market doesn’t go up by the same percentage every year: Some years offer better returns, while others may have negative returns.

Invest more aggressively:

If the homeowner refinances their mortgage and invests what they save on monthly payments plus $24,000 a year, in 15 years they will have paid off their mortgage and have an investment-account balance of $623,701.
If the homeowner does not refinance their mortgage and invests the $24,000 a year, in 15 years they will have paid off their mortgage and have an investment-account balance of $533,099.

Pay mortgage more aggressively:

If the homeowner refinances their mortgage and uses the amount they save on monthly payments plus the $24,000 additional income to pay it down more aggressively and then invest, in 15 years they will have paid off their mortgage and have an investment-account balance of $599,662.
If the homeowner does not refinance their mortgage and uses the $24,000 additional income to pay it down sooner and then invest, in 15 years they will have paid off their mortgage and have an investment-account balance of $572,449.
Fry’s recommendations
Best action: Refinance and invest more aggressively, because a 15-year fixed mortgage with a rate of 3.19% is much lower than the market’s expected rate of return.
Second-best action: Refinance and pay the mortgage aggressively. If the homeowner doesn’t agree with long-term investment-return estimates and would rather act more conservatively, they can pay off the mortgage and then invest and still come out OK.
Third-best action: Don’t refinance and pay the mortgage more aggressively. The homeowner will be debt-free 99 months sooner by putting an extra $24,000 a year toward the loan balance.
Worst action: Don’t refinance, don’t invest, and spend the extra cash instead. If the homeowner did not refinance and decided to spend the money, they would not have extra retirement savings, if that’s their goal.
Second-worst action: Don’t refinance, and still invest the extra cash. A 5.84% interest rate on the loan is higher than the market’s expected rate of return. If the homeowner is locked into a higher interest rate, it’s best to pay off the debt first.

Whether to pay off your mortgage early or invest that money instead is a hotly debated topic among US homeowners.
Brian Fry, a certified financial planner who founded Safe Landing Financial ran a simulation for a homeowner with a 30-year mortgage who has some extra income to spend on paying off mortgage early or invest.
So the scenario is to find out what will net the greatest return: putting their additional income in a taxable investment account, or using it to pay down their mortgage sooner and then invest once their mortgage is paid off.
Fry also considered whether the homeowner refinances their mortgage to secure a lower interest rate.
Several assumptions were made to illustrate this scenario, so it’s important to consider your own unique financial goals and situation if you’re weighing a similar decision.
Debt can often negatively affect your path to building wealth, but it’s not all bad.
Still, if you’re a homeowner with a mortgage, you’ve likely weighed the decision to pay it off early, if you can afford to. It’s a worthy goal to be free and clear of all debt, but is it the right choice if you’re trying to optimize your every dollar?
That’s a common question financial advisors get from their clients. The answer however, really depends on the specifics of the situation. Generally, the biggest factor in deciding whether to pay off a mortgage early or invest your extra cash from a windfall, salary raise, or some other source is the interest rate.
“If you project a higher rate of return for your investments than your mortgage’s interest rate, then you should invest the savings,” Fry said. “If you project your mortgage’s interest rate to outperform your investments, then you should pay the mortgage off aggressively.”
Still, if you determine that the interest rate on your mortgage is higher than what you’d earn on investments, you may want to consider refinancing to secure a lower rate. In fact, refinancing can be a good option whether or not you ultimately decide to pay your mortgage aggressively.
But Fry said it’s also crucial to consider how far you are from retirement, how long you plan to stay in the home, whether you have other high-interest debt, the possibility of tax deductions, and the status of your emergency fund and retirement savings. There are non-financial factors to think about as well.
“It’s really important to have a good understanding of what you’re trying to accomplish before determining the best course of action,” he said. “A fee-only certified financial planner can help you plan for your unique financial situation and reach your financial goals.”
To help illustrate the debate between paying off your mortgage early versus investing, we asked Fry to run a simulation.

Pay off the mortgage early or invest?
The hypothetical
A homeowner just got a raise that will net them an additional $24,000 a year after taxes. They plan to stay at this job, and it’s unlikely they’ll get any more raises or cost-of-living adjustments. (This figure was used for the purposes of this calculation; a smaller raise or windfall would yield similar results.)

They have an established emergency fund and no other debt, and they’re already maxing out their 401(k) and IRA. They plan to stay in their home forever and retire in 15 years, at 65.

Their initial mortgage balance was $400,000 on a 30-year fixed-rate loan with an interest rate of 5.84%. They are 15 years into their mortgage and have a remaining balance of $282,221.

If they refinance to a 15-year fixed mortgage, their interest rate would be 3.19%. Refinancing costs are estimated to be $6,000, for simplicity. Generally, refinancing costs are 1.5% to 4% of the remaining mortgage balance.

Their nest egg is diversified, and they are looking to make the best financial decision about how to use the extra income to maximize their wealth. Do they use this extra money to pay off their mortgage more aggressively, or invest more aggressively?

The calculation
Fry used Right Capital, a financial-planning software, to calculate how much the homeowner would have in a taxable investment account in 15 years using a straight-line analysis.

The variables are whether they refinance their mortgage, and whether they put their additional income (and savings from refinancing, if available) into an investment fund or put it toward their loan balance.

Fry used the Vanguard Total Stock Market Index Fund, which has a long-term annual return of 5.38%, according to JPMorgan estimates. He said it’s important to remember that the market doesn’t go up by the same percentage every year: Some years offer better returns, while others may have negative returns.

Invest more aggressively:

If the homeowner refinances their mortgage and invests what they save on monthly payments plus $24,000 a year, in 15 years they will have paid off their mortgage and have an investment-account balance of $623,701.
If the homeowner does not refinance their mortgage and invests the $24,000 a year, in 15 years they will have paid off their mortgage and have an investment-account balance of $533,099.

Pay mortgage more aggressively:

If the homeowner refinances their mortgage and uses the amount they save on monthly payments plus the $24,000 additional income to pay it down more aggressively and then invest, in 15 years they will have paid off their mortgage and have an investment-account balance of $599,662.
If the homeowner does not refinance their mortgage and uses the $24,000 additional income to pay it down sooner and then invest, in 15 years they will have paid off their mortgage and have an investment-account balance of $572,449.
Fry’s recommendations
Best action: Refinance and invest more aggressively, because a 15-year fixed mortgage with a rate of 3.19% is much lower than the market’s expected rate of return.
Second-best action: Refinance and pay the mortgage aggressively. If the homeowner doesn’t agree with long-term investment-return estimates and would rather act more conservatively, they can pay off the mortgage and then invest and still come out OK.
Third-best action: Don’t refinance and pay the mortgage more aggressively. The homeowner will be debt-free 99 months sooner by putting an extra $24,000 a year toward the loan balance.
Worst action: Don’t refinance, don’t invest, and spend the extra cash instead. If the homeowner did not refinance and decided to spend the money, they would not have extra retirement savings, if that’s their goal.
Second-worst action: Don’t refinance, and still invest the extra cash. A 5.84% interest rate on the loan is higher than the market’s expected rate of return. If the homeowner is locked into a higher interest rate, it’s best to pay off the debt first.