Prepaying a mortgage versus investing

In short

A friend of mine once asked me whether he should pay off his house early or put that money to work somewhere else. I told him the question was a good one, and that honest people disagree on it. If you are holding a mortgage and have a little extra each month, you are weighing a sure thing against an uncertain one. Every extra dollar sent to the lender earns the mortgage rate, and it earns it with no risk. Every dollar invested might earn more or might earn less, and nobody can promise which. Start by finding your loan's interest rate and any prepayment penalty in your note. Then check whether any employer match or tax advantaged space is going unused. Last, decide how much uncertainty you can sleep with.

The whole of it

What it is

I once watched a neighbor stand at his mailbox holding a mortgage statement, looking like a man reading a very long letter from an old rival. You may know the feeling. Prepaying a mortgage means sending the lender more than the required payment, and the extra goes straight to the loan balance. Investing means sending that same money somewhere else, such as a retirement account, in hopes it grows. Both are ways of using spare cash. Neither is shameful, and neither is a trick.

The two choices differ in what they promise. A prepayment gives a known result. The borrower stops paying interest on the dollars repaid, and that saving equals the loan rate. An investment gives an unknown result. It may beat the loan rate over the years, or it may fall short, and the path can be bumpy along the way. So the real question is not which one is smart. It is which kind of certainty you value more.

How it works

If you have ever paid a bill early just to feel lighter, you already understand the heart of this. A mortgage charges interest on the balance owed. When the borrower pays down the balance, the next month's interest is computed on a smaller number. That is why an extra payment keeps working long after you send it. The interest it removes can never come back.

Many mortgages are built so that early payments are mostly interest. Extra principal early on shortens the loan more than the same extra amount sent late in the term. Some loans also carry a prepayment penalty, a fee the lender may charge if the borrower pays ahead too fast. The note and the closing papers say whether one applies. Always ask the servicer to apply extra money to principal, because otherwise it may be held as an early regular payment.

Investing works on a different engine. Money placed in a fund or account may earn returns, and those returns may earn their own returns. Over many years that can build a large sum. But returns vary from year to year, and some years are losses. A mortgage rate is a fixed price you pay. An investment return is a guess you hope comes true.

Taxes tilt the scale too. Mortgage interest may be deductible for some borrowers who itemize, which lowers the true cost of the loan a bit. Investment gains may be taxed, though retirement accounts can delay or remove that tax. The Internal Revenue Service explains the mortgage interest rules in Publication 936, Home Mortgage Interest Deduction.

The numbers, and where to find yours

I have a habit of keeping the important papers in one drawer, and it saves me many a frantic search. Four numbers matter here. The first is your mortgage interest rate, found on your note and every monthly statement. The second is your remaining balance, also on the statement. The third is any prepayment penalty, found in the note itself. The fourth is the match your employer offers on a workplace retirement plan, which the plan's summary document explains.

Some figures are set each year by law, so they are not printed here. The most a person may put into a workplace plan this year is the current figure, which the official source publishes each year. The most for an IRA is the current figure, which the official source publishes each year. The site fills in the verified figure with its source and date. The Internal Revenue Service publishes these limits on its retirement plan pages, and the Consumer Financial Protection Bureau offers plain guides on mortgages at consumerfinance.gov.

A worked example

Let me tell you about a woman I will call Maria. She owes $200,000 on her mortgage at 6 percent. She has an extra $500 each month and wonders where to send it.

First she looks at the sure saving. Her loan charges 6 percent a year, so $200,000 at 6 percent is $12,000 of interest in the first year, if nothing were paid down. Each dollar she prepays saves 6 cents a year. Over one year, $6,000 of extra payments, which is $500 times 12 months, saves roughly $6,000 times 0.06, or about $360 in interest. It is a modest figure, and it is certain.

Now she looks at investing the same $6,000. Say, for the sake of a plain example, an account grew 7 percent that year. Then $6,000 times 0.07 is $420. That beats $360 by $60. But the account might grow 2 percent instead, and then $6,000 times 0.02 is $120, far short of $360. Or it might lose money. The $360 from the mortgage never wavered.

Maria also has a workplace plan that matches. Her salary is $52,000 and the employer matches 3 percent. Three percent of $52,000 is $1,560 a year. If she skips that match, she walks away from $1,560 of free money. A match like that is an instant gain no mortgage rate can touch. So she puts in enough to earn the full $1,560 first. Only then does she weigh the rest of her extra cash between the loan and other investing.

She decides to split. She sends the match first, then puts the remaining spare dollars toward the mortgage, because the certain 6 percent lets her sleep. Another person, with a 3 percent loan, might choose differently. Same arithmetic, different life.

Where it goes wrong

I made a mistake once that cost me a few weeks of worry, so I speak from the porch and not the pulpit. The first trap is comparing a guess to a certainty as though they were twins. A 7 percent hope is not a 6 percent promise. The second trap is emptying your cash to prepay. A paid down house cannot pay the electric bill. Money sent to a mortgage is hard to get back out, so keep a cushion in savings first.

A third trap is forgetting the penalty. Some loans charge a fee for paying ahead, and that fee can eat the whole saving. A fourth is skipping a free match. That one is the costliest mistake of the bunch. Free is free.

Then there is the habit of chasing a headline. A year when stocks soared tempts a person to believe it always goes so. It does not. And a year of losses can scare a person off a plan that was fine. Neither mood is a good adviser.

Last, remember that you may carry other debt. A credit card often costs far more than a mortgage. Paying that off may beat both choices. Look at all your balances, not just the biggest.

Questions to answer before you leave this page

What interest rate does your mortgage charge, and have you found it on your latest statement? Does your note include a prepayment penalty, and have you read the line that says so? Is there an employer match on your retirement plan, and are you collecting every dollar of it? Do you hold any debt that costs more than your mortgage, such as a credit card balance? How many months of expenses sit in savings, and would you feel safe if the roof leaked tomorrow? Which would bother you more, owing less but owning fewer investments, or owning more but owing more? And when you picture yourself ten years from now, what does the peaceful version look like?