What is the number one rule of personal finance? Spend less than you earn. If you have worked hard for decades, followed a budget, and adhered to this rule, you may find yourself in the enviable position of earning more money each month than you need to cover your expenses. While you aren’t going to complain about the extra cash, you will need to decide what to do with it.
The most important factor when evaluating your options is that of growth. You don’t want to leave the additional funds sitting in a savings or checking account where you’re earning less than a percent of interest. Instead, you want your money to work for you. People usually end up doing one of two things with excess cash flow: pay down their mortgage or invest. Because both options make financial sense, it can be a difficult decision for people to make. Let’s look at the pros and cons of each strategy.
Which Will Give Me The Most Growth?
When deciding between these two choices, you want to figure out which option will give you the greatest payoff. In this case, you’ll find the answer by pitting your mortgage interest rate against your expected investment return. You can calculate some rough numbers to assess which decision would make more financial sense.
Let’s take a look at an example to give you some context. Say your mortgage interest rate is 5%. If you estimate that, based on your risk tolerance and time horizon, you can expect an investment return of 4%, it would make more sense to pay down your mortgage. Otherwise, you’re potentially throwing away 1%. However, if you are an aggressive investor and believe you could earn 8% on your investment, it would be more beneficial to invest.
This may sound simple on paper, but there are a lot of factors that could affect the outcome. And as we all know, even the best estimates aren’t guaranteed. It’s important to run a thorough analysis and consider taxes on investments, mortgage interest deductions, risk, and private mortgage insurance, among other elements of your financial life. An experienced financial advisor can run all of the numbers and conduct a complete analysis of your unique situation.
The Pros and Cons
There are some pros and cons to each choice that go beyond the raw math. Liquidity is a significant pro for investing. You’ll have greater access to the funds in case of an emergency. However, if you put the money towards your mortgage, it’s gone, for all intents and purposes. The only way to get the money back out is to sell your house or refinance your mortgage.
On the other hand, an advantage of paying down your mortgage is that your house will be paid off sooner. You will have a greater chance of being able to enter retirement without a mortgage, or at least have your mortgage paid off earlier in retirement. That way you can free up more of your money before your medical expenses start to build. If you invest, your mortgage will be another bill you have to pay while in retirement.
Another benefit of paying off your mortgage completely is decreasing your risk. Once you own your home free and clear, you never have to worry about a foreclosure or having your credit damaged by missed mortgage payments. However, you still have to pay your taxes and carry some risk of having a lien placed against your property.
Combining Options
For some people, it may make more sense to choose a combination of these two choices. For example, if you have less than 20% equity in your property, you may be required to pay private mortgage insurance, meaning you owe additional premiums on top of your mortgage principal and interest payments.
In this case, even if your mortgage rate is 5% and you can earn 6% on an investment, you may still earn a higher return on your money by paying down your mortgage. Once you pay it down to at least 80%, you free yourself of the need for private mortgage insurance and you can start investing, should you determine that is the ideal option for you.
What’s Right For You?
There are several factors to take into consideration when choosing whether to use your excess money to pay down your mortgage or increase your investing. No one strategy fits everyone, but at Grace Wealth Management, our goal is to provide a custom-tailored financial roadmap to help you reach your goals. To learn more about how we can help you calculate the best return on your money in your specific situation, contact me by phone at (949) 631-3840 or email at jpeters@cfiemail.com for a free initial consultation.
About Jim Peters
Jim Peters is an independent financial advisor and the founder of Grace Wealth Management Group, Inc., a full-service financial firm committed to helping people pursue their financial goals. With more than 24 years of experience in the industry, Jim combines his extensive knowledge with his genuine interest in helping people pursue financial independence. Beyond his experience, he is certified as both a Chartered Life Underwriter® (CLU®) and Chartered Financial Consultant® (ChFC®), meaning he has advanced training and knowledge in financial planning and insurance. Based in Irvine, California, Jim specializes in working with individuals, families, and businesses throughout Orange County. To learn more, connect with Jim onLinkedIn or visitwww.financialadvisorirvine.com.