Is it better to make extra payments to pay off your mortgage faster or to invest that extra money and just make regular mortgage payments? This is a debate that many of our clients have with themselves, so we are here to make sure you have the necessary information to make this decision.
Your mortgage is most often the largest loan you will take out in your lifetime. Many people hate being in debt, and their mortgage hangs over their head like a stormy rain cloud. Ridding yourself of this debt is an uplifting emotional feeling that you no longer owe anyone anything on your home! This makes sense: if being debt free is very important to you and you can get there sooner, why not make extra payments and save some money on loan interest?
According to the mortgage giant Freddie Mac, the average rate on a 30-year fixed-rate mortgage rose to 3.85% this week (Week of May 11, 2015). Warren Buffet, famed investor, said in a Bloomberg article earlier this month that he believes investors should expect a 6-7% return over time. Would you give up the opportunity to earn 6 or 7% versus making extra payments to prevent having to pay 4% interest (astute investors shake your head “no”)? This difference in interest rates, 3.85% versus 6.5%, is considered your spread. The larger the spread or the larger you expect the spread to be, the more beneficial it can be to invest versus making extra mortgage payments. Therefore, in order to determine if this is a beneficial strategy you must look at your current mortgage rate versus what you can hope to gain through an investment and how much risk that investment exposes you to. Risk is an important factor here, but remember this is a long term strategy and the risk should be measured as such, not on a 6 month or 1 year outlook.
Another thing to consider is cash flow. Say you make extra mortgage payment each year and build up a large amount of equity in your house. If something comes up and you need to get to that money then you have to take a home equity loan and it can essentially turn into a giant expensive ATM. However, if you were to invest this extra cash in something more liquid, you would be able to more easily access your money if you needed it.
Finally, there is the topic of inflation. With the Fed dumping liquidity into the markets over the past 7 years there are many people concerned about inflation. On the flip side, in this environment, most debt payments should be a fixed dollar amount. Thus, in real dollars, depending on inflation, it may cost you more to pay off your debt today.
When it comes down to it, this is usually a debate of finance versus psychology or math versus mind. However you want to say it, there is no wrong answer. If you can’t sleep at night because you hate debt and want it paid off immediately, then consider paying it off. If you want to use sound financial strategy to try to increase your net worth over time, then investing that extra cash may be for you.
Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through Level Four Advisory Services, a registered investment advisor. Level Four Advisory Services and Virtus Wealth Management are separate entities from LPL Financial.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for an individual. Investing involves risk including loss of principal. There is no assurance that the techniques and strategies discussed are suitable for all individuals or will yield positive outcomes.