Should I invest or pay off my mortgage?

If you find yourself in a situation where you have extra liquidity at the end of the month, it is not always clear what you should do with that money. You may be asking yourself, is it better to pay off mortgage or invest the money through my investment account?

How a Mortgage Loan Works

Should I pay off mortgage or invest? First off, some clarity: in the long term investing in a mortgage is another way of long term investing that can yield a high return if you decide to sell the house. What exactly is a mortgage? A mortgage is a loan given to a borrower to help them acquire a home or other property. The borrower signs the loan documents and consents to pay the mortgage lender in regular installments until the loan is repaid after all legal documents are signed during the mortgage closing. The typical loan term is 15 to 30 years. The financial institution then reimburses the seller for the full purchase price of the house and charges the borrower interest on the remaining loan balance.

Mortgage payments consist of two parts: interest on the loan and principal, which is used to reduce the total amount owed. A $1,000 monthly payment, for instance, would have $300 allocated to interest and $700 applied to the principle loan debt. Mortgage loan interest rates can change based on the economy’s interest rate environment, as we saw in 2022,  and the borrower’s creditworthiness.

A fixed-rate mortgage loan’s initial payments are primarily made up of interest. Later on, the principal is reduced with a bigger percentage of the loan payment. Due to the loan balance fluctuating over time—higher in the early years and lower in the later years—the share of the payment that goes toward principle and interest fluctuates. This makes sense because the interest rate is higher in the beginning when the loan sum is higher.

A lesser percentage of each payment is allocated to interest and more goes toward the principal as the principal balance of the loan is finally reduced by the monthly installments.

Pay Off Your Mortgage Early Vs. Investing

Should I pay off my mortgage or invest? When you ask any financial advisor what the better move of the two is for your financial planning, in most situations they will tell you overpaying mortgage vs investing is better. But why?

Reasons to Pay Your Mortgage Early vs. Invest

Is it better to pay off mortgage or invest? Just like with renting vs buying, in most cases, it makes more sense to buy and pay off your debts, especially high-interest debts like credit card bills or mortgages rather than re-investing extra liquidity into the market.

Prioritise debt

Debt should be your first priority; it can often be difficult to guarantee that investment returns will match the interest rate on your debt. Interest rates are currently low so it makes sense to take advantage of this and clear as much debt as possible.

If you wanted to invest the spare cash then the interest rate needs to at least match the interest paid on your mortgage. It would need to match that interest rate after all charges have been taken into consideration. That would include management fees, platform fees, exit fees, fund costs and taxes and the other charges many other providers will charge investors.

Focus on cost

These costs eat in to your investment returns and cost is the only part of an investment you can truly control. So is it better to pay off mortgage or save? If you do decide to invest, ensure you take advantage of the tax relief available to you. The Individual Savings Account (ISA) is one of the best wrappers available to you as it is incredibly tax efficient and flexible.Stocks and Shares ISAs let you combine the tax efficiency of the ISAs with market investing. When investing whilst holding debt it is important that you can access funds quickly and respond to changes in interest rates. Some tax efficient accounts will charge you a penalty for exiting early, this is not the case with the ISA.

Watch Henry Black, Head of Investment Consultants, explain the ISA

The same can be said of investment providers or even savings providers. On the market there are fixed-term savings accounts, withdrawal fees, early withdrawal penalties and quick withdrawal fees. Each of these costs negatively impact your real returns and could limit your chances of beating your mortgage rate.

Benefits of Paying Off Your Mortgage Early

Reducing the amount of interest you will have to pay in the future is one of the key advantages of paying off a mortgage. The amount of interest you pay increases with the length of the mortgage. In particular, if your home loan had a high interest rate when you took out your mortgage, paying off your mortgage early could result in significant savings due to the additional cost of interest.

Drawbacks of Paying Off Your Mortgage Early

An effective way to increase monthly cash flow and pay less interest is to pay down mortgage early. However, you won’t be able to deduct your mortgage interest from your taxes, and investing would likely bring in a higher return.

Another potential drawback of paying off your mortgage early are the prepayment penalties on mortgages. If you sell, refinance, or pay off your mortgage within a set period of time after closing on your initial mortgage — typically three to five years — you may be charged a mortgage prepayment penalty by the lender. If you’re waiting longer than five years to pay off your mortgage, you probably don’t need to worry about this fee because not all lenders impose it. However, you must always consult your lender first.

Comparing the Loan Interest Saved versus Investment Gains

As a general guideline, you should prioritize paying off debt with higher interest rates before debt with lower interest rates. A credit card or private student loan may have a higher interest rate than your mortgage, so paying those off sooner might be more advantageous.

But be careful not to make mortgage payments fall behind your higher-interest debt payments. Yes, credit cards can be pricey, and if you don’t make your payments on time, the card issuer might sue you. However, skipping a mortgage payment can be more worse because you run the danger of losing your house.

Consider your financial goals

Investors should also consider their goals with this spare cash; is it to save up to buy another house in the future, pay for a future holiday, or is it something longer term? Depending on when you need the money should help shape how much risk you are prepared to take. The longer you plan to invest the higher the risk you can take. With risk comes the opportunity for greater returns but also the chance for greater losses. You can consider investing in property as a way of generating additional income with less risk. Alternative property investments or UK REIT ETFs can be a good option in that regard.

Assess your risk appetite with Moneyfarm

Individuals need to ensure they get the advice they need. Digital wealth managers, like Moneyfarm, help you to understand your investor profile based on your attitude to risk, knowledge of financial instruments and personal circumstances. Based on your investor profile you are assigned an investment portfolio and historic returns can be seen for each of these.

Your mortgage should not stop you from saving, many individuals have these throughout their working lives. Investing regularly can be a good way to grow wealth over time and doing this in a flexible account such as the ISA allows for life changes. Ultimately the decision to invest or pay off your mortgage depends on how comfortable you are holding debt and your appetite for risk.

FAQs

What are prepayment penalties?

Some lenders charge a fee known as a prepayment penalty if you pay off all or a portion of your mortgage early. You would have agreed to this when you closed on your home if there was a prepayment penalty. Prepayment penalties are not present in all mortgages.

How does a mortgage work?

Mortgage payments consist of two parts: interest on the loan and principal, which is used to reduce the total amount owed.

What is an ISA?

ISA stands for Individual Savings Account, a savings account that you can send tax-free interest payments to, the main distinction between it and other types of savings accounts.