By Henry Zupko, MBA, CFP®
There are many rules and best practices when it comes to finances, but the most commonly held belief among experts is that you should earn more than you spend. If you follow that practice and have worked hard for decades to budget and save, you will likely end up with more money each month than you need. So, the next question is, what do you do with that excess income?
One obvious answer is to set that money aside in a savings account and let it accrue interest. While that’s not a bad place to start, the return on your investment is very low, even with a high-yield savings account. Another alternative would be to put that money to work for you by either paying down your mortgage sooner or investing the extra income. Let’s look at these two options more closely so you can decide which one is right for you.
What Makes the Most Financial Sense?
When deciding between these two options, you first want to know which option can provide the greatest payoff. In this case, it’s your mortgage rate versus your expected investment return. You can calculate some rough estimates to evaluate which decision would make more financial sense.
Let’s consider an example. 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 make more sense to invest.
This may sound simple on paper, but there are many factors at play. It’s important to run a thorough analysis and factor in 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 calculations and do a complete analysis of your unique situation.
The Pros and Cons of Each Option
There are pros and cons to each that go beyond the raw math. Liquidity is one big pro for investing. You’ll have easier access to it 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.
However, 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 sooner during retirement. That way you can free up more of your money before other, perhaps unexpected, expenses start to build.
Another benefit of paying off your mortgage completely is decreasing your risk. Once you own your home free and clear, you won’t have to worry about foreclosure or having your credit damaged by missed mortgage payments. However, you still have to pay your taxes and homeowners insurance and carry some risk of having a lien placed against your property.
Choosing a Combination of the Two
For some people, it may make more sense to choose a combination of these two options. 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 needing private mortgage insurance and you can start investing, should you determine that is a more appropriate option for you.
How We Can Help
I hope this general overview of how the decision process works has helped make things more clear. Aside from what this article discussed, there are other things to consider before you decide on how to best use your extra income. At Tranquility Path Investment Advisors, our mission is to help guide pre-retirees and retirees through the distribution phase of life and make the process as simple and tranquil as possible.
To learn more about how we can help you calculate the best return on your money in your specific situation, schedule an introductory meeting online or reach us at (908) 759-6322.
About Henry
Henry Zupko is founder and president at Tranquility Path Investment Advisors, LLC, an independent Registered Investment Advisor firm dedicated to putting their clients first, always. With over 30 years of experience, Henry sets the direction of the firm, manages, and in many cases personally interacts with clients to help develop financial strategies that set them on a tranquil retirement path. He is passionate about being a trusted partner to his clients, developing long-lasting relationships so he can guide them through life’s milestones, twists, and turns. In all he does, Henry strives to make a positive impact on others and help change their lives for the better.
Henry is a CERTIFIED FINANCIAL PLANNER™ professional and holds an MBA from the University of Massachusetts and a bachelor’s degree in electrical engineering from the New Jersey Institute of Technology. Henry is a proud Eagle Scout who loves traveling the world and spoiling his grandchildren. To learn more about Henry, connect with him on LinkedIn.
