When you buy a house, the resulting mortgage can feel like a weight on you - mentally and financially. If you end up with a surplus of cash, you may wonder if it’s better to pay off your mortgage or invest the money in the stock market. 
This is a common question in personal finance circles. Some people believe paying off your mortgage is a good investment, while others think putting your money in the market is a better option.
Who is right? The answer is complicated. No two people face the same financial situation. What is right for one person may be the wrong move for someone else. Let’s talk about when it makes sense to prepay your mortgage and when it makes sense to invest.
What to Do Before Paying Off Your Mortgage or Investing
Before going into paying off your mortgage vs. investing, let’s talk about when neither of those is a good option. Sometimes, if you have extra cash, there are better ways to spend it. Here are some scenarios that may be a better option.
Consult with a financial advisor
When you find yourself with extra cash - be it from an inheritance or an insurance payout - it may be tempting to spend it. Use it the right way and you can reap the benefits for years to come. Spend it heedlessly and you won’t know where it went.
Financial advice on the Internet is generic and doesn’t take into account your individual situation. What works for some people may be the wrong move for you. That’s why it’s best to talk to a trusted financial advisor who can take full stock of your finances.
A financial advisor can look at the full financial picture and make recommendations that fit your individual needs. Whether that’s paying off your mortgage, investing for the future or something else, it will help move you closer to achieving your financial goals.
Build an emergency fund
If you don’t have an emergency fund, this should be the first order of business if you find yourself with extra cash. An emergency fund serves as a cushion between you and financial calamity.
When you don’t have savings to cover unexpected expenses, you end up putting extra expenses on credit cards or scrambling to cover your bills. Having an emergency fund will help you pay for an unexpected car repair or a new water heater when the old one busts.
Aim for three to six months of living expenses to cover you when Murphy comes knocking on your door. If you dip into your fund to pay for something, make sure you build it back up to its previous level.
Pay off high-interest debt first
When you have high-interest debt, this should be your priority for any extra cash. Interest can add up, increasing your loan balance, and extending the time to repay the total amount.
Any extra money you can put toward paying off the loan will take months if not years off the repayment timeline. Most mortgages are low-interest debt, hovering around 4 to 5 percent. If you have higher interest debt (some credit cards can go up to 30 percent or higher), focus on paying that off first.
Once you have your high-interest debt under control, you can look at investing or paying down your mortgage if you still have extra cash. Make sure you also have an emergency fun in place to prevent you from taking on more debt.
Get employee retirement match
If you have a healthy emergency fund in place and no high-interest debt, the next order of business is looking at your retirement contributions.
Does your employer offer a match on contributions to their retirement plan? If so, make sure you’re contributing enough from every paycheck to get the full amount. This is free money that you can use to grow your retirement stash.
For example, if your employer matches dollar for dollar the first six percent of salary that you contribute to your retirement account, make sure you’re putting at least 6 percent of your salary away. This means you’re getting 12 percent of your pay added to your retirement account for half the price. You can’t get a better deal than that!
Should You Pay Off Your Mortgage or Invest?
You have a healthy emergency fund, you’ve paid off your debt, and are getting your full employer match. If you still have extra money you’re looking to use in the best way, you may consider paying off your mortgage or investing.
Which one is better for you? Let’s look at the pros and cons of prepaying your mortgage vs. investing in the stock market.
Pros of paying off your mortgage
Sometimes, it makes sense to pay off your mortgage. Here are some reasons prepaying the debt may be the right move:
- Peace of mind - One of the main reasons people like paying off their mortgage is peace of mind. It means that you own your home outright and no one can take it away if you can’t make your mortgage payments. It may make you feel more secure knowing that your home is yours no matter what.
- Save on interest - If you prepay your home loan, you will save a large chunk of cash on interest. For example, if you take out a 30-year mortgage for $350,000, you will pay $1,773.40 per month at an interest rate of 4.5 percent. If you increase your monthly payment by $1,000, you will shave off 15 years and 8 months from the loan repayment and save $163,451 in interest.
- Guaranteed ROI - Prepaying your mortgage gives you guaranteed return on your investment. If your interest rate is at 4.5 percent, you get at least that much as a return on extra money you put toward the loan.
- Eliminate PMI - If you put down less than 20 percent as a down payment, you may have private mortgage insurance (PMI). This is the bank’s way to ensure that they get their money back if your home is foreclosed and they’re forced to sell for less than you owe them. You can ask your lender to eliminate PMI if you pay down your loan balance to 80 percent or less of the value of your time.
- Reduce cost of living - If you want to reduce your cost of living and live debt free, eliminating your mortgage payment will lower your monthly outlay.
Cons of paying off your mortgage
Even if prepaying your mortgage is an attractive idea, it may not be the best use for your extra cash. It’s important to evaluate both the upsides and downsides of such a decision. Here are some reasons prepayment may not be a good idea:
- Lack of diversification - When you put all of your extra money toward paying off your mortgage, it means you will be heavily invested in real estate. A steep decline in the value of your time can have a negative impact on your net worth.
- Low interest rate - A mortgage loan is one of the cheapest types of debt. This means your return on investment will be much lower than if you invested the money in an index fund.
- Opportunity cost - Every dollar you put toward your mortgage is money that isn’t spent on something that will give you a better return. This may be paying down high interest debt, investing in the stock market or getting an employer match.
- Inflation reduces savings - Inflation rates hover around 2-3 percent annually. Coupled with low mortgage interest rates, this further devalues the value of prepaying your mortgage. Inflation eats away at the value of your mortgage, so it costs less.
- Still owe taxes - It may be exciting to think you will no longer have a mortgage payment on your home. However, keep in mind that you will still owe taxes and home insurance, which were lumped in with your mortgage payment.
- Reduces liquidity - Once you put the money in your home by paying off your mortgage, it may be difficult to get it out if you need to use it. Selling a home can take time, especially in a down market. Think twice before tying up all of your extra cash.
Pros of investing
Instead of prepaying your mortgage, you may consider investing in the stock market. Here are some reasons this may work for you:
- Diversification - Putting your money in the stock market gives you the opportunity to diversify your investments. You can build a portfolio of stocks and bonds and focus on index fund that follow the S&P 500 or the entire stock market. This gives you added exposure to different asset classes besides real estate.
- Better ROI - Mortgage rates have traditionally been lower than the return on investment from putting your money in the stock market. Currently, mortgage rates are hovering around 4 to 5 percent. As a contrast, the S&P 500 has averaged out to 10 percent annual return when you factor in dividends. You will get much better return on investment by putting your money in an index fund following the S&P 500 than prepaying your home loan.
- Inflation adjustment - When you invest in the stock market, your money grows along with inflation. If you park your money in a safe investment, it may not earn enough to even cover inflation, eroding the value of your money.
- More aggressive - Investing in the stock market is a good option for aggressive investors looking for a good return on their money. They risk their capital but hope to be rewarded with higher payouts over the long term.
Cons of investing
If you’re considering investing in the stock market, it’s important to understand the potential downsides to such a move. Here are several reasons this may be a bad idea:
- Can be risky - While the stock market has had positive returns there is no guarantee that this will continue to be the case. Historical returns are no sign of future market performance, just a guideline for what we may expect. There is nothing to say that the market may perform worse starting today and give you a lower ROI on any money you invest.
- Need to stay the course - When it comes to getting a good return on investing, we are own worst enemies. It difficult to watch your investments plummet with the next market crash. In fact, many people sell when the market takes a nosedive and end up losing money. If you want to make money in the stock market, you need to let it ride out the ups and downs and continue adding to your balance.
- No guaranteed return - There is no guarantee that the market will continue to go up and you will make money on your investment. There may be a big stock crash around the corner, or another recession and your investments can plummet in value. If you invest in the market, be ok with the potential ups and downs and understand that there is no guarantee that you will make money.
- Tax implications - Currently, the tax law favors investment income but that may not always be the case. As the tax regulations change, new laws could make it more expensive to invest.
The Bottom Line
There is no clear winner between paying off your mortgage or investing. Yes, stock market earnings have outperformed the ROI from prepaying your mortgage, but this strategy requires staying the course.
For many people, the peace of mind of owning their home outright far outweighs the money they can make in the stock market. In addition, investing in stocks for the long-term means weathering the ups and downs of the market.
Which direction you choose depends on your individual situation, risk tolerance and long-term goals.
This is a post from Clint Haynes, a Certified Financial Planner® and Financial Advisor in Kansas City, Missouri. He is also the founder and owner of NextGen Wealth. You can learn more about Clint at the website NextGen Wealth.