Comparing the loan interest saved versus investment gains
The advantages and disadvantages of paying off a mortgage early vary based on the borrower’s financial situation, the interest rate of the loan, and how close the person is to retirement. One important aspect to think about is whether it’s better to use that money for investing instead. It’s worth considering the potential interest savings by paying off the mortgage ten years ahead of time compared to the potential returns earned from investing that money in the market.
How Paying off a Home Affects Your Finances
When you make mortgage payments, there are two parts: interest on the loan and a portion that goes towards reducing the total amount owed. For example, if your monthly payment is $1,500, around $500 will cover the interest, and the remaining $1,000 will reduce the principal balance.
The interest rates on your mortgage can be influenced by the economy and your creditworthiness. A schedule showing all your loan payments over a 30-year period is called an amortization schedule. During the initial years of a fixed-rate mortgage, most of the payment is applied to interest. However, as the years go by, a larger portion of the payment is allocated to reducing the principal.
Let’s consider an example: If you have a 30-year mortgage with a starting balance of $200,000 and a fixed interest rate of 3.5%, this is how the payments would work out.
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| Components of a Mortgage | ||||
|---|---|---|---|---|
| Payment Number | Monthly Payment | Principal | Interest | Loan Balance Remaining |
| 1 | $898.09 | $314.76 | $583.33 | $199,685.24 |
| 109 (10 years) | $898.09 | $431.10 | $499.99 | $159,679.65 |
| 229 (20 years) | $898.09 | $611.45 | $286.64 | $97,665.59 |
| 301 (25 years) | $898.09 | $754.10 | $143.99 | $48,613.86 |
| 360 (last payment) | $898.09 | $895.48 | $2.61 | 0.00 |
In the first ten years of a fixed monthly mortgage payment, a larger portion mainly covers the interest. However, as time goes on, the percentage of the payment allocated to interest versus the principal balance starts to reverse. For instance, after 20 years, more than $611 of the payment goes toward reducing the principal, while $286.64 is used to cover the interest. In the final monthly payment, almost all of it, except for $2.61, is applied to paying off the remaining principal balance.
The reason for this change in allocation is that the loan balance is higher during the early years of the mortgage and gradually becomes smaller in the later years. As a result, more interest is paid at the beginning when the outstanding loan amount is higher, and less interest is owed as the monthly payments make a significant dent in reducing the loan balance over time.
How much interest will you save?
Some homeowners choose to pay off their mortgages early, and the benefits can vary depending on their financial situation. For retirees, reducing or eliminating mortgage debts might be a priority since they are no longer earning income from employment.
Let’s consider a scenario where a borrower has received an inheritance of $120,000, and they have ten years left on their mortgage. The original mortgage was $200,000 with a fixed interest rate over 30 years. The table below shows the cost of paying off the loan ten years early and the amount of interest that could be saved based on three different loan rates: 3.5%, 4.5%, or 5.5%.
| Cost to Payoff Mortgage Ten Years Early and Interest Saved | |||
|---|---|---|---|
| 10 Year Balance Remaining | Interest Rate | Total Interest Cost for 30 Years | Interest Saved |
| $97,665 | 3.5% | $123,312 | $20,270 |
| $104,735 | 4.5% | $164,813 | $28,411 |
| $111,657 | 5.5% | $208,808 | $37,618 |
The higher the interest rate, the larger the amount remaining on the loan will be with ten years left on the mortgage.
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Save interest by paying off the loan
If you have a 30-year loan with a 3.5% interest rate, the total interest cost would be $123,312. If you decide to pay it off ten years early, you would save $20,270.
While saving over $20,000 in interest is significant, it’s essential to understand that this amount represents only 17% of the total interest cost for a 30-year loan. By the end of the first 20 years of the loan, $103,042 in interest has already been paid (calculated as $123,312 – $20,270), which accounts for 83% of the total interest paid over the life of the loan.
How Investing Affects Your Finances
You might want to think about whether investing some or all of your money in the financial markets is a better option. The returns you could earn from investing might exceed the interest you’d pay on the mortgage during the final ten years of the loan.
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When making this decision, it’s important to consider the concept of “opportunity cost,” which means the potential interest you would forego by not investing in the market. However, evaluating an investment involves several factors, including the expected return and the associated risk.
In the table below, you can see how much money could be earned on a $100,000 investment over ten years at four average rates of return: 2%, 5%, 7%, and 10%.
| How Much $100,000 Can Potentially Earn in Ten Years | |||
|---|---|---|---|
| Invested Amount | Years | Rate of Return | Investment Gain |
| $100,000 | 10 | 2% | $22,019 |
| $100,000 | 10 | 5% | $62,889 |
| $100,000 | 10 | 7% | $96,715 |
| $100,000 | 10 | 10% | $159,374 |
These investment gains were compounded. Interest was earned on the interest and no money was withdrawn during the ten-year period.
Investment Gains vs. Loan Interest Saved
If a homeowner decides to invest $100,000 rather than using the money to pay down their mortgage in ten years with an average rate of return of 2%, they would earn $22,019. Comparing this to the earlier loan table where $20,270 was saved in interest from paying off the mortgage early at 3.5%, the difference would not be substantial.
However, if the average rate of return for the ten years is 5%, the homeowner would earn $62,889. This amount is higher than the interest saved in all three earlier loan scenarios, regardless of the loan rates being 3.5% ($20,270), 4.5% ($28,411), or 5.5% ($37,618). In this case, investing the money could result in higher earnings compared to paying off the mortgage early.
Indeed, repaying the mortgage instead of investing the money offers multiple advantages to the borrower. First, it saves the borrower from paying the interest that would have accrued on the mortgage, which can be a significant amount over time. Additionally, by paying off the mortgage, the borrower is no longer obligated to make monthly repayments, which frees up that money. This extra money can then be invested elsewhere, potentially with the same rate of return as the investment option, providing an opportunity for further financial growth. By repaying the mortgage, the borrower not only saves on interest but also gains the potential to utilize the funds for additional investments, increasing their overall financial flexibility and potential returns.
Different investments come with different risks
Different types of investments carry varying levels of risk. U.S. Treasury bonds are considered low-risk because they are backed by the U.S. government, ensuring repayment if held until their maturity date.
On the other hand, equities or stocks involve higher risk due to price fluctuations, known as volatility, which can result in losses.
If you decide to invest your money in the market rather than paying off your mortgage early, there’s a risk that you may lose some or all of your investment. In such a case, you would still need to make the remaining loan payments, even with the investment losses.
While the stock market can yield significant returns, it also carries the potential for substantial losses. Higher risk can amplify gains, but it can also lead to larger losses, making market risk a double-edged sword.
Achieving a 10% investment gain can be challenging, especially after considering factors like fees, taxes, and inflation. It’s essential for investors to have realistic expectations about their potential earnings in the market.
Frequently Asked Questions
What is compounding interest?
Interest “compounds” when it keeps earning more interest. Let’s say you invest $100, and it earns you $5 in interest over a period of time. If you leave that investment as it is, you’ll be paid interest on the new total of $105 because of compounding. This means that the interest you earn can also earn more interest, which can lead to larger investment gains over time.
How does the tax deduction for mortgage interest work?
The interest you pay on a mortgage loan of up to $750,000 is eligible for tax deduction on your federal return, but there are specific rules you must follow. If you are married and file a separate tax return, the limit for tax-deductible mortgage interest drops to $375,000.
To claim this tax deduction, the loan proceeds must be used to purchase or build your main home or a second home. Additionally, you must itemize your deductions on your tax return. However, it’s important to note that itemizing may not always be the best option for taxpayers.
What are some options other than paying off my mortgage or investing?
You might want to establish the security of an emergency fund to hedge against an ailing economy and to pay your mortgage should you experience financial distress. You might want to save for retirement instead, although this involves investing, too,
The Bottom Line
Before making the decision to pay off a mortgage loan early, it’s crucial to consider several factors: the interest rate, the remaining balance on the loan, and the potential interest savings. Borrowers can use a mortgage loan calculator to review the loan’s amortization schedule and better understand these aspects.
Furthermore, it’s essential to be aware that mortgage interest is tax deductible for many homeowners. When you pay interest on your mortgage, it can reduce your taxable income at the end of the year, which may have implications on your overall tax liability.
To make a well-informed choice, it’s advisable to seek advice from both a financial planner and a tax advisor. These professionals can help analyze your individual financial situation, goals, and tax implications, providing personalized guidance to assist you in making the best decision for your circumstances.
