Should you prepay a mortgage or invest extra money?

If you have a large debt, such as a mortgage, you may be unsure about the best use of any extra cash, like a windfall, bonus or raise. On the one hand, prepaying your home loan ahead of schedule allows you to whittle down the principal balance faster. On the other hand, investing extra money may allow you to grow your retirement or brokerage account faster.

With limited financial resources, knowing the pros and cons of different financial decisions is essential. This article will help you prioritize your money moves and build wealth faster.

Financial questions to ask yourself

Since everyone’s financial situation is different, it helps to ask yourself the following questions before making significant money decisions.

• Do I have enough emergency savings? Before sending extra money to your mortgage or investments, be prepared for an unexpected financial hardship. For example, would your cash reserve cover your expenses if you lost your job or business income? If not, use your extra cash to build a financial safety net to make dealing with an emergency easier.

How much emergency money you need depends on your income, expenses, debt payments and goals. However, a good rule of thumb is to keep at least three months of living expenses on hand. For instance, if you spend $4,000 monthly on essentials, you might maintain a $12,000 balance in an FDIC-insured high-interest savings account.

• Do I have the right insurance? Having various insurance policies, such as health, life, disability, auto and homeowners or renters policies, is another essential way to prepare for potential risks. If you’re uninsured or underinsured, an accident, illness or natural disaster could jeopardize your financial future. Review your insurance and fill any coverage gaps with your extra cash before prepaying a mortgage or investing.
• Do I regularly invest for retirement? Finder’s Consumer Confidence Index found that about 24% of survey respondents say they’re underprepared for retirement, and 12% say they’ll never be able to retire. A good rule of thumb is to invest a minimum of 10% to 15% of your gross income for retirement. So, it’s not wise to prepay a mortgage until you regularly invest some amount in a workplace 401(k) retirement plan, individual retirement account (IRA) or an account for the self-employed.

Should You Prepay a Mortgage or Invest Extra Money?

If you’re financially prepared for the unexpected and regularly investing for retirement, you can make the most of extra money by prepaying your debt or investing more.

First, list your debts, including your creditor, outstanding balance and interest rate. Then, sort the list by highest to lowest interest rate. In general, that’s how you should pay down debt.

For instance, if you have a credit card balance at 22% APR, a car loan at 10% APR and a mortgage at 6% APR, paying down the card first saves you the most interest on a percentage basis. Paying off debt gives you a straightforward, guaranteed return.

However, there’s less benefit to prepaying lower-rate debt, such as a 6% mortgage with tax-deductible interest, which makes it cost even less if you claim the deduction. Prepaying low-rate and tax-deductible debts — such as mortgages, home equity lines of credit (HELOCs) and student loans — should typically be your last priority because you could invest for higher returns instead.

The trick to knowing whether to prepay debt or invest is carefully considering which option will likely give you the highest long-term return.

When to invest extra money instead of prepaying debt

If you have the following types of debt, you typically come out ahead by investing extra money instead of prepaying them:

• Debts with low interest rates.
• Debts with potential tax deductions, making them less expensive on an after-tax basis.
• Debts securing assets you believe will appreciate, such as a home or business loan.

Paying down a mortgage early

But what does paying back a mortgage early look like? Let’s say you take out a $500,000 mortgage at 5% for 30 years with 10% down ($50,000). Over the life of that term, you’re looking at $869,641 in total payments.

Now, if you choose to start with an additional extra payment of $500 and an additional loan payment of $100 a month, not only will you shave two years and seven months off your repayment schedule, you’ll save $43,585 in interest payments.

Graphic source
While saving $43,585 in interest payments is nothing to sneeze at, if you invested the additional payments of $33,300 into the S&P 500, which averages a return of 10% a year, that $33,000 could potentially turn into roughly $158,568 over the same period. Graphic source

When to use extra money to prepay debt instead of investing

If you have debt with double-digit interest rates, such as credit cards or high-rate loans, your best financial move is to pay them off early and save the interest expense. Just be sure you keep enough emergency money in the bank.

And if you’re still conflicted about a debt-versus-investing issue, you can always do both. For instance, you could invest half your extra money and use half to repay debt.

About the author

Laura Adams is a money expert and spokesperson for Finder. She’s one of the nation’s leading personal finance and business authorities. As an award-winning author and host of the top-rated Money Girl podcast since 2008, millions of readers, listeners and loyal fans benefit from her practical advice. Laura is a trusted source for media and has been featured on most major news outlets, including ABC, Bloomberg, CBS, Consumer Reports, Forbes, Fortune, FOX, Money, MSN, NBC, NPR, NY Times, USA Today, US News, Wall Street Journal, Washington Post and more. She received an MBA from the University of Florida and lives in Vero Beach, Florida. Her mission is to empower consumers to live healthy and rich lives by making the most of what they have, planning for the future and making smart money decisions every day.

This article originally appeared on Finder.com and was syndicated by MediaFeed.org.