Some people get this wacky idea to pay down their mortgage faster than their original schedule of payments. This is a bad plan in many cases! Why?
Let’s assume some variables first:
In this example you’ve made 2 years of payments on your mortgage and you realize that you have an extra $500 each month accumulating in your checking account. You know that you need to do something smart with it, and you want to decide between $500 going to your mortgage or $500 going to your investment account. Let’s see how you fare 28 years from now when the loan is scheduled to mature.
With the extra $500 in monthly payments you pay off your loan in 20.5 years instead of 28 years. For those final 7.5 years you can invest that $500 PLUS $2,108.02 each month that no longer has to go to your mortgage. At the end of 28 years you have accumulated $295,517 in your investment account and you’ve saved $66,666 on lifetime interest payments. Pretty great, right? Yes, but you are missing out on a lot more!
Instead, let’s say you stick to your original mortgage payment and invest $500 each month for the next 28 years. At the end of 28 years your mortgage is still paid off, except now you have $434,314 in your investment account! That’s a difference of $138,797, much more than the $66,666 in interest payment savings! So, how did this happen?
The difference comes from the differential in interest rates. You pay 3% on your mortgage, but you earn 6% on your investment account. The differential between 6% and 3% is what creates the extra value. If you earned 7% instead of 6% the difference would be greater or if you only earned 5% the difference would be less. Pretty simple.
The only downside is if your investment return ends up being less than your mortgage rate plus the interest savings. In this example it is about 4.7%, and is different depending on your mortgage interest rate. Over a 28-year period, however, this result is highly unlikely if you are investing in the stock market. Since 1928, The S&P 500 has had never had a rolling 28-year return less than 7.5%
Hopefully this has convinced you to invest rather than pay down your mortgage early. And remember, this example is for investing in the publicly-traded financial markets. You can probably find a better return in your solopreneur business!