Recently, I had an email exchange with a reader about whether or not they should overpay on their home mortgage or take that overpayment and invest it. I spent some time with Excel and and I made a few interesting discoveries. I don’t want to bury you in numbers, so I’m going to minimize them in this discussion; you can verify the information here pretty easily with Google Spreadsheet and Bankrate.com.
I work best with examples, so I started out with a 30 year home mortgage of $200,000 at 6.25%. I wanted to figure out which was the better deal: investing $300 a month or paying $300 a month extra on the home loan. I assumed that the borrower was in the 28% tax bracket, so I took the value of the tax deduction and invested it or paid towards the mortgage, depending on the goal. Let’s also say that when the pay ahead plan pays off the house, they begin investing the full payment the extra $300.
What did I find? It took an investment return of 5.92% to match that of the value of paying off the mortgage early. In other words, it is in fact true that a good investment can make you more money than paying off a home loan early.
There are, however, one big factor to consider. Investing that extra money instead of putting it into the mortgage introduces an extra level of risk. In essence, you’re taking a home loan and investing the money from it if you choose to invest ahead. You’re investing when you have a significant level of outstanding debt. Never forget that outstanding debt is a significant risk, particularly if you do not have emergency funds to pull you through. If you do not have investments already before you begin paying off the mortgage, the extra risk simply isn’t worth it; using your home as collateral so you can play the market is not a healthy situation.
In short, you might get ahead using a home loan to invest if you already have a significant emergency fund and other assets. If you’re in this situation, you’re likely already living fairly frugally, as you’re not stretching your funds to pay for your home as many Americans do, so you’re probably not interested in such a scheme anyway.
The key here is risk management, and your home is not something worth risking when you can just get a 5.92% return (or so) just by paying ahead.