|How Much $100,000 Can Potentially Earn in 10 Years|
|Invested Amount||Years||Rate of Return||Investment Gain|
The above investment gains were compounded, meaning interest was earned on the interest and no money was withdrawn during the ten-year period.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 decided to invest $100,000 versus paying down their mortgage in 10 years, they would earn $22,019 based on an average rate of return of 2%. In other words, there would be no material difference between investing the money versus paying off the 3.5% mortgage (based on the $20,270 saved in interest from the earlier loan table).
However, if the average rate of return was 5% for the 10 years, the homeowner would earn $62,889, which is more money than the interest saved in all three of the earlier loan scenarios, whether the loan rate was 3.5% ($20,270), 4.5% ($28,411), or 5.5% ($37,618).
With a 10-year rate of return of 7% or 10%, the borrower would earn more than double the interest saved from paying the loan off early even with using the 5.5% loan rate.
The Power of Compounding
One of the reasons for such a difference between the investment gains and the interest saved from paying the loan off early is the power of compounding. If the $100,000 investment is not withdrawn during the ten years, the interest earned each year is reinvested, leading to interest being earned on interest, which can magnify the investment gains.
Before investing money in the market, it’s important for investors to determine their level of risk tolerance, which is the amount of money they’re willing to risk in order to make an investment gain.
Risks of Different Investments
There are various types of investments to choose from, and each has its own risk associated with them. For example, U.S. Treasury bonds would be considered low-risk investments since they’re guaranteed by the U.S. government if held until their expiration date or maturity.
Going back to our example, if the homeowner decides to invest their money in the market instead of paying off the mortgage ten years early, there’s a risk that some or all of that money could be lost. As a result, if the investment loses money, the homeowner would still need to make ten years’ worth of loan payments.
Determining Risk Tolerance
A person’s level of risk tolerance is often determined by their age, the amount of time remaining until the money is needed, and their financial goals. For example, retirees might be risk-averse since they’re not earning employment income any longer.
Conversely, younger people in their 20s or 30s have a longer time horizon, which means their portfolio has more time to recoup market losses. As a result, a younger person can invest a greater share of their portfolio in higher-risk investments such as equities.
The Market’s Double-Edged Sword
Although the stock market can provide sizable returns, there’s also a risk for sizable losses. In other words, just as taking on more risk can magnify investment gains, it can also lead to more losses, meaning market risk is a double-edged sword.
In our earlier example showing the various potential returns, a 10% investment gain is not an easy goal to achieve. As a result, investors should have realistic expectations as to what they can earn in the market.
Before deciding to pay off a loan early, it’s important to consider the interest rate, the remaining balance, and how much interest will be saved. Borrowers can use a mortgage loan calculator to analyze the amortization schedule for their loan.
Also, how that money could be used versus paying off the mortgage should be considered. For example, some of that money could be used to establish an emergency fund, save for retirement, or pay off credit card debt with a higher interest rate.
It’s also important to consider that mortgage interest is tax-deductible for many homeowners, meaning the interest paid reduces your taxable income at the end of the year. Before deciding whether to pay off your mortgage early or invest that money, a financial planner and tax advisor should be consulted.
What the Experts Have to Say:
Mark Struthers, CFA, CFP®
Sona Financial, LLC, Minneapolis, MN
A lot depends on the nature of the mortgage and your other assets. If it is expensive debt (that is, with a high-interest rate) and you already have some liquid assets, like an emergency fund, then pay it off. If it is cheap debt (a low-interest rate), and you have a good history of staying within a budget, then maintaining the mortgage and investing might be an option.
Some people’s instinct is to get all debt off their plate, but you want to make sure you always have ready funds on hand to ride out a financial storm. So the best course is usually somewhere in between: If you need some liquidity or cash, then pay off a large chunk of the debt, and keep the rest for emergencies and investments. Just make sure you take an honest look at what you will spend and your risks.