Should we pay down the mortgage or invest?

What do you do when you’re gifted an unexpected inheritance or find yourself with some extra cash? Should you use the extra cash to pay down your mortgage or should you invest it instead? There is no universal 'right' answer, but there’s probably one that’s right for you and your family.

Let’s step through how to think about this (nice-to-have) question. 

Some experts would suggest you make a decision based solely on the numbers. But we know life isn’t a spreadsheet (even though we do have one of those to accompany this article). Instead of following the traditional finance mantra of maximising your returns, our overarching approach is maximising your quality of life.

First, a couple of safety checks

Before paying off a chunk of your mortgage or investing, it’s good practice to save up an emergency fund, pay off any debt that’s costing you more than 7% per year (such as car loans or credit cards) and contribute enough to your KiwiSaver to receive your matching employer and government contributions.

Paying off the mortgage: how it works

Your regular mortgage payment has two parts: part of it pays for what your lender charges you for the loan (interest) and the other part is used to reduce the amount you owe them (principal). 

If you choose to make an additional payment, all of it goes towards reducing how much you owe (the principal). This has two benefits. First, you will be debt-free sooner. Second, you’ll end up paying less interest over the life of the loan. 

The financial return you’ll earn from paying off your mortgage is the interest on your loan. Mortgage interest rates at the moment are just shy of 6% p.a. but you may have locked in a lower rate. This return is risk-free since you are guaranteed to have saved yourself that interest, plus it’s after-tax. 

Check with your lender to ensure there are no early repayment penalties. Generally, fixed-rate mortgages have ‘break fees’ associated with early repayment, whereas floating mortgages can be paid off early at any time without any extra costs.

Investing in shares: how it works

Investing your funds in shares could possibly generate higher financial returns, but it comes with more uncertainty. The average return of the New Zealand stock market over the last 20 years has been over 10% p.a. (before taxes, fees etc.). However, as the chart below shows, there has been significant variation in the returns year on year ranging from gains of +30% to losses of -33%. 

Weighing up the three options

Option 1: Prioritise paying off the mortgage

Why you would do this

Peace of mind. You’ll sleep soundly at night knowing you’re one step closer to being mortgage-free. F-R-E-E-D-O-M. Also, as interest rates rise, paying off your mortgage becomes more attractive for two reasons:

• You are saving yourself from paying more interest.

• The gap between your mortgage rate and potential investing return narrows. If mortgage rates are 4%, the potential to earn more from investing may be attractive to you. But if your mortgage rate increases, you may be less willing to take on the risk that comes with investing. 

In addition, when interest rates rise, your minimum mortgage payment will go up - but since you’re already paying above your minimum mortgage payment, you’ll be better prepared to absorb the increase. Although this may mean you aren’t paying down your mortgage as fast, at least interest rate rises won’t come as a shock (ie. you don’t suddenly need to find an extra $200 per week to pay the mortgage). 

Lastly, paying extra on your mortgage is a simple solution because it’s low effort - the funds automatically come out of your bank account before you’ve had a chance to spend them. While you can set up a similar arrangement with auto-investment, it is an extra step. It sounds trivial but behavioural economics shows that even a little friction can reduce the likelihood that we’ll do something. If you intend to invest but find yourself spending instead (it happens to the best of us), paying off your mortgage is definitely the better wealth-building move.

What you would give up

In the long run, you could potentially have more money if you invest. You might decide to pay down your mortgage first and then invest later. However, because of compound returns, investing early makes a big difference.

• The power of compound returns

  The power of compounding lies in time. Sam and Mia both invest $1,000, earn 10% per year on their investments, and reinvest their returns (a fancy way of saying they leave their investments alone and don’t withdraw any of the gains until the end). The only difference is that Sam invests for 2 years and Mia invests for 20 years.

  At the end of 2 years, Sam has made $210. At the end of 20 years, Mia has made $5,730. Mia has invested for 18 more years than Sam but earned 27x the return.

Option 2: Prioritise investing

Why you would do this

For the potential of growing your wealth in the long-term, with possibly higher returns. 

What you would give up

You’ll have the obligation of a mortgage for the full term of the loan. As my friend puts it, “A mortgage is called a monkey for a reason - you want to get it off your back.”

To have a shot at long-term wealth, you’ll likely have to endure the whims of the stock market. If paying down your mortgage is the equivalent of going on the carousel at an amusement park, then investing is like going on a high-speed roller coaster. You need to be prepared to watch your investments drop significantly - potentially halve - at least on paper. It might be temporary, but not everyone is up for that ride.

Option 3: Porque no los dos?

Those of us who grew up in the 2000s might remember the El Paso commercial where a young girl is choosing between hard and soft tacos, before declaring, “Porque no los dos?” or “Why not both?”

You could put some of your extra cash towards your mortgage and invest the rest. 

Why you would do this 

You can still accelerate the paydown of your mortgage and take a shot at growing your long-term wealth. In addition to the benefits of compounding, reasons to invest include: 

• Diversifying your wealth: instead of having everything riding on your house, you have other sources of wealth. If something happens to house prices, you’ll have other assets that may potentially offset a decline in value.

• More financial flexibility: if you unexpectedly need cash, you can’t just sell your front bedroom, plus it takes time to sell. You can sell some or all of your investments on any business day.

• Real investing experience: the best way to learn about investing is to invest. It is a learned skill and staying in the game is one of the trickiest parts. What you think you’d do if your investments halve versus what you actually do can be very different, and there’s only one way to find out. 

What you would give up

You’re not getting mortgage-free as fast compared to directing all your extra cash towards your loan. In addition, for every dollar you invest, you’re trading off a guaranteed return from your mortgage for a risky return from investing. 

Try before you decide: the Crayon Mortgage vs Investing Trade-Off Tool

Kiwis love property. There’s a certainty to a physical asset and the security of knowing you own the roof over your head. And yet, you’re also thinking about what the extra long-term wealth could do for you and your family. 

So we’ve built a tool that shows you how much you could save by paying down your mortgage compared to how much you could make by investing.

By putting indicative numbers against these two options, you can decide whether the difference between your mortgage interest rate and the potential return on investments is worth the risk to you - and more importantly, what is going to maximise your quality of life.

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If you want to learn more about investing, check out our five-part series Investing in Shares for Your Kids (much of the material applies to long-term investing more generally).

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Now for the important legal part: Investing involves risk. You aren’t guaranteed to make money and you might lose the money you start with. The information we provide is general and not regulated financial advice for the purposes of the Financial Markets Conduct Act 2013. Please seek independent legal, financial, tax or other advice in considering whether the content in this article is appropriate for your goals, situation or needs. The information in this article is current as at 6 July 2022.

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Stephanie Pow

Founder and CEO, Crayon

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