If you're fortunate enough to have some disposable income lying around, you might want to use it to advance your long-term financial goals. If so, you can choose among many different options. Here's one such decision: Should you make extra principal-only mortgage payments, or should you invest the money?
There may not be a clear-cut answer to this question, because each choice -- to prepay or invest -- has some merits. So before making any decisions, you'll need to familiarize yourself with both options.
To begin with, you might try to calculate whether prepaying or investing gives you the greatest financial return. To come out ahead by investing, you'd need to find an investment vehicle that paid more than your fixed mortgage rate. For example, if you pay off a fixed-rate mortgage of 5 percent, you are in effect "earning" a 5 percent return, so if you found an investment that paid 6 percent or 7 percent annually, you could say that you'd be better off making the investment rather than prepaying your mortgage.
At first glance, you might think your choice is clear. After all, your reason, it shouldn't be too hard to find an investment that pays 6 percent or 7 percent. Over the past 80 years, large-company stocks have returned on average more than 10 percent annually, according to Ibbotson Associates, a leading investment research firm.
And yet, despite these figures, you can't necessarily conclude that investing always beats prepaying. For one thing, as you've no doubt heard, "past performance does not guarantee future results." And those impressive long-term stock market returns are just averages; though the market has trended upward over the long term, it can also go through extended periods of low returns, or even sizable losses. But when you pay down your mortgage balance each year, you're earning a regular, low-risk "return" in the form of interest savings. So you need to ask yourself if you can accept taking on greater investment risk in exchange for a potentially higher return.
Furthermore, you might find if psychologically beneficial to pay off your mortgage as soon as possible. And the less you owe on your house, the greater your profit when you sell it.
But other factors may weigh against prepayment. You generally get a tax deduction on your mortgage interest and this deduction, especially in the early years of your mortgage, can be considerable. Even more importantly, though, is the need to diversify. If you have all your money tied up in your house, and the housing market slumps as it has recently, your net worth might suffer more than if you had spread your money around a variety of assets, including stocks, bonds and government securities. Keep in mind, though, that diversification by itself cannot guarantee a profit or protect against loss.
Clearly, you'll need to weigh all these factors before deciding whether to prepay your mortgage or invest. Fortunately, it's not always an "either-or" question. One month, you could pay more on your mortgage while the next month, you could invest any money you have available. It's your choice -- so make the most of it.