Savings on Interest on a Loan vs. Investment Profits

It can be tempting to pay off a mortgage loan early if you've come into a large sum of money unexpectedly or have saved a substantial amount over time. Paying off the mortgage early can be a smart move, but it depends on the borrower's financial situation, the interest rate, and how close they are to retirement.

The option of investing that sum versus using it to invest the mortgage balance is also on the table. This article compares the potential savings from paying off a mortgage ten years early with the potential savings from investing that money in the market at varying rates of return.

 

The Basics of Getting a Mortgage

As the name implies, a mortgage is a loan taken out to finance the purchase of real estate. At the mortgage closing, the borrower signs the loan documents and agrees to repay the mortgage lender in monthly payments until the loan is paid off.

In most cases, the loan term will be between 15 and 30 years. Lenders will pay the seller their agreed upon price for the home and then add interest to the borrower's monthly payment.

 

Loan Money and Interest

There are two parts to every mortgage payment: interest on the loan and principal, which is applied to reducing the principal balance.

If you make a $1,000 monthly payment, for instance, $300 of that might go toward interest and $700 would go toward paying down the principal. Mortgage interest rates can shift based on the economy, the borrower's financial standing, and other factors.

 

Predicting the Duration of Amortization

An amortization schedule shows how much money must be paid back over the course of a loan's life, for example 30 years. In the beginning of a loan's term, the majority of the payment goes toward paying off the interest on a fixed-rate mortgage. Later on in the loan's term, more of each payment will go toward paying down the principal.

Below is a table depicting the mortgage schedule for a $200,000 loan with a 3.5 percent fixed interest rate and a 30-year term.

According to the data presented above, the initial ten years of the loan saw a greater percentage of the monthly fixed payment go toward interest. The interest portion of the monthly payment eventually became larger than the principal portion.

In the twentieth year, for instance, $611.45 was applied to principal while $286.64 went to interest. The entire previous monthly payment was applied to the principal balance, save for $2.61.

Because the loan balance is larger in the beginning and lower in the end, the proportion of each payment that goes toward principal and interest fluctuates over time. As the loan balance is larger in the beginning, the interest rate is also higher.

As the loan balance is paid down over time, the interest portion of each payment can be reduced as there is less interest to pay overall.

 

Premature Mortgage Payment

The advantages of prepayment vary from one homeowner to the next and from one mortgage to another.

Since they will no longer be bringing in an income from work, retirees may wish to do things like pay down or get rid of their debt. People may also choose to pay off their mortgage early in order to reduce their recurring monthly expenses.

 

Putting Money Into The Market

It's possible that a homebuyer's extra cash from paying off their mortgage early could be put to better use in the stock market. It's possible that after investing for ten years, the rate of return will be higher than the interest rate on the mortgage.

The interest lost due to not investing in the market is the "opportunity cost" that needs to be accounted for. The expected return and the associated risk are just two of many considerations when assessing an investment.

 

How Much Could You Make With $100,000 Over the Next Decade

Invested Amount	Years	Rate of Return	Investment Gain
$100,000	10	2%	$22,019
$100,000	10	5%	$62,889
$100,000	10	7%	$96,715
$100,000	10	10%	$159,374

 

Investing Profits versus Foregone Loan Interest

At a 2% annualized rate of return, a homeowner would have $22,019 in 10 years if they invested $100,000 instead of paying down their mortgage. Investing the money or paying off the mortgage at 3.5% would yield the same result (a savings of $20,270 in interest, according to the loan table).

To contrast, if the homeowner earned an average annual rate of return of 5% over the course of the 10-year period, they would have $62,889 in their pocket instead of the $20,270, $28,411 or $37,618 they would have saved on interest payments under any of the three initial loan scenarios.

Even with the low interest rate of 5.5%, the borrower would make more than twice as much by investing the money they would have spent on interest and paying off the loan early.

 

The Impact of Cumulative Effects

The power of compounding is one of the reasons why the investment gains are so much greater than the interest savings from paying off the loan early. In the event that the initial $100,000 is not withdrawn from the investment any time during the ten years, the interest earned each year will be reinvested, resulting in interest earned on interest, which can further increase the investment returns.

 

Adeptness to Danger

Before putting money into the market, investors need to figure out how much they are willing to take on in the way of risk in the hopes of a profit.

 

Variations in Investment Dangers

Every possible investment option comes with its own unique set of potential downsides. The U.S. government backs U.S. Treasury bonds until they mature, so investors can rest easy knowing they won't lose money on these bonds.

However, the volatility of equity or stock investments increases the possibility of experiencing financial loss.

To return to our example, the homeowner runs the risk of losing some or all of their money if they choose to invest it in the market rather than pay off their mortgage ten years early. Therefore, even if the investment fails, the homeowner is still responsible for making the loan payment for the full ten years.

 

Understanding Your Comfort Level With Risk

The age of the investor, the length of time until the funds are needed, and the investor's financial objectives are all factors that influence their risk tolerance. Those who have stopped working for financial reasons, such as retirees, may be more cautious.

People in their twenties and thirties, on the other hand, have more time in the market to make up for losses in their portfolio. Therefore, someone younger can afford to invest more of their savings into riskier investments like stocks.

 

The Double-Edged Sword of the Market

The potential for large gains in the stock market is balanced by the possibility of equally large losses. In other words, the market risk is a double-edged sword: increasing your exposure can increase your gains but also increases your losses.

After considering fees, taxes, and inflation in our earlier illustration of the various possible returns, a 10% investment gain is not an easy goal to achieve.Therefore, traders should set reasonable goals for their investment returns.

 

To Take Into Account Particulars

To determine whether or not it makes financial sense to prepay a loan, you should look at the interest rate, the loan's remaining balance, and the interest you'll save. A mortgage loan calculator can help borrowers examine their amortization plan.

It's also important to think about other uses for that money besides paying off the mortgage. Put it toward retirement or an emergency fund; pay down high-interest credit card debt; or buy a car with cash.

Mortgage interest is deductible for many homeowners, which means that the amount you pay in interest can reduce your taxable income for the year. Financial planners and tax advisors should be consulted before making the decision to invest or prepay a mortgage.