Those who are against prepayment on a mortgage argue mathematically in favor of investing those extra dollars with the expectation of creating a spread between the higher expected return on the investment and the interest rate on the mortgage. This is an argument for leveraging leverage to build wealth. A person could do both by investing additional dollars to create an account that would eventually become large enough to pay off the remaining mortgage balance.

Assumptions

• 30 year fixed rate mortgage of \$ 500,000 at 3% with a monthly payment of \$ 2,108

• \$ 1,000 / month in additional dollars available either to invest or to apply for capital

• A global equity allocation as an assumed investment portfolio, 50 percentile Monte Carlo simulation using historical returns from 1990 to 2020

• The effects of taxes are ignored for the sake of simplicity

Scenario 1: Pay \$ 1,000 / month additional capital on the mortgage

If a person were to make an additional \$ 1,000 / month payment on the principal amount of the mortgage, a 30-year payment plan would be reduced to just over 17 years. For the remainder of the 30 year period, a person could now invest \$ 3,108 per month. The expected value of this portfolio at the end of the original 30 year period would be \$ 1,051,000.

Scenario 2: Invest \$ 1,000 / month and pay off the mortgage when the portfolio value equals the outstanding capital.

Using the same investment assumptions, this is expected to happen by the end of year 13, reducing the time it takes to pay off the mortgage by 4 years. If we look at the 25th percentile of all simulated results, it would take 15 years. Now, if the person increased the investment to \$ 3,108 / month and could do so for 17 years instead of 13 years as in Scenario 1, the expected value of this portfolio would be \$ 1,745,882. Under the “4% rule”, an increase in wealth of \$ 694,882 could enable an additional monthly retirement income of \$ 2,316.

Scenario 3: Invest \$ 1,000 / month for the entire 30 year period and don’t prepay the mortgage.

To show this, I also calculated the expected value after 30 years if the person opted not to repay the mortgage early and instead invested the \$ 1,000 / month for the entire term. At the end of 30 years, that person would have the same home money and portfolio worth \$ 2,429,008. There is a clearly expected (though certainly not guaranteed) opportunity cost of prepaying a mortgage that should be weighed against the marginal utility of wealth that would be associated with a \$ 1,378,008 higher portfolio value that would add an additional \$ 4,593 monthly retirement income could generate.

Summary

The question: “Should I repay my mortgage early or invest?” is one of the most frequently asked personal finance questions. There is no obvious answer as it depends on many variables specific to each individual’s financial situation and risk tolerance. Because of the complexity of the decision, you may want to consider an hour of professional advice. In general, I recommend individuals focus on eliminating high-interest consumer debt and contributing to retirement accounts like 401k plans of the employer and Roth IRAs first before deciding how best to handle their mortgage.

Once this is achieved, the lump sum payments should be made out of cash and fixed income securities first, as repaying a mortgage is similar to investing in bonds. Then the next decision revolves around what you value most. Is it the financial peace of being out of debt and having a paid home at a young age, or the utility of higher expected wealth and later retirement income? Unless you’re leaning heavily in either direction, a reasonable decision may be to take a balanced approach that is similar to Scenario 2 for your situation.

Jesse Blom is a licensed investment advisor and Vice President of Lorintine Capital, LP. He is advising clients in the US and around the world on the plant. Jesse has been in the financial services industry since 2008 and is a CERTIFIED FINANCIAL PLANNER ™ professional. Working with a CFP® expert is the highest standard for advice on financial planning. Jesse holds a BS in Finance from Oral Roberts University.