Pay off the mortgage, or invest?

Should I pay off the mortgage faster, or use any spare money to invest? That’s a question we get a lot.

According to the textbook, the best approach is to pay off the mortgage as quickly as you can, before worrying about starting on your investing journey.

The floating mortgage rate is about 4.4 per cent at the moment, so if you make additional payments on your mortgage, that’s essentially the annual return you’re getting on that money.

Your other options for putting those funds to work will give you a varying range of returns. Term deposits are a very low risk option at around 1-2 per cent, depending on the timeframe, while managed funds, property and shares will deliver much more than this, albeit with a higher risk profile.

As an example, New Zealand shares have delivered an annual return of 10.6 per cent over the past 20 years, although this hasn’t always been plain sailing.

The market has had numerous ups and downs along the way, including a couple of big declines. The most notable ones are the GFC, when the NZX 50 index fell 44.2 per cent, and then last year in the wake of the COVID 19 pandemic, when it declined 29.6 percent.

As it always does, the market has recovered from these periods and moved on to new highs.

In contrast, the “return” one gets from paying down their mortgage is risk free. Whether you’re paying the floating rate of 4.4 per cent, or something higher or lower, you’re guaranteed to have saved yourself that interest.

That’s why paying down the mortgage wins every time, when you’re basing it purely on the numbers. There’s nowhere you’ll find a similar return with zero risk, and without any tax to pay on that return.

Here’s where we’ll deviate from the textbook and suggest that doing a bit of investing on the side can be a very good choice for many people.

While it’s hard to argue with the risk-free return of paying off your mortgage, the knowledge to be gained by educating yourself about money, shares and financial markets can be invaluable.

And let’s not forget about the power of compounding. The earlier you start to invest, even if it is only a little every month, the longer you’ll be in the market to benefit from the effects of compounding.

There are also some downsides to consider when choosing to pay off your mortgage. You will be what is known as ‘asset rich, but cash poor’ as you lock up a large part of your wealth in your home. And if you ever needed access to that cash, you’re in for a potentially lengthy wait with a degree of admin and fees.

Having some investments in the sharemarket allows for more freedom, and allows you to learn something along the way.

Financial literacy is an area where New Zealanders could do better, particularly when it comes to understanding our investing options outside of housing.

When you have some skin in the game, you often take a much greater interest in something.

Like a lot of things in personal finance, as in life, it’s not black or white and there’s not necessarily a right or wrong.

Paying down the mortgage as aggressively as you can is a very sensible move, and it’ll get you on the path to financial freedom much faster.

However, using some of that disposable income to invest along the way can also pay off over the long term. If you follow a few simple rules you should do well in the long-term, even if you experience a bit of volatility at times (which is also a good lesson).

You might even decide that doing a bit of both is best for you. While you’re unlikely to find a better risk and return trade off then making additional mortgage payments, you shouldn’t have to miss out on the compounding returns you’ll get if you start investing now rather than later.