You have spare money and two choices: reduce your mortgage or invest it. Paying down the mortgage can save interest. Investing might earn more, but the return is uncertain. Before comparing those percentages, check what it costs to make the extra mortgage payment. A repayment charge can consume several years of the advantage you thought you were getting.
You also need to ask when you might need the money and how a loss would affect you. A choice that looks best in a calculation may be hard to live with when prices fall or your income changes.
The decision works best when the numbers, your household budget and your comfort with risk all point towards a plan you can keep.
Compare an interest saving with a possible return
Suppose you have $20,000 left after setting aside emergency savings and money for known expenses. Your mortgage rate is 4%. Paying that amount off the loan would initially save about $800 a year in interest.
Now suppose you use a 7% yearly return in an investment example. On $20,000, that would be $1,400 before fees and taxes. It is $600 more than the mortgage interest saving.
But the two figures are different kinds of result. The mortgage saving follows the interest rate and loan terms. The investment return is an assumption. You could earn more than 7%, earn less or lose money.
This example leaves out repayment charges, taxes and changes to the loan balance during the year. Those omissions matter. Start with the lender's figures for your actual mortgage, then compare both choices over the same period.
Check the mortgage terms first
A fixed mortgage rate gives you more certainty about the interest saved while that rate applies. With a variable rate, the saving can change. A fixed rate due to end soon also tells you less about the years ahead.
If your mortgage has a charge-free overpayment allowance, find out how much of it you have already used and when it resets. A yearly allowance does not necessarily run from January to December. The contract determines the relevant period and the balance used to calculate your limit.
The rules also differ between countries. In the UK, MoneyHelper recommends checking your overpayment allowance before paying extra. In the US, the Consumer Financial Protection Bureau explains that not all mortgages have a prepayment penalty and that small extra principal payments do not normally trigger one. Neither is a substitute for checking your own loan.
Ask what an extra payment would change. Would your required monthly payment fall, or would you pay off the loan sooner while keeping the same monthly bill? Do not assume that paying off part of the balance immediately gives you a smaller payment.
Paying off the whole mortgage can remove that bill. You will still have other housing costs, such as repairs, insurance and any local property taxes.
A fee has to beat the alternative, too
When a lender quotes an early repayment charge, it is tempting to divide it by the interest you would save. That misses something: the money could earn interest while you leave it in savings. Savings make the effect of the fee easier to see because the example does not need an assumed stock-market return. Investing could do better or worse, so the result below is not a break-even point for investing.
Take a separate, simplified example. You can put $25,000 towards a mortgage charging 5%, or keep it in savings earning 3%. Assume those rates stay unchanged, there is no tax relief on the mortgage interest and no tax on the savings interest. The annual comparison is $1,250 of mortgage interest avoided against $750 earned in savings. Repaying is ahead by $500, before any charge.
Now suppose the lender quotes a $1,500 charge for that repayment, paid separately. Dividing the charge by the full $1,250 saving suggests you recover it in about 1.2 years. Dividing it by the $500 advantage over savings gives three years. The second comparison answers the question you actually face.
This rough comparison holds the balances and rates constant and leaves out compounding, the time value of money and interest you could have earned on the separate fee. It shows why the charge belongs in the comparison with your alternative, rather than being measured only against the loan's interest rate.
I would ask the lender to compare paying now with paying after the charge ends or the allowance renews. Waiting may cost mortgage interest, while the money can earn interest in the meantime. Sometimes that wait is expensive; sometimes it is cheaper than the charge. Use the actual dates and costs before committing money you cannot easily retrieve.
Allow for tax and account rules
Tax rules can change the comparison. In some circumstances, mortgage interest reduces your tax bill. That lowers the cost of borrowing, but only by the tax saving you actually receive. Where no relief applies, there is nothing to subtract.
Investments have their own rules for interest, dividends and gains. Some accounts offer tax benefits but restrict when you can take money out. Employer contributions to a retirement account, where available, can also make that route more valuable.
Use the rules for your country, account and circumstances. A strategy written for another country’s tax system may not work for you. And a tax deduction does not make mortgage interest free: you still pay the part you do not get back.
If Dutch tax rules apply to your home and savings, I offer personal tax advice.
Keep money for unexpected bills
Before either choice, check your emergency fund. Money you might need for a repair or a period without work should not depend on a good investment result or a new loan approval.
If you invest $20,000 and its value falls by 30%, you have $14,000. If you then need the full $20,000, you are $6,000 short. A later recovery cannot pay a bill that is due now.
Paying down the mortgage creates a different access problem. The money is in your home, rather than in your bank account. Getting it back may require borrowing again or selling. A lower income can make new borrowing harder to arrange.
Some mortgages let you withdraw previous extra payments or use linked savings to reduce interest. These features depend on the contract. Check how they work before counting on them.
Can your finances handle a loss?
Start with the practical effect. Would a fall in your investments stop you paying bills or force you to delay an important plan? Look at your income, savings, other debts and the date when you need the money.
Someone with a secure income and plenty of savings may be able to leave investments alone for years. Someone planning a move or facing uncertain work may need the money sooner.
Consider problems happening together. A weak economy could affect both your job and your investments. Being able to manage either problem alone does not always mean you could manage both at once.
How would the loss feel?
Your ability to afford a loss and your reaction to it are not the same thing. You may have enough savings but still lie awake worrying about falling prices. Or you may feel confident about investing while having little money available for a bad month.
Losses can feel more painful than gains of the same size feel rewarding. This is called loss aversion. Disliking debt is a separate feeling: you may find a mortgage stressful even when the interest rate is low.
These feelings deserve attention. They do not automatically make a decision right or wrong. Worry may reveal that you are taking too much risk, while confidence may hide a problem you have not considered.
Think in money rather than labels such as cautious or adventurous. If your $20,000 became $14,000, could you leave it invested? How would you feel if your mortgage payment still had to be paid every month?
Choose a plan you can keep
If a large fall would probably make you sell in panic, investing less may be a sensible choice. A higher expected return does little for you if you abandon the plan after a loss.
That does not mean every worried investor should put all spare money into the mortgage. You might feel more comfortable with a smaller investment, more emergency savings or a better spread of investments. Spreading money across different holdings can reduce reliance on one business, though it cannot prevent a wider market fall.
The same honesty is needed about savings habits. Money left available may slowly turn into spending on a better car, holidays or everyday upgrades. My article on lifestyle inflation explains how this can happen even without one large purchase.
Extra mortgage payments make that money harder to spend. Some people find this helpful. Others need the freedom to use it later. A separate account and regular investment payments may help you stick to your chosen purpose while keeping some flexibility.
You can use more than one approach
The choice does not have to be all mortgage or all investing. You could keep a suitable cash reserve, make some extra repayments and invest some of the money left over. There is no single split that fits every household.
Think about the next few years. Someone nearing retirement may want lower monthly bills. Someone planning a move may need cash for the move. A business owner may need more savings to cope with irregular income.
Paying down the mortgage also leaves more of your wealth tied to your home. Investing can spread some money into other assets, but brings investment risk.
Review the decision when your rate changes, your income changes or a major expense gets closer. The aim is a plan you can afford in a difficult year as well as a good one.