Should I use my extra money each month to invest or pay towards the balance of my mortgage?
I have about $1,000 extra each month that I want to either invest or pay towards the principal of my mortgage ($81,000 with a 5.75 percent interest rate). What would be the best use of my money?
I'm of the opinion that even a 5.75% mortgage rate is low cost money. Over a 100 year period and even during the past 30 years stocks have averaged a 10% annual return and bonds 6%. So if you were to invest 50% in equity funds and 50% in bond funds you would most likely make 8% over the long term and that is an significant improvement over 5.75%. Also an investment portfolio will be less risky than home equity and much more liquid. As your investments grow you could always withdraw to pay off the house if that makes you feel more secure.
First, is your mortgage variable or fixed? If variable, It would for sure make sense to allocate the extra $1,000 per month to your mortgage. We're in a rising interest rate environment and will likely only see rates go up from here for the foreseeable future. If fixed, the decision is a little harder. Obviously, you cant go wrong with working towards paying off debt. However, you may consider putting extra towards long term investments such as an IRA or Roth IRA. We know over extended market cycles, depending on the time period you measure from, the stock market can average anywhere between 8-10%, which is greater than your 5.75% on your mortgage. Maybe you consider, maxing out your IRA and then using the excess towards paying down the debt. You can never get back a year's worth of contributions to retirement accounts and the fact they're capped means its harder to play "catch up". The earlier you can put more funds into retirement accounts the better so you can take advantage of decades of compounding.
Again, it's a balancing act. You can't go wrong with accelerating your debt payments, especially at that interest rate. However, I wouldn't necessarily fault you for deciding to contribute some to a tax advantage retirement account.
I like the pay down your mortgage idea; it's a 5.75% rate of return on your money guaranteed -- no bank out there is offering that. However, if you don't have sufficient cash reserves on hand I'd probably do that too, maybe 50/50 or something that feels comfortable. Cash reserves are very important to have and justify giving up some of that 5.75% to have. If you are comparing the rates of return on investments vs your mortgage then keep in mind that you are effectively borrowing money to invest. Want to do that? It's leverage plain and simple and when think in those terms it means whatever investment you choose just got riskier.
Congratulations on having the extra $1,000 each month! This will go a long way towards your financial goals. While there are a number of other factors to consider in order to give an exact recommendation such as other debt, retirement savings, emergency savings, age, current income, taxes, etc. I will try to point you in the right direction on how to think about the problem.
First of all you want to make a decision that puts you in the best situation on an after tax basis. Taxes are important here because if you have the ability based on your current income to contribute to an IRA then this would be a great place to start. The money that you contribute will reduce your current taxes and then will grow tax free until you decide to take the money out after age 59.5 or are required to start taking the money at age 70.5. Not maxing out your 401k contributions would be another area to consider as well.
Additionally, the mortgage interest you currently pay is also tax deductible. The combination of lower taxes makes the 5.75% return requirement a little bit lower.
In either case, whether you decide to invest or pay down debt, you are making a good long term financial decision for yourself!
If you already have a sufficient cash reserve and you do not need money for any major purchases, you should pay down your mortgage.
How much should your reserve fund be? One rule of thumb is 6 - 12 months of expenses. That would give you flexibility in case your employment situation changes. We usually lean toward six months if two people are employed. And, we lean toward 12 months if only one person is employed.
So, if your expenses are $4,000 per month and you and your spouse both are employed (somewhat equally compensated), your cash reserve should be about $24,000. ($4,000 X six months = $24,000).
Hope this helps!