Investing Vs. Paying off your mortgage early

If you have spare cash, should you invest in the stock market or pay off your mortgage early?

I'm going to assume for this article that you're on course for retirement. (Follow my four-step guide to work out whether you are.) I'm also going to assume that you're not overstretching yourself with your mortgage. Finally, I'm going to assume that you have no other debts, except perhaps interest-free ones, or a student loan.

That's a pretty sweet position to be in. But what should you do if you're lucky enough to have some spare money as well? (By which I mean either a lump sum or spare monthly income after bills; it works for both.)

Should you invest it in the stock market or pay off your mortgage early?

Look at your return

In order to justify investing rather than repaying your mortgage early, you need to get a return that beats mortgage interest rates. Otherwise your debt is costing you more than your investment is earning. So, if your average interest rate over the length of the mortgage is 6.5%, your investments, after charges and taxes, need to make 6.6% per year or better, on average.

Over short periods of time, anything can happen to the stock market. This means it can plummet. So you should invest only if you intend to do so for at least five years, preferably ten or more. Anyone who can't do this would certainly be wiser to pay off their mortgage early.

If you can invest for a long time, whether you should do so depends on your attitudes to money and risk.

Over long periods, the stock market has performed well. Over a hundred years or so it has gone up by roughly 10% to 11% per year, on average. However, in recent years - the past 25 for example - the increase has been just 7% to 8%. Factor in charges for dealing in shares (and possibly some tax, too) and what you get comes down some more.

There is an oft repeated mantra to consider here: 'Small differences in investment returns matter. A lot.'

However, this goes both ways. If investment returns over the next few decades dip another percentage point or two, you might end up wishing you'd repaid your mortgage instead!

My view

Personally, I really like the idea of repaying my mortgage early. (When I stop travelling around and settle down long enough to buy a property, that is.)  It's comforting, because the return is largely known.  Once you've paid off your mortgage, that's it. There's no more interest to pay. You own your own home.

Related blog post

• John Fitzsimons writes:

  Should you pay a fee for a decent mortgage?

  Some of the best mortgages in the market carry huge product fees. Is it worth paying a high fee in order to secure a competitive mortgage rate?

  Read this post

The most important word I used there is 'comforting'. Anyone insane enough to have clippings of all my articles on their walls will have gathered that I aim to be comfortable, not stinking rich. That's where I've set my expectations, and I can maintain my comfort right through to retirement with relatively little risk (and stress!).

What's more, if you pay off a mortgage early, you are guaranteed to save yourself thousands of pounds in interest payments (for more on this, have a read of Save thousands and shave years off your mortgage). There is no such guarantee when it comes to returns on investments, despite what I said earlier about long-term trends.

So, for my comfort level, I'd like historical annual stock market returns to have been quite a few points higher before I'd be prepared to take a chance. Because I have a known return by repaying early, I find the risk to investing instead is too high for the reward. Even if (or especially because) small differences matter a lot.

What's your view?

However, many of you may prefer to take on more risk. Perhaps you also have great faith in your own investment abilities. That's all fine, too. Let's face it, if you're in the position where you don't know what to do with your extra money, it's not an extraordinary risk you're taking!

This is a lovemoney.com classic article, originally published in March 2008 and updated.

More: Now is the time to buy property | Slash 10% off your food bill