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Here’s why paying off your mortgage early is a mistake

It is better to pay off your mortgage early rather than invest in ASX shares?

Ah… the old mortgage vs. investing question. If you indeed have a mortgage (this word incidentally is derived from a French translation of ‘agreement until death’) and you’ve asked yourself which is better to focus on, I think you deserve an award for just doing so.

Paying off the mortgage has long been the only financial goal of many a household – a goal which I think everyone should move beyond in our modern age.

Should paying off your mortgage be your first goal?

Don’t get me wrong, I think owning your own home and paying it off is a worthy and admirable goal to have – just don’t make it your only goal!

But even if you are paying off your mortgage, and are interested in investing yourself, you might be throwing all of your spare cash into the mortgage before worrying about the latter. After all, non-deductible interest is the thing that any financial planner will tell you to get rid of ASAP.

But looking at the numbers from one of my Foolish colleagues’ pieces over in America, I felt compelled to dig a little deeper.

So it goes without saying that a mortgage with a 3.5% interest rate is costing you 3.5% a year on your unpaid principal amount. In this era of low interest rates, it’s likely that your mortgage is in this ballpark. Now my American colleague has the benefit of having a 30-year fixed mortgage at 3.5% – something not normally available to us Aussies.

If interest rates rise back to ‘normal’ levels of 4-5%, we have a different beast entirely.

But let’s just assume interest rates stay around their current near-zero levels for a while yet.

So if you’re getting an immediate return of 3.5% with extra mortgage repayments, you’re already doing a lot better than just having your cash in the bank.

But here’s the kicker – those extra funds might be getting you a whole lot more if you invest them in ASX shares. Take a broad-market index fund like the SPDR S&P/200 Fund (ASX: STW) that basically represents the average of the entire Aussie stock market.

Index fund?

Since its inception in 2001, this fund has returned an average of 8.35% per annum (which doesn’t include the benefits of franking credits as well). Of that 8.35%, 4.7% came from dividend income payments – which usually tend to be higher over time as well.

This period includes the GFC, 9/11, the Euro debt crisis and a lot of other calamitous events.. and things turned out ok.

But don’t take my word for it, let’s look at some numbers

Let’s assume we have someone with a $500,000 30-year mortgage at 3.5%. The minimum monthly repayments for this mortgage would be roughly $2,245 (assuming no other costs), which after 30 years would result in $308,280 in interest costs. If this person put an extra $500 a month into these repayments, they will pay off the mortgage 8 years and 3 months sooner and will only pay $214,168 in interest – meaning you’d be $94,112 better off.

Awesome, right?

Now, let’s take the same mortgage, but assume instead of paying an extra $500 per month, we instead invested that $500 in an ASX 200 ETF like STW with an 8.35% return.

Yes, you’d be paying off the mortgage over 30 years with interest costs of $308,280 – meaning a total cost of $808,280.

But your share market nest egg will also have grown and compounded over this 30-year period – leaving you with a grand total of… $806,390 (even though only $180,000 of this is the cash you contributed).

So that’s a benefit of $94,112 for paying off the mortgage early, compared with $806,390 for instead investing in ASX shares. Nothing illustrates that famous Einstein quote that ‘compound interest is the eighth wonder of the world’ better than that!

I know which one I’d rather!

A few caveats…

Now, these calculations make a few assumptions.

One is of course that the only thing that matters to you as an individual and an investor is raw mathematics. There is a lot of intrinsic value to owning your own home outright – let’s call it the ‘sleeping well at night’ factor. It might be the right move for your mindset or that of your family to own your own home outright as soon as possible. If that’s the case, that is a totally respectable mindset to have and there’s nothing wrong with continuing down that path.

Money and numbers aren’t everything in this life, after all.

There’s also the issue of the share market and its volatility.

Just because an ASX 200 fund has historically made a certain return doesn’t guarantee this will continue. The next 18 years might see a rate average annual return higher than 8.35% or lower than 8.35% – no one knows. There might be a GFC style market crash the year before your mortgage is paid off and you will think yourself a fool (and not the good kind) for following such a strategy.

For us Aussie investors, inflation might start running wild at some point in the next three decades, at which point the Reserve Bank of Australia (RBA) might start hiking interest rates.

And as strange as it sounds, many people would lack the discipline to consistently invest $500 a month for 30 years straight. Sure, it sounds easy now – but what happens when that holiday to Barbados calls?

Sometimes, the “it’s just one week, it doesn’t matter” turns into a few – and then the whole compounding mechanism is kneecapped.

Foolish takeaway

There are a lot of things that could go wrong with this strategy. Some might eventuate, some might not. But just remember the fundamentals here – there’s a lot of difference between being $94,112 better off than $806,390 better off. And if you decide to pursue the latter strategy, that’s a pretty big buffer there.

I like the odds myself!

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Motley Fool contributor Sebastian Bowen has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.