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Getting an investment loan to put money into assets like stocks or real estate can help you build wealth. But paying down your mortgage faster also has financial benefits So how do you decide whether to invest or pay off your home loan sooner?
I compared the pros and cons of each option to help you determine the better choice for your situation. Keep reading for a detailed breakdown.
Overview of Investment Loans
An investment loan allows you to borrow money that you can use to purchase various assets. This type of financing helps you invest larger amounts than you could otherwise afford
Some common types of investment loans include:
- Margin loans – Borrow against your investment portfolio
- Non-purpose loans – General personal loans to invest
- Investment property loans – Mortgages for rental properties or fix-and-flips
Lenders look at factors like your income, credit score, and loan-to-value ratio when deciding whether to approve you. Interest rates are usually higher for investment loans than regular personal loans.
Pros of Using Investment Loans
- Access to more capital to potentially earn higher returns
- Interest on the loan may be tax deductible
- You can keep your own money invested while using borrowed funds
Cons of Using Investment Loans
- Requires qualifying based on your finances
- Higher interest rate than traditional loans
- Investments may underperform or lose money
- Can increase your overall risk level
Benefits of Paying Off Your Mortgage Faster
Paying down your mortgage quicker by making extra principal payments reduces the amount of interest you pay over the life of the loan. This can help you:
- Save thousands on interest
- Own your home outright faster
- Reduce monthly expenses sooner
- Build equity quicker
You shouldn’t pay off your mortgage early at the expense of high-interest debt or emergency savings. But once you have those bases covered, making extra payments can be a smart move.
Pros of Paying Off Your Mortgage Early
- Guaranteed “return” equal to mortgage rate
- Increase cash flow when your payment drops
- Peace of mind of owning your home
- Option to tap home equity if needed
Cons of Paying Off Your Mortgage Early
- Less money for other goals like investing
- Interest savings depend on your rate
- Potential mortgage prepayment penalties
- House values could decline
Factors to Consider When Deciding Between the Two
Determining if an investment loan or extra mortgage payments are better for you depends on your financial situation and goals. Here are some key points to think over:
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Time horizon – Investing tends to reward long-term investors willing to weather volatility. Paying off your mortgage quicker can make more sense as you near retirement.
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Risk tolerance – Paying off your mortgage guarantees interest savings without market risk. Investing provides the possibility of higher returns but with more risk.
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Mortgage interest rate – The higher your rate, the greater the guaranteed return from making extra payments.
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Investment outlook – Consider your expected returns based on your asset allocation and the broader market.
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Monthly cash flow – An investment loan preserves cash flow compared to extra mortgage payments. But be sure you can afford the loan payment.
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Account balances – Make sure you have adequate emergency savings and retirement contributions before pursuing either option.
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Tax implications – You can deduct mortgage interest and potentially investment loan interest. Investment earnings face capital gains taxes.
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Future plans – Will you stay in the home long enough for extra payments to pay off? An investment loan gives you more flexibility to move the money.
Scenario Comparison of the Two Options
Let’s look at a scenario to compare how investing with a loan vs. paying down your mortgage faster could play out:
- You have a $300,000 mortgage at a 4% interest rate
- You take out a $50,000 investment loan at a 6% interest rate
- You invest the $50,000 into an S&P 500 index fund expected to return 8% annually
- You put an extra $417 per month toward your mortgage principal
After 5 years…
| Investment Loan | Extra Mortgage Payments | |
|---|---|---|
| Total Interest Paid | $15,000 | $8,424 |
| Investment Value | $68,900 | – |
| Amount of Mortgage Remaining | $282,500 | $269,800 |
In this example, the investment loan results in more interest costs but also earns investment returns. The extra mortgage payments save on interest and pay down the balance quicker.
Over the long run, the compound growth from investing would likely outpace the interest savings. But paying down your mortgage faster gives a guaranteed return and payoff security.
Ultimately there’s no definitively better option. It depends on your risk tolerance, time horizon, and overall financial plan. A balanced approach can be prudent as well.
Tips for Deciding Between Investing and Paying Off Your Mortgage
Here are some final tips when deciding if you should get an investment loan or pay extra toward your mortgage:
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Run the numbers for your specific situation – interest rates, timelines, etc.
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Understand your risk appetite and prioritize guaranteed returns or growth potential accordingly.
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Consider what makes the most sense based on your timeline until retirement.
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Don’t sacrifice high-interest debt payoff or emergency savings in pursuit of either goal.
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Evaluate whether you can afford the monthly investment loan payment without overextending your budget.
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Review all costs, not just interest rates – account fees, advisor fees, margin costs, etc.
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Have a plan to pay off the investment loan or recoup invested funds for mortgage payoff.
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Re-evaluate periodically as markets, rates, and your needs change over time.
The Bottom Line
Whether investing or paying off your home loan faster is the better move depends on your personal financial situation. If your mortgage rate is low and you have a long investing timeline, pursuing solid growth assets could make sense. Nearing retirement or simply wanting to be debt-free? Paying off your mortgage quicker may be the way to go.
Ideally you can find a middle ground that lets you enjoy some of both benefits. Build wealth through investing while also making steady progress on your mortgage payoff. As always, make sure other financial basics like an emergency fund and retirement savings are covered first.
Second home vs. investment property definitions
There is a key difference between second home and investment property loans, and it all has to do with how you plan to use the place.
- Second home: A second home is an additional residence — one you purchase for personal use/enjoyment and live in or visit during part of the year.
- Investment property: An investment property is one you plan to rent out with the goal of generating income.
Of course, a property can sometimes serve both purposes. That’s true especially if you’re thinking about occasionally renting out the property when you don’t want to use it. Earning some money from your property doesn’t automatically make it an investment, however.
So how do you differentiate? Accurately defining the piece of property depends on how much time you spend in it. In a nutshell, it comes down to “the 14-day limit rule,” says CFP Elliot Pepper, co-founder of and director of tax services at Northbrook Financial, a Baltimore financial planning firm.
“Broadly speaking, if you personally live in your second home for 14 days or fewer — or less than 10 percent of the days it is rented — during a year, then it would be considered a rental property and the income earned would be taxable,” he explains. “But you would also deduct the expenses associated with the property.”
On the flip side, if you use the property for more than 14 days or more than 10 percent of the time it’s rented, any rental income you receive isn’t taxable — but you also can’t deduct expenses, says Pepper.
Second home vs. investment property mortgage requirements
Making the distinction between a second home vs. investment property is important not only for tax purposes but also when you seek financing for the home. Clear distinctions exist in the criteria for second home mortgages and investment property mortgages.
Second home lender requirements |
Investment property lender requirements |
|
|---|---|---|
| Credit score minimum | 620-680 or higher | 700 or higher |
| Down payment minimum | 5%-10% | 15%-25% or more |
| Debt-to-income (DTI) ratio maximum | 45% | 45% |
While the requirements differ, both types of properties share one big trait: Both are riskier prospects for lenders than a primary residence. That’s because if you were in a financial bind, you’d likely prioritize paying the mortgage on your main home versus a second or investment property.
Due to this added risk, lenders tend to require higher credit scores and down payments on investment property and second home mortgages. For instance, Chase and Navy Federal Credit Union both require a 15 percent down payment for an investment property — in contrast to 3 percent for conventional loans.
Investing vs Loan Repayment | 2022 | CA Rachana Ranade
FAQ
What is the difference between a home loan and an investment property loan?
What is the 2% rule for investment property?
Is it harder to get a mortgage for an investment property?
How to avoid 20% down payment on investment property?
What is an investment property loan?
An investment property loan is a mortgage for the purchase of an income-producing property. That includes buying properties to generate rental income or to renovate and sell for a profit (more commonly known as house flipping). There are also short-term hard money investor loans, allowing you to buy properties you plan to repair and sell quickly.
Should you invest instead of a home loan?
No guarantees: Historical investment returns can help estimate your portfolio performance, but the actual results will vary. You may lose money in some years. Still need to pay off home loan: When you direct money toward investments instead of your home loan, you’ll remain in debt longer.
Do investment property loans make a profit?
An investment property can result in a profit for its investor. Investment property loans are a tool for an investor to maximize their returns by leveraging the down payment, the length of the payback terms, and the interest rate.
When is it easier to get an investment property mortgage?
It gets easier to obtain an investment property mortgage when the economy is doing well. Mortgage lenders find these loans riskier than primary home loans and may restrict access during tough economic times to manage their risk level.