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The pros and cons of paying off your mortgage early vs buying an investment property

The pros and cons of paying off your mortgage early vs buying an investment property

Paying off your mortgage early can have several advantages. It enables you to own your home sooner by getting rid of your debt and saves money on interest charges. But is it the best option for you when it comes to wealth creation? Is it worth using your savings to diversify your investments when you have a hefty home loan to pay off? Or should you take advantage of low mortgage interest rates and use your savings to hit harder at your debt?

There is no one-size-fits-all approach that is right for everybody. Paying off your mortgage is rarely a bad idea, but you may also have the option to invest. While the former will reduce the amount you pay in interest and help build up equity in your home faster, the latter could potentially help you generate more wealth and build a second income stream by purchasing a rental property. However, there are also risks involved in borrowing more money to purchase a second property. You could risk losing both houses if you default on your mortgage so it’s important to make an informed decision.

The pros and cons of paying off your mortgage faster

There are some obvious financial and emotional benefits to paying off your mortgage early, such as owning your property outright without a mortgage hanging over your head. Once your house is mortgage-free, you no longer have to worry about the monthly repayments. You also don't have to spend your hard-earned cash paying interest charges to the lender. 

Making extra repayments to pay off your mortgage faster can lead to significant interest savings over the long term. For example, imagine you have a $500,000 mortgage for 30 years at a 2.20 per cent interest rate. Using a mortgage repayment calculator to find the monthly principal and interest repayments, the loan will cost you approximately an additional $183,461 in interest charges over the full term. However, if you decide to pay an extra $250 into your home loan each month, your debt will end four years and eight months earlier. Plus, you'd pay about $30,000 less in interest. Keep in mind that this example doesn't include fees and charges, and assumes the interest rate will remain the same over the full loan term.

While paying off your debt early can help boost your savings by reducing the amount of interest you pay on your home loan, it might not be the most financially savvy decision for everyone. For instance, people with multiple debts often prioritise paying off loans with higher interest rates first, as this can help to save on interest in the long run. As home loans tend to have lower interest rates compared to some other types of loans, it might be worth targeting other forms of debt before eliminating your mortgage debt. 

The decision to pay off your mortgage or purchase an investment property also depends on how far along you are on your home loan journey. Paying extra onto your home loan is often more beneficial when done early in the loan term due to the effect of compounding interest. Extra repayments at the beginning of a 30-year term are much more effective in cutting down the total interest you’ll pay on the loan than extra repayments made 15-20 years into the loan.

As you continue paying off the mortgage, you also build equity in your home that may be leveraged to renovate the property or meet some other requirement. Some people may also choose to keep their mortgage running to use the redraw facility. 

While you cannot sell a portion of your property to meet an emergency expense, you might be able to redraw some of the additional funds you've paid into the loan to meet your needs. However, it might be tricky keeping your mortgage open after retirement if you find it challenging to meet the repayments in the absence of a steady source of income. 

The pros and cons of buying an investment property 

It's possible to utilise the equity in your home to pay the deposit on a second property to grow your investment portfolio. Buying an investment property could help you earn rental income while minimising the impact on your cash flow as interest payments on an investment loan are tax-deductible. You may also see a capital gain from the eventual sale of the property. 

However, there's no guarantee that the property you buy will always increase in value. Therefore, it's worth researching your options and buying a property in a good location. If you're considering a specific house or neighbourhood, you can order a free home price guide to get historical data and trends regarding property prices, rental and vacancy rates in the area.

It’s also worth noting that you’ll be increasing your debt substantially by taking out another mortgage for a second property. Therefore it’s important to check whether you have adequate cash flow to simultaneously manage the repayments on two mortgages. While crunching the numbers, consider how you’re going to cover the repayments for vacant periods when there is no rental income. Occasionally, you'll also require some money for property maintenance but you might be able to claim some of these expenses in your tax return.

Should I buy an investment property or pay off my mortgage early?

If you're considering whether to buy an investment property or pay off your mortgage early, you'll need to consider the size of your mortgage first. If you owe more than 80 per cent of your home's current value, you'll find it difficult to refinance your home loan and use your equity to fund the deposit for a second home. Instead, you could think about paying down your home loan and building your equity to increase your ownership of the house. 

On the other hand, if you've got enough equity in your home, using it to purchase an investment property could potentially help you generate more wealth. However, it remains a risky option, and it’s advisable to speak with a mortgage broker or a financial advisor to ascertain whether you can afford to pay two mortgages in the long run.

If you take out an investment loan for the second property, it might be interest-only for the first few years. However, your mortgage repayments may jump significantly after the interest-only period is over. You also need to pay for property maintenance and other small expenses to make your rental property tenant-worthy. Even though the interest you pay on an investment loan is tax-deductible, you'll still need adequate cash flow to cover various additional expenses, including insurance and property management fees.

Eventually, the choice between buying an investment property or paying off your mortgage faster will depend on your financial situation and long-term goals. It's also worth considering other investment options, such as building your super, to contribute towards a more comfortable retirement.

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This article was reviewed by Personal Finance Editor Mark Bristow before it was published as part of RateCity's Fact Check process.



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