If you have a mortgage, and have been making payments on your home for a long time, the thought of paying it off might be very enticing. And if you're in the position to do so, you may wonder if it's a smart move, financially speaking. The best way to decide whether to invest or pay off your mortgage is to compare the after-tax return on your investments against the after-tax cost of your mortgage. The result will differ for each person. It depends on if you claim an itemized deduction for your mortgage interest, and how the Tax Cuts and Jobs Acts (TCJA) might affect you. In 2018 the TCJA raised the standard deduction, so that some people are better off if they don't itemize.
This change may mean paying off your mortgage for the sake of a tax perk may have less appeal. Your decision should weigh the potential tax benefit, or lack thereof, and a number of other factors that pertain to your specific situation.
What's the Difference Between Investing and Paying Off Your Mortgage?
|Paying Off Your Mortgage||Investing|
|The benefit increases as your top tax bracket decreases.||The benefit increases with the return on your investment, but higher returns come with greater risk.|
|The benefit increases as your return-on-investment decreases.||Keeping a mortgage and investing instead can make more sense for people who have higher incomes because they often have better loan terms.|
Let's use an example to see how this choice might play out. Suppose that your income puts you in a tax bracket where the marginal tax rate is 24%. The current return if you invest in a fund on the safe rather than risky side is 4%. Your mortgage interest rate is also 4%.
After paying taxes at a rate of 24% on the money you invest, you'd get to keep $76 out of every $100 of taxable investment income.
Your net cost on every $100 of mortgage interest that you pay would be $76 after you deduct the interest at 24%. This assumes that you itemize deductions on your tax return.
Either way, you're paying tax whether or not you invest and earn investment income or you cash in the investments to pay off the mortgage.
Your marginal tax rate is the percent in taxes that you pay on your top dollar of income. The 24% bracket applies to annual incomes from $172,750 to $329,850 as of the 2021 tax year, for people who are married and filing a joint return. Your income earned up to the $172,500 threshold is taxed at lesser rates.
But it's not that simple. Many other factors come into play.
Using the facts above, assume that you had an extra $1,000 that you could either invest or use to pay off a portion of your mortgage. You could earn 4% if you invest, so you'd earn $40 for every $1,000 that you invest. After paying taxes on this interest income at a 24% tax rate, you would keep $30.40.
It would save you $40 in interest cost if you instead use the $1,000 to pay off a portion of your mortgage, given that 4% mortgage rate. You'd save $38.40 after paying tax on this income at the rate of 24%, so you'd have an extra $8.40 if you paid off a portion of your mortgage rather than investing your extra funds.
Guidelines for Paying Off Your Mortgage
Interest rates, tax rates, and returns on safe investments can and do change, so you might want to keep these guidelines in mind as you weigh the pros and cons of paying off your mortgage.
- The benefit of paying off your mortgage increases as your tax bracket decreases.
- The benefit of paying off your mortgage increases as your investment return decreases.
- The potential benefit of investing increases as your investment return increases, but higher returns also entail greater risk.
- The long-term benefit of paying off a mortgage will not be as great for lower mortgage rates as it would be if your mortgage rate is higher.
Consider the level of investment risk you're willing to take on, as compared to the risk-free return of paying off your mortgage. Paying off the mortgage is a guaranteed return. Other investments may offer higher returns, but the return won't be a sure thing.
The Bottom Line
People with very high income or high net worth may benefit more from the use of debt and will probably have more access to a wider range of options in the mortgage lending market. The benefits of low mortgage interest rates, preferential tax opportunities, and compounding portfolio returns, make keeping a mortgage a wise option if you enjoy a higher income or net worth.
On the other hand, people with lower incomes or those lacking in investing expertise will find that paying down their mortgage is one of the best choices they can make. This is most true if they use the standard deduction rather than itemizing deductions on their tax returns.
The math may indicate that you should invest if you're able to get a higher investment return than your mortgage rate, but math isn't the only factor. Peace of mind can be priceless.
No investment is ever truly without risk. As with most financial choices, you should take into account your specific circumstances when you're thinking about whether paying off a mortgage early is the right move for you. (These include your age, health, income goals, tax filing status, and feelings about risk, just to name a few of the most common.) There are pros and cons to making such payments.
IRS. “Tax Reform Basics for Individuals, Tax Year 2019,” Page 6. Accessed Sept. 15, 2021.
IRS. "IRS Provides Tax Inflation Adjustments for Tax Year 2021." Accessed Sept. 15, 2021.
Consumer Financial Protection Bureau. "How Does Paying Down a Mortgage Work?" Accessed Sept. 15, 2021.