The best way to decide whether to invest or to pay off your mortgage is to compare the after-tax return on your investments against the after-tax cost of your mortgage. But this depends on claiming an itemized deduction for your mortgage interest, and the Tax Cuts and Jobs Acts (TCJA) raised the standard deduction in 2018.
This change made claiming the mortgage interest deduction less attractive for many taxpayers, because you can't claim the standard deduction and itemize your deductions, too. It's one or the other.
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 are associated with greater risk.|
|The benefit increases as your return-on-investment decreases.||Keeping a mortgage and investing instead can make more sense for high-income individuals because they often qualify for better loan terms.|
Here's a comparison of how this decision might play out. As an example, let's say that your marginal tax rate is 24%. The return on a safe investment is 4%. Your mortgage interest rate is also 4%.
You'd get to keep $76 out of every $100 in taxable investment income after paying taxes on that money at the rate of 24%.
Your net cost on every $100 of mortgage interest that you pay would be $76 after deducting the interest at 24%, assuming that you itemize deductions on your tax return.
Either way, you're paying tax regardless of whether you invest and earn investment income, or you cash in the investments to pay off the mortgage.
Your marginal tax rate is the percentage 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, assuming you're married and filing a joint return. Your income earned up to the $172,500 threshold is taxed at lesser rates.
Other considerations come into play, however.
Using the facts above, assume that you had an additional $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 invested. 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 additional $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 gauge the potential effectiveness 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.
Consider the level of investment risk you're willing to take on, 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 guaranteed.
- The long-term benefit of paying off a mortgage will not be as great at lower mortgage rates as it would be when your mortgage rate is higher.
The Bottom Line
As with most financial decisions, your specific circumstances—including your age, health, income expectations, tax filing status, and feelings about risk—should be considered when you're determining whether paying off a mortgage early is the right move for you. There are pros and cons to making such payments.
High-net-worth families may benefit more from the use of debt, and will probably have more access to different options available in the mortgage lending marketplace. The benefits of low mortgage interest rates, preferential tax opportunities, and compounding portfolio returns make keeping a mortgage a reasonable option if you enjoy a higher income or net worth.
Meanwhile, lower-income families without investing expertise will find that paying down their mortgage is one of the best financial decisions they can make, especially if they use the standard deduction rather than itemizing deductions on their tax returns.
No investment is ever truly without risk. 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 consideration. Peace of mind can be priceless.