Should I Invest or Pay off the Mortgage?
Depends on Investment Returns, Tax Bracket, and Mortgage Rate
To determine if you should invest or pay off your mortgage, you need to compare the after-tax return on your investments with the after-tax cost of your mortgage. Let us assume the following facts:
- Marginal tax rate: 25%
- Safe investment return: 4%
- Mortgage rate: 6%
For every $100 of taxable investment income, you get to keep $75 after paying taxes at 25%. For every $100 of mortgage interest you pay, assuming you itemize deductions on your tax return, your net cost is $75 after deducting the interest at 25%. Either way, you are paying tax regardless of whether you invest and earn investment income or cash in the investments to pay off the mortgage.
Keep in mind, after the Tax Cuts and Jobs Acts (TCJA) raised the standard deduction in 2018, many taxpayers began using the standard deduction rather than itemizing deductions on their tax returns. This change led to the mortgage interest deduction being unavailable to many taxpayers.
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.
If you invest, you could earn 4%, so for every $1,000 invested, you earn $40. After paying taxes on this interest income at a 25% tax rate, you would keep $30. If you instead use the $1,000 to pay off a portion of your mortgage, it would save you $60 in interest cost, given the 6% mortgage rate. After deducting by 25%, you save $45.
In this scenario, you save $15 by paying off a portion of your mortgage rather than investing your extra funds.
Mortgage Payment Guidelines
Obviously, interest rates, tax rates, and returns on safe investments can change. Here are five guidelines to keep in mind as you gauge the potential effectiveness of paying off your mortgage.
- As your tax bracket decreases, the potential benefit of paying off your mortgage increases.
- As your investment return decreases, the potential benefit of paying off your mortgage increases.
- As your investment return increases, the potential benefit of investing increases, but higher returns also entail greater risk. In turn, you must consider the level of investment risk you are 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 will not be guaranteed.
- At lower mortgage rates, the long-term benefit of paying off the mortgage will not be as great as when your mortgage rate is higher.
- If you have to decide between putting more money towards your mortgage, or into your 401(k) plan, the latter is often the better option.
Other Important Considerations
Like most financial decisions, your specific circumstances, including but not limited to age and health, income expectations, tax filing status, and feelings about risk, will need to be considered when determining whether paying off a mortgage early is the right decision 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 the different options available in the mortgage lending marketplace (e.g., variable-rate mortgages, fixed-rate mortgages, and refinancing opportunities). If you enjoy a higher income or net worth, the benefits of low mortgage interest rates, preferential tax opportunities, and compounding portfolio returns make keeping a mortgage a reasonable option. 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. If you are able to get a higher investment return than your mortgage rate, the math may indicate that you should invest. But, math is not the only consideration - peace of mind is priceless.