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, as in the example below.
Let's assume the following facts:
- Marginal tax rate: 25%
- Safe investment return: 4%
- Mortgage rate: 6%
You Have Choices, or Do You?
Using the facts above, for every $100 of taxable investment income, after paying taxes at 25%, you get to keep $75.
For every $100 of mortgage interest you pay, assuming you itemize deductions on your tax return, after deducting this interest at 25%, your net cost is $75.
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 and thus lose a tax benefit.
Opportunity Cost Example
Using this scenario, assume you had an extra $1,000 that you could either invest or use to pay off a portion of your mortgage.
- If you invest, you would earn 4%, so for every $1000 invested you earn $40. After paying taxes on this interest income, you would keep $30.
- If you use the $1,000 to pay off a portion of your mortgage, it would save you 6%, or $60 in interest cost, but you would no longer have the extra $60 to deduct on your tax return, so after factoring in the lower tax deduction, it saves you $45.
In this scenario, you save $15 a year by paying off a portion of your mortgage rather than investing your extra funds. ($15 = $45 net savings on mortgage interest - $30 net interest earned on investment).
Obviously, interest rates, tax rates and returns on safe investments can change. Here are four guidelines you can use to 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 returns increase, the potential benefits of investing rather than paying off the mortgage increase, but higher returns entail higher risk so you must consider the level of investment risk you are willing to take 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.
- At lower mortgage rates, the long-term benefit of paying off the mortgage will not be as great as if your mortgage rate was higher.
- If you can pay extra toward your mortgage, or put extra money in your 401(k) plan, often the better option is paying extra toward your 401(k) plan.
Other Important Considerations
Like most financial decisions, your specific circumstances including age and health, income expectations, tax filing status, and feelings about risk will need to be considered in determining the right decision for you. There are both pros and cons to paying off the mortgage early.
High net worth families may benefit more from the use of debt and have greater access to options available in the mortgage lending marketplace such as variable-rate mortgages, fixed-rate mortgages, and opportunities for refinancing. If you are a higher income/higher net worth person at the end of the day, the benefits of low mortgage interest rates, preferential tax opportunities, and compounding portfolio returns make keeping a mortgage seem reasonable.
However, lower-income families without investing expertise will find that paying down their mortgage is one of the best decisions they can make.
No investment is ever truly without risk. If you are able to get a higher investment return than your mortgage rate, the math says to invest. However, math is not the only consideration - peace of mind is priceless.