Paying Off Your Mortgage vs. Investing: Which Is the Smarter Financial Decision?

The decision to pay off your mortgage or invest depends on several factors, and there is no one-size-fits-all answer.

If your mortgage has a low interest rate (generally below 4-5%), it may be better to invest extra funds rather than pay off the mortgage early. This is because you can potentially earn higher returns by investing in the stock market over the long run compared to the interest savings from paying off a low-rate mortgage. The S&P 500 has returned roughly 10% annually since 1926, which would beat most mortgage rates we've seen since the rates settled down after the 1980s.^1,2 However, most people have a diversified portfolio that includes bonds or other fixed income (rather than having 100% invested in one company or asset class), which bring their portfolios' average returns down to less than 10%. The key is to understand what a reasonable expected return for your portfolio might be and comparing that to your current mortgage rate, your long-term objectives, and the risk you are willing to accept. If you are fairly confident that you can beat your current mortgage rate with your investment portfolio return, it may make sense to put the extra money to work in your investment portfolio.

However, if your mortgage has a high interest rate (above 6-7%), it might make more sense to pay your mortgage off faster to save on interest costs.³ If your interest rate is high, paying off your mortgage could provide a return equivalent to your mortgage rate, which might be more attractive than potential investment returns and the associated risks.

Over the long term, the S&P 500 has historically returned around 10% annually.⁴ If you can reasonably expect higher returns from investing compared to the interest rate on your mortgage, it may be better to invest and let your money compound over time. An important consideration for all investment decisions is to determine your investment time horizon. It is generally unadvisable to invest money in the stock market if your time horizon to when you will use the money is less than 5 years. In general, the stock market moves two steps forward and one step backward: higher over time, but not without short-term volatility. The 5-year-or-longer investment timeframe helps reduce the risk that your investment portfolio may be worth less than you originally invested when you need it. The other factor to consider has to do with the fact that most investment portfolios are not 100% stocks. The addition of bonds or CDs, for example, will bring expected portfolio future returns down but will also help smooth out the ride from a volatility perspective.⁵

Mortgage interest may be tax-deductible, which can reduce the effective interest cost. This may make paying off the mortgage less advantageous from a tax perspective. However, since the Tax Cuts and Jobs Act in 2017 doubled the standard deduction, many taxpayers are not itemizing their deductions on their federal income tax returns and therefore not getting a tax break on their mortgage interest.⁶ There are also limits as to how much interest is allowed to be deducted, which may be an important factor for an investor.

Investments in tax-advantaged accounts like 401(k)s and IRAs also provide tax benefits, but that is not where most people will invest the money that they otherwise would have used to pay down their mortgage. Taxable brokerage accounts are typically where these investments are made. These accounts can create tax impacts -- for example, any gains realized on the sale of the assets in these accounts that will be used to pay off a mortgage in the future will likely be taxable at long term capital gains rates. This tax drag would need to be taken into the equation.

Investments are generally more liquid than home equity. If you need access to funds for emergencies or other expenses, investing provides more flexibility than tying up money in your home. It is important that you have an adequate emergency fund before committing extra income to mortgage repayment or investments.

Being mortgage-free can provide psychological benefits and a sense of security. If being debt-free is a significant goal for you, this might weigh heavily on your decision. As retirement approaches, having a required monthly payment of $2,000 or more for a mortgage may weigh on your cash flow. Even though you may only owe $25,000 or $50,000 on your mortgage balance, your monthly payment may still be very high. Paying off your mortgage balance may be attractive to free up that monthly mortgage payment amount in retirement.

One of the benefits of paying off your mortgage early is saving on interest payments. By paying off your mortgage early, you may save a substantial amount of money on interest payments over the life of the loan. This is particularly beneficial if you have a high-interest mortgage.

Paying off your mortgage can also improve your cash flow and reduce financial stress. Without a mortgage payment, your monthly expenses decrease, improving your cash flow. This can free up money for other financial goals or unexpected expenses. It can also increase your peace of mind knowing that you have a major financial obligation out of the way and provide a sense of security and financial freedom.

Lastly, owning your home outright increases your home equity, which can be a valuable asset. This can be useful if you need to access funds through a home equity loan or line of credit in the future.

Using extra money to pay off your mortgage means those funds are not available for other investments, which means you may miss out on the potential for higher growth in your investment portfolio as investments have generally offered higher returns than the interest rate on most mortgages. Additionally, once you put money into your home, it becomes illiquid. Unlike investments in stocks or bonds, it's not as easy to access cash if you need it quickly. Finally, because mortgage interest is tax-deductible for many homeowners, paying off your mortgage may reduce your eligible deductions, potentially increasing your tax burden.

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Investing allows you to take advantage of compound interest and potential higher returns than the interest rates on most mortgages, which could lead to exponential growth in your investment portfolio and significantly increase your wealth over time. The greater liquidity of investments compared to home equity means that you can access your money more easily if you need it for emergencies. Additionally, certain investments, such as 401(k)s and IRAs, offer tax advantages. Contributions to these accounts can reduce your taxable income, and growth within these accounts is often tax-deferred or tax-free.

Investments are subject to market fluctuations, which can lead to losses. Unlike the return of paying down debt, investments can be unpredictable. Additionally, while investments have historically provided higher returns, there are no guarantees. Economic downturns can erode the value of your investments, which could impact your financial security.

By not paying off your mortgage early, you continue to pay interest on your loan. Over time, this can add up to a significant amount, particularly if your mortgage has a higher interest. Not paying off your mortgage early can also lead to financial stress -- carrying mortgage debt can be stressful for some individuals, particularly in uncertain economic times. Knowing that you have a major financial obligation can impact your peace of mind.

Paying off your mortgage might be a better option than investing in certain situations. Here are some scenarios where this could be the case:

• High-Interest Mortgage, Low Risk Tolerance: If your mortgage interest rate is relatively high compared to the potential returns from investments, paying off the mortgage can provide a return equivalent to the interest rate, which might be higher than what you could earn from investing, and reduces financial risk.
• Nearing Retirement: As you approach retirement, reducing financial risk becomes more important. Paying off your mortgage can lower your monthly expenses and provide a sense of security, making it easier to manage your finances on a fixed income.
• Desire for Financial Security: Owning your home outright can offer significant peace of mind. If the psychological benefit of being debt-free outweighs the potential financial gains from investing, paying off your mortgage could be the better choice.
• Tax Implications: If you do not benefit significantly from the mortgage interest deduction (e.g., if you take the standard deduction or if your mortgage interest is relatively low), the tax benefits of keeping a mortgage might not outweigh the benefits of paying it off.

Investing rather than paying off your mortgage might be a better option in some situations:

• Low-Interest Mortgage: If your mortgage interest rate is relatively low, especially if it's below the average expected return on investments, investing your extra funds could yield higher returns over time. For example, if your mortgage rate is 3% and you believe you can earn 7% from investments, the potential higher return might justify investing.
• Long Investment Horizon: If you have a long investment horizon, the power of compounding could significantly increase the value of your investments.
• Employer-Sponsored Retirement Plans: If you have access to employer-sponsored retirement plans, such as a 401(k) with matching contributions, it often makes sense to prioritize investing in these accounts. The employer match is essentially free money, providing an immediate return on your contribution up to the company limit.
• High Inflation Environment: In periods of high inflation, the real value of fixed mortgage payments decreases over time, making it cheaper to carry the debt. In contrast, investments might benefit from inflationary trends, potentially increasing in value.
• Strong Financial Safety Net: If you already have a well-funded emergency fund, minimal high-interest debt, and stable income, investing extra funds can be a strategic way to grow your wealth. A strong financial foundation allows you to take on the risks associated with investing.
• Retirement Savings Goals: If you need to catch up on retirement savings, prioritizing investments can help you reach your retirement goals faster. The compounding growth in retirement accounts can be critical for building a sufficient nest egg.

Deciding between paying off your mortgage vs. investing depends on various factors, including your financial goals, risk tolerance, investment horizon, and current financial situation.

Assessing these factors and consulting with a financial advisor can help you ask the appropriate questions and allow you to make the best choice for your circumstances. If you'd like to learn more about the wealth management strategies we use with our clients, you can contact one of our advisors here.