June 7, 2024

Should You Pay Off Your Mortgage or Invest?

Matthew McConnell, CFP®, AMPA®
One question that comes up quite frequently from clients is whether they should pay off their existing mortgage or use the extra funds to invest instead. As with many decisions like this, the answer is "it depends". The decision to pay off your mortgage or invest depends on several factors, and there is no one-size-fits-all answer. Here are the key considerations.

Mortgage Interest Rate

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 stock market 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 However, most people don't have a 100% stock portfolio and usually have some bonds or other fixed income that bring their portfolio average returns down to something 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. If you have a high confidence level that you can beat your current mortgage rate with your investment portfolio return, it may make sense to put your extra cash to work in your investment portfolio.

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

Investment Returns

Over the long term, the stock market has historically returned around 7-10% annually.2 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. The key here is the definition of "long term" as I find it generally unadvisable to invest money in the stock market if you have less than a 5-year time horizon to when you will use the money. 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 here was touched on in the mortgage interest rate section above and 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 to smooth out the ride from a volatility perspective.3

Tax Implications

Mortgage interest is tax-deductible, which reduces the effective interest cost.4 This makes paying off the mortgage less advantageous from a tax perspective. However, since the Tax Cuts and Jobs Act in 2017 doubled the standard deduction, most taxpayers are not itemizing their deductions on their federal income tax returns and therefore not getting a tax break on their mortgage interest.5 There is also a limit of $750,000 that can be deducted for mortgage interest, so if your mortgage is larger than that, you are not getting a tax break on the interest on the mortgage amount over $750,000.6 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, and 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.

Liquidity Needs

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.

Peace of Mind

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 still may be very high. Paying off your mortgage balance may be attractive to free up that monthly mortgage payment amount in retirement.

Example Scenarios

Here are some scenarios that may help shed some light on the decision making process.

  1. Low Mortgage Rate, High Risk Tolerance: Consider investing your extra income. If your mortgage rate is, for example, 3%, and you believe you can earn 7% from investments, the potential higher return might justify investing.
  2. High Mortgage Rate, Low Risk Tolerance: Consider paying off your mortgage. Eliminating a high-interest debt provides a guaranteed return and reduces financial risk.
  3. Balanced Approach: Split your extra income between paying down your mortgage and investing. This diversifies your financial strategy and balances debt reduction with potential growth.
  4. Close to Retirement: Focus on paying off your mortgage to reduce expenses in retirement. Being mortgage-free can lower your required retirement income and provide financial stability.

In summary, if you have a low mortgage rate, a long investment horizon, and can tolerate some risk, investing may be the better choice. But if you have a high mortgage rate, low risk tolerance, or prioritize being debt-free, paying off your mortgage could be the wiser decision. As always, it is a good idea to consult with your financial advisor and tax professional before making a decision on a mortgage reduction strategy.

If you'd like to learn more about strategies we use with our clients, you can contact one of our advisors here.

1Dimensional Fund Advisors. "The Uncommon Average." Dimensional Fund Advisors, n.d. [Online]. Available: https://www.dimensional.com/us-en/insights/the-uncommon-average. May 31, 2024; Freddie Mac. "Primary Mortgage Market Survey (PMMS)." Freddie Mac, n.d. [Online]. Available: https://www.freddiemac.com/pmms. May 31, 2024.

2Dimensional Fund Advisors. "The Uncommon Average." Dimensional Fund Advisors, n.d. [Online]. Available: https://www.dimensional.com/us-en/insights/the-uncommon-average. May 31, 2024.

3Fidelity Investments. "Investment Risk." Fidelity Investments, n.d. [Online]. Available: https://www.fidelity.com/learning-center/personal-finance/investment-risk. May 31, 2024.

4Tax Foundation. "Home Mortgage Interest Deduction." Tax Foundation, n.d. [Online]. Available: https://taxfoundation.org/research/all/federal/home-mortgage-interest-deduction/. May 31, 2024.

5Tax Foundation. "2017 Tax Cuts and Jobs Act Analysis." Tax Foundation, n.d. [Online]. Available: https://taxfoundation.org/research/all/federal/2017-tax-cuts-jobs-act-analysis/. May 31, 2024.

6Tax Foundation. "Home Mortgage Interest Deduction." Tax Foundation, n.d. [Online]. Available: https://taxfoundation.org/research/all/federal/home-mortgage-interest-deduction/. May 31, 2024.

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About the Author: Matt McConnell, CFP®, AMPA®

Senior Financial Advisor

Matt joined Hawaii Partners 3D Wealth Advisors in November 2020 after spending 21 years running his own financial planning franchise at Ameriprise Financial, LLC. Matt and his wife Uyen live in Honolulu and have one daughter. In his free time, he enjoys going to the beach or park with his family, as well as surfing, hiking, and playing ice hockey! Matt also helps run the annual St. Patrick's Day parade and participates in other volunteer work throughout the community whenever he gets the chance.

Matt's Bio