Should You Put Extra Money Towards Your Mortgage or Invest?

by Neal Frankle, CFP ®

Should you put extra money towards your mortgage or invest? Is it a good idea to pay off your mortgage ever? This is another great question Money Mavens hear all the time. And since I’m part of that fine bunch of bloggers, I thought I’d take a stab at trying to answer.

I’ve created a little guide to help you decide for yourself. But before you get started, you’ll need the following information:

1. What is your mortgage interest rate?
2. What are your monthly payments?
3. What tax bracket are you in?
4. How much can you earn in alternative investments?

Now let’s do some calculating:

First, calculate the after-tax mortgage interest rate. For example, if your interest rate for your mortgage is 5% and you are in the 30% marginal tax bracket, your after-tax mortgage rate is actually 3.5%. Why? Because under current law, if you pay mortgage interest, it’s deductible. You get a tax break for the interest you pay on your mortgage. So if you pay 5% to the bank but get back 1.5% from Uncle Sam, your net cost is only 3.5%.

Next calculate what your after-tax return is on alternative investments. For example, if you estimate that you can earn 7% with your investments but you’ll pay 30% in tax, you’ll really only net about 4.9%.

Now, if your after-tax return is higher for alternative investments, keep a high mortgage and invest as much as you can. In the example I gave above, that’s what you’d do. But if your after-tax mortgage rate is higher than your after-tax investment return, pay off the mortgage before you invest a dime.

This is the logic and it is correct. But in real life, it’s much more complicated:

1. If you have a variable rate mortgage, you don’t know what your interest rate is going to be in the future.

2. If you invest in equities and mutual funds, you don’t know what your after-tax return is going to be.

3. What if interest rates drop in the future: Should you refinance and invest at that time?

4. What if you carry a balloon payment mortgage? This changes all the calculations?

But even if we assume that we have a fixed rate on both your mortgage and alternative investment, the calculation still has flaws.

The main flaw of the calculation is that it completely ignores the emotional element of money.

My opinion is that money is there to create greater happiness. Sometimes you can create more money with your money but by doing so, you create less happiness. That isn’t a good trade-off if you ask me. I think this can happen with people when it comes to a mortgage. Let me explain.

Close your eyes for a minute and imagine you have a mortgage of $300,000 today but you also have $300,000 invested in the bank. How does that feel?

Now, close your eyes a second time. Imagine that you own your home free and clear. It’s yours. You don’t have to make any payments anymore. You don’t have a mortgage…but that’s because you used the $300,000 to pay it off. Now tell me how that feels? For some of us, just having that “debt free” feeling is worth a million bucks – even though it only cost $300,000.

There is no right or wrong answer when it comes to feelings. Actually, I think the only wrong answer is when you completely ignore the emotional side of money. When you do that, you forget that money is supposed to bring you happiness. You’re not supposed to sacrifice happiness for money.

Now this is not to say that you should totally abandon your intellect when you make financial decisions…you have to strike a balance. But the balance is not between money and happiness. The balance is between long-term and short-term happiness.

Let me share with you one more “calculator” that I use to help find that balance.

Let’s say your annual after-tax mortgage interest expense is $9,500. At the same time, your annual after-tax return on your investments is $15,000. Therefore, you save $5,500 every year by keeping your mortgage and continuing to invest your money. $5,500 every year is a lot of money. If you invest that money and earn 5% (net of tax), it grows to almost $70,000 in ten years. Is it enough to compensate you for the feeling of having a mortgage? That’s a decision you have to make on your own.

Of course if you hold on to your investments, you hold on to your risk too. There will be years when you earn significantly less than your expected rate of return. There is the risk that you’ll lose money in some years as well. Is that risk worth $5,500 a year? Again, this is a personal decision and there is no right or wrong answer.

You can see that your answer is influenced by four elements:

1. The size of your mortgage.
2. The difference between the rate you earn and the rate you pay.
3. How much time you have left to pay.
4. Your emotional makeup.

Bottom line: From a purely financial standpoint, it’s easy to calculate if it’s better to invest or pay off your mortgage. But from a happiness-maximizing standpoint, it’s really not that simple.

If you have a mortgage, what is your answer to this question? Are there other elements I’ve left out?

Interested in some other opinions? Here’s what some of the other Money Mavens have to say:

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{ 16 comments… read them below or add one }

Best Residential Conveyancing Services by GM Lawyers September 4, 2013 at 5:52 AM

Hmmm… It is hard to decide on where to invest your extra money. I guess you have to find a decent balance between practicality and emotions when you decide whether the money should go to mortgage or invest.

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Wendy June 27, 2012 at 5:51 AM

I only owe 1 1/2 years on my mortgage and as I’m recently widowed I want to pay it off and not have that debt hanging over me. Would it be wise to pay it off? Some people are telling me not to do it.

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Neal Frankle June 27, 2012 at 6:49 AM

I would need more information:
a. age
b. other debts?
c. what your other investments are earning
d. interest rate on the loan

That said, I don’t see a problem paying it off. What is the argument these others tell you against paying it off?

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John March 8, 2011 at 10:04 AM

Could one of the many experts who post on this site please help me with this facet of the conversation:
I have a $300,000 30yr fixed mortgage at 5.2% and $100,000 in the bank. I plan to own (or rent) the home for a long time (15yrs or more). Should I be looking into paying off a big chunk and refinancing at a lower rate for 15 yrs?

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Laura August 2, 2011 at 10:54 AM

You can also reamoritize your loan at your current interest rate. Payoff a large chunk at once and they have them reduce your monthly payment accordingly. Not many places know about this so ask. If you refi you just need to figure out how many months would it take you before you broke even on the costs.

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Aury (Thunderdrake) May 6, 2010 at 4:45 PM

Personally, I try to avoid owning a high mortgage in the first place. But this is because I have a very low standard of living, and don’t really require much of one to enjoy my life. If pressed, I’d ask myself “Does the mortgage have a higher interest rate, or will my portfolio earn me more?” Since there are ways to bail out of a mortgage, both harmful and fair. But with a portfolio, you can’t weasel in gain the same way.

Every case is different. So this is something someone should ask themselves and answer themselves. I’d rather build my assets than assume the responsibility of liability.

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Financial Samurai May 5, 2010 at 8:54 PM

Perhaps doing a little bit of both is a good idea. It’s all about comparing your mortgage rate to the risk free rate of return, which is currently close to 4%.

I would say any mortgage rate above 6.5% one should just focus on prepaying. 5-6% is not so clear, and under 5%, I’d just keep the mortgage for as long as the bank allows me to borrow.

Best,

Sam

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Panda Mike May 5, 2010 at 7:31 AM

I like the “how does this feel approach”, this is a big factor in one’s decision to pay off his mortgage faster or invest his money.

In my case, the decisive question was:
Can you beat your mortgage rate on the stock market?

If you take the compound interest power in consideration, as long as you can match or beat your mortgage rate in your investment portfolio, you will be better off with your investments.

For example: a mortgage of $100,000 at 5% over 20 years.
scenario #1: you pay down your mortgage (monthly payment of 657.13$). in 20 years, you will be done with your mortgage, so creating 100K of value (the amount of your mortgage).

scenario #2: you pay interest only for 5 years and you invest the difference at 5%. Interest only payment is $416.67 per month. You invest the difference ($240.46). At 5%, you get $98.838. You seem to be a loser but you kept your tax advantage all the way down which equals way much more than $1,200. Also, if you only invest at 5.5% instead, you get $104,752 (plus tax advantage).

This is why I rather go with scenario 2 ;-)

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JoeTaxpayer May 4, 2010 at 8:07 AM

There’s far more analysis we can all do on so many aspects of this issue.
A mortgage is somewhat unique in that it’s a 30 yr product you can renege on. I have $100K mortgage and $100K in the bank, if rates drop, it’s my choice to refi or pay off the mortgage. But if they rise with a vengeance, I may get 8% in the same bank I pay 5% on that mortgage. In my own post I failed to explore this further, pointing out that we are in a time of low mortgage rates as well as a relative low point in the market.
No one can predict for sure, but after the decade we had, it appears we are in for a better one ahead.

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Nunzio Bruno May 4, 2010 at 7:36 AM

This was a really great way to break it down. I get asked this question all the time..or rather have to go through a similar exercise to help people realize that in the long run while it may feel better to pay down that mortgage it’s not always the best utilization of available resources. (even though they might get the most perceived amount of utility out of it) Great post!

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Len Penzo May 4, 2010 at 5:45 AM

I agree that the decision is more emotional than anything else.

Because nobody can put a price on peace of mind, it becomes very difficult to compare the two alternatives.

All the Best,

Len
Len Penzo dot Com

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Tom May 4, 2010 at 4:18 AM

I believe this is the best post I have seen on this topic. I brings us to the common conclusion that the “emotional component” of financial decisions is often the largest component to consider. Consumers have many of the black and white answers to their money questions, but the emotional component and/or behavioral aspects is what makes the difference of making a plan work or not.
Thank you for the post and your blog.

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Evolution Of Wealth May 4, 2010 at 3:44 AM

Is it really that easy to calculate from a financial standpoint? 7% rate of return, that’s should be easy in theory but who’s been getting that lately? To me, saving on the side instead of paying off your mortgage is a great way to build wealth. Where else can you get access to such a large sum of money and have it work for you? I love the idea, but I could never do it with investments. What happens if years 20-30 of your mortgage you get performance like 2000-2009? Now we might have a real problem and all is for not. I don’t even think stocks should be brought into the conversation.

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Neal@Wealth Pilgrim May 4, 2010 at 5:05 AM

Evo,

I think you also make an excellent point. Actually, it’s the subject of a post by itself….What you should benchmark your debts/investments against?

If you only compare a fixed mortgage to a fixed income investment, you should almost always pay off your mortgage.

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Mike Piper May 4, 2010 at 3:42 AM

Additional complicating factors:

1. Even with a fixed-rate mortgage, your after-tax interest rate changes over time, given changes in tax policy over the years.

2. Your after-tax interest rate isn’t quite so simple as “interest rate x (1-tax rate)” because it also depends upon how much you have in other itemized deductions. For example, if this mortgage interest is your only itemized deduction, and it’s just barely above the standard deduction, the value of your HMI deduction is almost nil.

Mathematically, this question is a big ugly mess of unknown and changing factors. :)

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Neal@Wealth Pilgrim May 4, 2010 at 5:03 AM

Right on Mike. I believe the dynamics are exactly what make this issue so complicated or at least, difficult.

At the end of the day, you have to do your best with the knowledge you have at the time and move on.

Reply

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