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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