Pay Off Your Mortgage Early or Invest?

“Remind me why you still have a mortgage?”

Our financial planner posed that question to my husband and me about a decade ago. He pointed out that we weren’t getting much of a tax benefit from carrying the debt because such a big percentage of our payments were going toward the principal at the tail end of our 15-year loan. He could also see that we had the cash; it was sitting in our Vanguard municipal money market fund earning much less than our 2.875% mortgage rate. In other words, mortgage paydown promised a higher return on our money than it was earning in our investment accounts. We had been hanging on to the mortgage because a mortgage rate of less than 3% seemed like a great deal (and it certainly was relative to our very first mortgage of 8.75% in 1994). But the numbers and our household balance sheet argued otherwise.

A spike in inflation and 11 Federal Reserve interest-rate hikes later, the calculus around mortgage paydown has changed meaningfully. People with newer mortgages with higher interest rates may still want to accelerate mortgage paydown versus steering more into their investment portfolios. But many homeowners with more seasoned loans will want to hang back. That’s because now that yields and expected returns on safe investments are also higher, they can readily earn a higher return by investing than they could earn with debt paydown.

If you face the very common conundrum of whether to pay extra on your mortgage or invest in the market, ask yourself the following questions.

1. Do you need the liquidity?

A key starting question is whether you might need access to your money in the future. If you do, that argues against steering a big share of your available funds toward paying down a mortgage. You can tap home equity via a home equity line of credit if you need to, but it’s obviously much simpler to dip into a brokerage account if you have a cash need.

2. How do the ‘returns’ compare?

Next ask and answer: How does the ROI of a mortgage paydown compare with investing in the market?

The core “return” from debt paydown is straightforward: whatever your mortgage interest rate is. What’s interesting is that mortgage holders today hold loans with a broad range of interest rates, depending on when they took out the loan or last refinanced. Interest rates dropped significantly during the global financial crisis of 2009 and dipped lower still during the pandemic, making it a wonderful time for borrowers to secure new loans or refinance existing ones. In mid-2023, for example, Redfin reported that eight in 10 homeowners had mortgage interest rates under 5%, and one fourth had a rate below 3%. Mortgage rates began to climb in early 2022, however, and the average rate for a new 30-year mortgage is now close to 7%. That means that borrowers with newer loans will have to clear a higher hurdle with their investments than will people with older mortgages and lower rates.

Deciding on what type of return to assume for your investments is tougher. Because the “return” you earn from mortgage paydown is guaranteed, the most conservative investment comparison is with an investment type that’s similarly guaranteed. That’s the benchmark that my husband and I used when we decided to pay off our mortgage: We had cash in our account that was earning an interest rate substantially lower than the rate on the debt we were servicing.

With today’s higher yields on cash and bonds, however, mortgage paydown might not add up for people with older loans. In my recent roundup of capital markets forecasts, for example, most investment firms were forecasting a 10-year return for bonds of 5% to 6%. Forecasts for cash returns are generally lower than for bonds, largely because cash yields can be ephemeral; today’s higher cash yields may not persist into the future, especially if the Fed starts cutting interest rates later this year.

3. What’s your life stage?

In a related vein, life stage and time horizon can affect the attractiveness of debt paydown versus investing. More risk-tolerant types—specifically, younger people with very long time horizons until retirement—might avoid mortgage prepayment in favor of stock investing. While stock returns are not guaranteed, history suggests that over a several-decade period, they’ll likely be higher than even today’s higher mortgage rates.

But if you’re getting close to retirement, that means that your time horizon until you’ll need to begin tapping your portfolio has also shortened. It also likely means that your investment mix has gotten more conservative and your expected portfolio return has declined. In that instance, your investments might not necessarily outearn your mortgage rate. Moreover, permanently (or at least semipermanently) reducing your fixed expenses by paying off your home can be more impactful to your plan than making additional investment contributions later in life.

4. What are the tax implications?

Also, factor in tax implications—any tax breaks that you’re receiving to carry the mortgage as well as any tax incentives that you might take advantage of to invest or tax penalties you might pay to access your funds.

A key point here is that the tax advantages of carrying mortgage debt are much less than they once were. Beginning in 2018, the standard deduction amounts increased substantially. In addition, there’s now a cap on the deductibility of interest for new mortgages that exceed $750,000. The net effect of both of these changes is that more than 90% of taxpayers now use the standard deduction rather than itemize. And because mortgage interest is an itemized deduction, many mortgage holders aren’t able to earn a tax break on their interest. By extension, there’s rarely a tax benefit to hanging on to a mortgage.

At the same time, if you invest in the confines of a tax-sheltered vehicle, tax incentives can effectively boost whatever return you’re able to earn. For example, if not paying off your mortgage enables you to make higher pretax contributions to your company 401(k) plan, whatever return you earn there is effectively boosted by the tax break on the contribution as well as the tax-deferred compounding you enjoy while your money is in the account. (How much of a boost depends on your tax bracket, the account type that you choose, what you invest in, and your anticipated holding period.)

If you need to tap tax-sheltered assets or appreciated taxable assets to pay down a mortgage, be sure to get some tax advice before proceeding. That’s generally a negative in the “prepay” column.

5. What are your other carrying costs?

In addition to the mortgage interest that you’re paying, also factor in any other costs associated with the mortgage. A big one is private mortgage insurance, which is typically required for borrowers who have less than 20% equity in their homes. If you’re paying PMI, you have a strong incentive to pay down your mortgage to eliminate the extra expense. Alternatively, if you’ve seen significant appreciation in your home’s value since purchase, having the home reappraised could lift your equity above the limit.

6. Will your mortgage have a prepayment penalty?

While prepayment fees are less common than they once were, some lenders charge prepayment penalties to discourage early mortgage payoff. Contact your lender or read the fine print in your existing mortgage documents to see if this applies to you. It shouldn’t stop you from prepaying if doing so ticks some of the other boxes, but it’s a factor.

7. Do you need peace of mind?

If the math around whether to prepay a mortgage is kind of squishy—for example, your mortgage rate and your expected portfolio return are both about 5%—peace-of-mind considerations are a good tiebreaker. What brings peace of mind varies with each individual, though. Being debt-free feels great to my husband and me, but I recently suggested mortgage paydown to a friend who is between jobs, has the cash, and is over 60. She shuddered and told me that she hated the idea of pulling down her principal that much and felt confident her portfolio would outearn her 5% mortgage rate. And that, I think, is the right call for her.