Pay off your mortgage or invest: A homeowner’s dilemma

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It’s a complex decision.

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A mortgage is a big expense, but it’s only one part of your family’s budget. Decisions about it need to be made in the context of your entire situation. For some of us, it makes sense to pay down the mortgage as soon as possible and live debt free. For others, that mortgage is an efficient use of capital—a tax-advantaged way to maximize the “creature comforts” part of a 50-30-20 budget.

The short answer: Your interest rate, tax situation, and your “life security”—including your job security and access to cash—all play a role in the decision. But, from a purely economic standpoint, it’s all about opportunity cost—what you give up (including returns on other investments) when you choose one expenditure over others.

If you can make more in interest, dividends, or capital appreciation by investing any extra mortgage payments in an investment vehicle (such as the stock market or a certificate of deposit) than you pay in interest to the mortgage holder, you might consider keeping that mortgage. But what interest rate should you be comparing to the investment vehicles?

The easy answer is to look up the current interest rate on your mortgage. If it’s an adjustable-rate mortgage, make sure you know the terms, including any rate increases and when they’re set to kick in—particularly in a rising-rate environment. Is your mortgage interest rate lower than what you expect to return on other investments?

Next, check if you received a mortgage interest deduction on your last tax return. Ever since they doubled the standard deduction in 2018 (it’s $13,850 for singles and $27,700 for married couples as of the 2023 tax year), few households itemize deductions. If you’re one of those few, your effective mortgage rate might be lower. Let’s look at how that would work.

When you itemize deductions, any deductible amount you pay in interest over and above the standard deduction saves you that amount multiplied by your marginal tax rate. For example, on last year’s tax return, Donna and Bob (married filing jointly) were in the 22% tax bracket. Suppose in the coming year, they plan to itemize deductions with:

Their itemized total of $35,000 would be $7,300 over and above the standard deduction. So, by holding this mortgage, they save ($7,300 x 22%) = $1,606.

That $1,606 represents the actual savings, in dollar terms. If they wish to determine their net effective mortgage rate, they could look at that $1,606 as a percentage of their outstanding mortgage balance, and deduct that percentage from their rate. For example, if they owe $500,000 on their home, the $1,606 translates to ($1,606 / $500,000) = 0.0032, or 0.32%.

If their mortgage rate is 5%, their effective rate by holding the mortgage is (5% – 0.32%) = 4.68%.

So if Donna and Bob were to weigh the opportunity cost of paying the mortgage, the effective rate is a little lower than the stated mortgage rate. Not a lot—but it might make the difference between holding the mortgage or working to pay it off.

And, again, for the 90% of households (as of the 2022 tax year) that use the standard deduction, the effective rate is the same as the nominal mortgage rate—the mortgage interest deduction doesn’t affect your tax bill.

The big advantage of paying off your mortgage is that it frees up money for other uses, such as:

Although a monthly mortgage payment is a big one, there can be good reasons to keep paying it rather than trying to pay your mortgage off. Among them:

Ultimately, the decision about paying down debt versus investing comes down to opportunity cost—weighing other things you could do with the money. If your after-tax mortgage rate is 4.68%, but you have credit card debt at 22% and an auto loan at 6%, it’s wiser to pay down the credit card and the auto loan rather than the mortgage. That’s called the “avalanche method” for debt repayment.

Similarly, if you can invest your money in a low-risk option yielding more than your mortgage rate, or if you have a long time horizon and are comfortable with higher risk/higher reward investments, you might keep the mortgage intact and invest.

But if you have no other debt, a healthy retirement fund, you don’t itemize your taxes, and/or you just want the peace of mind that comes with being mortgage free—accelerate your mortgage payments, pay that debt off as soon as you can, and don’t look back.