Invest Or Pay Off Your Mortgage?
To determine if you should invest or pay off your mortgage, you need to compare the after-tax return on your investments with the after-tax cost of your mortgage, as in the example below.
Facts:
- Marginal tax rate: 20%
- Safe investment return: 4%
- Mortgage rate: 6%
Using the facts above, for every $100 of taxable investment income, after paying taxes at 20%, you get to keep $80.
For every $100 of mortgage interest you pay, assuming you itemize deductions on your tax return, after deducting this interest at 20%, your net cost is $80.
Using this scenario, assume you had an extra $1,000 that you could either invest, or use to pay off a portion of your mortgage.
- If invested, you would earn 4%, or $40. After paying taxes on this interest income, you would keep $32.
- If you used the $1,000 to pay off a portion of your mortgage, it would save you 6%, or $60 in interest cost, but you would no longer have the extra $60 to deduct on your tax return, so after factoring in the lower tax deduction, it saves you $48.
In this scenario, you save $16 a year by paying off a portion of your mortgage rather than investing your extra funds. ($16 = $48 net savings on mortgage interest - $32 net interest earned on investment).
- As your tax bracket decreases the potential benefit of paying off your mortgage increases.
- As your investment return decreases, the potential benefit of paying off your mortgage increases.
- As your investment returns increase, the potential benefits of investing rather than paying off the mortgage increase, but higher returns entail higher risk so you must consider the level of investment risk you are willing to take compared to the risk-free return of paying off your mortgage.
To factor in investment risk be sure to read Paying Off Mortgage Early Is A Guaranteed Return.
