Should I Pay Off The Mortgage Or Invest In The Market?

A reader e-mailed me this week to ask if they should pay off their mortgage or invest in their 401(k) for retirement. There are a lot of things to consider when making this decision, so there is not a single right answer for everyone. Here are a couple of questions I would recommend asking yourself when deciding between debt pay off and saving for the future. "Do I have an emergency fund?" If the answer is "Yes" then move to the next point. If the answer is "No" then I would strongly advise putting any extra money that you can towards building an emergency fund with 3-6 months of living expenses. "What is my mortgage interest rate?" If your mortgage rate is at 6% and you pay it off, you have gotten a guaranteed rate of return of 6%. This means you would need to get at least 6% in the market in order for investing to make sense, and really it needs to be a lot more to make up for the risk of the market versus the guarantee of paying down debt. If your mortgage is at 2.75%, it may not be quite as clear cut of a decision as if you are at 6%. "What is my tax rate?" Since mortgage interest is tax deductible, a 6% mortgage isn't actually 6%. If you are in the 35% tax bracket, then a 6% mortgage actually costs you about 3.9%. To get your actual mortgage interest rate, use the following calculation: Interest Rate * (1 -- tax rate). For instance, the above example would be: .06*(1-.35) = .039 or 3.9% "Do I itemize my deductions?" According to a 2005 study, only 54% of Americans paying mortgage interest actually get a tax benefit. This is because you can only deduct your mortgage interest if you are itemizing your deductions. Take a look at last year's tax return to see if you even itemized. If you did, how much more were your itemized deductions than the standard deduction? If this isn't a large number, then the above question of "What is my tax rate?" will be irrelevant. "Would I take out a loan to buy stocks?" When I ask clients this question, they always respond with NO! What if the interest rate to take out the loan was 5%? How about 3%? I can never get one to take me up on it. This is actually no different than choosing to save instead of paying down the mortgage! If you have $100 and decide to invest instead of paying down your mortgage, you are especially borrowing money to invest in the market. If you wouldn't do this directly, why would you do this indirectly? So what is the answer? As always, the answer is IT DEPENDS! Beyond the numbers, there is a huge psychological benefit to being debt free. I have never had a client pay off their mortgage and later regret it. I do believe though that you have to find a balance between paying down debt and saving for the future. If you have an emergency fund, I usually recommend at least fully utilizing your employer match on your 401(k), and then pay down debt as much as possible. Most clients chose a combination of debt payoff and savings, which is typically a good path to take. So what do you think? Are you trying to decide between debt pay off and savings? Have you paid off your mortgage and have advice for other readers? Feel free to share!

Comments

1. With extra cash: Would you pay mortgage or "Roth IRA" As you know Roth IRA is different than stock market because you can only contribute 5500 per year and the earlier you start Your RITA the better.
2. Hello Alan, This is pretty good.  A life coach might also mention the greater amount of flexibility a person has when his house is paid off.  In most cases, money can't be taken out of a 401k without penalty.  Having your house paid off if you want to buy a new home or relocate makes things much easier.
3. why would you multiply by 1? why not just jump to the next step
4. I am in a very similar situation here. Except for me instead of paying off a mortgage I am paying off student loans (which is funny because the job I have does not even require a degree but that is another story). My student loans have a 6.8% interest rate. So far I have decided to pay off my loans instead of investing my money. I have less than $6k to go so I will probably just finish paying them off and be done with it.
   
   By paying off my loans I am basically investing at a guaranteed 6.8% interest while receiving immediate benefits (return) on my investment in the form of less interest each following month. I would rather be investing but paying off loans 1st seems like the logical thing to do.
5. Would you borrow money to invest in the market? When comparing that with borrowing money to buy a house, then what's the difference? You're still borrowing either way. The difference becomes paying a lower "fixed" rate versus a higher "compounding" rate. To me it's a no brainer. Use leverage to exelerate growth. Do an interest only loan on the house, invest the difference every month with automatic withdrawels. Write off 100% of the payment on the house. Never pay it off. Equity is an illusion until it's realized. Realize it by using it every month.
6. Long term averages for stock market returns are 7 - 8% after taxes and fees. But even if your mortgage interest rate was break even with stock yields, you'd still be better off investing the money instead of locking it up in home equity. Best to refinance to the lowest rate possible! For mortgage rates at around 4% or less, it should be a no brainer!
7. His message is sound. His age has nothing to do with the quality of his advice. Would you rather get bad advice from someone who's 70, or good advice from a 30 year old? He uses classic CFP techniques.
8. Saw this video and thought what does this kid know. But after watching it was an excellent video. Love the concept of if you would borrow money to invest in the stock market. I've also never met one person who said they regret paying off their mortgage but I have met tons who said they regret investing in the stock market. the stock market should only be used after your mortgage is paid off and you have considerable assets. Why? Because the average Joe doesn't know anything about business and the stock market. So when the market sells off, they will end up panicking and selling out at the bottom. The net result from their investing will actually end up being negative over time because of this human nature component. 
9. very good!!!
10. Your advice actually make sense !!  A lot of other planners advise against paying down the mortgage regardless...
11. ur not a financial planner, ur a teenage kid
12. Liquidity is tied up if you pay off your house. the emergency fund is the first thing,as he suggests.Paying off debt is a guaranteed rate of return,but an investment can lose money, so it's not guarantee. there's a price for peace of mind. All these tax implications and other things mean nothing if you lose the roof over your head.
13. I was initially planning on paying off the mortgage early. We are at a 3.50% rate. Speaking to others in a financial forum convinced me otherwise. You can get a return in the stock market at 6% so that will be a 2.50% difference over 30 years. Alan would it depend though how high your loan is? How about $575,000? Would it pay to invest or just spend the next 18 years paying it off?