Pay off Mortgage or Invest? 3 Best Frameworks to Consider

For many homeowners, one of the major dilemmas many individuals face is whether to pay off their mortgage early or invest the extra money. 

My partner and I took a significant step financially in 2022 by purchasing a single-family house. Our mortgage carries an interest rate of 4.65%. Since then, the question of whether to pay off our mortgage early or invest the extra funds arises frequently in our discussions. In this blog post, we will explore three frameworks that can guide you in evaluating whether to pay off your mortgage or invest your funds. By understanding these frameworks and considering your personal circumstances, you can make a more informed decision that aligns with your financial goals.

Framework 1: Inflation Adjusted Asset Valuation

One way to assess the cost of your mortgage is by considering inflation. Inflation is the gradual increase in prices of goods and services over time, which erodes the value of money. It affects both your mortgage debt and your investments. To determine whether it’s more advantageous to pay off your mortgage or invest, compare the interest rate on your mortgage with the inflation rate.

If the interest rate on your mortgage is equal to or lower than the inflation rate, it means that the real value of your debt decreases over time. In other words, the purchasing power of the money you owe diminishes as inflation rises. This perspective suggests that, in inflation-adjusted terms, your loan essentially becomes “free” as your salary and investment gains from inflation may help cover the fixed mortgage payments.

By factoring in inflation, you can gain a clearer understanding of the true cost of your mortgage and evaluate whether investing your funds might yield higher returns. For our case, given the recent CPI of 4% vs. our mortgage rate of 4.65%, this framework is suggesting that we invest, rather than paying it off. 

Pay Off: 0, Invest: 1

Framework 2: Power of Compounding

Another crucial aspect to consider is the power of compounding. Compounding refers to the ability of an investment to generate earnings, which are then reinvested to generate further earnings over time. The earlier you start investing, the more time your money has to grow through compounding.

If you are relatively young and have a long time horizon until retirement, investing your extra funds may offer the potential for significant growth. By harnessing the power of compounding, your investments can generate substantial returns over the years. This may outweigh the benefits of paying off your mortgage early, as the long-term returns on investments could surpass the interest savings from early mortgage repayment.

Being in our 30s, we’re not that young and yet not too old. One way to think of it is assuming the retirement age of 60, we are around 25 years away. If I pay off $1000 per month, rather than invest, in 25 years, I’ll save $292,647 in interest. If I invest in the market with 6% return (using a more modest amount), it’ll amount to $662,666.01 in 25 years. The power of compound interest! 

Pay Off: 0, Invest: 1

Framework 3: Break Even Investment Return Rate

The third framework to consider is the break-even investment return rate. This framework focuses on finding the point at which the returns on investments outweigh the benefits of early mortgage repayment. To calculate the break-even investment return rate, we need to consider our marginal tax rate and compare it with our mortgage interest rate.

For instance, as a household, our marginal tax rate is 35%, and mortgage interest rate is 4.65%. To break even, I would need to achieve an after-tax investment return higher than the mortgage interest rate. In this case, a 4.65% after-tax return would require a pre-tax return of approximately 7.15% (4.65% divided by 0.65 to account for the 35% tax rate). Therefore, to make investing more attractive than early mortgage repayment, I would need to aim for an investment return higher than 7.15%.

By considering our tax implications and the returns required to break even, we can gain insights into the risk and potential reward associated with investing instead of prioritizing mortgage repayment.

Pay Off: 1, Invest: 0

Not All Benefits are Quantifiable 

In my journey towards financial freedom and time flexibility, I have come to appreciate the non-quantifiable benefits of being debt-free. The peace of mind and reduced financial burden that come with paying off a mortgage cannot be understated. 

Another area to consider if you are the type that will stay the course when it comes to investing, no matter the market condition. Reflecting on 2021-2022 market downturn, I found it difficult to stomach extraordinary ups and downs of my portfolio. Naturally, I took some losses and in hindsight should have held on to some investments. 

In contrast, the amount I put in to pay back mortgage early is “locked in”, unless I choose to do a refinance to take the cash back out. Plus, it is a great feeling to see the mortgage balance go down each month.

For me personally, I like to aim for a slightly accelerated pace of repayment. Right now, I’m allocating 20% of my monthly savings to a principal-only repayment, and invest the rest into the market. In our case, with $500 additional payment each month, the repayment period can be cut short by as much as 5 years.

What do you prefer when it comes to pay off mortgage versus invest?

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