Pay Off Mortgage Early or Invest in Retirement

If you are contributing the maximum amount in your tax deferred accounts (401k, 403b, IRA) and you have money still available to invest, what should you do? Should you use the funds to start paying off your mortgage early or invest the fund in your taxable accounts towards retirement?

This decision is based on the interest rate of your mortgage. If your interest rate is high you should start paying down your mortgage, if it is low you should invest the money. High and low rates are relative terms taking into account your current tax situation and options available for investing.

Current US Treasury Rates

To decide if your rate is high or low you need to know what the risk-free interest rate you could receive on your money. A typical proxy for a risk-free return is US government bonds. Current rates on US treasuries is available from the U.S. Department of Treasury. Looking at this site you should find the rate that corresponds to the remaining duration of your mortgage (or how long you plan to stay in your current home if you plan to sell your home before your last mortgage payment).

On Friday, February 6, 2015 the 20 year treasury yield was 2.28% and the 30 year treasury yield was 2.51%.

Tax Considerations

Income from US treasuries is taxed at your ordinary income tax rate (your largest income tax rate). Mortgage interest is deductible as an itemized deduction.

Assumptions:

  • 28% ordinary income tax rate
  • 3.00% fixed mortgage rate with 20 years remaining
    • The after-tax mortgage interest rate is 2.16% ( 3.00% x ( 1 – 28% tax rate ) )
  • 2.28% investment return for 20 years from current US treasury rates
    • The after-tax investment return is 1.64% ( 2.28% x ( 1 – 28% tax rate ) )
Scenario Mortgage Investment
Investment in Taxable Account 2.16% 1.64%
Investment in Tax-deferred Account 2.16% 2.28%
Investment in Tax-deferred Account
(unable to deduct mortgage interest)
3.00% 2.28%

Analyzing the scenarios above:

  • if you are already contributing the maximum to your tax-deferred accounts then you should pay down your mortgage early (investment in taxable account scenario above)
  • if you can still contribute to your tax-deferred accounts then you should invest in your tax-deferred account (investment in tax-deferred account scenario above) unless your mortgage interest is not deductible as an itemized deduction

Why not compare to Stock Returns

Even though your total portfolio return is estimated to be higher based on investing in stocks, you should not use your portfolio return because you have already decided on your appropriate asset allocation. In other words, ignoring your mortgage, you already can have more stocks in your portfolio and increase returns. If your current portfolio is 100% stocks, this is the only time where it is appropriate to compare your mortgage rate to stocks returns, since you have decided to not invest in bonds.

Other Concerns

Additionally, you may choose to pay off your mortgage early if you are opposed to having any debt, even though the math may say that you should invest (for instance, investment in tax-deferred account scenario above). You also may want to have liquidity by having investment funds available to cover an emergency fund instead of using those funds to pay down your mortgage.

Every persons situation is unique, but I hope this post gives you some additional information to decide what the best decision is for you. Based on the above analysis, I am paying down my mortgage as quickly as possible.

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