Should I Pay Off My Mortgage or Invest the Money?

It's a question every savvy borrower thinks about: Should I pay off my mortgage and be done with it? Or should I take the mortgage company's money and try to get a better return in the stock market?

To answer that question, we analyzed historical mortgage rates as reported by Freddie Mac and the S&P 500 returns over a 43-year period. Our initial inclination was that the stock market would beat paying down your mortgage, but mortgage paydown proved a stronger contender than we expected. As an investor, what "wins" for you depends on your investment horizon and tax situation.

For the 43 years starting in 1971 and ending in 2013, paying down a mortgage at that year's average mortgage rate was a better financial move than investing in the S&P 500 in 26 of those years or 60% of the time. Looking deeper into the results, if you had gotten a mortgage any time during or after the financial crisis (2008 through 2013), investing in stocks was a winning strategy. The S&P's compounded annual return over the five years following 2009, 15.29%, handily beat the average 30-year fixed rate of 5.04%. From 1997 to 2007, which includes the dot-com bubble and the lead-up to the financial crisis, paying down your mortgage was a winning strategy 10 out of 11 years.

We were curious about longer periods of time invested in the stock market and re-ran the numbers, comparing the 30-year fixed to the 10-year S&P returns. For the 10-year return rate, the result is similar to the five-year period: paying down a mortgage was a better return than the stock market 63% of the time or 24 out of 38 years. Surprisingly, paying down your mortgage would have been a better use of your money than investing in the S&P 500, even for a 10-year period.

Our initial analysis above doesn't factor in the impact of taxes. A common argument about this type of analysis is the different tax treatment of stock returns and mortgage interest. Usually, you get more benefit from stocks, due to a lower tax rate for stock gains. However, recent changes in the tax code actually give an edge to the 30-year fixed for many Americans.

The Tax Cuts and Jobs Act of 2017 reduced the use of itemized deductions, such as mortgage interest, because the standard deduction increased. Now, 82% of homeowners have standard deductions large enough that the mortgage interest deduction isn’t providing a tax benefit to them. Those who do benefit from deducting mortgage interest have a tax bracket of 24%.

Stocks held longer than a year are subject to long-term capital gains taxes, which, for the majority of Americans, is 15%. Here’s how this might work out. Say that both mortgages and stocks have a rate of return of 10%. Tax affecting the mortgage rate at 24% would create a rate of return of 7.6% while the comparable stock return tax affected at 15% would be 8.5%.

We put together two scenarios to understand the impact of taxes. In the first scenario, we taxed only stock returns and did not factor in the benefits of deducting interest. In the second, tax is factored into both stock returns and mortgage interest. With the S&P trailing the 30-year fixed in our original scenario, it’s no surprise that lowering the returns on the S&P for taxes while leaving mortgage rates unchanged tips the scales further toward the 30-year fixed. When both strategies are tax affected, the results get closer to an even race, and the S&P forces a tie when reviewing 10-year returns.

Retirement accounts such as the 401(k), Roth IRA, and Traditional IRA accounts are tax exempt while the money is invested, making them a great place to compound your money tax-free. If your investment goal is retirement accumulation, the tax treatment of retirement accounts is a reason to consider investing in the market rather than paying down your mortgage.

We're going to interrupt our analysis for a moment for a public service announcement. If your employer matches your contributions in a 401(k) or you're investing in another retirement plan that you have not maxed out, your choices are easy. Max out the matching plan first. By participating in your matching program, you'll achieve a 100% return ($1 becomes $2) even if you keep your dollars in cash. You’ll be beating both the stock market and whatever rate you have on your mortgage.

Now back to our regular analysis. Given that most homeowners will be taking the standard deduction, the scenario where the S&P 500 is in a tax-exempt account is actually our original scenario where neither is tax affected. For the relatively few people getting a tax benefit from mortgages, this is the scenario where the S&P 500 wins more often than paying down your mortgage.

Looking back, we were surprised to learn that paying down your mortgage was a real contender, more so than we would have initially guessed. It was a real lesson in stock market volatility to see that the mortgage has outperformed over these time horizons (five and 10 years). Here’s the final scoreboard:

The reality is you should be pursuing both strategies with your extra cash. Picking the winner in a given year is hard or even impossible. With a win rate between 60 and 63% for mortgages, there's room for a longer period when stocks win for years in a row. In fact, we've been in one of those periods. Since 2001, both five-year and 10-year returns of the S&P have won more often than the 30-year fixed. Diversifying your portfolio with both investments decreases your risk profile. While the S&P moves through its ups and downs, paying down your mortgage (if it’s fixed rate) provides a guaranteed rate of return.

Here are the four steps the data tells us you should be taking.

• Basics of the analysis:
  We started with this premise: What if you financed a home in a given year and you had an extra dollar to spend? How should you use that extra money?

• Mortgage interest tax benefit of 24%:
  Reviewing the 2018 tax return data from the IRS collected through July 2019, we found that over 50% of returns using the mortgage deduction were incomes between $75,000 and $200,000. We’ve assumed a 24% ordinary income tax rate for this group based on the current tax rates.
• Paying down your mortgage is a guaranteed statement:
  Home equity is not guaranteed, however, your mortgage exists regardless of your equity. Each dollar that you pay down lowers the total interest paid on your mortgage and makes future mortgage payments reduce a larger percent of your loan principal.