Should You Pay Down the Mortgage or Invest Extra Cash?

So, you’ve paid down all your “bad debt” … high interest loans, credit cards, etc. Congrats! Now that you have fewer payments to make each month, you may be debating if you should use that extra cash to pay down the mortgage or invest?

You’re not alone. This question is one of the most frequently asked and hotly debated in the Financial Independence and Debt Free Communities. We’ve flipped back and forth on it as well over the years.

Despite what people in the community might say, this is only partially a math question. Why? Because math isn’t the only thing that comes into play when dealing with real live humans. Additionally, while you can use assumptions based on historical market performance to calculate the “math,” no one can predict what future returns will be over the time horizon of your mortgage payments.

Thus, the answer is… it depends on your personal situation and risk tolerance. If being in debt causes you to lose sleep at night, then you should probably be paying own the debt no matter what the “math” tells you. If your finances are all shored up and you can tolerate a little uncertainty, then let’s math it up and see what happens!

First things first…

If you have high interest debt, such as credit cards, or any loans above 5%, my personal opinion is that debt should be paid down a little more aggressively than investing. That doesn’t mean that you shouldn’t invest at all, it just means that I wouldn’t throw every extra dollar I have into the market.

If you have access to a 401k at work with a match, then you might want to invest at least enough to get the match … unless you’re buried in credit card debt which often has interest rates from 15% – 30%. This one will certainly depend on your financial situation.

Finally, I believe that you should have a proper emergency fund before investing in taxable accounts or paying extra towards low interest debt.

These are, of course, my personal opinions and philosophies. Nothing within this blog post should be taken as investment advice.

Factors to consider in assessing whether to pay down the mortgage or invest

Besides the emotional factor mentioned above, the most important assumptions if you’re planning to analyze the math of this question are:

• Remaining mortgage balance
• Monthly payment (principal & interest only)
• Interest rate
• Expected payoff date (normal payments)
• Estimated payoff date under the “pay down mortgage” option
• Expected annual market returns for each time horizon
• What fund or asset class you plan to invest in

The best way to determine which method is most likely to be better (financially speaking, that is), is to calculate both scenarios and compare.

For these purposes, the first four assumptions are known. The last three are estimated or forecasted, but equally as important to the determination.

The expected market return is just an educated guess – you can’t control or predict this one. The types of assets you invest in and timeline it would take to pay down the mortgage faster are also both estimates, though you can somewhat control them. Because these last three assumptions are not known, you may want to play with different scenarios to determine which makes the most sense for your analysis.

For the purposes of demonstration, we’ll walk through an example below.

Example Analysis – Laying out the facts and assumptions

Below is the analysis I performed in October when determining whether we should switch strategies to pay down the mortgage slower and invest the difference.

Previously, we aggressively paid down the mortgage, allocating anywhere between a third and half of our extra cash towards it.

After reviewing the results of the analysis below, having already paid down the mortgage to a manageable size (<$200,000), we decided to change our focus to investing. Because of this, we also refinanced to a lower rate in November 2020.

For context, we have a robust emergency fund, no high interest debt, and max out our retirement and tax-advantaged vehicles first. This question for us is whether to pay down the mortgage or invest in our taxable brokerage accounts with anything in excess of that. 

Here are the known assumptions:

Option #1 – Pay the monthly mortgage payments only; invest any extra cash.

Option #2 – Use extra cash to pay down the mortgage as quickly as possible; then when the mortgage is paid off invest any extra cash (which will include the $1,735 previously paid to the mortgage).

The unknown assumptions are discussed further within the example below.

Hypothetical investments made:

We estimate that we could allocate an extra $2,000 per month (on average) to either pay down the mortgage or invest in our taxable brokerage account.

If we focus on paying down the mortgage, it would be paid off by Sept 2025 (~4.7 years). Nothing is invested in the taxable brokerage accounts until the loan is paid in this scenario. Beginning in October 2026, we would have an estimated $3,735 per month ($2,000 + $1,735) to invest.

If we focus on investing, we could invest the $2,000 per month the entire period. For this scenario, the loan would be paid off in May 2032 (~11.5 years).

On May 31, 2032, the balance on both loans would be $0, so we only need to compare the investment portfolios for each at that point in time to determine which is better. When analyzed this way, the amount of interest paid is irrelevant.

The analysis

This is where the other unknown assumptions come into play.

There are many in the community who assert that investing ALWAYS beats mortgage payments. I cringe when people use terms like NEVER or ALWAYS, because it’s usually not true in all cases. No one can say for certain that investing will beat the market in every scenario. Future market returns are unknown. They do not always correlate to historical returns… especially over shorter periods of time.

That said, historical market returns suggest that over a longer horizon, investing is more likely to beat paying down the mortgage if mortgage rates are reasonably low.

How long would it take to pay off if you focused on debt paydown?

The time horizon of the accelerated pay down is important to consider.

In our case, the real question becomes “Do I think the market returns for the next five years will be better or worse than the next 6+?” In those first 4.7 years, we’d be missing out on market returns while paying down debt. But after the mortgage payment is gone, there would be even more to invest in later years.

Market returns are likely to be more unpredictable and volatile when dealing with shorter time periods. The S&P’s worst 5-year return was -6.6% during the period ending February 2009 (not that long ago). So if we had decided to invest during that time frame, we’d have chosen a 6.6% loss over a guaranteed 3.125% savings. However, the upside of investing can be just as dramatic.

Over longer time periods, you’re less likely to experience negative returns, but even over some 10-years periods there have been small negative returns. 

Confession: IF we could comfortably pay off the mortgage in 2 or 3 years, we’d choose that option.

Currently, I feel like the market is overvalued and too volatile. I could be wrong, but that’s the kicker… no one knows. But since we were dealing with a 5-year period, the odds of having positive average returns exceeding our mortgage rate convinced us to perform this analysis.

What would you invest in?

What you plan to invest in matters as well. Asset class determines the range of likely market returns, as well as whether any portion of those returns (i.e. dividends, bond interest) will be taxed each year. 

The mortgage will provide a predictable tax-free return equal to the mortgage interest rate. It doesn’t receive the benefit of compounding that you’d receive in the market, but then again, that will matter less if you’re dealing with a shorter time period. 

We performed our analysis using both Vanguard High Dividend ETF (VYM) and the Vanguard Total Stock Market Index Fund (VTSAX). I’ll just include the VTSAX analysis to keep this post a manageable length. Though VYM offers a little more comfort in a down market, paying a larger quarterly dividend, the yield has recently fallen below 3%, which gives it less of an edge over VTSAX (currently yielding 1.4%).

What does the math say?

Well, it all depends on what market returns are. And since that is the big unknown factor here, you’ll have to make a prediction to finish the math.

We ran various market return scenarios using our facts and circumstances in an Excel-based model. The results below show which of our two hypothetical portfolios would be larger at the date the last mortgage is paid off, given a wide range of market returns that I believe to be plausible over the ~11-year time horizon.

Difference in Investment Portfolios at May 2032

_{*assumes 1.5% of return consists of qualified taxable dividends, taxed annually at 15% and reinvested}

As you can see from above, somewhere between returns of 3 – 4% (including dividends), the break-even point occurs whereby investing and paying the mortgage as slowly as possible becomes the better option.

To demonstrate further, let’s look at the 4% return for each scenario at the point in time the “Pay down” option mortgage is paid off (Sept 2025) and when both have been paid off (May 2032).

Comparison of options using 4% rate of return

In the above case, after about 5 years, you would be better off having invested by a little over $2k with returns of 4%, and after about 11 years that difference grows to about $6k.

I wanted to demonstrate this for two reasons. First, market returns can vary widely, but even within some reasonably cautious returns, the difference between these two strategies is not that big when spread over the number of years. If the returns over your time horizon are really good or really bad, then there will be a clear winner, but you won’t know that until after the fact. Second, the fact that mid-range returns won’t produce a huge difference over a 5 – 15 year period, should help you feel better about choosing whatever option that helps you sleep better at night.

That’s the math, so what’s our strategy?

I’m fairly pessimistic when it comes to market returns, though do believe that achieving returns above our break-even point is more likely than not over our ~11-year time horizon.

Additionally, after making the decision to “invest” we have since refinanced our mortgage rate down from 3.125% to 2.5%. Now our break-even point will occur between market returns of only 2 and 3%, which I’m a lot more comfortable with.

As mentioned in the recent post on our investment strategy, we’ve decided to focus on investing our extra cash going forward.

However, we did make one exception to this strategy for large windfalls (i.e. bonuses, stock compensation or other unexpected income over $5,000). For windfalls, we’ll use 1/3 of the “take home,” that is the net amount after taxes and any retirement or other withholdings, to pay down the mortgage to diversify and hedge our bets.  

Let’s perform an experiment…

And because we’re all big nerds in this house, I’m planning to track our actual returns (investing) vs. hypothetical returns (pay down mortgage) as an experiment. Why? Because it will be fun (or devastating) to look back and see if we made the right decision.

Stay tuned for future updates on this experiment to see how much better off (or worse off) we are! I’ll share the first update in a few months.