Should You Pay Down the Mortgage or Invest?

As yields on safe securities slunk ever lower over the past decade, advising accelerated mortgage paydown--above and beyond what a lender requires--was an easy call.

While mortgage rates were correspondingly low, it was all but impossible to find any investment that was guaranteed to return more than mortgage paydown would. People with conservative investment portfolios and/or those late in the life of their mortgages (and receiving minimal benefit from their interest deduction) had a particular incentive to prepay. Meanwhile, people with new mortgages, where interest composes most of the payment and accordingly enlarges the deduction, had less of a reason to prepay.

But the calculus behind mortgage paydown is changing fast. Specifically, the tax package that Congress passed in 2017's waning days reduces the incentives for carrying a mortgage. Yet a countervailing force is also in play--namely, that yields on safe securities have been trending up. If that trend persists--and it's a big if--that could leave some homeowners with lower rates on their mortgages than they could earn on other guaranteed investments. Such an environment would tend to diminish the value of prepaying the mortgage.

If you wrestle with whether and how much to pay down your mortgage, here's a closer look at the key questions to run through.

Can You Beat the 'Return'? The key question to ask when weighing mortgage paydown is what you'd do with that money instead. Can you earn a higher return somewhere else than you could with mortgage paydown?

At the risk of stating the obvious, paying down any other debt with higher interest rates should precede mortgage paydown, because the return on investment is guaranteed to be higher. Thus, paying down home equity loans/balances on home equity lines of credit should usually come before mortgage paydown, because their rates are invariably higher.

But what if you have no other debt and your alternative to mortgage paydown is to invest in something? Because prepaying your mortgage is guaranteed to earn you whatever your mortgage rate is, less the amount of any tax breaks you're receiving, only guaranteed investments count for an apples-to-apples comparison with mortgage paydown.

And here's where things are starting to get interesting. Until recently, guaranteed investment returns were no match for most mortgage rates, but rates have been trending up to the point that they're close to the rates on ultracheap mortgage rates. Most mortgages--even 15-year mortgages, which typically have lower rates than the 30-year ones-- are still higher than FDIC-insured investment types that offer daily liquidity, such as online savings accounts. But savings instruments that require you to lock up your money a little longer, such as three-year CDs, are now within spitting distance of mortgages that were taken out when the economy was still clawing its way back. For example, the average mortgage rate for 30-year mortgages was 3.4% in early 2013, whereas three-year CD yields are getting close to 3%. If the return on guaranteed securities eclipses your mortgage rate, that's a good reason to pull back on mortgage paydown versus investing. But most investors/mortgageholders aren't there yet.

Do You Need Access to Your Money? Don't stop with the ROI comparison. You also need to bear in mind your need for liquidity, and that's something you lose by steering your funds to mortgage prepayment rather than investing in some type of a cash account. It's true that you may be able to tap your home equity in a pinch, thereby retrieving some of the money you steered into mortgage paydown, but home-equity borrowing is going to be more costly than your mortgage rate. If you need a guaranteed return and ready access to those funds, use an FDIC-insured cash vehicle and de-prioritize mortgage prepayment.

Do You Need the Guarantees? Of course, spending a lot of time noodling over the best guaranteed return--your mortgage paydown versus investing in ultrasafe securities--only matters if you need guarantees.

Investors closing in on retirement have more reasons to value the sure things--either reducing their overhead in retirement (mortgage paydown) or building up their liquid reserves. On the other hand, if you're someone with a very long time horizon and a cheap mortgage who's saving for retirement, you have less reason to prioritize mortgage paydown. The returns that you earn on your equity and bond portfolios may not be all that impressive over the next decade, but they'll very likely beat mortgage interest rates over longer time horizons. That's especially true if you are eligible for matching contributions and/or a tax break on your investment accounts. This worksheet can help calculate an expected return for your investments relative to debt paydown.

Will You Receive Any Tax Breaks from Your Interest? In the past, the deduction available for mortgage interest was another big swing factor affecting the calculus on mortgage paydown. If you were deriving a lot of benefit from it--for example, you were early in the life of your mortgage and most of your payments were composed of interest--prepayments didn't make as much sense. But if you had had a mortgage for many years and were not picking up that much of a deduction, the advantage went to prepayment.

Yet thanks to the new tax laws, the mortgage interest deduction is apt to matter a lot less for most taxpayers than in the past. Starting with the 2018 tax year, the standard deduction amounts will be increasing to $12,000 for individuals and $24,000 for married couples filing jointly. Personal exemptions are going away, but those new higher standard deduction amounts still represent a giant increase over the 2017 standard deduction amounts of $6,350 for individual taxpayers and $12,700 for joint filers. Those higher standard deduction amounts will likely lead to a huge reduction in the number of taxpayers who itemize their deductions rather than claiming a standard deduction.

In addition, the new tax laws put a cap on the deductibility of interest for new mortgages that exceed $750,000. (For properties purchased prior to Dec. 15, 2017, interest on mortgages of up to $1 million is tax-deductible on Schedule A.) In addition, home equity loan interest will only be deductible if the loan is used to finance home improvements, not new car purchases or even basic home maintenance.

Those changes generally accentuate the case for prepayment over investing in other areas. If mortgage holders can't take advantage of the interest deduction, that effectively boosts their borrowing costs. Financial planning guru Michael Kitces does a deeper dive into the ins and outs of the deduction in this video.

Do You Pay Private Mortgage Insurance? Private mortgage insurance is another factor to consider when deciding whether to invest in the market or to pay down your mortgage. Lenders typically require you to pay for this insurance if you have less than 20% equity in your home. Thus, if you're on the hook for PMI, you have a strong incentive to get rid of it as soon as you possibly can, either by paying down your principal value aggressively (and thereby building up your equity in the home) or by having your home reappraised if you've made substantial improvements to it.