Pay Off the Mortgage or Invest?

A friend recently asked me — again — whether he should pay off a low-interest mortgage or invest.

When I was retired six years ago, I had three things going for me: First, I had an emergency fund with three years of expenses; second, I had paid down debt, including the home mortgage well before I was retired; and third, I had used the extra cash flow to max out on a mix of retirement savings options. That made my financial condition more resilient, when my retirement came sooner than I expected, one month before I turned 59.

So, my friend asked about the wisdom of paying off a mortgage before retirement, considering historically low mortgage rates. Wouldn’t it be better to invest the money in other assets?

The first time he asked, I produced a YouTube video, “What Rate Rates?” It depends, I replied.* What other debts are on the balance sheet? How does a 3-percent mortgage compare to the other debts, like an education loan, a car loan, or revolving credit card debt? If those rates are higher, then concentrate on those debts first, before considering paying down the mortgage.

Suppose a hypothetical future retiree had the following debts:

Before tackling a 3.11-percent mortgage, which was the average 30-year APR last year, this guy should get rid of the credit card debt and furniture loan at much higher APRs. Our future retiree is at least paying more than the minimum payment on his credit card debt. But if he goes to his credit card statement, there is a legally required table that shows what it would take to pay off the balance in three years. That would be a start! It would increase the credit card payment to $422.60 a month. Or, if he could bite the bullet and pay $1,089.45 a month, he would paid off the credit card debt in about 12 months. Could he come up with another $850 a month and do that?

My wife and I decided not to carry credit card debt. In fact, I had to pay off my credit card debt before we were married! For more than three decades, all credit card bills have been paid each month. It is a good practice to use the float, but stay out of the deep water of debt!

There are spreadsheets to help plan debt repayment. (See https://www.vertex42.com/Calculators/debt-reduction-calculator.html for one) The strategies include “snowball” debt repayments starting with the smallest debt, or “avalanche” repayments by tackling the highest interest rates first. Once that debt is repaid, the monthly cashflow is applied to the next debt on the list. In my YouTube video, I showed how our future retiree could repay all debt in seven years, including the home mortgage.

Debts with higher interest rates is perhaps the primary reason for not paying down the mortgage. But there are other reasons:

Lack of emergency savings. Every household should have at least six months of expenses in emergency savings, for the car repair, medical emergency, hot water heater repair, or sudden job loss. Unfortunately, surveys show most households could not find even $500 for an emergency, let alone build up emergency savings for at least six months of expenses. If you don’t have funds to tap in an emergency, hold off on repaying the mortgage.

You are missing out on the employer match. If your employer is matching 3 percent for a 6 percent contribution to a workplace retirement plan, and you are not contributing that full 6 percent, you are losing free money. Simple math: a guaranteed 50 percent return on that dollar toward the match is more than 16 times as beneficial than eliminating the mortgage rate. Earn the full match before you think about repaying the mortgage.

You itemize and deduct mortgage interest. If there are other reasons to itemize tax deductions, then the mortgage interest deduction may be a reason to keep paying a mortgage. But after the standard deduction was doubled in 2017, most filers do not itemize. The IRS reports only 11 percent of filers in 2019 itemized, and less than 9 percent took a mortgage interest deduction. In 2022, you can deduct the mortgage interest of a mortgage up to $750,000 for houses purchased after 2017, and for a mortgage up to $1 million prior to 2017. But keep in mind that the highest interest payments in the amortization table are in the first few years of a mortgage. If you recently bought a large home, and you itemize, there may be a reason to keep the mortgage.

So, my friend asked — again — does it make sense to pay off the mortgage?

I strongly believe that paying off a mortgage in my early 50s allowed me to invest the cash flow in maxing out retirement savings, especially when the IRS allows those catch-up contributions. But my circumstances are not the same as my friends’ circumstances. Again, it really does depend.

He has a 2.5 percent mortgage with about 15 years left. He is in his early 50s and plans to work until he is at least 67, maybe even 70. So he is likely to be close to paying off the mortgage before retirement. He’s already maxing out his 401(k) and Roth opportunities, but his spouse has room to save more. They recently came into a $150,000 inheritance and they were wondered should they pay down the mortgage or invest? They have about $190,000 left on the mortgage. So, the extra cash could nearly pay off the mortgage.

They don’t have other major debts to worry about. Unlike our hypothetical future retiree, they have no car loans, credit cards, or student loans with higher rates.

However, as he enters his 50s, he might want to build up taxable savings, including a cash cushion. As he gets older, he must recognize that any job loss could mean at least a year of job searching. I know it sounds like ageism, but it’s a fact of life. So 18 months of unemployment in your late 50s will quickly drain a six-month emergency fund. While he plans to work to 67, he could become forced into an early retirement.That is why he needs up to three years of expenses in the fund.

So, keeping the inheritance in a taxable account may be a better idea than putting it all into home equity. True, they could take out a home equity loan in an emergency, but taxable savings would be easier to tap in the event of a job loss or early retirement.

My advice, keep the mortgage and build up the cash cushion.

Where to keep the money? I recommend using high-yield savings for at least one year of the money, but I Bonds that can be left alone for at least a year could be another safe inflation-protected investment. Short-term treasury funds are another option. If rates rise and CDs begin to pay anything reasonable, a CD latter might be another option.

Many people look at what they are earning on equities in their retirement accounts and say why don’t I invest the cushion in the market. But consider this part of the safe portion of your investments. Don’t risk this money in the market. Continue to invest in retirement plans, both Roth and tax-deferred plans, and invest those funds in equity. But keep the cushion in cash and cash equivalents.

He and his spouse may want to pay down the mortgage with any future windfalls, such as annual bonuses, to ensure the mortgage is paid off prior to retirement. I have found I worry a lot less knowing that my monthly retirement budget doesn’t include the mortgage payment. Cash flow is key in retirement. If you can reduce the cash flow required, your retirement plans become a lot more resilient.

* I know it may sound like I’m a financial planning professional, but I have no special initials after my name. So, take this as entertaining ideas from one educated consumer to another. Always do your own due diligence, and seek out a professional, if you need one.