Investing Behavior
Should I Pay Off the Mortgage or Invest? The Math Is Simple Until It Isn't
The rule is interest rate arbitrage, and most of the time it holds. Here's where it breaks, and the couch analogy that explains why debt sometimes buys you more than it costs.
Short Answer
If the money will earn more than the debt costs, invest it. If it won't, pay the debt down. That rule is interest rate arbitrage and it holds the vast majority of the time. Where it breaks is that a 7% mortgage charges 7% every single year, while an investment that averages 10.5% is almost never actually 10.5%. It's positive 27 one year and negative 22 the next, so the sequence of those returns matters. When the two rates are close to the same, my bias goes toward paying the debt off, because the debt's number is the certain one. The exception is that debt also buys options, and options are worth something the arbitrage math can't see. The one line I don't cross is liquidity: never at the expense of your emergency fund or the cash you'd need if a year went sideways.
Most people who ask me this have already done the math in their head, and the math they did was right. If the money will earn more than the debt costs, invest it. If it won't, pay the debt down. That's the whole rule. Most of the time it holds.
The rest of this is about the times it doesn't hold, and about one thing the rule can't see at all.
Interest Rate Arbitrage Is The Rule, And It's Usually Right
Here's the plain version. If the interest you're going to earn on the money is more than the interest you'd pay on the debt, you should probably invest the money instead of paying off debt with it. That goes for any debt. A mortgage is just the most common example, so it's the one that gets asked about.
That's interest rate arbitrage. It's what wealthy people do all the time, and there's nothing exotic about it. You borrow at one rate. You earn at a higher one. You keep the difference.
The vast, vast, vast majority of the time it really is that simple. Mine is a 2% mortgage. That was a weird stretch of years, and I don't expect to see it again. At 2% there's almost nothing to argue about, and I have no plans to pay it off early.
Most mortgages aren't 2%. That's where this gets interesting.
A 7% Mortgage Is 7% Every Year, And The Market Never Is
Two People On A Couch, Both Worth Zero
There are exceptions, and this is the one I keep coming back to. I walked through it with a friend the other day. Picture two people sitting on a couch in front of you. They both have a net worth of exactly zero.
The Woman On The Left
She has a million dollars of assets and a million dollars of debt. Call it a million dollar investment account and a million dollar mortgage, both at the same rate. Her assumed return and her debt rate match. So she'll go on having a net worth of zero, more or less, with nobody doing anything.
The Person On The Right
No assets and no liabilities. Picture a homeless person. There's nothing there. Net worth of zero, the same as hers, and a spreadsheet looking at the two of them can't tell them apart.
What The Couch Is Showing You
The woman on the left has a whole lot more freedom and a whole lot more options than the person on the right. She can sell something. She can move money around. She can absorb a surprise without asking anyone's permission. He can't do any of that. For that reason there's a very strong argument to be made for not paying off debt, because the debt is what bought her the assets, and the assets are what bought her the options. That analogy is real. I don't think it gets made often enough.
What I'd Want To Know Before You Send That Payment
None of these are hard to find. They're just rarely all on the table at the same time, which is the only way the comparison is honest.
- The actual rate on the debt today, rather than the rate you remember signing for
- A reasonable assumed rate of return on the money, and how far apart the two numbers really are
- Whether you're itemizing, because mortgage interest does nothing for your tax bill if you're not
- How many months of expenses you'd have left the day after the payment clears
- Whether the money is liquid somewhere else, or whether the house becomes the only place it lives
- What clearing the payment does to your monthly cash flow, and what that frees you up to do
- Whether you'd sleep better with it gone, because temperament is a legitimate input and I won't pretend otherwise
Where My Bias Toward Paying It Off Runs Out
All that being said, I do tend to have a bit of a bias toward paying off debt, all other things equal.
The reason for the bias is that the couch is dramatized on purpose. It's built to make one point loudly. There are plenty of situations where you'd look at it, nod, and still not pay the debt off. But in general, when the two rates are close, I lean toward retiring the debt.
Not at the expense of running out of liquid capital, though. Not at the expense of sacrificing your emergency fund or anything of that nature. That's the line, and it isn't a soft one.
A paid-off house is an illiquid asset. You can't spend a kitchen. If clearing the mortgage leaves you one bad month away from a credit card, you've traded a rate you knew for one you don't, and the one you don't is worse.
I'll also be honest about what this piece doesn't do. There's no worked example here with a specific rate and a specific balance. Your answer depends on your rate, your bracket, what else you've saved, and how many years are left on the note. The rule of thumb takes ten seconds. Your version of it takes a conversation.
Follow-Up Questions
Does a 2% mortgage change the answer?
Completely, and mine is one, so I'll answer it directly. At 2% almost anything beats it, including cash sitting in a boring savings account for stretches of the last few years. I'm not paying mine off early and I'd have a hard time talking anybody else into paying theirs off either. Rates like that came out of an unusual few years. If you have one, it's an asset, and I'd treat it like one.
Does this apply to car loans and student loans too?
Yes. Interest is interest. The mortgage gets asked about because it's the biggest number on most people's balance sheet, but the same comparison runs on a car note, a student loan, or a business line of credit. What changes is the rate, and higher rates make the decision easier rather than harder. Once the debt rate is well above what you'd reasonably assume on the money, there isn't much of an argument left.
What if the two rates are almost exactly the same?
That's the case where I lean toward the debt, and sequence of returns is the reason. The debt charges you the same rate whether the market was up 27 or down 22. Your investments don't get that consistency, and a bad stretch early does more damage than the average suggests. When it's a coin flip on paper, the certain side of the coin is worth something.
Does the mortgage interest deduction change the math?
For some people, and for fewer than assume it. Mortgage interest only shows up on your return if you're itemizing, and there's a cap on how much debt it applies to (IRS Publication 936, IRS Topic no. 505). If you're taking the standard deduction, the interest isn't lowering your tax bill at all, so the rate you're comparing is just the rate. That's worth checking on your actual return before it goes into anybody's math.
Is a paid-off house the same thing as an emergency fund?
No, and I'd push back pretty hard on treating it as one. Home equity is real money that you can't reach on a Tuesday. A line of credit helps, right up until the moment you need it most, which tends to be when income has stopped and lenders have gotten nervous. Keep the emergency fund in something you can spend, and let the house be the house.
What if I just hate having debt?
Then say so out loud, because it's a legitimate input and I'd rather plan around it than argue with it. Some people sleep better with a paid-off house and no amount of arbitrage math changes that. My only ask is that you know what the preference costs, roughly, and decide it's worth paying. A decision you understand and still make is a good decision.
Sources
Related Talley Wealth Resources
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For discussion purposes only. This is educational and not individualized legal, tax, or investment advice. Any examples are hypothetical and for illustration. Please talk through your own numbers with the right professional before acting.