What do you do with extra cash flow after you have a basic level of financial security in place? You have an emergency fund, no high-interest debt, and you’re on track to retire at a normal age. A common desire is to live mortgage-free, so you might consider making extra payments in order to pay off your mortgage early. But is that a better option than investing those extra dollars? The answer, as with most personal finance questions, is “It depends”.

Before we look at the factors to consider, there’s one important principle to understand. Paying off debt is like earning a risk-free return of the interest rate on that debt. To see why, let’s look at an example.

Say you have a $10,000 debt with a 5% interest rate. You’re going to pay it off with 1 payment in a year. So 1 year from now, you’ll owe $10,500 ($500 of interest, $10,000 of principal). You also have $10,000 saved in a very high yield savings account, which is paying 5% interest. We could take that $10,000 and pay off your debt today so you won’t owe the $500 of interest in 1 year. You just saved $500 or 5% of $10,000.

Alternatively, you could leave the $10,000 in your savings account and earn 5% interest. At the end of the year, you’ll have $10,500 saved in the account ($500 of earnings, plus your original $10,000). This is exactly the amount you need to pay off your debt. So whether you paid off the debt early or invested it earning 5%, you end up in the same spot.

So, again, paying off debt is like earning a risk-free return of the interest rate on that debt.

The simplified mortgage pay off equation

At this point, we could say that the decision is:

In the very simplified example above, the decision on whether to invest or pay extra on your mortgage is clear, whichever has the higher return, do that. Of course, the real world isn’t that simple. There are a couple of complicating factors in the equation: taxes and risk.

How do taxes impact the decision?

Taxes play a factor on both sides of the equation. On the debt side of things, you may be getting a tax deduction for your mortgage interest. Mortgage interest is an itemized deduction on your tax return. If you’re utilizing the standard deduction on your taxes, you’re not getting a tax benefit from the mortgage interest. However, if you are itemizing, then the mortgage interest is tax-deductible. In that case, we need to adjust the interest rate down to reflect the tax benefit. For example, if your interest rate is 5% and you pay 30% of your income in taxes, then the tax-adjusted interest rate is 3.5% (5% * (1 – 0.30)). The tax deduction lowers the true cost of the interest.

Taxes also impact the investment side of the equation in that you have to pay taxes on your investment gains. If we assume an average tax rate of 20% on your investment gains, then a 5% pre-tax return turns into a 4% (5% * (1-0.20)) after-tax return.

With taxes in mind, we can update the equation to:

How does risk change the equation?

The other complicating factor is risk. In our examples so far, we are assuming that we know what the investment return is going to be. In reality, if we are investing in a combination of stocks and bonds, our return is unknown. There is a chance we could earn more than a 5% return, but there is also a chance we could earn a lower return, or even lose money.

To deal with this uncertainty, we want a “margin of safety” between our expected investment return and tax-adjusted interest rate if we’re going to invest our extra income. How big that margin of safety needs to be will depend on your individual risk tolerance. Someone might feel comfortable investing with an expected return of 1% over their mortgage interest rate, while another investor might want a minimum margin of 3%.

So the final equation becomes:

It’s important to acknowledge that this is not a one-time decision. If the stock market has fallen by 20%, making expected future returns higher, then maybe you invest rather than pay extra on the mortgage. Conversely, if the market has grown by 15%/year for 5 straight years, that’s a signal that expected future returns might be lower. In that case, you could pay extra on the mortgage rather than invest.

Investing can pay off your mortgage earlier

The most common reason I hear for wanting to pay off the mortgage is to free up cash flow. Wouldn’t it be great if you didn’t have to make that monthly payment? Well, investing could allow you to pay off the mortgage even faster! That is, if the after-tax investment return you earn by investing is higher than your tax-adjusted mortgage interest rate. Your investment balance will eventually be higher than your outstanding mortgage balance. You can sell those investments, pay off your balance, and live your mortgage-free life.

The decision to invest your extra cash flow or pay extra on the mortgage is not black and white. Your interest rate and the expected market return do play a heavy role, but so does your individual risk tolerance. Figure out your tax-adjusted interest rate and consider the expected market returns. Come up with your desired margin of safety and the decision becomes more clear.