Prepay the Mortgage or Invest? The Break-Even Return
Spare money beside a mortgage offers two returns. Paying extra principal pays a return you are certain of: your mortgage rate, after tax. Investing pays a return you can only expect. So the decision is not which one is better in general. It is which rate is higher for you, and there is one expected return where the answer flips.
Take an illustrative $320,000 balance with 27 years left, $500 a month to spare, and a 15-year comparison. Both paths spend the same total each month: the required payment plus the $500. The prepay path sends the extra to principal, then invests the whole freed-up payment once the loan is gone. The invest path keeps the mortgage on schedule and invests the extra. Because the house is kept either way, its value cancels, and what is left to compare is investments minus the remaining loan.
Start with the number that misleads people
At a 6.5% rate, the payment is $2,098 a month, and adding $500 of principal removes $150,545 of interest and pays the loan off 10 years early. That figure is correct, and it decides nothing.
It leaves out what the same money would have done elsewhere. Run the fair comparison, where the investor also puts $500 to work every month at an assumed 6% return, entered after tax so both sides compare on the same basis, and prepaying comes out ahead by $8,316 after 15 years, not by $150,545.
Interest removed from the loan
$150,545
Over the whole loan, comparing the mortgage with itself. It counts what the lender no longer collects, and nothing else.
Wealth gained by prepaying instead of investing
$8,316
Over 15 years at a 6% assumed return, counting what the invested money would have grown to. This is the number the decision turns on.
The rule in one sentence: prepay when your expected after-tax return is below the break-even return, invest when it is above, and when the two are close, the numbers stop deciding.
Prepaying is a bond you already own
The Bogleheads wiki frames the choice directly: paying down the loan "will give you a guaranteed return by reducing your future loan balance," so "it makes sense to treat paying down a loan like a bond investment, and compare this option to your other investment options." The wiki states the same idea from the other direction: "As a liability, a mortgage note is a negative bond."
That framing sets the fair comparison. Not your mortgage rate against the stock market, but your mortgage rate against a bond whose duration, roughly its payback horizon, equals the time left on the loan, because prepaying carries no market risk. The wiki is explicit: for a fixed-rate loan, "the proper comparison is to a bond with duration equal to the time it will take you to pay off the loan, because that is how long it will take you to realize the benefit." The Securities and Exchange Commission's investor site states the other half: all investments involve risk, and you should allow for market fluctuations over time. Comparing a certain return with an expected one is the difficulty of this decision, and no calculator removes it.
The break-even return, and why it is not your mortgage rate
Hold every input fixed and raise the assumed investment return. Prepaying wins while the return is low and investing wins once it is high enough, and the crossing point is exact. Below, the vertical axis is the wealth difference after 15 years: above the line, prepaying is ahead; below it, investing is.
The break-even return is close to the mortgage rate, but it is not equal to it, and the gap is worth knowing because the common shortcut is to compare the two directly. A mortgage accrues at the annual rate divided by twelve, while the return you enter is compared with its compounding already included. With no deduction, the break-even return is therefore your mortgage rate compounded monthly, which sits slightly above the rate on the statement; a deduction lowers it further, as the next section shows.
| Mortgage rate | Monthly payment | Break-even return | Above the rate by | At a 6% return |
|---|---|---|---|---|
| 2.75% | $1,400 | 2.78% | 3 basis points | Invest by $32,210 |
| 4.50% | $1,708 | 4.59% | 9 basis points | Invest by $15,249 |
| 6.50% | $2,098 | 6.70% | 20 basis points | Prepay by $8,316 |
A basis point is one hundredth of a percentage point, so the correction is 3 basis points on the 2.75% loan and 20 on the 6.50% one. It almost never decides the question by itself. It matters when your expected return sits within a rounding error of your mortgage rate, which is exactly when people reach for the shortcut.
Deducting the interest lowers the break-even return
If you itemize deductions, part of that interest comes back as a lower tax bill, so prepaying returns less than the rate on the statement. The model lowers the guaranteed return to the after-tax rate, and the break-even return falls with it.
Check that the deduction reaches you before you count on it. The Bogleheads wiki notes that "many homeowners take the standard deduction and thus get no tax deduction from the interest payment." Internal Revenue Service filing statistics for tax year 2018, the latest tally in this page's sources, show the same thing: most filers claimed the standard deduction. If you take it, your guaranteed return is the full rate, and the left-hand bar above is yours.
Four things the calculation cannot settle
- Liquidity. Money sent to principal is difficult to get back without borrowing again. The wiki's guidance is to build a significant emergency fund before paying down a mortgage, and not to prepay money you may need for something else.
- A loan that might be forgiven. Its rate is not the whole story. On a student loan that an employer or program may cancel, the wiki's advice is not to pay it down early unless the rate is very high, because prepaying forfeits that benefit.
- How close the answer is. When the two returns are near each other, the wealth difference is small and the tie-breakers are not financial. The wiki breaks a close tie toward keeping the loan: "If, by the sheer numbers, the decision is close, it may be better to keep the loan." Among the reasons it gives are liquidity and the option to refinance, which a repaid loan no longer offers.
- Certainty against expectation. The break-even return compares a guaranteed rate with a number you chose. Prepaying delivers its return; investing offers a range of outcomes around the return you assumed. Two people can read the same chart and reasonably choose differently.
Find your own break-even return
The prepay vs. invest calculator runs this month by month on your balance, rate, and horizon, and reports your own break-even return along with which side your stated assumptions favor. From there:
- Mortgage amortization to see what an extra payment does to the schedule.
- Compound interest to price the investing side on its own.
- Funding-priority guide to check that the mortgage is even the right target for spare money.
- Rent vs. buy guide for the decision that comes before this one.
How this is sourced
The guaranteed-return framing, the equal-duration bond comparison, the liquidity and forgiveness cautions, and the close-decision tie-breaker are quoted from the Bogleheads wiki. The presence of investment risk is quoted from the Securities and Exchange Commission's investor site, and the share of filers claiming the standard deduction comes from Internal Revenue Service statistics. Every dollar figure and every break-even return on this page is computed by the same model as the linked calculator, under the assumptions stated above. They are scenarios, not forecasts.
Sources
Grounded in authoritative primary sources:
This is educational, not personalized financial or tax advice. For your specific situation, talk to a licensed professional.