This study investigated converting abundant paper mill waste, de-inked paper sludge (DPS), into value-added medium-density fiberboard (MDF) panels. The objective was to repurpose this solid waste into a valuable material that aligns with the principles of a circular economy. Previous research has examined the addition of paper sludge to wood composites, but there is limited information on the specific incorporation of DPS into MDF production. This investigation offers new insights into this application. MDF panels were manufactured using hardwood fibers, with varying levels of urea-formaldehyde resin (10% and 12% by weight) and different loadings of DPS (ranging from 0% to 50% by weight). X-ray diffraction analysis revealed the presence of defective DPS fiber crystals. Contact angle measurements confirmed that DPS had poor wettability, corresponding to increased water absorption. As more DPS was incorporated, the mechanical properties of the panels progressively weakened due to defective fibers and poor adhesion between the fibers and the matrix. This was evident in scanning electron microscopy micrographs, which showed an escalation in interfacial flaws. Increasing the resin dosage noticeably improved the internal bond strength and reduced moisture uptake across all levels of DPS. However, at a DPS loading of 50%, the properties of the panels deteriorated by 36%–57% compared to the control MDF. Additionally, thickness swelling and water absorption increased significantly with higher DPS content, primarily due to the hydrophilic nature of the fibers. Based on optimization, it was determined that a DPS loading of 20% with a resin content of 12% provided the best balance between performance, waste utilization, cost, and moisture resistance. The reuse of abundant paper sludge supports the goals of a circular economy. However, strategies are required to tailor the processing methods and enable higher levels of recycled material without excessively compromising the key attributes of the product. Further research should focus on enhancing the quality of DPS and its compatibility with wood fibers and resin to enhance the performance of the composite material.