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Ask Dr. Don
By
Don
Taylor,
Ph.D.,
CFA
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Bankrate.com |
Paying down principal on a mortgage
Dear Dr. Don,
Is it wise to pay extra money each month
on your mortgage principal; or should you invest the money in a
mutual fund? Our interest rate is at 6.125 percent for 15
years. Can we earn that with current market conditions being what
they are?
Judy Jumpstart
Dear Judy,
Making additional principal payments on your mortgage can
substantially reduce the interest expense on your mortgage. Whether
or not it makes sense to make the additional payments depends a
lot on what the money would have earned if it were invested instead.
Paying down the mortgage is a sure thing. You know
what you're saving. You're saving the after-tax cost of debt on
your mortgage. It's the after-tax cost of debt that's relevant
because if you get to use the mortgage interest expense as a deduction
on your taxes, principal repayments save interest expense but reduce
the tax deduction.
You can estimate the after-tax cost of debt by multiplying
the interest rate by one minus your tax rate. If your marginal
federal income tax rate is 28 percent, then your after-tax cost of
debt is 4.41 percent. [6.125% * (1- .28) = 4.41%] If you can use
the interest deduction on your state income taxes, then add the
state rate to the federal rate when calculating the after-tax cost
of mortgage debt.
The table below shows how prepaying the mortgage reduces
your total interest expense, but just looking at the interest savings
isn't enough. If you don't make the additional principal payments
then you need to consider what you might have earned by investing
that money, and if you assume that you do make the additional principal
payments you need to consider how you will invest the money that
would have gone to the mortgage payments once the mortgage is paid
off.
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No
extra payment
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Extra payment of $150/mo.
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Loan rate:
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6.125%
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6.125%
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Loan amount:
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$100,000
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$100,000
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Loan term (months):
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180
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141
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Loan payment:
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$850.62
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$1,000.62
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Total interest:
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$53,112
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$40,277
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Invest:
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$150.00
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$850.62
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Months:
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1 - 141
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142 - 180
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Value of investments at end of 15 years, earning
4.41% after-tax:
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$31,899.87
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$35,599.12
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Est. value of lost tax deduction:
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$(3,593.86)
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$31,899.87
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$32,005.26
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The table puts the two alternatives on an equal monthly
cash flow basis. In both cases you're spending $1,000.62 in months
1-141, and $850.62 in months 142-180. The difference between the
two alternatives is in what portion of the monthly cash flow goes
toward the mortgage, and what is being invested.
You need to compare the two alternatives on an equivalent
monthly cash flow basis because you can't ignore the cash benefit
of not making the additional principal payment any more than you
can ignore the cash benefit of having the mortgage paid off early.
The table's results show that you're indifferent between
prepaying the mortgage and investing if what you expect to earn
after-taxes on your investment is roughly equal to the after-tax
cost of your mortgage debt.
What it comes down to in the end is what you can earn
on your investments. If you can earn an after-tax rate of return
on your investments that is more than the after-tax cost of debt,
you're better off investing rather than making additional principal
payments. If you can't, then you should pay down the mortgage.
Over time you'd expect to earn a higher after-tax
return in the stock market than your after-tax cost of debt, but
there are no guarantees. CDs provide a guaranteed return but have
trouble on an after-tax basis outperforming your after-tax cost
of debt. The more conservative you are in your investments, the
more likely that paying down your mortgage makes the most sense
for you.
-- Posted: Feb. 19, 2002
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