 Invest or pay off the mortgage?
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 Dear
Dr. Don,
Is it a good idea to liquidate our mutual fund investments, excluding 401(k) money, if it is used to pay off my home mortgage? I would then invest the money I would have used for mortgage payments every month?
Our mortgage is about $190,000 at 5 3/8 percent. I have 25 years remaining. We put away money every month, and we are quickly approaching where we could pay off our house. We also maximize 401(k) contributions each year. The mortgage on the house is our only debt.
Thank you,
-- Matt Mutual
 Dear
Matt,
Getting out from under the monthly mortgage payment before retirement is a great financial goal, but liquidating all your nonretirement investments to reach that goal today often doesn't make sense -- even when you plan on rebuilding that nest egg each month with an amount equal to your mortgage payment.
The scenario below approximates your situation.
For simplicity, I assumed you can pay off your mortgage today, even
though you've said you're not quite to that point.
 |
Scenario |
|
| Loan balance: |
$190,000 |
| Loan term (months): |
300 |
|
|
| Interest rate: |
5.375% |
|
|
| Monthly mortgage payment: |
$1,153 |
|
|
| Total interest expense: |
$155,788
|
|
|
| |
|
|
|
| |
|
| Stay invested: |
$190,000
|
Invest monthly mortgage payment: |
$1,153 |
| Investment horizon (months): |
300 |
Monthly investments: |
300 |
| Average annual yield: |
6.00% |
Average annual yield: |
6.00% |
| Expected value at horizon: |
$848,344 |
Expected value at horizon: |
$798,763 |
| Value of interest tax
deduction at horizon*: |
$106,600
|
|
|
*Estimated by assuming the monthly value of the mortgage
interest deduction (25 percent bracket) is invested at a 6 percent
average annual return.
You save the total interest expense by paying off
your mortgage, but you've cashed in your investments and lost the
investment income on that lump sum while you rebuild your portfolio. If
you use the mortgage interest deduction on your income tax returns,
you've also lost the value of that deduction.
Ignoring the value of the mortgage interest deduction,
and assuming that you can earn a 6 percent pre-tax return on your
investments, you're better off keeping your money invested in the
mutual funds and not prepaying the mortgage. The money is invested
in taxable funds so the pretax return on the two alternatives is
comparable without making an adjustment for capital gains or income
taxes. If you can use the mortgage interest deduction on your taxes
then it makes even more sense to keep the mortgage.
In general, if you expect your investments to earn
more after-tax than your mortgage costs you on an after-tax basis;
you should keep the mortgage and stay invested. Very conservative
investors often have a hard time meeting that hurdle, and prepayment
looks like a more attractive option to them.
Dear Dr. Don,
If I'm making a lot of money on the sale of my current house, should I put all the money down on the other house that is more expensive or should I take a higher mortgage and invest the other money?
-- John Jump-start
Dear John,
Read through my reply to Matt (above). While your situation isn't
exactly the same, my advice is pretty close. If you expect
to earn more on your investments on an after-tax basis then your
mortgage will cost you on an after-tax basis, it makes sense to
invest rather than to make a big down payment on your new home.
One way that your situation is different is that you're trading
up. Putting enough money down to avoid paying private mortgage
insurance, or PMI, is a good idea. That means at least 20 percent
down. A large enough down payment so you can afford the monthly
mortgage payment is also important. Bankrate's home affordability
calculator
can help you size the down payment from that perspective.
To ask a question of Dr. Don, go to the "Ask
the Experts" page, and select one of these topics: "financing
a home," "saving & investing" or "money."
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