Ask Dr. Don By Don Taylor, Ph.D., CFA • Bankrate.com

Additional principal payments or investments?

Dear Dr. Don,
Which would be best, to double the principal we are presently adding to our mortgage payment, or to take that extra money and invest it somewhere else, (i.e., money market, CD, etc.)? We have a 15-year mortgage at 5.5 percent and are paying an extra $125 every month as an additional principal payment.
Thank you,
Deb Discord

Dear Deb:
It makes sense to make additional principal payments when you save more on your mortgage interest expense on an after-tax basis than you would earn on your investments on an after-tax basis. If you can use the mortgage interest deduction on your taxes, and your marginal federal income tax rate is 27 percent or higher, then your after-tax cost of mortgage debt is between 3 percent and 4 percent. This Mortgage Tax Calculator can help you determine your after-tax cost of debt.

In the current interest rate environment, the after-tax return on money market investments and CDs aren't going to outpace your after-tax cost of debt. You can earn over 4 percent on a five-year CD on a pretax basis using Bankrate's Best Rates feature to find high-yielding CDs, but if you're in the 27-percent bracket for federal income taxes, the after-tax return is less than 3 percent.

Contributing to a tax-advantaged retirement account, especially a 401(k) plan where your employer matches all or part of your contributions, can be a better strategy than prepaying your mortgage -- at least up to the limit of the employer match.

If you decide to double up on your additional principal contributions, then Bankrate's Mortgage Calculator can show you how these contributions shorten the mortgage term and reduce interest expense.

-- Posted: Dec. 3, 2003