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

Prepay mortgage or invest?

Dear Dr. Don,
My wife and I purchased our first home six months ago. We put 5 percent down and took out two mortgages, a first mortgage at 5.38 percent for 80 percent of the total loan amount and a second mortgage at 6.75 percent on the balance. Both loans are 30-year loans. We have been paying $140 extra on the second and $50 extra on our first mortgage, which puts us on track to pay off our second in 10 years and the first in 26 years. Is this a good investment, or should we be saving the extra $190 dollars a month instead? Should we pay the total $190 on the second since the interest rate is higher? Any insight or suggestions would be helpful.
Thanks,
Jon Jointly

Dear Jon,
As you know, an 80-15-5 mortgage lets you avoid private mortgage insurance since the first mortgage is at 80 percent loan-to-value, which is the typical cutoff for requiring PMI. The second mortgage has a higher interest rate because of the higher risk (less equity) backing that mortgage. Having the second mortgage amortized over 30 years too is a little unusual for this type of structure, but it keeps the monthly mortgage payment lower.

Absent any prepayment penalties on the second, you should concentrate your additional principal payments on that loan instead of splitting the payments between the two loans. It will minimize your total interest expense on the loans.

The decision between making additional principal payments on your mortgage and investing the money depends on your attitude toward risk when you invest and whether this $190 a month is the only money available in your monthly budget to invest.

If you're already funding your retirement accounts, have three to six months' worth of monthly expenses salted away in an emergency fund and don't carry a balance on your credit cards, then it's your choice whether you want to add to your investments or reduce your mortgage loan balance. If your company is matching all or part of your contributions to a 401(k) plan and you're not taking advantage of the company match, then that should win out over the additional principal payments.

Here's the key: If you can reasonably expect to earn more on an after-tax basis on the investment than you pay on an after-tax basis on your mortgage, then you're better off investing rather than prepaying your mortgage.

-- Posted: March 22, 2004