 Pay
down the mortgage or invest?
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 Dear
Dr. Don,
As far as paying off my mortgage, I always pay enough each month
to equal one extra mortgage payment a year. If I have extra cash,
should I pay more? Or is there an incentive not to? Should I put
that extra money into savings? I am contributing into my 401(k),
putting money into savings each month and I have no other debt.
Where is my extra money best put to use?
Thanks,
-- Martha Mortgage
 Dear
Martha,
If you can earn more by investing the money than you save by paying
down the mortgage, then it makes sense to invest versus paying down
the mortgage. The apples-to-apples comparison is the expected after-tax
return on your investment versus the effective rate on your mortgage.
Not everyone can use the mortgage-interest deduction
when filing his or her income tax return. If you aren't using it,
then the effective rate on your mortgage is the interest rate on
the loan. If you are using it, then the effective rate is roughly
the mortgage rate times 1 minus your tax rate. With a 6-percent
mortgage and a 25-percent marginal federal tax rate, the effective
rate on the mortgage is 4.5 percent (0.06 x (1-0.25)).
My example ignores any interest deduction on your state income
tax return. Incorporating a state tax deduction further reduces
the effective rate.
It's pretty hard to beat 4.5 percent on an after-tax
basis in a CD or savings account. A high yielding five-year CD is
currently around 5.15 percent. The after-tax yield is 3.86 percent.
Again, I'm assuming a 25-percent marginal rate on federal taxes
and no state income tax (.0515 x (1-0.25)). Incorporating state
income taxes further reduces the after-tax rate of return.
Invest instead in the stock market, and you can manage
the tax impact of the investment earnings. Dividend income is currently
taxed at 15 percent for most taxpayers, as are long-term capital
gains. Invest the money in a tax-advantaged retirement account and
you change the timing of the tax impact and the applicable tax rate
on your investment earnings.
If you're fairly conservative with your investments
and don't want to look outside savings accounts for investment choices,
then paying down the mortgage isn't a bad idea. If you're taking
a bigger-picture view of investing for the future, it's not as likely
to make sense.
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