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Pay down the mortgage or invest?

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

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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.

Bankrate.com's corrections policy -- Posted: Jan. 23, 2006
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