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Making extra mortgage payments vs. investing

Dear Dr. Don,
Is it wise to pay extra money each month on your mortgage principal, or should you invest the money in a mutual fund? Our interest rate is at 6.125 percent for 15 years. Can we earn that with current market conditions?
-- Judy Jumpstart

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Dear Judy,
Making additional principal payments on your mortgage can substantially reduce the interest expense on your mortgage. Whether it makes sense to make the additional payments depends a lot on what the money would have earned if it were invested instead.

Paying down the mortgage is a sure thing. You know what you're saving. You're saving the after-tax cost of debt on your mortgage. It's the after-tax cost of debt that's relevant because if you get to use the mortgage interest expense as a deduction on your taxes, principal repayments save interest expense but reduce the tax deduction.

You can estimate the after-tax cost of debt by multiplying the interest rate by one minus your tax rate. If your marginal federal income tax rate is 28 percent, then your after-tax cost of debt is 4.41 percent. [6.125% x (1-.28) = 4.41%] If you can use the interest deduction on your state income taxes, then add the state rate to the federal rate when calculating the after-tax cost of mortgage debt.

The table below shows how prepaying the mortgage reduces your total interest expense, but just looking at the interest savings isn't enough. If you don't make the additional principal payments, you need to consider what you might have earned by investing that money. And if you assume that you make the additional principal payments, you need to consider how you will invest the money that would have gone to the mortgage payments once the mortgage is paid off.

How prepaying a mortgage
reduces your interest expense
 
No additional payment
Additional $150 monthly payment
Loan rate:
6.125%
6.125%
Loan amount:
$100,000
$100,000
Loan term (months):
180
141
Loan payment:
$850.62
$1,000.62
Total interest:
$53,112
$40,277
Invest:
$150.00
$850.62
Months
1-141
142-180
Value of investments at end of 15 years, earning 4.41% after-tax:
$31,899.87
$35,599.12
Est. value of lost tax deduction:
 
$(3,593.86)
 
$31,899.87
$32,005.26

The table puts the two alternatives on an equal monthly cash flow basis. In both cases you're spending $1,000.62 in months 1-141, and $850.62 in months 142-180. The difference between the two alternatives is in what portion of the monthly cash flow goes toward the mortgage, and what is being invested.

You need to compare the two alternatives on an equivalent monthly cash flow basis because you can't ignore the cash benefit of not making the additional principal payment any more than you can ignore the cash benefit of having the mortgage paid off early.

The table's results show that you're indifferent between prepaying the mortgage and investing if what you expect to earn after-taxes on your investment is roughly equal to the after-tax cost of your mortgage debt.

What it comes down to in the end is what you can earn on your investments. If you can earn an after-tax rate of return on your investments that is more than the after-tax cost of debt, you're better off investing rather than making additional principal payments. If you can't, then you should pay down the mortgage.

Over time you'd expect to earn a higher after-tax return in the stock market than your after-tax cost of debt, but there's no guarantees. CDs provide a guaranteed return but have trouble on an after-tax basis outperforming your after-tax cost of debt. The more conservative you are in your investments, the more likely that paying down your mortgage makes the most sense for you.

 

Bankrate.com's corrections policy -- Posted: Feb. 27, 2002
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