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Dr. Don Taylor, CFA, advice columnistInvest or pay off the mortgage?

Dear Dr. Don,
Is it a good idea to liquidate our mutual fund investments, excluding 401(k) money, if it is used to pay off my home mortgage? I would then invest the money I would have used for mortgage payments every month?

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Our mortgage is about $190,000 at 5 3/8 percent. I have 25 years remaining. We put away money every month, and we are quickly approaching where we could pay off our house. We also maximize 401(k) contributions each year. The mortgage on the house is our only debt.
Thank you,
-- Matt Mutual

Dear Matt,
Getting out from under the monthly mortgage payment before retirement is a great financial goal, but liquidating all your nonretirement investments to reach that goal today often doesn't make sense -- even when you plan on rebuilding that nest egg each month with an amount equal to your mortgage payment. 

The scenario below approximates your situation.  For simplicity, I assumed you can pay off your mortgage today, even though you've said you're not quite to that point.

Loan balance: $190,000    
Loan term (months): 300    
Interest rate: 5.375%    
Monthly mortgage payment: $1,153    
Total interest expense: $155,788    
Keep mortgage   Pay off mortgage  
Stay invested: $190,000 Invest monthly mortgage payment: $1,153
Investment horizon (months): 300 Monthly investments: 300
Average annual yield: 6.00% Average annual yield: 6.00%
Expected value at horizon: $848,344 Expected value at horizon: $798,763
Value of interest tax deduction at horizon*: $106,600    

*Estimated by assuming the monthly value of the mortgage interest deduction (25 percent bracket) is invested at a 6 percent average annual return.

You save the total interest expense by paying off your mortgage, but you've cashed in your investments and lost the investment income on that lump sum while you rebuild your portfolio. If you use the mortgage interest deduction on your income tax returns, you've also lost the value of that deduction.

Ignoring the value of the mortgage interest deduction, and assuming that you can earn a 6 percent pre-tax return on your investments, you're better off keeping your money invested in the mutual funds and not prepaying the mortgage. The money is invested in taxable funds so the pretax return on the two alternatives is comparable without making an adjustment for capital gains or income taxes. If you can use the mortgage interest deduction on your taxes then it makes even more sense to keep the mortgage. 

In general, if you expect your investments to earn more after-tax than your mortgage costs you on an after-tax basis; you should keep the mortgage and stay invested. Very conservative investors often have a hard time meeting that hurdle, and prepayment looks like a more attractive option to them.

Dear Dr. Don,
If I'm making a lot of money on the sale of my current house, should I put all the money down on the other house that is more expensive or should I take a higher mortgage and invest the other money?
-- John Jump-start

Dear John,
Read through my reply to Matt (above). While your situation isn't exactly the same, my advice is pretty close. If you expect to earn more on your investments on an after-tax basis then your mortgage will cost you on an after-tax basis, it makes sense to invest rather than to make a big down payment on your new home.

One way that your situation is different is that you're trading up. Putting enough money down to avoid paying private mortgage insurance, or PMI, is a good idea. That means at least 20 percent down. A large enough down payment so you can afford the monthly mortgage payment is also important. Bankrate's home affordability calculator can help you size the down payment from that perspective.

To ask a question of Dr. Don, go to the "Ask the Experts" page, and select one of these topics: "financing a home," "saving & investing" or "money."'s corrections policy -- Posted: Sept. 22, 2006
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