Dear Dr. Don,
I have enough money to pay down a little extra in my mortgage every month. But now I’m wondering: Should I spend the extra money on the mortgage or invest the money?
I have calculated the amount for monthly payments to know the lump sum to pay off the mortgage on the day I retire. My main worry involves how income taxes on investment income might change things.
If I invest and get an 8 percent return compared with a mortgage with an interest rate of 4.25 percent, the answer seems pretty obvious.
How does paying capital gains tax on the investment returns change the outlook?
— Ed Elucidate
You have a good handle on the issues. The key is whether you can earn more after taxes on your investments than you pay after taxes on your mortgage.
If you can fully utilize the mortgage interest deduction on your income taxes, then the after-tax rate on your mortgage is less than 4.25 percent. Bankrate’s mortgage tax deduction calculator will help you determine the exact rate.
When you take full advantage of the mortgage interest income tax deduction, you’re doing more than just replacing the standard deduction with the mortgage interest deduction. By contrast, when you replace the standard deduction with the mortgage interest deduction, it does not reduce your tax bill further.
Regarding investments, you can earn returns one of two ways. One is through interest or dividend payments. The other comes when the investment increases in value. Interest is taxed the year that it’s earned as ordinary income. Qualified dividend income is taxed at zero percent, 15 percent or 20 percent, depending on your marginal income tax bracket, which is the same as a long-term capital gain. Ordinary dividends are taxed at your marginal income tax rate. High-income earners may also owe a 3.8 percent net investment income tax.
The problem with calculating your after-tax return on your investments is that you won’t know the exact numbers until you sell them. So, predictions are hard there.
If you are more conservative with investing, it’s less likely that the after-tax return will beat the rate on the mortgage (also after taxes). Investing in a truly diversified stock portfolio — with a time horizon of 10 years or more — you would expect investing to provide a better return than prepaying the mortgage. For example, if you expect taxes to average 20 percent and to have a return of 6 percent on your investments, then your after-tax return is 4.8 percent. Since the after-tax rate on your mortgage is 4.25 percent or less, it makes sense to invest rather than make additional principal payments on your mortgage.
The 6 percent assumption for annual returns is fairly conservative for a stock portfolio. If you actually earn the 8 percent that you’re counting on, then it would make even more sense to invest.
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