Question of the week:I have a little extra money coming in each month, and I'm trying to decide what to do with it. Do you think I'm better off investing it or using it to pay down my mortgage faster? --Becka
Dear Becka,
This is an enduring question in personal finance, and like so many questions, there is no one right answer that works for everyone. Just take a look at some of the responses we received when we asked members of the Armchair Millionaire community about the wisdom of making additional mortgage payments versus investing:
Pay down mortgage. "Go to any online mortgage calculator and look at the dollar amount of interest you can save by increasing your mortgage payments just a little bit. Then look at the amounts you can save if you doubled or tripled your mortgage payment. That is all money you can put in your pocket (or into the stock market) after your mortgage is retired." --Don B.
Invest it. "Not only would I not pay off my mortgage early, I would take the biggest mortgage I could afford for 30 years in order to free up more to invest. A mortgage is some of the cheapest money around right now." --Richard
Do a bit of both. "Since I'm young with many years until retirement, I'd put more into the market and less into paying down the mortgage. The closer I got to retirement, the more I would put towards paying off the mortgage. --Brian F.
To understand which option is best for you, you'll need to do a bit of math and carefully assess your overall financial situation. The questions in my quick guide will help you make the best choice for your situation.
The Armchair Millionaire Guide for Deciding Whether to Pre-Pay Your Mortgage
- How much do you benefit from the mortgage interest deduction? To find out how much the mortgage interest deduction is saving you, look at how much you paid in mortgage interest last year, subtract the amount of the standardized deduction (in 2001, this was $4,550 for single filers and $7,600 for married couples filing jointly) and multiply this number by your combined federal and state tax rate.
Here's an example: Say you paid $15,000 in interest and you and your spouse paid 32 percent in state and federal taxes. Subtract your standard deduction ($7,600) from your interest ($15,000) and multiply that number by .32. The answer is $2,368 in tax savings. Obviously, the benefit is higher if you're in a higher tax bracket, while many homeowners don't itemize at all, thus realizing no interest deduction benefit.
- What's your real interest rate? If you take your tax savings into account, it lowers the interest rate you're effectively paying for your mortgage. In the example above, your tax savings were about 15 percent of your total interest payment. If your mortgage interest rate is 7 percent, and you subtract 15 percent from that, you end up with an effective interest rate of just under 6 percent.
- Can you get a better return somewhere else? Once you know the real return from "investing" in your mortgage, look around to see if you can do better somewhere else. Historically, the stock market has enjoyed an average annual return of about 11 percent. (Although you would need to take taxes into account if your alternative is a taxable account.)
- Do you have a better use for the money? Are you well on track to achieving your other long-term financial goals, such as funding your retirement? If not, your extra money is probably better used taking care of those goals.
- How comfortable are you with debt? Despite all the number crunching they may do, some people still are simply uncomfortable carrying mortgage debt, and this feeling is only exacerbated during rocky economic times such as these. If you're one of these people, weigh these feelings against the numbers.
THE BOTTOM LINE: Run the numbers, look at your other financial goals, and then balance them out against how at ease you are with carrying your mortgage for its remaining term. And remember that your decision is not set in stone-as your situation changes, you can always start or stop making those extra payments.
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