Real-World Number Crunching

Question of the week:I recently received an inheritance big enough to pay down my home mortgage. I have a great mortgage interest rate and monthly payments I can afford comfortably. I have no other large debts to deal with because I keep my credit cards clear and I don't plan on having children. Should I pay off my house? Or should I invest it? --Gus B. Dear Gus, Yours is certainly a nice dilemma to have, and you're to be congratulated for considering your two very attractive alternatives so seriously. We recently asked members of the Armchair Millionaire community to weigh in with what they would do if they were in your shoes. Here are just a few of the comments we heard: "Pay down the mortgage early. It's a guaranteed savings, risk-free, and if necessary, the money is there to borrow against at a later time." --Craig "Do both. Put 25 percent of the extra cash towards paying down the mortgage and invest the remaining 75 percent in stocks and bonds. Consider your home a partial 'investment.'" --Jeff "Invest, especially if you can do it through an IRA. You'll get the tax advantage of the IRA and still have the tax advantage of the mortgage." --Gregory As you can see, people hold widely varying opinions. Who's right? Actually, everyone. Because everyone is in a different financial situation, there's no single answer that works for everyone. This means that you'll need to do some thinking and run some numbers. At the heart of it, you need to do a cost-benefit analysis--something every MBA student learns inside and out. But don't be put off by the fancy term. It's really just means figuring the benefit of a particular course of action, subtracting the costs, and deciding if it's worth it to you. In your case, the benefit in paying off your mortgage would be the interest you would save and the peace of mind you'd achieve from being mortgage-free. The cost would be the lost opportunity of not investing your money elsewhere. Would the benefit outweigh the cost? That's for you to decide. My guide will help you crunch the numbers. The Armchair Millionaire's Guide to Crunching the Numbers State the alternatives clearly. Break your choices down into manageable parts that you can assess individually. Define each possible outcome and look at all the factors that will impact each. For your decision, some of the factors to consider will be the rate of return you might get on an investment, how long your money might remain invested, the interest rate you're paying on your mortgage, your job security, and any other financial goals you might have. Look for the hidden costs and benefits. Don't overlook the impact of both taxes and inflation. For example, you receive a bit of a tax break when you pay mortgage interest (assuming you itemize your deductions). Likewise, when figuring how an investment might grow, remember that inflation erodes that value of a dollar over time. For example, to have $100,000 in today's dollars, you'd need to have $134,000 in ten years (assuming 3 percent annual inflation). Be sure to include these factors in your calculations. Be realistic about investment returns. Many people look at average annual returns of a major market index like the S&P 500 and assume that they can earn the same returns over time. In the real world, though, most people actually earn less. A better way to estimate what your returns might be over the next ten years would be to look at what your returns actually were over the last ten years. Honor the intangibles. The major challenge in working any cost-benefit analysis is accounting for the intangibles--the things you can't measure in dollars. For example, how do you figure the value of the feeling you'd get from knowing your mortgage is paid off? For some people, it would be worth a great deal; for others, much less. Leverage online tools. There are plenty of online calculators that will do the math for you as you run different mortgage pay-off and investment scenarios. Good places to start are www.cnnmoney.com and www.bankrate.com. THE BOTTOM LINE: There's emotion involved in any big financial decision, but you also need to be clear-headed about the math. Be as rational as possible in considering all the variables and you'll have a great basis for making a sound decision.

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