You've got some extra cash. Should you invest it or use it to pay down your mortgage?
Prepaying part of your mortgage, you end up paying less in interest but you also lose part of your mortgage-interest tax break. Your true savings, then, can be expressed as the difference between your mortgage interest rate and the rate at which you take your deduction (a function of your total marginal tax rate). If that net percentage figure is less than the amount you could make investing the cash, you're better off investing it.
Here's an example: By adding an extra $50 per month on a $200,000, 30-year fixed-rate loan financed at 6%, you could whack nearly $28,300 in interest payments from the mortgage. How much of a return is that? For someone in the 28% federal-tax bracket, prepaying a mortgage with a 6% interest rate provides a 4.44% after-tax rate of return. (The rate is lower than the mortgage rate because of the tax break on the mortgage interest.) Now, if you could invest that same money in the market and earn more than 4.44%, after taxes, then you're probably better off with the investment.
The worksheet above gathers the information needed to do this calculation and gives you an answer based on your own investment assumptions. Notice that on Line 2 we've adjusted your mortgage rate to reflect the fact that interest on mortgages is usually compounded once a month instead of once a year. Sadly, this means that your true annual rate is a bit higher than the bank's stated rate. Lines 3 and 4 ask for your tax rates. If you don't know them already, you can get them from the IRS and your state department of taxation.
As for your investment-return assumptions, one warning: Remember that the rate you earn by prepaying is a guaranteed return. Investing your money otherwise carries all the attendant risks. The higher the assumed return, of course, the greater the risk. That said, if you're confident you can earn 8% or more in the market, this is definitely something to consider. The same is true if the spread between your prepayment return and your assumed investment return is small. Our recommendations should be taken with this caveat in mind.
Here's another caveat. If you do decide prepayment is the way to go, don't get suckered into a "biweekly prepayment program." These programs where you pay your lender or a third party for the right to prepay your mortgage are lousy deals. Typically, you pay a set-up fee somewhere in the range of $350, plus a monthly service charge of about $5 dollars. But here's a tip: With most mortgages, you can prepay anyway at no charge.
If you want to prepay, it's wiser just to add a little bit extra to your monthly mortgage check. But first, make sure there isn't a prepayment penalty associated with your loan. Fortunately, most loans don't charge one, although you're more likely to find one with an adjustable-rate mortgage (ARM).
Of those fixed-rate loans that do carry a penalty, the vast majority only penalize you if you prepay more than 20% during your first five years. With adjustable-rate mortgages, the penalty structure can vary, so be sure to read the fine print. Some loans penalize you if you prepay more than 40% of your balance over the first three years. Others may charge a penalty on a declining basis, with the penalty tapering off over a period of five years.