JoeTaxpayer's Blog JoeTaxpayer Older Articles

There are many who would tell you the advantages of pre-paying your mortgage, and while you may want to consider this, be sure these come first:

1) Deposit to capture the full match (if any) in your 401(k)

2) Pay off all your credit cards

3) Have six months (or more) of accessible funds* (next page)

4) Max out your retirement savings (401(k), IRA, and/or Roth IRA)*

5) Begin the college fund if you have children

Then ask yourself, if my mortgage is at 6%, and costing me maybe 4.32% (assuming 28% bracket), do I expect that the stock market will return less than 5.1% over the next X years? (5.1 is the return you need to net 4.3 based on a 15% long term capital gain rate). See Fairmark.com for an excellent guide to understand the bracket you fall into.

To put it another way, by socking away the extra payments in a good low cost index fund, you stand a good chance to come out far ahead, finding your portfolio growing to a sum larger than the balance owed on your mortgage. To decide if this makes sense for your situation, first understand what tax bracket you are in. Your tax bracket is the percent you will pay on the next dollar of income you earn, or your 'marginal' rate. Then multiply your mortgage interest rate, by (1-marginal rate). e.g. if your marginal rate if .28, you multiply your mortgage rate by .72. This gives you your after tax cost of the mortgage loan. Then divide that result by .85 (this is 1-.15 which is the maximum rate on long term capital gains). The final number is the break-even return you need to be better off than paying down the mortgage. Now, look at the long term returns for a time horizon of 10-12 years and decide if the risk is worth taking. If you are disciplined, and invest in low cost index funds, you will find that you may come out well ahead by investing vs pre-paying. You will also build a nest egg that a house cannot provide. Try to borrow money on your home the day after you lose your job, and see what interest rate they offer you, if they approve the loan at all.

(Continued)