Extra mortgage payment dilemma

This blog will be an extension of Dividendium, a website devoted to dividend investing. Because of that, the topics discussed will tend to lean towards the financial. However, I plan to discuss more than just dividend investing in this blog, which is what I will do today.

Recently, a friend said he was trying to find ways to save money. He had recently switched jobs and did not yet qualify to make contributions to the 401k at the new company. Because of this he stood to lose a lot of money to taxes that would have otherwise gone into his retirement accounts.

One of the tactics he thought to use was to pay down his mortgage. On a purely psychological note, this may be a good idea. The mental peace of knowing that you own your home and that you don’t have to make a mortgage payment every month should not be immediately dismissed.

However, our society encourages homeownership and so provides incentives like tax-deductible interest. So if we assume that his mortgage rate is 6%, and that he is in at least the 25% tax bracket (http://taxes.about.com/od/2006taxes/qt/2006_tax_rates.htm), then what is his return on the extra money that is being paid on his mortgage?

Let’s say he puts $1,000 extra into his mortgage over a year. 6% of $1,000 is $60. Since he doesn’t have to pay interest on that $1,000, it’s equivalent to saying that he earned a 6% return on that money. If he hadn’t put the extra $1,000 toward his mortgage, he would have had to pay the $60 in interest to the bank. So by paying $1,000 toward his mortgage he effectively saved $60, right?

Not exactly. We are forgetting that tax-deductible interest incentive. If he had paid those $60 in interest, he would have been able to reduce his taxable income by $60. Since he is in the 25% tax bracket that equates to ($60 x .25) $15 in actual tax money that he wouldn’t pay.

So in actuality, “investing” $1,000 extra into his mortgage only netted him $45 since he increased his tax bill by $15 when he didn’t pay the $60 in interest. So the actual return on that $1,000 is only 4.5% after taxes. That seems rather small now. So what are his other options to get a better return on that $1,000?

He could invest in a tax-free municipal bond fund. The return fluctuates, but will usually be above that 4.5% return after taxes, since there are no taxes.

He could invest in a tax-deferred insurance product. Generally you can get into a mutual fund within the insurance product that after fees will return at least 4.5% if not more.

He could invest long-term in a dividend stock in a taxable brokerage account. After a year he would qualify for the 15% capital gains tax rate. A conservative long-term gain for the market is 8%, which means after 15% taxes, he would still net a (8% x .15) 6.8% return.

From a purely logical point of view, this all makes sense, but it doesn’t address the psychological benefits mentioned before. My suggestion for that is to keep this money in a separate “house” account.

When you want to figure out how much you have left on your mortgage, subtract the amount in this account from the mortgage balance. When the balance in this account is greater than your mortgage balance, you’ve paid off your mortgage.

So at that point you could make all future payments from this account and continue to earn returns on that money. Or just make one large payment and be done with it. Or if you can still find higher returns than the current mortgage rates at that time, take out another mortgage, put the cash in that “house” account, and do it again.

Either way the idea here is to invest your money as efficiently as possible, considering all sides, including taxes and psychology.

If you have any comments, corrections, or questions about this post, or suggestions for future post topics, or for improvements to Dividendium, leave a comment or shoot me an email at contact@dividendium.com.

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