By FPA member Robert DiQuollo, CPA, CFP®

Last Updated: August 9, 2010

Can you save money by sending in extra principal payments to pay off your mortgage early? 

It all depends on the rate you’re paying, your tax bracket and how you’ll invest the money. The downside of paying off your mortgage ahead of time is that you’ll have less money to put into investments.

To determine what’s best, calculate the after-tax cost of the interest on the mortgage and compare it to your projected after-tax rate of return on your investments for at least the next five years. If the after-tax cost of the interest is higher than your current rate of return on your investments, then you should consider paying the mortgage down or paying it off in full. If it’s lower, don’t.

Let’s say you have a six percent mortgage, can deduct mortgage interest on your tax return, and are in the 25 percent tax bracket. Since your payments are saving you taxes, you’d multiply .06 percent by .75 = 4.5 percent — the after-tax cost of your loan.

If you believe that you’ll make more on your investments over the next five years, you should not accelerate your mortgage payments. In our example, if you invest in taxable investments, you’ll have to earn roughly six percent to 4.5 percent net of tax. Because of state taxes and favorable tax treatment of long-term capital gains, it’s a little more complicated than that, but it’s close enough to use as a guideline. However, if you can invest in a tax-free Roth Individual Retirement Account (Roth IRA), you just need to earn more than 4.5 percent to come out ahead.

How much is realistic? The stock market for the last 75 years, despite the 2008-09 meltdown, has produced an average return of about eight percent.

Generally, if you have a fixed-rate mortgage with a low rate, roughly five to six percent or less, paying it down rarely makes sense. It’s usually better to keep paying the mortgage and invest the extra cash. Investing in a well-diversified investment portfolio has historically returned greater than five percent. 

But if you would just invest the extra money in a bank certificate of deposit (CD) — yields are very low now — you’re better off paying down the mortgage.

If you mortgage carries a high rate or is variable and you can’t refinance at a lower rate because of a poor credit rating or a home that has lost its value, it usually makes sense to pay down the mortgage faster. If you do not qualify for itemized deductions on your tax return, it changes the equation because you get no tax benefits by having a mortgage. However, most people with mortgages can itemize.

FPA member Robert DiQuollo, CPA, CFP®, is President of Senior Financial Advisor of Brinton Eaton, a boutique wealth advisory firm in Madison, N.J.