Pros and cons of paying down a mortgage

Q: I’m considering making extra payments on my mortgage. I like the idea of not being in debt. What do you think of this idea?

A: Paying off your mortgage quicker may make sense. This financial move isn’t as clear as paying off high-interest consumer debt because mortgage interest rates are generally lower and the interest is generally tax-deductible. When used properly, debt can help you accomplish your financial goals and make you more money in the long run.

Whether paying down debt sooner makes sense for you depends on a number of factors, including your other investment options and goals. Financially, what matters in deciding whether to pay down your mortgage faster is your mortgage interest rate versus your investments’ rates of return.

Suppose you have a fixed-rate mortgage at an interest rate of 6 percent. To come out ahead financially, if you’re making investments instead of paying down your mortgage more quickly, your investments need to produce an average annual rate of return before taxes of 6 percent.

While mortgage interest is usually tax-deductible, remember that you must also pay taxes on investments held outside retirement accounts. While you can purchase tax-free investments, such as municipal bonds, over the long haul, these investments won’t typically earn a higher rate of return than the cost of the mortgage.

And don’t assume that those mortgage interest deductions are that great. You automatically qualify for the so-called standard deduction on your federal tax return. If you have no mortgage interest deductions — or less than you used to — you may not be missing out on as much of a write-off as you think.

Paying off your mortgage faster has no tax benefit. Putting additional money into a retirement plan, however, can immediately reduce your federal and state income tax burden.

In order for you to have a reasonable chance of earning more on your investments than it’s costing you to borrow on a mortgage, you must be aggressive with your investments. Notwithstanding their horrendous slide in 2008-09, stocks have produced annual average rates of return of about 9 percent to 10 percent.

Paying down a mortgage ties up more of your capital, reducing your ability to make other attractive investments. Some people feel uncomfortable paying off debt more quickly if it diminishes their savings and investments. You probably don’t want to pay down debt if it depletes your financial safety cushion. Make sure that you have access — through a money-market fund or other sources, a family member, for example — to at least three months’ living expenses.

*Provided courtesy of Eric Tyson, author of "Let’s Get Real About Money!" and "Investing for Dummies''