Mortgage pre-payment and mutual fund investing both have benefits to a consumer's long-term financial outlook. The mortgage represents debt, and eliminating the debt improves a household's net worth. Investing in a mutual fund has the same effect, and will usually have provide liquidity than a paid-down mortgage. Each situation is different and both options have advantages and disadvantages.
Investing in a mutual fund may produce better returns than prepaying a mortgage. This is especially true if you have a low-rate mortgage. If you invest in a growth stock mutual fund and were able to earn 8 percent on that investment, and your mortgage interest rate is 5 percent, you would, in theory, gain 3 percent annually by investing money in a mutual fund compared to paying that money on the mortgage.
If you only consider the difference between the mortgage interest and projected investment returns, the decision about investing in a mutual fund compared to prepaying a mortgage would be simple. However, the higher returns of some mutual funds are not guaranteed, and these funds can lose money, particularly in the short term. Pre-paying a mortgage is a guaranteed investment; your return will equal the interest rate on your mortgage and it is not affected by the stock market or mutual fund values.
Your mortgage interest rate is effectively reduced by the allowable tax deductions for mortgage interest. The rate is reduced by your marginal tax rate. For example, if you pay 6 percent as your mortgage interest rate, and are in the 25 percent marginal tax bracket, it is the same as paying 4.5 percent on your mortgage. This reduction in the interest rate improves the spread between mutual fund returns and the savings achieved by prepaying a mortgage.
Itemized and Standard Deductions
While you can save on your interest rate due to mortgage interest deductibility, other factors enter into the equation. As of 2010, the standard deduction is $11,400 for married people filing jointly. Married homeowners filing joint returns can also deduct up to $1,000 in property taxes without itemizing. If your total itemized deductions including mortgage interest are less than your allowed standard deduction plus the property tax deduction, you will receive no additional tax savings for owing money on a mortgage.
A mortgage always includes the risk that you will not be able to make the payments on your home and could lose it to foreclosure. To some, that risk should be eliminated at all costs, and this makes it more advantageous to prepay the mortgage rather than invest the extra funds. Others will argue that the mutual fund investment could be tapped in times of financial problems, but the investment value may be lower at that time, causing a loss rather than a gain.
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