01:00 AM EDT on Monday, May 1, 2006

If you're lucky enough to have some spare cash handy -- maybe from a bonus at work, or from an inheritance, for example -- should you use it to pay off the mortgage, or simply invest it? That's the question a man from Smithfield asked MoneyLine:

Q: I wondered if you could address the benefits of paying off a mortgage earlier than is scheduled . . , as opposed to taking that same amount of money and investing it. . . . When you consider that if I put that amount towards the mortgage, I will be losing the ability to declare mortgage interest on my tax [return], and I will be having to pay taxes on the interest that I gained from the CD . . . .

-- B.P., Smithfield

A: Before muddying the waters with tax matters, ask yourself what you'd prefer to do, said Angela M. Thomson, a director of the Financial Planning Association (Rhode Island chapter), a trade group for financial planners and others.

"The bottom line is your gut," your personal preference, she said. "You can run all the numbers in the world, but if you're not comfortable with the decision, then go with your gut."

Thomson, who teaches retirement planning at Bryant University's program for financial planners, said she had her house paid off by age 45, "because my personal preference is, I like being debt-free."

Sometimes, she said, "It's not a matter of how well the market does, or may do, but how well you sleep at night."

In other words, do you worry about having a mortgage hanging over your head? Are you so confident about the future -- about your job, your financial picture, your other financial obligations -- that having a mortgage isn't a concern?

Once you've resolved that matter, it's time to consider other factors. For example, paying down -- or paying off -- your residential mortgage loan gives you a guaranteed rate of return, generally equal to the interest rate on that loan.

If you borrowed $150,000 over 30 years at a fixed rate of 6 percent, you're paying about $900 a month. In the early years, the bulk of each monthly payment is interest; only a small amount goes toward the principal.

By paying off the mortgage earlier than scheduled, you're guaranteeing yourself a 6-percent return on your money. Why? For every dollar you apply directly to the principal (reducing the amount outstanding), you save the interest that you'd otherwise have to pay on that dollar of loan principal, according to Jack M. Guttentag, professor of finance (emeritus) at the University of Pennsylvania's Wharton School.

"The rule is that, absent any prepayment penalty, principal repayment yields a return equal to the interest rate on the loan," Guttentag said on his Mortgage Professor Web site:

www.mtgprofessor.com

If you're still undecided about what to do with that extra cash, first pay off credit card debt. That's because the interest rate charged on outstanding card balances is typically high -- and it's not tax-deductible, Thomson said.

What about investing? The general rule is, "If the mortgage beats the market, pay down the mortgage," Thomson said in an interview at Coastal Financial Planning Inc., her fee-only financial-planning firm in Lincoln.

In your comparison, make sure you use only those investment returns that are guaranteed, not returns that may go up or down. (That's because, when you apply cash to the outstanding principal on your mortgage loan, you're getting a guaranteed return -- a yield -- on your investment.)

Okay, so what about those tax issues you mentioned? If you're trying to compare the yield on paying off your mortgage against the yield from putting your money in a taxable investment, such as a CD, it really doesn't matter whether you calculate yield on a pretax or after-tax basis, according to Guttentag, author of The Pocket Mortgage Guide and The Mortgage Encyclopedia.

Even when you figure the after-tax impact of both options, paying down the mortgage still generally wins, he said. "The conclusion, that mortgage repayment earns the higher return, holds as before," he said. (If you're comparing the after-tax yield on a tax-exempt bond against the after-tax yield on paying off the mortgage, the bond may win.)

There are lots of factors to consider. The National Endowment for Financial Education (NEFE), in a report for AARP, said you are more likely to benefit from paying off your mortgage if you meet most, or many, of the following conditions:

You value the security of knowing that you own your home free and clear.

You are uncomfortable with loan-related stresses, such as market and interest-rate fluctuations.

You are paying a higher rate on your mortgage than you are earning on your current investments.

You have no consumer debt.

You can pay off your mortgage while still maintaining an adequate cushion of savings.

You'd rather use your mortgage payment funds to invest for the future.

You have less than 10 years remaining on a 30-year mortgage, so you're not getting a significant tax deduction.

The tax deduction is not that helpful because you're in a lower tax bracket.

You are planning to buy a smaller home or move to a less-expensive area soon. (You could use the proceeds from selling your current house to purchase a smaller home free and clear.)

NEFE says you're less likely to benefit from paying off your mortgage if you meet most, or many, of the following conditions:

Your primary goal is saving and investing for the future.

The interest rate on your mortgage is lower than the return you can earn on investments.

You have the discipline to stick to your plan and invest the money.

You can improve your financial situation by paying off higher-interest credit cards.

You can handle your mortgage payments comfortably, based on your current or projected income.

You have 10 years or more before retirement.

You have more than 10 years to pay on a 30-year mortgage, so the tax deduction is significant.

The tax deduction is useful to you because you're in a high tax bracket.

Read more at:

www.aarp.org/money/financial--planning

(Click on the link titled, "Should You Pay Off Your Mortgage Early?")

In the end, you may want to have an accountant, financial planner or other professional crunch the numbers for you, someone who can help you find the best answer for someone in your particular circumstances.

Neil Downing is a Journal staff writer and author of The New IRAs and How to Make Them Work for You. Questions about your money matters? Call us at 1-401-277-7484 and leave a message, or e-mail:

moneyline@projo.com

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