Alternatives to paying off your mortgage early

Suppose you have $200 a month burning a hole in your pocket and you want to make the most of it over the next 20 years or so. What are your options?

Spend the money.
Pay off mortgage principal.
Save or invest the money.
Pay of higher-interest-rate debt.

Let's take a look at each of these options.

Spend it. If you believe the credit card commercials, you may opt for a couple decades of annual tropical vacations--priceless. In this case, spending the money changes the definition of priceless to "no money in your pocket". Ah, but those memories of hangovers on fruity rum drinks!

Pay off mortgage principal. Remember, mortgage interest is tax-deductible, so you save a chunk on taxes to offset what you pay in interest on your mortgage. This tax deduction makes owning a home and paying a mortgage more affordable in the early years, when most of your payment is interest. But it would be silly to get a mortgage just for the tax deduction.

Using the previous example, your mortgage is $200,000 for 30 years at 5.25%. How much does this mortgage cost?

• Without any prepayments, you pay $197,585 in interest over the full 30 years. But that's without taking the tax deduction into account.
• If your tax bracket is 25%, you get a 25% tax deduction (in this example, $49,396) of the mortgage interest you pay. Your total out-of-pocket, then, is $148,149 (that's $197,585 minus $49,396). Keep in mind that, to get the benefit of the mortgage interest tax deduction, you have to itemize your tax return and have enough deductions to exceed the standard deduction, which is $11,400 for a married couple filing jointly in 2009.
• If you use the $200 each month to prepay principal, you chop $65,587 off the total interest, or $131,998 ($197,585 minus $65,587). Knock off 25% of the interest you pay for the tax-deduction and the interest tab is down to $98,998. You also shorten you mortgage duration to 21 years and 3 months.

Save or invest the money. Instead of paying off your mortgage early, maybe it makes sense to stuff your $200 a month into savings or investments. One key is to invest your money in relatively low-risk investments.

Whether investing makes sense depends on the return you earn. Say you start an automatic $200 monthly contribution to low-cost index funds with a moderately conservative asset allocation that is likely to deliver annual returns of 5% over the long term.

• If you contribute $200 per month for 30 years (a total contribution of $72,000), the balance at the end of the 30 years would be $167,426. You would earn $95,426 on your investment (don't forget that the interest compounds).
• Suppose you pay 20% in taxes on your investment returns, so you net $76,340.
• That means that at the end of 30 years, your out-of-pocket mortgage interest is only $71,808 ($148,149 from the after-tax deduction interest minus the $76,340 in investment earnings).
• In this example, you have to earn at least 3.75% on your investment to make investing the $200 per month more attractive than prepaying your mortgage. Right now, savings accounts and CDs don't deliver that return, so you would have to invest in some mixture of stocks, bonds, and cash, which means a slightly elevated level of risk. Make sure you're comfortable with the risk from the investments you use.

What about other debt? If you have several sources of debt, the rule of thumb is to pay off the highest-interest-rate debt first. But that's true only when the loan durations are similar. The length of mortgage loans sometimes means that prepaying your principal is the better route. For example, take the same $200,000 5.25% mortgage we've used so far. Say you also owe $5,000 on a credit card with a 19% interest rate.  Should you pay $200 toward the card or prepay your mortgage?

• If you make the minimum monthly payment of $100 on your credit card (assuming it's 2% of your balance), you would pay $4,985 in interest by the time you pay off the original bill.
• If you add the $200 to paying off your credit card, you would pay only $851 in interest, for a savings of $4,134.
• You already saw that you would save $65,587 in interest plus $16,397 in tax deductions (a total of $81,984) by prepaying your mortgage principal. Prepaying your mortgage is the winner by far in this case.