How Aggressively Should You Pay Down Your Mortgage?

At Morningstar, we spend most of our time trying to help investors identify the best stocks and mutual funds for their goals.

But it's the decisions you make before you invest in stocks or funds that have the biggest impact on whether you meet your goals or not. For instance, you know that saving even a little bit more each month can have a huge effect on the size of your eventual nest egg. But deciding what to do with those savings is a thornier issue. For instance, should you pay down your outstanding debts? Or invest in the market?

When it comes to loans that carry excessively high interest rates, such as credit card debt for which annual percentage rates often exceed 20%, it's a slam dunk: Pay it off. After all, you'd be hard-pressed to find any reasonably prudent investment guaranteed to earn that type of return.

But the arithmetic is a bit less cut-and-dried when it comes to another financial decision that many households grapple with every month: whether to prepay one's mortgage, and if so, how much to prepay. (When I say "prepay," I'm talking about paying more than your lender requires each month. Any excess reduces your outstanding balance, or principal.)

Financial planners have typically urged homeowners to prepay a small amount on their mortgages each month, say, an additional $100, in an effort to chip away at their principal balances. Such prepayments have the salutary effect of shortening the life of the loan and, thus, the amount of interest you end up paying.

Nevertheless, most financial planners haven't urged a more aggressive mortgage-paydown schedule than that, and some have gone so far as to call mortgage debt "good" debt. Why would mortgage debt be considered good? There are a few reasons. First, money remains very cheap in the sense that long-term interest rates are flirting with historic lows. Thus, you can afford to buy more house, and thus improve your standard of living, without causing the dollar amount of your monthly mortgage outlay to jump. Second, mortgage interest is tax-deductible, meaning that your effective borrowing rate is even lower than your stated mortgage rate. Last but not least, with interest rates as low as they are and the real estate and stock markets continuing their ascent, it hasn't been too much of a stretch to assume that your equity earnings or appreciation in the value of your home could outstrip your borrowing costs.

I don't dispute those benefits. But lately I've come to believe that a more aggressive mortgage-paydown schedule could make sense for many homeowners, particularly those who are inclined to invest in the market instead. That's because the prospects for other asset classes could be particularly paltry relative to their past returns. While long-term equity returns have been in the neighborhood of 10%-12% over long stretches, a host of investment pundits, from Vanguard founder Jack Bogle to stock market historian Jeremy Siegel, have argued that mid- to high-single-digit equity-market returns are more realistic going forward. The prospects for bonds are even less compelling. Prevailing long-term Treasury yields have historically been a pretty good predictor of long-term bond returns, and the recent 10-year Treasury note was yielding just 4%.

Those lower return projections make it hard to argue that any debt can reasonably be considered good debt, as it's not a sure thing that other investments will earn enough to offset your borrowing costs. I'm not suggesting that you think of investing in the market versus paying down your mortgage as an either/or proposition, mind you, but rather that you consider doing both simultaneously. And at the very least, potentially lower returns across asset classes, including real estate, argue against taking on a huge mortgage that limits your ability to do much of either.

Here are some key questions to ponder when deciding how to allocate your resources each month.

What's Your Time Horizon?
If you're a younger investor with a high percentage of your portfolio in equities, which have historically garnered better returns than bonds and cash, you could make a stronger case for paying less on your mortgage while putting more money into the stock market. Due to compounding, a dollar saved today is worth substantially more than one saved 20 years from now. Moreover, the larger your portfolio's equity stake, the more likely you are to be able to earn back your borrowing costs.

If, on the other hand, you have a big percentage of your portfolio in bonds because you hope to retire within the next 15 years, you have a smaller chance of recouping your borrowing costs and should think about paying down your mortgage on a more aggressive schedule.

Check out Morningstar's  Asset Allocator tool to figure out how much you should have in each asset class given your goals, savings rate, and time horizon. (Asset Allocator is free to Morningstar.com Premium Members; for a free trial membership, click here.)

Are You Taking Maximum Advantage of Your Tax-Sheltered Options?
If you're investing in tax-sheltered options such as an IRA and a 401(k), your rate of return is even higher than the return you see on your statement. That's because you're also receiving a tax benefit--namely, tax-free compounding--on top of your investment earnings. The upshot? You have a better shot of exceeding your borrowing costs when you invest in a tax-sheltered account versus a taxable account.

Those odds can get even better when it comes to a 401(k) plan. Why? Because sometimes your employer will match a portion of the contributions you make into the plan dollar-for-dollar. In other words, you're getting an instant 100% return on the dollars your employer matches. (If you're not contributing enough to take full advantage of any match offered by your employer, by all means try to do so!) Add that benefit to the tax-free compounding that you get while your money is in the plan and your return is likely to comfortably surpass what you'd get from mortgage prepayment.

401(k) matches aside, you'll also want to take a look at whether you're eligible to invest in other tax-advantaged options; here again, your aftertax return from these vehicles has a good chance of outstripping your borrowing costs. Morningstar's IRA Calculator shows you whether you're eligible to contribute to either a traditional or Roth IRA and also lets you know how much you can contribute each year.

How Much Is That Interest Deduction Saving You, Anyway?
One of the big reasons that mortgage debt seems more benign than other types of debt is that your interest is tax-deductible. This can be a particularly big advantage early in the life of your mortgage, when most of your payments go toward interest expenses.

But the deductibility of that interest may not be quite the boon you think it is. Here's why: As taxpayers, we have a choice of either itemizing deductions or claiming a standard deduction on our income tax forms; in 2004 the standard deduction for single filers was $4,850 and $9,700 for married couples filing jointly. If your itemized deductions aren't substantially higher than your standard deduction, your tax savings from interest-payment deductions probably don't amount to much.

That's an important consideration if your rationale for not paying down your mortgage has been predicated on the fear of squandering the tax savings that you thought you were garnering. After all, it's hard to lose what you're not getting in the first place! That realization, in turn, could bolster the argument for a more aggressive mortgage-paydown program.

Are You Paying Private Mortgage Insurance?
Private mortgage insurance is another factor to consider when deciding whether to invest in the market or pay down your mortgage. Lenders typically require you to pay for this insurance if you have less than 20% equity in your home. Thus, if you're on the hook for PMI, you have a strong incentive to get rid of it as soon as you possibly can, either by paying down your principal value aggressively (and thereby building up your equity in the home) or by having your home reappraised. (If you've made substantial improvements to your home or happen to live in an area that has appreciated rapidly, there's a chance that your equity in the home has already risen above the 20% threshold.)

Is Your Interest Rate Fixed or Variable?
There has been an explosion in the number of homeowners holding adjustable-rate mortgages in the past few years. That trend has been driven in no small part by the fact that ARMs typically sport rock-bottom interest rates in the initial years of the loan. That has allowed consumers to take out bigger mortgages--and, thus, afford larger homes--than might have otherwise been possible with a home loan with a higher, fixed rate.

The downside? After an initial guaranteed low-rate period, ARM rates "float" with prevailing interest rates, and the long-term trend in rates is likely to be upward. Thus, if you hold one of these mortgages amid rising rates, your borrowing costs can increase in a hurry. In that situation, you might be hard-pressed to recoup your interest costs through investments in the stock, bond, or real estate markets because those asset classes could be adversely impacted by the rising-rate trend or simply fail to keep pace.

That consideration is especially relevant for those of you who are banking on home appreciation to offset your borrowing costs. Generally speaking, rising interest rates tend to cool off the housing market. That could be a double whammy for homeowners who have taken out an ARM and are in the "floating" portion of the loan schedule. In a rising-rate scenario, you'd be facing a higher mortgage payment each month while at the same time the value of your home could actually be falling (along with that of the broader market).

A version of this article appeared Feb. 15, 2005.