You get a sizeable raise that leaves you with some extra money every month. Does it make more sense to send that extra cash to your mortgage lender or to your brokerage account?

Paper or plastic? Latte or macchiato? Hoodie or sweater? Every day we make choices; some are trivial and others are not. One of the more significant choices you may face in life is whether to use your excess cash to make extra mortgage payments or to fund your brokerage account.

Having too much money is a pleasant dilemma. You might be inclined to buy something expensive, or jet off somewhere for the weekend. But then your practical side sets in, and you decide to consider what's best for your financial situation. If you've already paid off your credit cards, set up an emergency cash fund, and maxed out your retirement contributions for the year, you may be left with only two choices: send more money to your lender to pay-down your mortgage, or invest the money in the stock market.

Big savings, big returns

To compare the two options from a numbers perspective, here's what you have to consider:

  • Mortgage pay down. The return you achieve by making extra mortgage payments is equal to your mortgage interest rate, less any tax deductions that you forgo by reducing your future mortgage interest. If you're currently paying a mortgage rate of 6.25 percent, you'll achieve a pre-tax return of 6.25 percent on any extra principal payments you make. Your after-tax return will be slightly lower, depending on your tax rate and how important your mortgage-related deductions are to your overall tax liability.
  • Increased investments. When you fund your brokerage account, you have the potential to generate a very high return-possibly in excess of what you'd save by paying off your mortgage. With the right investment strategy, it's possible to achieve long-term returns of 8 to 10 percent in the stock market. But here again, there's a tax effect to consider. To convert that 8 or 10 percent to an after-tax number, you have to reduce it by 1 minus your tax rate. A 30 percent tax rate, for example, reduces an 8 percent pre-tax return to 5 percent after-tax.

The sure thing or the gamble

When you make extra principal payments to the mortgage, you create a guaranteed return. And if your mortgage interest rate is below about 6.5 percent, that return is probably lower than what could be achieved (under optimal conditions) in the stock market. On the other hand, if you aren't confident in your investing skill, it might be wise to take the lower return associated with mortgage pay down, rather than risk doing poorly in the market.

Unfortunately, this is one of those choices that has no clearly defined right or wrong. One thing is certain: either option serves you better than spending your extra cash on designer hoodies and daily macchiatos.

Published on September 1, 2008