There's nothing like owning your own home free and clear. That's a goal near to the heart of almost everyone who has ever held a mortgage. Oh, the things you could do without a mortgage payment!

Paying off a mortgage is a noble goal, and one that can serve you well in retirement. But hang on, there's no rush. Despite the claims that you can save a fortune in interest by paying off a mortgage early, spreading the payments out over 30 years can be much smarter than putting your extra dollars into additional mortgage payments.

The interest paradox
While it is very true that a shorter mortgage incurs far less interest than a longer one, simply paying off your existing mortgage faster might not save you as much as you think. The key factor is that you pay most of the interest in the early years. It takes eight years to pay down the first 10% of the principal when you amortize a loan over 30 years. The rest of what you've shelled out is interest. By the time you are halfway through a 30-year mortgage, you've paid 67% of the interest. By year 20, two-thirds of the way through the mortgage, you've paid 84% of the interest.

Starting to make accelerated payments halfway through a 30-year mortgage will save you very little in interest. It would be better to put those extra payments into a money market account until they are actually due. Let the bank pay you interest instead.

Another problem is the way some lenders handle additional payments. Not all lenders automatically recompute the interest you owe if you reduce your principal faster than they expect. Instead, they follow their amortization table, which divides each payment into a set amount of interest and principal. So even though your balance is lower, the interest you are paying doesn't change. With this type of mortgage, an early payoff amounts to a long-term, interest-free loan to your mortgage company. Yikes!

The paradox is that even if you work it right and do save tens of thousands of dollars in interest, that decision could cost you far more in terms of lost opportunity. The real question is: What is the best use of your money?

The anti-mortgage
Imagine if you will, an anti-mortgage account. Instead of sending a bunch of extra bucks to your mortgage lender every month, you send them to a broad-market index fund.

Let's look at what might happen with a $100,000 mortgage at 7%. You could pay it off in 30 years at $665 a month, or in 15 years at $899 per month -- and you'd save about $78,000 in interest with the 15-year option. But suppose you went for the 30-year option, sending $665 to the mortgage company and sending $234 to an index fund -- your anti-mortgage account. That's the same amount out-of-pocket every month, right?

Fast forward 15 years. Your mortgage has been paid down to $74,018 and you have $106,397 in your anti-mortgage account (assuming an average annual return of 11%). At that point, you could, if you chose, convert your anti-mortgage account to cash, pay the capital gains taxes due, and use what's left to pay off your mortgage. Assuming a federal capital gains tax of 20% and a state capital gains rate of 5%, you'd even have about $5,000 left over -- but don't spend it, you'll be needing new carpet soon.

The anti-mortgage account gives you options. You could cash it in and pay off your mortgage early if you prefer, or you could keep saving and building up your net worth as you pay down your mortgage. Or you could do any of the myriad other things that cash money is good for.

The value of cash
There are two common reasons people cite for paying off their mortgage early: To provide a safety net in case they lose their jobs and to reduce income needs in retirement. The prospect of losing your home because you can't make the mortgage payments is scary -- no doubt about it. And the prospect of devoting most of your retirement income to a monthly mortgage isn't much better. But let's look what happens if you choose to invest instead.

Investing lets you build up a portfolio of securities that are easily converted to cash. Cash can make a lot of mortgage payments if you're collecting unemployment. Cash will also make car payments and buy groceries. Of course, if your house were paid for, you could always raise cash by taking out a new mortgage, except, oops, you're out of work. Bad timing. You might be able to get a mortgage, but not a very big one and not at very favorable rates. To get a decent mortgage loan, you need more than a lot of equity in your home: You also need regular income, which makes owning your home less useful in an emergency than you might think.

Here's an even better idea: Use the earnings from your investments to make your mortgage payments. Yep, that's right. Once your anti-mortgage is big enough to pay off the mortgage at one time, you can use the earnings from the account to make the monthly payments -- and keep the cash!

Here's how. Remember the example above where you ended up with an anti-mortgage account worth $106,000 after 15 years? Let's assume you retired at that point and don't want the burden of mortgage payments. Who could blame you? You could cash out your anti-mortgage account and pay off the mortgage, OR you could keep your money in the index fund and simply withdraw enough every year to make your mortgage payments. If you pull $10,600 out of the account each year, that will cover your mortgage payments and the capital gains taxes on the withdrawals.

Here's the best part: By the time the 30-year mortgage is paid off, your investment account will have dropped a grand total of $2,000. (Again, we are assuming an 11% average rate of return.) Talk about having your cake and eating it, too! By saving the extra payments instead of sending them to the mortgage company for the first 15 years, you've built up an anti-mortgage account, used the earnings from it to make your mortgage payments for the next 15 years, and after 30 years, you're left with $104,000 in cash.

Don't believe us? Take a stroll over to our Personal Finance area and play around with our mortgage calculator and savings calculator. Run some scenarios and see what happens. You may also want to check out our Home Center, which has more calculators and information about mortgages. Then let's discuss a few more reasons not to pay off your mortgage, and a few reasons why you might want to consider it.

A word about investment returns
We just compared paying off a low-interest mortgage ahead of schedule with investing the additional payments in an index fund. We assumed an annual return of 11% for the index fund. In a sense that's like shooting fish in a barrel -- if you have a loan at 7% and an investment bringing in 11%, it's pretty obvious that you will do better by investing than by paying off the loan early. The problem is that while mortgage rates are clearly spelled out and fixed (except for adjustable-rate mortgages), stock market returns are not. In essence, our entire argument rests on the performance of the stock market.

So where did that 11% come from, anyway? Did we just pick it out of the air? No, 11% is the average annual return (CAGR) for the S&P 500 over the period from 1926 to 2000.

We used the S&P 500 as our benchmark for two reasons: 1) The 75-year history gives us confidence in our expectations of its future performance, and 2) virtually anyone can duplicate the S&P 500's future performance simply by investing in a well-managed S&P 500 index fund. (If you decide to invest in other mutual funds, stocks you pick yourself, or pork bellies, all bets are off.) Estimating the S&P 500's future performance is the key. We know that its average return has been just a shade over 11% over the last 75 years, but we don't know how it will do next year.

We don't even care.

Next year's market performance is disturbingly unpredictable. But over 30 years, the span of a typical mortgage, the average return of the S&P 500 has been relatively consistent -- and always higher than fixed-income investments. All the depressions, recessions, crashes, crises, booms, bubbles, and busts simply balance each other out if you wait long enough.

Warning: statistics ahead! During the history of the S&P 500 there have been 46 30-year periods starting with 1926-1955, 1927-1956, etc, and ending with 1971-2000. The average annual returns for those 46 periods ranged from 8.5% to 13.7%, forming a nice bell curve with the mean at 11%. Of course, you won't average exactly 11% per year from your index fund over the next 30 years, but based on the past performance of the S&P 500, you have a 98% chance of getting more than 7% and an 83% chance of getting better than 9%. Your most likely average return will be between 10% and 12%.

Feel better? If the statistics didn't do it for you, just hang on to this thought: The worst average annual return by the stock market over a 30-year span was 8.5%.

Reasons to prepay
Even with the odds greatly in favor of investing versus an early mortgage payoff, for some people the bottom line is not the only consideration. Let's look at some legitimate reasons one might choose to pay off a mortgage early and then discuss the best way to go about it should you decide that an early mortgage payoff is in your best interest.

. Guaranteed returns. When you invest in stocks, your return is not guaranteed, but paying off a mortgage early gives you a solid, tangible return on your money. If you are looking for a guaranteed return, accelerating your mortgage payments gives you that, while index investing can't. Of course, with a low-interest mortgage, the return isn't very high (if you have a high-interest mortgage, refinance.)

. Forced savings. Some people just won't save, but they will make the mortgage payment. You do what you have to do to increase your wealth over the years. (You might also consider automatic investment plans. Most mutual fund companies will gladly pull a fixed amount out of your bank account each month and invest it as you have specified. The money's gone before you miss it.)

. Emotional satisfaction. Sure, that's a legitimate reason for paying off a mortgage early -- as long as you understand how much you are potentially giving up.

Guidelines for accelerated payoffs
Most of the pay-off-your-mortgage-early debate is emotional: The desire to own your very own piece of the Earth that no one can take from you, or the fear that investing will not provide the kind of return you expect. If those emotions are winning the argument in your mind, first argue with yourself some more. But if you end up deciding to pay off your mortgage early, here are some guidelines for making the payoff process work in your favor:

1) Make sure your other cash needs are funded first: retirement accounts, college funds, etc. Sinking all your spare cash into your home is under-diversification at its worst.

2) Start early. Making regular payments for five years on a 30-year mortgage then switching to a 10-year mortgage will cost you far more in interest than starting out with a 15-year mortgage. If you are well into a 30-year mortgage, run the numbers to make sure that you understand just how little you will really save.

3) Talk to your lender. To actually save money on interest, you need a "simple interest" mortgage where each month's interest is calculated based on the declining balance, or you need to reamortize the mortgage based on a faster payment schedule. Lenders may charge to reamortize so ask how much that costs, too.

Tax considerations
It may seem like we've saved the most important point for last, but actually tax considerations are not a driving factor in this debate. Tax savings are icing on the cake for those who pay off their mortgages slowly. If you work it right, paying off a mortgage quickly reduces the interest you pay, but that also reduces your mortgage interest deduction. While it's silly to spend money just to get a tax deduction, it's also silly to give up a tax deduction unless you net more money somewhere down the road. In this case though, we've seen that the investing option is likely to put more money in your pocket even before we consider the tax break, so what was the point of giving up that tax deduction again?

A second consideration is that while we used 20% as our federal capital gains tax rate in the examples in Part 1, investments made after Jan. 1, 2001 and held for more than five years will qualify for the new extra long-term capital gains rate of 18% (8% for those in the lowest tax bracket), making long-term buy-and-hold investments even more attractive.

Speaking of capital gains, the first $500,000 in capital gains on the sale of a principal residence can be tax free, so doesn't that make paying down the mortgage a better deal? Nope. The capital gain is the increase in the value of the home when you sell it. You subtract your net proceeds from the cost of the home to find your capital gain. The mortgage balance doesn't affect the capital gain in any way.

All tax considerations favor paying off your mortgage slowly and investing the difference.

Convinced?

If you find yourself still on the fence, try using our mortgage payment and savings calculators to compare the net effect of investing versus making additional mortgage payments for your particular situation. Visit our Home Center for more calculators, information on mortgages, and other abode-related goodies. And the Buying a Home discussion board is a great place to bounce ideas off Fools who've "been there."

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