Question: I have been paying my mortgage for 5 years and now some extra income. Should I make additional principal payments? My mortgage is a 30-year fixed at 6.25% interest.
And how does the taxation play a role here? I am in the 25% tax bracket.
Answer: If you prepay your mortgage or increase the monthly payment to pay of quicker, then your savings are 6.25% annually. What would you do with the money if you would NOT use it to pay down the mortgage?
You could put it in CD accounts which will yield maybe 4 to 5% interest. The benefit is that you are more flexible in case of an emergency (loss of job, health related bills).
There is zero risk in paying down the mortgage, and also zero risk in buying CD accounts, but the return of the mortgage is higher than the CD accounts.
If you buy stock, your risk is substantially higher. It is basically gambling. Your possible return is higher as well.
Investing in mutual funds on average yields 9% in the long term. However, in the short term, you may take losses. The risk is substantially lower than buying stock though.
The right decision also has to do with your age and your life, its schedule and what you expect to do in the future.
Taxation plays almost no role in the decision of whether to pay off early or invest otherwise.
Let's say you pay additional principal. That means you save interest in future payments. The interest is tax-deductible. So one could argue that the real cost of the loan is not 6.25% but 6.25% * 0.75 (since you are in the 25% tax bracket) = 4.7%
However, if your mutual fund yields 9% profit, you also pay 25% tax on that. So the effective profit is only 9% * 0.75 = 6.75%
Similarly a CD account yielding 4% effectively only returns 3% (4% * 0.75 = 3%)
The only exception is if your investment is pretax as a 401k plan or a tax-exempted bond. In that case you should compare the bond's full return against the prorated mortgage interest.
In your specific case - 6.25% is a pretty low rate. If you wait a little longer, you may find zero-risk investments such as savings accounts that will beat that return.
And now a completely different perspective on this topic:
If your mortgage is fully paid off, and your house gets hit by a hurricane or earthquake, then you are in more trouble than your neighbor who had only 10% equity in his place. You just lost all your house and try now to get money from the insurance. If the bank has the equity (and you have the mortgage) then the bank will deal with the insurance.
And there is also the thought that free and clear owners may more likely be subject to lawsuits if something happens to someone on your property. Not sure how relevant this is but I thought I should add it.