updated 10/19/2006 2:20:39 PM ET 2006-10-19T18:20:39

One obvious choice that many of us face when we've got some extra money to sock away is whether to apply it to our mortgage or our retirement. An extra mortgage payment is attractive because it reduces our principal and will cost us less in interest payments in the future. It also offers a guaranteed return.

If your mortgage is at 6.5 percent, you'll essentially earn that by not having to pay it on your principal-reduction amount. Socking the money away for your retirement is also attractive, as we all know that the more we save and invest for retirement (and the earlier we do so), the better off we'll likely be when our golden days arrive.

So what's the right choice? Well, our friends at the National Bureau of Economic Research recently released a report by Gene Amromin, Jennifer Huang, and Clemens Sialm that will inform your decision. Here's their abstract:

We show that a significant number of households can perform a tax arbitrage by cutting back on their additional mortgage payments and increasing their contributions to tax-deferred accounts.

Got it? It's clearly worth exploring your options a little more deeply. Tax-deferred accounts include 401(k) plans and traditional IRAs. (Roth IRAs do away with taxes altogether, though they accept only post-tax money.)

In such accounts, if you've invested in aggressive stocks or mutual funds, ones where you expect to earn, say, an annual average of 12 percent or even 14 percent, you should take that into account when comparing it with the 6.5 percent you'd make via extra mortgage payments. (Also take into account the risks involved — one option is much more of a sure thing.)

This topic was addressed on our Buying and Selling a Home discussion board recently — here are some of the thoughts of our board denizens (or read the whole discussion):

One writer nicknamed DeltaOne81 made a good point by noting that if 38 percent of U.S. households that are accelerating their mortgage payments are making the wrong choice, "doesn't this mean that 62 percent of those that have accelerated their mortgage payments are doing the right thing?" Dave Donhoff, a mortgage professional who frequents the board, later chimed in with a clarification, which then got clarified further. (Reading our boards can often be more illuminating than reading the original research report!)

Aj485 then offered his own perspective: "My mortgage payment (P&I) is about $1,000. To have an additional $1,000 per month expense, assuming a safe withdrawal rate of 4 percent ... $1,000 times 12, divided by 4 percent, equals $300,000. That's why I will pay off my mortgage before I retire — it affords me the ability to retire with $300,000 less in investments, because my expenses will be $12,000 less per year."

If you're interested in home-buying and selling issues, visit our Home Center, which features lots of money-saving tips and even some special mortgage rates.


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