Will it pay to prepay your mortgage? Here's a problem we all should have: your house is mortgaged, but you have enough cash available to pay off the loan and own your home free and clear. But should you do it?

Many veterans find themselves in this enviable position. A lifetime of hard work has allowed them to sock away an appreciable amount of money. Or perhaps they've inherited a tidy sum. Or maybe they're lottery winners. Whatever the source, there's now enough cash in the family coffer to send the mortgage company packing--but doing so may not always be wise.

"This decision involves emotions as well as finance, and it definitely is not a no-brainer," says Scott Dauenhauer, a certified financial planner and president of Meridian Wealth Management in Irvine, Calif.

Debt & Investment

For many people, the choice seems obvious: Pay off the loan early, and you no longer have to send the mortgage company a check each month. Talk about homeowner heaven! True enough, but that's only part of the picture. The real question is whether you'll be further ahead by (1) retiring the mortgage and eliminating that monthly expense or (2) investing the money, earning a return and continuing to pay the monthly mortgage.

The only way to know which of these two options makes better financial sense is to crunch the numbers. "The most important factors are your tax bracket, the mortgage interest rate and the return you can expect to earn if the money is invested" Dauenhauer says.

Let's say your mortgage interest rate is 7%, and you owe $100,000 on the house. But you have $100,000 in a savings account at your bank earning 2% per year. Here the difference is quite clear--you're paying out 7% while taking in only 2%. In this case, paying off the loan may well be a good idea, because it will effectively increase your return by a whopping 5%.

But the situation could be reversed. You may have a 6% mortgage while earning 10% on your invested money. Right now, a 10% return may sound like irrational optimism, but for several years in the late 1990s, the stock market produced annual returns of more than 20%.

Back then, it would have been foolish to sell an investment producing 20% in order to pay off a 6% mortgage. Comparing the mortgage rate to the rate of investment return is the essential first step in making the decision of whether to prepay.

Consider Taxes

You also must consider taxes. Since most mortgage interest is tax-deductible, the government is actually paying part of your mortgage for you.

For example, if you're in the 27% tax bracket and hold a 7% mortgage, the feds will pick up 1.89% of the interest expense (27% of the 7%). This reduces your actual, after-tax, mortgage rate to 5.11%. With this reduction, you might be tempted to invest your cash elsewhere for a higher return.

There's a flip side to the tax coin. If you invest the money rather than prepay the mortgage, you'll have to pay taxes on the returns. An investment (a CD, for example) that pays 7% interest will have those earnings reduced by taxes--in this example, by the same 27%, for a net return of 5.11%.

Stock (or stock mutual fund) investments, however, may be taxed at lower capital gains rates, which could tip the scale toward investing rather than mortgage prepaying.

You simply have to do the computations. In the end, Dauenhauer says,"If it makes sense on an after-tax basis to invest the money elsewhere, then you may want to refrain from paying off the mortgage."

There are other factors to consider, too. Like security. Paying of the mortgage is a sure thing. If you pony up $100,000 to retire your 7% mortgage, you are in effect earning a guaranteed 7% return on that money. However, if you invest the money (in the stock or bond markets, for example) anything can happen. You might earn considerably more than 7%, but you also could lose a bundle.

Another factor is liquidity. If you send off that big check to retire the mortgage, you no longer have access to the money. If an emergency arises, you might need to take out a loan. If the money remains in your possession, however, you can do with it as you please.

In any event, Dauenhauer says, "It's probably not a good idea to use all of your available cash to pay off a mortgage, because you should have a financial cushion for emergencies."

Another consideration is what you might do with the "extra" monthly cash you'll have if you do pay off the mortgage. For years, that mortgage payment served as a kind of forced savings plan that required you to sock away a specified amount each month rather than blow it on riotous riving. With the house paid off, will you continue some kind of regular savings plan, or will you find expensive hobbies to absorb the extra money?

Psychological Benefits

In the end, the most important aspects of the mortgage payoff dilemma may be psychological and emotional, not financial. "Many people feel a lot safer having their mortgage paid off and knowing that no matter what happens, the house will still be theirs," Dauenhauer says.

"If paying off the mortgage satisfies an emotional need, then go ahead and do it even if it doesn't make perfect financial sense." On the other hand, if it doesn't bother you to be in debt--even during retirement--you could let the numbers alone make the call.