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Gary,
I am in the process of buying a condo. I have enough cash to put down 30% but am only putting down 20% (to avoid PMI). I have no debt. Is it better for me to put 30% down for the house or invest it? I am in the 28% tax bracket. With the tax break in mind it seems that if I can earn at least 7.5% return it is better for me to invest the money and not put 30% down or try to pay the mortgage off early. Is this correct reasoning?
Here is another question for you. I have the ability to take the 20% down payment out of my 401K program at work and pay myself back the interest (9.5%). Is this something I should do?
--Financially confused Erik

Erik asks a great question. It's a question that many of us face as we move from home to home. And it's not an easy question. Part of it can be reduced to simple math. But part of it is more subjective and depends on the feelings of the homeowner.

We'll try to do two things. First, we'll help Erik do the math. Then, we'll help him phrase the subjective questions in a way that will allow him to decide what's most important to him.

The basic numerical comparison is fairly simple. Can I earn a higher rate of interest than the rate on the mortgage? If you're earning 10% on your money and the mortgage is at 7% you will end up with more money. But how much more money will you have?

To answer that question you'll be calculating two separate answers and then comparing them. First, how much will the mortgage cost us after we adjust for taxes saved because of the deduction. You'll begin by multiplying the amount that you're considering prepaying (say $10,000) by the interest rate on the mortgage (7%). The answer ($10,000 x .07 = $700) is the amount of interest you'll pay during the year.

Now we'll multiple the amount of interest paid ($700) by your tax rate (say 28%) to determine how much you'll save in taxes. ($700 x .28 = $196) So for the circumstances we've described you'll save (or earn) $196 because you had a higher mortgage to deduct from your taxes.

Finally, we'll subtract the tax savings from the interest expense to figure out what it's really costing us to borrow the money ($700 - $196 = $504). For the example we've created we're actually spending $504 to borrow the $10,000 for the year.

What about if you invested the money instead? The calculation is similar. You'll multiply the original investment (our $10,000) by the rate of return on the investment (10% this time) to see how much you'll earn ($1,000). Then you'll multiple those earnings by your tax rate (still 28%) to see how much of that will be consumed by taxes. In this case it's $280 ($1,000 x .28).

To determine what we've actually earned after taxes will take our interest income of $1,000 and subtract the taxes of $180 from that. So we ended up earning $720 on our investment. If we compare the $720 earned to the $504 mortgage cost the difference is $216.

It's easy to see that if the yield on the investment is greater than the cost of the mortgage you'll end up with more money. But that can be very misleading.

Why? Because we need to include the predictability of the investment return. Take a look at your business section. It would be very surprising if you found guaranteed investments (like CD's or money funds) with a return higher than mortgage rates. Usually when people say they can earn more they're thinking of riskier investments. Stocks and other investment vehicles.

That's not to say that you can't earn more than you're paying on your mortgage. If things go according to plan it's possible. But, then again, you might not. And you need to consider whether that level of uncertainty is acceptable to you. Some people like risk. Others do not, especially when their home is involved.

Now let's take a look at Erik's 401k question. What he's proposing is borrowing from his retirement account. Many 401k plans have these provisions. Interest rates are set and a payment plan is determined. In effect, Erik would be paying himself interest. This type of loan is becoming more popular all the time.

But, there are some cautions to consider. First, the interest rate on this loan is likely to be higher than what you would pay if the borrowing were included in your mortgage. Can you really afford higher payments at this point?

Second, this type of loan is usually for a shorter period of time than a mortgage. That means that each month you'll need to pay back a greater portion of the principal than if you had included it in your mortgage. Again, that means writing a bigger check each month.

Next is the biggest concern. If you leave your job for whatever reason (new job, layoff) you'll need to pay off the entire amount now. If you can't pay it back you'll be facing some ugly tax penalties. Losing your job and having to wipe out your savings to pay off a 401k loan is a pretty tough road. A home equity loan would be the probable source of money, but if you used the 401k loan for a down payment, you might not have enough equity in your house to swing it.

Erik's letter implies that instead of using saving for the down payment, he would use the loan. That's OK if you can earn a similar amount and the money is available if you have to repay the 401k loan suddenly.

Only Erik can decide how bold he wants to be. Traditionally, owning your own home has been a part of the American dream and a good investment besides. But investing often includes surprises. When you're dealing with your home, you'll want to decide in advance whether surprises are acceptable.

Thanks again to Erik. Hope you enjoy your new home!

Do you have a time or money saving idea that wasn't included in this article? Please send it to tips @stretcher.com. We get the best ideas from our readers!

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