We're saving $2,400 per month - should we pay extra on our mortgage or invest in mutual funds?

RK writes:

Big fan of your blog already. My wife and I (mid and late thirties) would love your opinion on the following: We currently own a loft. We have 25 years remaining on our mortgage at 6.2% with $400K left to pay. We have a $30K emergency fund, no credit card debt and we both contribute 12% of our pay to our 401(k)s. Currently, we have $2,400 to save every month, and in the next six months, we'll also be finishing up our car loan. We'd like to take that money ($425) and continue to have it automatically withdrawn. Should we put our savings towards the mortgage every month to reduce the term or would we be better served by investing it in mutual funds?

First, let me say that anyone who starts their question with "Big fan of your blog..." gets moved to the top of the question pile...Seriously, I'm not sure that paying down the mortgage would be my first choice. 6.2% is a little on the high side, but it isn't so high that I'd be in a mad rush to pay it off. Also, I am assuming that you are asking for advice about what to do with the full amount you are saving each month -- not just the $425 car payment.

You are currently saving 12% in your 401(k)s, which is excellent, but are you maxing out your contributions? If not, I'd consider that as an option as well. Since you are both in your 30s, you could be contributing as much as $15,500 each this year. If you could get to the point where you are saving 15% of your salary, your retirement should look great. Don't forget that you can also make contributions to your IRAs. If you make less than $169,000 per year, I would strongly recommend contributions to Roth IRAs.

After taking care of additional retirement savings, I'd be inclined to invest your extra savings in a mix of tax efficient mutual funds. As you may know, the long term return of large cap equity mutual funds is about 10% per year. Right now, paying off the 6% mortgage may seem like the smarter move, but long term, investing in the market will probably serve you better. Also, remember that the mortgage is costing you signficantly less than 6.2% on an after-tax basis.

Also, you don't mention whether or not you have children, but money saved in mutual funds could one day be used for paying college expenses, or buying a second home, or any number of other purposes. I just like the flexibility of having some money available for long term goals (even if you are not exactly sure what those goals might be). You just never know when you might need money for some worthwhile purpose and you wouldn't want all your non-emergency fund money tied up in home equity.

For example, in 2010, there is a window for people who make more than $100,000 per year to convert their traditional IRAs to Roth IRAs. This could be a very smart move for a lot of people, but anyone making the conversion will owe income taxes on the amount converted and it would be great to have a pot of money to draw the tax money from.

In summary, if you feel strongly about pre-paying the mortgage, I would never tell you that it is a bad idea. I just think you should be aware of some of the other alternatives.