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Should I pay down the mortgage or build savings?
Q: I owe approximately $70,000 on a mortgage. The home was purchased in 2005 for $149,000, and now the interest is fixed at 4 percent. Current payments are just under $800 a month. I have saved $70,000 that is earning 1 percent, and have no major bills or debt besides the mortgage. I would like to keep enough for six months in an emergency fund, and put a big chunk toward the mortgage. Is this OK?
A: There is a recurring theme to questions like this: There is no one right strategy for all people, because it really comes down to the specifics. In your case though, you have certainly set yourself up to deal from a position of strength.
Prepaying your mortgage is a worthwhile option to consider, because it is hard to imaging refinance rates getting low enough to justify your refinancing again (assuming that is how you got a 4 percent rate after originally buying in 2005, when rates were considerably higher). Thirty-year mortgage rates are currently at around 4.5 percent, and 15-year rates are at a little above 3.5 percent, so unless there is a major slide in refinance rates, 4 percent is probably the best you are going to do.
So, as for the prepayment option, here are some things to consider:
- Potential tax benefits. While your mortgage is at 4 percent and interest on savings accounts is at 1 percent or lower, keep in mind that the deductibility of mortgage interest does narrow this gap somewhat -- if you are in a tax position to take advantage of it. Just make sure you have factored this in when weighing your options.
- Prepayment penalties. Check your mortgage to make sure there is no penalty for paying off the loan early. If so, those penalties often have expiration dates, meaning you might want to invest the money for now, and pay off the mortgage after the prepayment penalty expires.
- Income. It sounds like your balance sheet is in good shape, but what about your income? Are you earning enough to cover your bills, and most importantly, how confident are you in your source of income? If you have any doubt about your income, lean toward keeping your money liquid.
- Retirement savings. You might consider putting some of your money into retirement savings rather than your mortgage. Between the tax deduction of mortgage interest and the tax deferral of retirement earnings, you stand an excellent chance of earning more on money invested this way than you are paying on the mortgage.
In any case, congratulations on your sound financial approach. By focusing on saving rather than spending, your options come down to different ways of doing something constructive -- building wealth.
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