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Prepaying mortgage may not make financial sense

You should have, at a minimum, an emergency fund equal to three months' worth of basic expenses before you consider paying off a low-rate, potentially tax-deductible debt.

November 15, 2009|Liz Pulliam Weston | Money Talk

Dear Liz: We refinanced our house in January for a 30-year fixed rate of 4.625%. We are paying about $513 a month extra toward the principal, which will allow us to pay off our mortgage in 16 years.

We have 20-year term life insurance policies to cover the mortgage in case the worst happens to either of us. Both my husband and I contribute to our 403(b) retirement accounts at work.

However, we don't have any emergency cash fund in our banks. We figured we can always borrow from our 403(b) accounts. We both have good credit scores (above 750). We have no debt besides our mortgage.

Any financial advisors out there would tell us to invest that $513 a month into mutual funds or stock because of all the good reasons that I'm sure you know better than us.

However, this is how my calculation works: We'd be saving about $100,000 interest if we pay the mortgage loan off in 16 years. On top of that, we won't have to make any payment for the remaining 14 years, which would be almost $200,000. The total saving is about $300,000.

Is there any mutual fund out there that can yield that much money if we decided to invest in it? Is it a good idea to do what we are doing right now based on our financial situation?

Answer: Actually, $513 a month invested in a mutual fund would result in about $765,000 after 30 years, assuming an average annual return of 8% (which is the minimum investors have received in every 30-year investing period since 1928, according to Ibbotson Associates).

Even if you look just at the 16-year repayment period, investing the money would recoup about twice what you expect to save in interest.

But you need to consider more than potential investment returns when deciding to prepay a mortgage. You have to look at your entire financial picture and make sure all your bases are covered before you pay off a low-rate, potentially tax-deductible debt.

Your lack of an emergency fund is worrisome. Yes, you can tap your retirement funds, but those loans could become taxable, permanent withdrawals if you lose your jobs and can't pay the money back.

It's far better to have cash in the bank to cover the unexpected expenses and financial setbacks that life can present.

You should have, at a minimum, an emergency fund equal to three months' worth of basic expenses before you consider prepaying your mortgage. A fund equal to six months' worth of expenses is even better.

Since you're a homeowner, you also should set aside a separate, sizable amount to cover major home repairs -- $2,000 at least, although $5,000 is better.

Pay down debt when you can

Dear Liz: In a recent column, you advised someone to pay off credit card debt with his emergency fund. I agree that "Clinging to cash that's earning less than 2% doesn't make sense when your debt is . . . costing you a double-digit interest rate."

But isn't that "old school" thinking? Aren't we all supposed to be in "survival mode" now and building up our emergency funds instead of paying off debt?

I am recently divorced at age 65, with no chance of getting a job soon. I did not get spousal support as my ex is on Social Security and a pension (which goes away when he dies). I got half of a very shattered IRA, which I am going to need to live on.

I am in the same boat, faced with carrying $8,000 of credit card debt or using funds that I need to live on to pay off the debt. What's your answer to my problem?

Answer: Take a close look at what credit card companies are doing to their customers these days. They're doubling or tripling interest rates, even for people with good credit. They're lowering credit limits and slamming shut accounts, endangering people's credit scores. They're experimenting with new fees.

Why would you put up with that if you had a choice? People who don't pay off their credit card debt with their savings when they can are choosing to bind themselves to companies that have made it quite clear they don't care about their customers' financial well-being.

The key phrase there is "when they can." If you're facing a layoff or already unemployed, you really do need to be in survival mode and conserve your cash. That means paying the minimums on your debt until your economic situation improves.

If your situation doesn't improve, or if issuers raise your rates to the point where you can no longer pay your minimums, you may need to consider credit counseling or even bankruptcy to deal with this debt.

Liz Pulliam Weston is the author of the book "Your Credit Score: Your Money and What's at Stake." Questions for possible inclusion in her column may be sent to 3940 Laurel Canyon Blvd., No. 238, Studio City, CA 91604, or via the "Contact Liz" form at Distributed by No More Red Inc.

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