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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.

Now, you could probably build a substantial nest egg if, as soon as you paid off the mortgage in Year 16, you started investing your mortgage payment plus the extra $513. But you’d never make up the ground lost by not investing the monthly $513 from the start.

Also, 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.

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4 Comments

1

I wrote a similar post called “Your Mortgage: When 30 beats 15″ http://evolutionofwealth.com/2009/09/15/your-mortgage-when-30-beats-15/

I was talking about the same thing you are of course I didn’t mention using mutual funds because I don’t think I could ever give anyone advice that would put money they definitely needed at risk. Do you feel like mutual funds would be risky for the someone?

2

The argument about prepaying mortgages often revolves around the returns you could get investing the money instead, but I think that distracts from the more important issues of financial flexibility and how well your other bases are covered. Before you start prepaying your mortgage you need to make sure you’re on track saving for retirement and your kids’ college educations (if the latter is an important goal for you), that you’ve paid off all other debt, that you have an emergency fund and that you’re adequately insured (life, health, disability and maybe long-term care, depending on your situation). Most people will have their hands full getting all that done and still having cash left over to live their day-to-day lives.

3

Paying off your mortgage might normally be something wise for a retired person. But with housing prices plummeting in many parts of the country, I would not recommend paying off your mortgage. It may work well for some, but not for most.

4

If someone is planning to walk away from a devalued property, I can see your point. If she’s not, though, I wouldn’t count a lower housing price as a reason not to prepay a mortgage. Or perhaps I’m missing something?