Q: Over the next 12 to 18 months, my wife and I are planning to build or buy a new home in the $400,000 to $500,000 price range. We have saved enough money to pay off the current mortgage ($130,000) on our home which is worth approximately $220,000.
Should we pay the mortgage off now or wait until we sell it? Our mortgage interest rate is 5.25 percent and we’re earning approximately 4 percent on our savings.
Mathematically it makes sense to pay off the mortgage, but I’m having a hard time thinking about emptying our savings account. Thanks in advance.
A: Mathematically, you’re right — it doesn’t make sense to have your cash earning interest of 4 percent (on which you’ll pay taxes) when you’re paying out 5.25 percent all in after-tax cash. It’s about a 2 percent loss. If you’re going to keep your funds liquid, you’ll either have to boost the rate of return you’re getting on your liquid assets to make it worthwhile, or accept the loss of income as the price of doing business short-term, because you’ll need that money soon.
Then there’s the idea of having your cake and eating it too. You could pay down most of your loan, perhaps $75,000 to $100,000. The rest of your payments will then go a lot further toward paying off your mortgage, and you’ll keep a fair amount of cash in the bank — just in case.
Since you’ve been able to amass that kind of savings, it’s clear that you’re living well below your means, so I’m quite sure you’ll be able to quickly build up that reserve again. By the time you buy or build in another year or two, you may be able to pump up your reserves by another $10,000 to $20,000.
But you should also look for a better rate of return on your cash. Consider moving the remainder of your cash into a higher-interest savings account. There are several online savings accounts at DiscoverBank, ING Direct, and Emigrant that are all paying about 5 percent.
You could also open up a money market account at an investment company like Fidelity, Charles Schwab or even Vanguard. These accounts also pay in the neighborhood of 5 percent, all of which would make your money work harder for you. Some of these investments are not guaranteed, and are not FDIC insured, so be careful where you put your money. Most savings and checking accounts at banks and savings and loans are insured up to $100,000 by the federal government. Most mutual funds and money market accounts are not insured.
If you don’t need all of your cash for the new place, be sure to take advantage of opening up a Roth IRA for yourself and your spouse, which will allow you to stash away a total of $8,000 this year, which will then grow tax-free forever.