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  Dear
Dr. Don,
I am 31, my wife is 26 and we have no children. Our combined gross
income is $100,000. We are one year into a 30-year mortgage at 6.125
percent with $125,000 remaining (appraised at $160,000). We have
a combined net worth of approximately $230,000. We have approximately
$125,000 in retirement investments split between 401(k) and Roth
IRAs.
I have an emergency fund of about 16 months of expenses
consisting of three six-month CD's at $5500 each and a money market
fund at about $18,000. I will maximize my 401(k) contribution at
$14,000 this year and my wife will contribute 35 percent of her
income, about $8,400, into a 401(k). We both also have Roth IRA's
that we fully fund at $4,000 each. We also have an outside retirement
investment account that we contribute $4,000 to annually.
The only debts that I have are the house and a student
loan ($12,000 at 3.85 percent). After paying all of our bills each
month and funding all of our retirement accounts we have about $1,000
surplus. My question is, what should I be doing with this extra
cash? Paying down the house, paying off the student loan, put more
money in my wife's 401(k), invest more in outside retirement accounts
or something else entirely? -- Brian Betwixt
 Dear
Brian,
It certainly appears that you have your ducks in a row. I did a
back of the envelope calculation and estimated that you're living
on about $33,000/year while saving or investing $46,400. That $33,000
number doesn't quite jibe with your $34,500 emergency fund equating
to 16 months worth of living expenses but, as I said, it's a back
of the envelope calculation.
If your investments earn more on an after-tax basis
than the after-tax cost of the debt then it doesn't make sense to
cash in your investments to pay down or pay off your debt. For example,
your student loan debt is at 3.85 percent and that interest expense
may be tax deductible. You should refer to IRS
Publication 970, Tax Benefits for Education, if you're uncertain
whether the interest expense is tax deductible. If the after-tax
cost of your student loan is 2.9 percent, then hold on to the loan
if your investments are expected to beat that on an after-tax basis.
Assuming you can use the mortgage interest deduction
on your income taxes, your after-tax cost of mortgage debt, ignoring
state taxes, is around 4.6 percent. You may have a harder time finding
investments you're comfortable with earning after-tax returns greater
than 4.6 percent. Investing in stocks or mutual funds should do
that for you over the long term if you are willing to accept risk
associated with those returns.
I don't know enough about your risk tolerance or professions
to say this with certainty, but it looks like you have too much
money sitting in cash as an emergency fund. Just laddering your
short-term CDs by investing in six-month, one-year and 18-month
CDs would give you some pickup in yield, but you might consider
putting some of this money in U.S. Savings Bonds. True, there's
now a one-year minimum holding period and there's a three-month
interest penalty if you redeem them in the first five years, but
the potential increase in yield would be worth it. Just spread the
investment out while keeping a cash reserve until the savings bond
investments become redeemable.
If you're most comfortable paying down the mortgage
then go ahead and do that. You can always change your mind later
and tap the equity with a home equity loan and use the proceeds
to invest in something other than real estate.
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