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Dear Dr. Don,
I'm 55 years old. My credit card balances should
be paid off by the end of this year. Should I
use the money -- about $1,000 a month -- that
I had budgeted to pay down my credit cards to
instead start paying down my second mortgage or
to increase my 401(k) plan contributions? The
second mortgage is at 6.7 percent with a balance
of $30,000 and 10 years remaining on the loan.
-- Joe Juncture
Dear Joe,
If your company matches all or part of your 401(k) contributions, you should, at a minimum, contribute up to the limit
of the matching contributions. That's free money. Take advantage of it.
After that, I'd have you compare
what you expect to earn on an after-tax basis
on your 401(k) investments with the effective
(after-tax) interest rate on your mortgage. Bankrate's
Mortgage
tax deduction calculator will let you estimate
the effective rate on your mortgage. I'd have
you make this comparison even though the investment
income in the 401(k) plan is tax-deferred until
you start taking distributions from the account.
In general, the more conservative you are with your investments, the more sense it makes to prepay your
mortgage. Trying to build wealth when you earn less on your investments than you pay in interest expense is an uphill
battle. But it can also be a signal that you're too conservative in how you invest.
The table below shows the expected
results of the two scenarios on a pretax basis
with an assumption that your investments earn
8 percent. (My numbers won't match your situation
exactly, but they should be very close.)
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Expected results of 2 scenarios |
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The assumption is that one way or another you've got nearly $1,344 in your monthly budget starting in
January 2009 for mortgage payments and 401(k) investing. If you use all the nearly $1,344 in the front end to pay down
your mortgage, you'll have it paid off in November 2011.
At that point, you'll be able to commit
nearly $1,344 a month from then on through the
original loan maturity date (a period of 90 months)
toward 401(k) investments with an expected pretax
yield of 8 percent. If you decide instead not to prepay
the loan, you have 113 months (starting in January
2009) of investing an additional $1,000 in your
401(k) account, again at an expected pretax yield
of 8 percent.
With the 8 percent investment assumption, you have a bigger increase in your retirement nest egg by not
prepaying the mortgage.
If you can use the mortgage interest deduction on your taxes, the benefit is even greater than the $2,750
difference because of the tax savings, most of which will come in the early years of the loan. Invest those tax savings
and you'd see an even bigger differential.
It's true that prepaying your mortgage gives you guaranteed savings while investing in the financial markets
makes for more volatile returns. However, here's an example where, with fairly conservative investment returns, it makes sense
to not prepay your second mortgage.
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