Spend home sale profit on mortgage or 529?
Dear Dr. Don,
After paying off my existing home, I recently purchased a new home. I put 20 percent down on my new home and got a 4 percent fixed-rate mortgage on $250,000. I expect to get about $175,000 when I sell my existing home. I am contemplating putting $78,000 into Section 529 college savings plans for my three children, ages 12, 8, and 2, and maybe putting the balance into mutual funds in my joint investment account. Should I fund their 529 accounts or pay down my mortgage?
-- Doug Diplomas
My rule of thumb is that you pay down the mortgage when the effective rate on the mortgage is greater than the expected after-tax rate of return on your investments. You have a great rate on that new mortgage. If you can fully utilize the mortgage interest deduction on your taxes (which simply means that the deduction isn't just replacing the standard deduction when you itemize expenses on your income tax return), then your effective rate on your mortgage is somewhere between 2.6 percent and 3.4 percent, depending on your marginal federal income tax bracket and your state income tax rate. That's pretty cheap money. You can use Bankrate's mortgage tax deduction calculator to come up with a more precise estimate.
There are two main types of Section 529 college savings plans: prepaid tuition plans and tax-advantaged investment accounts. You should always consider your home state's plans first, especially if contributions to a plan only generate a state income tax deduction if you contribute to your home state's plan. If your state offers a prepaid tuition plan that is guaranteed by the state and grows at a rate equal to college cost inflation, it's likely that this is a better choice than prepaying the mortgage, especially for the younger children.
Whether a Section 529 investment account or your own investment account's after-tax earnings can beat the effective rate on your mortgage depends on the account fees and expenses and how the monies are invested. With the bar set this low, however, you should be able to earn more after-tax on your investments than you pay after-tax on your mortgage. It won't work if you're ultraconservative in your investments, but a well-diversified portfolio of financial securities should be able to do better than a mortgage prepayment strategy.
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