Pay down mortgage or increase savings?

Dear Debt Adviser,
My question is regarding paying off some balance on my mortgage versus putting additional money in the bank. Here are the numbers:

I have two home loans. The first is a $312,000 interest-only loan at 5.875 percent APR. It’s an ARM until 2011. The second is a $57,000 fixed-rate loan at 8.75 percent APR.

My job is very stable and I have about $35,000 in savings. Should I put more money in savings or pay off my mortgage? If I should pay off my mortgage, which loan should I try to make extra payments toward — the first loan or the second? Thanks.
— Aami

Dear Aami,
2011? Like next year? I believe the first thing you need to address is your ARM that’s coming due in 2011. Interest rates are outstanding right now and likely to only go up. Providing that you can afford it, I recommend that you consider refinancing both loans into one fixed-rate loan, and now rather than later.

I am glad to hear that you have a fairly significant amount of money set aside in an emergency savings account. In today’s economy, I would feel more comfortable if you had 12 months of living expenses in your savings account. Even if your job appears stable, the employment market is not. Additionally, other unexpected things happen in life, some that we have no control over, such as an illness or accident that can interrupt your employment and cash flow. While a cash cushion may not be a panacea, a fat bank account can make a shock to your financial system so much less stressful because you don’t have to worry about finances while you are recovering.

In general, I don’t recommend paying off your mortgage quickly as a financial goal. Conventional logic says that paying off your mortgage is as American as mom and apple pie. Plus, it is thought that if you pay off your mortgage, you’ll have lower expenses. True, but those dollars you put into your house will not be invested and working for you. Paying off your mortgage requires that you tie up a significant amount of your net worth in a single asset that is not liquid and does not generate income. Experience has shown that real estate doesn’t always increase in value as was once thought. So, a reasonable amount of leverage (your mortgage) coupled with a good investment plan may yield your best return and keep you benefiting from a tax advantage as long as mortgage interest is still deductible. Because I don’t know your age, and my advice would be different if you were 30 as opposed to 50, I’ll let you know what I’d do with some of your discretionary funds if you were in your 30s, 40s and 50s.

For those in their 30s and 40s, I advise that once you have financed your emergency savings cushion, you need to begin funding your retirement. Small amounts put away in a traditional or Roth IRA can deliver a huge return over a long period of time. In addition, I want you to put some money aside for funding big expenses such as college for your children and/or other long-term financial goals.

If you are in your 50s or older, I want you to assess your retirement position. My suggestion is that a reasonable goal should be to get to a position where you have at least half of your mortgage paid down by your projected retirement date. This will allow you to consider a reverse mortgage or to refinance the lower balance, giving you lower payments. Unless you have a very high net worth, paying off the mortgage means hundreds of thousands of dollars are being diverted from investment that could provide an income stream in retirement. That’s when most people need all the income they can get.

Good luck!

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