Mortgage prepay better than extra cash

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Dear Dr. Don,
My husband and I have an ongoing debate about which is a more prudent way of handling our money.

At various times of the year, we have extra cash from bonuses, etc. He thinks we should save the money to use as a down payment on a future house (which we hope to buy in another three years to five years).

I think it should be used to make extra payments against our existing mortgage so that we’ll have less to pay off on the old home when we do buy a new home in the future. This makes sense to me because the interest income we would earn in savings is lower than the interest charges we are accruing month by month.

We are four years into a 30-year fixed 5.75 percentage mortgage with a $95,000 payoff amount. What is your advice on the issue so we can settle our debate once and for all?
— Lynn Loans

Dear Lynn,
I’m with you. As long as you’re earning less after-tax on your savings than you effectively pay after tax on your mortgage, you’re better off paying down the mortgage on your existing home.

Bankrate’s “Mortgage tax deduction calculator” can help you figure out the effective rate after tax on the mortgage.

If for some reason you were planning on owning both homes for a period of time, I’d give your husband’s position a little more credence. In that case, his plan would preserve a measure of financial flexibility that might come in handy in financing the second home.

You should have a liquidity cushion, or emergency fund, available to you before you get too carried away in paying down the mortgage. But if you’ve got liquid funds available for a financial emergency, you can feel pretty comfortable making the additional principal payments.

There are some other considerations as well. For example, if you’re not saving for retirement and one or both of your employers offer a 401(k) or 403(b) plan with matching contributions, you should be contributing to these plans — at least up to the limit of the company match.