Boost Savings Before you Prepay Your Mortgage

Dear Dr. Don, My husband and I have just paid off all of our debt, except for our house and our truck. The truck will be paid off within the next few months.

Our plan is to put enough into savings so we have enough to feel secure if one of us was to lose our job. Once that is done, we plan to put all extra money toward the house to pay it off early so we can sell it and use the proceeds as a down payment on a larger house.

Is this a good plan, or would it be better to put the extra money into savings and then pay the house off in one lump sum when we can? -- Angie Allocates

Dear Angie, Prioritizing your savings is smart. I'd put building an emergency fund ahead of prepaying your mortgage. How big should your emergency fund be? For most people, three to six months' worth of living expenses is a good target. You adjust the target based on the stability of your incomes and jobs, and the availability of other resources like an investment portfolio.

Once you've built up your emergency fund, you can focus your attention on investing. If your choices are prepaying the mortgage or saving, it's likely that making additional principal payments on the mortgage is the way to go. My rule of thumb about the decision to prepay the mortgage is this: If you expect to earn a lower after-tax yield on your investments than the effective interest rate on your mortgage, you should pay down your mortgage. Savings rates are so low now that it's easy to choose prepayment.

Like many finance professionals, I distinguish between savings and investment. The typical saver is more concerned about protecting principal than in growing purchasing power. People invest to be able to increase their wealth and purchasing power.

If either of you work for a company that has a 401(k) or 403(b) retirement plan where the company matches all or part of your contributions to the plan, you should contribute up to the limit of the company match before using that money to pay down your mortgage. In most cases, the company contributes 50 cents for every dollar you contribute, up to a set dollar amount. Making 50% on your money trumps prepaying your mortgage.

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