Ask Money

Paying down debt

Chris Farrell Apr 21, 2010

Question: My wife and I live in a home that was originally purchased in 2005 for just over 200K with an “80-10-10” loan. 10% down, 10% home equity (at prime), 80% in a 30 year fixed mortgage with a pretty decent rate (5.375%).

We’ve been pretty good about paying off the second mortgage and it’s at less than $3K balance and we’ve been putting $400 or more into it each month. A couple of months ago, we also started adding an additional $100 each month to principal on our primary mortgage. Aside from a car loan (ending in May), we have no other outstanding debts and our credit cards are paid in full every month.

These days, the interest rate on the second mortgage is much lower than that on the primary, but that has, of course varied over the life of the loan.

My question is, in the long term, would we be better off decreasing the amount we’ve been putting into our second mortgage and put that money into the primary principal?

Or should we be putting that same money into savings to build up our 4 month buffer? Alan, Chapel Hill, NC

Answer: I would concentrate on getting rid of the second mortgage. Yes, the interest rate on it is very low right now. But it’s a pretty safe bet that interest rates will start moving up as the economy gains upward momentum.

The trend will be toward higher long-term interest rates. The big surprise could be how fast the Fed shifts gears and hikes its benchmark interest rate, which is currently at zero.

And then I would recommend focusing on your emergency savings once you’ve paid off the home equity loan. The household emergency savings goal used to be a cash cushion equal to three to six months worth of expenses. But with heightened financial insecurity in recent years, along with the disturbing increase in how long it takes to get another job, that savings rule-of-thumb has been extended to six months to one year. For many people, that’s an almost impossible goal to reach. (It’s still worth trying for, however.) But clearly you’re good savers and in your case I bet you could set aside that much money. You could accelerate your mortgage payments once you’ve increased your pot of safe savings.

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