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My cash flow is up. Now what?

Chris Farrell Mar 11, 2011

Question: Recently my ARM ended the fixed rate portion and moved into the variable rate segment. In doing so, my interest rate dropped quite a bit, reducing my payment by ~$700/month. The rate is re-evaluated every 6 months, so I would expect it to start creeping back up over the next year or so. My question has to do with what to do with my money in the interim. The options I am considering are:

1) Save like mad. I already save around $600/month and have a decent amount saved, most of which is in the break glass in case of emergency fund. Savings account earns just over 1% APY.

2) Keep paying the full amount into the mortgage, aggressively paying down as much of the principle as I can while the rate is low.

3) Pay off my car loan. I have a car loan that is at 4.75%. I could use the extra money to pay that down quickly. This also brought up the question of whether I should just use the some of the savings to pay the car out flat, depleting the savings (not including the emergency funds) and then use the extra money from the reduced mortgage payment to rebuild it quickly.

I’m torn. More savings always sounds good. Paying off the car is also appealing because it eliminates a monthly payment (though it’s not too high) and that rate is higher than what I earn on my savings or what I am currently paying on the Mortgage. Aggressively paying off a mortgage generally seems like a good idea as well. What do you think is the best thing to attack first? Eric, Pepperell, MA

Answer:An unexpected benefit from interest rates staying down so long is that a widely anticipated implosion of plain-vanilla adjustable rate mortgages didn’t happen. (The same can’t be said for the more exotic and toxic subprime ARMs.)

These are all smart options you’re considering. I’m glad your thinking about the best way to take advantage of the extra cash flow to boost savings. You really can’t go wrong, but I would use extra cash flow to focus first on accelerating your car loan payments and getting rid of it quickly.

As you say, it’s your highest interest rate debt. It’s always a good idea to pay off what you owe on a depreciating asset.

Once the car loan is gone I would shift to bulking up your savings. Even though you aren’t making much (okay, almost nothing) on the savings it gives you greater freedom of choice in the future. In essence, you can turn your emergency fund into an opportunity fund. And you can always take a chunk of savings later on and pay down your mortgage if that’s what you decide is the best use of the money.

I would also look into shifting out of the ARM and into a fixed rate mortgage. Use this time to research how much it would cost you to make the change. Rates will go up eventually, although the day of higher-rate reckoning still seems a way off. So, are you comfortable continuing with the ARM even if interest rates go up or would you prefer locking in today’s mortgage rates? This is a good time to figure it out.

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