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The trade-off: Savings vs. mortgage

Chris Farrell Apr 3, 2012

Question: I have a question about the best place to invest, given a choice between paying a little extra on my mortgage versus putting that money into savings. I’m a 28-year-old grad student in the biomedical sciences. I bought a condo at the end of 2008 (got a pretty nice deal), and refinanced last year at 4.6 percent. I bought the condo as an investment and plan to sell it someday (maybe 5 years from now, fingers crossed). The valuation when I refinanced already showed a pretty decent amount of equity, so it should turn out to be a pretty decent investment (barring some sort of disaster). I had been paying an extra $200 on my mortgage every month, mostly just because I really like that feeling of making progress toward owning more than simply paying a huge chunk of interest. I have what you guys lovingly call an FU fund (it bounces around $3,000-5,000 depending on repairs, etc.), and I have been saving into a Roth IRA. 

My question is: Once I’ve reached my $5,000 contribution limit, what should I do with any other funds I might have? When I look at the interest rates on various savings accounts, they are all way lower than the 4.6 percent I’m being charged on my mortgage. I do recognize my condo as providing me with a service, and my minimum payment now is actually less than the rent I was paying on a studio 4 years ago! But, if I think of the equity I gain as a sort of savings account for a future upgrade, I’m just not sure how to compare my options. The simplified thought process I currently go through is that any extra I pay on my mortgage saves me 4.6 percent in interest that I would have to pay, while that same money would only earn me maybe 2 percent in a savings account, so it is better to save 4.6 percent by never having to pay it. Am I totally off? Does what I’m asking even make sense?

I love the show. Thank you so much for all the important topics you cover! Erin, Boston, MA

Answer: What you’re asking makes a lot of sense. Plenty of people are wrestling with variations on the same question. A big reason for the struggle is you’re definitely getting a higher rate of return by accelerating payments on your 4.6 percent mortgage compared to earning, at best, 2 percent on your savings.  

However, I don’t think the rate of return argument is a slam-dunk, end-of-story calculation. What I want to do is offer some other thoughts and strategies to consider. It isn’t a case where one approach is right and another wrong. Instead, it’s a brief for understanding the trade-offs from concentrating on accelerating your mortgage payments and being comfortable with them.

One concern I always have is diversification. Are you putting too much of your savings into a single asset — your home — which is also located where you go to school and work? It’s a lot of financial exposure to one asset in one region of the country. Diversification pays. As Don Quixote de la Mancha said, “Tis the part of a wise man to keep himself today for tomorrow, and not venture all his eggs in one basket.”

Another concern is whether your emergency fund/opportunity fund — your FU fund — is large enough. I know your Roth IRA is a backstop to your emergency/opportunity fund. You can always withdraw the contributions — not the earnings — without penalty or tax hit. Still, you’ll want to leave the Roth alone if you can.

You might want to boost your emergency savings. For instance, will you move once you’re out of grad school? If that’s a possibility, you’ll want to have savings to tap to pay for the move. It’s always expensive to pick up stakes. You might not be able to see your place, either. (Although looking at the market over the next 5 years, you’ll probably be able to sell it.) 

The cash portion of a healthy savings account isn’t only an emergency fund; it’s also an opportunity fund that lets you take advantage of intriguing developments that come your way. For now, some of the savings could go into safe parking places for money, such as savings accounts. But eventually you could invest in longer-term mutual funds on a regular basis. The advantage of having money in taxable accounts is you can always sell it (hopefully at a profit) and pay capital gains.

The more savings you have, the greater your financial freedom and lifestyle.

However, by all means, go ahead and accelerate your mortgage payments if that is what you decide is best after thinking through these various points.

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