I have $60,000 in cash and equivalents. My mortgage payment for a two-family home is $740 a month and expires in 2015. I live on one side of it. I am 33 years old. Should I use this money to pay off my house or invest in something? I also have a three year old with no real significant saving plan for her yet.
FPA member Dave Demming, Jr., CFP®, of Demming Financial suggested that you are in a great position financially. “You’ve got great flexibility and that’s a great thing to have,” said Demming. “I think you can tackle a few action items and come out ahead by addressing each priority.”
FPA member, Gail Senay, CFP®, of UBS, suggested that the answer to your question is not an easy one. Here’s a snapshot of what they had to say.
Build an “Emergency Fund”
“I would encourage you to have an emergency reserve of three to six months general living expenses in a savings and/or limited term bond fund,” said Demming. “The amount is dependent on your employment stability and your income consistency. Some occupations with variable pay may require a larger cushion.”
Demming noted that if you do end up paying off the mortgage — as your savings interest rate likely isn’t nearly as high the mortgage — it would make sense to establish a home equity line of credit simply as an emergency credit line. It should have a minimal annual fee and can be found in the prime plus or minus a half range. The prime rate is about 3.25 percent as of this writing.
Paying Off the House
“There are a number of things to consider with the flexibility you have,” said Demming. “First, what interest rate is the mortgage on the two-family home? Is it reasonable in today’s interest rate environment and if so, should it simply be maintained because you are paying mostly principal in the last few years of a mortgage? With the payoff coming within five years, it most likely is not an option to refinance. So, the next question becomes, how liquid are your other investments? Paying off the mortgage will suck up a good portion of your cash and emergency reserves if the balance outstanding is $35,000-$40,000. However, you surely will pick up some great cash flow from saving the $740 a month. If you have a stable income and have a moderate to lower risk tolerance, it may make sense to pay off the mortgage. You’ll have the ability to replenish your savings into other investments and/or you could begin funding education accounts for your daughter.”
For her part, Senay said she would need more information to answer your question. “You say that your payment on the two-family is $740 per month and expires in 2015,” she said. “Does that mean that you have an adjustable rate mortgage (ARM)? What is the balance of the mortgage, what interest rate are you currently paying and is the $740 payment something that is easily managed by your current paycheck or is meeting your monthly obligations a struggle? The answers to these questions could determine if the balance needs to be paid down or paid off. Another item to consider is how long you plan on living in the home.”
Demming suggested that you consider setting aside — if you’re eligible — $2,000 a year into a Coverdell Education Savings Account (Coverdell ESA) for your daughter, and then possibly use a Uniform Transfer to Minors Act (UTMA) account and/or a 529 Account in Ohio Tuition’s Trust for her benefit as well. For his part, Demming said his preference is in Vanguard’s Age Dated Target Allocations for Ohio.
Senay also said putting money into a 529 plan for your daughter's education is also an option. She too suggested using the Ohio Tuition Trust Authority, which manages the 529 plan and as an Ohio resident, she noted that you may be able to get a maximum $2,000 state tax deduction annually for deposits to this type of investment.
“Again, some of the issues listed above should be addressed prior to funding this type of account, since money deposited in a 529 may only be used for post secondary education,” Senay said. “If it is taken out of the account for any other reason, a penalty may be applied.”
“After establishing the 529 and Coverdell ESA accounts, you could individually consider funding a Roth Individual Retirement Account (IRA) up to $5,000 on an annual basis as long as your adjusted gross income is below certain phase-out thresholds,” Demming said. “The phase-out thresholds are: Head of Household $105,000-$120,000 Modified Adjusted Gross Income (MAGI), Married filing Jointly $167,000-177,000 MAGI.”
“Roths are great for younger individuals who may, in a bind, need liquidity,” said Demming. “Because your after tax contributions are already taxed income, you can extract your contributions without penalty. The earnings should stay invested as there are penalties and taxes associated with a pre 59 ½ withdrawal unless an exception is met.”
Saving for Retirement
In addition to saving for college, building an emergency fund and paying down your mortgage, Senay suggested that you need to consider saving for retirement. “Are you currently saving for your retirement?” she asked. “I know it seems like a long way off, but remember that you can always borrow for educational needs for your daughter, but you cannot borrow for retirement. Are you funding a 401(k), Traditional IRA or a Roth IRA?”