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Q: We have lived in our home for 15 years and have refinanced several times. About 18 months ago I refinanced to a five-year balloon note at 3.75 percent, amortized over 30 years. The original amount borrowed was $193,200, with a monthly payment of $895. In order to retire the debt in five years I have paid $3,550 each month, applying the excess to principal.
With interest rates rising, I am now able to get a better return elsewhere, like a 4.5 percent three-year bank CD or a 4 percent Internet account, both FDIC-insured.
I plan to reduce my monthly payment to $895. I would like your suggestions on how to invest the extra $2,655 each month so that I may earn additional interest, keep control of my money and still pay off my mortgage after five years. We are 50 years old, have a comfortable amount of savings and plan to live in our home for many years.
A: If the choice is between CDs and a quick mortgage pay-down, keep on paying down the mortgage as fast as possible.
You may be able to earn more with the extra money today — like the 4.5 percent CD you cite — but that interest income is taxable.
So your after-tax return will be 3.24 percent if you are in the 28 percent tax bracket, or 3 percent if you are in the 33 percent tax bracket. (It's a good bet you are in one of those if you can handle a $3,550 monthly mortgage payment.)
As a consequence, you could go through a great deal of effort and receive very little real benefit.
I suggest you consider another option. If you are planning on working for a good number of years and have a secure income, you might start investing the additional money to build a diversified portfolio of equities.
You'd still have the deductions for the low interest-rate mortgage, but most of the return on your equity portfolio would be either tax-deferred or taxable at only 15 percent. It might also provide a higher return than your mortgage interest rate. Since equities tend to have higher long-term returns than CDs or bonds, this could work out very well for you.
The operative word here is "could." While the CD/rapid pay-down trade-off pits two certain results against each other, the equity portfolio/rapid pay-down trade-off pits an uncertain return against the contractual cost of your mortgage.
I'd treat it as a business risk and invest in equities, then review the situation when the 3.75 percent interest rate changes at the end of the fifth year.
The higher your new rate, the less beneficial it will be to continue "investing the difference."
And remember, this is a reasonable idea if you plan to be working for many years.
The closer you are to retirement, when you will no longer have income from work, the greater the risk.
Questions about personal finance and investments may be sent to Scott Burns at The Dallas Morning News, P.O. Box 655237, Dallas, TX 75265; by fax at 214-977-8776; or by e-mail at scott@scottburns.com. Questions of general interest will be answered in future columns.
