Reconsider That Mortgage Prepayment

• ByBankingMyWay.com,
• On 4:07 pm EST, Wednesday January 21, 2009

Prepaying a mortgage can save tens of thousands of dollars in interest over the life of your loan. But with uncertain economic times and historically low mortgage rates, prepayments may not be the best use of your money.

Instead, consider boosting your rainy-day fund or using extra money to pay the cost of refinancing your mortgage. The economy shed 2.6 million jobs in 2008, and many economists expect the recession to last well into 2009. "It's imperative to have a cash reserve," says Hank Hanau, financial planner and founder of HFH Planning in New York. "Six months of expenses is a good target."

What if your emergency fund already meets that target? Say, for example, you live in New York City and are two years into a $250,000 30-year fixed rate mortgage at 6%, with a monthly payment of $1,499 and you find yourself with $4,000 in extra cash.

Using that money to prepay your mortgage would save you $16,596 in interest over the life of your loan.

Another option for the money is to add a seventh month to your existing rainy-day fund. This is especially important if you are self-employed or are the sole wage-earner. But if you are comfortable with the size of your cash reserve, consider refinancing.

In the New York metropolitan area, rates on 30-year fixed rate mortgages generally hover around the 4.75% offer from Elmira Savings Bank or the 4.875% offer from Evans National Bank . Refinancing your mortgage at 4.75% and using the $4,000 to cover the closing costs would save you $46,028 in interest over the life of the new loan -- or $29,432 more than you'd save using that money as a prepayment.

But refinancing only makes sense if you plan to live in your home long enough for your reduced monthly payments to exceed your closing costs -- 16 months in the above example. If you think you might move before then, consider investing that money instead.

"If the return in a safe investment is more than the rate you are paying on your mortgage, then prepaying may not be the right move," says Hanau.

Hanau recommends investing in short-term tax-exempt mutual funds like the Vanguard Short-Term Tax Exempt fund.

Buzz up!