Whenever I have a money question, I go to Cash Commons. There, users ask and answer all sorts of questions in a very helpful way. When I received this question, it seemed like a matter of opinion, so I wanted to get a few views on what the best idea way, and more importantly, why.
I have both a mortgage on our house, and a home equity line of credit. The mortgage rate is fixed (4.4.%) for 15 years. The home equity is variable, right now, it is only 2.24%. I am trying to accelerate payments beyond the minimum to get out of debt more quickly.
When the home equity rate is higher than the mortgage rate, it is a no-brainer – pay the minimum on the mortgage and throw any extra money into the home equity loan.
However, when the home equity loan is lower, like now, it is a little more tricky. It may seem obvious to pay the minimum on the home equity and pay off more of the higher interest mortgage. That would be the clear choice, if I could count on not needing to tap the home equity line down the road. But, what if I anticipate some large expenses down the road, for which I would need to borrow?
If my home equity is close to the ceiling, then I won’t be able to borrow against it when I need it. No matter how much I’ve paid off my mortgage, I can’t get more from that source if I need it. So, what’s the best strategy in this situation? (And, you can ignore the issue that as the home equity gets closer to the ceiling, that hurts my credit rating a little. For the current purposes, I don’t anticipate taking out any other loans, and I pay my credit cards off each month.)
After posting this question over at Cash Commons, I got some interesting opinions.
After breaking down the situation, Mighty Bargain Hunter was a proponent of building up cash reserves, then paying down the Home Equity Line of Credit (HELOC), then the mortgage. He argues that cash in the bank buys time, even if it costs a little in the short run and that the rate on the HELOC will eventually increase to a rate higher than the mortgage, making it worth it. I agree that the cost of building up cash is low (Matt would lose less than 1/2 a percent in interest if he chooses a savings account instead of the HELOC).
Dr. Dean agrees and says that rates will rise this year so the HELOC should be the biggest concern, and the more that is paid in the short-term, the less left over there will be when the rates increase considerably. Again, a good point, and he notes that what the market will do in 2010 is his main reason for his thinking. Plus, if rates continue to stay low, he can always try to refinance to keep his mortgage rate low for far into the future.
My take is a little big different. It’s extremely hard to know what will happen in the next year in terms of the market. At some point, interest rates will rise, and when they do, some think they will rise to a high rate in a short period of time. Whether this happens in the next year, nobody knows for sure.
The uncertainty of the situation is what makes this question difficult. Right now, Matt can make larger payments on the mortgage and effectively “earn” 4.4% on his investment. Alternatively, he can pay down the HELOC, “earn” 2.4% in the short-term, and when the interest rates rise, “earn” more. But when will the interest rates rise to 6 or 7%?
Since it’s impossible to know, I am a proponent of taking the guaranteed return after building up some cash reserves. That way, Matt can pay off a chunk of the HELOC when the interest rates rise while only “losing” 2.4% (4.4% on the mortgage – 2.% that he can earn with a savings account such as SmartyPig), and then earn that 4.4% by paying off the mortgage. In this scenario, he doesn’t take too much risk, spreads out his “investments” slightly, and knows what kind of return he is getting.
When the interest rates on the HELOC begin to rise, it may be time to switch to making payments there because once the markets improve (whenever that may be), they may rise quickly and it will make sense to pay that down as quickly as possible. But until then, my vote is to pay the mortgage and earn a guaranteed return on your investment rather than trying to time the market to come out slightly ahead.