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When to Pay Down Your Mortgage With Extra Cash

It can be smarter to prepay instead of letting money sit in the bank.

Say you manage to set aside $50 to $100 a month by reducing your spending.

What's the best way to use that money?

In today's markets, it might make sense to prepay part of your mortgage rather than save the cash in a money-market or other savings account.

Interest rates have declined across the board in recent months. But rates on savings accounts and CDs are down more than those on credit cards and mortgages.

Using spare cash to pay down expensive credit card debt remains a good idea. And given today's low rates on cash investments -- many money funds are paying 3% or less -- it may now make sense to use your extra cash to pay down your existing mortgage as well.

Let's say you have five years left on a 30-year mortgage. You might be able to lower your interest rate by


. But if you replace your old loan with a 15-year mortgage, you'll be saddled with refinancing costs as well as 10 more years of interest payments.

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On the other hand, you could use your extra savings to boost your monthly payment by $100. That move would save you $1,077 in interest payments over the final five years of a 30-year $200,000 mortgage with an interest rate of 7%.

By contrast, if you choose instead to deposit that money in a savings account every month at a 2% rate, you stand to earn only $312 over five years. If you invested in a money market account and earned 4% returns, you'd accumulate $640 in interest over five years -- but that's still far less than the savings you'd realize by using the same cash to prepay your mortgage.

That said, there are a few things to consider apart from your potential returns.

A savings account can offer a buffer against financial emergencies, as well as a fund for taking advantage of investment opportunities. If you don't have access to funds to cover unforeseen medical bills or other unplanned expenses, then consider building up your savings before you pay down your mortgage.

Similarly, you may want to consider the impact that a rate increase could have on your situation. For example, let's say you have 15 years left on your 6% fixed-rate mortgage. If interest rates rise as the economy recovers and inflation picks up, that mortgage might look like a pretty good deal. Meanwhile, you might be able to invest new cash at higher rates.

Best advice?

Consider using new cash to prepay your mortgage unless you have a low-interest loan that has another 10 or more years to go. In that case, you might want to hang on to your cheap mortgage and put the cash aside so that it can earn higher yields when the economy recovers.

Peter McDougall is a free-lance writer in Freeport, Me.