Question: I currently have a 30-year fixed mortgage at 6.5 percent in the amount of $215,000. I also have a 30 year 2nd trust at 8 percent for $26,000. I would like to begin paying additional principal to these mortgages. Should I prepay the 2nd trust first because the interest rate is higher? Or should I prepay them both equally. What's your recommendation when it comes to paying extra to 1st and 2nd mortgages?

Answer: Your instincts are right -- pay off expensive money first. This would mean you should pay off 8 percent debt before 6.5 percent debt.

Now that we're on the subject, let's talk about debt management. A lot of folks tend to pay very close attention to their investments and very little attention to their debt. A proper investment portfolio should consist of the right mix of stocks and bonds that are appropriate for the owner's risk tolerance and financial objectives. You can call this asset management.

These same folks may have a high-rate mortgage and high-interest credit card balances. That makes no sense.

Remember that any high-rate debt you have will offset the earnings you reap from your investments. The bottom line here is that you must make your assets earn more than the interest you pay on your loans.

Let's get back to your situation. You have excess cash flow that you want to use to prepay your mortgage. This is a good thing and you should certainly pay off your more expensive 2nd trust money first. But before you do that, it doesn't hurt to make sure that this is absolutely the best place to put this money.

When you make extra payments to a mortgage, think of it as making an investment. If the interest is tax deductible you are prepaying a mortgage that is actually costing you an after tax rate of perhaps six percent. The question remains: Is this the best place to put your extra money? It depends. Ask yourself these questions.

What other debt do I have? If you have other consumer debt that's not tax deductible, you're probably better off getting rid of that first. As I said, it's best to pay off expensive debt before cheap debt. This usually means paying off credit cards and other consumer loans.

Do I currently have a savings or investment account? If you have very little savings, it might not be a bad idea to systematically put this money away for a rainy day. Remember that prepaying a mortgage makes your money illiquid. You can't retrieve it unless you sell the home or take out another mortgage.

Can I expect to make a return that exceeds the cost of the mortgage? In other words, if you decide to put the money in some other investment vehicle such as stocks or bonds, can you earn a better return than the after tax cost of the mortgage?

Do I max out my tax deferred retirement account? I'm a big fan of IRA and 401K plans. The money is definitely illiquid, but it's also tax deferred until your about 62 years old and it's a great "forced savings" that prepares you for your golden years.

Are there are prepayment penalties to consider? If so, how much?

With any luck, you have thought about all these things and have decided that it's best to pay extra towards your 2nd trust. But in case you haven't, this is food for thought.

For more articles by Henry Savage, please press here.

Published: January 30, 2002

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