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| Decision Center | Dilemma: Should you pay down or build up?
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Sometimes its smarter to use extra cash to pay off your mortgage; sometimes you should stoke investments. It all depends on your situation.
By Scott Burns
Few questions are more vexing. No question, if you are in the position to ask it, is a better sign of good financial health.
A reader in Georgia, asks this question for his son: "He and his wife, both 31, have no debts other than a 30-year mortgage on their home purchased two years ago. They are contributing 15% of their combined total income of $130,000 to their respective employers' 401(k) plans. They estimate that they could contribute up to 25% to their 401(k)s, but instead they have been applying the additional 10% to paying down the principal on their home loan.
"Over the long haul, which alternative, increasing their 401(k) savings or principal deduction, should be their No. 1 priority?"
The answer: It depends
The answer depends on your age, your tax bracket and future inflation. For more than 50 years, American homeowners have benefited from borrowing as much as possible for as long as possible. Until 1977, we borrowed at regulated interest rates that were barely over the rate of inflation. As a consequence, you paid back much less purchasing power than you borrowed. The result was a larger and more affluent middle class.
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Even in the period that followed, when interest rates exceeded inflation, homeowners benefited from interest rates that were often below the appreciation rate of their houses.
Note that this is not universal. There have been periods and places where home values declined. Homeowners in much of the Midwest and central parts of the country aren't to be confused with homeowners on the East or West coasts where, for some, homeownership has been like holding a winning lottery ticket.
Many financial planners argue that you should be slow to pay down the debt because:- its net cost is zero when tax benefits are considered, and
- you can earn a higher return investing the money elsewhere.
I agree with the first part. I think the second part is cheap talk -- easier said than done.
The most-crucial element
In fact, the most important issue isn't relative returns. It's financial strength. That comes from liquidity and security. Both are important at all ages. You can own your home free and clear, but if you have no other assets you will be forced to sell it if you lose your job. That's why I measure financial security in staying power.
What's staying power?
It's how long your liquid financial assets -- not money in your 401(k) -- will support your current standard of living (and debt). Surveys routinely show that most Americans will be in deep trouble within a few weeks of losing their job.
To avoid major losses when you are forced to sell assets (like your house or car), you need to have liquid assets -- deposit accounts, money-market accounts and short-term fixed-income mutual funds -- that will provide staying power. The longer your staying power, the better.
Staying power pays off
This is not entirely defensive. If you have staying power, you are more likely to be aggressive in wage and salary discussions. If you don't have staying power -- if every dime of income is committed before your receive it, and you don't have any savings -- you can't argue very forcefully because you can't afford to lose your job.
The benefits of a staying power fund can be substantial. First, it earns an interest rate approaching 4% in the current market. Second, if you have three months of income in your fund and it allows you to negotiate just one percentage point more in salary, the additional "return" is another 4%. That's a total of 8%, simply for having some cash on hand.
The same fund, if large enough, can also help you buy real bargains because you'll have cash when most don't. Remember, the fastest way to empty a room, anywhere in America, is to ask how many can come up with $5,000 without borrowing.
Bottom line: Priority one for young couples is to build a staying-power fund, not additional 401(k) contributions beyond capturing their employer match.
Once the fund has been established, additional savings should go into longer-term investments based on safety, expected relative return and long-term goals. A 30-year-old should build investment assets. A 50-year-old, on the other hand, needs to put emphasis on debt reduction because all but the most affluent should plan to eliminate debt service by the time they retire.
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MSN Money's editorial goal is to provide a forum for personal finance and investment ideas. Our articles, columns, message board posts and other features should not be construed as investment advice, nor does their appearance imply an endorsement by Microsoft of any specific security or trading strategy. An investor's best course of action must be based on individual circumstances.
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