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Making Extra Payments

By Philip J. Beavers, CFP,
WEAC's Member Benefits Specialist

November 1998

Financial Planning Seminars
Achieving Financial Independence

It's usually a good idea to pay off your debts

As you probably know, the best long-term passive investment available to public school employees is a quality tax-sheltered annuity (TSA) payroll deduction plan. The investment avoids current federal and state income taxes and continues to grow tax deferred until you begin withdrawals after retirement. However, for shorter term, more accessible investments, you may be looking for low-risk, liquid investment options.

For lowest risk, consider paying off or paying down debt. It does not make sense to look for investment ideas at the same time you have consumer debt. You should work toward eliminating taxable interest payments before considering other investments.

It may be a bit less obvious when considering paying down a mortgage because the interest is tax deductible. Some financial experts argue that homeowners would be better off investing any spare cash into the stock and bond markets. The arguments are that you will earn a higher investment return, ensure easy access to your money, and continue to have tax deductible mortgage interest.

First, consider investment returns. History suggests that stocks would return about 10.2% per year, and a 30-year treasury bond has a current interest rate of about 5%. Thus, a balanced portfolio (50% stocks and 50% bonds) might deliver 7.6% per year. That may be better than your mortgage rate, but there is no guarantee that you will make 7.6%. The average diversified U. S. stock fund lost 15.02% during the third quarter of 1998. The average fund lost 4.9% year-to-date through September 30, 1998. The last down year for both stock and bond funds was 1994. The average stock mutual fund lost 2.09%, and the average bond fund lost 3.57%. If we agree an after-tax, risk-free investment return levels off at around 6%, it is obvious that you would have to take an investment risk to do better than paying extra on your mortgage.

There is also the question of your mortgage interest deduction. If you choose to invest your spare cash rather than pay down your mortgage, you might have greater investment earnings on which to pay taxes. Unless you plan to invest through a tax-deferred annuity, the tax advantage of interest deduction is offset by the taxes you need to pay on the investment return.

Paying extra principal payments on your mortgage may have the following additional advantages:

  • Once you have paid off your mortgage, you have eliminated a major monthly expense which makes it easier to retire.
  • If you pay off the mortgage by the time your kids go to college, that will free up money for tuition bills.
  • If you pay down your mortgage instead of accumulating investments in a taxable account, you probably improve your family’s chances of qualifying for student financial aid.
  • Finally, making extra mortgage payments has the virtue of simplicity. You won’t have to spend hours at the library or with an investment advisor trying to figure out which stocks, bonds, and/or mutual funds to buy.

Money market mutual funds

Most money market funds are not insured. However, risk is quite low due to the type of investments they can make. Recently the U. S. average money market rate was approximately 5.0%. The NEA Insured Money Market Fund yield was 5.31%. The WEA Credit Union yield was 3.97%. Contact the WEA Credit Union at 1-800-457-1142 or the NEA at 1-800-345-0397.

U.S. Government Treasury Securities

U. S. Treasuries can be purchased direct at no cost and carry no investment risk other than the liquidity consideration. In addition to safety, the income received from treasuries is exempt from state taxes. You can buy three-month to two-year treasury notes. To obtain a tender form to buy treasuries direct, write or call a Federal Reserve Bank: FRB Chicago, P.O. Box 834, Chicago, IL 60690 (312-322-5369), or FRB Minneapolis, 250 Marquette Avenue, Minneapolis MN 55480 (612-340-2075).

Certificates of Deposit

CDs come in various maturity periods with higher rates for longer maturities. The following are average CD rates throughout the United States:

  • 6 months = 4.48%.
  • 1 year = 4.68%.
  • 5 years = 4.96%

No-load, short-term corporate bond mutual funds

This would be for members willing to accept a low interest rate risk. Current yields range from 5.64% to 6.47%. Fund families to consider include: Scudder (1-800-225-2470), Strong (1-800-368-1030), Vanguard (1-800-662-7447), and USAA (1-800-382-8722).

Tax-free money market funds or municipal bond funds

Municipal bonds may be a good choice for members in the 28% or higher federal tax bracket who are willing to assume an interest rate risk. Federally tax-free fund yields are 3.6% to 5.9%. At the 28% federal tax bracket, a 4.5% tax-free yield would be equivalent to 6.25% fully taxed. To determine the equivalent fully taxed yield, divide the tax-free yield by 1 minus your federal tax bracket. Municipal bond funds are available from the mutual fund families listed above.

Posted October 19, 1998