Recently my oldest bought a new house. She and her husband sold their old home for a nice profit and were trying to decide what the best use of the money was as they were trying to decide if they should pay down their new mortgage or add money to their retirement accounts as well as their son’s college fund. When they asked my advice I responded with a single question: “What is the interest rate on your new mortgage?” When they told me that it was a 3.4% fixed rate I told them to fund the retirement accounts and the college fund. It was simple math. The interest rate earned on those accounts was greater than the amount spent on the interest of the mortgage. This is why it is very important to carefully choose your local mortgage broker. There are several factors that you need to consider and you need to do comparisons among your options so you can come up with the right company that will help you with your goals.
The bottom line on a financial question is generally going to have something to do with interest rates. As a general rule if the amount spent on interest is less than the amount to be earned, you go with the amount to be earned.
If their mortgage interest rate was, for example, 12% and the potential to earn from saving the money was 6% I would have said to pay the money to the principal of the mortgage and fund the accounts over time instead of a lump sum.
The easiest way to remember this most basic financial rule is that you want to PAY as little interest as possible and COLLECT as much as possible.
If there had been credit card debt involved my answer might have been slightly different. I would have asked about their overall debt load (amount of available credit compared to the amount of overall credit) and the interest rate on the cards. I almost always suggest paying off credit cards over saving the money because of the way the interest rate is calculated, the rate of interest itself and the overall effect to your credit score. In the event you are unaware, most credit card companies charge interest after 30 days which means that even if you pay the card in full every month you still pay interest. Further, most credit card companies have a set day that they inform the credit reporting agencies about your debt load.
What that means in practical terms is if they report to the reporting agencies on the 15th of the month then your balance on that day is what the credit reporting agencies see. They don’t see that you pay it off in full every month. This is not good for your credit score.
When in doubt either talk to a financial advisor or remember to pay off high interest rates as fast as possible. After that you are in a much better position to save for college and retirement.
