A reader (let’s call him Ralph) wrote in with the following interesting situation (that has some parallels to my own):
About a year ago my wife and I bought a new house with no money down and a 30 year fixed rate mortgage locked in at 5.5%. This meant of course that we would be paying PMI for the first twelve years or so of the mortgage assuming the value doesn’t go up.
About a month ago, I switched jobs and literally doubled my salary. We have no intentions of changing our lifestyle at all and we plan on just investing the extra income but we are trying to decide what to do with it. Should we use it to pay off our mortgage above everything else? Should we invest it? Should we just pay it off down the PMI rate and then invest it?
We both have student loans that are around 4% but no other debts at all.
Ralph is in a pretty exciting situation that’s going to open a lot of doors for him in the long run. Suddenly, he’s in a position to start saving 80% or so of his previous take-home pay, which is going to make an enormous difference in the long run. Plus, they have no credit card debt, which would be the first major obstacle to overcome. They’re really in great shape here.
First of all, I would build up a nice hefty emergency fund, probably as much as six months’ worth of take-home. Given that you’re intending to live on your previous take-home, I would just have the fund include that amount plus your wife’s take-home. Put this money in a savings account that earns 5% APY (like HSBC Direct) and just let it sit there to protect you against a rainy day.
Second, I would pay the house mortgage down to 78% and get off the PMI. PMI averages around 0.5% of the value of the mortgage each year with no real return, and by accelerating the payments you can get out of PMI pretty quickly (just a few years), giving yourself several years where you don’t have to pay the PMI that you would have to if you didn’t pay ahead. This can net you 5% of your mortgage value. Even if you’re tempted, though, don’t stuff the emergency fund in here to get it over with, because I’ve seen time and time again that when I use my emergency fund to get something paid off, I need that fund the very next day.
After that, spend some time figuring out what your goals are. For some people, it is being completely debt free, so if that’s the case, focus on paying down your highest interest debt (in this scenario, your house) and then follow it with lower interest debt. You may also want to sock cash away so that you can pay cash for an automobile purchase (put the cash in a high-interest savings account until you’re ready to just write a check for the automobile). Investing is another option at this point – start building an investment portfolio, but know what your goal with the money is before you start (retiring early, building a dream home, etc.).
In short, if you’re actually committed to using the extra money to get yourself on a solid financial plane, the ability to use 80% of your salary solely for this purpose will help quite a lot. Good luck!