Debt and That Squished Feeling

Dear Mary: We would like to enlarge our small two-bedroom bungalow. Our kids are reaching the teen years, and we need more space. We have always budgeted our money.

We have $6,000 in our emergency fund and drive two paid-for cars, and our only debt is our mortgage. We have college savings accounts for our kids and tithe to our church. Our annual income is about $140,000.

We have five different bids, and they all came in about the same at $160,000 to add three rooms upstairs, plus a stairway. Even though I know adding 900 square feet will increase the value of our home, I feel queasy about increasing our mortgage debt. What is your advice for us? — Sam and Edie

Dear Sam and Edie: I can understand that you are nervous about taking on a big new monthly payment, one that could well double what you are paying now — plus increased property taxes. Here’s a good way to find out if you can reasonably afford to do this:

Figure out your new monthly payment, including taxes and insurance, using any online mortgage calculator. Starting now — this month — live as if you have already taken on this new expense. Start making this payment to yourselves, on time and without fail. Every month. How does that feel? Can you sleep? Stressed out of your mind? You’ll know in a few months if you can handle this.

It seems to me that you are in a fairly good financial situation. You have no unsecured debt; you are preparing well for the future; and you have a substantial income. I am concerned, however, that your emergency fund is kinda thin. You need at least six months of living expenses in that account.

All things considered, provided you are comfortable with the added expense and can quickly beef that emergency fund, this sounds like a reasonable risk that will improve your lives and increase your net worth, too. This is exciting!

Dear Mary: I am retired and have a mortgage of $89,000 at 5% interest. I have enough money in my 401(k) to pay off the mortgage. Should I do this? — Ron

Dear Ron: I don’t have enough information to begin to advise you on this because it depends on your age, the total amount in your retirement account and how you have those funds invested currently. But I can give you some ideas to consider.

Like all investments, money in a 401(k) is money at risk. Even if you have selected low-risk investments, you could lose it.

Your debt, on the other hand, is a sure thing, and investing in it will give you a guaranteed return of 5% (the exact rate you are now paying). This is how that works:

Let’s say you are currently paying $4,000 a year in interest on your mortgage. If you take $89,000 from your account and pay it off, you get to keep that $4,000 every year going forward. That is your return on the $89,000 investment you made in your debt. It’s a sure thing, regardless of what happens to the market or real estate values, and a wise move if you have sufficient money to do that, which it appears that you do.

Knowing your home is paid for offers a certain amount of security in the face of a changing economy.

However, if doing this would deplete your retirement account and you have many years ahead of you, it may not be wise for you to invest your money in this way at this time.

Especially in retirement, you need the security of readily available cash. I recommend you get sound advice from a fee-only financial planner. Hope that helps!