Should I Prepay My Home Equity Loan?

The Question: Does it make sense to sell mutual funds to prepay a home-equity loan?

The Answer: Jeremiah Bodner is well on his way to a junior membership in the millionaire's club. The 34-year-old bachelor owns a condo and two rental properties and has saved $285,000, including $100,000 in retirement accounts. Bodner, who lives in Berlin, N.J., makes $72,000 a year as a social studies teacher and on the side runs a vending business selling hot dogs at a local flea market. "When everyone else is having fun on the weekends, I'm working my stands," he says.

Although his finances are in solid shape, Bodner can't help fretting about a $59,000 home-equity loan, on which he's paying a fixed rate of 8.5%. "Making that loan payment every month seems like a waste of money," says Bodner, who's considering selling some of his mutual funds to pay off the debt, even if it means paying capital-gains taxes. Worried about the recent gyrations in the stock market, he'd like to eliminate the loan while lessening the possibility that his portfolio will take a big hit. But he wonders if a loan payoff would be the best use of his savings.

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Other options. Bodner does have other ways to make his debt more manageable. That 8.5% rate is slightly higher than current rates for similar loans, which have been averaging 8.2%. With his good credit rating, he could probably get a lower rate by refinancing.

But it usually doesn't make sense to refinance unless you can shave at least one percentage point from your interest rate. Otherwise, the cost of refinancing will eat away at your savings on the new loan.

Plus, Bodner's debt comes with a valuable benefit: The interest on the home-equity loan is tax-deductible. As a single filer who doesn't qualify for some tax deductions and credits that families can claim, the loan interest is one of the few deductions available to Bodner, says Diane Park, a financial adviser in Minneapolis.

Solid portfolio. Paying off a home-equity loan at 8.5% is the equivalent of earning a taxable return of 8.5% on your money. If Bodner's fund portfolio is earning less than that, it might make sense to sell some of his holdings to repay the loan. If his funds have the potential to earn more than 8.5%, he should hang on to them.

A peek at his assets helps settle the issue. Bodner invests in a solid portfolio of low-cost Vanguard funds, including domestic and international index funds and an energy-sector fund. So he's well diversified and very aggressive.

U.S. stocks have delivered an average annual return of a little more than 10% over the past 80 years, so it's fair to assume that over the long term Bodner's portfolio will beat the 8.5% return he'd get from paying off his loan. "His mutual funds are earning a buck," says Frank Presson, a financial adviser in Tucson, Ariz., "and his house will appreciate whether he owns it free and clear or has a loan."

Even if the market looks as if it's headed for a fall, that's no reason for Bodner to pull back on his stocks. He doesn't plan to retire for decades, and timing the market to get back in at the right time is a loser's game.

It might be different if he had a bigger portion of his assets in bonds or cash, which would reduce the chances that his portfolio would out-earn the 8.5% he'd get by paying off the loan. As it is, however, he's better off keeping the loan and building his nest egg.

If the debt bothers him, he can always make extra payments out of the income from his rental properties, says Pat Hinds, a financial adviser in St. Cloud, Minn. "Depending on the term and the amount of the loan, paying ahead can shave off a few years," says Hinds.