Pay off the mortgage?

We owe about $26,000 on our first mortgage. It has a fixed rate of 4.875% and a monthly payment of $300. If we continue to pay as scheduled, it will be paid off in about 9 years. We also have a home equity line of credit (HELOC) with a balance of zero and a current rate of 4.5% (it is prime minus 1%).

My kids' grandparents have given us about $20,000 to be applied toward the kids' future college expenses. Rather than put this money in the kids' 529 plans, I'm thinking about using this money to pay off our first mortgage, then taking the current $300 per month that we pay to the bank and writing that check to the 529 plan instead.

Here's why. Because of the current state of turmoil in the stock, bond, and credit markets, I'm not going to make a big lump purchase in my 529 plan. Instead, I plan to dollar-cost average over the next 6 months. I'm concerned, however, about the possibility of huge gyrations in the stock market. In particular, the S&P 500 P/E is still around 20 (forward). Given uncertainty around upcoming earnings, and the fact that P/E is about double what it normally is during a recession, it is within the realm of possibility for stocks to fall 20-40 percent over the next year.

In the mean time, the money is sitting in a money market account paying 3.3% (thanks, Ben) while the mortgage is costing me 4.75%.

If I were to take the money and immediately pay off the mortgage, I would stop the month-to-month bleeding caused by paying 1.45% more on borrowed cash than I'm getting on saved cash. Further, by buying 529 shares over the next 8 years instead of the next six months, I would have a more effective dollar-cost average.

Ordinarily, the biggest reason not to do this would be inflation. Specifically, if inflation were to heat up to 5 or 10 percent, the value of that borrowed money would begin to erode. Further, cash interest rates would rise to above the inflation rate, and my cash would suddenly be earning more than the cost of the mortgage.

Except, of course, that inflation is already close to 5% and interest rates have been moving down (see Helicopter Ben, again).

A hybrid scheme would be to pay off the fixed rate mortgage with a mix of cash and money from the HELOC, since the HELOC has a rate lower than the fixed loan. (By way of comparison, a fixed rate 15-year originated today would cost around 6%.)

What to do. What to do?