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Kelley wrote recently with the sort of dilemma I get asked about all of the time: Is it better to invest or to prepay a mortgage? We’ve covered this topic in the distant past, but it’s time to review the debate for current readers. First, let’s look at Kelley’s e-mail:
My husband and I are on the right track. At age 25, our only debt lies in our home mortgage. We have the six-month emergency fund in place, I currently meet the 3% 401(k) match offered by my employer, and I started a Roth IRA for myself and my husband last year. I started each Roth IRA with $4,000.
My financial advisor recommended for us to max out each of our Roth IRAs each year. My husband disagrees. He thinks paying off the house is a bigger priority. Starting this year, we’ve made an extra payment on our house each month. If we continue doing this, we can have our house paid off in nine years rather than 30 years. However, we can’t do both.
Currently we’ve decided to throw $1,000 into each Roth each year until the house is paid off. Is this the wise decision? Or is it better to put more toward the Roth IRA and less toward the house?
I understand either option is good because I’m saving money. I’m just curious of which route would be wiser.
Kelley’s right: Both of these options are good. This is like choosing between an apple and an orange. Both taste good, and they’re good for you &madsh; but is one better for you in the long run?
What the experts say
Three years ago, when we last covered this topic (holy cats! — where has the time gone?), I collected the following roundup of advice from personal-finance books:
- Ric Edleman (Ordinary People, Extraordinary Wealth): Never own your home outright. Instead, get a big 30-year mortgage and never pay it off — regardless of your age and income. “Every time you send an extra $100 to your mortgage company, you deny yourself the opportunity to invest that $100 somewhere else.”
- Suze Orman (The Laws of Money): Invest in the known before the unknown. Paying off your mortgage offers a guaranteed return on investment. “You cannot live in a tax return. You cannot live in a stock certificate. You live in your home.”
- Elizabeth Warren (All Your Worth): Save 20% of your income. Use 10% for retirement savings, 5% to accelerate your mortgage, and 5% to save for future dreams. “Paying off your home also does something many financial planners neglect to mention: It gives you freedom. Once that mortgage is gone, just imagine all the freedom in your wallet.”
- Dave Ramsey (The Total Money Makeover): Prepay your mortgage if you can, but only after you’ve saved an emergency fund, and only if you’re putting at least 15% of your income toward retirement. Don’t use a program designed by a broker; use your own self-discipline.
- Dominguez and Robin (Your Money or Your Life): “Pay off your mortgage as quickly as possible.” This book, too, was written when interest rates were higher. Also, the authors emphasize frugality over investing.
Financial authors don’t agree on this subject. Maybe the personal finance gurus writing for the web can clear things up?
- Liz Pulliam Weston at MSN Money: Don’t rush to pay off the mortgage. “You’ve got better things to do with your money, like saving for retirement, building an emergency cushion or even living it up a little.”
- Walter Updegrave at CNN Money: If you’ve funded your retirement, and if it will make you happy, then pay down the mortgage. Otherwise, it makes more sense to invest.
- Laura Rowley at Yahoo! Finance: Using very conservative figures, investing instead of prepaying the mortgage yields an extra $400 per year. If you feel compelled to pay down your mortgage, do it. But realize you’re paying a price to do so. (She offers more details at her blog, as well as tips on how to estimate the investment return you need to earn to make it worthwhile.)
- Bankrate: Pay down your mortgage if your investments would be conservative. Invest if you’re planning to do so for the long term.
- USA Today: It depends on your income, your monthly expenses, your risk tolerance, and your desire to own your home free and clear.
- Kiplinger’s: Invest unless you’re near retirement
- The Dollar Stretcher: Mathematically, it makes more sense to invest, but it all depends on your risk tolerance.
- My fellow pfbloggers at Bargaineering and Million Dollar Journey recommend that a person do a little of both: pay down the mortgage some and invest some. Free Money Finance says: “If you have the discipline to save/invest the money you would be using to pay off the mortgage, it’s likely that saving/investing is the better option. But if you’re more the “average” person out there managing your money, I still believe it’s a better option to pre-pay your mortgage.”
The Rowley article offers some interesting background to this debate:
Why do so many people choose to put extra money into a mortgage when other options would likely increase their wealth? “This is really remnant of Depression mentality that has persisted from generation to generation,” says [one expert]. At the time, most mortgages had one- to five-year terms, with a lump sum payment due at the end.
“Any shock to income meant you couldn’t afford your payment — mortgages were much more susceptible to economic uncertainty,” [the expert says], and roughly one-quarter of Americans were unemployed during the Great Depression. “It’s fine to pay down your mortgage if it gives you peace of mind, but you should recognize what that peace of mind costs.”
If you’re facing a similar decision, you may find this calculator useful: prepaying your mortgage vs. investing.
The bottom line
My conclusion in 2007 (and the one I still hold today) is that unless your mortgage rate is very high, it makes more sense mathematically to invest your money. But most gurus agree that psychologically, you should do what works for you. If paying off your mortgage would take a weight off your shoulders, then pay off your mortgage. Sure, you might be losing a bit in the long-term, but you’re still making a smart choice. As I said earlier, it’s like choosing between an apple and an orange. One may be better for you, but they’re both good.
Ultimately, I kind of like the choice that Kelley and her husband have made. They’re prepaying their mortgage and putting some toward retirement. But enough of what I think. Kelley really wants to know what you think.
Which option is better? Should she and her husband be pumping as much as possible into their Roth IRAs? Or should they be paying down their mortgage as quickly as they can? Have you been faced with a similar dilemma in the past? What did you choose to do? And would you make the same choice again?
This article is about Ask the Readers, Choices, House and Home, Retirement Friday, 2nd July 2010 (by J.D. Roth)
When in doubt. Hedge your bets. 50% option 1 and 50% option 2. This covers other questions like “When I travel abroad should I change my money now or later”. You wont get the optimum outcome, or the worst outcome, you will end up somewhere in the middle. It’s the path of least risk.
I decided to pay off my mortgage and with a little good fortune I’ll be done in 3 yrs give or take. My choice was between saving more for retirement (I’m currently saving 12% + 4% company match) and the FREEDOM of being completely out of debt and never being tied to my house. I cannot wait!
In most cases, I’d probably be inclined to go for the Roth.
I think it’s worth pointing out though that if your advisor is paid either a) commission or b) as a percentage of assets you have with him, then he has a conflict of interest here. He makes more money if you go with the Roth than if you prepay the mortgage.
Of course, that doesn’t necessarily make it a bad choice…
These types of blanket recommendations drive me crazy–because they don’t mean anything unless you know the type & rate & amount of the mortgage. Also it makes a HUGE difference if like now, there are no safe investments making even 5%.
Personally, I’m maxing my Roth 403b & also I’ve been dumping some lump sums into my mortgage since early 2009. Because I get a guaranteed rate of return = my mortgage rate less my tax savings on the interest. When CDs are paying less than 2%, paying down my small (50K) 4.5% mortage makes a lot of sense. I want to have it paid off by the time my kids start college, which is pretty close.
But everyone keeps lecturing me, “why are you paying off your mortage?! You could make more investing!”. Uh, where?
Since they are already putting some towards retirement, I would continue to pay down the mortgage. The difference between a 30 and 9 year mortgage is a significant amount of interest over the lifetime of the loan. In my opinion, the less interest the bank gets the better. And if it’s paid off in 9 years, they’ll only be about 34 and have all that extra money to put towards retirement. And still have quite a long time to do it.
I agree that it all depends - I’m in the UK and have a ridiculously low mortgage rate at the moment. Even with pretty low savings interest, my savings are earning twice the rate of my mortgage interest (3% vs 1.3%!), so we’re just socking money into the savings account. When interest rates rise, if the mortgage rate gets to the same as the savings rate, we’ll pay it all over.
But then, we’re really conservative risk-wise, so we’d always prefer a bird in the hand to two in the bush…
Wow…remind me never to read Ric Edleman’s books.
I personally prefer Ramsey’s approach. Investing for retirement is certainly important, but like all investing, there is ALWAYS risk involved. Paying off your mortgage is a sure thing though. If disaster struck and you lost your income and depleted your emergency fund, you’d be much better off without having to worry about a mortgage payment than you would with a bunch of extra money tied up in a Roth IRA or a 401(k). If you were forced to make an early withdrawal of that money, you’re completely negating any mathematical advantage that you may have gained from investing over paying down the house.
So save a decent chunk for retirement, but throw everything else at the house. Once the house is paid off, you can do whatever you want with that money that you used to send to the bank every month.
We are at about the same age and stage as Kelley and her husband. We are hoping to have our house paid down in 7 years. Our reasons are:
1) The 2008 stock market hiccup reminded us that investments aren’t a sure thing
2) We want the extra space in our budget in our 30s-50s when we are hoping to have kids
3) Our rate of retirement savings already allows for a comfortable lifestyle in that stage. Putting an extra $15000 a year into retirement savings would mean we’d be taxed at a higher rate during retirement.
4) This is our first debt and it makes me feel a little ill when I consider owing that much money.
Another twist to add to the mix…
When my kids go to college (starting 8 and 11 years from now), will it be better for us from a financial aid package standpoint to have paid off the house, resulting in having saved less for their college funds, or to stuff that money in their college funds and still have another 10 years of house payments?
I am implicitly assuming that we will qualify for some sort of financial aid package, (perhaps because I am implicitly assuming that both of them will be accepted at the most expensive schools in the nation — hey I’m a parent, of course my child is brilliant!). But I think the question is valid even if we have to foot the entire bill — would it be better not to have to worry about a house payment, or better to have invested the money?
I’m with Karen, investments are yielding pretty poorly right now. It makes good financial sense to pay off your mortgage and the feeling of freedom you get from no mortgage is worth it’s weight in gold. Also judging by the number of mortgage foreclosures in the US right now… if a few more people had worked on paying off their mortgage - the bank wouldn’t have had to repo their home!!
If I had listened to the experts- I would have lost everything in the dot com crash!
That being said. At her age I would invest in retirement FULLY and then pay a bit down- only if she had the cash. Most likely she will move many times before she finishes working. Put her money in a Roth- then she can use it in her next home.
At our age (52&60 and retired) we paid off the house. It is worth the peace of mind.
I like Eliz Warren’s advice. 10% retirement (why not split it half into pre tax 401 and half into a Roth) and 5% into mtg prepay. That’s covering several bases.
I think it depends on more on future goals. They are 25 years old and could have the home paid off in 9 years. Without a mortgage payment they have a lot more flexibility in their life. What if they have kids and want someone to stay home, will the mortgage prevent that from happening?
What type of mortgage is it? If an ARM definitely pay it off…if fixed that changes things. Is any of it in a HELOC that would be a variable interest rate? Pay off the HELOC and then reevaluate.
Also think about risk/reward and their tolerance level. If the mortgage is 5% and we assume 7-8% return you’re talking 2%-3% which is not a huge spread.
Personally I’ve adopted a hybrid approach over the past few years of paying to retirement and to the mortgage.
This is an endless debate, which completely fascinates me every time. Some like to consider your mortgage as a negative bond with a guaranteed rate of return. Keeping your mortgage ‘offsets’ the bond portion of your portfolio. A paid off mortgage also increases cash flow.
OTOH, keeping a mortgage allows greater liquidity. With your assets tied up in your house there is an inherent opportunity cost, assuming that you ‘know’ the better opportunity ahead of time.
I tend to put retirement planning first, because your tax-advantaged space is use it or lose it. For the average person:
1. Get 3-12 months expenses in a money market or similar fund (I plan to use I-bonds that are >1 year old).
2. Invest up to the full company 401k match and then max out the Roth IRA.
3. Choose between maxing out the rest of the 401k and making accelerated mortgage payments. Either is a good option. Doing a little of both gives you some diversification, since no one can predict the future.
I would run the numbers based on your expected retirement age and need, and work backwards to see which option works best for you. It may be in your best interest to fill up the tax-advantaged space now, otherwise if you pay back the mortgage early you could be out of room in tax-advantaged accounts and stuck investing in a taxable account only and owe more in future taxes.
@Mike Piper (#1): Hopefully they use a fee-only financial planner.
@Joe (#6) Absolutely agree about fee-only planners.
Still, fee-only planners who charge a percentage of assets are subject to this conflict of interest. The “pay off debt or invest” question is one reason I’m a big fan of hourly-fee planners rather than assets-under-management planners.
Agreeing with Karen, each situation would be so case specific as it relates to psychology and economics that I am not sure it wise for Kelley to “ask the audience”.
What is the mortgage balance and interest rate? Would refinancing allow the best of both worlds? Where are they at on their amortization schedule? What is their tax bracket? Are they planning on moving anytime soon?
In the end Kelley would need to quantify her psychological desire to pay off the mortgage and compare it to the hard numbers relating to her specific situation.
The conclusion i arrived at by creating a spreadsheet to analyze the variables http://goo.gl/IMlz (or download it from http://goo.gl/Z2Y0 as Excel) is this:
The primary factor in determining whether you should payoff your mortgage is your tolerance for risk.
In short, if your tolerance for risk is low, you are better off paying your mortgage down since it is a better long term and safe investment for you.
If your tolerance for risk is high, you’ll be better to invest since your investment return will (possibly) outpace the savings from not paying mortgage interest.
As you reduce risk, and as a consequence, investment return, you reduce the amount of your investment returns prior to paying off your mortgage. As a result, you can catch back up to where you were faster. This seems like a good situation since people that prefer less risk are likely the same group of people that will feel secure not having a mortgage payment.
Also, i recommend not making extra payments to your mortgage every period. If you intend to pay off your mortgage early, save the money in an investment (probably safe, low risk) and pay the mortgage off when you’ve save the entire sum. The only benefit to making extra payments to a mortgage each month is if those payments reduce your payments over time which isn’t typical.
It’s more about mind than math, right? While it’s easier to see the interest savings from your mortgage, investing NOW is probably mathematically better. The economy and stock market are shaky. Historically, it will level out and grow at an average rate of 8-12%. It’s just not instant gratification. As for investing in retirement (rather than just making investments), I feel like that can be a tough pill to swallow. I get my full employer match, but beyond that, I want to get some financial benefits from what I do with my money BEFORE I retire. At 31, having my mortgage paid off in 8 years means I’ll be 39 when I make that last payment. I’d like to think that gives me some good “young” years to make the most of that financial freedom. Maybe I can even start my own business at home with very little startup capital. Plus, the thing about having low mortgage rates is that there is almost NO tax savings. My annual mortgage interest this year will only be slightly more than my standard deductible. I know we’ll need “a lot” of money in retirement, and I don’t recommend that you skimp on it, even when you’re young, since compounding interest is important, but I feel like we’re too young to put ALL of our eggs in that basket. Enjoy life before retirement!
I found these lines particularly interesting:
“Why do so many people choose to put extra money into a mortgage when other options would likely increase their wealth? “This is really remnant of Depression mentality that has persisted from generation to generation,” says [one expert]. At the time, most mortgages had one- to five-year terms, with a lump sum payment due at the end.
“Any shock to income meant you couldn’t afford your payment — mortgages were much more susceptible to economic uncertainty,”
The current Canadian system is much closer to this system than I had realized. We normally sign up for a 1-5 year term, and then renew after that time period (lump sum isn’t due). A 30 year (or even 10 year!) mortgage term is very rare.
JD, does your advice on this change for your Canadian readers? Or are the basics the same?
What I didn’t understand was if their employer 401k max was met. (16,500/year). If that has not been met, I would put the money in the employer plan to protect it from taxes. If I had to choose between the Roth and mortgage, I might consider the mortgage. Being entirely debt free so young would be incredibly liberating.
i think a lot depends on if you LOVE your house. i love this house - it is my greatest joy and hobby. also a lot of people change houses frequently. I don’t. this is my forever house. my ex and i paid a 15 year mortgage in nine years.
why sink money into something when you are planning to move in a few years?
there is an indescribable sense of security from being debt and mortgage free. i am sitting in a “paid for” house. i pay about $500 a month in taxes and insurance and $250 freedom account for upkeep.
in my neighborhood, a similar property rents for $1300.
Kelley left out the most critical piece of information: the interest rate on her mortgage.
If you have a 5% mortgage, paying it down early is a risk-free, guaranteed, tax-free 5% return on the money.
The major question to ask is, do you think you can get a better deal anywhere else?
Are your Roth IRAs a better deal? Depends on what they’re invested in. Depends on how well it performs. Depends on your risk tolerence.
I like to look at diminishing returns. For example:
If I pay an extra $50 on my $290 student loan payment, it will be paid off in 17 years instead of 25 (cutting off 8 years of payments!)
If I pay an extra $100 per month, I’ll be paid off 11 years faster (14 instead of 25).
If I pay $200/month extra, the loan will be paid off in 10 years instead of 25.
If I pay double ($290 extra), I’ll be paid off in 8 years.
And if I paid $1000/month total, I’d be paid off in 4 years.
To me these numbers mean that paying an extra $50-100 each month (especially toward the beginning when I’m paying a lot of interest) gets me a lot of bang for my buck. Just $50 a month saves me 8 years, but the next $50 extra only cuts 3 more years, and the next $50 cuts less than 2 more years, etc.
So I pay an extra ~$100 each month and save the rest.
You can do the numbers for yourself and see the point at which it stops making sense to pay extra.
Mortgage, mortgage, mortgage. Then you’ll be in your 30s with a paid-for home. Imagine the financial freedom you’ll have!
As Dave Ramsey says “100% of forclosures had a mortgage”
Statistically, no one who owned their home outright ever was foreclosed on. That’s quite the safety net, your cash inflows can go down drastically, but your worries won’t be as bad if you no longer can afford an IRA, vs no longer affording your house! If your cash flow goes down before it’s paid off, you have a lot of equity, you can sell for the cash, or get a HELOC.
The couple doesn’t mention what they want to do in their 30s, but no mortgage means extra cash flow each month for perhaps a stay at home parent, perhaps the ability to start a new business, perhaps kick the retirement savings into high gear. They are saving for retirement, I would plug their retirement savings numbers into a calculator, with conservative %s and the earliest date they’d like to retire, and see if it is do-able. If not, maybe cut it so that 25% extra goes to investing, 75% of the mortgage.
And the answer to why pay off a house you may sell one day: if you SELL a house you OWN, you get to keep ALL the proceeds. If you don’t own your house and you sell it, you pay the bank first and get whatever’s left over. Who cares if they are planning to move? The proceeds from selling the current house can be used to pay down the mortgage on the new house.
My husband and I (28 and 30) are debating this very thing. We’ve decided to pay extra on our mortgage for one simple reason: we don’t have the discipline to keep our hands off our savings, but we DO have the discipline to leave our home equity untapped. That’s just us…
We paid off our mortgage in 9 years. We were putting the maximum that my husband’s employer allows us to contribute (7%). I have a Sep IRA because I have my own housecleaning business and I worked for 12 years for a school contributing to a 403B until I was laid off. Once the house was paid off, we bought a rental property and held it for 7 years. Two of our children got full academic scholarships, the rental property paid for one child’s college, and we are paying out of pocket for the 4th child. We bought one rental property in Florida last year that we pay extra on the mortgage,and we are closing in July on a 2nd property with two brothers as co-investors that will not have a mortgage. We need a smaller emergency fund because we have only one small mortgage on the rental property. During times when we don’t have a tenant we can always use the property in Florida for vacations. I say pay down the mortgage.
They don’t mention the loan to value ratio of the house. If they put 0% down, then by all means they should prepay the mortgage. They are likely already underwater. If they were responsible and put down 20%, then they have some equity in the house and should invest.
Also, they should consider making 1 extra payment per year. This frees up plenty of money to invest and will still cut off a significant amount of interest.
I have an interesting wrinkle on this…
What if you are either:
1 - Not planning on staying in your property till the end of the mortgage? I own a condo, which is great for a single 28 yr old. But not going to work in a few years if I’m married with children.
I mention this, because I understand the benefit of paying off a mortgage in 23 years instead of 30, if you are planning to be there the whole time. If you lose your job in year 24, you don’t have a mortgage payment.
2 - Planning on renting the property when you move out? I am considering this and would rather save/invest my money for possibly a down payment on another property.
In both cases, I feel that I am losing liquidity by prepaying my mortgage and not gaining much. But I’m willing to be convinced otherwise…
Being dual income, we pay a lot in taxes, so we max our 401K first. We have had our home for 10 years. If I had made the decision to pay mortgage faster, I think I would have been better off given the negative rate of return in the last decade.
I really don’t get the people who say they’re better off investing. Those assumptions are based on long term historical returns. They are talking about a 9 year time horizon here, which is much more volatile.
Market Investments aren’t tangible until you cash them out and buy something. In 2008, I would have been happier with a paid for roof over my head vs watching my brokerage account evaporate. That in itself made us funnel more cash towards the mortgage. (we always prepaid a little and it did add up fast)
My house doesn’t disappear and then come back again in 12 months..it’s there for me to live in the whole time.
If we’re talking about a scant 9 years to totally pay down the mortgage, that sounds like a smarter move. If Kelley’s family suddenly suffers from job loss or other financial crisis in 10 years, at least they won’t lose their home.
$400 per year or whatever the “cost” is sounds like a reasonable premium for “keep your home” insurance.
I think the best advice here is: don’t always listen to so-called experts or gurus. Some of that advice is just ridiculous - never own your home? Huh? The thing to remember is ALL of them are basing potential return on investments on past performance. I’m not so sure the stock market will even generate 6-7% annually going forward. Our system is deeply flawed, anyone can see that.
Truthfully, this is more about psychology than math. We’re going through the same thought process as Kelley right now. Do we take the guaranteed 5% by paying off our mortgage or take on a little more risk and try to beat that with stocks? It is a tough decision, I find myself going back and forth almost weekly.
I agree with #21 that it really depends on how you see the house - is this where you want to live forever? Do you have a lot of ties to the area? Will your occupations allow you to stay there? If you want kids in the future, is the house a good size for that and in a good neighborhood/school district?
It is hard to predict all of this at 25, but if you are pretty committed to the home, I think prepaying has nice benefits. If there’s a decent chance you’ll move in the next 20 years, I would invest. I don’t know what % of income you are saving for retirement right now, but I’d get that to at least 10% before doing anything else.
My suggestion is the same as the one from Dave Ramsey.
STOCKS IN THE LONG TERM OVER ANY 30 YEAR PERIOD IN THE PAST 200 YEARS HAS AVERAGED 11%.
Prepaying your mortgage early without retirement in mind will save you around 5.5%.
Keeping this in mind, I would say after you have maxed out your 401k and Roth contributions, any money still left over should be divided equally between prepaying mortgage and further investing.
This above suggestion is because you are still 25 years old. If you were say 50 years old I would say prepay mortgage.
But it all depends on how risk tolerant the investor is.
Why must this be an either/or question? Accelerate the mortgage payments to pay it off in 15 years. Use the other to increase retirement savings. Or maybe you pay off the house in 20. Work it out.
Also, the house isn’t as sure a thing as people might think. Career changes, children or a parent moving in with you could all make you need to change the housing situation. You are in your 20’s, life likely has some curve balls in store for you.
Also, do you have your life and disability insurance in order? It’s easy to get in your 20’s.
Ok I would say that you are really doing the same thing. Paying down your mortgage and investing are the same thing.
When you pay down your mortgage faster than the amortization period the only benefit you have is more equity in your home. You only realize that equity when you sell your home and that is not always guaranteed. As we have seen recently there is just as much risk in paying down your mortgage than investing in a similar type asset. Now you can improve your cash flow by refinancing your debt after you have built up your equity position to lower your monthly payment, but if you are just paying down your mortgage to pay it off it doesn’t have much added benefit than peace of mind to know when you sell you have some equity cushion. I would rather put my money in more liquid assets where I had more freedom of choice. What to do with your money seems to be the age old question, and alot of that depends on factors that are not uniform to every person. (Age, income, location, cash flow, etc.)
Do you know where to invest right now?
I don’t.
So I chose to pay off the house.
I’m an airline pilot. every 6 months, my job is in jeopardy, getting a medical exam which could ground me for the rest of my life.
It’s a huge piece of mind to know that this house would be paid off, and I have a place to live, even if I end up flipping burgers somewhere…
Granted, I have 12 months expenses in a emergency fund, and maxed a 401K. That’s what I do first, before anything else.
I go with the guaranteed.
investing is not much better than gambling in Vegas lately…
We were a duel income family, but my husband lost his job in June. He is eligible for unemployment, but let’s imagine that he is not able to find a job in 6 months and his benefits run out. At that point, my income will have to cover all of the bills we both paid with our incomes… including the mortgage. I will be able to do it, but I’m not sure if I can continue to fund retirement and emergency savings while doing so (I will try) — our budget will be very tight with NO room for extras. If our mortgage had been paid off, this would not be such a worry. Assuming he does get a job, I think we are both agreed that paying off the mortgage will a priority for us.
Personally I want to pay as little for my housing as possible so I can breathe easier and maybe enjoy life a bit more than if I’m sweating the $1200 mortgage payment every month.
If they can afford the normal mortgage and can max out the Roth IRAs I would max out the Roths. The markets are down right now so they are basically investing at a discount. The markets will rebound and the returns will be so much higher.
Saving for retirement is a race against time and with the power of compounding the sooner you get in the better.
I also agree with @Jason (31) in that they are young and there will be changes down the road
Once I’d maxed out my Roth type accounts (RRSP in Canada), I started both paying down the mortgage and investing. When I started paying the mortgage down, my rate was at almost 5% and now it’s at 2.9% (was at 2.6% for awhile) so it’s kind of dumb to keep overpaying on it but there’s almost nothing owing on it and I’m too lazy to change it.
I think it depends on the tax implications for Canadians at least since if you put money into RRSP’s when you’re at a higher income bracket, you save more money on tax - that’s a guaranteed ~20%+ return for most people. I’ve advised my 22 y.o. son to build up his RRSP contribution room and use it when he’s in a higher income bracket.
If the person has self-discipline - which it sounds like she does, they really don’t need the “mind over math” prescriptions that Orman gives.
You have caps on how much you can contribute to retirement annually - caps on your 401k, caps on your Roth, etc. Obviously the younger you begin contributing the more money you’ll have contributed and more it will have grown by the time you reach retirement. Sure having the flexibility of no mortgage would be nice, but you don’t want to get too late of a start on saving for retirement because you can’t go back and play catch-up due to these annual caps.
First pay off all other debts, get an adequate emerg. fund, get your company match on 401k (you’ve done all these), contribute to your Roth whatever amount brings you up to 12% total retirement savings (this includes your 401k totals) and then prepay your mortgage.
My goal wouldn’t be to pay off the mortgage ASAP, but to have it paid off before I retire. Of course I bought my home at age 36. If I bought my home in my 20s I’d be shooting for having it paid off by age 50, 55 at the latest. I think planning on paying your house off in 25 years or less is a very attainable goal and still give one the flexibility to save for retirement and other needs.
Thinking about all the almost-retirees lately who lost 60% or so of what they invested and are now being foreclosed on, I would tell her pay the mortgage first.
People tend to think of their own situation more optimistically than they think of the economy as a whole. Everyone thinks they will come out ahead investing. If you pay off the mortgage, you have a place to live in and/or rent out when times get tough. If you invest everything, the market crashes and you have 15 more years of mortgage payments left, times will not be so good for you. What’s so bad about Depression era thinking anyway?
@Raghu: Whether Dave Ramsey says that or not, it’s absolutely false.
Just in the US, the 30-year periods ending on Dec 31 of 1957-1960, 1966, 1974, 1975, 1977-1995, 2002, and 2008 all had compounded annual returns of less than 11%. (And that’s before accounting for inflation or any investment costs.)
UTILIZE THE TIME VALUE OF MONEY
Why not do things the easy way, and utilize the time value of money?
Why use present-value dollars to pay off your present-value debt? Once you have a mortgage locked in, the relative value of that loan will continuously drop.
As a real estate investor, I want a situation where I put in a little effort and get a big payback. Let inflation work for you. After 10 to 20 years of owning a house, the value of the dollar goes down as the value of your house goes up.
Think back to when you were younger, and how much more you could buy for a dollar than you can now. Remember 5-cent packages of chewing gum, gasoline for 15 cents a gallon, a steak dinner for 30 cents? I don’t either, but many people say that’s the way it was, so it probably is true.
The point is, the easiest way to pay your mortgage with is to just wait a few years and pay with future dollars, which will be worth a fraction of today’s dollars.
APPRECIATED EQUITY
An even more efficient way is to use appreciated equity to pay off a mortgage. In other words, buy an extra house, rent it out for several years, and finally refinance or sell it. Then use the equity from your second house to pay off the mortgage on the first house.
For example, if you put an extra $200 a month into the principal of your house, how long will it take to pay off the loan?
Answer: A lot longer than selling an appreciated property and using the cash to retire debt.
I don’t know enough about your situation from what you’ve said, but here are the factors that affected our decisions:
– mobility: If you see yourself in the house for the long-term, then prepaying makes sense. If you see yourself selling it, moving on, and starting another mortgage elsewhere before the house is paid off, it makes less sense.
We’ve lived in 8 places in 17 years.
We prepaid for a while on one house, until we decided it wasn’t our “forever” house.
– retirement plans: If you see yourself getting a pension or having some other form of steady income after age 65 or so, then slow down savings. If you expect to be living off of retirement savings, put everything in there you can, especially in your 20s and 30s.
No pensions here. We max out every retirement savings vehicle we can use.
– timeframe: You’re quite young — if you’re planning to be in the house a long time, you have enough savings, and the mortgage is a big part of your monthly budget, by all means, pay it off. It will free up a lot of your monthly budget for a while to come.
We’re in our 40s, and know the area but probably don’t own the house we’ll need in 2 years or so. Maybe we’ll prepay that mortgage? Also, the mortgage is about 1/2 of our housing cost (insurance + property taxes + utilities for the rest), so it isn’t a big a deal for us as you’d think.
– refinance instead? You’ve already bought your house, but you could also save a chunk of money and refinance your house for a smaller mortgage, which might reduce your interest rate and the size of your mortgage payment going forward. You could also choose a very short term, like 10 years instead of the 30.
We sort of prepaid our mortgages on #2 and #3 by putting down a 45% and 40% down-payment on those properties. That’s why the mortgage is only 1/2 of our housing cost.
Seriously, if you are 25 and can do it, max out the Roth.
Before reading any of the other comments, I’ll put down my initial thoughts:
I help people answer this question every single day…and it all comes down to “location, location, location”…of your money. The 3 tests for any investing decision ae SAFETY, LIQUIDITY, and RATE OF RETURN.
Kelley and her husband are doing awesome!! But…I know there’s always a “but”, the biggest glaring hole I immediately see is NO money going into a LIQUID investment? Putting all your money into retirement or prepaying the mortgage leaves you high and dry when big life events happen. And we all know LIFE HAPPENS. 6 months of living expenses is a start, and that’s great. But where’s the college fund? What if you decide, at age 40, to buy a vacation home? What if you lose a job and it takes 1+ years to find another? Here’s my formula I teach:
1. Cash-Cushion (first money goes here - they have this)
2. Eliminate consumer debt (we coach families on debt-repayment plans)
3. Build liquidity - invest, whether it’s stocks, bonds, CD’s…just build those accounts that will be readily available for you between 25-65.
4. Pay off your house.
I know emotion plays a big role, and if you can do all of these at the same time, terrific! But when your income goes away, and you’ve plopped $100,000 inside of your house to pay it down…but it’s just not quite completely paid off…you STILL have a payment to make, and now you cannot qualify to get that money back out of your house to feed the family, pay for car insurance, still take the family trip you’d been planning for 8 months, etc. etc.
My 2 cents…but you guys are doing awesome at 25. Congrats!
I like your idea of splitting it, but I would put at least half the maximum on the IRAs, possibly more. 3,000 out of 4,000 for instance, and extra payments for the rest.
You might focus on the fact you’ll have to pay more interest on your mortgage if you wait longer, and that’s true, but don’t forget that when you’ve completely paid off your mortgage and freed your cash flow, your IRAs will still be capped. You won’t be able to put more than the maximum every year.
You have a bit more freedom with your mortgage, you can make extra payments as big as you want, as often as you want. You don’t have to make an extra payment every month, but if you don’t know, you can always make bigger payments later, without an upper limit.
So I would keep slitting it up between the two, but focus more on the IRAs. Unless you pay an insane amount of interest on your mortgage, that is.
Because I bought my home in my later years (45), and it is a 30 year mortgage, I plan to make extra mortgage payments. I am on a bi-weekly schedule to begin with, so that will cut my 30 year mortgage by some. But I would like to cut it even more. I think I may be a part of the depression mentality. I cannot stand having debt. It kills me to think I have debt - even if it’s “just” my mortgage. I hate owing anybody. But that’s just me.
I agree with “Kelley left out the most critical piece of information: the interest rate on her mortgage.” Also important is how much time left before retirement, and how much is already in the retirement accounts– are they on track to retire comfortably at this point.
A 401(k) or Roth is only going to be getting low interest rates for a portion of the time that it is invested. It will be tax-advantaged forever over all of its earnings, which will be higher some years and lower others. Eventually the house will be paid off no matter what, but those additional payments will not be doing as well in terms of tax advantage when they come closer to retirement.
In the future as you earn more you may also not be eligible for the ROTH which will lose you the advantage of that type of tax benefit (since the regular IRA helps your taxes this year and the ROTH IRA helps your taxes when you draw down).
I tend to think: take advantage of tax-advantaged accounts before pre-paying your mortgage, UNLESS your mortgage rate is more than ~7% or adjustable-rate. (Though in that case– fix your credit and refinance!) Also, if you don’t like the options in your 401(k) at work, then go for the mortgage before any additional contributions after the match.
Assuming that the couple in the example has a fixed rate 5.5% mortgage…
I would say: Keep up with the employer match. Then max out the IRA ROTHs. Then you can either pay down your house or max out the 401(k), whichever makes you happiest (slight leaning towards the 401k if you don’t care, leaning towards the house if you need more motivation to save).
Doing this will max your returns with the employer match. Will provide additional tax diversification in retirement with the ROTH. And will provide additional savings or satisfaction if there’s any money left over after that.
@25, 26 Except in Texas where some foreclosures just had poorly cut lawns or forgot to pay their HOA dues. @#$# HOA.
@35 A better number to use would be 7%. There’s a big difference between averaging over any set period a person is likely to have to invest and averaging over the lowest point of the stock market period to the highest or from the entire time the stock market has been around, a time before they understood Black Scholes or had the kind of communication needed for efficient markets. There is A period of time where the market averaged 12% but 7% is a much better future prognosis. If believing in the 12% makes you more likely to invest at all, go for it, but don’t plan your life around 12% returns. And don’t think that 6% returns are half of what his tables show with 12%… compound interest doesn’t work that way, even if he’s “half wrong.”
I’m leaning towards a combo but because they are SO young, I’d lean the heavier percentage towards retirement (maybe 80/20, 70/30). They have a really good chance at making some good returns there. I think it’s admirable to pay your mortgage in nine years instead of 30 but 15 is also incredible and socking money away for retirement from so young is excellent.
And whenever you need a psychological boost, take a look at your 401k or IRA balance. That always makes me feel better (honestly).
@Bev(#10) - careful not to judge too broadly. Life is about cash-flow. So, everyone choosing to pre-pay their mortgage (I’m an “it depends” person so you know)…assume you’re on pace to pay that 30-year loan off in 15 years. The calculators show you the hundreds of thousands you will save by doing so. Now, what happens if in 10 years, you lose your job? You have tons of home equity, but you’re 5 years from paying that mortgage off…and by the way, your mortgage payment hasn’t changed one bit as you pay extra (assuming a normal principal and interest loan). My point here is LIFE WILL HAPPEN, and unfortunately the ONLY save place to be is with NO mortgage at all, or all your money somewhere liquid and save. Until then, you’re kind of stuck in the middle. With this recent economic downturn, I talk to families all the time who “did everything right”. They put 20% or more down when they bought a house; they fill up their 401(k); they had 6 months of reserves…but we’ve learned that sometimes this isn’t enough. Fortunately the families with enough money in the bank were able to survive until the income was replaced. Yes, the freedom of no mortgage is HUGE! But many foreclosure victims were smart, responsible people who tried doing everything right.
It was easy for us to decide to pay off our mortgage (and it did help that we had excellent employer- matched retirement growing nicely) partly because we had not gone for “all the house you can afford.” We bought a house with all we needed, but we didn’t buy something that was new or huge, so were able to put 20% down to begin with and go from there. We had rented for seven years and knew we were not going to move soon (or ever!) and bought a house we were confident we would be happy to live in for a long long time. We did significant remodeling — mostly after the house was paid off and we had saved up for the work we wanted done, which has kept up the value of the house.
We’ve been thinking about maybe going into a condo situation when we are older; having fully paid off the house years ago we’ve been able to save a lot and combined with selling this house (even in this market) we expect to have enough to buy a condo outright if that’s what we decide.
I believe this couple should work out their goals before inputting this money into either their retirement or morgage. If they fully fund their retirement for the next 10 years it is likely that they will input too much money into their tax defered retirement fund which they cannot access until they are 60. I they are looking to retire before 60 they would likely be better off investing that money into their morgage and keep it out of those accounts. Either way they are in good shape. At 29 I have put a chunk into retirement savings knowing that I will likely be strapped for cash later with a larger house payment and kids. They may want to consider setting a goal these items.
I see a lot of people saying that if this is a long term house pay the mortgage. Why should that factor in? The only factor (besides the rates) that should effect the decision is your likelihood of foreclosure. If you can sell the house the equity will be returned to you.
If this was a “starter home”. When you sell and buy a new one you can put more down on the next home. Unless I’m not seeing something. Now refinancing is a different story.
I’ve always wondered. If you have maxed out the tax advantaged retirement accounts but your mortgage is low (<5.5%) and you are young, is it still better (math wise) to invest in a taxable account?
Fascinating discussion as always, and great comments from everyone on here. Love it.
I remember 3 years ago when you brought this up too.
2 quick thoughts before taking the kids to school:
1. Remember to focus on the “NET” cost of borrowing those mortgage dollars. If you are itemizing your deductions and writing that interest off on your taxes each year, a 5% mortgage is not really costing you 5%. That also means when you pre-pay it, you are not really saving 5%. Depending on your tax bracket, a 5% mortgage is really costing you around 3.5%. THIS is what you’re saving when you send an extra $100 into Wells Fargo or whoever. So, mathematically, can you bet 3.5% by investing long-term? Umm, probably.
2. Emotional financial decisions often ruin us all in the long-run. Emotionally we hate having a big mortgage and payment. But before attacking it crazily and paying it down, do what a few others have mentioned too (#36 Jason)…is your family and income protected with appropriate insurance? Are you fully funding your future? Have you figured out how to pay for college for the kids (if you choose to), do you have your “buckets” of savings for short and mid-term goals like vacations, remodeling the house, etc.? These are all realities throughout our lives…and I’ve seen too many families spend every last penny to pay down their mortgage and lose sight of all these other goals and dreams.
Off to school! Check back on this later! Way to get everyone engaged J.D.
oops… got cut-off before …
That 12% number is also the “nominal” return… which includes periods of high inflation, which I hope we will never see again if the Fed is doing its job.
@45 Thanks for looking that up. I’m fairly sure Ramsey doesn’t claim that any 30 year period has that kind of returns. Elizabeth Warren also uses that number in her book, and she should know better. I think it’s used to encourage people to do what they should be doing but aren’t doing for irrational reasons. Adding an additional 5% return makes it look like anybody can become a multi-millionaire… when in reality they’ll probably be just getting the million or so they actually need to live comfortably, which is much better off than they would be if they hadn’t had the kool-aid.
I think it matters a lot whether you want to stay in the home or plan to move soon.
We plan to move in the next 2 years to another home and so will need the cash as a downpayment. If we invest, 2 years is too short a time given market volatility. So, we have chosen to prepay 50% more than the minimum required each month. In 2 years time, we will have a lower mortgage loan balance and more equity in the home to move into the new house.
As someone in my 30s who is also thinking of pre-payment, I appreciate this discussion. I especially like what Trevor has to say about liquidity. We have no debt except for our mortgage - approx. 125,000 at 6.5%. Our emergency fund is good but of course could be better. We pay up to the 401K match and contribute to one Roth (but do not max it out). We have two old cars and enough of a car fund to pay cash for one but not two. We have two young children. Earlier this week we had discussed refinancing but had decided to prepay instead, since we might only be in the home for 4-5 more years. But this discussion leads me to think we should keep the money liquid instead. If life continues to be good and my husband employed, we can always use that money as a down payment in addition to our equity on our next (hopefully forever home). That would position us to actually prepay our second home well before retirement.
And if health problems or unemployment strike, we have more of a cushion.
Great discussion!
Personally I’m a fan of pay off the mortgage quickly AND max out Roths. In this case, we don’t know how much they make or what their spending is like — only that they “can’t do both”.
But I think they’re overlooking something. What are the chances that a couple in their 20’s will never get a single raise or better job over a 9 year period?
Pretty slim, I’d imagine. So if it were me I’d work on bringing in more money and reducing expenses in order to reach both goals.
maxing out my roth ira is one of my top financial priorities each year. once the year is gone, you don’t get another chance to put that money in again and it grows tax free.
Invest it. Because of inflation over 30 years, mortgage rates are even lower than what you pay in real terms. Its complex math, but you will really lose out big over the 30 year life of a typical mortgage by prepaying. Most interest is going to paid early in the loan, the later years after the principal is reduced you pay less interest. Investing of course, works exactly the opposite. The earlier you start the more you make over the long run. By paying down the mortgage first and investing later, its a double whammy of inefficiency. Not only that, but the value of your home will most likely increase over time, and inflation will cause the savings you will receive in 10 years to be worth less.
Money now is always worth more than a similar amount of money in the future. Doubling your mortgage payment now so you wont have a mortgage payment 10 years from now makes no sesnse at all.
Don’t forget circumstances like if someone is below 80% on their mortgage LTV ratio (gasp! paying less than a 20% down payment?). Then prepaying will help get rid of that PMI premium.
But generally yes, if you can invest in a Roth IRA, then the tax code is pushing you toward that option. Since your interest there will be tax free, while the loan interest is tax deductible.
Wouldn’t the recent lessons in the housing bubble burst show that paying off the house could be incredibly risky?
I know lots of young families that bought a house in the last 5 years that cost $$$$ because the prices were so inflated everywhere in the market. Most of them put down a large down payment.
But now that (at least in Florida) houses have dropped a ton in value - didn’t they just pretty much throw all that money out the window because they now could not ever sell their house for the inflated price of the market at the time they had to buy?
We bought our house when the market was just starting to go down, but was still able to get a loan with a small down payment. Even though we went to a smaller town outside the city limits to cut the average price of a house in half, after 3 years the economy still has us upside down on our loan over $50k. And several of our friends in town are now down over $100k.
I know that there is nothing they can do about it right now - but lets say they HAD paid off their mortgages as fast as they could. Wouldn’t they have just thrown out all that money due to the crazy drop in home prices?
I think they should max out retirement funds first and build up a bigger EF. And what are the odds that someone is going to stay in their starter home forever? For me, I want to be mortgage-free in 8 years (retirement date) plus I already max out Roth and 401(k) savings and have a large EF. Not having to pay a mortgage during retirement is a good ideea for anyone as long as they plan on staying in that home.
I disagree with the conclusion to a certain extent. I pay an extra principal payment-about $350-a month on my mortgage. If I didnt I would most likely spend the $$ on stuff, not necessarily save or invest it. Its “pocket money”. It makes more sense to me to pay off the mortgage and certainly beats throwing the $$ away on shopping. Im already maxed out on everything else and have no debt.
I say that you’ll feel more empowered if you pay down the mortgage.
If stock prices fell to one-half where they are today, I would take it the other way.
Rob
I’ve been luck with my house! I decided to pay it off early and the stock market has done horrible during the time period, so I think I made out.
Now that the stock market is low (no longer overpriced, I hope), and the interest rates on mortgages are low, I don’t think I’d be as quick to pay off my home mortgage first. In fact, I’m contantly trying to stop myself from buying a bigger house (my family doesn’t want to me, just me…)!
I think (I hope) over the last few years, we’ve all learned that it’s a lot wiser to think of our homes as a place to live, than it is to think of them as an investment. Given that, I’d far rather secure the place I live before I invest in the future. So would I pay off my mortgage first? You can bet on it. With that off my plate, I’d feel like I had nothing but freedom, endless horizon to run into. Well, that, and safe high yield investments are hard to come by these days… and having a free place to live? That’s pretty darn safe.
But that’s psychological. And I think, in the end, when you’re talking about something as personal as a home, that’s probably the best way to make the decision. If you go with your gut, you’re far less likely to second guess yourself later.
I’m also in my early twenties, and while I don’t have a mortgage, I contribute to my Roth as feverishly as possible. I work in financial planning for a fee only firm and have a good understanding of the tax benefits of both mortgage interest and tax-sheltered retirement accounts.
Trust me, max the Roth first.
Like others have mentioned, if you don’t use the Roth contribution in a year, it’s gone forever. The extra cash flows after the mortgage is paid off may not have the opportunity for that kind of beneficial tax treatment.
What others should be emphasizing here is that should some sort of emergency occur you can withdraw contributions made to the Roth to cover expenses (like a mortgage payment) without penalty. In this scenario, you get the advantage of higher returns (in your twenties, you can tolerate an aggressive retirement portfolio) as well as a safety net in case things don’t go as planned. This only works with the Roth, so to me it’s a no brainer.
PAY THE MORTGAGE FIRST. We inherited a chunk of money when Husband’s mom died, and debated whether to pay off the house or invest that money in the stock market. We did put a little into the market…but we paid off the house first.
Then the market crashed, and we lost a good-sized chunk of the original money. Not only that, but Husband’s job was threatened, and we had less income coming in. Having no mortgage to pay made all the difference in the world.
What if the market crashes again? (There is some precedent for this happening.) What will you say to yourself when you have to keep making the mortgage payment then? The tax benefit just does not offset that security. I’m betting there are plenty of financial ‘experts’ that are STILL making mortgage payments, because they took their own advice. (Added benefit: your house value is not counted when you fill out FAFSA forms for college financial aid.)
PAY OFF YOUR HOME! PAY OFF YOUR HOME!! If you don’t, then housing will continue to be your biggest expense *for the rest of your life*. As soon as your mortgage is paid off, you will have a huge monthly surplus in your budget. You can funnel part of that into retirement savings to make up for lost time.
If you put it all into retirement savings, you won’t benefit until you’re old enough to withdraw. If you pay off your house, you’ll benefit from extra income immediately, and also during retirement.
Makes sense to me.
(NB: I guess if they’re not planning to stay in this house it’s a *slightly* different story, but then again maybe not.)
Everyday tips @20 said ‘Being entirely debt free so young would be incredibly liberating.”
I paid off the mortgage one month after my 64th birthday. Was already otherwise debt-free and still putting 25% into a 401(k).
It’s ‘incredibly liberating’ at ANY age.
When I bought my house at age 45, taking over a 30-loan with 26 years left, simple math said I would be 71 when I paid it off and, even though it was a low payment, I didn’t want it to extend into my retirement, so paying off the house was a priority, along with keeping up the retirement account (40% until my hours and pay were cut about a year ago).
Age is a major factor and maybe I would have thought differently had I been 20 years younger when I bought the house.
It’s all an individual thing, taking into account age, attitude toward money and risk and what you feel is most important.
In the end, I’ll go along with Jason Beck @18 who said ‘It’s more about mind than math.’
It’s not rocket science. Just run the numbers. What return does $1000 invested give you versus $1000 payment into your mortgage? Don’t forget to include risk and liquidity factors in that and tax implications too. Once you do that, answer should be pretty clear.
I’m doing the same thing right now with paying down student loans versus investing. I did the math and it turned out that paying down the loans was a much better idea. However, that might change in the future if investment yields go back up and risk goes down a bit.
A couple of points that I haven’t read yet:
1. What if someone owned their house “free and clear”, but they have the opportunity to take out an investment loan at 5% (deductible) interest, on the promise that maybe you can earn an 8-10% average on the investment? Would you advise them to do it? That’s a risky form of arbitrage, don’t you think?
2. What’s the first thing you read when you look at any investment opportunity? “Past performance is not indicative of future results”. Mutual fund guy doesn’t mention that, they primarily look at the 30 year period when the baby boomers were kings and 401k’s were invented and tell you that’s how it will always be.
3. Is it fair to question the motives of people who work in the investment industry (mutual funds, 401k planners, etc.) as to why they would advise dumping more money into your 401k (where they profit while you have very little idea what companies are being invested and you have zero say in how those companies operate) rather than paying off your mortgage early?
4. No offense to #64 Brenton above, but do you really want to base your decision on “complex math” that you don’t really understand?
5. What would the millionaire next door do (WWTMNDD)? Yes they own blue chip stocks but they don’t trade (i.e. no brokerage or other investment management fees), they have smaller mortgages, and their wealth tends to be focused in areas where they have control.
PS - I’m not saying investing in stocks is bad, I’m just saying it’s riskier, especially when leveraged on debt.
The trick is that no one knows what the stock market is going to do next. Over the last 15 years it has lost money. I, most inconveniently, started investing in mutual funds through my 401K during just that period of time. The only people who have made any money on my 401K were the people who sold it to me. Read ‘Liar’s Poker’ and pay close attention to the way investors are regarded.
If you look at guaranteed returns (to the extent that ANY return is really “guaranteed”) you will find rates lower than those you are paying on your mortgage. So if it’s a choice between investing in something safe and paying off your mortgage, pay off the mortgage.
Also, if it’s a choice between investing in something risky and paying off your mortgage, pay off the mortgage. Because there’s a reason it’s called “risky” - and if you still don’t own the place you live in, you can’t afford to take that kind of risk.
We live in a totally different world than the one where “the stock market will consistently return 10% and your house will always increase in value.” Sure, an IRA grows tax-free, but that’s assuming it grows! You are probably better off paying your taxes now, because rates are certain to go up. Don’t ignore what the government is doing just because it’s depressing.
The last thing I would advise these people do is pour a whole bunch of money into Wall Streets schemes in the name of saving for “retirement.” These young people should pay off their home and enjoy some financial freedom, and stop fretting about their old age.
We could easily see the Dow plunge to below 5,000 - in fact, I think it is likely. But if you get yourself completely out of debt, you can weather any storm.
I feel very strongly about this. It is no accident that 4 out of 5 of the personal finance writers you cited recommend paying off the mortage ASAP. My husband and I have low mortgage rate of under 5% and we are within 10 -15 years of retirement (I’m younger). There is NO place in the stock market, bond market, or elsewhere that I can now make a guaranteed 7% average return, which would be roughly 5% return after taxes are paid, to gain me the guaranteed savings that paying off the mortgage does. Look at market returns over the past 15 years and the predictions for our country’s lack of growth. When are we going to get better than 7% guaranteed return. Plus, with the mortagage paid off, we will be free of monthly mortage payments and therefore have tremendous flexibility to take a part-time job(s) rather than a full time job(s). While it isn’t optimum, we can always borrow against the home equity or take a reverse mortgage in an emergency situation. Perhaps an entrepreneur who wants to pour money into a lucrative business does not want to tie up his or her money in a house, but for the average person, particularly older generations, paying off the mortgage is the best way to go, I think.
This is quite a great debate. I used to think that paying off a mortgage was good use of money. I have since changed my mind for some of the same reasons out lined in the previous comments. Mostly, you do not have use of the money. It is “locked” into your home.
One thing that is not mentioned here, is the cost of home ownership without a mortgage. Real estate taxes in New Jersey, where my home is located is extremely high. My real estate tax is over 8K per year. That is cheap compared to friends who are paying 14 - 15,000 a year in real estate taxes.
This means even if the mortgage is paid off, monthly RE tax obligation can be $1250/month, if RE tax is 15k/year.
After we have an emergency fund, this is exactly our question. I know what I want to do, which is to apply additional money towards paying off house versus putting more into retirement. My concern: our first child will be ready for college in 10-11 years. How does college financial aid calculate savings in home equity versus savings for retirement(401)? If I have a fully or mostly paid off home will I be penalized for this?
Here’s Walter Updegrave on tax diversification:
http://money.cnn.com/2004/03/25/retirement/investing_taxes_0404/index.htm (the limits may be out of date, but the general information is still right).
I’m surprised I’m not seeing more posts on it.
The Roth is a wonderful deal because you don’t pay taxes when you withdraw the earnings. Unless tax law changes (and it might) there are income limits on whether or not you can contribute to a ROTH (except this year when you can convert a regular IRA to a Roth). So it is likely that a young couple will not have this form of tax diversification available anymore once the house is paid off because their incomes will have exceeded the limit.
Most 401(K) plans decrease your taxes this year, but you still have to pay taxes on the earnings. Traditional IRAs are the same way. If (dividend and capital gains) taxes go way up in the future (and they may), you will lose a lot by not having taken advantage of the Roth for your long-term retirement savings.
That’s why I would choose a Roth over mortgage prepayment (unless the mortgage rate is really high). (But still after the employer match– a guaranteed 50-100% return can’t be beat.)
Maybe someone suggested this, but I don’t have time to read all the comments.
Have you run the numbers to figure out how much you need for retirement? Google “ballpark estimator” and plug in the numbers. It’s a very good online calculator that will tell you the % of income you need to set aside for retirement.
Once you have the final number, then play around with other online calculators to figure out how much will have saved in 9 years if you a) payoff your mortgage and b) you invest more in your retirement.
Taking those two amounts, figure out if after paying off your mortgage you can still save enough for retirement by applying what you pay for your mortgage to your retirement. You should take into account if you’ll have children by then, etc.
Or, if you get a tax refund because of the mortgage interest, you could apply the tax refund to your mortgage and put your monthly savings towards retirement.
Is it wrong to be happy that this post does not really apply to me? Now, instead of reading it today, I can concentrate on the World Cup!
If I were fortunate enough to be in your position, I would pay off my mortgage in 9 years, continuing to put $1000 in retirement each year. Then I would throw a big fat party when my mortgage was paid off.
I think that doing what feels right to you is the best decision. We all know that “rational” economic decisions are only made in text books.
What if you invest that extra $X per month in a Roth IRA, and ten years later another recession comes and you A. Lose your job and B. Your investment values decrease by a large percentage. Are you going to end up losing your house if you can’t make the house payments anymore? Can you cash in your investments (at the worst possible time) and pay off the house?
As another commenter said, a bird in the hand is worth two in the bush. I chose to be a homeowner rather than a renter for the security that having a home brings, and it’s 99% more secure if I own it outright and the bank cannot take it from me if I fall on hard times.
@Diane your tax obligation is there whether you have a mortgage to pay off or not. And I imagine the mortgage is a much larger chunk of change.
@Jen that is a very good idea, and also a matter of being secure (rather than maximizing income). I care about money to make me safe and healthy, not to make me rich. Or maybe I should say, to me, being rich means not having to worry about ending up without a house or without health insurance, probably because I grew up in a family that had a very hard time financially after my father was laid off, and I’m acutely aware that you can go from safe and sound to stressed and uninsured in a very short time. I will do that retirement calculation, thanks for the advice!
We share your interest in paying off the house early. We paid off our house in 9 years. We did it by putting most of our salary increases, bonuses, windfalls toward the mortgage. From the beginning we set up automatic monthly principal payments ($40 then),and it was an easy thing to adjust as our incomes rose. Only the last two years we were able to be as focused as you are now. (no car payments, no major house repairs, emergency fund in place.)
I would consider adding more to your baseline retirement savings up front,and especially if children are part of your plans. We maxed out our 401ks during the payoff period. I never got that instant thrill from funding extra to our retirement savings, but at 40 I’m feeling more secure having solid retirement savings habits. Having the house paid off is a savings bonus.
If extra money comes in, it’s very satisfying to add the extra money to the mortgage and see the change in the amortization charts. “Honey, we just saved ourselves another month of payments and all that interest.” Make the most of your amortization charts and reward yourself at the big milestones. I became a big geek about these things. “Yay! We’re paying more on principal than interest!” was one of my favorites.
Pay off the mortgage.
Ten years ago we decided that was our goal. Six years ago we accomplished it. I can’t say I have ever thought over the last six years…”gosh I wish I had a mortgage to pay this month”
My husband is self employed and it give you a huge amount of cushion if the economy goes down, as long as you keep your lifestyle the same as if you still had the mortgage.
Diversify, diversify, diversify. Especially at that age (I’m also in the same age bracket as Kelley).
‘Investing’ in your mortgage should be a component of your portfolio, like anything else. It should not be your ENTIRE portfolio. It’s an asset class (real estate). Your savings accounts are an asset class (cash). Your stocks and bonds are asset classes. Diversification is the key. Nicole @82 mentioned tax diversification as well, which I think is a great point too.
Kelley will only know what the ‘right’ answer was in retrospect. We don’t know what the housing market, the stock market, tax rates, or inflation will be over the next 40 years. The only safe path is diversification. Do a little bit of everything. Rebalance regularly, INCLUDING your mortgage prepayment.
There are several issues that appear to be missing here:
1) What interest rate are you paying?
2) You need to calculate the effective interest rate on the loan by adjusting it for tax consequences.
Mortgage interest is tax-deductible, but only if you itemize. So are you itemizing deductions? How much difference is there between the standard deduction and your itemized deductions. If it is less than the interest you paid, then that is the actual amount of interest that is deductible.
What is your marginal tax rate? What will it be in the future? If you have a 20 years left on your mortgage, you need to consider how much you will save in taxes over the remaining life of the mortgage.
3) What are the current returns on alternatives for investment? What will be the return on alternatives in the future? Again, if you have a 20 years left on your mortgage, you need to consider how much you would make with that money invested over the next 20 years.
4) Those first three things tell you whether you come out ahead financially in the short run. If the effective interest rate on your mortgage is 5%, then there are no alternatives right now that will guarantee you that return. But once you have made that payment, you can’t take it back. Even if inflation pushes interest rates skyhigh.
5) There is one other issue with IRA’s. You are limited to an annual contribution. You can’t make up in the future for contributions you fail to make now. With a Roth IRA, your earnings are tax-exempt, unlike the traditional IRA where they are only deferred. So if you put $5000 into your Roth IRA you will never have to pay money on the earnings. By contrast, you will have to pay taxes on whatever you save in interest from paying off your home.
In addition, unlike the money you use to pay off your mortgage, the principal in a Roth IRA is available to you with no penalties at any time (although not the earnings) for any purpose. You can even use it to pay off that mortgage in the future if your circumstances change.
I think the emotional security having paid for a home is largely a function of ignorance. You may feel more secure, but you really aren’t. Paying off an established low-interest mortgage on which all your fees have been paid doesn’t make sense unless you are certain you will never need that money for any other purpose. Because if you do, getting it will likely be a lot more expensive.
It depends on the variability of future cash flows, i.e. I think this really boils down to the likelihood of continued future employment. e.g., if you’re a GM Auto Worker I would definitely pay off my house because there may not be a job in the future to contribute to a IRA. But if I work at the Pentagon I would definitely take the long range view. It all depends on your personal set of circumstances.
Man I sure wish I was in this enviable position — and at such a young age –25? I wasn’t even thinking about this type of thing then. Most of the commenters before me are soooo lucky and I hope they know it!!
One thing I always wish when reading all these posts is actual income figures and histories were given more often by the contributers…I often get the feeling that everyone is married and has had a two income stable situation from the day they stepped out of college.
Well back to my debt snowball and fixing my credit score.
I used the mortgage calculator and it said I would be better off pre-paying. I think it also matters how soon you are pre-paying the mortgage. The more you can pay earlier on the mortgage, the more you save over the life of the loan (beauty of compounding).
I wouldn’t be pre-paying the mortgage if my budget were tight or if I couldn’t save for home repairs. We’re also saving about 15% towards retirement (6% 401(k), 4% 401(k) match, 3% company cash value pension contribution, $1,200 Roth). Plus, we will be getting maybe a couple hundred dollars a year in tax deductions from the home, if that, and I don’t think I could beat a 4.75% rate on the market right now. Diversification is the key, and to me, pre-paying a mortgage is like another diversified savings account.
I am one of those people who did a consolidation mortgage and actually made the same payment I had been making on the other debts and paid them all off in 2 years and 10 months. It may be emotional but the ability to make investments since has been unbelievable. It gives you options. I enjoy living much more without the debt. I made rental home purchases and have one paid off and one with a mortgage I am escalating the payments on. We have both a 401K and a 457 and an IRA and Roth IRA. All funded to the max each year. We could retire right now on more than 10K per year. All because we eliminated a $485 a month mortgage in the 90’s. I say pay off the mortgage and have options. I know it can be done. It is not easy and those were lean years. But well worth it in the long run.
For my husband and I, we think paying off our house the sooner is the better. We know that our friends do not have the same priorities, but to us, not having a mortgage payment is a freedom that is PRICELESS. I think that Kelley & her husband have a great game plan. They are not ignoring retirement, they are still contributing. They could use a little extra money (like tax returns and gift money) towards retirement if they like, but I think by paying off their house in 9 years, they’ll have every opportunity to invest and spend their money how they like in 9 years. That is very fast, on a 30 year mortgage.
It does sound like her husband is a little bit more excited about this plan than she is and I understand that… but I think they are already ahead of the game by having no non-mortgage debt and by having solid foundations for their savings and retirement savings. I agree with Suze O. that you LIVE in your house not in stock certificates or retirement plans.
Amen Courtney (#88)…well said!
- Asset diversification
- Tax diversification
- Time diversification
3 critical areas to minimize risk and maximize overall financial safety.
I thought about this one for a long time. 8 years ago we bought our first house. 3 months ago, we paid it off. I am big into investing and decided the peace of mind of having zero debt outweighed the thought of earning a little more percentage on my investments. Depends on the person.
Lura - I hear you! I was thinking the same thing.
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I’m not gonna read all the comments since this is an “ask the readers” and we’re all chiming in kind of blindly with our advice rather than trying to build on what previous comments say, and that’s okay.
For people this young, I would actually advise going with the husband’s desires and paying off the house.
BECAUSE: They will both probably earn more in later years. Without a house payment, they will be able to save massive amounts for retirement - if they stay in the house. And even if they don’t, they will have a large amount of equity to roll into a new residence later.
ALSO BECAUSE: it’s a guaranteed return on their money, whereas over nine years, they are not likely to earn anything like the average mortgage’s interest rate anywhere else.
ALSO BECAUSE: if one of them stops working in the next decade to raise kids, they have no house payment and their income requirements will be much lower, making the income reduction shock effect much less.
Actually, I’d advise the same even if they were in their 50s. Much better IMO to have a paid-for residence in requirement than a huge retirement account - and huge income needs to meet mortgage or rent payments.
Oh and btw upon reading the comments there WERE some very nice build-upons, so sorry for that.
And don’t forget the 401(k) - which gets the company match - and the Roth - which doesn’t - are different accounts.
I had a Roth. I chose to roll it over into an HSA since DH and I are statistically certain to require at least some medical care prior to retirement, whereas there is at least some chance that one or both of us won’t even live that long.
Especially driving in L.A. every day.