A recent family vacation and viewing the Canadian financial channel prompted an impassioned discussion – if a person has extra money left over, what to do – pay off the home mortgage early, or contribute to the retirement accounts?
I say – contribute to the 401(k) (or Roth IRA, or whatever retirement account is available). Here’s why:
Let’s presume a person has a $100,000 mortgage, for simple math purposes. Let’s also assume a 30 year mortgage and a 5.75% interest rate (this seems to be pretty standard when analysts make estimates). This makes the payments $583.57/month. The total amount of interest paid over 30 years on this mortgage is $110,086.23.
Now, if I suddenly have an extra $200/month available to me, here’s what happens if I place it towards the mortgage principal: the loan is paid off in 16.5 years as opposed to 30, and I only pay $54,986.58 in interest, a total savings of $54,876.49 from what I would have paid from making minimum mortgage payments for 30 years. My brother pointed out that, once the mortgage is paid off, the entire $583.57/month + $200/month ($783.57/month) can be placed in the retirement account. If we assume an 8% rate of return on the 401(k), putting $783.57/month into the account for 13.5 years will give us an account value of $231,829.75. Subtracting out our personal contribution of $126,938.34, the pure earnings on the account during this time amount to $104,891.41.
So what did we earn by paying off the mortgage early and then contributing fully to the 401(k)? $54,876.49 (money saved from not paying extra interest on mortgage) + $104,891.41 (earnings on the retirement account) = $159,767.90.
Compare that now to paying minimum mortgage payments for the full 30 years, and putting just $200/month in the 401(k) over this same time frame. After 30 years, the 401(k)’s value is $293,630.08. Our personal contribution to it was $72,000.00, so subtracting that out, our pure earnings are$0 (money saved on interest from paying off the mortgage early, which of course we are opting not to do) + $221,630.08 (earnings on the retirement account) = $221,630.08.
For simplicity of calculations, we have only compounded the interest annually (which, in actuality, the earnings on the 401(k) are continuously compounding as we’re adding money every month and the value of the account is constantly changing). Inflation is also not included (3–3.5%). Finally, we have also not included the tax breakdown (money into the 401(k) goes in pre-tax, thus lowering taxable income and favoring the 401(k) contribution over paying off the mortgage early, since the $200/month would be taxed prior to being put towards the loan; also mortgage interest can be deducted, so it’s not costing as much as it seems to pay the interest as there are breaks for it). And remember – both people still own the same house at the end of 30 years, but one has a retirement account worth $60,000 more than the other. And while home loans are easily available, it’s not as feasible to get a loan just for living expenses during retirement (how do you pay it off, unless you sell your assets?).
So I stand by my assertion that it makes more sense to contribute to the retirement account over paying off the mortgage early. Miracle of compounding interest indeed!
Of course, both options make more sense than blowing a lot of money each paycheck on shoes and purses, a pastime of several colleagues who laugh about not putting money away for anything long-term.