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.
Your logic is good Miss Jode-eye. Of course you are assuming the mortgage type is 30-year fixed, and many in the past few years have strayed away from that type in favor of variable rates. You have to consider the risk of interest rate rise. Of course you also have to consider the liklihood that you won’t live in a house for 30-years, and thus effectively may see very little benefit of prepayment.
My parents used to tell me proudly how they’d prepaid their mortgage(s), and in their zeal to attack debt, they also show me their lack of understanding about leverage, which you essentially are demonstrating. That money can be used for better purposes than low-interest debt with increasing equity [i.e., as your house hopefully increases in value, your effective rate of return is higher the less principal you've paid in].
Let me present a slight twist. What if I have a HELOC that financed part of my home purchase or an addition? Current HELOC rates are more like 9%. Since HELOCs reamortize immediately, my interest payment goes down the very next month, unlike the mortgage where the payment is the same but the term is shortened. Thus every dollar paid in for principal generates an immediate 9% annualized return.
Even when the rates were lower [they generally follow prime], I still paid into the HELOC. Why? Aside from the fact that my lender was annoying me and I wanted to get rid of them quickly:
-I was maxed in my 401(k) and IRAs. Plus I determined I was saving enough for retirement. It occurred to me that there comes a point when you save too much for retirement that you can’t necessarily access until ~60 years old. What if I want become financially independent (retire) at 50?
-I believe in the need for a kitty of emergency cash, and since a HELOC can also be withdrawn in an emergency, it serves as just that.
-Furthermore, since the interest here is much higher than my mortgage (6.25% fixed) paying the HELOC before making extra mortgage payments will always make sense.
So I argue the answer, as with most things this complex, is: it depends.
All valid points, Jamus. I agree that, depending on the interest rate, it makes sense to get a HELOC paid off. I see a HELOC as a credit card of sorts, and most financial advisors would advise paying off higher interest debts first, then contributing to investment accounts. For ease of math and for the purpose of comparing a true mortgage vs. saving for retirement, I kept things simple.
Recently I was reading an article in Money, and when the publication uses young couples as financial examples for improvement, they often talk about their huge debt loads – and they always seem to include their “massive student loan debt.” I totally disagree with this – unless someone has an outrageously high student loan interest rate, I don’t consider this true debt that can be compared with credit card debt. The interest rates usually aren’t that high, and the interest is tax deductible. The same applies to mortgage interest. Credit cards – not so much.