Reader’s Question: Should You Pay Your Mortgage Off First Or Invest For Retirement?

by Hank Coleman

Here is the next installment in our the Reader’s Questions Series which highlight questions emailed to me by you, the readers of Money Q&A. This one deals with whether you should pay your morgage off first or invest for retirement. Be sure to find out at the end of this article how you can receive a free copy of Dave Ramsey’s book, The Total Money Makeover if your money question is chosen to be featured on an upcoming blog post.

If you’re not familiar with Dave Ramsey’s book, you should run right out and get it. It is one of the best personal finance books that everyone should read. Now….on to our reader’s question.

Should you follow Dave Ramsey’s baby steps to the letter? Or, can you switch them up a little bit? For example, one reader just asked if he should use $2,000 per month to fund his retirement or pay off his mortgage early?

This is a great question, and it is one that a lot of people struggle with when they tackle in Dave Ramsey’s seven baby steps. Should you do all the steps in order? Should you delay investing to pay off debts? Do you really need to invest 15% of your income for retirement?

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These are all great questions. I asked Zack a few more questions over email these past couple of weeks to get more of the back story. After fully funding his emergency fund, he will have $2,000 per month to either invest for retirement or pay off his mortgage early. Here are a few more questions he asked me about.

Paying off PMI is a great investmentHe asked, “Should I pay extra $1,000 per month on mortgage and put $1000 per month into Roth IRA for each of us? Or, pay the total $2,000 per month on the mortgage and $0 into the Roth IRAs and be done with the mortgage four years earlier?” Is it a big deal to delay investing in the Roth IRA for four years?

This is not exactly your cut and dry financial problem that a planner would face. There are quite a few moving pieces to Zack’s situation and back story that goes along with his family’s individual situation.

It is important to remember that each family’s situation is different, and all of the different aspects need to be weighed in order to come up with the best possible outcome. This can also be difficult if you’re living paycheck to paycheck.

Some of the other factors that made Zack’s case unique were that he already had $350,000 in a 401k retirement plan, no children living at home, a wife earning a military pension, and several other factors.

So, with all of that being said, here are a few things to consider about Zack’s own personal financial situation.

How Much Does Delaying Retirement Savings Hurt?

One thing that Zack has going for him and his wife is that they are very close to retirement age, and they have already been saving some for their retirement. Zack told me that he is 50 and his wife is 52.

If you were just starting out and in your 20s, delaying the start of your retirement investing could be disastrous, but delaying in your 50s isn’t much better either. If we assume that Zack and his wife will retire at the age of 65, he would have 15 years to invest in a Roth IRA if he started now at age 50 or he would only have 11 years if he delayed investing.

Putting $1,000 per month into two Roth IRAs for Zack and his wife for 15 years earning an average annual interest rate of 8% would grow those Roth IRAs to $346,000. That is quite a lot of money to forgo in order to pay your mortgage off.

How Much Do You Save In Interest Prepaying Your Mortgage?

Find your next home with ZillowOne great aspect of Zack’s plan is that he will add a $1,000 monthly principle payment to his mortgage even if he invests in a Roth IRA. But, should he skip the Roth and double his extra principle payments to $2,000 monthly?

When Zack told me about his plan to pay off his mortgage early by paying the extra $2,000 of monthly cash flow that he and his wife have coming in, he said that doing so would help him pay off his house four years early. His mortgage balance is currently $225,000, payments are $1,300 each month, and his interest rate on his 30 year fixed rate mortgage is currently 4.5%.

Typically, at these levels with these specific details about his situation, Zack would pay off his 30 year mortgage without adding any extra principle payments and would pay $185,000 in total interest over the course of the 30 years he had the mortgage.

If he started paying extra to his mortgage according to his plan starting in 2014, he would save approximately $57,000 by paying an extra $1,000 per month or approximately $76,500 by paying an extra $2,000 per month on his mortgage.

Wrapping It All Up

On a $225,000 mortgage with an interest rate of 4.5% for 30 years, Zack would only pay $185,415 in interest payments and a total bill of $400,415 for his house ($225k + 185k) when he decides which bill to pay first. While $185,000 in interest payments is nothing to sneeze at, they are a drop in the bucket to the potential $346,000 nest egg he could build investing in a Roth IRA.

Speeding up his mortgage payments and throwing large sums of money at his mortgage may make him feel better, but it most likely is not the best use of his resources. Zack’s mortgage rate is so low that it would be a better use of his capital and a better bill to pay first if he earns a higher rate of return on his investments.

In most cases, he would not even save enough in interest than he was putting into his mortgage payments since most payments at the end of the mortgage are comprised of more principle than interest anyway.

In the end, you should definitely follow the Dave Ramsey baby steps in order. They are set up for a specific purpose based on years of data collected. There is a reason that investing for retirement comes before you pay your mortgage off completely.

Past Readers’ Questions:

Do you have a money question that you would like to ask? Email me your money, investing, retirement, savings, or other question to Questions[at]MoneyQandA.com. If I pick your question for the next article in the series, I’ll send you a free copy of Dave Ramsey’s book, The Total Money Makeover, or you can pick from any of these other free books instead.

Thank you all so much for all of the questions! I would really like to turn this into a weekly series of blog posts answering your questions every Monday. So, please keep them coming!

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About Hank Coleman

Hank Coleman is the founder of Money Q&A, an Iraq combat veteran, a Dr. Pepper addict, and a self-proclaimed investing junkie. He has written extensively for many nationally known financial websites and publications. Hank holds a Master’s Degree in Finance and a graduate certificate in personal financial planning. Email him directly at Hank[at]MoneyQandA.com.


Hank Coleman has written 578 articles on Money Q&A. Learn more about Money Q&A on Twitter @MoneyQandA and @HankColeman.


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{ 6 comments… read them below or add one }

Jai Catalano

I think there are ways to pay off the mortgage that allow you to do other things with your money. Bi monthly payments and paying a bit to principle come to mind but adding to retirement is very important and sometimes gets overlooked by the youth.

Reply

Newlyweds on a Budget

I’m young so Iwould definitely be contributing to retirement before thinking about paying off my mortgage early.

Reply

TB

I had nearly the exact same question — great post! Thanks for the well-thought-out response!

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SB @ One Cent At A Time

I buy this idea. Pu your money to maximize profit. if earning is more than loan interest then it makes sense to invest while continuing with paying monthly amount on mortgage.

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MoneySmartGuides

Definitely max out all of your retirement savings options first. From there, any leftover money can go towards pre-paying your mortgage to get rid of that noose as quickly as possible. Once that is paid off, you will have a sizable nest egg and by being debt free, will be able to do so many things that you’ve dreamed of.

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Michael Kitces

It’s worth noting that investing for an 8% growth rate instead of paying down a 4.5% mortgage is essentially only getting paid an extra 3.5% for taking the risk of a portfolio. The historical equity risk premium is closer to 5% – suggesting that the investor is not being paid sufficiently for the risk being taken. And to say the least, there is nothing certain about earning a full market return in “just” 15 years; if the reader had followed this advice for the past 15 years, the equities would not have outearned the borrowing rate AT ALL, much less hitting the 8% mark (or an even higher amount that probably would have been projected for equities in the late 1990s).

The point is simply that keeping a loan while investing in equities is the equivalent of investing with leverage, and it has risk. Equities don’t necessarily give the returns we want over a finite time period, especially as “short” as 15 years. If the loan happened to have stocks as collateral (a margin loan) instead of the real estate (a mortgage loan) would will still be encouraging the reader to invest in stocks with leverage? Should the advice really be different just because the collateral changed?

Just some food for thought. I’ve written about this further at: http://www.kitces.com/blog/archives/313-Why-Keeping-A-Mortgage-And-A-Portfolio-May-Not-Be-Worth-The-Risk.html

Regards,
– Michael

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