Should I use additional income to pay off debt or invest it for retirement?
I am 35 years old and my wife is 38 years old. Currently, her income is free to be used as we see fit. I pay all the bills and expenses and really want us to think about our future, specifically retirement. My question is, would it be wise to use her income to pay off our mortgage, which can be paid off in 6 years using her income (principal only payments of $25K/year)? Or, should we use it to invest? My thinking is paying off our mortgage first will give us more money to invest after it's paid off.
Hi! This is very impressive - you and your wife are doing so well in living so within your means that you only need one income and that you have a house that even could be paid off in 6 years….way to go!
First thought: I wonder if you are both employed at places that have 401(k) plans. If so, before making additional payments to the house and/or investing, I would advise you both to fully max out the amount you can contribute to those plans. In 2017 that would be $18,000 each of you could contribute to you your plans (assuming you both make at least $18,000) for a total of $36,000 that is tax-deferred each year for your family and builds toward your retirement. Plus many companies match a part of their employee contributions. You get the benefit of paying fewer taxes now and contributing toward your retirement.
You also want to make sure you have an emergency fund of 3 – 6 months of expenses.
If you are both maxing out the 401(k) and have an emergency fund, then you might want to split the difference in the plan you mention above to get the benefit of your non-tax-deferred investments growing while also paying off your mortgage faster. You probably have an awesomely low interest rate on your house mortgage and rates are likely to go up, so if you’ll be staying in that house it would be nice if theoretically you could make more money on your investments than you are paying in interest on your mortgage. But since there is no guarantee that you WILL make a certain return on your investments but you know you will pay that amount on your mortgage, you are taking a risk in investing. People have found it to be a worthwhile risk and a good way to grow the amount you earn, but you want to be aware of that risk in making your decisions!
Finally, if you have or are planning to have children, you may also want to contribute to a 529 plan for their college education.
Best wishes to both of you!
For most Americans there is an inherent desire to get out of debt as soon as possible. We should consider many key factors before making the decision to pay off mortgages sooner than planned. Let us review some of the top considerations.
- How does paying off my mortgage affect my financial goals? Paying of a mortgage seems like a sensible thing to do. That said if you are sacrificing other financial goals such as saving for retirement or saving for your child’s college education it may not be in your best interest. Understanding if you are on pace or on plan to complete those goals are a key consideration. If you are not sure I would suggest this to be a starting point.
- Are you considering current rates? During periods of low rates it may be in your best interest to lock in favorable financing. According to freddiemac.com the average annual rate in 1981 was 16.63%. This kind of rate should be closely monitored for possible opportunities to refinance. However in 2016 average annual rate was 3.65%. Many companies leverage debt to grow and without debt they may not reach their full potential. It is in our best interest to understand that paying off a mortgage prematurely may not be an effective strategy during periods of low interest rates.
- Are you considering tax benefits? For many American trying to find ways to save on taxes during tax season is high on our agenda. Are you paying down one of your biggest tax benefits? You could be. Keep in mind that interest on your mortgage currently is tax deductible. This is a major consideration. If you happen to be in the 35% tax bracket and hold a 5% percent mortgage loan you could be saving 1.75% as a deduction on that rate. Understanding tax code can be complicated especially when the code changes. It is recommended that you consult your tax professional to ensure you are not missing out on possible tax benefits.
- How would your current risk mitigation strategy be affected? Having a risk mitigation strategy is key for long term success. It is important to consider having certain measures in place in the event of an emergency. Having three to six months of living expenses set aside helps us overcome possible situations such as a loss of employment or an out of the usual major expense. Further do you have risk mitigation strategies such as estate planning documents, disability insurance, and life insurance? If not you may have unnecessary risk that can be mitigated.
Keep in mind if after all the analytics and considerations you are stressed and losing sleep at night because you have a mortgage. You may just need to pay it down.
Unfortunately there is no way to answer your question because you didn't provide the most important information required: the interest rate on your mortgage, when it began, and when it ends. If you have a 15-year mortgage--which I am just guessing based upon your ages and data--then the actual interest rate on the mortgage decreases each year because of amortization. In other words, you pay almost all interest in the early months and almost all principal in the final months; it's not evenly distributed. One big mistake many people make with mortgages, especially 30-year mortgages, is that they pay off their balances when they have 5-7 years to go on their mortgage and their payments are almost entirely principal. Often the effective interest rate is only 1% and can be even less in the final years. It makes no sense to pay off a loan with an effective rate of 1%--you are getting essentially free money.
On the other hand, if the mortgage is relatively new and you are still paying a lot of interest then it can be worthwhile to reduce your total interest payments by prepaying it--of course assuming that there are no prepayment penalties or fees involved.
The main disadvantage of not paying off your house is that paying off a mortgage requires no calculations or complicated decisions. You just make payments and live happily. If you start investing your money then you have to decide what to do with it--which is not easy. That is especially true if you plan to buy U.S. stocks near all-time highs when they will likely drop more than half as they did in 2000-2002 and 2007-2009. I would recommend staying away from U.S. stocks until after they collapse for a third time this century. If investing seems scary, then just keep prepaying your principal on your mortgage until you're emotionally ready for the challenge.
This is a great question for a couple under the age of 40. Professional money managers will tell you that under most if not all circumstances, you should invest your free cash as mortgages over the past few years have a very small rate of interest that should be absorbed with tax benefits. Part of the reason for this declaration is that the more money they manage, the more money they make and if you think I am taking this is a shot at investment advisors in general, I believe this is generally true. Having said this, there are both financial and psychological reasons for paying off the mortgage as early as you can. The first one and probably the most important is psychological which would mean that your home is totally and completely debt-free which is highly unusual for someone of the age of 45. Don't underestimate the value of a debt-free home as there is always circumstances where you can use the equity in the house if something comes along of value. In addition, let's assume a 25% tax bracket. The interest deduction in and of itself is not all that valuable even in the highest brackets. If you pay a dollar of deductible interest in a 25% tax bracket, Uncle Sam will return $0.25 of each dollar and your out-of-pocket is the other $0.75. Now let's reverse this. Let's assume you have a of dollar taxable income and no interest deduction. Under this scenario, you will pay Uncle Sam an extra $0.25 in taxes but you get to keep the $0.75 for other purposes including investments. In addition, take into consideration that many of us believe the markets are not only generously priced, but maybe overly priced and although you are both young enough to withstand a couple of full market cycles, I would not recommend being overly aggressive with the markets as high as they are. I wish you much success and good luck.
Short answer: No, you should not put off investing for 6 years in order to pay off your mortgage.
Why? you will need to invest significantly more money six years from now to achieve the same goal.
Assume you want to have $2,000,000 for retirement at age 65, and can earn 7% a year on your investment.
If you start now, at age 35, you need to set aside about ~$18,000 a year ($1,530 a month)
If you wait and start at age 40, you will need to invest ~$27,000 a year ($2,270 a month) to achieve the same goal.
If you wait 10 years (age 45) you will need to invest ~ $42,000 a year ($3,480 a month) to achieve the same $2 million goal.
Bottom Line you will have to invest significantly more than $150,000 (your wife's income of $25,000 * 6 years ) if you wait to invest.
If $2,000,000 is a reasonable goal for you, consider investing $18,000 for retirement and paying down $7,000 on your mortgage.
Step 1: Set up an emergency fund (6 months of living expenses)
Step 2: Protect your income and the value of your property with the proper insurance, such as disability, life, property
Step 3: Maximize the value of your investment
- If you have a 401(k) max out your contribution and make certain you receive the full amount of any employer match
- Contribute to tax-deferred retirement accounts, such as an IRA (pay attention to IRS rules on contributions)
- If you have or plan to have children consider a Coverdell and/or 529 Plan to fund education expenses
Step 4: Diversify
- Consider all investment vehicles (securities, real estate, etc)
- Create portfolios which may differ in risk profile based on when you expect to use the funds (time horizon).
It is best to speak review your entire financial situation and goals with a financial professional before making any financial decision.