pay it off or focus on IRA

behaviorkeltonJune 28, 2006

There's another thread on something similar, but let's continue...

I'm still having trouble getting this issue straight:

By paying off a house, one is safely achieving a decent interest rate (~6%). I'm not sure what happens, exactly, to that interest when one also considers the tax write off of the interest... so perhaps someone cares to offer some info on that.

If a mortgage is paid off, a person can get a lifelong "return" on the investment by living almost rent free (property tax is always there). So in today's money in my location, that equates to ~$875, tax free for the rest of your life (free rent). That number will likely be much higher when you figure that rent will be higher in the future. What kind of investment can do that?... guaranteed? (Do annuities compete with this sort of reasoning?)

The longer you live, the more of a "return" you get for your paid-off house. Is my thinking correct here?

Of course, if you pay off a house and find that you have no liquid assets...that's a problem!

So I suppose I'm asking:

What are the factors to consider when deciding on whether to contibute to an early mortgage payoff or a retirment account given that both will play a role in one's retirement life?

There is always that much discussed emotional benefit of actually owning the place in which you reside. I am somehow reluctant to say I'm a "homeowner" when, in actuality, the bank owns it. It's kinda like the habit of saying "I'm building a house" when the contractor is really doing the building of it!


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Our financial advisor told us to own our house outright or own very little of it. Anything in-between was tying up our money so that we couldn't invest it elsewhere and at risk if we experienced a financial set-back. I think that is good advice.

We opted for owning outright. I am not financially savvy enough to do better than 6 - 7% on my money and I thoroughly enjoy the peace of mind that comes with owning outright.

I advise my children never to make extra payments on their homes. The money is better invested in more liquid assets. Even an IRA can be tapped if necessary. In the event of job loss or catastrophic illness they can continue to pay their mortgage using their investment savings, but if they have made extra payments to their mortgage instead, the lender will not credit the extra payments to what is due and owing TODAY. Also, when they go to sell their homes, which will almost certainly occur before the end of their lives, they will not make a better profit on their homes because they have more equity. In fact, just the opposite would be true.

One thing I think you left out of the equation you are trying to put together is the power of compound interest. The interest you save by not making a house payment stays the same, but the money you put into your IRA will grow because you will get interest on your interest.

It also makes a difference of course, what you save by writing off the interest portion of your mortgage, but since we don't know your income bracket, we can't possibly value that savings.

So... I guess what I am saying is that if it is a choice between making extra payments on your mortgage or contributing to an IRA - contribute to the IRA.

If instead you have the money to pay off the house right now or in the very near future, then I would say go with whatever helps you sleep at night, which for me would be paying off the house.

    Bookmark   June 29, 2006 at 1:02PM
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You're making a couple of faulty (if not dangerous) assumptions:

- You assume that housing will always increase in value at the rate of 6-7% a year. While that may have been true over the recent several years, it is looking more and more like housing prices either will stall or drop as a reaction to some overheated markets, an overextended customer base, and tighter credit/higher interest rates. That's not even including factors largely beyond your control (Love Canal, anyone?) or having to sell at a specified time and not being able to ride out market peaks and valleys. If you ignore that for the increase in value of housing, then you ought to do that for stocks/bonds, etc.
- People tend not to count the cost of maintaining or improving their house. Three years ago I bought a house in an "emerging" neighborhood. Since I bought, I've added a foot of insulation to the attic, put in vents for the range and bathroom, updated all the kitchen appliances and the flooring, put in some new light fixtures, and poured a new patio. While some of these were my choice to do, some of them are plain ol' maintenance and what I spent on them has to be accounted for as part of what that house has cost me. Even if you get to pay off the mortgage and live "rent-free", you need to consider the ongoing cost of maintenance. And you need to think about what the money you spent could have done for you elsewhere. It's not like the money you spent paying up the mortgage would have sat there, doing nothing. Or it shouldn't have.

    Bookmark   June 29, 2006 at 3:01PM
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I don't think the OP was assuming a 6 - 7% rise in housing costs, I think he was referencing the 6 - 7% he wouldn't be paying to the morgage holder. An increase in the value of the house would be a bonus.

Of course houses don't always appreciate. Neither does the stock market and neither does the bond market.

The maintenance costs that you mention have to be paid whether or not your house is paid for. It makes no difference at all.

    Bookmark   June 29, 2006 at 6:50PM
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Yes, I was assuming 6% interest. Now that I have moved into this house (today), I am definately feeling the pain of the various things that need fundamental repair... more than I originally predicted.
Man, I thought I was done being a naive home buyer, but I'm being taught a lesson I suppose. So my vision of upgrading the home have turned to visions of simply making the home sound! Oh well... that's my issue.
So I know what you mean by home maintainance. I've been renting for a while, but I remember when I owned ten years ago, that I was continually amazed at the upkeep. And not just home also have to maintain the tools used to maintain your home! Lawn mowers and weed wackers need tools just to keep them running, paint brushes need paint brush cleaning material, etc. etc.
Funny how all of my memories of home maintenance angst are hitting me like a ton of bricks ... and it took the purchase of another home to make it happen! (not funny "ha ha")
So I guess I'll see how it goes.
And yes, I did forget to consider the value of compounding interest with investments which is a valid point.
Another point is that I do believe that I am more likely to "leave the money alone" if I pay down the house. If I invest, I am more likely to freak out and pull out during market swings.
I will contribute to the IRA... it's just a matter of how much!
Oh, I get it "OP" is Original Poster.. took me a while

    Bookmark   June 29, 2006 at 8:38PM
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Interesting points brought up in this thread:

Liquidity: A house is a fairly illiquid asset, but so is an IRA, so that's a wash.

Deductibility: Interest on a house is deductible, but so are contributions to an IRA, so that's almost a wash too.

Return on Investment: ok, now this gets to the meat of the issue. It depends on what kinds of investments you have in the IRA. If the interest on your house is 6%, then the investments you have the IRA in need to have a reasonable expectation of exceeding 6% as well. And really, if they're only going to return 8%, that means you are getting a risk premium of only 2% over the house, which isn't much of a reward compared to the risk-free return you could get by paying off the house.

Capital gains: Problem with the above paragraph is that is assumes the house value stays exactly even with inflation. Most likely it will exceed inflation by at least a little.

This means that you will want the IRA to have a rate of return that: A) exceeds the interest rate on the house AND B) exceeds the rate of capital gain on the house AND C) provides a rate of return that rewards the extra risk of the stock market (minus the risk of the housing market).

If you can pick IRA investments that will do all that, fund them, otherwise pay down debt first. Interestingly, if you assign a higher risk to the housing market than you do the stock market, the required rate of return to justify the investment drops... possibly even below the interest rate on the house.

Also, there's maintenence on the house which could sink the whole deal, but to me the maintenence costs are generally offset by the shelter value the house provides. Another wash.

    Bookmark   June 30, 2006 at 11:35PM
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"Shelter Value".... I think there was another term used for just that by a financial guy on TV. To live at my standard of living here in Knoxville, I'm going to pay $900 a month... and that's for an apartment. That money is just gone.

That's not a revelation to anyone here, but this finance guy used a term for the utility of the money spent on a mortgage. He was considering not only the investment value of a mortgage/homeownershiop, but the fact that you get a (somewhat) free place to live with that same money.

I'm not sure how this all shakes out with the various other financial variables, but I hadn't considered that aspect of home ownership.


    Bookmark   July 1, 2006 at 1:15PM
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I was thinking about it, and I think maybe I made some very bad advice. I'm ignoring the power of compound interest on the IRA - with an IRA, its important to get money into it as early as possible so that it grows for the longest possible time.

For shelter value, most people say its the cost that you would pay anyway to rent a comparable property. To me that seems like an overstatement - maybe a better number would be what you would pay to put all your stuff in storage and live in the smallest apartment you can stand.

Maybe a middle ground compromise would be best: say you have an extra $400 a month in your budget, then put an extra $200 a month on the principal of your mortgage, and $200 a month in the IRA.

    Bookmark   July 2, 2006 at 11:07PM
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As U.S. homeowners can deduct mortgage interest, if your mortgage interest is 6% and you're in 33% marginal (i.e. top, for you) tax bracket, 33% of that 6% is 2%, leaving you with a net cost of mortgage of 4%.

In Canada we can't deduct mortgage interest - but when we sell owner-occupied home, capital gain is free of tax.

If you own a bond (taxable-interest type) paying 5% and you're in 20% tax bracket, your after-tax rate of return is 20% less than your apparent earnings, or 4% - outside of tax-deferred IRA.

The costs of owning a home are larger than was originally suggested: there's higher insurance rates (if you're in an apt. you insure only your furnishings), costs of a new roof on occasion, repairing cracked basement wall, replacement of furnace, etc.

Many financial advisors in Canada say that every worker should own our tax-deferred retirement plan - but some of us are less than enthusiastic about them, for reasons that relate to lower tax rates on certain types of return on non-retirement-related investments, both in terms of current income and on cashing of assets later.

Some homeowners seem to forget that, were their money not invested in a home, it could be earning (whatever) rate of return invested elsewhere. Out of which they would need to deduct their costs of rental. Plus (expected) increased value of their home on sale after a number of years.

Many clergy in our country used to live in church-owned homes and some felt that such homes did not relate well to familes with 4 kids and empty-nesters, plus they said that they wanted to profit from the increased value of homes, over a number of years ... so they wanted to own their own homes (and the church pays tax-free rental allowance).

I said that they'd profit a lot lower than they figured ... for clergy move fairly often, and each move would usually require sale of their current home ... with the real estate people pocketing a substantial portion of the increased value of the home since the last move.

If I'm a renter and get transferred ... or downsized, with no current local job prospects, requiring a move to secure satisfactory employment, if I rent an apt., all I need do is hire a moving truck. Not so if I own a home.

There are many nuances that relate to the wisdom of buying a home or renting, or paying down a mortgage rather than ivesting for retirement, one of them being having enough asset on hand that one can survive fo half a year or so with no paycheque, if required.

I don't always have it, but I have a line of credit at the bank, unused at the moment, that costs me nothing to maintain,which I can draw on as I choose.

Some years ago when I asked a local bank whether I could make a loan, using strong assets as collateral, they said that would be O.K. - so I moved about 2,500 miles to take a commission sales position. When I went to that bank for a loan and they wanted to know what rate of income I'd have ... they turned me down for the loan! So ... I had to withdraw some of my tax-deferred retirement asset (on which I paid minimal tax, having low income that year).

Good wishes as you pursue greater knowledge about how money works: not only does enhanced knowledge increase one's power ... it pays well, on occasion .

ole joyful

    Bookmark   July 4, 2006 at 3:00PM
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