Looking for tools to solve a minor personal finance question.
November 29, 2018 5:59 AM   Subscribe

Let's say I have, annually, $6,000 dollars available that I can either A) Put into my IRA account for retirement, or 2) Pay towards my mortgage. What I'm looking for is some kind of way to assess which is the better move for me, or whether it makes much difference which I do.

I don't really want to give out a lot of my personal details (although I am 54, if that helps) and have somebody on here solve it for me, but would instead like some tips on how to figure this out for myself, either through an online tool or just good ol' math. (Although, if you are someone with a lot of finance skills and firmly believe PAY OFF MORTGAGE FIRST or IRA FIRST or whatever, I'd be happy to get your advice.)
posted by JanetLand to Work & Money (12 answers total) 3 users marked this as a favorite
I firmly believe you should put the money in your IRA. Like, the actual details will depend on your mortgage interest rate and your marginal tax rate, but in the vast majority of cases IRA will be the better deal.
posted by mskyle at 6:13 AM on November 29, 2018 [3 favorites]

The mortgage is a guaranteed return, the IRA is not (unless you put it into something that has a lower interest rate than the mortgage). But I would instead base it on how much other liquid savings you have. If you have plenty to see you through a temporary job loss, a major house repair, etc. then the mortgage makes sense. If not, you may want that cash again, and the IRA is better; withdrawals of contributions to Roth IRAs are penalty-free.
posted by metasarah at 6:17 AM on November 29, 2018 [1 favorite]

This is not financial advice; you should consult a professional.

You can make this a very simple question or a hard question. Put most simply, is your mortgage rate above or below the expected rate of return on the assets you’d purchase in your IRA? The long term returns on the stock market have been in the neighborhood of 7%—if that’s higher than your mortgage rate, it’s rational to invest rather than pay down debt.

But it’s obviously more complicated than that. The historical market returns are great, but many believe we’re on the cusp of a bear market, if not just a significant correction. How soon do you need that money? What reserves do you have? What’s your tolerance for risk?

How long do you plan to stay in your home? If you prepay on a mortgage it generally just shortens the term, rather than reducing your monthly payments. Your payments can be reset if your mortgagee will “recast” the amortization, so the reduced principal is paid off on the original maturity date.

Another consideration is that while both a residence and an IRA are tax advantaged savings vehicles (since a significant portion of the gains on the sale of a primary residence are sheltered from tax), it’s very hard to get money out of the home “account” but relatively easy to get money out of an IRA (subject to potential penalties, natch). If you lose your job and need money for food, it’s a lot easier to get that $6k from the IRA than from the equity in your house.
posted by Admiral Haddock at 6:18 AM on November 29, 2018 [7 favorites]

I do not have a specific tool, but the two things I would consider is what your mortgage rate is versus what your expected rate of return is in you alternative investment (IRA) including tax considerations of both and LIQUIDITY. Your personal liquidity. Do you have access to emergency cash? If you pay down the mortgage, it is hard to get that $6k back in an emergency unless you have a HELOC. Also, it is not an all or none proposition. You can put some towards your mortgage and some toward your retirement.
posted by AugustWest at 6:20 AM on November 29, 2018 [1 favorite]

Here's how I'd prioritize this, because I prioritize predictability in the event of a layoff or emergency, but I am 40, have an existent but insufficient retirement cushion to which I contribute biweekly, and am FTE. Also, I have kids, which it sounds like is not a concern for you.

1) Three months of liquid savings
2) High-interest consumer debt (incl car, not incl mortgage or student loans)
3) Additional three months of liquid cash
4) Additional retirement
5) College savings
6) Mortgage principal
7) Max out retirement savings
8) Student loan principal

Am not a financial genius but I do work at a bank so am surrounded by financial advice content.
posted by chesty_a_arthur at 6:28 AM on November 29, 2018 [6 favorites]

This is still not fincial advice.

You don’t mention whether your IRA is traditional or Roth, but consider the tax benefit of a deductible IRA contribution, as well.

For simplicity’s sake, say you make $100k and are taxed at 25%. Your net after tax is $75k. You don’t get a deduction for prepaying your mortgage, so your tax bill is $25k—that’s just money out the door.

If instead you put the $6k into a traditional IRA, you deduct the contribution, so you pay tax on $94k. The tax out the door is $23.5k, saving you $1,500. That’s extra money in your pocket, which you can put to other uses, including prepaying your mortgage. Two bites st the apple.

Do consult a professional, though. The deductibility of IRAs phases out, rates are subject to change, other benefits may be available, etc.
posted by Admiral Haddock at 6:50 AM on November 29, 2018 [5 favorites]

Another reason I would say that an IRA is almost definitely the right choice for you is that you are 54 years old - you can withdraw from your IRA without penalty starting at age 59 1/2. So money in your IRA is quite liquid for you. If you decide five years from now that you'd rather use the money in your IRA to pay off your mortgage, you can just do it! (Although if it's a traditional IRA you will need to pay taxes on your withdrawals at that time.)

And you can only contribute $6000 a year to your IRA (and that only while you still have earned income, i.e. income from work). You can contribute as much extra to your mortgage as you want, any time, forever.
posted by mskyle at 7:00 AM on November 29, 2018 [3 favorites]

What are your goals? I had a goal of security, and I paid off my house ahead of schedule. I love the security. This was when rates were higher, I think I was at 6% or so.

You might consider a goal of having the house paid off when you are planning to retire. Mortgage rates are still quite low, so paying off a 3.5% interest loan that generates a tax break can't compare to @ 10% return (over time) from the stock market. You could establish a separate account to be used to pay your mortgage in retirement. That would feel pretty secure. Options:
Roth IRA - pay taxes on it now, no taxes later.
401K - no taxes now, pay tax when money is withdrawn.

Always pay off any credit card debt, and debt over @ 8% or so, because the stock market is volatile and debt is a millstone. School loans, depends on the rate. And having easy access to 6 months of expenses makes life feel so much better.
posted by theora55 at 7:09 AM on November 29, 2018 [1 favorite]

One thing to think about is where you are at in your mortgage. Is your mortgage brand new, or have you already been paying off for years? Since most (all?) mortgages "front load" the interest, it makes a difference whether you have paid a lot of that already or still have many years left on the mortgage.

You should be able to find financial calculators that will show you what the effect is if you pay $X additional money against principle. For example, I'm early in a mortgage and according to the calculator provided by my lender if I pay $X against principle now it's essentially saving me twice that down the road. That is, if I pay $6,000 today, it's basically like paying $12,000 towards the end of the loan. That's a pretty good return.

I've been paying on my student loans a long, long time - so $6,000 against that is like ... I dunno $6,005. Not worth it.

I am with @chesty_a_arthur when it comes to liquid savings, except I shoot for 12+ months. (Former freelance writer here. I made good money, but publishers pay slowly & erratically, and I have seen at least two major events where reliable clients/publishers either cut back drastically or just fold outright... so I've basically planned for a very, very long drought in a worst-case scenario.)

I am not a financial adviser or expert, but I firmly believe there's a downturn/correction coming - especially with the silly games Trump is playing around tariffs with China and others, Brexit, and (my perception, at least) of general instability around the world. To be fair, I expected a deep market correction in early 2017 and was dead wrong about it.

What I would do in your shoes is look at just how effective paying the mortgage off would be and prioritize liquid savings and then paying off mortgage if it's your highest interest debt. As others have said, if you have any other higher interest debt then pay that first for sure.
posted by jzb at 8:53 AM on November 29, 2018 [1 favorite]

The math to a halfway decent approximation is not hard, I think, it's just that it requires picking certain variables based on speculation.

First step: if you are planning on contributing to a traditional IRA, then you don't actually have $6000. You have $6000 plus whatever taxes you save from deducting the $6000. E.g., if your marginal tax rate is 25%, then you have $8000, with the $2000 flowing back at tax time if you don't adjust your withholding to get it over the course of the year. If you're just spending that $2000 on ordinary consumer consumption, then you've effectively negated (for future return purposes), the deductibility of the contribution. If you want to invest it, too, you will have to invest part of that in a post-tax account since you'll be over the IRA limit at $6500.

If you're prepaying principal on your mortgage, you are using post-tax dollars and this doesn't apply.

Any compound interest calculator will tell you what your returns on an IRA investment will be--it's just that you will have to guess the return rate, which is in no way guaranteed. Add in the return from your "excess funds" investment. (For simplicity, you can assume investment in the same investment for both.) Then you have to knock off whatever you think the tax rate will be at retirement. There you have it: your post-tax returns on this strategy.

Similarly, a loan total payment calculator will allow you to compare your total payment on the mortgage as it stands now and as it would stand with $6,000 less in principal. That's your gain from that strategy. It's already in post-tax dollars.

The practical issues of liquidity and such are well-covered above, I just wanted to give you some rough math.

[Side note, which OP may want only to skim: (a residence and an IRA are tax advantaged savings vehicles (since a significant portion of the gains on the sale of a primary residence are sheltered from tax)

I think this is misleading in this context. As a general rule, thinking of a loan that you take out as a "savings vehicle" is incorrect in a dangerous way. Your residence can be considered a "savings vehicle," I suppose, but it's not a tax-advantaged one in quite the same way an IRA or Roth IRA is, whereby, if you correctly anticipate the movement of your marginal tax rate, you will be tax-benefited even if the investment return is zero. If you "saved" the initial value of the house over the course of repaying the mortgage and there's no appreciation on the house, there's not really a tax advantage. More to the point, though, we're not really talking about the house, but about prepayment on the mortgage. Let's assume that there are gains, that the value of the house goes up due to the market. Prepayment now doesn't affect that appreciation and it doesn't get you a bigger share of it--if you buy a house at $200K and sell at $400K, you're entitled to the $200K appreciation regardless of whether your equity is $40K or $100K. In fact, prepayment on the mortgage actually reduces your leverage, meaning it reduces the rate of return on your investment unless you can invest the freed-up cash from the interest you're not paying somewhere that outperforms the leveraged appreciation on the house.]
posted by praemunire at 10:32 AM on November 29, 2018

The absolute and unimaginable freedom of having -No- mortgage.

Everything else is hypothetical gibberish.
posted by Afghan Stan at 2:06 PM on November 29, 2018 [1 favorite]

Check if your mortgage allows recast. You could pay 6k towards mortgage, recast and have say a $75 less a month payment (you would need to ask your bank to do the math) which reduces your required cash flow for bills per month. From you can start throwing the difference into an IRA etc and make saving part of your monthly budget. (Prioritizing habits.)
posted by typecloud at 6:52 AM on November 30, 2018

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