Put more into 401k, fund Roth for spouse, or pay down piggyback mortgage??

[CompoundInterestFan]

My wife and I have recently paid off the last of our CC debt, so now we have about $100-$200 extra each month. Here's our current situation: I'm putting enough into my 401k to get the employer match plus a little extra, and my Roth is fully funded. We haven't opened a Roth for my wife yet simply because we haven't been able to fund it. Now that we have more money each month, I'm trying to decide whether to put more into the 401k, start funding a Roth for my wife, or pay extra on our piggyback mortgage (rate is 7.55%).

I'm leaning towards paying extra on the mortgage mainly because of the higher interest rate. Ideas? Suggestions? Admonitions?

[Darryl]

Congratulations on killing the card debt.

If you don't already have a fully funded emergency account. I would do that first, some here I think successfully argue that you may think about your Roth as part of an emergency fund as you could get at your after tax contributions without penalty if you had to. Funding a Roth for your wife could give you access to more cash in a real emergency. If that has been dealt with, I think you're right it is tough to beat a 7.55% guaranteed rate of return and paying off debt sure does feel great.

[Peaceful_Warrior]

Originally Posted by Darryl

I think you're right it is tough to beat a 7.55% guaranteed rate of return and paying off debt sure does feel great.

It's not really a 7.55% rate of return though. After tax deduction, it really is only about 5%. Given that he can also be getting about 5% out of any money market account out there, I think it's actually financially wiser to invest that money if he's looking to make a purely financial decision.

The way I see it, after some number of years the assets of investing at 5% will far outweigh the buydown on the 2nd mortgage. Especially when given the fact that the invested assets could eventually pay off the mortgage *and* still exist after the mortgage is gone. Also, as the 2nd mortgage becomes smaller the income tax deduction will also become smaller - so buy paying down the mortgage he is losing both the opportunity cost of investing the money and also paying more in taxes each year.

Interest rates have to be a lot higher than 7.55% for it to be *financially* wiser to pay down the mortgage instead of invest.

However, there is no denying that having no debt and a paid off mortgage does feel really good.

Best thing to do is run the numbers in a spreadsheet.

[lar717]

Roth Question --- If I have earned income and my spouse doesn't, can we add money to my spouse's roth IRA since I had earned income? We file a joint return if that makes a difference.

[saluki9]

Originally Posted by lar717

Roth Question --- If I have earned income and my spouse doesn't, can we add money to my spouse's roth IRA since I had earned income? We file a joint return if that makes a difference.

As long as you meet the income requirements for the Roth the answer is yes.

[EngineeringMyFinances]

It's not really a 7.55% rate of return though. After tax deduction, it really is only about 5%.

But the comparison is valid. If you could find a savings account paying 7.55% interest, the effective return after taxes would be the same as from paying ahead on the mortgage.

I think that if you're young, you should put priority toward a spousal Roth IRA, with the emergency fund considerations that Darryl mentioned. The decades of tax-free growth are hard to beat. But when considering withdrawals of principal from a Roth IRA for emergency purposes, be aware that many custodians have minimum balance requirements and you may have to end up pulling it all out paying penalties on the gains. You should have at least one-month's expenses in savings outside a Roth IRA that you would access first.

OTOH, if you're going to retire in a few years and pull the money out of the Roth, then you're probably better off paying off the piggy-back mortgage, reducing your cash outflow in retirement, and saving on the extra interest.

[CompoundInterestFan]

Just wanted to add some information to address questions people had: I have an emergency fund, about 3-4 months worth, and I'll be adding another month or so next year. So I feel like I've got that covered. Also, I'm fairly young (33), so retirement is still a long way off.

[Gotadimple]

Originally Posted by CompoundInterestFan

Just wanted to add some information to address questions people had: I have an emergency fund, about 3-4 months worth, and I'll be adding another month or so next year. So I feel like I've got that covered. Also, I'm fairly young (33), so retirement is still a long way off.

1. Establish sufficient emergency fund so that you sleep well at night.
2. Start a spousal Roth
3. If the investment choices in your 401K are good performing funds, max out the 401K in those investments -- even if you don't get the matching funds.
4. Start to think about asset allocation across all of your investments.

-- Rita

[Peaceful_Warrior]

Originally Posted by EngineeringMyFinances

But the comparison is valid. If you could find a savings account paying 7.55% interest, the effective return after taxes would be the same as from paying ahead on the mortgage.

Not exactly. One still has to account for the opportunity cost of not investing the money that they used to pay down the mortgage.

The asset continues to grow and provide income even after the mortgage is paid off, whereas the money put into the mortgage sits idly.

Therefore, if we look only at 'interest rates' what you say applies. But if we look at 'returns' (i.e. how much money we make over the course of implementing this decision) then the there is a point at which it is financially unwise to pay down a mortgage (even if the interest rate is higher... say 10%).

In the short term, it probably doesn't make a big deal. But if we're talking 20-40 years of wealth building, then the total return of investing far outweighs the savings of paying down the mortgage.

[EngineeringMyFinances]

The asset continues to grow and provide income even after the mortgage is paid off, whereas the money put into the mortgage sits idly.

I stand by what I said earlier. The comparison was between a money market or similar account paying the same interest rate as the mortgage. After the mortgage is paid off, the mortgage payments along with the extra payments could be deposited in the money market account for the same returns. While your point about the effective non-deductibility of mortgage interest below your standard deduction is a valid one, I doubt it would be enough to compensate for the difference between a 10% mortgage Vs a money market account paying 5%. I'm not going to the effort of modelling this in a spreadsheet -- the OP could do this with his actual situation considering his other deductions if he thinks it important.

And since the OP is a young person, my earlier advice to contribute to the spousal IRA stands as well.

[Peaceful_Warrior]

Originally Posted by EngineeringMyFinances

After the mortgage is paid off, the mortgage payments along with the extra payments could be deposited in the money market account for the same returns.

You must not have modeled this in a spreadsheet nor are you demonstrating knowledge of compounding over time. The invested asset continues to compound during the time the mortgage is being paid off, whereas the mortgage being paid down is acting like a savings account (not a money market fund account) which does not take advantage of the benefit of compounding.

Until you do the math on a spreadsheet, what I'm saying just won't 'click'. I know because I used to believe that paying down the mortgage was the financially wisest thing, and I didn't believe people who told me these same facts until I modeled it myself.

I've modeled it before (not sure where the spreadsheet is anymore), with several variables and given the interest rates over the last year or so, including investing the mortgage payment after the mortgage is paid off and compounding that as well.

It's very difficult to financially justify paying off a mortgage when given the opportunity to invest at a remotely close rate... especially if using the Roth since it's a tax-free investment, so the compounding over time really builds the asset to a place that the person could pay off the mortgage and still have money left over.

Over the long haul, there is a world of difference between not paying 5% (aka paying off mortgage) vs. compounding 5% (i.e. investing).

If you really want an eye opening experience, don't take my word for it. Model for yourself the difference between investing vs. paying off a mortgage.

Until you run the model, it is likely that everything I say will fall on deaf ears.

Originally Posted by EngineeringMyFinances

And since the OP is a young person, my earlier advice to contribute to the spousal IRA stands as well.

I also think in this situation that contribuing to the spousal IRA is financially the right thing to do... since he seems to be more interested in the financial benefits of having more assets than of the emotional benefits of having a paid off mortgage.

[EngineeringMyFinances]

whereas the mortgage being paid down is acting like a savings account (not a money market fund account) which does not take advantage of the benefit of compounding

So what you're saying is that on a 30 year mortgage, that an extra $100 paid with the first payment only reduces the 360th payment by $100 because there is no compounding on mortgage payments.

If you find your spreadsheet, feel free to post it and we'll figure out where you went wrong.

[CompoundInterestFan]

I did a basic model in Excel, but I'm not sure if it's correct (I'm a novice at Excel). I have "funding the Roth" beating "paying off the loan" even when the Roth ROR is lower than the mortgage payment. Spreadsheet's attached.

One note: Although the mortgage term is for 30 years, it balloons after 15 years, so I've adjusted my monthly payments to pay it off before then. Paying it off in 30 years would result in a monthly payment of $165.47.

[Peaceful_Warrior]

Originally Posted by CompoundInterestFan

I did a basic model in Excel, but I'm not sure if it's correct (I'm a novice at Excel). I have "funding the Roth" beating "paying off the loan" even when the Roth ROR is lower than the mortgage payment. Spreadsheet's attached.

One note: Although the mortgage term is for 30 years, it balloons after 15 years, so I've adjusted my monthly payments to pay it off before then. Paying it off in 30 years would result in a monthly payment of $165.47.

You might refinance before the balloon is due to take advantage of either reasonably low interest rates (lower than 7.55% as your credit improves and your equity increases), or to take cash out.... which is fun to invest (since home equity due to property value increases sits idle unless it's pulled out somehow). Whenever I can get cash out of a mortgage and invest it at a decent rate, I jump all over that. You can only do this up to $100,000 and still keep the full mortgage interest deduction, though.

This increases the duration of the mortgage, which also results in even more significant gains by leveraging the cheap debt from the mortgage to fund more profitable investments for more years. In other words, the longer one can carry a low interest mortgage and commit to investing, the more assets they'll have over time.

I never thought to PV the stuff when I did my model, but makes sense.

Another interesting model is to assume you have a lump sum and can make a choice to either pay off the outstanding balance of the mortgage or invest it. This is a very good illustration of the ultimate extreme - paying off the mortgage so early that interest on it is never even paid.

It's also interesting to note that as your income increases, that $100 that you can put either way could become larger. To make your model more interesting, replace all of the $100 entries with a variable (i.e. point to E2 which has the $100 in it). Then you can easily experiment with investing say, $200 or $300 instead of $100.

[EngineeringMyFinances]

I'll have to study your spreadsheet a bit more, may be a few days if I have further comments as it's late in the evening and I have to go to my Mega-corp job tomorrow and have other activities (yes, I have a life outside work and planning for retirement ).

But here are a few initial observations and reactions. My earlier statements were comparing effective interest rate returns after taxes for paying ahead on the mortgage Vs depositing the money in an after-tax savings account. Your spreadsheet does not address after-tax returns, only before tax.

The spreadsheet I would set up would do calculations on a monthly basis, not a yearly basis using the FV function. Using the FV function on a yearly basis makes it difficult to adjust for paying off the mortgage mid-year and increasing monthly contributions elsewhere for part of a year. Going monthly makes the spreadsheet longer, but that's OK -- Excel can handle it. Also, your spreadsheet doesn't show the interest paid and the effect on taxes, which will of course vary depending on what other deductions such as state income tax and property taxes. Which in my case exceed my standard deduction so any mortgage interest would be fully deductible.

But using your spreadsheet shows that there is compounding applied to added payments against a mortgage. Increasing payments in your Scenario 2 by $100/month in 2008 for an additional $1200 paid against the mortgage results in a difference of over $2600 to the computed balance in 2019, from $3275 to $638. Compounding in evidence.

Another factor appears to be that for a given year in your spreadsheet the mortgage balance is at the beginning of the year, while the Roth IRA balance is year-end. Will have to study this another day when it's not so close to my bed time.

[EngineeringMyFinances]

Originally Posted by CompoundInterestFan

I did a basic model in Excel, but I'm not sure if it's correct

Turns out tonight's activity was canceled. I've made a new spreadsheet to do the calculations you attempted. I do the calculations 1 month at a time. This allows mortgage payments to be switched to Roth contributions mid-year. As would be expected, the Roth balance is higher if you pay off the higher interest rate mortgage before starting the Roth. (Keep reading, this is NOT what I recommend.)

This spreadsheet does not tell the full story. It does not calculate the effect on your taxes. However, it is accurate if you do not have enough deductions to itemize. But if you do itemize, then you should add a calculation for the reduction of income taxes. Breakout the interest calculation on the mortgage into its own column, add up the interest paid, and calculate the income tax refund from the mortgage deduction. What do you do with the added refund? I think you should add it either to the mortgage or to the Roth.

As young as you are, I'd prefer to put money in the Roth even if the effective mortgage interest rate isn't reduced by tax deductions. Being the fan of compounding interest that you are, Roth contributions are compounded until you withdraw them -- how long will that be? Compared to how long will be the term on your mortgage? And how long will the term on your mortgage be if 5 years from now you decide to move?

In fact, since Roth contributions (but not the interest) can be withdrawn without penalty, you could consider making the minimum mortgage payment so that you could increase the Roth contribution. Then when the balloon payment comes due, pull enough principal out of your Roth to take care of it, and you'll have the interest still in your Roth.

Play around with the spreadsheet some more and see what works best for you.

[CompoundInterestFan]

Hey, thanks for putting that together; I'll start playing around with it and see what I come up with.

Originally Posted by EngineeringMyFinances

Being the fan of compounding interest that you are, Roth contributions are compounded until you withdraw them -- how long will that be? Compared to how long will be the term on your mortgage?

Well, those are good questions. Given the estimates I've done so far, I don't see much possibility in being able to retire before 55. I'd like to have any mortgage paid off by then, so even if I couldn't fully retire, I could drastically reduce my expenses.

Originally Posted by EngineeringMyFinances

In fact, since Roth contributions (but not the interest) can be withdrawn without penalty, you could consider making the minimum mortgage payment so that you could increase the Roth contribution. Then when the balloon payment comes due, pull enough principal out of your Roth to take care of it, and you'll have the interest still in your Roth.

My initial reaction to that is skepticism, but then again, if the numbers support it, then that sounds like a good idea.

[Peaceful_Warrior]

Originally Posted by EngineeringMyFinances

As would be expected, the Roth balance is higher if you pay off the higher interest rate mortgage before starting the Roth.

Thanks for modeling that - it was eye opening for me. I understand why my model before yielded different results. I was taking into account the mortgage interest deduction, and in my case with a pretty large mortgage balance at low interest it is a no-brainer without question to invest instead of pay down the mortgage as long as the interest rates are remotely close.

I was surprised to see that with equal interest rates, both scenarios come out equal which was helpful for me to understand compounding within the mortgage. I always understood it was there, but without running exact equal scenarios I couldn't see that it was also equal.

However, if the mortgage interest deduction is not available, then I see from your model that whichever has the best interest rate will yield more total assets.

Also, if the interest rates are similar, then investing in the Roth makes more sense because it provides more liquidity and if income increases, the mortgage can always be paid down more later on whereas the Roth has a max.

And what I already knew, but good to state for those reading - if a tax-free investment is not available, then paying down the mortgage makes the most sense (unless the interest rate difference is significant).