This post is part two of my contribute to retirement or pay down your mortgage debate. Part I can be found here. Rather than argue for one side or the other, I have run some real life scenarios to see what I would do:
SCENARIO THREE- equity in home is modest and so is retirement portfolio (there is contribution room but it is not massive): This is the hardest scenario to judge. As a general rule, I would apply the tax analysis and contribute to retirement first. However, I am going look at this tax rule in a slightly different light- if your annual rate of return in your retirement portfolio is less than the interest rate on your mortgage then contribute to your mortgage. If you have a low rate of return in your investment portfolio (especially in a low interest rate environment), you need to stop doing what you are doing and figure out what you are doing wrong (either you are chasing the latest fad, paying too much in fees or have poor asset allocation). In the meantime, putting more money into your retirement portfolio before you fix the problem is throwing good money after bad. Until you fix your portfolio, you may as well guarantee a return of investment equal to the interest rate charge on your mortgage by paying down the mortgage.Verdict: contribute to retirement unless your rate of return in your retirement portfolio is below the interest rate charged on your mortgage; in this situation, you need help with your portfolio. Get some and pay down your mortgage in the meantime.
SCENARIO FOUR- significant equity, large retirement portfolio: Why you are reading this blog is beyond me! You clearly have mastered debt managment and investing. Congratulations- please share your success formula with me. Verdict: you tell me, you’re clearly doing well!
Some other things to consider:
- The higher your income, the more likely you should contribute to your retirement because you need to defer taxes. Unless you are highly leveraged, in this case, you may want to pay down the mortgage to reduce your debt exposure.
- If you are self-employed, your choices are a little more complicated; if you are in a business which require a lot of leverage (such as manufacturing), you may want to pay down your mortgage in order to build up equity so you can borrow against it (if you are self-employed, you understand that the bank asks for your first born as collateral no matter how successful your business). In a good year, you may want to contribute to your retirement to defer more taxes. Given that I am self-employed, my choice really depends on what type of year I am having and what cash flow is like at any particular period of time.
- It never hurts to do both at the same time.
- If in doubt, pay down the mortgage- its simple, elegant and it works. Here’s something which startled me- I raised my mortgage contribution $64/month in April and my amortization was reduced immediately by 8 months!
- In times of increasing interest rates, it may be more beneficically to pay down a variable rate mortgage. Increases in mortgage rates not only makes the cost of borrowing higher but tends to dampen the return on investment of certain types of equities (for example, banks and consumer discretionary stocks tend to drop as interest rates rise). Given that my variable mortgage just went up 0.1% and it may go up again, I am more inclinced to start paying down my mortgage.
I am sure a Ph.D thesis could be written on this topic (I suspect it already has been) but these are some consideration I would consider before making my decision between paying down my mortgage or contribution to retirement.
June 6th, 2007 at 12:31 pm
The problem with trying to compare the mortgage rate to your investment return is that you can’t predict either for any relevant length of time.
In my case I’m about to start a five year term on my mortgage so I know that the mortgage rate will be 5.19% for that period. However I have no idea what the rate will be for the 8 years or so after that 5 year term - I’m hoping it will be paid off in about 13 years.
My investment return? Forget it - I use a long term estimate of 7% return for my portfolio which I believe is a valid assumption over a time period of at least 15-20 years. I can still use this 7% figure as an estimate for the next 13 years but the odds of it being very accurate are unfortunately not that good.
Interesting posts!
June 6th, 2007 at 12:44 pm
Thanks for the comments. I am a big believer in trends- if the trend has been that a particular individual has, year over year, returned less in their retirement than their mortgage rates than it is mostly likely that they will continue to do the same. They are clearly doing something wrong especially in light of how low mortgage rates have been the last several years. This individual is better off paying down the mortgage in that case. I am assuming a large sample size- a person has not done well for years on end. If so, it seems unlikely that they will turn it around suddenly unless they are very lucky. In such an event, the safer choice is to pay down the mortgage as a means of avoiding further damage to themselves.
I hope these posts get people thinking out of the “either or” box on this issue.
June 6th, 2007 at 9:49 pm
That’s not a bad way to look at it.
I guess another situation would be someone who is a very conservative investor. Since their return would not likely be more than their mortgage rate, the mortgage option would win out pretty easily.