Wednesday, May 23, 2007

Save money for retirement - avoid these pitfalls! Part 1

As previously stated, due to an uncertain future of tax rates, health insurance costs, college costs for kids, changing government regulations, and increased life expectancies, I believe it is near impossible to predict how much we'll actually need to save for retirement. Therefore, the amount you need is A WHOLE LOT! That's all you need to know - you need A LOT. And if you need a large pile of money for retirement, you need to start saving now. The sooner you make the pile of money "sorta big," the bigger it will be upon retirement.

Here is the first pitfall that I believe you need to avoid on your road to retirement:

1. Don't prepay on your mortgage.

I expect heat for this, especially since I once was making prepayments on our mortgage. And I would actually encourage a discussion amongst my readers - if you disagree, or if I'm making any specious arguments, please let me know!

If you have excess cash each month, you have a choice. You can prepay on your mortgage, you can invest the money for retirement, or you can do a mixture of the two (or you can spend it willy nilly, not a choice for Q!). Here is what you need to know: investing for retirement should be the winning choice if you can invest the cash for a rate of return greater than what you would save by paying off the mortgage early.

For example, I have a 5.5% 30-year mortgage. We currently itemize on our taxes due to the large amounts of interest we're paying on two mortgages (principal residence and lakehouse). Because we itemize, we get a tax break on this interest. I believe we're in the 28% tax bracket, so the net damage to our finances due to paying interest on our mortgage is actually about 4%. So I am in effect earning 4% on any money I place towards prepayments on our mortgage. As we lose the ability to itemize (not sure when this will happen, but it will happen), my return would them shoot up to 5.5%.

Can you beat 5.5% by investing your excess cash instead? Currently, it couldn't be any easier! An FNBO Direct Savings Account will do the trick. If you decide to lift a finger and put even a little effort in to investing the money, you should be able to earn 8% a year. If you get aggressive, you can probably average a 10% return a year (reduce this rate of return if in a taxable account, do not reduce the rate of return if your retirement funds are in a Roth). Heck, I don't think it's sustainable, but my basket of small cap stocks earned 32% in the last year, doubling the return of the S&P 500. (Lord, why isn't that sustainable?!?!?)

Clearly, investing your excess cash is the winner. When running the numbers on yourself, your percentages will obviously vary based on your mortgage interest rate and your tax bracket. But in most cases, you should be able to generate a higher return by investing than in owning your house more quickly. A 10% return wallops a 4% return! For example, on $50,000 invested in year 0, with no further monies invested, an annual 4% return would leave you with $162,000 after 30 years. A 10% annual return would leave you with $872,000. To quote Shaggy, "ZOINKS!" Another eye-opening example is down lower in this column.

Therefore, risk factors and all other things being equal, always choose the higher rate of return.


Why, then, do people choose to prepay on their mortgage?

1. I don't want to pay all of that interest. If you run a 30-year amortization table on your mortgage, you will see some scary dollars going to interest. I have always gone to Karl's Mortgage Calculator to run numbers on various apartment building scenarios. Plug some numbers in and look at the damage. A 30-year, $300,000 mortgage (assuming 20% down, this is a $350,000 house) will have you shelling out $347,515 in interest over 30 years - equal to the price of the damn house! But, if you prepay just $500/month, you will shave off $161,000 in interest. Sounds great, right? Instead of thinking in dollar terms, you have to think in percentage terms. $161,000 in interest savings sounds great right now because we're all dirt poor! But, if you invest that $500 a month and achieve a 10% rate of return, you'll have $996,482 in 30 years - almost $1 million! Here's the deal, plain and simple -- Don't live in a large house with massive mortgage payments unless you can afford it, get the lowest mortgage interest rate you can, and then don't pay attention to the raw dollars in interest you're paying because it will mess with your head.

2. I want to be free of my mortgage payment. It's the largest monthly expense for most people. Once your house is paid off, you're free. Waaa-hooo! I will not lie to you - it will be a grand day when my house is paid off. But I will not be free. I still need to invest my way towards retirement. Then I will have to navigate my way through an uncertain future, making sure I have health insurance, paying for college for two kids (should my wife and I wish to do that), and paying for two weddings. Ugh! Look at it that way, and realize that your house is not a vehicle to drive towards retirement. A very fat brokerage account is what you need.

3. How could it possibly be good to keep debt around? That's not what the experts say! It does seem counter intuitive to keep debt around, especially just so you can get the mortgage interest deduction. Of course, as demonstrated above, you're not keeping the debt around because you like it, and you're not keeping it around for the tax deduction. You're keeping it because you wish to continue to live in your house, and there is a demonstrably superior place to apply your excess cash.

Part deux to come. Continue saving!

14 comments:

samerwriter said...

I disagree with the notion of not prepaying your mortgage for a couple reasons (more than a couple, but for now a couple will suffice):

1) Most people *do not* get the full tax break they think they are getting from their mortgage. Why? Let's say you are married and you don't itemize. Your standard deduction is somewhere around $10,000. Now let's say you pay $10,100 in mortgage interest. Now you're itemizing, but you're only ahead by 28% * $100, NOT 28% * $10,100.

Of course that's a simplistic scenario. Many people will have other deductions (state tax, property tax, charitable contributions, etc..) but the fact remains that you generally do *not* get the full tax benefit if you are itemizing due to your mortgage interest.

Oh, and as soon as the government decides you make too much money, they phase out a portion of the interest deduction anyway. Expect this to get worse in the future. From listening to the likely presidential candidates, I half expect successful people to lose many deductions.


2) Owning your house is a sure thing. The stock market is not. If I own my house outright, all I need to ensure I have a place to go every night is enough money to pay my property tax. The appropriate comparison to determine if you should prepay your mortgage would be to a guaranteed investment, such as treasuries.


Now clearly there is a balance to be struck. Just as you shouldn't invest 100% of your money in treasuries, you shouldn't invest 100% of your money in prepaying your mortgage. My wife and I put somewhere around 20% of our "extra" money (after other retirement savings) towards our mortgage, and the remaining 80% into a taxable investment account. That puts us on track to have our 30-year mortgage paid off in a few more years.

Q said...

Samerwriter,

Thanks for coming by my site.

Regarding the tax break, it is true that you do not get the full tax deduction if the following things occur:
1. You take the standard deduction
2. You are subject to phaseouts due to your large AGI on your tax return.

Even in such a case, you will over time be able to beat the return you'd receive by prepaying your mortgage (if you believe history). The historical return of the stock market is 10%/year. Even after taxes, you're talking about 7% a year. And a 7% return will beat most mortgage rates out there.

If you stunt the growth of your retirement portfolio because you're prepaying on your mortgage, it will be that much harder to catch up. It is much much more beneficial to begin maxing out your savings at age 30 than it is at age 45.

That's why I advocate saving the very maximum you can each month, starting as early as you can.

Regarding your house being a sure thing, my message is that the only thing young people should be concerned with is saving massive amounts for retirement. Because you can live in a big house, a small house, an apartment - but if you don't have enough saved up for retirement, you've sentenced yourself to some terrible Golden Years. You have to do everything you can to create the biggest pile of retirement money you can, and the numbers show that the earlier you start, and the more you pump in, the more you'll have.

I certainly do appreciate the balance you've struck. Depending on your situation, I think you'll be OK with your 80/20 distribution.

alex said...

Also prepaying on your mortgage reduces your leverage on the house. If you own 100% of your home, a 4% appreciation on a $100K home, nets you 4%. If you own 20% of your home, that 4% appreciation nets you a 20% return.
A FNBO account won't beat 5.5%. Your forgetting that your FNBO account will be taxed at your marginal rate (28% + state tax rate), thus your tax adjusted return would be lower than 5.5%.

Q said...

alex, good point on the FNBO income being taxed. I would not personally invest the bulk of my money in such an account, as greater returns can be had in the stock market.

KMull said...

I can see both sides. The way I see it, as long as you aren't piling on more consumer debt you will be doing something right.

I've also read an argument that saving up two years worth of living expenses (instead of paying that toward the house) would essentially lighten your stress load ... if you lose your job, you have two years of mortgage payments + incidentals saved up.

To each his own.

plus6 said...

I tend to keep it simple with this subject. I pay enough extra each month on the mortgage to equal one extra payment per year. That should allow me to pay the mortgage off approximately 6-7 years early. It's something I can reasonably afford and I do not notice it whatsoever and have been doing it since I bought the house. Maybe I could get slightly better return elsewhere but this seems to be the happy medium for me.

Mark said...

When you say "You can prepay on your mortgage, you can invest the money for retirement, or you can do a mixture of the two (or you can spend it willy nilly, not a choice for Q!)" I don't think you set up the options neutrally. That is, I don't think everything that isn't "invest" or "pay down mortgage" is willy nilly spending.

We balance current comsumption against saving for future consumption. Our goal is to invest 50% of our gross income. We max 401(k) and Roths then contibute enough in after-tax dollars each month to reach that goal. Actually, 401(k) matches put us over that goal, but I can live with that.

We base our budget on the remaining 50%, less taxes. Part of that 50% is a modest prepayment on our mortgage (5.5% 15 year). The prepayment means we go out to eat less, for example, it doesn't mean we invest less because we already meet our investment goals. If we didn't prepay the mortgage, that money would still be part of current consumption (maybe paying someone to mow my lawn rather than doing it myself), not investing.

Could we stop the prepayment and change our investment goal to 51% or whatever? Sure... we could also get rid of DirecTV, broadband internet, going to college football games, and countless other things that make the present more pleasant, in order to invest more. Still investing 50% of our gross income seems good enough, even if not the maximum conceivable amount.

The extra principal payments mean will we pay off our 180 month mortgage in 130, a bit over 4 years early. The peace of mind that brings, combined with our 50% investment rate, is worth more to me than the incremental (probable) increase in our portfolio if we poured every available dollar into it. Prepayment, especially on a low interest mortgage, almost certainly isn't the way to increase your retirement portfolio by every penny possible. Of course, neither is having two daughters but there are considerations other than how big your retirement stash is going to be.

Investing Blog said...

Hey,

Great Blog! Point #1 really hits home because my mother is struggling with a similar situation. She cannot understand how NOT paying extra monthly mortage payments can save you money in the long run.

I'm emailing her a copy, so she may read this at once.

Great post!

Matt said...

I agree with the fact that a 30 year fixed should not be paid off early but should a 2nd mortgage (7.17% over 15 yrs and I'm 26) be paid off early since the rate is higher? I used the 2nd to purchase a timeshare and pay off a high car loan.

Q said...

Matt,

Without knowing more about your personal financial situation, it's hard to say. Are you able to itemize on your taxes?

You might want to see if there is a way to refinance that 2nd mortgage. I have to admit I don't know if it's possible to get a lower rate on a 2nd mortgage or not.

In your case, it might make sense to do some prepaying. Run the numbers using your specific info (tax rate, projected rate of return on your investments, etc.) and see where you come out.

PT said...

Q, this is a great way to start your series. I'm going to try and catch up on the rest today.

My feelings are the same concerning no pre-payment of your 30 year, fixed, low interest mortgage. However, for these piggyback loans (>8%) that most new homeowners have, I say they should pay them off asap.

IMO prepayment of the first loan should only happen once you've got your retirement options maxed out.

Jon said...

Another thing to consider with prepayment is security.

If you lose your job after 10 years, and you still have 10 years on your mortgage (instead of 20 because you prepaid), what does the bank say? "Oh, that's okay, you prepaid so we just won't charge you for a few months!" I don't think so.

If you instead put your prepayment in a stock account or whatever, you can access that money to continue your payments. $100-$200 a month for 10 years, with interest, will give you a fairly large "house emergency" fund.

Cara said...

Lots of retirees nowadays consider saving up money for their loved ones' future. This will not only make them more stable, but it will also make them think less of how their lives are going to be when they get too old and weary. It can prevent them from worrying about where they can get resources from in the future. If you want to prepay on your mortgage, then it's up to you. As long as it makes you happy and at peace when you get old. =)


-Cara Larose

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good ideas