Your Mortgage or Your Retirement

The title of this article is more ominous than its content. I don’t expect you to have to decide whether you want to own a home or retire comfortably. I think you can have both — if you plan well. But I recently ran across some interesting information about how you might want to spend your extra dollars.

One obvious choice that many of us face when we’ve got some extra money to sock away is whether to apply it to our mortgage or our retirement. An extra mortgage payment is attractive, because it reduces our principal and will cost us less in interest payments in the future. It also offers a guaranteed return. If your mortgage is at 6.5%, you’ll essentially earn that by not having to pay it on your principal-reduction amount. Socking the money away for your retirement is also attractive. We all know that the more we save and invest for retirement (and the earlier we do so), the better off we’ll likely be when our golden days arrive.

So what’s the right choice? Well, our friends at the National Bureau of Economic Research recently released a report by Gene Amromin, Jennifer Huang, and Clemens Sialm that will inform your decision. Here’s their abstract:

We show that a significant number of households can perform a tax arbitrage by cutting back on their additional mortgage payments and increasing their contributions to tax-deferred accounts (TDA). Using data from the Survey of Consumer Finances, we show that about 38% of U.S. households that are accelerating their mortgage payments instead of saving in tax-deferred accounts are making the wrong choice. For these households, reallocating their savings can yield a mean benefit of 11 to 17 cents per dollar, depending on the choice of investment assets in the TDA. In the aggregate, these mis-allocated savings are costing U.S. households as much as 1.5 billion dollars per year. Finally, we show empirically that this inefficient behavior is unlikely to be driven by liquidity considerations and that self-reported debt aversion and risk aversion variables explain to some extent the preference for paying off debt obligations early and hence the propensity to forgo our proposed tax arbitrage.

Got it? It’s clearly worth exploring your options a little more deeply. Tax-deferred accounts include 401(k) plans and traditional IRAs. (Roth IRAs do away with taxes altogether, though they accept only post-tax money.) In such accounts, if you’ve invested in aggressive stocks or mutual funds, ones where you expect to earn, say, an annual average of 12% or even 14%, you should take that into account when comparing it with the 6.5% you’d make via extra mortgage payments. (Also take into account the risks involved — one option is much more of a sure thing.)

This topic was addressed on our Buying and Selling a Home discussion board recently. Here are some of the thoughts of our board denizens (or read the whole discussion):

DeltaOne81 made a good point, noting that if 38% of U.S. households that are accelerating their mortgage payments are making the wrong choice, “doesn’t this mean that 62% of those that have accelerated their mortgage payments are doing the right thing?”

Dave Donhoff, a mortgage professional who frequents the board, later chimed in with a clarification, which then got clarified further. (Reading our boards can often be more illuminating than the original research report!)

Aj485 then offered his own perspective:

My mortgage payment (P&I) is about $1,000. To have an additional $1,000 per month expense, assuming a safe withdrawal rate of 4% … $1,000 times 12, divided by 4%, equals $300,000. That’s why I will pay off my mortgage before I retire — it affords me the ability to retire with $300,000 less in investments, because my expenses will be $12,000 less per year.

If you’re interested in home-buying and selling issues, visit our Home Center, which features lots of money-saving tips and even some special mortgage rates.

If you’re thinking about buying real estate as an investment, consider an alternative that you can get into and out of much more easily: real-estate-focused mutual funds. Motley Fool Champion Funds recommendation Third Avenue Real Estate Fund (FUND: TAREX), for example, has grown at an annual average clip of 21.3% over the past five years, enough to turn $10,000 into more than $24,000. Its current top holdings include Forest City Enterprises A (NYSE: FCEA - News) and Vornado Realty Trust (NYSE: VNO - News).

Non-real-estate funds can deliver similar or better returns, with a little more diversification. Consider, for example, the Legg Mason Opportunity Fund (FUND: LMOPX), with a five-year average annual return of nearly 16%, invested in the likes of U.S. Steel (NYSE: X - News), and IAC/InterActiveCorp (Nasdaq: IACI - News). Remember, of course, that past performance doesn’t guarantee future returns, and always do your own due diligence before you invest.

This entry was posted on Wednesday, October 18th, 2006 and is filed under Home Mortgages. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.
« Planning for longevity
Deal yourself a new hand of credit cards »

Leave a Reply

Sponsors

Tags

How Credit Scores Affect Mortgage Applications

With a good credit score an applicant will receive prompt response from many lenders, all of them offering low interest rates and low down payment options. The loan amount offered also may be high. On the contrary a low credit score would result in a lot of rejection from various mortgage financers. Because creditors wouldn’t come forward easily to give credit to individuals that have a history of difficulty in repaying existing loans. After all, creditors take risk when they finance mortgages against the credit history of a debtor. Naturally, they will wish to remain on the safe side and pick up less risky ones that have good credit histories. A good credit score means less chance of missing on payments and therefore less risky.

But there are some real risk takers that will come forward to finance mortgages for individuals with bad credit scores. They would charge high down payments and always high interest rates though. They may also fix additional charges for every little paper work and may charge high closing rates. The loan amount offered will also be considerably less. The individual with poor credit scores will not have much choice but to accept the terms and conditions as there are no other alternatives. This is a tight situation and to avoid this you must have a good credit score.

People with bad credit may fall in to the trap of ’secured loans’. Secured loans are the ones where the loan applicant offers an asset as collateral security. The lender becomes secure about the repayment of the loan and not the borrower. Securing a loan with bad credit score becomes easy only when the applicant is willing to offer some asset as collateral security. This again is a very dangerous situation where an individual runs the risk of losing his entire collateral asset in case of failing to pay the loan installments in time. An individual should always avoid such type of a loan.

Resort properties normally require large amounts of finance which a person with bad credit may find it difficult to obtain. So it is always advisable to keep your credit score high. Incase the credit score becomes low due to unavoidable financial reasons it can be improved upon. There is no need to lose hope simply because a person has a low credit score. If the property that he intends to buy has good equity he should go out and try to obtain finances for it. There are many sub prime lenders willing to offer their services.

For a review of your credit report as it relates to a mortgage loan and a consultation on the best loans available to you, give us a confidential, no obligation and no cost call.