The following is an excerpt from the book The Sound Mind Investing Handbook - A Step-By-Step Guide To Managing Your Money From A Biblical Perspective 5th Ed.
“If we can’t afford to make extra principal payments on our home mortgage and at the same time put money into our retirement plan, which should have the priority?” . . .
. . . is a question I receive quite often. Unfortunately, there’s no one-size-fits-all answer—your age, your tax bracket, what you would do with the tax savings from your mortgage interest, how long you expect to live in your home, and your general attitude toward being debt-free all play significant roles.
Let’s say that two readers of this book who have different goals are each wrestling with this question. Rob is leery about the long-term health of Social Security and wants to begin building his retirement funds immediately. Mort thinks being in debt is more of a concern and plans to use any monthly surplus to make additional principal payments on his mortgage.
For comparison purposes, let’s make their two situations identical: They both have new $120,000, fifteen-year 6% fixed rate mortgages; both can set aside $1,100 out of each month’s paycheck (their monthly mortgage payment is $1,013, leaving them each an extra $87 for payment of the principal or investment in a retirement account); both are in the 31% tax bracket (25% federal plus 6% state), and both have the opportunity to contribute to a retirement plan at work that will earn 8%, which is 2% more than their mortgages are costing them.
When they make their first month’s mortgage payment, $600 of it is tax deductible as interest expense. This will lower each of their taxes by $186 a month (31% of $600). What they do with that $186 savings can make a big difference.
Let’s assume that both Rob and Mort would like to get their hands on that savings sooner rather than later. They would get it back when they filed their income tax returns anyway, so why wait? So, they both change the withholding instructions they give their employers so that about $186 less is withheld for income taxes each month. By adding that amount to the extra $87 left from their monthly surplus, they each now have an extra $273 to work with. Rob contributes his $273 into his company’s 401(k) plan while Mort takes his $273 and makes an extra principal payment on his mortgage.
Now here’s where it can really get confusing. To construct an accurate picture, we have to recognize that Rob gets a second tax deduction—this time for putting money into the retirement plan. Rob’s $273 contribution is worth another $85 tax savings, which he could then also put into his 401(k). But then that $85 contribution would save him an additional $26 in taxes, which he could also put into his 401(k). But then that $26 . . . well, you get the idea. If Rob took maximum advantage of this, he could ultimately put $396 into his company retirement plan that first month (his $87 monthly surplus plus the tax savings of $186 for mortgage interest plus another $123 in tax savings for contributing to the company 401(k)).
Assume that both men are able to take the maximum advantage of the available tax savings as the years pass. Mort pays down as much extra on his mortgage each month as he can and pays it off completely in a little over 11 years. At that point, he shifts all the money he formerly put toward his mortgage each month into his retirement plan. He also adjusts his withholdings to take maximum advantage of the tax savings his contributions create.
At the end of fifteen years, their experiences can be summarized this way. Both men had the same out-of-pocket expenditures—$1,100 per month over fifteen years, totaling $198,000. In return, they both accomplished paying their $120,000 mortgage loans in full and were able to invest for retirement. It’s interesting to note that, although they proceeded according to different time tables, Rob and Mort ultimately saved an equal amount ($35,043) on their taxes. This was due to each of them always taking full advantage of the tax-deductibility of mortgage interest and 401(k) contributions with their surplus dollars.
The important difference in their financial situations after 15 years is found in the value of their retirement accounts. Rob’s 401(k) grew to $107,092 and Mort’s to $79,392. Although they had both saved the same amount in taxes which could then be invested for retirement, Rob’s savings were “front-loaded.” That meant he could put them to work in his 401(k) earlier than Mort could. In this way, Rob was able to take greater advantage of the tax-deferred compounding of profits. The difference in his 401(k) would have been even greater if Rob’s employer contributed matching funds. Mort’s retirement account later came on strong, but Rob’s head start was too great.
Should you follow Rob’s example? Perhaps, but not necessarily. To make it work, you’ve got to be able to aggressively use all of the tax savings, and more important, you need 15 years of relative stability in your job, the economy, and the tax code. That seems to be asking a lot from the next decade.
The advantages of following Mort’s approach are: It more quickly provides the security of debt-free home ownership, which will better enable you to weather any economic storms; in case of an emergency, the wealth in your home is more accessible than assets tied up in a retirement plan; and while Rob’s return in the 401(k) could fall or (even turn negative), Mort’s interest savings on his mortgage is guaranteed.