Should you pay down your mortgage or fund a Roth IRA? Many people think you have to choose—and there are good arguments on either side.
Putting extra money into paying down debt could help make you mortgage free much sooner than just making regular payments. On the other hand, investing for retirement through an IRA will produce vital retirement income. Not having to pay a mortgage in retirement doesn’t mean you don’t have to buy groceries.
What makes the most sense, however—if you can take the time to plan for it—is doing both. What that means is budgeting to pay extra on your mortgage while, at the same time, investing in a Roth IRA. It may require some financial juggling and compromise, but it’s possible to reduce mortgage debt and invest at the same time.
Let’s look at the benefits, then some ways to make it happen.
Balancing Your Investment Risk
Think about each option as an investment. Investing in your mortgage by paying down that debt is widely regarded as risk free and equal to the interest rate on the mortgage. This means that if your mortgage interest rate is five percent, your risk-free return is roughly five percent.
Since 1928 money invested in the S&P 500 has returned about 10 percent on average. Investing in the stock market, of course, is risky, and those returns have been uneven at best. If you stay in the market long enough, your return could equal 10 percent. If your tenure as an investor happens to coincide with several market downturns, however, the return could be much less.
Doing both will let you, in a sense, hedge one risk with the other. And it will encourage you to start earlier (or invest more), making the most of the power of compound interest over time.
Weighing the Psychological Benefits
It may be that the psychological benefit of paying off your mortgage over 15 years trumps the logic—not to mention the risk—of investing in an IRA. It’s possible you could be free of your mortgage in 15 years.
That accomplishment feels very real when you no longer must make a house payment—likely one of the biggest bills you pay each month. Not only that, you will own real estate free and clear, and real estate is traditionally a good investment.
Paying off debt feels like an accomplishment, but so is saving for your future. It may be worth putting up with more years of having mortgage debt hanging over you in order to build up your IRA savings and be in a better position in the future. That does mean, of course, that if things go very badly in the market, you could find yourself still in debt with a portfolio worth less than the amount you invested. But if you hold steady, as happened after the Great Recession of 2008, those battered investments could well recover their value over time.
Diversifying Your Assets
Here’s another reason not to focus just on your mortgage: If you pay off your mortgage early, your house suddenly becomes a very large part of your net worth. It may be your largest or even only source of emergency funds in the event of a layoff or medical emergency.
The problem is, you’ll still be vulnerable to economic conditions, maybe the very ones that caused you to lose your job. In a soft market you may not be able to sell your home to raise cash, and without a job you may not even be able to take out a second mortgage or home equity line of credit.
Such is not the case with investments in a Roth IRA. Assuming you don’t touch your earnings, you can withdraw your contributions without taxes and without penalty at any time. After age 59½—if you have a Roth account that is five years old or more—you can withdraw earnings as well. So the Roth is, in many ways, a better safety net than home equity.
The Question of Taxes
Mortgage interest is tax deductible (and your Roth contribution is not). Paying off your mortgage early eventually robs you of deductions you would have otherwise enjoyed.
On the other hand, if you’re in a higher tax bracket you may not be benefiting as much as you think. Suppose your current mortgage rate is five percent, but your combined federal and state marginal tax rate is 40 percent. This means that the effective interest rate on your mortgage is only three percent (five percent times 0.60). This means the mortgage isn’t costing you that much: It could make that probable 10 percent return on your Roth IRA investment even more attractive.
To make matters worse, paying off your mortgage could make it impossible for you to itemize deductions on your tax return, as mortgage interest is the single largest deduction for most people.
You have to wait for the tax benefits on money invested in a Roth IRA: You get to withdraw both your original contributions—and all the money those contributions earned over the years—tax free on retirement.
How to Do Both
Why not pay extra on your mortgage while, at the same time, investing in a Roth IRA? This is the part that requires planning and, ideally, the help of a financial advisor to budget for the best approach. It may require some financial juggling and compromise, but it’s possible to reduce mortgage debt and invest at the same time.
- Focus more on retirement investing in the early years. First, you’ll benefit from the compounding factor of getting as much money in your account early as your budget (and IRS rules about maximum yearly contributions) will allow. Also, your income will be lower and you may be more likely to fit the income limitations for contributing to a Roth than when you are older and (probably) richer.
- Develop a mortgage payoff schedule. Some people make two payments a month, rather than one. Your financial advisor can help you plan this out, including offering several options you can choose among depending on your other needs and the economy. Speaking of which….
- Time your investment/mortgage-payoff calendar to economic conditions. Direct more of your money to investments when the market is up and more to paying down your mortgage when that makes more sense (as long as you observe annual IRA investment limits). Comparing your ongoing return on investment between the two strategies can help guide your decision.
You may not pay off your mortgage in 15 years, but you eventually will—and more quickly than if you hadn’t sped up your payments. By combining that with attention to retirement savings, you’re likely to reach retirement with that debt out of your way and a larger nest egg that will let you truly enjoy the next chapter in your life.