Quick 401k vs Debt question

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Quick 401k vs Debt question

Postby adam61 » Fri Apr 05, 2013 4:08 pm

I've been utilizing 2 systems over the past few years to dramatically decrease our debt and slowly increase our 401k contributions until they max. However, I've only given basic thought to how the 2 interact and when/if I should rebalance my plan to pay off debt with my plan to grow IRA contributions. Here's where I'm at.

I am 31, Wife 35, No Children.

Over the past 5 years I have completely paid off all credit cards, car payments, both my and my wife's student loans, paid off second mortgage, and significantly reduced the balance on my first mortgage. My only remaining debt is a 15yr mortgage at 2.95%. As I've paid off debt I've used the technique of rolling the payment of the paid off debt into the remaining payments. So I now pay principal and interest of $2,150 monthly (the normal payment is ~$1,150). With these larger payments I have 54 payments remaining until I would be debt free.

We have also slowly changed from no ROTH and 10% in 401k's to maxed Roth's and 17% in 401k contributions. We are currently increasing our 401k contributions by 2% each year around annual raise time to a max of ~25% (In about 4-5 years) which would max all tax advantaged space from that point on. Currently we have about 1.8 years gross annual household salary in retirement accounts and 12 months of of emergency funds on top of that. We currently contribute $11,000 to our ROTH IRAs and about $24,000 to 401(k)s plus matching contributions of about $6,500.

In 4.5 years we would be debt free and maxing our tax advantaged space regardless, so the question is really around the mid-term decision of how to allocate those resources. It seems like financially it's a better use of funds to max the tax advantaged space now, as we can't get that back. However, my wife and I are pretty debt averse, and being just 4.5 years away from a debt free goal is a little hard to give up. It also gives us more flexibility from that point forward to never feel the need to get back into debt or to drop from our tax advantaged maximums.

I think we're trying to blindly continue to pay our debt down because the prospect of being debt free is so exciting, but I wanted to step back one time and review if I was making a disasterous financial decision by doing that, or just leaving a little money on the table in exchange for piece of mind.

Thanks for your help!!
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Re: Quick 401k vs Debt question

Postby Twins Fan » Fri Apr 05, 2013 4:30 pm

I'd say you're doing just fine!!

You have a low interest rate on your mortgage, so some will tell you not to pre-pay anything and just pay on schedule there. Then invest more because you will likely get a higher return that way. Your effective interest rate on the mortgage is probably close to being in the 1's depending on your tax bracket and assuming you itemize the interest for taxes.

Others will say there's no better feeling than being debt free, and don't worry for a minute about how the "numbers" work out.

From reading your post, it seems being debt free is a high priority to you and your wife. You should be debt free in about 4 1/2 years and you're increasing your contributions to retirement accounts along the way. I say stick to your plan.
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Re: Quick 401k vs Debt question

Postby adam61 » Sat Apr 06, 2013 2:34 pm

Thanks for your response. I did not state it in the original post but I do not have enough deductions to itemize, so the effective rate is also 2.95%.
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Re: Quick 401k vs Debt question

Postby 100CountryGoal » Sun Apr 07, 2013 4:24 am

It's highly probable (I'd surmise 80%) that you'll be financially better off fully taking advantage of tax-deferred savings vehicles (tax-wise and via returns hopefully above 2.95%). I'd personally go this route unless you feel you'd likely earn a lot less money if you lost your current job and foresee a plausible scenario of financial hardship in the coming few years. . . or if your wife is strongly in favor of paying off the mortgage sooner. After all, happiness is not just about the numbers on your statements, but it does help.

P.S. Great Job!!
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Re: Quick 401k vs Debt question

Postby grabiner » Sun Apr 07, 2013 11:53 am

adam61 wrote:Thanks for your response. I did not state it in the original post but I do not have enough deductions to itemize, so the effective rate is also 2.95%.


Therefore, paying off the mortgage is a guaranteed 2.95% return, and you will get the return in less than five years. You can't get a guaranteed 2.95% return in less than five years with your investments, which makes paying down the mortgage particularly attractive.

The downside is that you will miss out on some tax-deferred savings, because you may max out your 401(k)s and have to save in taxable accounts in the future But how likely is that?

Are you planning to have children? If you do, the children will increase the amount you need to spend, leaving you less for your 401(k), and will provide more opportunities for tax-deferred saving if you need to do it (529 plans for their college tuition). If you aren't planning to have children, it's a closer decision, but debt aversion is a good justification for an early paydown.
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Re: Quick 401k vs Debt question

Postby python99 » Sun Apr 07, 2013 12:23 pm

I have heard many talk about paying off the mortgage...that it is similar to "buying a bond" that has the effective rate of the payed off mortgage. Which on face value makes much sense, however it seems to me that once you do that your "stuck" with that return and "bond" forever and would not be able to take advantage of raising rates if or when it happens unless you do a re-fi or HELOC...and in that case you would be doing that at a higher rate thereby negating the whole concept.

What is your opinions on the above...just wondering how others view this.

Thanks
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Re: Quick 401k vs Debt question

Postby cherijoh » Sun Apr 07, 2013 12:35 pm

One thing that you should consider when making this decision is the quality of your 401-K plans - are there good choices such as low expense ratio index funds? If so that would give additional weight towards maxing out your 401Ks. If there are only poor selections with high expense ratios then I would lean more towards paying down the mortgage.

Personally, I think the xx% guaranteed return for paying down debt loses much of its power when you are talking about an historical low interest rate on a fixed rate mortgage. You may not be able to guarantee a 2.95% return, but it is likely that over the course of 5 years you could do better than that in your 401K if you had access to good low cost index funds. The guaranteed return argument is a whole lot more persuasive if you are taking about 18% on a credit card!!

It just doesn't take into account the opportunity cost for losing that tax-advantaged space. You and your wife may not be with the same employers in the future and there is no guarantee that you will have access to any type of 401-K plan in the future. How would you feel if you were limited to just Roth IRA contributions? Would that give you enough space down the road for the tax inefficient portion of your retirement portfolio (i.e., bonds, REITs, etc)? Or what if you suddenly had access to only crappy funds with excessive expense ratios? Those situations might cause you to regret the lost opportunity of not filling out your 401ks.

But the decision isn't purely financial and rational - you have to put a value on the "peace of mind" of being debt-free. What is that worth to you and your wife?
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Re: Quick 401k vs Debt question

Postby grabiner » Sun Apr 07, 2013 3:41 pm

JambokLive wrote:I have heard many talk about paying off the mortgage...that it is similar to "buying a bond" that has the effective rate of the payed off mortgage. Which on face value makes much sense, however it seems to me that once you do that your "stuck" with that return and "bond" forever and would not be able to take advantage of raising rates if or when it happens unless you do a re-fi or HELOC...and in that case you would be doing that at a higher rate thereby negating the whole concept.


But the same thing is true when you buy a bond. If you buy a 10-year Treasury bond for $10,000 with a 2% yield, you are guaranteed to get $100 every six months and the $10,000 principal after 10 years. You can't take advantage of rising rates; if interest rates rise to 4%, you won't be able to sell the Treasury bond for $10,000. (You can still sell the bond and buy a new bond with a 4% yield, but the new bond will have a lower principal value, so you won't wind up with any more money.)

There is an asymmetry in the other direction, which is a slight advantage for keeping the mortgage. If you have a mortgage at 5% and interest rates fall to 4%, you can refinance your mortgage, keeping the same principal but paying a lower rate. If you buy a Treasury bond at 5% and interest rates fall to 4%, the Treasury can't refinance its bond, and must continue paying the higher yield; alternatively, you can sell the bond for a capital gain and reinvest the larger amount at 4%. Municipalities and corporations can refinance their bonds, but only under limited terms (the "call" provisions in bond contracts).

However, the asymmetry isn't likely to be of any benefit to the OP; it is unlikely that the OP's mortgage rate will decline by enough to make it worth refinancing before the OP pays it off.
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