Halfway through a high-interest mortgage: pay off, or invest instead?

[mjb]

Hi everyone. Hopefully this is an interesting exercise for all the engineers out there!

I'm 37, in the US, and firmly in the 15% tax bracket. (AGI from my 2013 1040 was $24,000. Barring a drastic life change, this won't go up much.). I just started getting my shit together a few months ago after reading this blog, and now I'm trying to decide what to do with the money I'm now saving every month.

The short version: I'm more than halfway through a 10.25%, 15-year mortgage. Since the majority of my interest payments are behind me (due to the amortization schedule), should I start funneling money into an IRA instead of paying down the mortgage?

The long version: I have an 80/20 mortgage on a home I bought in July 2006. It's currently a rental in a very strong rental market -- less than a mile from a huge public university -- so I'm not worried about covering the mortgage long-term.

The 20% mortgage stats:

 - principal balance is $15,000
 - Interest rate is 10.25%
 - I have 86 payments (of 181 total) left -- about 7 years
 - Payoff date is currently July 2021

Instead of paying extra on the principal each month, I'm considering instead putting this extra cash into my IRA. (Current balance: $20k, and it's all I've got for retirement savings).

According to my bank's amortization calculator, by paying an extra $458/month ($5500 yearly IRA cap / 12 = $458), I'll have the mortgage paid off in 2 years. I'll save:

 - about $6000 in interest, and
 - cut 5 years off the loan.

But, because of amortization, the bulk of my interest payments are already behind me. What if, instead of paying off the mortgage quickly (despite its high rate), I put that money into my IRA or a Roth IRA for the next five years instead?

I did some calculations, and figuring a 7% return - 3% for inflation:

 - I'd make about $3500 in interest/dividends
 - I'd gain at least $550/yr from the Saver's Credit on my taxes (more if I can get my AGI down) -- so $2750 in tax credits + $3500 in interest, $6250
 - I'd be able to fund my IRA for two extra years that I couldn't otherwise

The last point seems to be the biggest benefit. Figuring that I'll live to my mid-70's, over the course of 40 years, that extra $11,000 invested should compound to about $52k.

What do y'all think? Am I missing something? Thank you!!

[feelingroovy]

The short version: no.

The long version: figure out any way you can refinance that.  The balance is too low to get a true mortgage and it would be silly to pay closing costs, but consider a home equity loan or line of credit.  You could probably even get a personal loan at a better rate than that (unless your credit is terrible).

I would even resort to 0% credit cards at some point.  Not sure if you're quite low enough to get there, but you've got to be close.

[electriceagle]

The advice to invest before paying off a mortgage applies only when the mortgage is at a low interest rate. Suppose that someone with a combined state/federal tax burden has a mortgage at 4%. The net interest rate is 2.66%. Since typical index fund returns are 7%, it makes sense for them to invest before paying down principal.

Your mortgage's interest rate (10+%) is higher than typical investment returns. You should try to refinance it any way that you can.

If you have good credit, your local credit union may give you a debt consolidaton loan at around 7%. Thats not great, but it is a good first step.

Another option might be a home equity loan. Can you take out a home equity loan at a lower rate and use it to pay off the 10% mortgage?

[mjb]

Never mind, I am an idiot!

I didn't take into account that the reason the interest portion of my mortgage payment goes down isn't because of amortization, but because the principal balance is going down while the overall payment amount stays the same.

I will hammer away at the mortgage after all. Thanks!

[Cheddar Stacker]

Umm, I think you might have misread the advice. If you can pay it off quicklly by all means do so, but if not the are plenty or 4% interest HELOCs available online and you should at least consider that. 10% is absurd in the US and nothing you said makes me think you are anywhere else.

You are correct in taking into account the savers credit and the limited window each year for IRAs, but you might be able to do both if you refi instead of payoff. Good luck!

[MDM]

I didn't take into account that the reason the interest portion of my mortgage payment goes down isn't because of amortization, but because the principal balance is going down while the overall payment amount stays the same.

I will hammer away at the mortgage after all. Thanks!

Yes.  People may not realize that in a typical mortgage they are always paying the same interest rate on whatever principal remains.

[Mr. Frugalwoods]

Agree with the other sentiments that it's time to pay it off or get  HELOC.  It certainly won't qualify for a traditional refinance since the balance is so low.

While I often tend towards the "pay into retirement accounts, you don't get a second chance for this year" camp... this interest rate is high enough that it constitutes a hair on fire treatment.

How's the 80 loan looking?  Is that something you want to let ride?

[mjb]

Agree with the other sentiments that it's time to pay it off or get  HELOC.  It certainly won't qualify for a traditional refinance since the balance is so low.

The purchase value of the home (which I haven't had looked at it since, but home prices in this market have been very stable) is $116,500, and I owe about $102,000 between the two mortgages. I'm not sure I'd qualify for a HELOC big enough, but I'll call my bank on Monday.

While I often tend towards the "pay into retirement accounts, you don't get a second chance for this year" camp... this interest rate is high enough that it constitutes a hair on fire treatment.

Agreed, though if the math works out, would putting enough in my IRA for the Saver's Credit help offset this?

How's the 80 loan looking?  Is that something you want to let ride?

It's a re-fi done in 2010. 30-year, 5.325%. Not amazing, but between refinancing costs and my lower income, i'm not sure I could get a rate low enough to justify a re-fi.

Thanks everyone!

[mjb]

I didn't take into account that the reason the interest portion of my mortgage payment goes down isn't because of amortization, but because the principal balance is going down while the overall payment amount stays the same.

I will hammer away at the mortgage after all. Thanks!

Yes.  People may not realize that in a typical mortgage they are always paying the same interest rate on whatever principal remains.

Exactly. I mean, it makes total sense to me, so I'm not sure why I didn't connect the dots there.

[Mr. Frugalwoods]

While I often tend towards the "pay into retirement accounts, you don't get a second chance for this year" camp... this interest rate is high enough that it constitutes a hair on fire treatment.

Agreed, though if the math works out, would putting enough in my IRA for the Saver's Credit help offset this?

Totally fair point.  The math might work out just slightly if you assume normal historical market performance.  But over the short term market performance assumptions aren't really valid.  In this case I'd still take the short term guaranteed return from paying off the mortgage.

[Heart of Tin]

Agreed, though if the math works out, would putting enough in my IRA for the Saver's Credit help offset this?

Probably. Consider the amount of your contribution that qualifies for the credit an "instant return" on your contribution, kind of like a 401k employer match. If you only qualify for a 10% credit, then you should pay down the 10%+ mortgage instead. If you qualify for 20% or above, contribute to the maximum amount that applies towards the Saver's Credit, then put the rest toward your mortgage.

[mjb]

Agreed, though if the math works out, would putting enough in my IRA for the Saver's Credit help offset this?

Probably. Consider the amount of your contribution that qualifies for the credit an "instant return" on your contribution, kind of like a 401k employer match. If you only qualify for a 10% credit, then you should pay down the 10%+ mortgage instead. If you qualify for 20% or above, contribute to the maximum amount that applies towards the Saver's Credit, then put the rest toward your mortgage.

That's what I'm thinking as well.

Unfortunately, as I freelance, my income varies wildly, so I won't have a good idea as to what my AGI (and, as such, my Saver's Credit) will be until closer to the end of the year. I'll work on the mortgage until then, and maybe start funneling money into the IRA then if it makes sense.

Thanks for the insights and math checks!