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Mr. Maroon

January 28, 2015

Optimizing Debt Repayment and Retirement Contributions

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Mrs. Maroon and I are currently working to identify the optimal approach to our remaining debt repayment and endowment contributions, and we need your help! Our conversations debates have occurred daily since we received our recent breeze-fall. The only remaining debt in the Maroon household is our mortgage, of which the details are as follows:

 

  • Home Value: $219,900
  • Loan Amount: $208,905
  • Period: 30 years
  • Interest Rate: 4.625%
  • PMI: $94.01
  • Taxes and Insurance Escrow: $309.69
  • Principal and Interest Payment: $1,074.06
  • Total Payment: $1,477.76

 

As it stands for 2015, we have budgeted for $82,000 to be distributed amongst our investments and mortgage. Beginning in August 2014, we set the monthly payment to a fixed amount of $2,000. It’s simple, it’s automatic, and it gives us a little bit of extra principal to attack that pesky PMI. Not too much, though. After all, the rate is low and the market, in the long term, is seemingly a better opportunity cost. Or is it?

 

 

To Kill or Not to Kill

 

There are a number of disputes on whether it is financially optimal to kill a mortgage. The math, I admit, seems simple. I have $219,900.

 

I buy a house for $219,900. I have no money, but I have a house.

 

OR

 

I put 5% down and invest the remainder, $208,905, in the stock market for 30 years, over which I anticipate 7% inflation-adjusted earnings, and I buy a house based on the loan above. At the end of 30 years, my total out of pocket for the house will be $219,900 in principal PLUS $177,757 in interest PLUS $9,401 in PMI for a grand total of $407,058! But, if I invest the $208,905 and pay my monthly payment from the 7% inflation-adjusted earnings, at the end I have a house and, as an added bonus, I’ve grown my investment to $327,567 by investing the difference between the earnings and house payment each month. As long as I’m earning more than I’m spending, I’m good! But hasn’t that behavior gotten us into trouble before? Isn’t our goal to rid ourselves of expenses?

 

A house and money in the bank is the obvious choice, provided our anticipated growth proves true. Unfortunately, we can only speculate on the growth. Even more unfortunate is that the debt is a certain and fixed expense, for thirty years, no less. And what greatly affects our early retirement isn’t what we make, but what we spend.

 

So, what is the optimal solution for an early retirement that is founded in minimizing living expenses and incredibly dependent upon the whimsical economy? Oh, and did I mention there’s a catch? The Maroons want to sell the existing house in Oklahoma, build a new house at the beach, and retire there in June 2020 – a short 65 months from now.

 

Let’s take a look at three options… But first, some assumptions:

 

  • Inflation-adjusted 7% growth in the market
  • Appreciation of the value of the house will offset sales fees so that equity is considered the amount of cash we walk away with at the sale
  • Annual contributions to investments are assumed as equal monthly contributions to simplify the math
  • For the sake of this exercise, let’s budget $120,000 for the new house
  • We don’t get any raises and all contribution limits do not change
  • Recall from The Master Plan Revisited that our endowment goal is $35,000 per year to include $30,000 from dividends and long-term capital gains (an endowment of $750,000) and $5,000 of supplemental income from selling pizza peels
Our debt monster!


Our debt monster!

 

Option 1

 

As I mentioned above, our current approach is to pay a fixed $2,000 per month to the mortgage, leaving $58,000 to be divvied up like such: $36,000 into two 401(k)s, $11,000 into two Roth IRAs (we make too much to benefit from Traditional IRAs), $2,400 into a 529 CSP, and $8,600 into taxable investments. The results look like this:

 

  • Endowment value: $686,233
  • Cash from sale: $79,365

 

Using the 4% Rule, that’s $27,450 per year to live on. Awesome, but not quite where we want to be. And we don’t have enough to build a new house free and clear, resulting in a 30-year mortgage with $2,618 in annual payments, making our actual endowed annual income $24,832 and, thus, requiring an even larger endowment or additional supplemental income.  That means only one thing – more work! Have I mentioned I’m ready to retire NOW?

 

Option 2

 

Instead, we kill the mortgage dead. The caveat here is that we no longer benefit from our tax-deferred 401(k) contributions, so we have $10,000 less to play with. Putting $72,000 per year against the mortgage gives us a payoff date of April 1, 2018, 39 months away, after which we regain the $10,000 tax savings and invest all $82,000 in investments like such: $36,000 into two 401(k)s, $11,000 into two Roth IRAs, $17,500 into a 529 CSP, and $17,500 into taxable investments. The results look like this:

 

  • Endowment value: $496,786
  • Cash from sale: $219,900

 

We walk away with cash for our house and an extra $100,000 of tax free money for three years of living expenses*, but our endowment hasn’t grown well, we’ve given up $30,000 of our hard-earned money in taxes, and we’ve lost out on employer matches for three years. However, if we don’t have to touch our endowment for three years, it continues to grow and tops out at $612,500. That’s a not-too-shabby $24,500 per year, but still isn’t at our $30,000.

 

Option 3

 

As we learned in Option 2, We need to maximize our tax-deferred investments or we owe Uncle Sam a huge chunk of what we don’t contribute, so let’s leave the 401(k) alone and put the rest, $46,000 per year, towards the mortgage. The results look like this:

 

  • Endowment value: $541,832
  • Cash from sale: $219,900

 

With the help of an additional $40 per month from our slush funds to the mortgage, the house is paid off on June 1, 2020 – just in time to sell it and walk away with enough to build our new house and $100,000 to live on for three years, leaving our investments to grow to $668,038 and us with $26,721 per year to live on. Imagine we could live for four years on that $100,000 and let our investments continue to grow for yet another year without touching them – suddenly we’re at $716,330, which is $28,653 per year and that, ladies and gentlemen, seems like the obvious choice.

 We hope to watch this kind of progress for our own forever home!


This would look much better at the beach!

So, which option would you choose? Have a better idea? What’s your game plan?

 

~Mr. Maroon

 

[* Mrs. Maroon Note: All of this math makes perfect sense to me until we start to estimate how, exactly, we will withdraw this 4% (or so) per year once we retire, and do so without incurring extra taxes or fees. The Traditional IRA to Roth IRA conversion makes sense, but we need five years of living expenses readily accessible until we can begin pulling from the Roth IRA. The idea of having living expenses for three, or even four years, while we rearrange our money to make it accessible seems like a huge benefit to me.]

Moneystepper 2015 Savings Challenge
A Breeze-Fall
  1. Comment by Robin — January 29, 2015 @ 7:14 AM

    Holy math!!
    I normally always always always go the route of paying off the mortgage. This is because I’m very cautious when it comes to investing and I can’t think of anything more exciting than sending off that last mortgage payment. Our number one goal right now is to pay off our house by August of 2016 and we think we will live in this house for many years to come. However, in your situation, if you are just planning on selling that house in a few years, then I’m not sure it’s to your advantage to pay it off so quickly, especially if you opt to neglect your 401k to do it. I would at the very least invest in your 401k up to the company match, but I think you already know that.
    I think option 3 is the clear choice, but since you’re selling the property, I’m not sure I’d even pay extra on the mortgage at that point. (And I can’t believe I just said that.)
    Robin recently posted…Things I Am Saying “Yes” to This YearMy Profile

    Mr. Maroon Reply:

    Being truly debt free would be awesome. Whether we pay for this house or we pay for the next house, we’ll still be paying for a house. If we pay this one off, unless we decided to buy a more expensive house in the future, we’ve got a paid for house for the rest of our lives, regardless of which house it is.

  2. Comment by Holly@ClubThrifty — January 29, 2015 @ 7:46 AM

    I like option 1! Your house looks cute- congrats!
    Holly@ClubThrifty recently posted…4 Reasons Zero-Sum Budgets Are AwesomeMy Profile

    Mr. Maroon Reply:

    Thanks! Option 1 always seemed adequate to us, but it’s hard to argue with math.

  3. Comment by Mrs SSC — January 29, 2015 @ 8:33 AM

    I had to caffeinate myself to read through this one 🙂 OK – so, I like option 4 – or at least here is another option you could consider. Personally, I HATE PMI. It just annoys me. What happens if you focus on paying enough to knock out your PMI as quickly as possible? Then just pay the mortgage as normal, and invest the rest.

    Mr SSC and I have a nice sized mortgage, but since we plan to move and downgrade when we are done working, we are in no rush to pay off the house. Especially since our dollars earn more money as investments then they do by paying off the mortgage early.
    Mrs SSC recently posted…That’s right! I don’t own a Keurig!My Profile

    Mr. Maroon Reply:

    Great idea for yet another little analysis!

    By my calculations, if we loaded the mortgage upfront with our monthly average of the available $82,000, we could drop PMI like the bad habit that it is in five months. That would leave ample opportunity to catch up on 401(k) and save ourselves from Uncle Sam.

    But then, if we back off to the minimum monthly mortgage payment until June 2020, reality sets in. That leaves us with only $71,668 in equity and sets us up for a 30-year note on the “beach” house with monthly payments of $259. Not too bad, but it means needing an extra $77,000 in our endowment to cover that expense – more work.

    Then, on the investment side, we have a little bit of growth this year followed by 4 1/2 years of better growth by making the minimum mortgage payment. The result is $263,200 in our endowment to start 2016 and $695,500 in June 2020. That’s $27,800 per year, which isn’t shabby, but then there’s that silly mortgage payment bringing our true annual endowed income back to $24,700.

    At first glance it doesn’t help us.

    I want to believe that it’s better to use low interest debt to our advantage, but it’s just looking like our situation warrants something different. Either way, I can’t wait to move to the beach!

  4. Comment by Harmony — January 29, 2015 @ 3:37 PM

    It looks like you’ve considered all of your options – either way you’re in great shape to move forward with your plans and sink your toes in the sand very soon. So inspiring to someone like me who still has such a long way to go.
    Harmony recently posted…11 New Ways We’re Going To Save Money This YearMy Profile

    Mr. Maroon Reply:

    Sometimes it feels like we are so far behind. The key is to improve everyday, even if that means just avoiding mistakes you’ve made in the past. Great job in just getting started!

  5. Comment by Kim@Eyesonthedollar — January 30, 2015 @ 8:38 AM

    You sound like me, always playing with different scenarios and changing your mind of what to do. We always seem to come back to a #3 like choice of still investing in retirement plus paying extra toward our house. It would be fun to put everything into it and pay if off in a few years, but that does mean wasting money on taxes and interest lost.
    Kim@Eyesonthedollar recently posted…Planning Ahead To Save Money On Kid ExpensesMy Profile

    Mr. Maroon Reply:

    It’s the engineer in me…always thinking, even after I’ve made a decision. I’m constantly trying to improve. What can I say? I’m a huge nerd.

    Mrs. Maroon Reply:

    If we could get paid for changing our minds, we’d be bazillionaires…

  6. Comment by Mr. Captain Cash — January 30, 2015 @ 1:45 PM

    Mrs. Maroon,

    You should definitely take advantage of your employers match program otherwise your throwing away a minimum 100% return on investment. What if you made your mortgage payments and set up a home equity line of credit to invest the continually building equity within your home?

    Mr. Captain Cash
    Mr. Captain Cash recently posted…Moneystepper’s 2015 Savings Challenge Update!My Profile

    Mr. Maroon Reply:

    Borrowing money to invest is a little beyond our comfort zone. The math works, but the debt doesn’t. As long as we owe money to someone, we’re a slave to them and our endowment will always have to be larger than if we didn’t. Sure, we’re potentially missing out on bigger growth. But our goal isn’t to get rich…it’s to get FREE!

  7. Comment by Jason @ Islands of Investing — January 31, 2015 @ 4:38 AM

    Wow Mr Maroon, some fantastic, well thought through scenarios there. and I’m so excited about your goal in 65 months time!

    Option 3 definitely seems to make the most sense, but so much of it also comes down to your own daily comfort or ‘well-being’ factor – even if the maths tells you it’s the best thing to do, some people just put a huge value on having a mortgage paid off (I’m personally at the other end of the spectrum, at least at the moment – I’d want to be investing as much as possible, but I’m certainly not going to suggest that path for you!)
    Jason @ Islands of Investing recently posted…Million Dollar Islands update – 31 January 2015My Profile

    Mr. Maroon Reply:

    I can’t leave this whole thing alone. It’s quite complex and the associated analyses are mind numbing.

    You’re quite right that the mental aspect of it is certainly important. Were it not for our mental health, we might as well just work for the remainder of our lives.

  8. Comment by Tawcan — January 31, 2015 @ 6:40 PM

    Some fantastic thoughts and great stuff on breaking down the math. I think I like option 3 myself.
    Tawcan recently posted…How we got started with dividend investingMy Profile

    Mr. Maroon Reply:

    I’ll admit that it fascinates me to run different scenarios in Excel. These are three of about two dozen different scenarios I’ve estimated and represent the best, worst, and middle-of-the-road options. No matter how many times I run the math, we’re always most advantaged by being out of debt when we retire while investing the remainder.

  9. Comment by M — February 1, 2015 @ 7:09 AM

    Hi. I’m in the UK, so I have no idea what PMI is, but let me tell you what we are doing, and maybe that will help you decide which of those options to pick.

    We got a house for £289,950 and our mortgage was about £160,000. Our house is now worth £389,000 and the mortgage is around £153,500. I re-mortgaged our house to a lifetime tracker rate, which is Bank of England Base Rate +1.49%, so it’s currently 1.99% in total.

    We could put £150+ overpayments towards the mortgage and pay it off in under 15 years. OR, we could invest that money every month. The markets typically return more than 7%, and given that inflation is currently hovering at or below 2%, it makes no sense to pay off the mortgage. We can gradually grow our money and in the same time as it would’ve taken to pay off the house early, we would be able to pay off the house AND have thousands of pounds of spare money.

    I don’t worry about the economy, since you can invest globally, there will always be somewhere that is growing when another place is slowing. And if inflation goes up, it is eroding the value of the debt against the house, whilst the house value continues to rise too. Investing in consumer stapes stocks can also hedge against inflation, since they pass on the costs to the customers.
    M recently posted…Are Stocks Cheap Right Now?My Profile

  10. Comment by Elroy — February 2, 2015 @ 3:01 PM

    How long are you planning on living on the “4% rule?” It is important to note when the original “trinity study” was originally done, it had a caveat of 30 years and some failure rate. Certainly, if looking at a 40-50 year retirement, 2%, 3% max is what I would be looking at and am planning for.

    For your question regarding how to fund early retirement from your tax advantaged accounts, I plan to use a healthy mix of taxable investments. I plan to sneak under the 15% tax bracket and pay 0% taxes. Also, the aforementioned “roth ladder” and I will initiate a 72t if I have to…but if I pull the plug at 45, I only need 15 years of expenses to be covered by investments in taxable accounts, or in your case, 5 years.
    Elroy recently posted…Israel – Masada & Dead SeaMy Profile

  11. Comment by Tonya@Budget and the Beach — February 2, 2015 @ 4:50 PM

    Well I know nothing abut houses and mortgages, but I do think your house is really cute! Sorry I can’t offer much help. 🙁
    Tonya@Budget and the Beach recently posted…A Financial Utopia?My Profile

  12. Comment by Shannon @ Financially Blonde — February 2, 2015 @ 7:34 PM

    I would say to pay off the portion of the mortgage you need to reduce PMI and then invest the rest. As long as you make more than 4.625%, your money is better optimized.
    Shannon @ Financially Blonde recently posted…Music Mondays – Crash and BurnMy Profile

  13. Comment by Rebecca @ Stapler Confessions — February 3, 2015 @ 7:54 AM

    Oh man, I need to come back to this post after I’ve had my morning coffee! My knee-jerk reaction is to pay off enough to get rid of the PMI and invest the rest. Even though you’ll continue being leveraged with monthly payments on the mortgage, you should have enough money invested to meet your obligations if you get into a cash flow jam.
    Rebecca @ Stapler Confessions recently posted…February Financial Update: Results from our Spending FreezeMy Profile

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