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Ask Dr. Don

Bigger house or save for retirement?

Dear Dr. Don,
The home's current value is about $90,000. Our home is very small but livable, although our son just moved back in with us for at least a year, maybe more.

We earn about $107,000 a year, but have not saved enough for retirement. We are 54 and 51 years old and would like to retire around 60 to 62. In addition to the home equity loan payment we are paying college tuition and related costs for our son who is finishing junior college this year and will have at least two to three more years to finish his bachelor's degree. Our question is this: Should we be looking for a better, bigger home and take on a mortgage for 15 or 20 years or should we pay off our home equity loan here, begin serious saving for retirement and make do in our little house?

We are not sure what the tax savings would be if we had a bigger mortgage and don't know how to compute that. We both will have government retirements and Social Security but just don't know what to do about housing. Can you give us some advice please!
Jean Joinder

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Dear Jean,
I'd lean toward making do. Although your empty nest isn't empty anymore, it's a short-range problem that doesn't require a long-range solution. Upsizing concentrates your investments into a single piece of real estate and you'll take on all the risks of that market.

One advantage of upsizing is when you're ready to retire you should be able to sell your home and not have to pay any federal taxes on the capital gain. IRS Publication 523, Selling Your Home, provides greater detail on the capital gains tax exclusion on the sale of your primary residence.

Being able to use the mortgage interest deduction reduces the effective rate of your mortgage loan, but you're still paying interest on the loan balance. With a $200,000, 15-year fixed rate mortgage at 5.50 percent you'll make monthly payments of $1,634.17, total payments of $294,150, and have total interest expense of $94,150 over the term of the mortgage. If the mortgage interest deduction saves you about one-third of the interest expense in reduced taxes you've still effectively spent $62,767 on interest. That's money that could have gone toward retirement savings.

If you invested the $1,634 a month over the next eight years at an average after-tax return on 6 percent, you'll have more than $200,000 as a retirement nest egg with no need for another seven years of mortgage payments.

Paying off the home equity loan gives you a return on your money equivalent to the after-tax cost of debt on the loan. If you use the mortgage interest deduction on your taxes your after-tax cost of debt is the loan rate times one minus the marginal federal income tax rate. You've reduced interest expense and rebuilt the equity in your home.

Your goal of retiring in your early sixties doesn't seem to be very realistic if you don't have much put aside besides the $64,000 equity you have in your home. Savings needs to be a bigger priority.

It would help you to hire a fee-based financial planner to review your retirement goals, income available to you in retirement and your current household budget. The planner would be able to determine if you can realistically meet your early retirement goal and what financial commitment it would take on your part between now and then to reach that goal. The National Association of Personal Financial Advisors (NAPFA) can help you find a fee-based financial planner in your area.

-- Posted: Sept. 24, 2003

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