Invest in your IRA, not just your house

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Dear Dr. Don,
I am refinancing my home, and I do not know whether to choose a 30-year fixed-rate mortgage at 3.75 percent or a 20-year fixed at 3.5 percent. If I went with the 30-year mortgage, I would use my savings to pay one extra mortgage payment per year and place $1,200 per year into a Roth individual retirement account. I am confused as to which is the better investment if I decide to sell my home five to seven years down the road as I’d like. You should also know that I have no other investments to speak of. I would greatly appreciate any insights. Can you please shed some light on which scenario would be best?

Many thanks!
— Jack Jericho

Dear Jack,
There’s more to life than paying off the mortgage. Investing for retirement is a sound financial goal too. Based on what little you’ve shared, let me demonstrate how you might look at your options.

First, you want to compare “apples to apples.” An additional principal payment combined with your IRA contribution should equal the difference between the two mortgage payments. So your monthly spending would be the same regardless whether you use the 30-year or the 20-year mortgage. If you can afford the 20-year option, you would be able to allocate the difference between the two payments.

I chose a Roth IRA contribution because it’s made with after-tax dollars. I picked the additional principal payment to match your stated goal of making an extra mortgage payment once a year; I just spread it over the year instead of doing a lump sum once a year. Also, I ignored the impact of the mortgage interest deduction on your taxes.

I used Bankrate’s Mortgage Interest Calculator with an amortization schedule to determine the total interest expense and ending loan balance after seven years for the two loans. Bankrate’s Savings Goal Calculator will give you the estimated value of the Roth IRA account after seven years.

When I ran the numbers, using a $200,000 loan amount as a hypothetical and the rates you gave me on the two loans, it showed the homeowner with a much lower loan balance after the seven-year horizon is up when you plan to sell your home. You can input your own numbers to mirror your specific situation.

Would you rather have the additional $18,500 in equity from your home or nearly $16,300 in a tax-advantaged retirement account that will continue to grow over time? The money is close enough in the example that I’d say the choice comes down to personal preference. But I would lean toward putting savings in the Roth IRA, since you say you don’t have any investments besides your home.

Not everyone can contribute directly to a Roth IRA, but you have the option to make nondeductible contributions to a traditional IRA and then convert it to a Roth IRA.

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