Buying a house: reality check
First, know that buying is not necessarily better than renting. If you feel like you are throwing away money on rent, or want to buy a house as an investment rather than as a place to live, you may want to think twice. Paying rent is not throwing money away, just like paying your water bill is not throwing money away. Furthermore, there are numerous reasons why investing in a house purely for investment’s sake is not the best idea, including that investing in the stock market is likely to give you higher returns and be less risky than investing in a house. You should run the numbers and do some research tailored to you and your situation to find out if buying or renting is better for you.
Second, know that you will only be approved for a mortgage if you have a low debt-to-income ratio, a decent credit score, and a stable income. If you’re approved for a mortgage, this means you probably have a decent income and an amount of debt that the bank is comfortable with. This also means that you can probably afford to pay more than the minimum on your current loans and put some of your income toward your retirement savings. If you can’t afford a mortgage, focus on paying down your debt and building up your retirement savings.
Balancing a mortgage with your 401(k) and your loans
The reason we hate credit card debt and love 401(k)s is because of compound interest. Unlike simple interest, which grows linearly, compound interest grows exponentially. Compound interest is working against you if you owe credit card debt, and works for you if you’re investing in your 401(k). This means that it’s in your best interest to pay off credit card debt and any loans with compound interest as fast as possible, and invest in your 401(k) as soon as possible. Student loans and car loans are typically simple interest loans, which are much better for you as a borrower than compound interest loans like credit card debt.
Knowing whether your mortgage, loans, and 401(k) accrue simple interest or compound interest, and what the interest rates are, will allow you to prioritize where it’s wisest to put your money. Mathematically, it’s smartest to pay off compounding, high-interest loans first, like credit card debt. Then you’ll be left with simple interest loans and your 401(k). While it might feel good to pay off your simple interest loans as fast as possible, the compounding effects of your 401(k) that happen over time cannot be recovered. Because the average return of the stock market is 7% in the long run and because your 401(k) compounds, the sooner you invest in your 401(k), the better. If you have only simple interest loans below 7%, you’ll likely make more money investing in your 401(k) than you will save by paying down your simple interest loan. It’s best to calculate the interest accrued on your own loans on a simple and compound interest calculator to figure out where you should be putting your money.
While mortgages are simple interest loans, a mortgage with amortized payments behaves more like a mortgage with compound interest. The compounding effect comes from varying principal payments that come with amortized payments, not compounding interest. Thus, while interest is not compounding on a mortgage, you can reap compound-like benefits from paying larger amounts sooner.
Because your mortgage and your 401(k) both have compounding effects, they are where you can make/save the most money. For example, if you had a mortgage with a 5% interest rate and a few student loans with 4% interest rates, and are investing in your 401(k) (estimated to be a compounding 7% interest rate over the long run), then you will get the most bang for your buck by putting extra money toward your 401(k), then toward your mortgage, and lastly toward your student loans. Conversely, if your mortgage has an interest rate higher than 7%, you could save more money by putting extra payments on your mortgage than you would make putting that money toward your 401(k).
The bottom line for balancing debt, retirement, and a mortgage
As always, look into building an account buffer and paying off all credit card debt, and any other loans with compound interest. An account buffer ensures that you have a small amount of readily available money for when life happens, and having zero credit card debt protects you from the negative side of compounding interest.
From there, it makes most sense mathematically to put your money toward whichever loan or investment saves or creates the most money. If your mortgage is below 7%, the math points to putting all of your extra money toward your 401(k). However, remember that the stock market does not come without risk. Rather than putting all of your eggs in one basket, think about putting a certain percentage of your income toward your 401(k) (remember to max out your employer match if available), a smaller percentage of your income toward extra mortgage payments, and the smallest percentage toward extra loan payments, assuming relative interest rates as in the example above.
It’s best to apply the logic of comparing interest rates and interest rate behavior (simple vs. compound) to the debt, retirement, and mortgage interest rates in your actual life to make sure you’re making the smartest financial moves. If you want to get serious about managing each payment wisely, try tracking the effects of extra payments on your mortgage and the effects of extra payments on your loans with easy-to-use, pre-made spreadsheets that do the math for you. All you need to do is plug in the principal amount, the interest rate, the term of the loan, and the loan start date. You can plug in extra regular payments and one-time bonus payments to see how paying more now can reduce the total interest you pay over the life of the loan. If you have one spreadsheet for each loan you have, you can compare the effects of extra loan payments on different loans and choose wisely where to put your extra loan payments. Take a half-hour to set up a spreadsheet for each loan you have, and you’ll be confident having visibility into your loans for the rest of time.
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