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Opportunity Cost – Trading Financial Gain for Security

June 1, 2010 · 19 comments

in Personal Finance

Whenever I think about the extra twenty-five cents I seem to have at the end of every week, I try to decide what the absolute best allocation of that money is.    That is because, we want to have enough money to do the following:

  1. Retire early
  2. Travel
  3. Afford health care

However, we are in our early forties now, and we don’t have as many ‘compounding years’ as we did when we first started working.  Since we also don’t have as much time to save, we have to maximize each spare dime we have.  That leads me to the question – what am I giving up by investing a certain way?

For example, we really want to get our house paid off.  We have an aggressive payment plan, even though our interest rate is only 4.75%.   Is paying off this debt getting us closer to reaching our three goals than putting  our money elsewhere?   In other words, what is the opportunity cost of paying off our mortgage?

One option for discretionary funds is to contribute to a 529 college savings plan.  In Michigan, you get a tax credit for money placed into a 529 account (up to 10,000 dollars), and the tax rate in Michigan is 4.6%.   Besides the tax benefit, there is also the chance that the  investment will grow (or drop), and you may also earn dividends on your investment.  Chances are, we would make more on our money by investing in a 529 plan than paying off our mortgage.    So there may be opportunity cost by investing spare money into our mortgage versus our 529 account.   However, we are willing accept a possible smaller return (debt reduction) to gain the security that comes from having less debt.   (Side note:  We do save for college.  However, we do not contribute the maximum amount allowed for tax benefits.  This is an area I may be revisiting.)

Another place for us to invest our extra money besides our mortgage is general savings, which in our case, would be used for when we hopefully retire early.  This is where I really struggle.  Could I ‘make’ more money by investing  in high-yield dividend stocks than I would gain by putting that extra money toward paying off the mortgage?  The answer is probably yes.   Again, we are trading financial gain for security.   I just keep thinking that when the mortgage is paid off, the reward of not having that debt hanging over us is well worth the amount of money we would forego by investing more aggressively.    However, I know that we have a killer interest rate and a lot of people would say we are crazy to put our money toward paying off the mortgage.

So, what do you think?  Are you willing to trade financial gain for security?  Or, do you focus more on generating income through your investments and let the debt take care of itself?

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{ 16 comments… read them below or add one }

Budgeting in the Fun Stuff June 1, 2010 at 1:51 pm

Usually I save aggressively and let the debt take care of itself, but we recently plunged into the idea of debt freedom. Even though our car loan is “only” at 4.6%, we’re decimating our savings accounts to pay it off. We’re then paying ourselves back and attacking the mortgage even more than we already do…

Financial security (debt freedom) will feel even sweeter than stock returns.

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Kris June 1, 2010 at 2:09 pm

Hey Budget – that is what I am hoping for, that freedom will feel fantastic. Of course, that freedom is way down the road for us.

Another thing I am hoping is that if a lot of our ‘savings’ is hidden in our home, that come financial aid time for college, we may possible get some if we don’t have as much in savings. Who knows though. We probably don’t qualify for anything, but it is worth a shot. I have no idea what the limitations are on financial aid these days.

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Budgeting in the Fun Stuff June 2, 2010 at 10:15 am

My parents seriously thought about buying land for their retirement dream house just so my little sisters would be eligible for financial aid. Thankfully, my younger sister who is currently in college got merit scholarships like I did and my parents bank accounts didn’t matter so much…

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Kris June 2, 2010 at 4:19 pm

BFS – I think Michigan got rid of a lot of their state-funded scholarships because our state is broke. Why finance education, right?

I would love if my kids earned some scholarships. However, I think that is getting harder and harder because there is so much competition out there for the same money. Good job to you and your sisters!

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Vitaeus June 1, 2010 at 3:10 pm

Pay off the house, the freedom you will gain from having to pay less per month for your living expenses, will pay big dividends, when you are looking to pay for kids college and for your retirement, whenever that is.

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Kris June 1, 2010 at 8:11 pm

Vitaeus – thanks for the support – and for stopping by!

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Money Reasons June 1, 2010 at 8:25 pm

I think I ran the numbers a few different ways, and I think by paying off the our house first, it cost me a thousand or 2 vs investing it. But the extra security was worth it for me (the cars have been paid off years ago). The last few years I had a mortgage rate comparable to the one that you had, but I figured I got this far, I should just finish it off.

Lately, the stock market has been so bad, that I’m pretty happy with my choice to pay off the house first. While I enjoy the feeling of being debt free. Now I’m in the “what is the best move next” mode with the increased cash flow.

As for my retirement, I’ve been pushing a lot into my 401k for over 10 years, so it’s hurt because of the market, but still doing okay (not great but okay).

I’m doing decently enough with respect to my kids 529 plans (40 for my son, 30 for my daughter), but still need a lot more…

Currently, I’ll be able to sock away more money into investments because of the increased cash flow from having the house paid off. I will create a fund of some sort to pay real estate taxes and fund better vacations. Ideally, I hope to invest in stock dividends that will someday pay enough of a yield to pay for both of these.

I have to admit, I’m not sure if the route I chose was the best, but I do think doing all at once (home extra payments, 401K, Roth, 529) has worked out well enough for me. Perhaps not the best plan, but still a plan that is good enough (at least for me).

Sounds like you and I share similar thoughts in this area 🙂

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Kris June 1, 2010 at 9:49 pm

Mr. Reasons: The market is a killer these days, unless you are a swing trader and make all the right calls!

By the way, you are doing fantastic in the amount you have saved for your kid’s college fund, not to mention also having your house paid off. Congratulations! Keep saving!

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Young Mogul June 1, 2010 at 8:35 pm

I can understand the security that comes from having less debt–but, for me, it is no debt EXCEPT the mortgage. As long as you have an emergency fund that would cover the mortgage in the case of illness or job loss and you will have the home paid off by the time you retire, I don’t really understand the rush. Personally, I would use the money for other things. For me, I need to find a balance between debt reduction and living now–not putting life off until retirement. Do you feel you are delaying until retirement things you could be enjoying now?

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Kris June 1, 2010 at 9:47 pm

Young Mogul – Oh I am very much living in the now, probably too much so! There is only so much we can contribute to retirement anyway. Its just that I am aggressively paying down the mortgage as much as I can because I hate having that house payment over my head. However, I do not sacrifice other areas to do so.

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Squirrelers June 1, 2010 at 10:32 pm

I like the way BFS put it: “Financial security (debt freedom) will feel even sweeter than stock returns.” For many of us, that’s probably the case.

I suggest thinking about which option will make you rest easier at night.

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ForexTrader January 10, 2011 at 2:19 pm

Hi

I must say that the freedom you have when you donâ??t have to pay off your mortgage is priceless. I was lucky and I inherited a small house from my grandparents. But I have a lot of friends who have invested the extra money into all sorts of investments and thought that the mortgage will be paid off by the profits their investments will make in time. Now their investments are more or less worth less than they have invested and they still have to pay off the mortgage.

Keep up the good work.

Cheers Alex

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Kris January 10, 2011 at 10:06 pm

Alex, you were smart in that you stayed in the house you inherited instead of getting greedy and selling that to buy a big house. Good job!

It is amazing how much people will ‘gamble’ with investments. If these past few years have taught me anything, it is that no investment is risk free, especially not your house.

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WealthGoals July 9, 2011 at 8:23 am

I feel that same way, I’d love to pay off my mortgage and not have that monthly payment. We would have so much extra money every month. We had 2 mortgages, and I just paid the smaller one off. Now we have an extra $200 every month which is very nice! I’m not at a point where we are paying off our main mortgage yet, but I hope to start doing so in a couple years!

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Kris July 10, 2011 at 11:10 am

Wealthgoals- it sounds like you are doing a great job though. Any reduction in debt in something to be celebrated!

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