Paying off mortgage to buy stocks creates risk

ADVICE: PERSONAL FINANCE
Paying off mortgage to buy stocks creates risk
By ERIC TYSON
King Features Syndicate

Q: Should I pay off my home mortgage early? I am single, just turning 40 and have two years left before the interest rate rises on my 30-year adjustable rate mortgage, which is fixed for the first three years at 4.5 percent. I owe about $125,000. I have been a saver all my life, and this is my only debt. I entered into the ARM last year with the idea that I would pay it all off in three years, so I am not concerned with what future interest rates will do. I could pay off the mortgage now and still have about $40,000 in savings, but 4.5 percent interest doesn't seem too bad considering the tax benefit on mortgage interest. But if the rate rolls over at 6.5 percent in two years, does it make the most sense to pay it off and start investing the additional free cash flow in stocks at that time?

A: The answer to your question depends on how you're investing your spare cash. If you were keeping it in a savings account earning just 2 percent to 3 percent, you'd be better off paying your mortgage off now.

You didn't say how you invest your money, but I would say that at your age you should be reasonably aggressive. You should have about 70 percent or so in stocks with the remainder in bonds. With that kind of a mix, you should earn more than the cost of the mortgage.

Note, though, the key word being "should." To earn more than the cost of your mortgage, you must take a fair degree of risk.

If your mortgage rate goes to 6.5 percent in two years, I would think very strongly about paying off the mortgage, especially since you'd still have a major cash buffer.

If you take this course of action, then you could gradually feed excess monthly cash flow into a mixture of mostly stocks and to a lesser extent bonds (ideally in a tax-advantaged retirement account).

Q: What is the advantage of putting nondeductible funds into an IRA? Are there any limitations on the amount of money one could put into an IRA that is nondeductible?

A: The advantage of contributing money without an upfront tax deduction into an IRA is that the investment earnings compound without taxation until withdrawal. The investment earnings would be taxed when they are withdrawn. The annual contribution limit is $4,000 (but if you're age 50 and up, you may contribute up to $4,500 per year).

With the newer Roth IRAs, into which you also make nondeductible contributions, under current tax laws, your investment earnings also compound without taxation. Upon withdrawal, however, your Roth IRA investment earnings are not taxed so long as you meet basic requirements.

Not everyone may contribute to a Roth IRA — married taxpayers with adjusted gross income in excess of $160,000 and single taxpayers with an AGI above $110,000 are not eligible.

So long as you are eligible for a Roth IRA, I would recommend contributing to that over a nondeductible regular IRA.