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Save for Retirement Now or Payoff Your Mortgage First?

Two of the most important components of retirement planning are a generous retirement savings plan and a mortgage free home. But if limited resources force you to make a choice, which goal should get the lion’s share of your extra income? Should you save for retirement now or payoff your mortgage first?

There are three basic choices:

1) Emphasize retirement and let the mortgage slowly amortize itself into extinction
2) Throw all extra funds at the mortgage, and once it’s paid you’ll have even more money to put into retirement
3) A hybrid plan where you try to do both at the same time

This isn’t a good solution-bad solution debate. There are plusses and minuses no matter which way you go, and fortunately all three can get us where we need to go. Which one we choose will depend largely on individual circumstances and preferences.

Retirement savings first, mortgage later

Save for Retirement Now or Payoff Your Mortgage First?
Save for Retirement Now or Payoff Your Mortgage First?
Advantages: By building retirement savings early, we’re not only maximizing the time value of money but we’re getting the advantage of tax deferral in the process. The bigger the pile accumulated early, the less we’ll need to commit as we get closer to retirement—the hard work will already be done.

Disadvantages: Much of the advantage of frontloading retirement depends on the performance of the stock market. If the market doesn’t turn in decidedly positive returns, the whole scenario weakens considerably. Stocks also carry a substantial risk of loss; paying off a mortgage, by contrast, has none of that risk.

Mortgage payoff first, retirement savings later

Advantages: The biggest impact of prepaying a mortgage takes place in the first few years. This is because mortgage payments are overwhelmingly comprised of interest in the first few years. The sooner you can pay down the balance, the sooner the interest/principal divide begins to work in your favor. By making prepayments early, the term of the loan will be reduced. You can cut your term in half by making substantial prepayments in the first few years. Once your mortgage is paid, your cash flow will improve enabling you to save money at a higher rate than ever before.

Paying down a mortgage effectively locks in a rate of return equivalent to the interest rate on your loan. A guaranteed 5-6% return on mortgage payoff will look really good the next time the stock market hits the skids. This is no small advantage given that the stock market has experienced two major slides in just the past 10 years.

Disadvantages: When funds are committed to mortgage prepayment, there are only two ways to get it out in an emergency: borrow it out or sell the property. The first defeats the purpose of prepaying, and the second is disruptive and difficult to pull off, especially in a weak housing market.

As you pay down your loan balance, the mortgage interest tax benefit will decline. Also while prepayments will shorten the term of the loan, your payment will remain the same until the loan is fully paid.

The Hybrid Solution—juggling both at the same time

Advantages: By taking on both projects simultaneously, you make steady, if slower, progress on two important goals at the same time. You also keep your options open to favor one over the other at some point in the future when it may become advantageous to do so. For example, another crash in the stock market may create a one time buying opportunity when you’ll want to shift excess funds to retirement savings to do some bottom fishing. Alternatively, once your mortgage balance falls to a certain level, you may want to concentrate funds there if you might be able to pay it completely in three of four years.

Disadvantages: You’re pouring money into two long term projects at once, limiting the impact on both while quite possibly draining your budget for two plans that offer no immediate benefit. There’s a compelling school of thought that we’re most effective when we throw all of our effort behind a single worthy goal.

My personal opinion

Everyone’s situation is different and there are no hard and fast rules, but since I generally favor savings ahead of debt payoff, I think that for the typical homeowner it’s best to emphasize building up retirement savings over mortgage payoff. This is especially true if you’re early in either situation.

Time is an important factor with retirement savings; the biggest advantage comes when you’re able to plow a lot of money in early. Delaying or minimizing contributions in the early years will have serious opportunity costs.

Mortgages are what we might call patient debt. A 30- or 15-year fixed rate mortgage isn’t going anywhere. The payments are fixed for the term of the loan and the rate will never increase. They’re also self-amortizing, so even if we do nothing more than make the scheduled payments, the principal balance will go down, albeit slowly. Unlike credit cards and some other forms of debt, we can afford to leave mortgages alone until we’re ready to deal with them.

It might be better to focus on maximizing retirement savings early on, then shift resources into mortgage prepayment later. If you reach a point where your retirement savings are larger than your mortgage, the effort will seem that much easier.

Two exceptions…

There are however two exceptions on this opinion: 1) if you have minimal equity in your home or 2) if your mortgage is of the exotic variety.

If you purchased your home with a minimum down payment—or even more if it was with 100% financing—and your equity position has gone negative, this is a situation that demands immediate cash infusion until the equity deficiency is cured.

The same is true of exotic mortgages—adjustable rate loans, balloons, interest only and anything of the sub-prime variety. In the current real estate market, a refinance could be complicated if the value of your home has fallen significantly. Rebuilding equity is critical.

Adjustable rate mortgages depend on low rates. Don’t allow the calm rate environment of the past few years to lull you into thinking that low rates are forever. Balloon loans could cause a need to refinance, and equity could be a problem. On interest-only mortgages the only way to reduce the balance will be to make direct principal reductions. And sub-prime loans just need to go away, period.

Any of these mortgage types, along with a weak equity position, might have you in a crisis where the loan represents a near term threat to either your financial position or to your household stability. The mortgage should necessarily be the priority to receive any excess funds.

But apart from these two exceptions, I think the emphasis should be on retirement savings first.

Which camp are you in, retirement savings first, payoff the mortgage first or taking on both at the same time?

( Photo courtesy of mortgagepaymentplan )


53 Responses to Save for Retirement Now or Payoff Your Mortgage First?

  1. Why do you have to invest for retirement? Couldn’t you negate the disadvantages listed by not investing in stocks but instead putting the money in something that is less risky. You set up a side fund, separate from your retirement, that is able to pay your mortgage off at any time if you need it to. As long as you don’t this fund continues to grow and enjoy compounding interest. Will that give you the best of both worlds?

  2. EOW–that’s a really good point, but the Wall Street crowd won’t make much money on it! I agree, there’s an obsession with staying “fully invested” all the time, and it hasn’t entirely served everyone well. Balance is so important.

  3. When we refinanced our house 7 years ago we decided to do a 10-year mortgage for the balance and force ourselves to pay it off before our daughter went to college. Took some scrimping for a few years to make the larger payments but when those first tuition bills hit it will be nice to have no mortgage.

  4. gn–being debt free opens up options that we wouldn’t have otherwise. You’re probably finding you have more stress-free time, and can do many of the things you couldn’t before. Smart thinking doing the 10 year loan. If you can afford it, it may be the best way to eliminate your mortgage without having to make extra payments.

  5. The answer depends more on the emotional components of the person in question than the finances – since in most cases emotions and financial “mindset” matter more than logic. Lots of people prefer not to have that ominous debt on their shoulders. Other don’t have the discipline to save regularly and not raid those savings for piddly-crap.

    Emotions aside (purely logical) it is best to pay as little as possible towards the mortgage and put that money aside to investments instead. This allows for savings which are liquid and available. Money in home equity is locked up where you can’t get at it without paying a fee and getting permission (a new loan) from the bank. On average, money properly invested will have a greater after-tax return than the after tax cost (interest rate). Finally, with inflation in our future, the loan will be paid off with cheaper dollars – adding another 2% average to the arbitrage (in real purchasing power terms).

    If you can get your head around these concepts, sleep at night and have the discipline to stick with the strategy, the numbers dictate that paying off a mortgage is never the best option. Then again, everybody is different.

  6. John – You and I are on the same page. Good point about inflation, that’s a big one that I missed.

    I completely agree that the path to financial success is largely an emotional/psychological one. If we don’t address it at that level we may doom the best laid plans. You have to wonder how many people can’t find success and blame external factors when it’s what goes on in our heads that may have the biggest impact of all.

  7. This is one of my favorite topics to debate! Personally, I prefer knocking down the mortgage first. We’re only in year 1 of a 30-year mortgage, but we’re making extra principal payments. We’re also saving for retirement through 401(k)s, and saving for a rainy day, too. I think once the mortgage balance dips to where we’re comfortable, we’ll focus more on retirement savings.

  8. RainyDaySaver – As I said in the post, all of these approaches will work, but we do have to find the one that works best for us personally. None of us can succeed playing someone else’s game.

  9. Whatever one’s priority, I’d say not to miss the matched 401(k) funds. After that, a guaranteed 5-6% isn’t too bad. Unless of course you see t-bills back at 8%, then why not just buy t-bills at 8% while paying the bank at 5%?

  10. Joe – Very good point, the 401k match is a compelling reason to emphasize retirement savings. Of course in this econonmy so many companies have eliminated it as a way to cut costs, but if your company gives it, go for it.

  11. Great question – one that my wife and I regularly discuss! I seem to be wishy washy, at times wanting that dumb mortgage paid off (even tho’ it’s only at 4.875%) and then ramping up the retirement savings.

    I like EOW’s idea too.

    I’d add a third exception however, and that is conscience.

    There are many people who hate any and all debt with a passion and their consciences won’t allow them to carry debt because they view it as slavery. I would encourage them to just go ahead and pay it off because you don’t want to violate your conscience.

  12. Jason – I fully agree, you have to do what feels right. Even though I favor retirement savings over mortgage payoff, I’ll be the first to admit that the people I know who have stayed out of debt have done extremely well for themselves, maybe better even than the savers!

  13. Kevin – Isn’t paying off your mortgage saving for retirement, b/c you increase equity and decrease debt?

    Same no? It’s just accounting, with some liquidity issues involved.

  14. FS – Very true, which is why I’ve included both in the same debate! We need both in equal measure, a healthy retirement savings plan and a house owned free and clear. It’s really a matter of which works best for you individually.

  15. I think I actually favor the combined option, but I would lean towards putting more towards the house. I think I would prefer to not have a house payment over having money in a 401k that I can’t touch until I’m 59 without paying huge penalties. You have consider the retirement mostly off limits just as the equity in the house is hard to get at. With the house paid off my wife and could afford to have either of us lose a job and not really be phased by it. That would be a great place to be.

  16. Derek – You’re hitting on something really important, that all long term plans are subordinate to short term necessity. The loss of a job for an extended period changes everything. Also, a job loss MUST be figured into any future plans since it’s become so common today, even for people once thought to be in “safe” careers. In truth, there are no safe fields any more!

  17. It is really a three way question
    1 The house
    2 Retirement
    3 Other Debt

    Figure out which one gets you the best return on your money, then hammer away at it until, the conditions change. For me, the Other debt is slightly higher interest than the house and is WAY better than you can get without playing with fire (stocks), so I am getting rid of the other debt, when that is all gone I will likely split between the house and retirement, with some going towards education for my 2 girls.

    Your mileage may vary and First, STOP digging the hole deeper

  18. Vitaeus – YES, so right about “other debt”. That has to be the first to go, and I plan on handling that in another post. There’s no point in doing any of the above if you have other debt, since it usually carries even higher rates and takes a disproportionate share of income.

  19. I’m in the invest for retirement camp. You just don’t need to miss out on power of compound interest.

  20. Ken – that’s one of the biggest reasons for favoring retirement savings. In truth, mortgage debt isn’t going anywhere, at least not if it’s fixed rate.

  21. We favor fully paid or fully mortgaged. We view the area in between these two points as “no man’s land.” Therefore, we would tend to favor retirement savings (some deferred and some not) over using a mortgage as a mechanism for saving. The other option, of course, is renting which also has its advantages depending on where we are in the boom-bust cycle. We don’t view a mortgage as necessairily being a marriage. In our view, divorcing ourselves from a mortgage is definitely an option.

  22. Steven and Debra – I’ve actually read that very position in the past and consider it to have merit. It does depend however on the long term view of the housing market and of the economy.

  23. Financial Samurai:
    “Isn’t paying off your mortgage saving for retirement, b/c you increase equity and decrease debt?”

    I think there is a huge difference. Return On Equity Is Always Zero

  24. This subject is very timely for me because it is something I’ve been wrestling with. I’m 52 and have decided to put my full attention on paying off my mortgage. If everything goes according to plan, I can have my mortgage paid off in 3 years. This means I will not be making a Roth contribution and only putting the minimum in my 401k at work to get the company match during this time. Why am I doing this? Because it is really the best return right now. My mortgage rate is 4 percentages higher than I could get in a CD (not taking into account the tax effect. So why not pay it on my mortgage and get a better return? I plan on socking away the max for retirement after I have my mortgage paid. As I get nearer retirement, I don’t plan having all my money in stocks and mutual funds, so I will put a larger amount in guaranteed investments like CDs. I’m hoping in 3 years CD rates will be much higher than they are now.

  25. Norm, it sounds like you’re on the right track. Since you’re relatively close to retirement age, debt elimnation becomes more important than asset accumulation. You’ll be elimnating a payment, probably the largest one you have, and that will be worth more to you than anything a larger retirement portfolio could buy.

    If you pay off the mortgage in 3 years, you’re only 55, and that gives you plenty of time – and extra budget room – to build up savings. Since you already have a retirement base, it may grow incredibly once the mortgage is gone and you can throw everything you’ve got into savings. You won’t be able to do that with a mortgage on your back.

    This is just my own opinion, but pretty financial projections aside, it’s been my anecdotal experience that most people accumulate the bulk of their investment worth during an advantageous time in life when income is unusually high and expenses are unusually low. That’s not an excuse to not save regularly, but it does offer hope to anyone who may feel that their efforts to date might be looking inadequate.

    There are “fast forward” periods just as there are “stuck in the mud” periods. Clearning the deck of debts is one of the best ways to move into a fast forward period.

  26. I agree that saving for retirement first is the wise choice. I tend to agree with Dave Ramsey’s plan, save up emergency money, pay off all debts (except for the house), save up an even better emergency fund, then save for retirement. The house just keeps getting payed off like usual, unless of course you come up on the kind of money to do both.

  27. Liberty, I agree as well. Mortgages are long term, patient debt and because of this, we can tend to other financial pursuits while this one slowly liquidates.

  28. Interesting article. As you say one size does not fit all and it all depends on someone’s personal circumstances and life objectives.

    I basically do a bit of both – take advantage of employers pension scheme, and pay off the mortgage – but my emphasis is HEAVILY on paying off the mortgage as quickly as possible. Here’s why – in UK you can’t take income from a personal pension plan until you are 55, and a government pension until around 65+ (depending on your current age) – which is bad news if you want to retire at 50 like me!

    Pension schemes just don’t have the flexibility of alternatives, but as mentioned I do take advantage of employer contribs and tax status. Unfortunately here in the UK the government has meddled in personal (private) pensions to the point of destruction. ISAs here are a tax-free haven – but the interest rate currently sucks the big one.

    As mentioned my approach has been to pay off my mortgage. When I retire I intend to spend some time travelling, and rent my house out, so that will generate a reasonable income for me. After that I get to live rent free, which helps. :)

    The other thing I have done is build passive income streams – individually they don’t make much, but together they make more than enough to live on – without requiring much work on my part (I will be retired after all).

    So my advice would be, if you want to retire early, get that mortgage paid off (assuming you don’t have credit card debt and you have a reasonable emergency fund etc.), and get a little passive income business going!

  29. Tony – Thanks for the transparency with your personal financial situation. I really like the passive income streams concept, because as I discuss elsewhere on this blog, most of us will need some sort of income generating capacity after retirement to cover what government checks and private retirement plans won’t cover. And especially to deal with inflation!

    Paying off debt is a way of creating an income stream because if frees up income that would go for debt service. But more tangible income streams are very well advised.

  30. The most liberating day in my life was the day my wife and I paid off our mortgage. She feels the same. It changes how you think about every money issue. You suddenly see that there is no rule that you must be a wage slave until you turn 65. It’s a major click moment.

    I don’t think you can understand this until you’ve sent in that last check and experienced the feeling.

    Rob

  31. Rob – I think there is no right or wrong way to do it; it’s really a matter of personal preference. Having no mortgage payment is a huge burden lifted, but another advantage that I didn’t touch on in the post is that a mortgage payoff is a goal that is attainable, but what’s the “goal” with a retirement plan, and how much is ever enough.

    Building up a retirement plan can be a bit like having a arms race with yourself because the goal is never actually reached. In reality, we need to learn to live within the framework of what ever reasources we have available, and of course paying off your mortgage frees up a lot of resources!

    Ultimately, the end game is to have a goal, and whether you emphasize retirement savings or mortgage payoff matters less than your overall forward motion.

  32. I agree with you it depends on personal preference and comfort. The current interest rates and potential returns on investments also need to be considered.

    Many people do both at the same time, the hybrid option, I think its because they don’t know which one to focus on.

  33. In my opinion, savings for retirement should be carefully planned to make sure that retirement will not be a troublesome situation in a financial sense, up to the point where a person doesn’t have enough money to survive for long. It is hard to save when one has debts to pay, but with a wise usage of money, I do think it’s possible.

  34. Marty – One of the points in the post is that paying off debt usually has a greater positive impact on cash flow than saving up an equivalent amount of savings. If paying off $10,000 in debts will eliminate $500 a month in payments, that’s a whole lot of cash flow for a relatively small investment.

    We’re all concerned with maximizing income for retirement, but lowering outgo is just as important–even more so if you have limited resources.

  35. Which option to choose really depend on how your current and future (if you know it) financial situations. I am not trying to pay off my mortgage at the moment, I want to use the spare bit of cash to try different investment.

  36. Two equally important options to choose from. Wow, now you got me thinking! My number one agenda is to save and what will effectively help my present situation and my future is definitely something to think about.

  37. the equation is very simple… a paid for home is far solid than money into somebody Else’s hand. besides with so many scandals out there nowadays….

  38. great article! Like you…i’m in favor of saving before paying off debt. The way I see it if poop hits the fan i want to be able to take care of MYSELF first. Everyone else (debt collectors) come in second. typically people get in financial binds because they haven’t saved. One bad situation comes up and it snowballs.

    I think if your mortgage payment is manageable and you have a good % rate, invest in your retirement for sure!

    btw – your site seems to be registering an error?

  39. 401k – Yes! If you can’t take care of yourself, you’ll never be able to pay your debts anyway!

    On the error, it looks like you made two comments, and BOTH ended up in the spam filter! Wish there was a better way to deal with spam, but we’re all at the mercy of common systems.

  40. Savings/investments over mortgage because the time will allow you to build interest. I am curious as to what you think about retirees will have to rent or don’t have plans to buy a home because they are single and won’t have a need for a lot of room? I know many people who live in So Cal and will not be able to afford to buy ever.

  41. Jackie – You’re bringing up an outstanding point on retirees renting. While I don’t think there’s one answer for everyone, I do think renting is a better option for a lot of seniors on a number of fronts.

    For one thing, renting means you don’t have to make repairs. Not only does that save money, but it also leads to a simpler life. A lot of retirees like to travel, others have health problems–home repairs are a distraction and an extra expense in both situations. The tenant doesn’t have that problem. Then there’s cutting the lawn, shoveling snow, etc–I don’t think I want to do those when I’m retired! And if you can’t…then there’s an extra expense.

    As to the purely financial side of it, everyone thinks in terms of owning as a way of living “rent free” once the mortgage is paid. I have a few problems with that concept. For one thing, you will still have taxes, insurance and the aforementioned repair and maintenance costs. But beyond that is the financial opportunity cost. When you own a house, a lot of capital is tied up in it. Sure you might not have a mortgage payment, but you also aren’t earning any money on it. It kind of cancels out.

    Now right now with interest rates as low as they are, that makes sense. But if rates on savings return to historic norms, it won’t look so good any more. The problem is magnified in high cost areas, where hundreds of thousands of dollars are tied up on bricks and mortar, rather than in financial assets earning income.

    That’s just an opinion, and one I might be writing a post on very soon!

  42. I like having the house paid off. There’s less government involvement. Fattening up the 401K is only good if you are careful about avoiding losses in the 401K account. A lot of people just put the account on auto-pilot. When the market gets hammered it takes years to recoup. Plus, what Derek said about not having access to you own money prior to age 59 and a half with out mega penalties is very sobering.

  43. Hi Mike–It’s true that paying off the mortgage is a guaranteed outcome, while a 401k could drop in value in a matter of months. If that happened you’d wish that you paid off the mortgage instead.

  44. Hi Pauline–That’s actually true at these rates. Mortgage rates are right at the level of inflation, so you’re better off to keep your mortgage open and invest for higher returns.

  45. Pauline:

    I see where you’re coming from, but it’s wise to be cautious. We do have low interest rates now – but for how long? If you look at the money printing in the USA, the money supply has been inflated by over 300%, and the Fed is printing billions more each month. Meanwhile government debt is fast approaching $17 trillion and more worryingly the annual deficit is around $1.6 last time I checked. They’d have to nearly double taxes, or spend a lot less, to cover that (ain’t going to happen). So my fear is we are maybe a year or two away from high inflation and, as a result, high interest rates. Given the continued expansion of the money supply I wouldn’t we surprised if we saw inflation/interest rates up at around 10 to 12% within a few years. Now the government will not want high interest rates – not with 17 trillion of debt on their books, so they will do their damndest to avoid that, but there comes a limit to what they can do. Actually the situation is a bit more complicated than that because there’s the (declining) value of the dollar to consider, but I don’t want to drone on too much! ;)

    Also, the stock market gains over the last couple of years have been almost entirely as a result of the Fed’s money printing, rather than a boost in underlying economic performance – just check the GDP figures and compare to the amount of money printed. Also, if you look at the graphs of money printing against stock market the close correlation is scary. At some point the money printing has to stop, because of dangerous levels of inflation, and even more dangerous high interest rates, and when that happens there’s only one way the stock market is going to go.

    You do make a good point, indirectly, that in a high inflation period you’re paying down with dollars that are actually becoming worth less due to inflation, which is a good thing, but with higher interest rates you better be able to afford that monthly payment, and there’s no guarantee that your wages will actually increase with inflation (most people’s don’t now) – they’ve been stagnant these last couple of years.

    Still, there are timescales to consider, as long as the Fed keeps printing money, the stock market will go up (more or less). But how long have we got before the gravy train stops? It could be two years, or five? I don’t know. My guess is two years.

    The big advantage of having your mortgage paid off is you don’t have to worry about any of this! Like Mike Craig said above it’s nice to have the mortgage paid off – great for stress free living! It keeps things simple and that’s my main reason for having paid off my mortgage quickly. It’s also quite nice to live “rent free”.

    I’m not saying you’re “wrong”, just there are two ways to look at this! Cheers, Tony

  46. Hi Tony–I agree with what you’re saying, but if inflation and interest rates go to double digits, having a 4% or 5% mortgage will be a good position. And having money free (not used to payoff the mortgage) for investment could be even better in that environment, like borrowing at 4% and earning 10-12%. Still, with all of the macro economic distortions out there we have to avoid the temptation to think that we know how it will play out. I have a feeling that when the inflation dam breaks this time around, it will be a lot different than what it was in the 1970s when this last happened. Everything is so…complicated.

  47. Hi Kevin, You are right – it is complicated, and there are so many variables. I think everyone will need to crunch their own numbers. It all depends on size of mortgage, remaining term, your own priorities, your own sense of how things will play out and how much faith you have in the powers that be, how much you earn, how much you spend and how much spare cash you have laying around, whether you can fix your rate and at what level etc. There aren’t any simple choices here and I wasn’t trying to say there were – I just wanted to put the point across that the expectation of continuing low *mortgage* interest rates could be problematic, especially if the stock market goes south – you could end up getting rammed from both ends so to speak. Cheers, Tony

  48. What about the not yet mentioned plan of saving up (for years) and then buying your house cash, and foregoing the mortgage from day one?

    In that case, you can either invest the cash in short-to-medium term investments (depending how long the saving will require), or, if you are risk averse, just sit on the cash in the bank. Then when you have enough to buy in your range, you buy, and you skip the whole mortgage approval process, all interest, all PMI, and you may even be able to tip the seller to go with you (I’ve heard) over a higher deal that is pending mortgage approval.

    This takes a long time and leaves you with little in retirement savings, depending on the price of your home. But it means no mortgage interest payments at all, puts you in an (mostly) invulnerable position (in terms of cash-needing emergencies) up until then, does allow investment prior to your home buy (or at least CDs if they’re paying anything). What it takes, though, is discipline and patience.

  49. My grandparents did that because they lived on a strick “cash on the barrel” system. Also, prices were a lot lower then. There’s merit to that approach, and it forces you to buy a less expensive house too.

  50. Good post Kevin. While both have merit I’d lean toward funding retirement. Paying off you mortgage assumes that you will stay where you are currently living once you retire, this may or may not be the case. As empty nesters the past couple of years my wife and I toy with the idea of downsizing our house and perhaps moving elsewhere at some point. While there are no guarantees in the markets, funding retirement early and consistently has been a winning formula for my clients over the years.

  51. Hi Roger–That’s a consideration I hadn’t thought of. If you plan to trade down on your home, then paying off the mortgage becomes a bit less important, as long as you plan to buy the smaller home without taking a mortgage.

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