Retirement Savings vs. Mortgage Prepayments

Those Wall Street kids always have multiple eggs in various baskets, but here on Main Street, the average family has just two big investments: their home equity and their retirement savings. So, whenever we are blessed with a windfall or a little wiggle room in our budget, we’re inclined to either sock it away in our nest egg or into the nest itself. But which is better in the long run: investing in your retirement or paying down your mortgage?

Most homeowners assume that it’s the latter. And according to a study by the National Bureau of Economic Research, 6 out of 10 of them are right. But where do you fall in the retirement savings vs. mortgage debate? Unfortunately, as with all vexing conundrums, there’s no clear cut answer and there’s no magical calculator that will give you the right answer. Instead, you’ll have to give some critical thought into the pros and cons of paying down your mortgage or investing into your 401(K) or IRA. This article should help you get started.

Paying Down Your Mortgage

Those who invest with their gut usually pick the mortgage for one simple reason: it’s debt. And while mortgages are widely regarded as “good debt,” most homeowners would rather own their homes free and clear as soon as possible rather than remain beholden to the bank. We call this “debt aversion,” and in many cases, it’s a healthy and natural anxiety. Anyone who has ever made the mistake of allowing a “cash advance” on a credit card account knows the stupidly high cost of borrowing at high interest rates.

The issue with paying down mortgages, however, is that it’s a long term investment and a perhaps overly cautious one at that. On paper, it seems to make sense. If you paid an extra $100 a month on a 30-year, $250,000 mortgage with a 6 percent interest rate, you’re looking at $52,000 in savings from avoided interest and an early payoff of about four and a half years. With the same mortgage and $500 extra, you’d save $144,000 in interest and unburden yourself of the mortgage 14 years faster.

But there are two wily forces that erode away at those alluring dollar figures: inflation and tax breaks. The money you save in interest is spread out over 20 or so years - meaning that a portion of that $144,000 won’t actually be worth quite as much as it is down the road as it is today. Secondly, mortgages are some of the cheapest loans you can get. Aside from the relatively low interest rate, mortgage interest payments are usually tax deductible both on the state and federal level. So, in reality, you may actually only be paying in the ballpark of 4 to 4.5 percent interest on your mortgage. Keep that figure in your head and meet us down at the next section.

Saving for Retirement

Earlier, we mentioned that there is no magic formula for determining whether it’s more prudent to pay down your mortgage or invest in retirement. That’s actually only half true. Whenever you’re faced with the dilemma of paying down debt or investing, the question you should ask yourself is: “Can I make a better return on investment than I’m paying in interest?” In the case of your mortgage, the answer is often “yes.”

Remember from above that the interest rate was about 6 percent, at its highest, and as low as 4 percent when tax deductions were factored in. So, if you can find somewhere to put that same extra $500 you were going to pay towards your mortgage and invest it somewhere where it will give you a return of more than 4 percent, you’d be golden. Lucky for you, that kind of return isn’t hard to find.

Granted, the stock market recently took a painful blow in recent years, but even so, investing in the long run has historically shown to have steadily favorable returns. The S&P 500 - an index which tracks to the largest publically traded U.S. companies - has a historic return of about 7 percent over the last 50 years. And that includes the 1973 oil crisis, the dot-com bust and the subprime mortgage crisis. Even a very conservative portfolio would likely fare better than the 4 percent baseline savings of paying down a mortgage.

But the benefits don’t end there. Retirement savings accounts also get hefty tax breaks - either in the form of tax-deferrals for 401(K) or tax deductions for an IRA - which benefit from inflation in the opposite way as the interest savings from a mortgage prepayment. Even better, many employers will match up to 50 percent of your 401(K) contribution which is absolutely free money right up front.

Factoring in the perks of tax breaks, employer matching funds and historical market performance, it’s easy to understand a situation where investing in your retirement savings may be better than paying down your mortgage. Still, it’s best to consider your own options and your own situation before making a decision. Depending on how far away retirement is, what kind of mortgage you have and what other financial burdens, goals and contingencies you have, it still might be best to pay down your mortgage. But resisting the natural urge to pay off your mortgage as soon as possible and taking time to assess your financial situation may save you heaps of money in the long run.