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Should I pay down my mortgage or add to my retirement account?

Dahna Chandler
The Mortgage Reports contributor

Extra money: Should I pay down my mortgage?

If you’re wondering, “Should I pay down my mortgage?” you probably have some extra money and several options for spending it. Typically, personal finance decisions require making trade-offs between funding what’s necessary now and what might be in the future.

Refinance your mortgage without “starting over”

Is it best to pay down your mortgage or build your retirement fund? It seems like a smart financial move to pay down that enormous debt and then build your retirement account. That depends on when you plan to retire, your income, assets, tax situation, and your debt and investing perspectives.

Verify your refinance eligibility (Sep 22nd, 2020)

Adding to retirement

If your income is stable, and you’ve got an emergency fund in place, the next most important consideration is time.

If you’re far from retirement age, it’s smarter to put money toward retirement. Because you have time on your side, the time value of money and power of compound interest work in your favor. That means more money you put away sooner, the more interest on top of interest you’ll earn with that money.

Should you retire with a mortgage? Or pay it off first?

Here’s how that works. At 30 years old, you decide to consistently put $10,000 a year or $833  per month in your 401(k). Getting the average S&P annual return on stocks, about seven percent  adjusted for inflation, in 30 years, you’d have $1,016,236.

You’ll also own your home outright, having paid $215,220 in interest.

So, what happens if you pay down your mortgage instead?

Paying your mortgage down

Some experts say it makes sense to pay down your mortgage in the early years when you’re only paying interest. That reduces the lifetime interest on the mortgage, decreasing your home’s overall cost.

That’s true if you plan to stay in your home for 30 years, but most people only stay in their homes seven years. If you do stay in your home for 30 years, and paid $833 extra per month, you’d have it paid off in 14 years and eight months, saving $119,153 in interest. But that’s not all.

How much do you really save by making extra mortgage payments?

A comparison over a 30 year period should consider the fact that you’d continue to invest $10,000 a year into your retirement account and could also continue to invest the amount of your mortgage payment — $2,265 a month altogether.

That continued investment over the remaining 15 years and four months of the loan’s term would yield, at seven percent, and additional $743,958.

So in 30 years, you own your home outright (having spent just $96,454 in interest) and have $743,958 invested. The difference is that by investing after paying off the mortgage rather than earlier, you’ve deprived yourself of the opportunity to earn higher returns over a longer period.

What if you have less time?

So there is a pretty compelling case for saving for putting retirement first if you’re younger. But what about those who are closer to retirement age?

If you plan on retiring in 15 years, are you better off paying off your mortgage, or adding to savings?

If you take out that $300,000 mortgage and pay an additional $833 a month, in 15 years, you’ll have paid off the home and had an additional four months to invest your total $2,265, for a total of $9,140.

What could you do with the savings from a 15-year mortgage?

If you choose to invest in retirement instead, in 15 years, you’d still owe $193,627 on your house. And you’ll have $264,030 in savings. If you paid off the mortgage with your savings, you’d still have $70,403.

As long as the (after-tax) return you get on your investments is greater than the (after-tax) cost of your mortgage, the numbers favor investing.

However, there’s another consideration.

Risk makes a difference

Paying off your mortgage is a largely risk-free proposition. But the stock market is not. And as you approach retirement, most experts recommend that you choose safer investments than the sort that pay a seven percent return. Because if you lose that money, you don’t have time to replace it.

How to get a mortgage when you’re retired

If the appropriate investments for the older homeowner pay a three percent return, you have a different picture. In 15 years of paying the additional $833 a month, you own your home free and clear and have $9,140. But if you invest at three percent, in 15 years, you owe $193,267 on the house and have savings of just $189, 068. That’s not enough to even pay off the mortgage.

In that case, it would cost you nearly $14,000 to invest instead of paying down the mortgage.

Liquidity

A major downside of paying down your mortgage is that once you put that money into your home, the only way to get it back out is to refinance or sell. In addition, your home value could drop, like that of any other investment.

It’s easier to get your investment money back out if you need to. Many times, you can borrow from your 401(k) account. (If you withdraw from an IRA, you’re usually subject to penalties and taxes, making that a poor choice.)

Read this before you borrow from your 401(k)

When you retire, you can take out money from your IRA penalty-free, but you’d still have to refinance or sell to turn home equity into cash. And with a good retirement plan, you put money into diverse investment funds that span many industries. That allows you to avoid some risk.

What are today’s mortgage rates?

Current mortgage rates are low enough that it’s usually a good idea to invest your money elsewhere rather than accelerate the mortgage. However, if interest rates rise, that could alter your calculations.

If you can’t stand the idea of keeping mortgage debt, think long term. Instead of paying your mortgage down, invest in a fund paying a higher return than your mortgage rate. Once the account balance equals your mortgage payoff, you can choose to leave the money alone or pay off your loan.

Verify your refinance eligibility (Sep 22nd, 2020)