On the list of financial priorities, which comes first — paying off your mortgage or saving for retirement? The answer isn’t simple. On one hand, owning a home with no mortgage attached to it provides long term security knowing you’ll have a place to live with no monthly payment except property taxes and insurance. However, you’ll also need income to live on if you plan to retire, and how much you save now will have a big impact on your quality of retirement life.
We’ll discuss the pros and cons of whether you should save for retirement or pay down your mortgage, or maybe a combination of both.
Pros of paying down your mortgage vs. saving for retirement
The faster you pay your mortgage off, the sooner you own the home outright. However, there are other benefits you’ll realize if you take extra measures to pay your loan balance off faster.
You could save thousands in long-term interest charges
Most homeowners take out a 30-year mortgage to keep their monthly payments as low as possible. The price for that affordable payment is a big bill for interest charged over the 360 payments you’ll make if you’re in your “forever” home.
For example, a 30-year fixed $200,000 loan at 4.375% comes with a lifetime interest charge of $159,485.39. That’s if you never pay a penny more than your fixed mortgage payment for that 30-year period. Using additional funds to pay down your mortgage faster can significantly reduce this.
Even one extra payment a year results in $27,216.79 in interest savings on the loan we mentioned above. An added bonus is that you’ll be able to throw your mortgage-free party four years and five months sooner.
You’ll build equity much faster
Thanks to a beautiful thing called amortization, lenders make sure the majority of your monthly mortgage payment goes toward interest rather than principal in the beginning of your loan term. Because of that, it’s difficult to make a real dent in your loan principal for many years. You can, however, counteract this by making additional payments on your mortgage and telling the lender to specifically put those payments toward your principal balance instead of interest.
Not only do you pay less interest over the long haul with this strategy, but you build the amount of equity you have in your home much faster. And to homeowners, equity is gold — you’re closer to owning your home outright, and equity can also be a resource if you need funds for a home improvement project or another big expense.
You won’t lose your home if values drop
When you contribute extra money into a retirement account, there is always the risk that you’ll lose some or all of the money you invested. When you contribute money to paying off your mortgage, even if the values drop, you still have the security of a place to live, and are increasing the equity in the home, no matter how much it’s ultimately worth.
Making extra payments ensures you’ll eventually have a debt-free asset that provides shelter to you and your family, regardless of what happens to the housing market in your neighborhood.
Cons of paying down your mortgage vs. saving for retirement
There are some cases where paying down your mortgage faster might actually hurt you financially. Before adding extra principal to your mortgage payments, you’ll want to make sure you aren’t doing damage to your financial outlook with an extra contribution toward your mortgage payoff.
You might end up paying more in taxes
The higher interest payments you make during the early years of your mortgage can act as a tax benefit, so paying the balance down faster could actually result in you owning more in federal taxes. If you are in a higher tax bracket in the early (first 10 years) of your mortgage repayment schedule, it may make sense to focus extra funds on retirement savings, and let your mortgage interest deduction work for you. Of course, everyone’s tax situation is different, so you’ll have to decide (with help from an accountant ideally) if it makes sense to itemize your taxes in order to claim mortgage interest payments as a deduction.
You won’t get to enjoy the return on your paydown dollars until you sell
The only real benchmark for figuring out the value of paying down your mortgage is to look at how much equity you’re gaining over time. However, the equity doesn’t become a tangible profit until you actually sell your home. And the costs of a sale can take a big bite out of your equity because sellers usually pay the real estate agent fees.
Home equity is harder to access
The only way to access the equity you’ve built up is to borrow against it, or sell your home. Borrowing against equity often requires proof of income, assets and credit to confirm you meet the approval requirements for each equity loan option. If you fall on hard financial times due to a job loss, or are unable to pay your bills and your credit scores drop substantially, you may not be able to access your equity.
Pros of saving for retirement vs. paying down your mortgage
Depending on your financial situation and savings habits, it may be better to add extra funds monthly to your retirement account than to pay down your mortgage. Here are a few reasons why.
You may earn a higher return on dollars invested in retirement funds
The growth rate for a stock portfolio has consistently returned more than housing price returns. The average return in the benchmark S&P stock fund is 6.595% for funds invested from the beginning of 1900 to present, while home values have increased just 0.1% per year after accounting for inflation during that same time period.
Assuming your portfolio at least earns 7%, if you consistently invest your money into a balanced investment portfolio, you can expect to double your money every 10 years. There aren’t many housing markets that can promise that kind of growth.
Retirement funds are generally easier to access than home equity
Retirement funds often give you a variety of options for each access, with no income or credit verification requirements, and only sufficient proof of enough funds in your account to pay it back over time. For example, a 401k loan through the company you work for will just require you to have enough vested to support the loan request, and sufficient funds left over to pay it off over a reasonable time.
Just be cautious about making a 401k withdrawal, which is treated totally differently than a loan. You aren’t expected to pay it back like you would a 401k loan, but you could get hit with taxes and penalties.
Cons of saving for retirement vs. paying down your mortgage
You’ll need to weather the ups and downs of the market
Most people who have invested money in the stock market or tracked the performance of their 401k over decades have stories about periods when the value of those investments dropped substantially. While the 7% return on investment is a reliable long term indicator how much your retirement fund might earn, the path to that return is hardly linear.
For example, if you were considering retirement between 1999 and 2002, you may have had to delay those plans when the S & P plummeted over 23% in value in 2002. If you look at each 10-year period since the 1930s, every decade has been characterized by periods of ups and downs.
Calculating the benefit of paying down your mortgage vs. saving for retirement
If you’re torn as to what to do with that extra cash or windfall, let’s look at an example of someone who has an extra $200 to put into either their nest egg or their mortgage each month for the next 30 years.
For this scenario, we’re going to assume their retirement account earns an average 7% rate of return and that their mortgage loan balance is $200,000.
Here’s how much they’d save:
|Savings From Paying $200 per Month Down on Your Mortgage|
|Years Paid||Mortgage Interest Savings||Extra Equity in Home||Total Interest Savings and Equity Built Up|
|22 years 6 months||$50,745||$200,000||$250,745|
One thing you may notice about the mortgage savings chart — it includes how much extra equity you’re building. Often only the mortgage interest savings is cited when people look at how much you save with extra payments, but that ignores the fact that you’re building equity in your home much faster as well. So not only do you save over $50,000 in interest with your extra contribution, you replenish $150,000 of equity that was used up by your mortgage balance.
As you can see, adding that extra $200 to their mortgage principal each month saved them about $200,000 in the long haul — but the real savings don’t stop there.
By adding an extra $200 to their mortgage payment each month, this borrower turned their 30-year loan into a 22-and-a-half year loan and became mortgage debt-free seven years faster.
That means, in addition to saving $50,000 in interest savings and gaining $200,000 of equity, they also no longer have a mortgage payment. That frees up $998.57 per month that they can now use as discretionary income. That’s an extra $89,871 they could potentially save over that 7.5 year period.
When you add that to the $250,745.41 they saved on mortgage interest and earned in home equity, they’re looking at a total savings of $340,616.
That gives the mortgage paydown a $54,000 net positive edge over saving that extra $200 for retirement, as you can see in the table below.
|Savings From Contributing $200 per Month to a Retirement Fund|
|Years Paid||Retirement Balance|
The one caveat for this retirement calculation is we assumed the saver was starting at a $0 investment balance. If they already had a healthy balance in their nest egg, they might actually come out in better shape than paying down their mortgage.
There are clearly benefits to each option, and you should consider running your own calculations with your real numbers to get the best answer for yourself.
Paying down your mortgage and saving for retirement at the same time
There’s a fair case to be made for both paying down your mortgage and saving more for retirement, but why choose? If you’re somewhat on track with your retirement savings goals, and like the idea of having your mortgage paid off quicker, you could allocate a certain amount to each.
Pick a number you feel comfortable paying to your principal every month, and then to your 401k, and put it on autopilot for a year. Any time your income increases, or you get bonuses, divide up the amount between principal pay down and retirement additions.
Let’s look at what happens if you evenly divide up your $200 per month between investing your retirement and paying down your mortgage. We’ll use the same $200,000 loan at 4.375% referenced above, and look at the lifetime results.
|Savings From Paying $100 Down on Your Mortgage Until Paid Off|
|Years Paid||Interest Savings||Extra Home Equity||Total Interest Savings and Equity Built Up|
|Savings From Contributing $100 to a Retirement Fund for 30 Years|
|Years Paid||Retirement Balance|
Balancing the $100 investment in both strategies still yields a six-figure retirement balance after 30 decades, a debt-free house after 26 years, and shaves off $30,000 in mortgage interest expense. If you don’t like putting all your eggs into one financial basket, this may balance the risks and rewards of each option.
Looking at the short term and the long term may provide you with the best framework for making a good decision about how to spend dollars on retirement versus extra mortgage payments. Be wary of any financial professional that tells you one path is absolutely better than another.
Having a stable source of affordable shelter is equally as important as having enough income to live when you retire, so a balanced approach to paying down your mortgage and savings for retirement may help you accomplish both goals.