The biggest question I hear about mortgages is whether or not you should pay them off. There’s no simple answer for anyone’s individual situation, but it gets even more complicated when you factor retirement savings into the equation.
Does it make sense to pay down your mortgage or save for retirement? These are two of the biggest “purchases” of your life, so it’s important to understand this situation from all angles.
Where Are Your Priorities Right Now?
There are several things to keep in mind when thinking through this question. On one side, you have the financial impact of the decision, and on the other, how you feel about your situation emotionally. You also need to consider the practical matters at hand, and this is where we need to place the focus to get started.
According to a November 2015 report from the Mortgage Bankers Association, the average loan size for purchase applications is $301,200. In other words, the average homeowner chooses to take on over $300,000 in debt when they buy a house. As for the average retirement account balance? A 2015 report from Fidelity concluded that the average employee 401(k) balance was only $91,800.
The numbers speak for themselves. Buying a home has long been considered a rite of passage on your way to becoming a well-rounded, secure adult. Society’s unspoken rule is that you should own your home when you reach a certain age.
The concept of proactively saving for your own retirement, however, is rather new to our society. Not too long ago, there was no need for a 401(k) plan or any other kind of self-funded retirement account. Most workers were covered by a pension plan at work. (Today, only 11% of workers have access to a pension.)
For most people, taking on a mortgage is a given, which can subsequently cause a drive to aggressively pay it off. And you can’t blame someone for wanting to own a home outright. It’s a great feeling. But it’s still just a feeling, and doesn’t mean that you’ve “made it.” After all, a home is not going to guarantee you a secure retirement life, only a well-funded retirement account can do that.
Herein lies the problem. How are you supposed to balance paying down your mortgage with saving for retirement? Which one comes first?
Prioritizing Your Mortgage or Your Retirement Savings
As is typical with planning for anything, there is no one right way to do it because you don’t know what the future holds. What you can do is focus on a few major factors that can help you understand the pros and cons of each option.
Paying down a mortgage feels great. There’s nothing like watching the balance owed move closer to zero. Plus, the faster you pay it off, the less you pay in interest. What’s not to love about that? But the numbers may tell another story.
As a financial planner, I often discuss the opportunity cost of taking this path with my clients. What alternative choices are they not able to benefit from because of their decision to pay down the mortgage? What else could they have done with their money, and might that other choice have yielded a better financial result than aggressive mortgage payments? In this case, that other opportunity is investing for retirement.
The Impact of Opportunity Costs
If you look at the current state of mortgage rates, it’s obvious that we’re in an extremely low rate environment. According to the same Mortgage Bankers Association report cited above, the average interest rate on a conventional 30-year fixed mortgage was 4.18% in late November 2015. With lower rates comes less expensive interest payments.
Let’s say you by a home and get the average 30-year fixed mortgage of $301,200 with an interest rate of 4.18%. Over the life of the loan, you’ll end up paying a total of $528,985 for your home. The monthly payment would be $1,469.41 and the total interest paid over the life of the loan would be $227,785.
If you decide to make larger monthly payments of $1,853.91, you’d knock off 10 years from the loan and pay only $143,737 in interest – a savings of $84,048 over the life of the loan.
What About Investing?
Now it’s time to switch gears and look at the other opportunity that we chose to forgo: saving for retirement. Based on research done at NYU’s Stern Business School, the compound investment return of the S&P 500 Index from 1928 to 2014 was an annualized 9.6%. We’ll use this investment return rate in our example to illustrate the other opportunity.
Instead of making additional monthly payments toward the mortgage, what if you invested that extra money into a retirement account for 30 years? You would save $384.50 every month instead of paying extra on your mortgage (this number comes from subtracting $1,469.41, the normal monthly payment, from $1,853.91, which is the amount you paid in when making larger payments in the example above). Let’s say you put this money into a Roth 401(k) (the Roth is used here to avoid the income tax implications of investing pre-tax dollars into a retirement account – the monthly investment amount is after tax dollars just like the mortgage payment).
After 30 years of investing $384.50 every month into your Roth 401(k) with a compound return of 9.6% per year, your account balance would be $798,381.
By paying down your mortgage early, you saved $84,048 in interest payments on your loan. But if you paid your mortgage at the normal rate instead of paying extra, and allocated the extra funds to your investments, you would end up with nearly $800,000 in your account — which means you would save over $700,000 more by prioritizing saving for retirement. Plus, you may benefit from a little peace of mind knowing that you are contributing to a secure financial future.
Going by Numbers, Saving for Retirement Should Be Your Priority
There are certainly emotional considerations to contemplate here, but the numbers don’t lie.
Based on today’s interest rate environment, and assuming you can invest future dollars at the historical return of the S&P 500 (you can’t actually invest directly in this index), the numbers say that saving for retirement will produce a better result than paying down your mortgage.
(Disclosure: this comparison does not take into account the potential tax deductions available with mortgage payments. However, we also didn’t take into account the increased return that an employer matching contribution would add to the retirement account either, which has a much bigger impact than the tax deduction.)
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