Prepay Mortgage or Increase Retirement Savings?

by Gary Foreman

Should you put extra cash toward paying down your mortgage or contributing more to your IRA and 401k? Use these guidelines to determine the best option for your financial future.

Dear Gary,
I read your mortgage prepayment article with interest. I appreciated the formula for calculating how much the prepayment actually pays.

On “Sound Money,” the Minnesota Public Radio syndicated program about personal finance, the topic of prepayment came up. They suggested not prepaying the mortgage unless you are already contributing the maximum to your IRA and 401(k) plans. The Sound Money guys’ rationale was the proverbial magic of compound interest at a tax-deferred rate.

What do you think? I know I’m not putting enough away in my IRA and 457 account (my employer does not offer a 401k) but I am paying $100 extra on the mortgage — because it’s adjustable rate and I want to reduce the principal before the rate maxes next year. But is it better to prepay my mortgage or save more for retirement?
Nann

Thanks for a good question. The “Sound Money” answer is probably right if:

1. Your rate of return on the retirement plan is greater than the cost of your mortgage – and –
2. The rate of return on the retirement plan stays above the cost of your mortgage – and –
3. You don’t lose your principal in the retirement investment – and –
4. You don’t need to remove that money causing taxes and penalties.

What factors should you consider when choosing whether to prepay the mortage or save more?

Let’s begin by talking about the money you’re investing. (Whether you’re putting money into a retirement plan or prepaying your mortgage, you’re investing in your future.)

Consider tax advantages

In the case of money that you’re putting away in a retirement plan, you should be investing pretax money. In other words, any money that you put in your IRA, for instance, is not included in your taxable income for that year. So taxes have not been paid on that money making it ‘pretax’ money.

If you take that same money in your paycheck you will pay taxes on it. After paying those taxes you will then be investing ‘after-tax money’ in prepaying your mortgage. So the clear winner on that question is putting the extra money into a retirement plan.

Consider investment returns

Now let’s take a look at return on your investment. Typically, the retirement plan is going to come out ahead here, too. Just compare the interest rate on your mortgage to the rate you’ll get in the retirement account. Unless your mortgage has an unusually high rate or you choose a very conservative investment in your retirement account, you’re probably better off in the retirement account.

One thing to consider here is that the interest rate on both the mortgage and IRA could change. You might have a variable rate mortgage. The rate of return on your IRA will almost certainly vary over a number of years.

Another consideration is employer matching money. Many employers will match part or all or your 401k investment. That makes the return on investment very good. Be sure you know when the vesting schedule makes the employer contribution your money. (Related: Should You Contribute to a 401k If Your Employer Doesn’t?)

How safe is your investment?

The next thing to consider is the safety of your investment. “I’m more concerned with the return OF my money than the return ON my money.” I don’t know who said it first, but he or she was right. Here prepaying the mortgage comes out ahead. There’s no question that a dollar prepaid on your mortgage reduces your mortgage by that amount. Short of theft, there’s no way to lose your investment by prepaying.

Investing in your 401k or IRA can be a bit more risky. Many people limit themselves to insured CD’s or other ‘guaranteed’ investments. But others, looking for a higher return, take more risk. That’s not to say that risk is bad. But you need to factor that risk into your decision.

When will you need to have the money available to you?

The biggest variable in deciding between prepaying your mortgage or investing in your retirement is also the hardest to quantify. That involves the question of when you will need to have the money available to you. Unless you can see the future this will be an area where your ‘best guess’ will have to do.

If you won’t need the money until you reach age 59 1/2 the retirement plan works fine. However, if you do, you’ll pay a hefty penalty and taxes, too. Any early withdrawals are subject to a 10% penalty. So if you withdraw $1,000 you’ll pay $100 in penalty and also add $1,000 to your taxable income for that year.

Under certain circumstances you can ‘borrow’ money from your 401k plan. But there are rules to follow. (See Expert Interview: How a 401k Loan Affects Future Wealth.)

Any money that you prepay to your mortgage is available to you without tax consequence. You will have to go to the trouble to refinance your home or take a home equity mortgage to get at it, but it can be done without paying penalties and taxes. Of course there will be mortgage closing costs to consider.

Don’t forget that carrying a mortgage means carrying debt.

One final comment on prepaying your mortgage. I have a real aversion to debt. I know of stories from the Depression where people lost their homes even though they had paid off almost all of the mortgage. Now we’re facing a possible recession. No one can tell you if times will be as tough as they were in the U.S. during the thirties. But with the current inflation rate and the level of government debt, some economic troubles are pretty likely.

Being debt free in times of economic upheaval can be a real advantage. Many people who had a little money did quite well during the Depression. But many who owed just a little lost almost everything. We may never have another depression like The Great Depression. But if you’re debt free, there will always be more financial opportunities available to you than the person who’s heavily burdened by debt.

Only you can decide whether to prepay your mortgage or use that money to fund a retirement plan. If there’s a reasonable probability that you’ll be able to leave the money until retirement, you’ll want to seriously consider the retirement plan option. Otherwise you might want to put some in retirement and some in your home.

This is a case of choosing between two good answers. The only ‘wrong’ answer is to not save any of your money. That’s the one answer where you’ll definitely lose!

Related:

• How Mortgage Prepayments Work
• Why You Shouldn’t Pay Off Your Mortgage Early
• Should I Pay Off My Mortgage Before I Retire?
• Should I Stop Contributing to My 401k To Pay Off Debt?
• The 7 P’s of Early Loan Repayment

Reviewed October 2022

About the Author

Gary Foreman is a former financial planner and purchasing manager who founded The Dollar Stretcher.com website and newsletters in 1996. He's the author of How to Conquer Debt No Matter How Much You Have and he's been featured in MSN Money, Yahoo Finance, Fox Business, The Nightly Business Report, US News Money, Credit.com and CreditCards.com.