Retirement plan decisions made easy
Drill Down: Contribute to a 401k or Pay Down Your Mortgage?
Would you like to pay off your mortgage? Some people can shrug off six figures of debt, but other people feel a weight on their shoulders. They want to burn the mortgage and be debt free. Good for you if you are one of them, but...
Making extra payments on your mortgage should be a lower priority than funding your retirement plan.
Making extra payments on the mortgage to pay down the balance due does not add to your flexibility should you lose a job or have an unexpected bill. This is a weird thing about mortgages: no matter how much extra you paid in the past, you still have to make your monthly payment in full. (There is one type of mortgage, called an “Option ARM,” that does allow a lower payment in some cases.)
Assume your mortgage payment is $1,000 a month, but for each of the past six months you’ve been paying $1,500. You’ve sent in a total of $3,000 more than your required payment. Don’t you think you should be able to skip one, or two, or even three payments? Well, you can’t. You are legally obligated to keep making that $1,000 monthly payment. So paying down the mortgage does not provide you with flexibility.
One way to think of paying off debt is that you earn a return equal to the interest rate on the debt. What should you do if you have an extra $1,000 lying around? If you put it in a certificate of deposit at the bank you might earn, say, five percent interest. If you pay down your credit card balance, you might earn 18 percent interest. You’re not technically earning interest, but avoiding interest is just the same.
Now back to your mortgage payment. It is probably the lowest interest rate debt you have. Because there’s equity in your home, lenders have given you an interest rate not much higher than the very best borrowers in the world have. You don’t earn very much by paying off the mortgage. In fact, you’re very likely to earn a higher total return in your 401k account than you pay in mortgage interest.
Bill Says: Fully fund your 401k plan first, before you consider paying extra on your mortgage.
Please close this window to return to the main lesson page.
You are not logged in. Log in or create an account.
Click here to sign up for our monthly newsletter delivered via email.
Lesson 1: What the Heck is a 401k, and What’s So Great About It?
» Lesson 2: Contributions to Your 401k
Lesson 3: Investments “Cook Book” Approach
Lesson 4: Investments: How Investments Work
Lesson 5: Loans and Hardship Withdrawals from Your 401k
Lesson 9: Your 401k, Your Other Assets, and Your Life
The 401k ebook is available in text, audio, and video formats. The current selected format is video. You may also switch to the audio or text formats by clicking on the icons at the top of the main lesson page.