Savings Smackdown: Which is Better -- Pre-Paying a Mortgage or Saving for Retirement?

I've gone on record quite a few times saying that I'm in favor of people paying off their mortgages. That's what I did personally, it's worked for me, and that's why I recommend it. In addition, I've seen numerous people who have decided not to pay off their mortgage and "invest" instead blow it by spending the extra money instead of investing it. Come to think of it, I've NEVER seen anyone successfully do it. So, while in theory it may be better to invest extra money versus paying off a mortgage (I'm not saying it is or isn't at this point), the practicality of the issue tilts in favor of the mortgage pre-payment option.

That said, I recommend several other financial moves that take priority over paying off your mortgage. Like what, you may ask? Like contributing to your 401k to get the full employer match, paying off your credit cards, and paying off any other debt that has a higher interest rate than your mortgage. After these, paying off your mortgage is a viable option.

But which is better even at this point -- saving more for retirement or pre-paying the mortgage? Well, a new study attempted to answer this question and they came to this conclusion:

Although mortgage rate, income tax brackets, and 401(k) contribution limits varied among households, in about 40 percent of the cases putting the money in a retirement fund beat paying the mortgage off early, the study found.

Said another way, the pre-payment option was better in 60% of the cases.

But the results aren't totally clear. Consider the following:

Amromin says the study probably underestimates the number of households that would benefit from switching a mortgage prepayment into a tax-deferred retirement account, because the researchers made a number of conservative assumptions:

• They assumed investors didn't get a 401(k) match from their employers. In reality, more than 90 percent of plans managed by Vanguard, one of the largest 401(k) administrators, offer a match.

• They presumed the investor would put the money into a low-risk investment -- Treasury bonds or highly rated mortgage-backed securities. Someone investing in equities would likely do better: Between 1926 and 2003, stocks returned an average of 10.5 percent a year on investment, while government bonds averaged 5.45 percent, according to Ibbotson Associates.

• They assumed individuals had a constant income tax rate over time. But retirees often slip in a lower tax bracket, making 401(k) contributions during peak earning years even more valuable. According to Federal Reserve data, 41 percent of households are in the top tax bracket before retirement, while only 18 percent are after retirement.

• The researchers excluded state tax obligations, which would also make the tax-advantaged features of the 401(k) more worthwhile during peak earning years. Currently, 43 states impose an income tax.

In the scenario I propose, item #1 wouldn't apply since I recommend contributing to get the full match before pre-paying a mortgage. But the other three are good points -- and are ones that likely make the saving/investing option a much better option financially for most people as long as they can actually do it (in other words, as long as they can save the money versus just spending it.) It's all good in theory, but from what I've seen it's not executed well practically. I'm not sure I could do it (and keep up with it) and I'm pretty disciplined. Maybe if I made the savings automatic there would be no way to mess this up.

And then there's the "touchy-feely" benefit of feeling better because your house is paid off. This is not a big issue for me (though I must admit that not having a payment every month is great) but is huge for some people.

So which is better? Well, if you have the discipline to save/invest the money you would be using to pay off the mortgage, it's likely that saving/investing is the better option. But if you're more the "average" person out there managing your money, I still believe it's a better option to pre-pay your mortgage.

Comments

[Lord]

You can also consider this a case of where it makes more sense. Is the after tax cost of debt less or more than the long run rate of appreciation? Only in metropolises is it less. In cities, it is neutral. In the country it is more, and most if not more than your investment gains would be paid in debt service.

[jp]

I find it hard to believe that you have never seen anyone successfully carry a mortgage and invest at the same time. I buy index funds through a monthly auto investment program while maintaining a home mortgage. I do this because I am young and willing to assume the risk of keeping more assets in the market. If I were closer to retirement, I would pay off the mortgage. FYI, I only do this after maxing out 401k and IRA contributions.

[Ciji]

I guess I'm of the former group and in the minority. Why give the bank my hard-earned cash for them to lend and make more money, when I can use it to make more money for myself?

[David A. Porter]

Hey FMF,

Long time no blog! I am back on the blogging seen having gone into retirement at the tender age of 50. I still want to let you know that I still disagree with you on this one.

One of the chief reasons I was able to retire to Scottsdale, Arizona from Lansing, Michigan was that I used my mortgage loans to free up home equity which I then invested in reasonable investments in the market and real estate around the country. For example, a home that I bought 5 years ago doubled in value in three years. If I had all my cash tied up in my home, earning nothing, I would still be sitting in Michigan. For 20 years, I carefully never let my home have more equity than 20%. When it had more, I refinanced and pulled the cash out and put it to work elsewhere. This took time and I was VERY VERY careful with what I did with this cash. But it paid off in spades!

I believe that if you have the cash to pay off your mortgage, then your mortgage IS, if you want it to be, paid off.

I have a big fat mortgage here in Arizona and thankfully the cash to pay it off if I desire. Last month, the cash that is not tied up in my house went up in value 2%. That is a WHOLE lot of mortgage payments AND cash that my house would not have paid me. To top it off my mortgage is tax deductable so my net cost is really only around 4%.

Come on FMF, you are a very smart guy. Surely you must concede that your advice does not apply to all. Surely there are some disciplined people who can take advantage of the arbitrage. If you are paying 4% for money and can get an 8-10 percent return, how can that not be better.

Sorry, like Simon Cowell would say, gotta disagree with you on this one.

I see you are past a million visits! Holy crap batman! You are a blogging animal. Keep up the good work and open up that mind of your just a little bit.

All the best,

David A. Porter
President/CEO
Mortgage Broker Coaching
Scottsdale, Arizona!!!!!

[plonkee]

Hmmm. I'm a bit concerned about this. I don't like to think I am any better than average when it comes to self-discipline - mostly because I'm not.

I'm in the middle of buying my first house at the moment (and have been for months :( ) and there isn't really any extra cash to add in to the mortgage payment unless I cut back on my retirement / other investments.

I know that either investing or paying off the mortgage is a good option, and for any one set of circumstances, one of them will be financially the better decision, but do I really have the will power to keep investing if no one else does?

[FMF]

David --

So good to hear from you!!! And that you've escaped the great tundra up north!

Though it's probably a bit hot down there now, huh? ;-)

If I wanted to, I could probably retire at 50 as well (still several years off for me), but why do that? What would I do with my days? Plus, it doesn't look like you're totally retired either (still have a job/company.)

A few thoughts:

1. Yes, you have to be very careful in making sure you manage your cash correctly. You were and you did. Most aren't and can't.

2. I agree with you that in theory your way is best (by the numbers) but the practicalities make the other option better for most people. (in other words, they aren't careful like you note to be.) I will concede that no one bit of financial advice applies to every person all the time. That's why I wrote my post saying that the answer to every personal finance question is "it depends." Maybe you missed that one in the 700 or so pieces I've cranked out since I last heard from you.

3. I'll give you this one by a nose if you say I was correct on the zero-interest mortgage debate. ;-)

So very good to hear from you, David. Stop by more often if you get the chance and be sure to ready that guest room for me come January. ;-)

[David A. Porter]

FMF,

I guess I define "retirement" as getting to the point where you don't have to get up every morning and go to the office to make a buck. You are right, at the age of 50 I am way to young to go fishing everyday.

The company you mention is a new company that I created as a way to keep my mind and ambitions stirred up, but primarily as a way to give back to the industry that allowed me to be where I am.

Arizona is like a different planet from Michigan. We are having a blast and we do have a guest room if you ever need it. Now that we are settled here, I have created a new blog and look forward to rekindling our relationship.

Keep up the good work!