Retirement savings vs. accelerated mortgage payments
August 15th, 2005 | by mbhunter |FreeMoneyFinance.com had a post today about an Ask the Experts article on CNN Money. The scenario: A couple in their late twenties, both are maxing out their employers’ 401(k) match, and are paying down their mortgage with the extra money. The question: Is this good, or should they save for retirement more?
The author of the Money article, Walter Updegrave, sees the benefits of either paying down the mortgage faster or saving more for retirement, and he opts for the latter for this couple, stating that their prospects of finding an investment that will beat their current mortgage rate over the long haul is very good.
That may well be true. But if their mortgage rate is 6% (as he assumes) then right now they’d be hard-pressed to do better than that with another investment. Let’s knock off a percent or so for the lost mortgage interest tax deduction — so their effective “return” is only 5%. This is essentially a “tax free” “return” of 5%, because the government hasn’t found a way to count “avoided financing costs” as income. The extra principal goes right toward their home’s equity, as does all of the accumulated interest on the amount of additional principal you pay.
This is how mortgage prepayment can be viewed as an investment: instead of a compounded increase in an asset, you have a compounded decrease in a liability. Both have exactly the same positive effect on your net worth.
Money should seek out where it’s treated the best. At a tax-free 5% rate of return, money sure isn’t getting abused. Might it do better somewhere else in the long run? Of course. But the mortgage deal is a pretty good bird in the hand.
2 Responses to “Retirement savings vs. accelerated mortgage payments”
By JLP at AllThingsFinancial on Aug 17, 2005 | Reply
Personally, I’m not a big fan of paying down a mortgage quickly. This couple is in their 20s. The long-term ROR in the stock market has been north of 10%. By investing in the market rather than paying more on their mortgage, this couple will build significantly more wealth in the long-run. Is it guaranteed? No. But, keep in mind that their house is most likely appreciating in value each year. They get the appreciation whether they have a mortgage or not.
The only way I see paying down a mortgage quicker than normal is if you have a high interest rate. Otherwise, it makes more sense to allocate your resources where they get the best return.
That’s my 26.4 cents worth!
By mbhunter on Aug 18, 2005 | Reply
Hey, JLP — welcome and thanks for stopping by and leaving a comment! Hope that your Technorati ranking is on the way up again after we got kicked off the sidebar-link bandwagon
Maybe I’m pessimistic, or contrarian, or a little bit of both. I just don’t see much better right now, right this moment, than paying down a 6% mortgage. If they have an ARM (the article didn’t say) I’d be paying that puppy down as fast as I can, because I don’t see interest rates going down. Because money has been so easy to get over the past few years, just about every investment sector is overpriced, or so it seems. Stocks are no exception in my book.
To defer to your reasoning, though, they do live in CA, so who knows how high their home price will go. Until they sell, though, the only way that they can use that appreciation is to take out a HELOC — with interest payments of their own. So if they’re not moving, what good does the appreciation do them? They still have to live somewhere. The extra payments toward the house will protect them from going upside-down on their mortgage in the event of a downturn.
If they’re planning to move, then sure, sock it away in a retirement account and enjoy a 7-digit gain when they sell it next year. Or whatever.
Still, a 5-6% guaranteed, tax-free compounded reduction in their debt is nothing to sneeze at. There are definitely worse places to put excess money.