Better Use of Money: Extra Mortgage Payments or Retirement Savings?

If you’ve got a little extra money sitting around, how should you invest it — in your home mortgage or your retirement?

This quandary is faced by millions of Americans who are beginning to think about the time when they will no longer be working, and if paying down their home loans is the best use of their financial assets.

Both options have their advantages:

• An extra mortgage payment is attractive because it reduces our principal and will cost you less in interest down the line. In addition to the benefits of surpassing the amortization schedule, this offers you a guaranteed return — if your mortgage is at 6.5 percent, you’ll essentially earn that by not having to pay it.
• Socking the money away for your retirement is also attractive, however, as we all know that the more we save and invest for retirement — and the earlier we do just that — the better off we’ll likely be when the golden years arrive. The beauty of compound interest is not to be overlooked.

So what’s the right choice?

The National Bureau of Economic Research recently released a report by Gene Amromin, Jennifer Huang, and Clemens Sialm that may help you reach the best decision for you. Here is what the trio of experts had to say:

“A significant number of households can perform a tax arbitrage by cutting back on additional mortgage payments and increasing their contributions to tax-deferred accounts. Using data from the Survey of Consumer Finances, we show that about 38 percent of U.S. households that are accelerating their mortgage payments instead of saving in tax-deferred accounts are making the wrong choice.

For these households, reallocating their savings can yield a mean benefit of 11-17 cents per dollar, depending on the choice of investment assets in the TDA. In the aggregate, these misallocated mortgage payments could be costing U.S. households as much as 1.5 billion dollars per year.

Finally, we show empirically that this inefficient behavior is unlikely to be driven by liquidity considerations and that self-reported debt aversion and risk aversion variables explain to some extent the preference for paying off debt obligations early and hence the propensity to forgo our proposed tax arbitrage.”

Got that? It’s clearly worth exploring your options a little more deeply. Tax-deferred accounts include 401(k) plans and traditional IRAs, and may offer you more in capital gains than paying off home loans ever could.
In such accounts, if you’ve invested in aggressive stocks or mutual funds, ones where you expect to earn, say, an annual average of 12-14 percent, you should take that into account when comparing it with the 6.5 percent you’d make via extra payments on your fixed-rate mortgage.

Of course, if you read between the lines a little, the picture is muddier.

If 38 percent of U.S. households accelerating their house payments are making the wrong choice, does this mean that 62 percent of those that have accelerated their mortgage payments are doing the right thing? And with the housing market so up in the air, wouldn’t you want to pay that loan off sooner if you could?

There is also the very lucid point that by paying off a home mortgage as soon as possible, one knows exactly what one is allocating money too — and getting out of debt. An investment account can fluctuate, and for many, a payment on their mortgage loan is the thing they’re most comfortable with.

Bottom line: Think it through, crunch the numbers every which way and make the right call based on your situation. The good news is that you’ve got the savings to begin with — it’s a good problem to have, this one.