Don't Rush Your Mortgage Payments: Invest in Retirement Plans Instead

[Jun 24, 2008.]

When take out a mortgage loan to buy a house, the first impulse is to pay it off as soon as possible, so that you would be free of debt, the proud possessor of your own home. However, despite its emotional appeal, paying off a mortgage quickly is not always the wisest course of action.

Researchers from the University of Michigan's prestigious Ross School of Business, from the University of Texas, and from the US Federal Reserve Bank of Chicago recently gathered some data about how much Americans are really paying when they pay off their home loans. This data was presented in a study called "The Tradeoff Between Mortgage Payments and Tax-Deferred Retirement Savings." What they found is that 16% of American homeowners make extra payments to pay off their mortgages early. These Americans are spending a combined total of over $1.5 billion a year by paying off their mortgages quickly, amounting to $400 spent per individual homeowner.

The research suggests that at least 38% of the homeowners in question are spending those $400 needlessly. They would do better to put the money they spend extra mortgage payments into retirement plans such as the 401(k). According to the researchers, a long-term investment such as the 401(k) will yield 11% to 17% more per initial investment than paying off your mortgage early.

People are tempted to pay off their mortgage early because the amount of money that they will save on paying off the interest over time is exaggerated in their minds. A typical interest rate for a mortgage loan of $250,000, to be paid off over the course of 30 years, is 6%. At this rate, paying an extra $250 monthly can save you about $100,000 in potential interest, and allow you to pay the mortgage off completely 9 years ahead of schedule. This is true.

However, mortgages tend to have very low interest rates compared to other types of loans, and, moreover their interest is usually tax-deductible. Depending on your income tax bracket, the amount of interest you're actually paying on that 6% mortgage is often more like 4%. Even without the deductions, 6% is a low rate. Conversely, when you pay off your mortgage early, the money you save is future money. Take into account a reasonable rate of inflation, such as 3.1%: after 25 years, $50,000 worth of savings in interest you don't have to pay is worth less than half that amount in today's terms.

By contrast, consider a plan like 401(k). The money you invest in these plans is already tax-deductible. Or, in the case of the Roth IRAs, the money isn't tax deductible, but you pay no taxes on it once you're retired and ready to cash in the account. Either way, that is a lot more tax-deductible money than just paying off the interest on a mortgage loan.

Plus, when you're investing in a 401(k) plan, you're investing in money markets. In addition to being tax-deductible, these investments tend to yield greater returns than what you would be saving by quickly paying off a loan with a 6% interest rate.