It is important to strike a balance between paying off debt and investing. However, it can be difficult to discern what the best option is. In this post I will discuss the tradeoffs between paying off your house early vs focusing on building your nest egg for retirement.

What to Do Before Paying Down Your Mortgage or Investing

While you may want to jump straight into decreasing your mortgage or boosting your retirement fund, you should solidify your financial base first. Be sure you do these three things before making an extra payment toward your mortgage or investing in other areas of your retirement.

1) Pay Down High-Interest Debt

Do you have high-interest debt such as credit card debt, payday loans, or accounts with variable or high interest rates? If the answer is yes, this debt is costing you and it is mostly hidden from your budget since it sneaks in as a finance charge on your statement. 

For example, if you have $2,000 on a credit card at 20% interest, the credit card company is charging you roughly $400 per year in interest. Before paying down a mortgage or investing in a retirement account (which will likely net you WAY less than 20%) it makes sense to prioritize eliminating those outsized hidden finances charges as soon as you can.

You may want to research the avalanche method to pay down your high-interest debt. This method involves you writing down all your debt balances from the highest interest rate to lowest. Then, you make minimum payments on all your debt but contribute all your extra cash toward the one with the highest interest rate until it’s paid off. Then, continue to pay off the debt with the second-highest interest rate and so on until they are all paid off. This minimizes how much the banks get out of you and puts more money in your pocket in the long run.
 

2) Build an Emergency Fund for when “Life Sh** Happens”

Experts recommend having at least three to six months of expenses set aside in case of emergency. Although some people are not comfortable with less than two years of expenses set aside. If you put money into your mortgage or retirement account, you can’t get it back quickly. It isn’t “liquid” in the sense you can access it right away like a savings are checking account. 

Whatever your risk tolerance is, it is a good idea to plan for the worst by having some sort of emergency fund for when life happens (car breaks down, loss of job, roof leak, medical emergency, eviction, etc). Check into the savings or money market accounts your bank offers for a good place to store your emergency fund and also consider turning off auto draft to make it more secure.

There are exceptions that could substitute for an emergency fund but they come with strings attached… Some Roth IRA accounts allow you to withdraw your original contribution without penalty (but there are rules, time limits, etc). Some 401(k) plans offer hardship loans, but you don’t want to hassle with that when you need money right away. Setting up a HELOC on your home is another way to ensure easy access credit, but getting one setup takes time and requires that you have equity in your home and good credit.
 

3) Max Out Your 401(k) Match

If your employer offers a 401(k) match and you are not contributing, then you are leaving free money on the table. Therefore, make sure that you are getting the most out of your retirement fund by maxing out your company’s match before making other retirement contributions or paying down your mortgage.

For example, let’s say that your employer matches 100% of the first 4% that you put into your company-sponsored 401(k). If you contribute 4% of your income, they will match that amount, thus doubling your 401(k) contribution, and giving you an immediate 4% raise!
 

Investing vs. Paying Down Your Mortgage

Now that you know what you should do before investing or paying down your mortgage, you can decide which option to choose. There are two numbers to consider when deciding between an investment or paying down your debt. They are:

• The interest rate on your mortgage.
• The returns you will receive on your investments.

Your mortgage is costing you interest. Your investments earn interest (in theory). 

The interest rate on your mortgage will be on your statement. It really adds up. For example if you borrowed $300k at 4.5% that is $13,500 per year in interest alone (a whopping $1,125 in interest per month). So paying ahead on your loan would help reduce that - permanently.

In terms of what you can expect to get in the market check see the following calculators we created which are based on historical backtesting. Always keep in mind past results do not guarantee future returns.

• Historical Returns for Various Stock vs Bond Portfolio Allocations
• Building Your Nest Egg Calculator

It only makes sense to invest in the markets if the rate of return is expected to be higher than the rate interest on your mortgage. It needs to be higher to compensate for the risk of loss in the market. But that isn’t the end of the story, there is more to consider.
 

When You Should Invest First

The market can be volatile and trying to time it in the short term (1 day to 10 years) is a bit like gambling. Most of the time the stock market sees average returns of about 7% over multi-decade spans. Generally, mortgage interest rates are below this, and currently very low 3.5-4%. 

This means that you will see a higher rate of return on your investment than what you are paying on your mortgage and should invest rather than pay down your mortgage.

Additionally, your investments will earn compound interest. Compound interest means your money will be growing and making even money over time.

For high-income individuals / households, maxing out retirement account contributions (beyond the employer match mentioned above) can be a nice tax perk - several thousand dollars per year in extra money in your name. In a way the IRS is paying you to prioritize investing vs paying down your mortgage.
 

When You Should Pay Down Your Mortgage First

While compound interest and higher interest rates are compelling reasons to prioritize saving for retirement, there may be situations where it makes sense to pay down your mortgage first.

There are three main reasons:

1. Give yourself flexibility to refinance at a lower rate or better terms. This is especially true if:
   1. The home was purchased with a small down payment (below 20%). In this situation there is very little equity in the house. That leaves no wiggle room in case of a down turn and makes it very hard to refinance in case rates drop.
   2. The loan is an adjustable rate mortgage (ARM) where the bank will raise your payment in the future.
2. Give yourself a permanent return on your money. Paying off debt early locks in the return on those dollars.
3. Emotional security once you pay off the entire house. No longer having a mortgage payment provides a huge boost of confidence and flexibility in life.

One simple trick for paying off your home early is to calculate what your monthly payment would be with a 15 year loan and pay that each month. Just keep the 30 year loan in place. That way you pay it off twice as fast but can fall back to lower payments if needed.
 

The Bottom Line

Based on historical data (which is no guarantee) people who are able to take the long term view are better off investing in their retirement before paying down their mortgage when given the choice between the two. 

However, before investing or paying down debt, you should always be sure to secure your financial base by building an emergency fund, eliminating high-interest debt, and making sure to take advantage of your employer’s 401(k) match. 

Then, you can focus on building your net worth by eliminating a mortgage or bolstering your retirement. Navigating big financial decisions is not something you should have to do alone. Therefore, you may want to speak with a financial advisor. They will be able to help you make ongoing financial decisions that set you up for prosperity in the future.