Squared Away Blog

September 27, 2012

Paying Mortgage Faster Not Best Option

Americans have been paying down their high-interest credit cards like crazy. Once you do, financial advisers say, think hard about the best use of that spare cash.

With mortgage interest rates at historic lows – they’re scraping 3.5 percent on 30-year fixed loans and 2.8 percent for 15 years – paying extra on the mortgage should no longer be a priority. This simplifies what is a difficult decision for many of us: what’s next?

Saving for retirement and paying off student loans are now the top priorities, in that order, according to two financial advisers interviewed by Squared Away. But paying off the mortgage is a mistake that many people continue to make: mortgage debt outstanding has also declined in recent years, from $11.1 trillion in 2008 to $10 trillion currently, according to the Federal Reserve.

“Paying off a mortgage – I’m not a big fan of that,” said John Scherer of Trinity Financial planning near Madison, Wisconsin. He proposes that his clients funnel the extra money that had been used to pay credit cards into other personal finance “buckets.”

Unfortunately, spending more is a common response when someone gets their credit cards off their back. It makes “people feel so liberated,” they run their card balances back up, said Christine Isham, a financial adviser with Northern Financial Advisors, just north of Detroit.

Both Isham and Scherer agreed that additional 401(k) contributions should probably come first. The IRS maximum on 401(k) contributions is $17,000 for people under age 50 and $22,500 for people 50 and over. There are a few reasons that 401(k)s come first.

First, Americans’ 401(k) savings have flat-lined and too many are ill-prepared for retirement, according to a new assessment by the Center for Retirement Research, which funds this blog.

Second, since contributions are deducted from taxable income, “you get the biggest bang for the buck,” said Isham. And if your employer has a 401(k) matching program, then initiating contributions also untaps “free money” lying on the table. Ignoring the match is a silly mistake, but one that workers make all the time.

Further, Scherer said that investment returns in your 401(k) – his and other estimates range from 5 percent to 7 percent annually – exceed the going mortgage rates. It makes more sense to invest in a higher-yielding investment than to pay off a low-cost debt.

These record low mortgage rates are naturally working to improve your financial prospects in the future. The advisers are effectively saying: don’t sweat the mortgage. Isham noted that another benefit of low mortgage rates is that they are a great hedge against inflation: if mortgage rates rise in the future, “you have won the game.”

Paying down student loans is next – and after the 401(k) contribution. Again, rates on college loans – even if they were to return to 6.8 percent after the current, temporary reduction – are still well below the returns one receives on a 401(k), if their tax benefits are taken into consideration, Isham said.

In addition to the fact that contributions are tax-free, investments also accrue interest tax free. These benefits make 401(k)s a great deal in a low-rate environment like the one we’re experiencing.

“If it’s 30 years later, and they have $1 million in their retirement plan, and they still have student loans,” Isham said, those loans are “not going to matter.”