Two of the most important components of retirement planning are a generous retirement savings plan and a mortgage free home. But if limited resources force you to make a choice, which goal should get the lion’s share of your extra income? Should you save for retirement now or payoff your mortgage first?
There are three basic choices:
- Emphasize retirement and let the mortgage slowly amortize itself into extinction
- Throw all extra funds at the mortgage, and once it’s paid you’ll have even more money to put into retirement
- A hybrid plan where you try to do both at the same time
This isn’t a good solution-bad solution debate. There are pluses and minuses no matter which way you go, and fortunately all three can get you where you need to go. Which one you choose will depend largely on individual circumstances and preferences.
Retirement Savings First, Mortgage Payoff Later
Advantages: By building retirement savings early, you’re not only maximizing the time value of money but you’re getting the advantage of tax deferral in the process. The bigger the pile accumulated early, the less you’ll need to commit as you get closer to retirement — the hard work will already be done.
Disadvantages: Much of the advantage of front-loading retirement depends on the performance of the stock market. If the market doesn’t turn in decidedly positive returns, the whole scenario weakens considerably. Stocks also carry a substantial risk of loss; paying off a mortgage, by contrast, has none of that risk.
Mortgage Payoff First, Retirement Savings Later
Advantages: The biggest impact of prepaying a mortgage takes place in the first few years. This is because mortgage payments are overwhelmingly comprised of interest in the first few years. The sooner you can pay down the balance, the sooner the interest/principal divide begins to work in your favor. By making prepayments early, the term of the loan will be reduced. You can cut your term in half by making substantial prepayments in the first few years. Once your mortgage is paid, your cash flow will improve enabling you to save money at a higher rate than ever before.
Paying down a mortgage effectively locks in a rate of return equivalent to the interest rate on your loan. A guaranteed 4-6% return on your mortgage payoff will look really good the next time the stock market hits the skids. This is no small advantage given that the stock market has experienced two major slides in just the past 10 years, and looking shaky again right now.
Disadvantages: When funds are committed to mortgage prepayment, there are only two ways to get it out in an emergency: borrow it out or sell the property. The first defeats the purpose of prepaying, and the second is disruptive and difficult to pull off, especially in a weak housing market.
As you pay down your loan balance, the mortgage interest tax benefit will decline. Also while prepayments will shorten the term of the loan, your payment will remain the same until the loan is fully paid.
The Hybrid Solution — Juggling Both at the Same Time
Advantages: By taking on both projects simultaneously, you make steady, if slower, progress on two important goals at the same time. You also keep your options open to favor one over the other at some point in the future when it may become advantageous to do so. For example, another crash in the stock market may create a one time buying opportunity when you’ll want to shift excess funds to retirement savings to do some bottom fishing. Alternatively, once your mortgage balance falls to a certain level, you may want to concentrate funds there if you might be able to pay it completely in three of four years.
Disadvantages: You’re pouring money into two long term projects at once, limiting the impact on both while quite possibly draining your budget for two plans that offer no immediate benefit. There’s a compelling school of thought that we’re most effective when we throw all of our effort behind a single worthy goal.
My Personal Opinion
Everyone’s situation is different and there are no hard and fast rules, but since I generally favor savings ahead of debt payoff, I think that for the typical homeowner it’s best to emphasize building up retirement savings over mortgage payoff. This is especially true if you’re early in either situation.
Time is an important factor with retirement savings; the biggest advantage comes when you’re able to plow a lot of money in early. Delaying or minimizing contributions in the early years will have serious opportunity costs.
On the other hand, mortgages are what we might call patient debt. A 30- or 15-year fixed rate mortgage isn’t going anywhere. The payments are fixed for the term of the loan and the rate will never increase. They’re also self-amortizing, so even if you do nothing more than make the scheduled payments, the principal balance will go down, albeit slowly. Unlike credit cards and some other forms of debt, you can afford to leave your mortgage alone until you’re ready to deal with it.
It might be better to focus on maximizing retirement savings early on, then shift resources into mortgage prepayment later. If you reach a point where your retirement savings are larger than your mortgage, the effort will seem that much easier.
There are however two exceptions on this opinion:
- If you have minimal equity in your home, or
- if your mortgage is of the exotic variety.
If you purchased your home with a minimum down payment — or even more if it was with 100% financing — and your equity position has gone negative, this is a situation that demands an immediate cash infusion until the equity deficiency is cured.
The same is true of exotic mortgages — adjustable rate loans, balloons, interest only and anything of the sub-prime variety. In the current real estate market, a refinance could be complicated if the value of your home has fallen significantly. Rebuilding equity is critical.
Adjustable rate mortgages depend on low rates. Don’t allow the calm rate environment of the past few years to lull you into thinking that low rates are forever. Balloon loans could cause a need to refinance, and equity could be a problem. On interest-only mortgages the only way to reduce the balance will be to make direct principal reductions. And sub-prime loans just need to go away, period.
Any of these mortgage types, along with a weak equity position, might have you in a crisis where the loan represents a near term threat to either your financial position or to your household stability. The mortgage should necessarily be the priority to receive any excess funds.
But apart from these two exceptions, I think the emphasis should be on retirement savings first.
Which camp are you in, retirement savings first, payoff the mortgage first, or taking on both at the same time?