Making extra mortgage payments in order to cut the amount of interest paid is quite popular these days. The theory is that you’ll save interest and then be able to save money for other things later. But, I’m not sure this is the right approach if you’re not fully saving for retirement, because you’ll miss out on years of compound interest.
This year, the maximum 401K contribution is $16,500. The maximum Roth IRA contribution is $5000. That means a couple (assuming you both have 401K options at work), could contribute $43,000 a year to retirement. Obviously, most people can’t afford to contribute that much, but you should be contributing at least 10% of your income to retirement before you consider paying off a low-interest debt like a mortgage.
The Cost of a Mortgage Over Time
If you have a fixed rate mortgage, the interest portion remains flat for the life of the mortgage. So, in 20 years time, the $1500 costs far less than it does now. Yes, it’s still $1500, but your income will have increased just to keep pace with inflation. The mortgage will become a smaller and smaller portion of your monthly expenses, meanwhile, the money you save for retirement grows and grows and grows.
You Can’t Make Up for Lost Time
So let’s say you decide that it’s more important to be debt-free than it is to save for retirement. Let’s take an income of $50,000 as an example. You save only 3% for retirement ($1500) and put an extra $5000 a year towards your $150,000 mortgage at 6% interest. Now you have an extra $899 a month you can spend on other things, like retirement. We’ll also assume you don’t earn any raises, just to keep things simple. If you follow this option, you’ll pay $72,697 in interest and pay off your mortgage in 14 years and 2 months. Meanwhile, you’ve saved $31,000 for retirement at a very conservative growth of 4% (plus 3% inflation). Once you add the mortgage funds to your retirement in year 14, you’ll only manage to save $107,780 in 30 years.
Now let’s look at saving 10% for retirement and paying the mortgage over time. You’ll pay $173,000 in interest on the mortgage over 30 years. You’ll also save $104,000 toward retirement in 14 years, and $434,812 over 30 years.
So, yes, you’ll save $101,000 in interest, but you’ll lose $327,000 in retirement savings. That seems like a bad deal to me.
Retirement is Almost Always the Highest Priority
Certainly, you should make sure you have an emergency fund with six months of living expenses before you max out your retirement. Make sure you can pay your mortgage or rent and other vital bills.
Next, find a way to balance your credit card debt and your retirement goals. We kept our retirement savings low while paying off credit card debt, because credit card debt costs far, far more.
However, before you start saving for your dream home, or a boat, or a fancy car, or even deciding to pay off your mortgage early, make sure you max your retirement as much as your budget will allow. Yes, you won’t have to worry about making mortgage payments when you’re retired if you pay off the mortgage early, but you may not have enough money to heat that house if you don’t prioritize your retirement.