Should I Pay Down My Mortgage or Save More for Retirement?

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Living on less money than you make can lead to complex financial decisions.

For example, should you use your free cash flow to pay down your mortgage or invest it toward your retirement?

That question used to be easy when the stock market was going gangbusters as part of a long-standing bull market. The Fed pushed interest rates to historically low levels. And 15-year mortgage rates below 3% were fairly common.

Now the average 30-year fixed mortgage rate hovers above 7%. And depending on how long it takes to continue to tamp down inflation, that number could rise even more.

It’s becoming a more complicated choice to invest your extra dollars or to pay down your mortgage, especially if you’ve recently bought a house. Which should you prioritize?

That’s what a listener of the Clark Howard Podcast recently asked.

Should I Pay Down My Mortgage or Save the Maximum for My Retirement?

Should I pay extra on my mortgage or save for retirement?

That’s what a Clark listener asked on the May 31 podcast episode.

Asked Jarrod in Florida: “My wife and I are currently maxing out our Roth 401(k)s and it’s all we can do financially. But we are curious if it might make more sense to put a portion toward our $500,000 mortgage [with a] 6.35% [interest rate].

“It just seems unlikely we will match that in the market and it would give us a feeling of safety to have a paid-for home.”

Clark marveled at the way Jarrod and his wife are saving. IRA contribution limits are $6,500 in 2023 for those under 50 years old. By contrast, the contribution limit for a 401(k) account is $22,500 this year.

So Jarrod and his wife are putting at least $45,000 in post-tax dollars into Roth 401(k) accounts.

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“If you wanted to dial it back and do $5,000 less each year in the Roth 401(k) and put that additional $10,000 toward the mortgage, you’d still be saving a great amount of money toward retirement and you’d be getting a guaranteed 6.35% return on your money,” Clark says.

“[You’ be] taking down that $500,000 mortgage month by month by a decent amount of additional prepayment of principle.”

Paying Your Mortgage vs. Saving for Retirement: The Raw Math

The average annual return of the S&P 500 (1957 through 2022) is about 10.1%. So in the long term, dollars that are fully invested in the broad stock market should outperform the 6.35% interest on the mortgage rate.

However, that’s often not the case in the short term, even for a period of years.

Plus, if you’ve invested in Clark’s recommendation inside of your 401(k) account — a target date fund — you will not be 100% allocated toward U.S. equities. The closer you are to your expected retirement year, the more your allocation should shift toward fixed income such as bonds.

So you probably shouldn’t expect a 10% annual return on your 401(k) investments if you’re following Clark’s recommendation.

3 Reasons To Consider Clark’s Second Option

Raw math isn’t everything when it comes to financial decisions. Clark constantly references behavioral economics.

In this case, Jarrod and his wife get three potential benefits by taking a percentage of the money they’re putting into their 401(k) accounts and shifting it toward paying the principal on their mortgage.

1. Setting Themselves Up To Refinance Their Mortgage

The market has priced in Fed interest rate cuts by the end of 2023 for some time now. But the Fed itself has been more hesitant to suggest that cuts are coming any time soon.

The latest CPI number, which the U.S. government refers to as the measure of record for inflation, dipped under 5% in April. That’s down from a peak of 9.1% in June 2022. However, the Fed’s stated goal is to push inflation down to 2%.

No one knows exactly how long it will take for the Fed to halt its interest rate hikes and even start making cuts. Markets suggest that it will happen at some point. But there’s still a lot of disagreement about when any of this will happen, and to what degree.

“As the Federal Reserve is ultimately successful, which they will be after a lot of trial and error, in getting inflation down, interest rates will also come down,” Clark says. “And the opportunity will come down the road where you’ll be able to refinance this mortgage.

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“If you keep doing the prepayment of principle by diverting some of the money you’re putting into the Roth 401(k), maybe you’ll get the balance down enough that when the right opportunity strikes to refinance, you go into a 15-year refi instead of a 30-year refi.

“The interest rates on 15-year loans usually are about a half-point lower.”

2. Hedging Against Poor Stock Market Performance

Clark preaches a “set and forget” stock market strategy.

Keep contributing money to your retirement portfolio throughout your career, he says, and increase the amount you’re contributing over time. Don’t try to time the market.

However, some people are more squeamish about the typical ups and downs that the U.S. economy and the stock market cycle through.

In Jarrod’s case, he can lock in the equivalent of a 6.35% return on some of the money he and his wife are currently putting into their 401(k) accounts.

And as Clark explained, that could eventually result in, say, a 1.5% discount on that mortgage rate if they refinance into a 15-year mortgage in a few years.

3. Peace of Mind

There’s nothing better than laying your head down on your pillow at night and not feeling worried about your finances.

A hedge like I’m describing in this section may be the thing that keeps Jerrod and his wife feeling emotionally stable even when there’s a bad day, week, month or year in the stock market.

And remember, Clark isn’t suggesting that they abandon their retirement saving and investing habits. They’d still be putting money into the market.

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Final Thoughts

The choice to pay down your mortgage or save is getting more interesting with the current higher mortgage rates.

Either way, if you’re doing the kind of saving that Jarrod and his wife are, you should pat yourself on the back.

“Congratulations to both of you on the enormous amount of money you’re throwing into your Roth 401(k)s right now,” Clark told the couple on his podcast. “Good for you.”

Remember that in most instances, the choice to save, invest or pay off debt doesn’t have to be all or nothing.

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