Mortgage vs. 401(k)

Should you pay down your mortgage or contribute to your 401(k)? Some questions to consider.

Should you use your surplus cash to pay down your mortgage or make a contribution to your 401(k)? In an ideal world, you could afford to do both. However, for most people, especially those with relatively new mortgages and high tax rates, it’s best to invest in a 401(k) first.

When you consider what’s best in your situation, you’ll want to take into account how much cash you have available, the rate of return on your 401(k), how much your employer contributes, the interest savings you’ll achieve by paying down your mortgage and – of course – your tax bracket.

For starters, look at the consequences of making an extra lump-sum payment on your mortgage. Remember your mortgage-interest tax benefit will be reduced if you pay less interest. As a general rule, homeowners with large mortgages that are relatively new get the biggest tax benefits.

Next, figure out the benefit of contributing the same amount to your 401(k). Any matching contribution your employer will make is an immediate gain for you. Add the tax deduction for the first $13,000 of your contribution ($16,000 if you are over 50) to the estimated return on investment for your total contribution, including any grant from your employer. Compare this number to your potential mortgage interest savings to determine whether you should put your extra cash in your 401(k) or your house.

If you do the math, it’s generally better to max out on tax-assisted savings plans before you pay down your mortgage. If you have enough cash, the best course may be to make the maximum tax-deductible 401(k) contribution, then use what’s left over to make an extra mortgage payment.

Your decision may also be influenced by emotional issues. If you’re getting close to retirement and have only a few years left on your mortgage, paying it down may bring you a heightened sense of security. It may be sensible from a financial point of view too, because your monthly loan payments are probably mainly principal at this point in time, making the mortgage-interest tax savings available to you relatively small.