Should I increase my 401(k) contributions, or increase my mortgage payments

Question

I have about $150k remaining to pay on my mortgage. There are 7 years left at a 3% interest rate, then after that the rate goes variable and increases to about 10%+. There's no penalty for paying the mortgage early.

I don't have much in my 401(k). My current employer doesn't pay any matching contributions. I have 20 years until retirement.

My wife and I both work, with reasonable salaries, enough that we can afford to max our our 401k AND pay significant mortgage payments.

But my question is, should I max out my 401(k) contributions ($19k per year as of 2019), or should I reduce my 401(k) (to zero for now?) and put all the money into paying off the mortgage early?

Is my reasoning correct that:

a) If my 401(k) investment returns were reliably at a higher rate than my mortgage, then I should put my money in that.

b) But my 401(k) returns are not reliably higher than the mortgage rate (since they may go down, and especially since the mortgage rate goes up substantially in 7 years)

c) Therefore I should pay off the mortgage first.

So 401(k) to zero for now?

Answer 1

At a high level, what you are asking is "should my assets be mostly concentrated in some mutual funds or in my primary residence?" I would answer that some low-cost, passive-index mutual funds are usually a much better bet. I am assuming you will always remain a US resident.

You have laid out two options - aggressively invest in your 401(k) or aggressively prepay your mortgage.

If your 401(k) is invested in an appropriate, low-cost, stock-heavy portfolio of passive index funds, then I am confident it is much likelier to be the better long-term investment than your house.

The long-term return on the S&P 500 is around 9-10%, but the long-term average return on residential real estate (i.e. without rental income) is around 3-4% in Case-Shiller. There is lots of variability based on metro area, neighborhood, etc. So you might be in a great area or a bad area and get very different returns (nice areas are expensive to buy, so a good investment is a bad area that unexpectedly becomes good, not an already-good area that gets slightly better). But most of us should expect that 3 decades of owning a home is a much worse return, close to historical average inflation, than 3 decades of owning a few passive index funds.

The main argument for paying off your house is the simplicity of not having a loan. If that strongly appeals to you, then go for it. Some people are very stressed by loans, some people are very happy feeling debt-free, and if either of those applies to you, then the subjective value of prepaying your mortgage is important. Your long-term financial picture is likely to be less robust and lower-growth. So, if you just want to know the financially and mathematically best answer, aggressive 401(k) beats aggressive mortgage-paying. But if you place a personal premium on prepaying debt, then that is a valid choice (akin to consumption - trading future gains in order to consume your contentedness at reducing your debts).

A few other notes on timing and taxes. Timing generally favors earlier 401(k) investments. If you are considering doing a few years of aggressive 401(k) and a few years of aggressive mortgage, do the 401(k) first. Your 401(k) will not grow until contributed, but your home value will change regardless of whether you prepay your mortgage. So aggressive 401(k) contributions in years 1, 2, and 3 is better than in years 4, 5, and 6. Even the accumulating interest on your mortgage is unlikely to cost enough to cancel out the gains that your funds will likely accumulate.

Also, I am not going to wade too far into taxes, but note that completely paying off your mortgage may not be tax efficient, especially if you are high income. But just bear in mind that prepaying your entire mortgage will deprive you of the mortgage interest deduction. Also, if you are high income, then 401(k) pretax is a great way to shave off some tax.

If your mortgage is going to balloon to 10%, then you might look at whether you want to renegotiate into a fixed rate. You can also avoid the balloon by selling before then and getting a new mortgage on your new place. The problem in 2008 was all the people who could no longer evade the balloon by jumping to a new loan or a new house, because their home values had plummeted and credit was hard to find. That is unlikely to repeat in the same way, but there is more risk as you get closer to the balloon that you might, for a variety of reasons, find it difficult to get a new loan - for example, loss of job/income makes you unable to qualify for a new loan.

Answer 2

There's not really a "wrong" answer here, just a choice between risk and reward. You didn't mention how far you are from retirement, so it's impossible to say if your current saving plan is enough.

If my 401k investment returns were reliably at a higher rate than my mortgage, then I should put my money in that.

reliably is the key word here. Usually it will be higher than 3%, but sometimes it will be less (and sometimes much less). So long as you don't need that cash to live for a while, you can probably afford to take some additional risk in exchange for higher expected returns.

especially since the mortgage rate goes up substantially in 7 years

This is what caught my attention. I have no idea where mortgage rates will be in 7 years, but since they're still at relatively very low rates it's not unreasonable to assume that they'll be higher. So at least have a plan to pay off your mortgage before it jumps. If that's not feasible, then you might look at refinancing to a fixed rate in the near future. That at least eliminates that interest rate risk.

Also, depending on what your current tax situation is, you might be better off putting some of your savings in a Roth IRA instead of (or in addition to) the 401(k) since you aren't getting any match. The trade-off is paying tax now vs paying tax later. If you plan to have a large retirement account, then the withdrawals could put you in a higher tax bracket, so paying the tax now might be beneficial in the long run.

Answer 3

Both of your choices have drawbacks. You currently have a nice low interest rate on the mortgage, so there is no point to paying it off now. OTOH, if you put all the money in a 401k, you aren't going to be able to touch it without paying penalties.

I'd suggest a third alternative, which is to invest at least some money outside the 401k. That way, you'll have some fairly fluid assets, which means you should be able to refinance the house at much less than 10% before the ARM period expires.

PS: Also consider your current marginal tax rate. If the dollars you might put into the 401k are taxed at 35%, you might make a different choice than if they're taxed at 10-12%.

Answer 4

Don't mess around with retirement, unless your plan is to survive on the pittance from Social Security. Max out that 401(k).

But that only works if you invest it properly. Yes, there is a "properly".

With 20 years to go before retirement begins, you need to invest for the long term obviously. When investing long-term, you want to target equities with the highest growth regardless of their short term volatility.

Generally growth and volatility are a matched set, an asset with a lot of one has a lot of the other.

I'm not going to grind through the gory details of selecting good investments. I'll merely present as proof-of-concept the university endowment. This is a pile of capital that is meant to be kept forever, to produce annual income to support university projects and grow with inflation. Given the very long planning horizon, volatility is immaterial - they are optimized for max long-term growth at any volatility. Given the scrutiny they get by University Boards of Directors and wealthy alumni, they are prudently invested.

Those last 2 words together melt the brains of regular folk. How can investment in the risky stock market be prudent? Because "risk" is actually volatility, and like I said, volatility is immaterial over a long planning horizon. A prudent endowment might be 65% in domestic stock index funds, 15% in foreign stock index funds, 5% in REITs, 10% in muni bonds and 5% in whatever. You can get all that stuff in your 401(k) except maybe the REITs.

When you do all this, your average returns over the long term are are very impressive, and will be much higher than any mortgage rate, and will assure you a pleasant retirement. So as an experienced endowment manager, "401(k) vs mortgage" isn't even a question :)

Answer 5

Whether the 401(k) investments are reliably returning rates higher than the mortgage interest is not the issue. What is important is whether the risk adjust (geometric) mean of the investment returns is higher than the mortgage interest. Unless you are highly risk averse, the stock market's risk-adjusted return is significantly higher than 3%. And since there's no prepayment penalty, you can refinance once the 3% term runs out.

There is a further argument for 401(k) in that mortgage interest is tax deductible, and the returns on the 401(k) are tax-deferred. This means that diverting money that would have paid down your mortgage into your 401(k) serves to shift your tax burden into the future (tax deductions now, taxes later), giving you an interest-free loan from the IRS.

Answer 6

There is no way that your mortgage rate goes from 3% to 10+% in 7 years. It sounds like your mortgage is a 10/1 ARM where the rate is fixed for 10 years and then adjusts annually after that. That adjustment will be based on some benchmark rate such as LIBOR plus a fixed amount, say, 1.25%. The 12-month LIBOR rate right now is in the 2.25% range so if you had a LIBOR + 1.25% mortgage that was resetting now, it would go up to 3.5%.

Beyond that basic formula, there are two types of caps that come into play to protect you from huge increases. There will be a cap on how much the rate can increase in a single year and a cap on how much the rate can increase over the life of the loan. I'm willing to wager that the 10+% rate you're talking about is the life cap. If your life cap is, say, 10.5%, that protects you if we go back to 1989 when LIBOR hit 11% because your rate would only adjust to 10.5% not LIBOR + 1.25% = 12.25%.

It's useful to be aware of the life cap because it shows you what can happen in a worst-case scenario. But I can say with some confidence that no one in the United States has had their mortgage hit their life cap since the turn of the century. And while there is no guarantee about what interest rates are going to do over the next few years, it is quite unlikely that rates are going to go up 7 or 8% by the time your mortgage resets. If rates do jump like that, that implies that inflation will be much higher and the nominal returns on all your bonds will be much higher as well. Assuming your income increases at least with inflation, you'd expect much higher annual raises in that scenario not the small cost of living adjustments that you're likely used to from the past few years.

That said, there are lots of mortgage companies and lots of mortgage products so maybe you want to Crazy Al's House of Crazy Mortgage Products and Small Appliances and got a deal on an exploding 10/1 ARM and toaster oven combo where the rate really jumps up to 10% after 7 years. Even if that's the case, you'd never actually pay the 10% rate because it would be obviously worthwhile to refinance at that point into a lower rate. Unless interest rates have jumped precipitously or house prices have cratered and you're severely underwater or you decide to declare bankruptcy in year 9, you should have no difficulty getting a lower rate in 7 years.

With that out of the way, the other answers are very good so I won't go over that ground again. If you're making a decision mostly based on financial returns vs. mostly based on emotional comfort, you'd really want to compare the expected cost of the mortgage against the expected 401(k) returns not the worst case mortgage cost.

Answer 7

Pay off the mortgage. My wife and I paid off the mortgage on our first house in five years; three kids later, second house took seven years. Haven't had a mortgage in...what, 10 years? Wow, time flies. Have put three kids through college on savings in the meantime because our income was going to us instead of a bank. Pay off your mortgage - you'll be doing yourself a gigantic favor.

Oh, and find a new employer. One that contributes nothing to your 401K is basically saying they don't care about you or yours. So tell 'em bye-bye and find a company that values its employees.

Answer 8

There is insufficient information to adequately answer the question. According to your inputs, your monthly payment if you were to pay down the loan within 7 years is $2379. But you don't state what your normal payment should be. To contribute the maximum to your 401(k), you would be contributing about $1580/month. So suppose we take the difference as the "normal" payment, so $795.67/month. In such a case, at the end of 7 years, you would still have to pay $110734 approximately subject to 10%+ interest.

The critical piece of information that is missing is how many years you have until you retire, because the longer you have, the better it is to invest in the 401(k) now. For example, if you contribute the maximum per month for 7 years, but you are 30 years old now and will begin taking distributions at 65, then the accumulated value at an very conservative average annual rate of return of 5% is already $618906, not counting any additional contribution after those 7 years. If you switch gears at the end of those 7 years and pay $2379/month at 10% interest on your mortgage, you would pay it off in approximately 5 more years.

Conversely, if you paid off the mortgage in 7 years but put nothing in the 401(k), you'd have only 28 years to contribute to your 401(k), and the accumulated value of 7 years at the maximum rate is then $439845, a difference of $179061.

The calculations change dramatically if you factor in taxes on distributions, and the years until retirement. It's also more complex if you do a mixture of both strategies. Without more concrete information, I am reluctant to calculate more scenarios. Ideally, you would want to provide the following information:

1. Projected number of years until retirement
2. Total amount you are able to contribute to either 401(k) or mortgage on a monthly basis
3. Amount of 401(k) employer match if known

Answer 9

In addition to your options a), b) and c) there might be potentially attractive alternatives. Like mortgage refinance in near future to get rid of the balloon. Or mortgage re-payment with funds borrowed from your 401k.