Pay down mortgage or add to 401(k)?

My wife and I have a monthly mortgage payment of $3,200 per month and our combined income is $180,000. We each made the maximum contribution to our 401(k) accounts of $15,500. I calculated that for the past 3 years, if we had redirected our 401(k) contributions to pay down our mortgage we would have done much better. Do you think it is wise to pay off our mortgage as opposed to contribute to our 401(k) account?

Wealth management, like life, has many risk and reward opportunities. Over the Thanksgiving holiday, my wife, daughter and I piled into our car and drove to New Jersey to visit relatives. We were fortunate to hit little traffic and for much of the way I set the cruise control at 72 miles per hour. I wanted to get to New Jersey as quickly as possible, but did not want the risk of getting a speeding ticket. I felt that at 72 miles an hour, I was unlikely to get a ticket in a 65 mile per hour zone. This was the maximum speed I could drive without significant risk of being pulled over. Unlike Burt Reynolds in “Smokey and the Bandit”, my appetite for risk of receiving a ticket was pretty low and I did not want to encounter Sheriff Buford T. Justice (Jackie Gleason).

Similarly, when it comes to investing money, you need to honestly assess how much risk you want to take. With the market suffering significant losses over the last year, many have lost their appetite for risk, and rightfully so. However, if you believe the stock and bond markets will return to their historical averages and provide a long term 7 to 8 percent return, then I believe you will perform much better off contributing to your 401(k) account. There are several reasons that I prefer contributing to a 401(k) account. They are as follows:

1. Tax deductions – Contributions to your 401(k) account are tax deductible, while paying off your mortgage early is not. For example, last year you and your wife contributed $31,000 to your 401(k) accounts. If you chose not to make these contributions, you would only receive approximately $20,000 after tax. You could then use this $20,000 to pay down your mortgage. Based on this equation, your family’s wealth is $11,000 greater by contributing to the 401(k) than to paying down your mortgage. You have the additional $11,000 to compound on a tax deferred basis.

2. Mortgage interest is cheap – For the past several years interest rates for 30 year fixed mortgages have been between 5.25 and 6.5 percent. They are currently around 5.5 percent. These rates are historically low. Additionally, the interest paid on the mortgage will likely be tax deductible. As such, your borrowing rate is significantly lower on an after tax basis.

3. Inflation – Mortgage loans do not adjust for inflation. Let’s assume you took a $500,000 loan to purchase a home. Inflation for the past few decades has averaged about 2.5 percent. If you consider inflation, $500,000 in today’s dollars will only be worth approximately $390,000 in ten years. Inflation basically reduces the real amount of your mortgage. If you made no principal payments on the mortgage, the lender will have lost $110,000 in purchasing power and you will be the beneficiary of this. Furthermore, assuming the value of the home increases (again you have to consider that long term trends will continue and not the current short term market) you will receive all of the increase in value of the property.

The above thoughts are based on normal stock, bond and housing markets. If you do not believe that the long term bond and stock markets will perform positively, then you should pay down your mortgage. However, if you believe the markets will return 7 to 8 percent, their long term historical averages, then I believe you will perform much better off by continuing to contribute to your 401(k) account.