Wise to pay off mortgage before retiring

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Dear Dr. Don,
We recently refinanced our home at a 4.625 interest rate for 30 years. I am currently 49 and my husband is 54. We both would like to retire in 10 years. I would like to know if it would be more beneficial for us to (1) pay an extra $500 per month to the principal of our loan to pay it off in 10 years or (2) put the extra money into our savings account (currently at 3.13 percent annual percentage yield).

We don’t have any other credit cards, etc., to pay off. We are currently contributing 8 percent to a 401(k) and 10 percent to a savings account. Also, I know that investing in my 401(k) may be another option, but given the market fluctuations I am not sure if I want to do that. (I have lost approximately one-third the value of my account.) I guess that the home interest used when filing my taxes may also be a factor as well. Your advice would be appreciated greatly.
— Conflicted Kim

Dear Kim,
If there is an employer matching contribution to your 401(k), you should contribute up to the limit of the matching program. A typical employer match is 50 cents on each dollar you contribute, with the match limited to 3 percent of salary. If that’s how your plan works, contribute 6 percent of salary to get the full 3 percent of salary match. That’s a 50 percent return on your money. You can usually choose a conservative investment in your 401(k) that has no risk to principal.

It’s a sound financial goal to pay down or pay off your mortgage prior to retirement. The amortization schedule on Bankrate’s mortgage payment calculator will show you how the additional monthly payment of $500 per month will shorten the loan and reduce the total interest expense.

When deciding whether it makes sense to prepay a mortgage, I compare the after-tax return on investments against the effective rate of return on your mortgage. If you can earn more after-tax on your investments than the effective (after-tax) rate on your mortgage, you’re better off investing. Down the road, you can decide to cash in your investments to pay down or pay off your mortgage.

If you compare a 4.625 mortgage to a 3.125 annual percentage yield on savings, you’re going to decide that it makes sense to prepay the mortgage. The more conservative you are in investment choices, the more likely it is that your after-tax investment return won’t exceed the effective rate on your mortgage.

Bankrate’s mortgage tax deduction calculator estimates the effective rate on your mortgage, but assumes you can fully use the mortgage interest deduction. You can use the same calculator to calculate the expected after-tax return on your investments — just “zero out” the closing costs.

If the mortgage interest deduction mostly replaces the standard deduction on your income taxes, you don’t receive the full benefit from the tax deductibility of the mortgage interest expense. The extent that your mortgage interest deduction combined with your other deductions exceeds the standard deduction determines the tax benefit.

With only 10 years until your expected retirement, this is a great time to meet with a financial planner to see if you’re on track to meet retirement income goals. A planner should be able to provide a more holistic approach to your finances and give you greater confidence in your decisions prior to retirement. The Bankrate feature “Financial planners: Not just for millionaires anymore” provides a nice overview on making the decision to hire a planner.

To ask a question of Dr. Don, go to the “Ask the Experts” page, and select one of these topics: “Financing a home,” “Saving & investing” or “Money.” Read more Dr. Don columns for additional personal finance advice.