Should You Save More For Retirement Or Pay Off Your Mortgage Early?

One of the most common questions we get is whether to put savings toward paying off a mortgage vs. investing more for retirement. This question is tricky because the answer can vary depending on which stage of life you’re in. Are you in the accumulation phase of trying to build wealth or in the distribution phase of using that wealth to generate income?

The Accumulation Phase

First of all, make sure you have enough savings in an emergency fund to cover at least 3-6 months of necessary expenses before paying down your mortgage. While paying down your debt may make you feel safer, it’s actually safer to have some money in savings that you can use to continue making those mortgage payments when Murphy’s Law kicks in. Even if your mortgage is paid off, you’ll need emergency savings to keep the lights on, food on the table, your car in the driveway, and gas in that car if something happens to your income.

You may want to invest if you think you can earn more than you would save in interest by paying your mortgage down faster. At the very minimum, you’ll want to max out any match you get in your employer’s retirement plan. Beyond that, it depends on what the interest rate is on your mortgage and what you can expect to earn by investing instead.

The former is pretty easy to figure out, but the latter depends on how aggressively you invest. As a rule of thumb, I like to assume a 4% average annualized return if you’re conservative (25-50% in stocks), 5% if you’re moderate (50-75% in stocks), and 6% if you’re aggressive (75-100% in stocks). Those numbers are below historical averages to be on the safe side.

Finally, don’t forget the impact of taxes. You can reduce your mortgage interest rate by your tax savings if you itemize. For example, if your mortgage rate is 4%, you’re in a hypothetical 25% tax bracket, and you’re able to deduct all the mortgage interest, that mortgage is really costing you 3%. If you’re investing in a tax-advantaged account, you can treat the earnings as tax-free. (This is true even if you’re contributing to a pre-tax account because it works out that way mathematically.)

The Distribution Phase

Once you retire, your focus shifts from accumulating wealth to generating cash flow. In that case, paying off your mortgage usually gives you more bang for the buck. That’s because even if your investments earn an average return of 7% a year, that doesn’t mean you can safely withdraw even 5% a year as income.

Why? Well, we all know the stock market is volatile. There have been 15-20 -year time periods when returns were well-below average, which were then followed by 15-20 years of above-average returns. When you’re putting the same amount of money periodically into your investments (like you do in a retirement plan), this can be beneficial because you’ll naturally buy more when the market is performing poorly and prices are low, and less when the market is doing well and prices are high. Of course, this assumes that you maintain consistency with your investments.

However, when you’re withdrawing money from your investments, the math can work against you. If you happen to retire during a long period of poor returns, you can end up depleting your account before the good times roll around. That’s why research has found that you could historically withdraw no more than about 4% of your portfolio and increase that each year with inflation without a significant chance of running out of money in 30 years.

When you factor that in, you can probably save more in mortgage payments by paying off your mortgage in retirement than you would earn in income by having that same amount of money invested and withdrawing 4%. The tax benefits of keeping a mortgage later in life are also significantly reduced because most of your later payments are principal vs. deductible interest and you may be in a lower tax bracket in retirement. For those reasons, you’ll probably want to plan to pay off your mortgage around your retirement date.

As an example of this, I spoke to a 34-year-old woman who had managed to accumulate $2 million with her husband and planned to retire soon. They also had a $350k mortgage costing them $16,800 a year and two rental properties with mortgages of $150k and $130k that could net $22k and $10k respectively if the mortgages were paid off. Paying off those mortgages would be like getting a 4.8%, 14.7%, and 7.7.% yield on that cash respectively because they would no longer have to make those mortgage payments. Compare that to the 4% they could probably safely withdraw from their investments. In fact, they discovered that by paying off their mortgages, they wouldn’t need to withdraw anything from their investments at all!

There is one last thing to keep in mind. Be aware of any tax implications if you’re selling investments, especially if they’re coming from a taxable retirement account. You may want to spread it out over time to avoid pushing yourself into a higher tax bracket.

As you can see, whether you should use savings to pay off your mortgage early or invest more isn’t a simple yes or no answer. It depends on the particulars of your situation. But of course, even making the wrong choice here is better than not saving at all.