After paying the mortgage and the utilities, putting gas in the car, and buying dog food for Fido, the average American has a whole lot of choices for how to save and invest money.
The list is virtually endless, but one available option is to pay down your mortgage faster than scheduled under your loan. I recently wrote about some research that studied whether it's a better idea to prepay your mortgage or maximize your contributions to a 401(k).
The research found that nearly 40% of households who prepay their mortgage made a financial mistake. On average, each of those households could have gained an extra $400 each year by maximizing their 401(k) contributions instead.
This study starts to answer the question about prepayment for people who still have room to stuff more money into those retirement accounts. But, what does that mean for people who already maximize their 401(k) contributions? A number of readers emailed me to ask that very question.
There's one very nice thing about academic studies. The professors and researchers who conduct them get to look for appropriate data sets, narrow their research field, and ultimately answer a very specific question. They can report their findings with confidence, and they show you the evidence for their conclusions.
Our lives tend to be messier than all that. But we can learn a thing or two from the academics when trying to sort out some of our own financial decisions. When faced with a seemingly endless array of opportunities, how do we pick the best and most profitable course? It helps to ask yourself your own set of narrow, targeted questions.
First, ask yourself why you're thinking about prepaying your mortgage. This may be the most important question. The academic research found that many people who opted for prepayment over a fatter retirement savings account had a strong aversion to debt. Put another way, they got a lot of peace of mind from knowing their house would be paid off quickly.
If I explained the financial disadvantages of prepayment to all of those people, some might change their minds and choose a more financially profitable course. Some might not, knowing they'll sleep better at night if their mortgage debt remains their priority. Knowing your debt and risk tolerances is a good first step toward making the right financial decisions.
If you've already maximized your 401(k) contribution, and you're still wondering whether it's a good idea to prepay your mortgage, it's time for a different set of detailed questions. Now, you'll have to investigate the advantages of prepaying your mortgage when compared with the other uses for your money. Tackle each of these uses one at a time.
Prepayment vs. spending? No question about it, prepayment wins every time.
Prepayment vs. savings? If you don't have three to six months of expenses sitting in an emergency account, think about establishing one with your extra money. It's true that you can draw on your home equity in an emergency. That's certainly not as easy as writing a check out of your money market account if you don't have some kind of home equity credit line already established when emergency strikes. If your savings are in good order, however, it may be more to your financial advantage to pay down your mortgage.
Prepayment vs. an IRA or Roth IRA? Here you have a lot of variables to weigh, but the IRA may come out on top. You reduce your eventual interest payments when directing your money toward your mortgage. However, with an IRA you may earn a higher return, and you'll also have the advantage of some tax savings. Taking the time to ponder some hypothetical scenarios and crunch a few numbers on online calculators would be to your benefit.
Prepayment vs. college fund? For some parents, their home equity is their college fund. However, you can get some tax advantages and often a better return by stashing that money in a college savings account like a 529 plan. This may be another good question for your Internet calculators.
Of course, all of these scenarios depend on a million variables that we personal finance writers know nothing about, like your mortgage interest rate and your goals. If you're really stuck, find a reputable adviser to compare some different scenarios for you. Paying for a little time with a good, fee-only professional can be money well spent if it leads you down the most profitable path. Get some advice for seeking advice right here.