Your housing expenses and retirement contributions are among your most important expenses each month, so it can be hard to decide which to increase when you have more disposable income. Money isn’t the only factor and there isn’t a single right answer to choosing to pay down the mortgage or put more money toward your 401(k).
Financial Benefits of 401(k) Contributions
To figure the amount you’ll make by contributing to a 401(k) plan, estimate the rate of return you expect and multiply it by your contribution. For example, if you expect a 7 percent return on your $10,000 contribution, you can expect a $700 return for the first year. However, big gains aren’t guaranteed, and your 401(k) could lose money. If someone guarantees you a high rate of return on the next “can’t miss” investment, watch out. No matter how well managed your 401(k) plan is, you can’t be 100 percent certain it’s going to reach your estimated rate of return.
For some people, contributions to a 401(k) plan give the added benefit of matching employer contributions. When figuring your expected gains from the 401(k) contribution, make sure you account for the employer match. For example, if your employer matches your contributions up to $5,000 each year, and you contribute $10,000, you’re essentially contributing $15,000 because of the employer match.
Extra Mortgage Payments
The financial benefit of paying off your mortgage is in the interest that you don’t have to pay because you paid off the mortgage early. If you itemize your deductions so you can claim the mortgage interest on your taxes, you have to adjust the interest rate to account for the tax benefits. To do so, subtract your tax bracket from 1 and multiply the result by your interest rate on your mortgage. For example, if you have a 6 percent mortgage and fall in the 25 percent tax bracket, after accounting for the tax break, you’re effectively paying 4.5 percent in interest. To figure your interest savings, multiply your tax-adjusted interest rate by the amount you’re going to pay on the mortgage. For example, if you’re going to pay $10,000 extra on the mortgage and your tax-adjusted rate is 4.5 percent, you’ll save $450 per year.
Depending on your personality, getting your mortgage paid off faster can be like lifting a weight off your shoulders. Once your mortgage is paid off, you don’t have the same worries about losing your home if you fall behind in your mortgage payments. Though investing in stocks might have given you a higher rate of return, the 401(k) could also go down and you can’t live in a stock certificate like you can a home.
Mark Kennan is a writer based in the Kansas City area, specializing in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."