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Related topics: mortgage, home financing, debt, interest rates, Liz Weston

Cratered interest rates, a volatile stock market and a dismal real-estate situation make it vividly clear: The only decent, guaranteed return you can find these days is by paying off debt you've already incurred.

If you're carrying credit card debt at 11%, for example, every dollar you pay off earns you an instant 11% return on your money.

That's a great return in a world where:

  • One-year certificates of deposit average much less than 2%.
  • Yields on short-term Treasury securities are close to zero.
  • Many retirement funds are down 40% or more from their peaks.
  • Home prices are still bottoming out.

So shouldn't we be tackling all our debt, including our mortgages?

Image: Liz Pulliam Weston

Liz Pulliam Weston

Not so fast.

There are situations where paying down a mortgage makes sense, such as when you're approaching retirement or when reducing your principal will get you a much better deal on a mortgage refinance.

But most people still have better things to do with their money, even in this environment, than to pay down a low-rate debt that's often tax-deductible to boot.

And if you're "underwater" on your mortgage, paying it down is probably the last thing you should do.

The urge to be free of debt

It's not that I don't understand the impulse to speed up the day that you own your home free and clear. There's something psychologically satisfying about knowing the bank can't take your castle.

Besides, the numbers can seem pretty impressive. Let's say you have a 30-year, $250,000 mortgage at 6% interest. Your monthly payments are $1,498.88. By paying an extra:

  • $100 a month, you could save nearly $52,000 in future interest and pay off the loan four and a half years early.
  • $250 a month, you could save nearly $100,000 in future interest and pay off the loan nine years early.
  • $500 a month, you could save nearly $144,000 in future interest and pay off the loan almost 14 years early.

So who wouldn't go for that, right? Indeed, a March 2007 study (.pdf file) co-authored by a Federal Reserve economist estimated that 16% of U.S. households pay extra on mortgages each year. But anyone who really understands money would realize the savings aren't all they're cracked up to be.

For one thing, mortgages tend to be some of the cheapest money you can get, and, as mentioned earlier, the interest is often deductible. If you're in the 25% federal tax bracket, that 6% interest rate may be costing you as little as 4.5% if you itemize and even less when you factor in state income taxes. (Your tax break depends on the amount of interest you pay and the total of your other itemized deductions.) Even if you don't get any tax break at all on your mortgage, though, the rate is still dirt-cheap compared with that on most other loans.

Furthermore, those seemingly impressive interest savings are spread out over future years, when their value will be substantially eroded by inflation. Remember, a dollar 25 years from now probably will be worth less than 50 cents is today, given a 3.1% inflation rate.

Need a guaranteed return? Try 50%

Contributions to a workplace retirement plan will get you a lot further ahead, for a variety of reasons:

  • While many employers have recently curtailed such practices, workplace plans often still offer matches, typically 50% of every dollar you put in up to 6% of your pay. If you're not contributing enough to at least get the full company match, you're leaving free money on the table (and missing out on an immediate 50% return).
  • You save taxes on the money going in. Federal tax brackets range from 10% to 35%; there are also federal tax credits when lower-income workers make retirement contributions. When the money comes out, you'll owe taxes, but most people's tax rates fall in retirement compared with the period when they're working.
  • Even with the recent turmoil, over the long term your money can earn better returns in the market compared with paying off low-rate debt. Based on historical returns, a mix of 60% stocks, 30% bonds and 10% cash would earn an average of more than 8% a year in most 20- to 30-year periods, according to market researcher Ibbotson Associates. You may doubt we'll ever return to the days of long-term gains in the stock market, but we will.

Even if you stick your money in a cash account, the upfront benefits of retirement plan contributions are compelling enough that you should opt to put money there rather than your mortgage.

In fact, the Fed study found that homeowners who prepay their mortgages blow more than $1.5 billion a year, or $400 per household, by accelerating their loan payments instead of contributing more to their retirement accounts.

The research found that at least 38% of those who were making extra payments on their mortgage were "making the wrong choice." Instead, these households would get back 11 to 17 cents more on the dollar by putting the money into a workplace retirement plan such as a 401k.

The study didn't mention Roth IRAs, but they're another account you should take advantage of if you possibly can. You don't get a tax break upfront, but the money comes out tax-free in retirement.

If you're already maxing out your retirement funds, though, your next step still shouldn't be making an extra mortgage payment.