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Should I put my raise toward a 401(k) or the mortgage?

Posted by  on Aug 13, 2014
 

Q: I just got a raise, and I'm wondering what's better in the long run -- putting that money toward making larger contributions to my 401(k) plan or toward accelerating my mortgage payments? I refinanced last year at 4 percent, if that makes a difference.

A: One way to frame this decision is to think of your mortgage rate as a hurdle any alternative use of the money would have to clear. In other words, you could save that mortgage rate by prepaying your mortgage, so an investment would have to offer a higher return to be the better option. By refinancing last year, you lowered that hurdle to 4 percent -- lower, in fact, when you factor in the fact that that interest is tax deductible. So, you need to estimate the potential for any investment to exceed that tax-adjusted mortgage rate.

This may be a tough call from an investment standpoint, but two other factors could influence your decision:

  1. Years to retirement. Your 401(k) plan will provide you a source of liquidity in retirement, while equity in your home will be a less liquid asset. If you foresee being able to pay off your mortgage several years before retirement, you will still have time to build up your 401(k) balance. However, if you are closer to retirement, building your 401(k) may be more useful.
  2. Employer match. If larger 401(k) contributions would increase your ability to take advantage of employer matching contributions, this should be added to the expected return from the 401(k). Unlike the estimated return on your investments, the extra boost from an employer match has the added benefit of being a sure thing.

Finally, keep in mind this is not an all-or-nothing decision. Your circumstances might push you one way or the other for the reasons described above; but if you find yourself caught in between, there is no reason not to direct some of your extra earnings toward the mortgage and some toward your 401(k).



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