If you’re lucky, you earn enough to have a bit of leftover cash each month. If you’re smart, you’re looking for ways to make use of those extra bucks instead of frittering them away on frivolous purchases. Investors in this situation often reach a point where they need to determine if it’s better to pay down debt by paying off a mortgage early or to build their nest egg by directing extra money into their 401(k).
401(k) Matching Funds
If your employer provides a 401(k) or a similar 403(c) plan, it may also offer matching contributions as part of that benefit. While the details of employer-matching plans vary between retirement plans, many employers contribute $0.50 out of their pocket for every dollar of your own money you put in your 401(k), up to a limit of your overall pay, such as 6 percent. If your 401(k) offers employer-matched contributions, always take advantage of that offer. It’s like free money that goes straight to your nest egg, and it’s foolish not to take advantage of it.
A Question of Rates
If you’re maxing out your employer-matched contribution to your 401(k), your next consideration should be toward putting your money to work where it’ll make the most impact and offer the higher interest rate. Compare your mortgage’s interest rate to the return your 401(k) earned in recent years, but don’t overlook any maintenance fees or commissions that can eat into 401(k) returns. Place your excess cash into the vehicle with the highest interest rates, whether it’s working to defray future interest payments or to accrue value in your retirement account.
A Question of Risk
On the other hand, paying down debt is similar to an investment without risk. Paying off a mortgage with a 5 percent rate is in many ways like making an investment at 5 percent for the duration of the mortgage, with one key exception: There’s no risk involved. Your house is a solid asset that isn’t subject to the creditworthiness of bond investments, the performance of companies in stock investments or the poor decisions of your fund manager. While you may get a larger return this year on your 401(k), it’s by no means guaranteed to perform like that in the long term.
Before you start sending leftover money to your lender, determine if your mortgage has a prepayment penalty. Some lenders place these penalties in loan documents to prevent you from refinancing quickly or paying off the home in advance, moves that reduce the lender’s return on the mortgage. You may also consider using your excess cash to fund a refinance, which will enable you to get better terms on your home, and potentially pave the way to smaller mortgage payments, allowing you more to invest in your 401(k).
Wilhelm Schnotz has worked as a freelance writer since 1998, covering arts and entertainment, culture and financial stories for a variety of consumer publications. His work has appeared in dozens of print titles, including "TV Guide" and "The Dallas Observer." Schnotz holds a Bachelor of Arts in journalism from Colorado State University.