Paying off the Mortgage Vs. Investing Pretax Dollars

Paying off your mortgage means not having to worry about foreclosure.

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Owning your home is the American dream, and most Americans can think of a lot better things to spend their paychecks on than their monthly mortgage payment. So, it's no wonder many people want to get ahead on their payments. However, contributing money to a pretax retirement plan, like a 401(k) or 403(b), may actually be a better option in certain situations.

Mortgage Payment Advantages

Paying down your mortgage means you own your home outright sooner, and you pay less interest to your lender. By paying off your mortgage, you know how much you'll be saving rather than taking a gamble with your investments. Plus, if your interest rate is higher than your return on the investments, you're saving more than you'd earn. Plus, there's the emotional relief of knowing you own your home free and clear. For some people, there's no investment return that can match that peace of mind.

Mortgage Payment Drawbacks

Paying down your mortgage has its drawbacks. First, as you pay off your mortgage, you have a smaller mortgage interest deduction. Second, putting your income towards a pretax plan makes more sense when you can get a higher rate of return on the investment than you're paying in mortgage interest. For example, if you think you can make 6 percent investing in the stock market, and you're only pay 4.5 percent on your mortgage, it makes more sense to invest. Third, depending on the terms of your mortgage, you might owe a prepayment penalty. Any prepayment penalty would be listed in your mortgage terms, but you might be more comfortable (and save some time) if you just call your lender and ask.

Pretax Investing Advantages

Savings in a pretax retirement account instead of paying down the mortgage means you don't have to pay taxes on the money until you take the money out -- even the earnings on the investments grow tax-free. Plus, the IRS limits how much you can put in a pretax plan each year. For example, in 2013, you can only put in $17,500 per year in your 401(k) and 403(b) plans. If you're 50 or older, the limit is up to $23,000. However, if you don't use up the limit for any given year, you lose it -- you're not allowed to contribute extra in a later year to make up for it.

Pretax Investing Drawbacks

Even with a higher rate of return on the investments in the pretax account, putting your money in a retirement plan means stashing it away. Once the money's in the plan, you can't take it out before age 59 1/2 without paying a 10 percent early withdrawal penalty. For example, if you put the money in this year, but then next year you need to use it, you'll pay early withdrawal penalties -- if you can even get the money. If you put it in a 401(k) or 403(b) and haven't left the company, you can't get the money out unless your plan allows for hardship distributions.