I was listening to a financial radio show where listeners call in their questions. A man called in with a frequently asked question; “my wife and I have a 30 year mortgage at 3.5%, we have a little bit of extra money now and were wondering if we should pay down the mortgage faster or put the money into our retirement accounts?” The financial expert gave the standard advice and said “fund the retirement accounts.” He then gave a detailed explanation why funding a retirement account was much better. Unlike most callers this one had some guts and told the expert he was not convinced and then hung up. The caller’s negative reaction got me thinking; is the standard advice wrong?
The standard advice is based on a simple rule that compares the cost to borrow versus the return on investment. In graduate school I had a Dutch professor who constantly stated this idea. If you can borrow at a lower rate than you can earn, borrow as much as you can, was his philosophy. For example, if a person can borrow $100,000 at 4%, and the stock market is returning 10%, then by investing all of the $100,000 in the stock market you will earn 6% (10% minus 4%).
The rule seems simple and fool-proof. The financial expert on the radio show was saying the same thing my Dutch finance professor stressed. The expert was telling the caller that the average return on investing in either stocks or bonds over the long-term was greater than the 3.5% he was paying on his mortgage. By investing in stocks or bonds the caller would make more money.
The problem with this advice and the caller’s disbelief is that this rule misses life’s risks. During the Great Recession tens of thousands of people lost first their jobs and then their homes. The standard advice is great, but it is based on one key assumption; a person always has enough income to pay off their mortgage. Funding a retirement account (especially one that doesn’t allow hardship loans) means the money is locked up and cannot help a person when their home is in jeopardy.
My advice would have been different. I would create a separate bank account for the extra money. Putting it in a plain savings account means if and when a crisis arises the family has some cash available. If no crisis occurs during the year and none is foreseeable in the near future, I would make a 13th mortgage payment at the end of the year. Making one extra mortgage payment a year on a 30 year loan shaves off about ¼ of the time until the home is free and clear. Then after making a 13th payment I would put the rest into a retirement account and start the extra savings plan all over again.
Funding your retirement is important. However, reducing financial stresses in your life before retirement means you end up at retirement happier, healthier and less crazy about money.