Don't rush to pay off that mortgage

By Liz Pulliam Weston

Cratered interest rates, a still-scary stock market and the eroding 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 around 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 in free fall.

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

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.

• Talk back: Do you want to pay off your mortgage?

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 households 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.

Continued: Establish priorities

Establish priorities

You need to look first at all your other debt. Chances are, if you have any, it's accruing at a higher interest rate than what you're paying on your home loan. That's especially true for credit card debt: It makes no sense to save less than 6% by prepaying a mortgage when you're paying more, probably much more, in nondeductible interest on your plastic.

What if you're free of other debt? You can start to tackle that mortgage, right?

Not quite. There are other threats to your financial security you need to address, especially:

Financial inflexibility. Fewer than three in 10 households have enough savings to withstand even three months of unemployment. Half say they live paycheck to paycheck at least some of the time, according to a survey commissioned by the Consumer Federation of America. Having an emergency fund equal to at least three months' expenses (plus access to a home equity line of credit) can make the difference between a rough patch and financial disaster; that should be your priority after saving for retirement and retiring high-rate debt.

Then there's the issue of:

Inadequate insurance. If you have people financially dependent on you – minor children or a spouse who needs your paycheck to pay the mortgage -- you need life insurance and usually plenty of it. (You can use MSN Money's Life Insurance Calculator to see exactly how much.) In addition, you need adequate health insurance, since medical bills are a factor in half of all bankruptcies.

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Also crucial: long-term disability insurance, which most Americans don't have.

Fewer than 30% of all workers have long-term coverage, according to the U.S. Bureau of Labor Statistics. Yet your chances of disabling accident or injury are pretty high: At age 30, for example, you have more than a 50% chance of being disabled for three months or longer before you turn 65, according to the Council for Disability Awareness. One in seven U.S. workers is disabled for five years or more.

Wouldn't it be ironic if you skipped disability coverage to prepay your mortgage, then wound up losing your house? The bottom line: If you have access to long-term disability coverage at work, buy it.

OK, so what if you're maxing out your 401k and Roth IRAs, sitting on a pile of emergency cash and insured up the yin-yang? I still wouldn't necessarily attack that mortgage. If you have kids, for instance, you might want to be tucking more away into a 529 college savings plan to make sure they aren't saddled with student loans, as too many young graduates are today.

Again, assuming the money is invested prudently in a mix of stocks, bonds and cash, you should make a much better return than what you can get prepaying your mortgage, and the money is tax-free when used for college.

Of course, you could pay down your mortgage, assuming you'll be able to tap that equity later to pay college bills. But that's a gamble, because lenders are making it tougher to tap home equity as property values fall.

Who really shouldn't prepay

Some folks, of course, aren't dissuaded by counterarguments. They want those safe, guaranteed returns of paying down a mortgage.

There is one large group of homeowners whose returns may not be safe or guaranteed, however: those who are already underwater.

If you owe more on your house than it's worth, you're at high risk of foreclosure if you lose your job or suffer some other financial setback that makes it hard to cover your payments. You can try paying down your mortgage faster to build up equity, but continually falling home prices will make it hard for you to gain any ground. What may happen instead is that you lose your house anyway, along with all that extra money you paid. (Prepaying a mortgage could reduce the amount you still owe in some states; consult a bankruptcy attorney for details if you're nearing the brink.)

A smarter choice typically is to build up your emergency fund instead. That extra cash could help you make payments in the future if your financial life goes south or help you get a fresh start if you wind up losing the house.

What if you're approaching retirement? Now the math changes a bit:

• The tax benefits of a mortgage are typically minimized by the time you hit retirement age. Plus, trying to make mortgage payments in retirement often means having to take more out of tax-deferred accounts than you otherwise might, which can make your tax situation worse.

• Furthermore, paying off your loan tends to substantially reduce your living expenses, which is a great benefit on a fixed income.

I'd still contribute the maximum you can to retirement accounts and make sure you have a fat emergency fund. But if you want to make extra mortgage payments to be debt-free by retirement, that's not a bad choice. This may be the one situation where the price for peace of mind is actually pretty reasonable.Liz Pulliam Weston is the Web's most-read personal-finance writer. She is the author of several books, most recently "Your Credit Score: Your Money & What's at Stake." Weston's award-winning columns appear every Monday and Thursday, exclusively on MSN Money. She also answers reader questions on the Your Money message board and helps middle-class families cope at Building a Brighter Future.

Updated Nov. 18, 2009