In these days of high unemployment and declining home values, people are searching for ways to regain control over their financial lives. For many, that includes paying off debts as quickly as possible. After all, if you no longer have a mortgage, the banker can't foreclose on your house. If your credit card balances are zero, the collection agency will stop calling. If you've retired your auto loan, the repo guy won't be knocking on your front door.
But sometimes paying off debts - especially a mortgage - shouldn't be your first priority. For example, it's wise to establish an emergency fund to keep from going further into debt when you encounter the inevitable bumps on life's journey. Also, if your employer matches contributions to your retirement account, it makes sense to contribute up to the matching amount before paying off debts. That's because an employer match represents a very high return on your investment. And the longer your money is invested, the longer it has to grow. With a relatively conservative return of 6%, your money will double in about 12 years and double again in 24 years.
By withdrawing retirement funds to pay off a low-interest mortgage, you lose the opportunity to earn a return on those withdrawals. Let's say you pull $100,000 from your retirement account to pay off a 5% fixed-rate mortgage. If you plan to retire in 24 years and the return on your investments averages 6%, that $100,000, if left in the account, could have grown to $400,000 by your retirement date. Withdraw the money now and that earning power is lost forever. You're giving up a return of 6% to pay off a debt that costs less than 5% (when tax-deductible interest is factored into the equation). In addition, withdrawals from tax-advantaged retirement accounts can generate enormous tax consequences. If you're under age 59½, expect to pay a 10% penalty (in addition to general income taxes) on that $100,000. That means you'll need to withdraw substantially more than $100,000 to pay off your mortgage today.
Generally speaking, it's prudent to establish an emergency fund, contribute to retirement accounts (at least up to the matching percentage offered by your employer), and pay off high-interest credit cards and loans — before you consider raiding a 401(k) account to pay off the mortgage.
