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Your Mortgage Debt May Be Fine How It Is, But How's Your 401(k)?

NEW YORK ( TheStreet) -- What a relief! After months and months of cautious budgeting and self-denial, you've finally wrestled your credit card debt down to zero. Congratulations!

But now what? Where should you put the extra cash you'd been using to pay down that debt?

With "deleveraging" in fashion, your first thought might be to start paying down your mortgage. After all, it too is charging interest, and any prepayment calculator will show that extra principal payments can cut tens of thousands of dollars off your mortgage interest charges over the life of the loan.

But not so fast. Paying Mortgage Faster Not Best Option, says the headline in the Squared Away Blog of the Boston College Financial Security Project. With mortgage rates at record lows, mortgage prepays don't save the borrower very much, the blog argues, making upping your 401(k) contribution probably a better option.

That may well be good advice for many people. But others might still find a mortgage prepay attractive. Let's break it down.

A prepay means paying extra principal, reducing the debt and avoiding future interest charges on that amount. If your mortgage charges 5% and you prepay $100, you'll save $5 in interest per year, which is just like earning 5% on your $100.

That sounds great if interest charges are 5%, or 7% or 8%, as they were not so long ago. And, as we said in a recent column, a prepay can make a lot of sense if you have an older mortgage with a rate in that range and cannot get approval for a refinancing at today's rates, averaging around 3.5% for a 30-year fixed-rate loan.

But if you do have one of today's low-rate loans, the return on the prepay is pretty small. (Taking a step back, it would not make sense to pay down a 3.5% mortgage if you had credit card debt charging 15%, as you'd "earn" 15% getting rid of the card debt.)

But once high-rate card debt is gone, the Squared Away Blog suggests using spare cash to max out your 401(k). If the 401(k) has a suitable mix of stocks and bonds, it's likely to earn more over the long run than the 3.5% you'd earn paying down the mortgage. The 401(k) contribution and earnings provide generous tax benefits, while a mortgage prepay actually reduces the tax deduction from mortgage interest. And favoring the 401(k) is a no-brainer if your contribution will get a matching contribution from your employer.

But suppose you'd paid down your credit cards and were putting the maximum allowed into your 401(k). Should extra cash now go to the mortgage, or to an ordinary taxable investment such as a mutual fund?

The key issue here is how that taxable account would be used. If you'd choose stocks or stock funds and have time to wait out downturns, you could well earn more than on a 3.5% mortgage prepay. And your money would be easier to get at.

But if you were considering a taxable investment in bonds, a prepay could be better. Many bonds and bond funds are yielding less than 3.5%, and those investments could fall in value if rising interest rates reduce demand for older bonds with today's stingy yields.

With a mortgage prepay, there's no such risk: the return, equal to the mortgage rate, is guaranteed. For many investors, a mortgage prepay, even at today's low rates, can be a safer and more profitable option than bonds, especially if the bonds or bond funds would be held in a taxable account.

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