Pay Off a Mortgage at Retirement?
Henry K. Hebeler
7-4-08
One of the big decisions at retirement is whether you should retire your mortgage when you retire. There are many issues needing consideration, and the conclusions for one issue may be quite different than for another issue.
Let’s first consider some of the financial aspects. The first consideration is whether your home equity will be a better investment than the part of your savings you will use to pay off the mortgage. To come to a conclusion here, you need to consider how much time you have left on the mortgage, the interest rate, your return on your savings and the tax rates.
If you still have 20 years left on the mortgage, you will need to consider results for a very long period. During that interval, your mortgage interest rate will stay the same, but the return on your savings will likely vary all over the place. Tax rates will also vary as will the rules for deductions of mortgage interest on your tax returns. If you have just a few years left on your mortgage, there is less time for tax rates and rules to change, but savings returns can go either way very quickly.
The most fundamental rule is that paying off a mortgage is only financially viable if the after-tax return on your savings will be less than the after-tax interest rate on your mortgage. If a large part of your savings is based on the stock market, then there is likely to be more uncertainty about your long-term savings return than if the investments are in, say, laddered bonds or CDs. Also, remember that over very long periods, retirees tend to get more conservative and (I think prudently) reduce the amount of stock in their portfolios.
The after-tax interest rate on your mortgage depends on whether you are in a tax bracket where you can deduct mortgage interest. In either case, the after-tax interest rate is (Mortgage Interest Rate) x (1 – Tax Rate for mortgage deductions), but the tax rate is zero if you can’t deduct mortgage interest on your return. If you can deduct the interest, the tax rate would be your ordinary income tax rate.
It also makes a difference whether you will use money from a deferred-tax account (think 401(k) or IRA) or from a currently taxable or tax-exempt account. If you are considering using savings from a deferred-tax account to pay off a mortgage, then you should first determine whether such a draw will increase your income tax bracket. If so, it’s likely that you would want to pay off the mortgage over several years with small enough payments to reduce your tax liabilities.
No matter which kind of taxable account you will use to pay off the mortgage, the after-tax return has the same formula: (Return on Investment) x (1 – Tax Rate on investments). If the money will come from a deferred-tax account, the tax rate will be your ordinary income tax rate for the remainder of the number of years you have left on the mortgage payments. Of course, if the draw from savings increases this tax rate, you must account for that. If the money will come from a taxable account, then you will have to estimate the average future tax rate you will have on your investments considering tax rates on interest, dividends and capital gains.
So, from a pure financial comparison basis, you would pay off the mortgage if (Mortgage Interest Rate) x (1 – Tax Rate for mortgage deductions) is greater than (Return on Investments) x (1 – Tax Rate on investments).
But there are some other very important financial considerations as well. The first of these is liquidity. Remember that, unlike your savings, you cannot sell just a small part of your home to get cash for retirement. You must take out a loan of some kind. This may well be a more expensive loan than your current mortgage considering both interest rates and points. Therefore, it’s important to have enough in investment accounts to satisfy your retirement spending needs for most of your retirement years.
Another financial consideration is the allocation of your overall wealth. If you pay off the mortgage, you increase the equity (market value less debt) in real estate and reduce the equity amount in your savings in stocks and bonds. If you consider that your home is an investment, either for a short term or until you are forced into a nursing home, then you have to consider whether its value will increase more than your investments.
So, if you look at a home as a financial investment, you have to consider whether your community is vibrant and growing or whether it is in a depressed area that’s unlikely to improve. You also have to consider what may happen to home real estate values in general. For example, I think that the huge increase in the number of retired people that is coming will increase the demands for small homes and reduce the relative value of large homes.
Finally, there is the reason that most people think is the most important reason to pay off a mortgage at retirement. That’s being debt free. It’s good to know that you won’t lose your home if something happens that you would be forced to miss some mortgage payments.
But let’s think about this some more. Suppose you are thinking about selling your home anyway in the next few years. That might be a reason not to pay off your mortgage now so that you have more cash available to secure the replacement home. Or suppose the death of you or your spouse is imminent. Then both the cost basis of your home and investments may increase to market values on the date of the death thereby reducing tax libabilities. Or suppose that you are anticipating many years of high inflation. Inflation effectively reduces the size of your mortgage payments relative to everything else while your Social Security payments and returns (hopefully) will increase with inflation.
There is so much emotion attached to home ownership, that if there is a need to take a large fraction of savings to pay off the mortgages, most people would be well advised to get an independent view from a professional financial advisor. Getting this kind of assistance for $500 to $1,000 might well be the best investment they could make.