Should I Pay Off My Mortgage Before I Retire?

Michelle Barron |
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A common question among people preparing for retirement is whether it is beneficial or not to pay off a mortgage early. Given the current low-interest environment, most financial calculators will tell you that in the long run, you are better off to keep your mortgage and instead invest the funds to target a growth rate that is larger than your current mortgage interest rate. If only it were that simple. As with most financial questions, there are many considerations, including one that touches on an essential part of finance, emotions.    

According to the US Bureau of Labor Statistics, housing expenses are among the largest monthly budget items. It is easy to ascertain that it would be nice to eliminate one of the most significant expenses from your budget. Reducing expenses could reduce your overall retirement cash needs and put the retirement goal a bit closer, or you could consider the possibility of a more lucrative retirement lifestyle. The big question is does it make sense for you.  

 Where Should I Get The Funds To Pay Off My Mortgage? 

Unless you are nearing the end of your mortgage term, mortgage balances are typically chunky. Generating enough cash to pay off your mortgage can be challenging and may incur tax consequences. It is important to think through the implications of generating large amounts of money for the payoff. 

Taking cash from retirement accounts or investment accounts has the potential to generate a tax liability. Any time you take money from traditional retirement accounts, the distribution amount will be treated as ordinary income for you. Even more painful, if you are under the age of 59 ½, there is an extra 10% early withdrawal penalty that gets tacked on. Roth accounts are potentially better from a tax perspective in that distributions can come out tax-free if you are over the magic age of 59 ½ and have met the 5-year rule requirements.  

Taxes from distributions can have further-reaching impacts than you might initially imagine. For one, they can bump you into a higher tax bracket. They can even increase your medical insurance costs if you are on Medicare or are receiving healthcare subsidies. 

It's not just traditional retirement accounts that could create a tax liability. Investment accounts also pose the potential for taxes. If you sell appreciated securities to generate your cash need, those gains are taxed depending on how long you held them and your Adjusted Gross Income. If large enough, they could also impact your Medicare premiums.  

Pre-paying a mortgage should ideally be considered when you are holding a substantial amount of funds in cash or low-risk assets outside of a retirement account, or you have an excess of cash flow. Never forget that maintaining an emergency reserve is critical for your financial stability, and reducing your cash below certain limits is not recommended. 

How Can Paying Off My Mortgage Benefit My Retirement Investment Portfolio? 

With the possible reduction of future cash needs, you may consider an investment portfolio that is less focused on capital preservation and strategies to provide a steady income and consider alternatives that are more skewed to growth for future retirement needs. Paying off a mortgage also creates a relatively risk-free asset, with the potential for your home to appreciate. Besides, given the current interest rate environment, your cash assets produce little or no yield and are vulnerable to inflation. For example, if you have a savings account paying you 0.1%, and inflation over the last 12 months is estimated at 1.7%, you have a negative real yield on that money.  

Depending on the type of mortgage you have (fixed or floating rate), you may be in a situation where increasing inflation is lowering the value of your cash or investment yields while your interest is going up. Your house, on the other hand, may increase in value, particularly in today's housing market. 

What's the Argument for Investing the Money Instead?  

Mortgage rates are generally much lower than the long-term returns of the stock market. Since its inception in 1926, the average return on the S&P 500 has been around 11-12% annually. The average rate on a 30-year fixed-rate mortgage is about 3.33% as of 3/31/2021. You are essentially borrowing the bank's money and investing it for a much higher potential return. From a purely financial perspective, keeping money invested, especially in retirement accounts with tax-free growth, is often the optimal choice.  

The operative word there, however, is potential. Last year certainly brought home the concept of risk to many investors. This time the markets quickly reversed the considerable drop we saw during the COVID pandemic but only with the help of a very active Federal Reserve and quickly-passed stimulus. In normal circumstances, without significant economic rescue provisions, it would take 3.7 years at 10% return per year to recover from a 30% market drop. Even a small market downturn can put you underwater on the investment – if you're paying 4% on your mortgage and the market is down 6%, you've lost money. 

A Final Word 

While the financial considerations unquestionably come into play when deciding to pay off your mortgage, your emotional well-being and overall goals should have an impact on your decision too. Paying off your home can provide a sense of security and peace, even if keeping your mortgage has the potential to offer larger portfolio values in the future. Paying off your house may help you sleep at night, especially when volatility persists in the investment markets. Your emotional well-being is priceless.

Your legacy goals can also come into play. A recent study by Fannie Mae found that 64% of 60- to 70-year-old homeowners plan to remain in their current homes. And 62% of these individuals plan to leave the house to their children/estate. If this is your plan, leaving a mortgage-free home within your estate that can be enjoyed by heirs or easily monetized can make sense.   

At some point, we all ponder the decisions that we make, some good and some not so good. I will say in all the years that I've been doing this; no one has ever expressed regret in not having a mortgage payment during their retirement years.   

There are many things to think about, and we are always happy to get into the details with you and create a plan that can help you achieve your goals.  

This material is provided as a courtesy and for educational purposes only. Please consult your investment professional, legal or tax advisor for specific information pertaining to your situation. The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. Indexes are unmanaged and do not incur management fees, costs, or expenses. It is not possible to invest directly in an index. The future performance of an investment or strategy cannot be deduced from past performance.