Ask Bud - Paying Off a Mortgage Early

  • Question
  • Should I pay off my remaining mortgage before retiring?

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Answer from Bud

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    You certainly would want to pay off a mortgage early if (1) the after-tax interest is higher than the after-tax return you confidently can get from your investments, and (2) if you still have significant investments remaining after paying the debt.

    Let’s look at the first requirement using after-tax rates: After-tax interest and after-tax returns are before tax values multiplied by the quantity (1 – Tax Rate). Suppose your mortgage interest was 7%, your income tax rate was 30%, your confident return on investments was 5% and the tax rate on dividends and capital gains on your investments was 20%. If the mortgage interest is deductible in your case, the after-tax interest rate would be 7% x (1 – 30%) = 4.9%. The after-tax return on your investments is 5% x (1 – 20%) = 4%. In this case you would want to pay off the mortgage because 4.9% is greater than 4%.

    If you would have to use deferred-tax investments (IRA, 401(k), etc.) to pay off the mortgage, it is unlikely that you would want to do so even though the returns in a deferred-tax investment are not taxed until withdrawal. But when withdrawn, they are taxed at your ordinary income-tax rate, not the lower rate applicable to dividends and interest. Further, it is likely that your principal will also be taxed at ordinary interest rates, and if you are under 59 ½, you may pay a 10% penalty as well.

    Now let’s look at the second requirement for remaining investments: It’s obvious that if you didn’t have enough investments to pay the remaining debt, you couldn’t afford to pay off the mortgage. However, if your investments are just slightly above the amount to pay off the mortgage, it is unlikely that you would still want to do this, because you need some cash reserves to pay for emergencies and large ticket items like a new automobile or roof replacement. If you have to debt finance these purchases, you likely will have higher interest rates for these purchases than you had on your mortgage.

    Moreover, if the total of your pension and social security income is insufficient, and you know you are going to need income from your investments, the little left over after accounting for paying off the mortgage and reserves would likely be insufficient to make adequate retirement payments.

    Another consideration is that you may decide to sell or rent the home at some time in the future because you’d like higher income. If you are cash strapped after paying off the mortgage, you may feel compelled to take an offer significantly lower than you thought the house should really sell for. If you decide to rent the home, the mortgage provides leverage that will give you a greater return on your investment.

    Of course if the housing market plummets, you could find yourself in the position where your mortgage exceeds the value of the house. For that reason, it’s good not to carry a large mortgage into retirement if you think you will be selling within the next few years. In fact, my view is that if you want to downsize in the future to gain retirement income, the best time to downsize is likely to be now, not later. Put the cash from the downsizing to work right away in some investment.

    If you think you are going to need a reverse mortgage for your retirement, it is also unlikely that you would want to pay off your mortgage early. Paying off the mortgage means you will lose the tax deduction while forcing you to obtain the reverse mortgage earlier because you will be cash strapped earlier. Anyone contemplating a reverse mortgage ought to look at the NewRetirement reverse mortgage pros and cons or AARP.

    What might be a better approach: There is a clever strategy that can help retirees with a mortgage that will be paid off significantly before the age you might die. A mortgage has a finite end point. Let me start by explaining the obvious, and then I'll show you how you can take advantage of the finite end point. Let's say that your mortgage's last payment will be August of 2015. And let's say that before that date your debt payments were $1,000 a month. In September of 2015 and thereafter, your mortgage payments are zero. OK, that means that there is a step increase in September of 2015 for the amount that you can spend for everything other than the mortgage payments.

    Now, it's possible to determine a spending budget for everything except the mortgage payments that is constant in real terms over your entire retired life without having one budget level before the mortgage ends and $1,000 larger budget afterwards. The trick is to make the calculation.

    This is easy if you use almost any retirement planning program because a mortgage is simply a minus investment. Simply reduce your taxable investments by the mortgage amount, or, if you have to use a deferred-tax account, reduce that balance by the mortgage divided by (1 - Tax Rate). Then calculate how much you can spend. If you decided to enter your home equity in a program that accounts for taxes, home equity already has subtracted the mortgage and the program should work properly.

    Even simpler is an approximation I often use in my writings. Simply divide the current mortgage balance by life expectancy for an annual budget decrement. Let's say that the remaining mortgage was $75,000, your payments were $1,000 a month, and your life expectancy was 25 years. That means you would have to reduce your retirement budget for everything exclusive of the mortgage by $75,000 / 25 = $3,000 a year, not by $12,000 each year. THAT'S A HUGE DIFFERENCE! I just gave you $9,000 extra spending money before the mortgage was paid off. After the last mortgage payment, you’ll still be able to spend the same amount as before the last payment.

    The figures below show the differences in annual spending and investment balances between what might be a better approach that I recommend and the common approach of including mortgage payments in the budget rather than excluding them. In each case, we start with a $500,000 investment balance and the $75,000 mortgage which is paid off at the rate of $12,000 a year in eight years. Note what commonly happens to the amount that people can spend for everything other than their mortgage in both cases.

    So you didn't have to pay off the mortgage before you retire -- and all of a sudden you've got a lot richer considering the amount you can spend before the mortgage is paid off. And you have lots more investments to work with than if you reduced investments by $75,000 at 65. If you want some information on the theory behind this, see J. K. Lasser’s Your Winning Retirement Plan (Wiley, 2001) or Getting Started in a Financially Secure Retirement (Wiley 2007).

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H. K. Bud Hebeler is author of J.K. Lasser's Your Winning Retirement Plan, Getting Started in a Financially Secure Retirement, and retirement articles on www.analyzenow.com. He is often quoted in The Wall Street Journal and other financial publications.

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