Should you pay off your mortgage before retirement?

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Is it a good idea to retire with a mortgage? Most individuals will jump through hoops to live mortgage-free, whether or not it makes the most financial sense. Of course, all things being equal, it’s always best to cut back on spending. But in most cases all is not Equal: Paying off a mortgage early or giving up a mortgage altogether usually comes at the expense of something else. Retiring with a mortgage generally poses no financial risk and is sometimes the best financial decision. But paying off a mortgage before retirement also has advantages. Here’s when it may — or may not — make sense to pay off a mortgage before you retire.

Paying off your mortgage early can reduce costs in retirement, but it also reduces cash flow

Use extra income or savings to pay off a mortgage faster moves your most liquid asset (cash) into a very illiquid asset (your house). In the most extreme examples, this is called being “housing poor”. Since being house poor is never a goal, you’ll want to consider all of your resources before opting for mortgage payment acceleration.

On the other hand, not having a mortgage in retirement can be beneficial if it reduces overall lifestyle costs and the amount you’ll need to withdraw from your portfolio in retirement. Depending on the situation, this may mean being able to retire earlier or a greater likelihood of don’t run out of money. Especially in bear markets, it’s important to have relatively low fixed costs because you may be able to avoid hard selling to pay the bills.

However, if the goal is to pay off a mortgage before retirement to spend potential mortgage payments on other things during retirement, the math may not work. On the one hand, any savings from retirement home debt are one-time savings (interest costs). Adding new positions to a retirement budget in perpetuity, increasing each year with inflation, will not result in net savings.

Other than that, the money isn’t there if you want to use it for something else in retirement, like a down payment on a snowbird condo or helping your grandkids go to college.

Don’t be afraid of leverage

Leverage occurs when your expected rate of return on an investment exceeds financing costs. If you can borrow money for less than an amount you can reasonably expect to earn by investing the funds instead, it makes sense to keep the loan.

For example: a homeowner has a mortgage with an interest rate of 3%. Their long-term average expected return is 5%. They use leverage to get a better financial result.

After a period of record mortgage rates, most savvy homeowners refinanced. With an ultra-low cost of borrowing, retiring with a mortgage can be the best choice financially. Especially when, in the current rising rate environment, investors can earn more than 4% per year by buying a risk-free 2-year Treasury note (as of 9/23/22). So, at least for a while, investors don’t even need to invest in volatile stocks to get a return above the cost of debt. The hurdle is much higher for those getting mortgages now.

After-tax borrowing cost and hurdle rate

With state and local taxes (SALT) now capped at $10,000 and standard deductions rising to $25,900 for married taxpayers (plus $1,400 if over 65), fewer taxpayers are getting itemized deductions . Without detailing, most charitable donations do not have any tax advantage, for example. Having a mortgage interest tax deduction can tip the balance in favor of the breakdown.

Consideration should also be given to the after-tax cost of debt and the net return of an investment at opportunity cost.

Following the previous example:

  • The net cost of a mortgage at the rate of 3% is 2.28% for taxpayers at 24% who detail their deductions. The cost remains 3% for those who do not detail.
  • The after-tax return on a 5% investment is 3.8% assuming short-term capital gains in a 24% tax bracket, increasing to 4.25% using a gains tax rate in long-term capital of 15%.

As illustrated above, the hurdle rate is quite low for homeowners in this situation, which means paying off a mortgage before retirement could mean leaving money on the table. The break-even return on investment compared to someone with a 3% cost of borrowing is 3.53% (assuming long-term capital gains) or 3.95% for capital gains. short-term capital (such as treasury bills).

Next, imagine that a borrower has a much higher mortgage rate, maybe 5%. Now the calculation changes significantly. The break even the hurdle rate is 5.89% and 6.58% respectively. In this case, it’s probably not worth the investment risk. While that helps make the case for mortgage repayment priority, it’s still not a slam dunk.

Other factors to consider before paying off your mortgage before retirement:

  • Will you live in the house long enough to live mortgage-free years?
  • If you can’t pay stopped your mortgage, there may be little reason to pay it down Unless you have a variable rate loan, making additional mortgage payments will not affect your monthly payment.
  • As the previous chart illustrates, rates have recently risen sharply. But there is little reason to think that mortgage rates will stay at current levels over the long term. So for borrowers with higher rates, future refinancing opportunities can cast doubt on whether free cash flow should be used to pay off a mortgage today.
  • Homeowners on the final stages of a mortgage may see a low and dwindling principal balance and be tempted to wipe it out before retiring. Before making this final transfer, remember how loan amortization works. When a new loan is issued, the interest component of the fixed payment is much greater than the amount allocated to the principal of the loan. But at the end of the loan term, this relationship is reversed and the debt service charge is only a fraction of the payment.

Emotional reasons usually drive the decision to prepay a mortgage. Peace of mind can help you sleep at night (which is important!), but it won’t fund a decades-long retirement. So before you use extra cash or an unexpected windfall to pay off your mortgage sooner than expected, consider the value of future flexibility. After all, goals often change over time.

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