When does it make sense to payoff your mortgage before retirement?

It is relatively easy to make paying off your mortgage a goal, largely because you think it will “feel good” or because you imagine that it will be “liberating” to throw a mortgage burning party. But be careful that you are not mixing a critical financial decision with an emotional reaction. It may seem illogical, but there are many reasons why it is sometimes a better financial decision not to pay off your mortgage. That said, there are also some very good reasons for paying off your mortgage prior to retirement. The balance is often tipped by the amount the client spends on their lifestyle budget, the amount they have saved in available non-home assets, their tax liability, the source of the money used to pay off the mortgage and what they have decided to do for unexpected expenses.

For most of our clients, a mortgage on their principal residence is a low-rate loan that can be used (since 1997) to reduced tax liability (usual tax refunds drop the effective mortgage interest rate by as much as 1-3% for our clients). A mortgage repayment is stretched out (amortized) over a long period of time (15 or 30 years are common) with most of the interest paid during the first 2/3rds of the amortized period. When combined with inflation and a healthy appreciation in real estate valuations, a mortgage provides the buyer an opportunity to expense a very low cost loan while building equity in the home with money that would otherwise (at least in part) go toward rent. A mortgage loan can also be used to maximize and grow savings pre-retirement, obviously freeing clients to use these savings later while in retirement. The argument can also be made that a diversified portfolio started with assets that might have been used to pay off a mortgage (though not guaranteed) can yield a rolling average of 6-9% (with a margin of safety) and provide assets that grow above the mortgage rate and that are available for use outside of the home asset.

Many of our clients will have reduced or no earned corporate income during their retirement years, and plan to rely primarily on portfolio, pension, and social security to support them for 30-40 years. During this time they might have lower taxable income, but that is only true if their lifestyle expenses are low enough (something that is difficult to do in the Bay Area). If not, they might increase their taxable income to support their lifestyle and would benefit from available tax deductions (including mortgage interest). Most of our clients would like to remain in their homes throughout retirement, but this adds a further complication if they do not have enough non-home assets to support their annual budget. We find that home owners are surprised that they can’t tap most of their home equity (at reasonable costs) until they sell their home.

Paying off a mortgage is sometimes worth considering when the client has sufficient assets to support retirement outside of (i.e., above and beyond) their home. As an example, consider someone with a lifestyle expense in retirement of $100K annually (after social security). We can roughly estimate that they will need about $3M in portfolio assets to support their lifestyle and to ensure that they will not be forced to sell their home to support themselves. This $3M is only an estimate since it may not be sufficient if there is no supporting plan to cover unexpected expenses. But assuming there is sufficient savings and buffer, paying off the mortgage becomes a viable option which would reduce lifestyle budget (since there should be no mortgage payments) and tax liability.

Since several clients would like to hear scenarios that highlight the advantages of paying off their mortgage prior to retirement I’ve outlined two below:

1)  When a client plans to live in a mortgaged home until they need care, have low lifestyle expenses AND enough money outside of their home asset to support their lifestyle budget, including maintenance of their home. In this situation (particularly when their tax rate will not benefit greatly from remaining Schedule A deductions) the reduced expense derived from not paying a mortgage provides measurable benefit and real financial freedom. In addition, leaving a home with little or no mortgage is popular with those who wish to provide a legacy. However, clients have to be prepared for a potential increase in taxes in retirement particularly if they need to draw more from their portfolios. There is also the possibility that they may need to sell their home to unlock equity to cover unexpected expenses.

2)  Another scenario that encourages paying off the mortgage pre-retirement applies to clients with a low taxable income, sufficient non-home assets to support their lifestyle expenses and a sudden influx of cash to cover their mortgage (this cash must be more than the amount they can contribute in a tax advantageous manner and not needed to support their lifestyle).

It has been clearly demonstrated that anyone with a fully diversified portfolio benefits most from maximizing tax-advantaged savings prior to retirement. Usage of funds that could be contributed to these types of accounts to pay off a mortgage often results in too much home and not enough cash (house rich, cash poor, as the saying goes). This is particularly the case in areas where home appreciation is high and home equity grows, but can’t be accessed cost effectively. A misconception is that a large mortgage is the best way to reduce taxes because you can minimize them through Schedule A deductions. This is patently not true. The best way to minimize your taxes is through tax-deferred savings, not deductions. Do note that in retirement, neither tax deferral nor the option to obtain a mortgage at a reasonable rate may be available.

Each person needs to consider the best way to manage their mortgage payments in retirement. In this article, I have sought to help you recognize some of the key components that factor into whether it makes sense to pay off your mortgage prior to retirement. It is important that you realize that there is no single answer for everyone and that we must balance your budget, taxable income, amortization period and plan to cover contingencies during retirement before making this decision.