Mortgage Payoff? Freedom vs the Math
Financial planner Diahann Lassus views as misguided the “obsession” some baby boomers have with paying off their mortgage before they retire.
But Jane Rose, who has done just that with the loan on her home in Cherry Hill, New Jersey, has discovered how liberating it is. “I’m such a happy camper,” she said.
The math versus the emotion, the rational versus the irrational, head versus heart – that’s a simple way of framing a complex issue. Many boomers looking ahead to their retirement years are grappling with whether to pay off their mortgage before they retire or shovel any spare funds into their employer’s 401(k). Both arguments have merit for very different reasons.
First, the math. The alternative to paying off the mortgage – extra funds for the 401(k) – will provide more savings, more net wealth (assets minus debt), and more financial flexibility in retirement, according to many financial planners and an economist here at the Center for Retirement Research (CRR).
“There are few problems in life that aren’t mitigated by having a lot of money,” says Anthony Webb, CRR senior economist.
Indeed, directing extra contributions to a 401(k) is particularly attractive to well-heeled boomers in high tax brackets, who benefit the most from having both tax breaks: the federal mortgage interest deduction and the 401(k) tax deferral for contributions.
Other considerations, however, can tilt the balance toward paying more on the mortgage.
The mortgage interest deduction isn’t as valuable as it was when mortgage rates were higher and generated a larger deduction. Tax rates also generally decline in retirement, when incomes are lower. Those who expect to have low or zero tax rates in retirement will get little or no tax advantage from holding on to a mortgage and keeping their savings in a 401(k).
Investing a larger 401(k) balance in the stock market, with its high expected return, is also risky – and pursing this strategy hinges on being able to bear that risk. Rose, who paid off her mortgage, warns against “assuming the 401(k) will just make money. They can lose money.”
Then there’s the emotion. “It’s rarely about the numbers only,” said Rose, who is retired and vice president emerita at RTD Financial Advisers.
She was pleasantly surprised by how comfortable she felt being mortgage-free. “I have no car payments. I use credit cards and pay them off. I have no debt. No other payments.”
Perhaps the emotional downside of paying off the mortgage is having less saved for those unexpected expenses like medical bills. Lassus urges that those who are driven to pay it off should consider that “their money is just getting stuck” in an illiquid asset – the house. If it needs a new roof, where will they find the money to fix it? Having more savings provides financial flexibility, including the ability to eliminate the mortgage later.
So here lies the dilemma: the comfort of having reserves but a mortgage vs the comfort of owning a house, free and clear, but having less savings.
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The happy medium between paying off the mortgage early and having enough funds for roof repairs is called an emergency fund. This will allow you to have funds at any giving notice and still allow you to pay off your mortgage early.
Asking a “financial advisor” if a person should put their money to work for them rather than go completely debt free (including mortgage) is like asking the wolf to keep an eye on the chickens. Seriously. As a real estate broker I know the “party line” on the huge advantages of the mortgage interest deduction but that “savings” still comes at a cost. My husband and I have been debt-free for 5 years now and with what we have saved by that, we have been able to reinvest in ways that secure our retirement. Going debt free was the best thing we ever did.
Hi Kathy,
Kudos on being debt-free for over 5 years and saving more
I’m in finance (CFP® professional)- enjoyed reading your wolves comment but we’re not all that bad
High “expected return”?
Clever name for a return that is not expected.
That’s not an economist. That’s a member of the financial-insiders’ self-interest club, using the most misleading term in financial history to try to dupe us. Or has he been duped himself?
This one is not worthy of the great CRR.
When doing the math – you should consider this and I dont read very much about it.
Even if you pay off the house – you will stay have taxes and insurance to account for. Additonally – paying down your mortgage is a combination of principal and interest. Since the principal is same wherher you pay it slowly or all at once – then what you are left with is an interest payment….which due to current interest rates is smaller than it has been in the past AND which still is tax deductible.
So deciding to use a large amount of principal for what might be a relatively small gain – something to think about.
Having “split the difference” recently myself, I see both sides of the issue. I paid off a home equity line of credit, but not the 7 years left on my first mortgage.
One item not directly mentioned is some of us older folks take the standard deduction which is now larger for me vs. itemizing deductions. This is largely due to the benefit of amortization late in the loan…more of my monthly payment is principal, not interest.
So for us ordinary folk, the “mortgage interest deduction” is a phantom and the analysis offered is for the wealthy.
Just another reminder to junk the whole interest deduction thing which clearly favors the wealthy and the real estate industrial complex. If you want to help people with the cost of housing, then allow a “housing deduction” across the board for all but limit it to reasonable rental costs, period.
We paid off our house. Now that money can go towards investments. We hadn’t been able to deduct mortgage interest for some time before we finished, so that was a non-issue. Yes, we have a lot of money tied up in a non-liquid asset; however, we have bought ourselves extra cash flow now and the security of not having to pay for the house monthly–and if things go really south, this is an asset that creditors cannot take.
To everyone who commented!
Thank you for your thoughtful input!
I am sure that many pre-retirees and retirees will get even more from this blog by considering what you’ve suggested they consider.
Kim (blog writer)
When I retired in 2011, I had an $1100/month mortgage payment plus $700/month for real estate taxes. I sold my home in 2012, paid off the mortgage and relocated to the South. The sales proceeds plus savings bought a new house in 55+ community. Having no debt is great comfort to my wife and me.
Homeowner’s premiums are $1200 and property taxes for this year are $1100. The only change to my income from 2011 is the addition of required minimum distributions. Without high property taxes and mortgage interest deductions, I now pay more income tax to Uncle Sam than in 2011 because most of my income comes from qualified plans.
No complaints. We did what was right for us.
Take the money you were going to use to pay off the mortgage and put it in the bank that holds the mortgage at, let’s say, 2% with direct payment from that account. This way you will have no mortgage payment (so to speak), a net of perhaps 3%, the mortgage tax deduction, and, oh yes, your money available if you have a disaster.
It’s like having your cake and a full stomach.
The error with the thinking of investing vs. paying off the mortgage is the failure to account for downside risk. After all, you’re most vulnerable to downturns in the market in the period from 5 years before retirement to 5 years after retirement (http://www.wsj.com/articles/SB10001424052702304866904579268332305015074).
Investment management in retirement is *not* about trying to maximize returns. It’s to ensure that you have enough money so that you don’t run out of money before you run out of heartbeats. One way to help accomplish that goal is to reduce the needed income to cover your expenses by reducing your expenses. What’s the surest-fire way to reduce your expenses? Pay off debts.
Trying to maximize your nest egg via risk tradeoffs solves for the wrong problem.
Additionally, as research from RAND shows, retirees who have annuities or pension income are happier than those who have an equivalent amount invested in the market (https://www.rand.org/content/dam/rand/pubs/drafts/2008/DRU3021.pdf). The corollary would also hold true: those who have a lower set of expenses to meet should also be happier.
Investors are subject to overtrading (http://blog.futureadvisor.com/research-shows-overtrading-undermines-returns/) and are much more likely to sell low and buy high (http://www.advisorperspectives.com/commentaries/heron_010610.php). So, by advising them to invest in the market, we’re recommending that they subject themselves to behavioral biases and fundamental risks of investor herding behavior when they choose to put money into the market rather than pay off the mortgage.
Finally, don’t fall for the “I’m saving in taxes” trap. The mortgage tax break only applies inasmuch as you already are above your standard deduction. Otherwise, the effect is reduced pro rata. Use a standard deduction even with your mortgage? You get no mortgage tax break, as your taxes would be the same with or without the mortgage.
There’s also a value to the lack of stress that many of the commenters have alluded to which is not accounted for in the equation. We’ve been completely debt free for years and I can assure you that we eat our own cooking in terms of executing on our recommendations and probably spend no more than 7 hours a year on our personal finances – 30 minutes a month budgeting and an hour a year DCA/rebalancing.
Don’t overthink the problem!
When else can someone get a guaranteed 3.5 – 5% return other than by paying off the mortgage? Over the long-term, the stock market will likely do better, but with added risk. Over the last 5-10 years of the mortgage, trusting the stock market returns to beat the returns of early mortgage payoff is more of a gamble.
I was waiting for Treasury yields to go above my mortgage rate, but it’s looking unlikely at this point.
I agree with Daniel. My mortgage is 4.550%. If I pay that off, I immediately get a risk free return on that. The stocks are falling – or at least high risk – so if it goes down 5%, I’m making 9.55%, or better. My house is more free. I now have cash on hand. In 10 years, if I sell my house for even what I paid for it and get the full amount back in cash to replenish my retirement account to some degree plus the interest, I’ve saved while sitting in my hands. If the market comes back, I can move my funds back into the market and attempt to increase what I took out. And I always have a roof over my head and my family. Not really a bad deal. Look at the spread on tax saving. I pay a dollar and get back 30 cents. I save a dollar and keep 70 cents. So the spread now is really $1.40. Lose a buck and find 30 cents on the sidewalk. Save a dollar with hole in my pocket, but still have 70 cents left. This really is a no brainer unless the stock market is booming and you pick well.