One of the more common questions we get from clients approaching retirement is whether they should pay off their mortgage early or continue with the monthly payments into retirement.
The best answer for you goes beyond the numbers, although that’s part of it. So while each person or family’s situation will ultimately determine the best answer for them, here are some key factors to consider.
What is your interest rate and is it fixed or variable?
Where will the money come from and what would you do with it otherwise?
What are the tax implications involved?
What is your monthly payment and how does that fit with your retirement cash flow plan?
What’s your “sleep at night” factor?
Let’s break each of these down a bit more.
1. What is your interest rate and is it fixed or variable?
A common rule of thumb here is if you’re paying 7% or less on your mortgage, then you’d likely be better off investing the money for the long-term than paying off your mortgage.
If your rate is variable and you expect rates to rise, that would suggest in favor of paying it off, but you may want to wait until rates DO rise, just to take max advantage of the time value of money with investing.
But keep reading…
2. Where will the money come from and what would you do with it otherwise?
Oftentimes when having this conversation, our clients are also deciding whether to take a lump sum pension distribution or choosing monthly payments for life, where the argument in favor of taking the lump sum would be to use that to secure housing, presumably for life.
Alternatively, you may be looking at using an inheritance or taking a large distribution from your 401k or IRA, in which case the above investment-related question is relevant.
If you’re a more conservative investor and prefer to keep your investments in more stable securities such as bonds or other fixed income, then paying off your mortgage may be the better option, from a straight-up math perspective. On the other hand, if you’d be pulling from a portfolio (or considering starting one with your inheritance) that would be invested more aggressively in stocks or other more growth-oriented investments, then you may be better off leveraging the higher long-term growth in the market and keeping the debt at a lower rate.
Simply put, if you’ve got funds in your IRA that are averaging 8% over the past 10 years, for example, and you intend to keep those funds invested that way, keeping a 5% mortgage essentially “earns” you 3% for each year you keep the funds invested, all other factors aside.
On the other hand, if you’d spend the money on other assets or experiences that don’t hold their value as well as a home, such as an RV, travel, dining out or other “toys,” from a straight long-term growth perspective, you’re better off using that money to pay off the mortgage and saving the interest.
But what about the tax deduction? Let’s talk about that next.
3. What are the tax implications involved?
This is actually a two-part answer.
First, let’s talk about the tax deductions you can take as a homeowner. You may be surprised to hear that you probably aren’t getting the tax benefits you think you’re getting from holding a mortgage, at least under the current tax law, which is set to expire at the end of 2025.
According to the Tax Policy Center, since the Tax Cuts & Jobs Act (TCJA) went into effect in 2017, only about 10% of taxpayers are itemizing deductions, which is fancy tax-speak for (typically) writing off mortgage interest and property taxes, among other allowable deductions.
For the rest of us 90-percenters, the standard deduction offers a bigger write-off than you’d get under the current tax law, so having a mortgage and paying property taxes isn’t saving you a dime on taxes. The reasons behind this are fodder for a different (and probably much more boring) blog post, but feel free to reach out to us to discuss if you’d like to better understand.
However, it’s worth noting again that the tax law as we know it at the time of this publishing is set to expire on December 31, 2025, and the changes that made itemized deductions less beneficial for most homeowners go away, so there’s a chance you could once again see a bigger tax benefit from writing off mortgage interest, property taxes, charitable deductions, state taxes, etc.
Will the law actually expire? That’s up to Congress and we didn’t come here to talk politics, so we’re going to move on to the other tax aspect of paying off your mortgage early, but just know that this is a moving piece that may or may not be a part of this decision for you.
The second part of the tax question is what tax implications, if any, would you have for the money you’d use to pay off your mortgage? If you, for example, took that pension lump sum and then used it to pay off your house, you’d have to pay ordinary income taxes on that entire lump sum payment in the year you took it. Depending on the amount, it could push you into a much higher tax bracket than you’re used to, which should absolutely make you think twice.
On the other hand, if you’d be selling appreciated stock in a taxable account, then for most of us, you’re looking at a 15% capital gains rate on any long-term growth.* And if the money is in a Roth account? Then you don’t need to worry about income taxes on the distribution, just the potential lost future growth of those funds discussed above in point 2.
*rates are higher if you’re in the top most tax brackets or you’ve held the investment for less than a full year.
4. What is your monthly payment and how does that fit with your retirement cash flow plan?
There are financial planners out there who would tell you that this shouldn’t be part of the decision because from a purely logical standpoint, it probably shouldn’t. But at The Prosperity People, we recognize that the most rational decision isn’t always the simplest or best for all circumstances, so we need to discuss this factor.
There are many ways to put together a retirement spending plan, which (shameless plug) is something we love to help our clients with, and we know that some people really want to find a way to have their fixed expenses covered by a guaranteed income source such as Social Security or an immediate income annuity. And if you put your post-retirement budget together and find that it’s enough to cover all your costs if you just didn’t have that pesky mortgage, we get it.
Important reminder here though, if this is a factor for you, is to make sure you’re still budgeting for property taxes, insurance and repairs and maintenance because those don’t go away once you own your home free and clear. And if you’ve been escrowing your insurance and taxes, you’ll have to set up a new system to make sure you have funds available when those bi-annual or annual bills come due, should you decide to pay off that mortgage.
5. What’s your “sleep at night” factor?
The final factor is not something that any calculator can account for, and that’s how this decision will affect your overall money mindset in retirement. You may run the numbers and find that paying off the mortgage early will cost you excess taxes, lost investment opportunity and give you more than enough wiggle room in your budget, but if you know you’ll sleep better at night knowing that you’ve eliminated one big monthly payment from your budget, then that might be all that matters.
Our role as your financial advisor isn’t just to tell you what the best answer is to these big questions. It’s to make sure you understand the pros and cons and then support you in whatever decision you make, regardless of what the numbers say. After all, it’s YOUR definition of prosperity that matters.
If you’re not a client of the Prosperity People but you’re wondering whether or not you should pay your mortgage off early, among other big money questions, we’d love to talk with you. Reach out today to schedule a chat so we can start you on your path to prosperity.