If you're like most people, paying off your mortgage and entering retirement debt-free sounds pretty appealing. It's a significant accomplishment and the end of a major monthly expense. However, for some homeowners, their financial situation and goals might call for attending to other priorities while chipping away at their home loan.
Let's look at the reasons why you might—or might not—decide to pay off a mortgage before you retire.
You might want to pay off your mortgage early if …
- You're trying to reduce your baseline expenses: If your monthly mortgage payment represents a substantial chunk of your expenses, you'll be able to live on a lot less once the payment goes away. This can be particularly helpful if you have a limited income.
- You want to save on interest payments: Depending on a home loan's size and term, the interest can cost tens of thousands of dollars over the long haul. Paying off your mortgage early frees up that future money for other uses. While it's true you may lose the tax deduction on mortgage interest, you'll have to reckon with a decreasing deduction anyway as more of each monthly payment applies to the principal, should you decide to keep your mortgage.
- Your mortgage rate is higher than the rate of risk-free returns: Paying off a debt that charges interest can be like earning a risk-free return equivalent to that interest rate. Compare your mortgage rate to the after-tax rate of return on a low-risk investment with a similar term—such as a high-quality, tax-free municipal bond issued by your home state. If your mortgage rate is higher than the interest rate on an investment asset, you'd be better off paying down the mortgage.
- You prioritize peace of mind: Paying off a mortgage can create one less worry and increase flexibility in retirement.
Consult with your financial advisor before deciding to pay off your mortgage—either through regular payments or a lump sum. They can help you project the impact this decision can have on your portfolio. If you decide that a lump sum is the most appropriate way forward, consider tapping taxable accounts before your retirement savings. "If you withdraw money from a 401(k) or an individual retirement account (IRA) before 59½, you'll likely pay ordinary income tax—plus a penalty—substantially offsetting any savings on your mortgage interest," says Rob Williams, managing director of financial planning, retirement income, and wealth management at the Schwab Center for Financial Research.
You might not want to pay off your mortgage early if …
- You need to catch up on retirement savings: If you completed a retirement plan and find you aren't contributing enough to your 401(k), IRA, or other retirement accounts, increasing those contributions should probably be your top priority. Savings in these accounts grow tax-deferred until you withdraw them.
- Your cash reserves are low: "You don't want to end up house rich and cash poor by paying off your home loan at the expense of your reserves," says Rob. He recommends keeping a cash reserve of three to six months' worth of living expenses in case of emergency.
- You carry higher-interest debt: Before you pay off your mortgage, first close out any higher-interest loans—especially nondeductible debt like that from credit cards. Create a habit of paying off nondeductible debt monthly rather than allowing the balance to build so that you'll have fewer expenses when you retire.
- You might miss out on investment returns: If your mortgage rate is lower than what you'd earn on a low-risk investment with a similar term, you might consider keeping the mortgage and investing what extra you can.
A middle ground
Depending on prevailing mortgage interest rates, it may make sense to simply refinance into a shorter term loan if your goal is to pay off your mortgage quicker or into a loan with a lower interest rate if you want to decrease your monthly payment to free up funds for your savings. Or, if your mortgage has no prepayment penalty, an alternative to paying it off entirely is to chip away at the principal. You can do this by making an extra principal payment each month or by sending in a partial lump sum. This tactic can save a significant amount of interest and shorten the life of the loan while maintaining diversification and liquidity. But avoid being too aggressive about it—lest you compromise your other saving and spending priorities.
"Have a plan where you can both invest and pay down principal on a mortgage before or early in retirement," Rob says. "You don't have to make an all-or-nothing decision."
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