Some people enjoy the peace of mind that comes with a debt-free retirement. But warm and fuzzy feelings should be weighed against solid financial facts.
When it comes to paying off your mortgage, for example, first take a look at the interest rate. “If the rate on your mortgage is low, you might be better off holding onto your cash—or even investing it, assuming you’re reasonably confident you can get a higher rate of return than you’re paying on the loan,” says Rob Williams, vice president of financial planning at the Schwab Center for Financial Research. "But, at the same time, reducing debt, and ideally eliminating it, all else equal, should be on your list of goals before retirement."
With interest rates are at a record low, including sub-3% mortgage rates, it may be tempting to refinance a mortgage or not pay it off. But it’s worth keeping in mind, that it's hard to get a 3% guaranteed investment return from any investment today. Being "reasonable confident" you get a higher rate of return involves risk. It’s important to evaluate your risk tolerance before making a decision.
Here are the pros and cons to consider before retiring a home loan.
- Limited income: Your monthly mortgage payment may represent a significant chunk of your expenses. Eliminating it can greatly reduce the amount of cash required to meet monthly expenses.
- Interest savings: Depending on its size and term, a home loan can cost thousands or even 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 mortgage interest tax deduction, the savings on servicing the debt can still be substantial. Besides, the closer you get to paying off the loan, the more of each monthly payment goes to principal, decreasing the amount you can deduct.
- Predictable return: Investments can go up—and they can go down. But no longer paying interest on a loan can be like earning a risk-free return equivalent to the mortgage interest rate. Being relatively confident of earning a return that exceeds the mortgage rate is not the same thing as being certain of earning that rate. There's a risk of loss too.
- Peace of mind: Numbers aren’t everything, so if you’re determined to retire your mortgage, consider tapping taxable accounts first. “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,” Rob says.
- Insufficient retirement savings: If you aren’t contributing enough to your 401(k), IRA or other retirement accounts, this should probably be your top priority. Savings in these accounts grow tax-deferred until you withdraw them.
- Insufficient cash reserves: Rob recommends keeping a cash reserve of three to six months’ worth of living expenses in case of emergency. “You don’t want to end up house rich and cash poor by paying off your home loan at the expense of your reserves,” Rob says.
- Higher-interest debt: Before you pay off your mortgage, first retire any higher-interest loans—especially nondeductible debt like that from credit cards.
- Opportunity costs: One way to determine if investing the funds is preferable to paying off your mortgage is to compare your mortgage interest 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 (assuming the issuer is from your home state. You may have to pay taxes on out-of-state municipal bonds). If your mortgage is costing you less than you’d earn, you might consider keeping it.
- Diversifying your investments: Maintaining your mortgage allows you to hold more of other asset classes. And overconcentration carries its own risks—even when it’s in something as historically stable as a home.
A middle ground
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.
You could also consider refinancing. Current interest rates are relatively low, and depending on the type of loan you have, refinancing might make sense for you. If this is something you’re interested in pursuing, make sure you do a thorough cost-benefit analysis before pulling the trigger. If you refinance, though, avoid the temptation to take out more equity, or increase your debt. The goal, ideally, should be to reduce debt on your primary home over time—not increase it.