When should I pay off my mortgage? It is a question many older Americans find themselves asking, and the current financial climate complicates what might otherwise be an easy decision.
Mortgage rates have been low since the end of the great recession,1 and at the beginning of the year, the average 30-year fixed mortgage rate was 3.22%. As a result, many homeowners have refinanced their loans, and these favorable terms often extend far into retirement. Meanwhile, the interest rates of investment-grade bonds, currently at 4.5%,2 have been rising. This means that investing in bonds (rather than paying down the principal on your mortgage) could return more than the cost of your mortgage.
If you are an older American who can consider paying off your mortgage, we will look at some of the reasons you may choose to do that—or opt instead to keep your home loan into retirement.
Benefits of Paying off Your Mortgage Early
There are good reasons to consider closing out your home loan ahead of schedule, whether by adding to your monthly payment or contributing a lump sum to the balance owed.
- Interest savings: Paying off your mortgage early reduces the total interest you pay on the life of the loan. The amount of savings depends on the total of the principal-only payments and how early into the loan schedule they are applied.
- Lower living expenses: By eliminating your mortgage payment, your monthly living expenses may drastically decrease. And when living expenses go down, so does the amount of emergency savings you might need to feel secure.
- Greater cash flow: The cash you would have spent on mortgage payments can be put toward other goals.
Given these benefits, some people might consider withdrawing money from their retirement plan to pay off their mortgage. Generally, this is not recommended, because even if you wait until after age 59 ½ to avoid penalties, the tax hit of taking a large distribution could potentially push you into a higher tax bracket. That is why it is important to understand all the key factors at play.
Understanding the Tax Impact
Prior to 2017, many taxpayers were able to claim their mortgage interest as a tax deduction, saving them hundreds (or thousands) of dollars every year. Then in 2018, the standard deduction was raised, limiting the number of people who could take this deduction.
If you are a taxpayer who still qualifies for this deduction, it is important to consider how much tax you will save annually, factoring in both your home loan and tax bracket. Taxpayers who can deduct their mortgage interest may see a tax increase once their mortgage is paid off.
Let us assume a taxpayer in the 22% tax bracket has a 4% mortgage rate, and they can fully deduct the interest. This brings the after-tax cost of their mortgage to 3.12%.
This taxpayer should compare the 3.12% after-tax cost of their mortgage with the after-tax return they could earn from a bond. A 4.5% taxable bond yield leaves an after-tax return of 3.51% (though state income taxes could further erode this yield). If the taxpayer does not receive tax benefits from their mortgage interest, the bond’s after-tax return of 3.51% would fall short of covering the 4% mortgage.
Evaluating Liquidity
An essential part of financial planning is making a portion of assets quickly and easily accessible. This is partly for emergencies, but also to take advantage of financial opportunities. Before putting after-tax assets into paying off your home mortgage, make sure you have a sufficient emergency fund. Retirees with substantial assets but little income may have trouble qualifying for a new mortgage or home equity line.
Seeking a Higher Return Than Your Mortgage Rate
As we have discussed, it may be worth directing extra money to investments (rather than your home mortgage) if you are able to earn a better return. And with interest rates currently on the rise, investment-grade bonds are an obvious choice. The key calculation is to compare your after-tax mortgage rate with the after-tax yield of the bond. You may be able to earn enough bond interest after taxes to cover your mortgage interest.
Investing in stocks is another option, and the average annual return of U.S. stocks over the last 50 years (10%) is far higher than the interest many borrowers pay on their home mortgages.3 But this return is far from guaranteed, and past performance doesn’t always indicate future results. It is best to balance the risk of market returns with the more certain savings of paying down your mortgage.
Another factor for many retirees is the peace of mind (and freedom to chase other financial dreams) that comes with paying down debt. This can make it tempting to pay off your mortgage early, even though it might not be the best option. A financial adviser can help you assess your investment choices, evaluate the tax implications, and discuss other options you might not have considered.
Rick’s Insights:
- Some taxpayers can itemize deductions to receive tax benefits from their mortgage interest.
- Retirees with substantial assets but little income may have trouble qualifying for a mortgage.
- The key calculation is to compare your after-tax mortgage rate with the after-tax yield of an investment-grade bond.
- The average mortgage interest rate by state, credit score, year, and loan type. Business Insider, September 1, 2022.
- Moody’s Seasoned Aaa Corporate Bond Yield, as of September 19, 2022.
- Average stock market return, calculated by Mike Price, The Motley Fool. Updated August 10, 2022.
