The decision whether to retire with or without a primary residence mortgage is a key planning issue for most retirees. This has become even more of an issue as housing values have fallen and mortgage rates are at historic lows. Does it really make sense to pay off a mortgage when rates are hovering around 4%?
Prevailing logic holds that one should pay off the mortgage prior to retirement. Grounded by the experiences of the Great Depression when people did lose mortgaged homes, this wisdom runs contrary to our current tax code, potential returns from alternative investments and the need for liquidity.
Today’s tax code allows a tax deduction for mortgage interest paid on a principal or second home. To understand this benefit let’s assume the interest rate on your mortgage is 4% and you are in the 25% tax bracket. You pay 4% interest and the IRS credits 1% back when you file your taxes. The net cost to the taxpayer is 3%.
Paying interest for the sake of a tax deduction does not make sense. However, if the alternative is to keep the principal sum that would be used to pay the mortgage invested, earning an after-tax return greater than 3%, then there is a valid reason for not paying the mortgage.
Finding the money to pay off the mortgage can be a tax issue as well. If the principal sum required must come from either selling investments which will generate a taxable gain, or withdrawing a lump sum from a retirement account—all of which will be taxed at ordinary income rates—it might be better to continue mortgage payments and avoid the higher tax bill. This spreads the taxes over a much longer period.
Conventional wisdom encourages those wishing to pay off their mortgage to do so by making additional monthly payments. However, if that same money were invested in an alternative investment, earning the equivalent after-tax return as the interest payment saved by paying off the mortgage early, the homeowner is faced with an interesting choice.
Which would you prefer, a paid for house at the end of the accelerated payment period or a continuing mortgage and a liquid investment amount equal to the interest you would have saved, had the mortgage been paid off early? When the tax consequences are factored into this equation, plus the investment return potential, paying off the mortgage early has little advantage other than peace of mind.
Finally, the need for liquidity in the retirement plan must be considered. A paid for home is an illiquid asset. It is easy to refinance when one is working and can show the ability to repay the loan from earnings. Lenders aren’t quite so anxious to lend money when there are no wage earnings.
Capital required for repairs, replacement of capital item such as appliances, automobiles, etc. and potential medical expenses are reasons enough to maintain liquidity. If all available capital is tied up in the house, a retiree is short on options when it comes time to pay such expenses.
A possible solution to this liquidity problem is to refinance just prior to retirement. If the existing mortgage has been paid down, the principal sum to be refinanced will be smaller, allowing for lower payments. Of course these payments will be stretched out over a longer term, implying that the house might never be entirely paid for, but by keeping liquidity intact, the retiree might have a sounder financial situation.
- Paying your mortgage off from a retirement account can be a costly mistake. It takes a long time to make up 25% or more in taxes to save 4% mortgage interest.
- Until income tax rates are greater than 100%, it doesn’t make sense to have a mortgage just for the tax deduction. Accelerate mortgage payments while you are working to be debt free when you retire.
- Liquidity is an important factor in your retirement plan. Don’t tie up all your capital in a home that is an illiquid asset. Careful planning is required before you retire.