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According to the Employee Benefit Research Institute (EBRI), home and home-related expenses are the single largest spending category for older Americans.
It’s understandable then to be tempted to pay off your mortgage if you are retired or getting closer to retirement.
Before you do that, though, there are four questions you should ask yourself to make sure it’s the best move for you.
Question #1: Where will the money come from?
Many people have a big chunk of their wealth in tax-favored retirement plans, like 401(k)s and IRAs. And money you withdraw from those accounts is taxable at your ordinary income tax rate. Plus there’s a 10% penalty if you’re younger than 59 and a half.
So it’s certainly conceivable that you’d need to withdraw at least $130,000 to pay off a $100,000 mortgage.
But that’s not all …
Suppose you’re collecting Social Security benefits?
The additional money you withdraw from retirement accounts could push your income up to the point that 85% of your benefits become taxable.
Even if the money is coming from other sources that are not taxable, such as Roth IRAs and jointly-owned brokerage accounts, sinking that money into a home means it won’t be available if you need a large amount down the road.
Question #2: Is there a better use for the money?
Do you have a large credit card balance? The average American household has $8,400 in credit card debt and is paying 17.21% interest.
If you fall into this group, it would make more sense to get rid of that burden before considering paying off a low-interest rate mortgage.
The same if you aren’t contributing enough to your 401(k) to receive a full-employer match. For instance, a 50% match on the first 3% of your contributions is like getting a guaranteed 50% return on those dollars.
How about your investments?
The S&P 500 returned about 5% in 2018, a far cry from the 12% long-term average. Even with that, if your money is currently invested in ETFs or mutual funds that track the overall market, the return far exceeded the 4% or so you’re paying in mortgage interest.
So keeping the mortgage is a no-brainer … right?
Not so fast …
Stocks might not do as well in the future. Moreover … they could easy have a negative return if investor sentiment turns against you.
Consider this phrase that’s in every mutual fund prospectus or investment disclosure:
“Past results are no guarantee of future performance.”
Whereas paying off a mortgage, with for example a 4% interest rate, gives you a guaranteed return.
Question #3: Is your mortgage interest deductible?
Deducting mortgage interest has frequently been one of the benefits of home ownership. But for many, the 2017 Tax Cuts and Jobs Act changed that.
The Tax Act almost doubled the standard deduction from 2017. For 2019 it’s:
- $12,200 if you are single or married filing separately
- $24,400 if you are married and filing jointly
- $18,350 if you are a head of household
Those high limits mean there’s a greater chance that you’ll simply take the standard deduction rather than itemizing your deductions, which include mortgage interest.
In other words the way the tax law stands now, mortgage interest could become worthless to you as a tax deduction.
For example, if you file married jointly and had $6,000 in property tax, $10,000 in mortgage interest, and $3,000 in charitable contributions, your itemized expenses would total $19,000.
However, the standard deduction is $24,400 … so your mortgage interest didn’t give you any tax benefits.
What’s more, there are caps on the size of the mortgage in which interest is deductible: $1 million if you bought before 2018; $750,000 thereafter.
There’s one more factor to consider before paying off that mortgage …
Question #4: Liquidity vs. illiquidity
A home is an illiquid asset, meaning that it generally cannot be quickly sold without taking a loss. On the other hand, your bank or brokerage account is liquid … it can be sold easily because there is a large number of buyers and sellers.
When you take money from a liquid account and pay off your mortgage, you are reducing the liquid portion of your net worth and increasing the illiquid portion.
If you are still determined to pay off the mortgage with your liquid assets, you might consider opening a home equity line of credit — a HELOC — for as much as the lender will offer.
A HELOC would give you access to your home’s equity in the event you needed cash in a hurry, say for an emergency. And you will only pay interest on what you borrow.
You’ll have to pay a fee to open a HELOC, and there might be annual fee. But at least then you won’t have to tap your IRAs or other liquid accounts for withdrawals.
Bottom Line
Going into retirement mortgage-free can be comforting.
Yet getting rid of that debt may not always be the best strategy.
Before making the decision consider your overall financial situation, including risk tolerance, other assets you hold, and whether you plan to stay in the home during your golden years.
And if you understand the logic of keeping the mortgage but know you’ll sleep better if it’s paid off … pay it off.
To a richer life,
Nilus Mattive
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