A common question asked by many of our new clients is, “Should I pay off my mortgage?” If you are retiring in a few months and have a $150,000 balance on your primary home, do you use your retirement funds to pay off the balance of your home, or do you keep paying the mortgage payment during retirement? There are various circumstances like age and personal finances that influence the appropriate response.
Let’s suppose you have that mortgage balance of $150,000 at an interest rate of 3.25% and a monthly payment of $1,100 per month. Many financial advisors would pull out a calculator and show you a linear projection that keeps your $150,000 invested with them, makes an average of 7% per year and nets you 3.5% after accounting for mortgage interest, before calculating your mortgage deduction on your Federal tax return. On paper this sounds good; you make more money and the advisor collects more commission. However, there are some flaws in this thinking.
One of the biggest questions when deciding the right time to retire is, “How much cash flow do you need to live on comfortably during retirement?” In our example, a $1,100 per month payment could be significant in a retiring middle-class household. The $150,000 left in investments actually would have to produce a return of 8.8% for 15 years to maintain the principal until the home was paid off. Instead, by paying off the home, the retiree’s cash need would decrease by $1,100.
A portfolio rate of return of 8.8% over a 15-year period is very possible if invested aggressively, highly in stocks based on an investor’s higher risk tolerance. However, it is important to understand that 8.8%, or any positive rate of return, is never guaranteed when investing in index funds, mutual funds or individual securities. If funds are used to pay off the home, you are guaranteed a 3.25% rate of return in our example. How? By not having the mortgage, you are saving 3.25% in mortgage interest and possible other fees such as PMI.
I often hear of advisors telling their clients not to pay off their home because it would mean losing their tax deduction for the mortgage interest. Let’s look at the math behind this advice. If you have a home with a monthly payment of $1,100, and the interest portion is $400 per month, you have paid around $4,800 in interest that year, which creates a tax deduction. If your home was paid for, you would lose this deduction.
If you don’t have the $4,800 tax deduction, and you’re in an 18% tax bracket, you will have to pay $864 in taxes on that $4,800. According to the mainstream advisor’s math, we should send $4,800 in interest to the bank, so we don’t have to send $864 in taxes to the IRS. I think the client should live mortgage free and not make an $864 trade for $4,800.
Also, due to the new State and Local Tax (SALT) deduction cap of $10,000, as well as the increased standard deduction amounts, a lot of clients are no longer itemizing their taxes in the first place.
If your house was paid off, would you take out a loan to invest it in the stock market? Amazingly, many people reading this would actually pause to think about it. The answer should be no. Why would you risk your house to make more money? Greed. So by not paying off your mortgage, you are essentially putting your home at risk, or at the very least, your retirement income.
I think the differences of opinion on this subject come from how advisors get paid and if they have the capacity to think independently from their corporate literature. Large national brokerage firms would stand to lose a lot of commission revenue if their thousands of brokers nationwide were told to give sound, unbiased and conflict-free financial advice. Looking at my peers, it seems that the fiduciary-fee-only advisors say to pay it off, whereas the national brokerage firms gamble with their clients’ best interests.
At Wiser Wealth Management, we believe that your house should be paid for by retirement to help free up cash flows. However, there is a process to most efficiently achieve this.
If all your retirement money is inside a tax deferred account, paying off the home in stages may be the best option. If you retire in November, you could pull out one half the payment immediately and withdraw the other half in January of the next year, keeping your withdrawals taxed at a lower rate in each year. You can take the funds out over a three-year period or more depending on your tax situation. Planning for tax efficient withdrawals is different for every client. You should discuss this type of strategy with your tax advisor. Also, your portfolio manager should keep the funds allocated for home payoffs in a CD or a short-term financial instrument because you do not want to put these funds at risk.
When the world news cycle and noise is rocking your portfolio with volatility and markets are hitting 52-week lows, many individual investors tend to get very conservative or even move to cash. A good financial advisor can help you keep your eyes on the big picture, but in the end, it is the client’s decision on what action takes place. If the client feels better paying off the mortgage at this point, then he or she has sold their portfolio at a rock bottom price to have the peace of mind that at least their house is paid for. The problem now is that there is less of a portfolio working to generate income and growth for retirement. We want clients to remain invested in the stock market while also setting aside additional money to pay extra towards the mortgage. Paying off the home by retirement allows the client to have the peace of mind at the start of the retirement journey, better long-term investing behavior and hopefully a larger nest egg for themselves.
One of the most common exceptions to our payoff rule is a situation in which the home payoff is a very big number and the retirement fund is lower than it needs to be to generate retirement income. This is where hard decisions have to be made. The retiree can downsize the home, work longer or possibly refinance the home to get a lower payment while understanding that the home will never be paid off. Generally, working longer is the better option, but sometimes, such as when retirement is forced, downsizing is the only option.
Another possible exception involves the source of a client’s income. Perhaps you and your spouse have six-digit annual pension payments. If so, this might change how we think about your financial security. Of course, this depends on where these pensions are coming from as well.
For those clients in their 20s and 30s, the plan should be to avoid becoming house poor. A 15-year mortgage would be an ideal situation. A good rule of thumb is that principal, interest, taxes and insurance should never be more than 25% of your gross income. This is still pushing it and most clients should try to stay below 20%. Unfortunately, many investors at this stage of life already have significant debt from student loans and/or credit cards. One tip for avoiding this problem is to ignore what your friends and family have attained and live within your means.
For those individuals within 10-15 years of retirement, plan to start making those extra payments now in order to eliminate a mortgage at your retirement date. Your retirement lifestyle will be better for it.
It is impossible, and not our intent, to give financial advice online without first knowing each client’s unique situation and circumstances. While we at Wiser Wealth Management believe that your home should be paid for by retirement, deciding how to best pay off debt is one of the many parts of the cash flow management process done within our financial planning process.
Click here to schedule a consultation with one of our financial planners.