Should You Retire Your Mortgage Before Retiring?
Should you own your home free and clear before you retire? This is one question that frequently arises when developing and implementing a retirement plan. The answer to this question would seem to be an obvious no brainer. In retirement, a person or couple, will likely have a fixed income composed of retirement investments, social security, rental income, and perhaps pensions. Additionally, more retirees are seeking part-time work for both extra income and more so, to remain mentally & physically active. Thus, retiring without mortgage debt (or any other debt to boot) sounds like a very good thing.
According to the Pew Research Center, 10,000+ Baby- Boomers will turn 65 (SSI-full benefit retirement age) every day for the next 19 years.1 So, why not make extra mortgage payments to get the job done before retiring from your current employment? The reality is that the decision is not as cut and dry as it appears. There is a fundamental opportunity cost to consider. If you decide to put more money toward your mortgage, what could that money potentially do for you if you were to direct it elsewhere?
Really, the question to ask is: should you pay down low-interest debt, or should you invest the money into a tax-advantaged account that could potentially bring you a higher future return?
Mortgage loans are near all-time lows. As we all are aware the current interest rates on most mortgages are below 7%, in many cases below 6%, and in several cases at or below 5%! You can usually deduct mortgage interest, so if your home loan carries a 6% interest rate, your after-tax borrowing rate could end up being 5% or lower. Even for the 20%+ of American homeowners who presently find that their mortgage is underwater, the low interest rate and tax benefits still endure despite the "pain" of depreciated home values. (I talk more about this shortly.)
Ultimately, when paying your mortgage off early you are directing excess capital away from accumulation in other assets; and counting on greater value in reducing your debt than building the rest of your nest-egg. Thus, part of the answer is empirical, as in paying off a mortgage at 6% or investing the excess capital in an investment with a return greater than 6%. Another component of the answer is the emotional comfort of being debt free, particularly at a time when in most cases your earning power is diminished.
Further, it can emphatically be said that one should focus attention on a credit card or other non tax-deductible interest rate debt before going full bore at mortgage debt.
What if your house is underwater? Prepaying an underwater mortgage may seem senseless to you, or maybe you really love the house and are planning to retire at your current address. In either case, you could benefit from directing extra mortgage payment money toward one of your other goals that you need to accomplish at or during retirement, such as some account(s) with the potential for tax-deferred growth, a savings fund for health or emergency needs, or needed insurance coverage. After considering all the components of your retirement, the better move on an underwater home might be to not pay extra on your debt or adjust how much extra you are paying.
What the FED Says. In 2006, the Federal Reserve Bank of Chicago presented a white paper from three of its economists titled "The Tradeoff between Mortgage Prepayments and Tax-Deferred Retirement Savings". The study observed that 16% of American households with conventional 30-year home loans were making "discretionary prepayments" on their mortgages each year - that is, payments beyond their regular mortgage obligations. The authors concluded that almost 40% of these borrowers were "making the wrong choice." Their white paper argued that the same households could get a mean benefit of 11-17¢ more per dollar by reallocating the money used for those extra mortgage payments into a tax-deferred retirement account.2
Now as regular readers of the Foresight and my Market Commentary know I am not one who could be accused of being a fan of the Federal Reserve and its policies. Still, as a person who is very objective and agnostic in my reading and reviews of the sources of financial information, this study was well stated and poignant.
Other alternatives for your extra cash. Let's talk taxes. You save taxes on each dollar you direct into IRAs, 401(k)'s and other tax-deferred retirement oriented investment options. These dollars have the chance to grow without current taxation until you either reach your desired retirement age or age 70 ½ (when mandatory distributions must begin). Most Americans may enter a lower tax bracket in retirement, so your taxable income and federal tax rate could be lower when you withdraw the money out of that account. (of course future tax policy could change this situation).
Another potential benefit of directing more funds toward your 401(k), 403(b) or other employer sponsored retirement plan is: The company you work for may provide an employer match, and then you are able to collect "free money".
Besides the cost benefit advantages of tax-deferred retirement investing, also consider insurance needs during retirement. Most families are underinsured and the money for extra mortgage payments could be directed toward long term care insurance for baby boomers, disability coverage for younger families with 20+ years to retirement, or life insurance to provide for surviving dependents.
Always remember that once money is paid towards your mortgage debt, it is gone, and that money you accumulate in other assets can be accessible (inclusive of some possible restrictions & penalties).
Let's Think.The decision should really focus on your assumptions for retirement, as they will guide what empirical data and emotional comfort are necessary and important for you. If you are a little more conservative and prefer to have more expenses controlled during retirement, then you may lean toward paying off your mortgage before you retire. There is no doubt when you pay off a debt that you owe, you effectively get an instant return on your money for every dollar. Plus you have "comfort" in the certainty of one less future expense. So if you are tantalizingly close to paying off your house, then you may just want to go ahead and do it because you love being free and clear.
On the other hand, paying off your mortgage early while not having enough saved to meet your retirement needs is not the best choice. Once you look at the projections for your current retirement savings rate and what you will potentially need to meet your retirement goals, you may decide to direct extra money towards retirement investments. This is especially true if you tend to be more bullish/optimistic and believe there are opportunities in the market that will perform along the lines of its long-term historical averages which will provide you higher returns than the interest on your debt.
There is not a one-size-fits-all answer to this question even though many would like you to believe it. If you're unsure which direction may be most beneficial to you, perhaps now you have an enhanced framework to ask even better questions of yourself or to the qualified financial professional you work with.
Citations.
1 - http://pewresearch.org/pubs/1834/baby-boomers-old-age-downbeat-pessimism
2- chicagofed.org/digital_assets/publications/working_papers/2006/wp2006_05.pdf [8/06]
According to the Pew Research Center, 10,000+ Baby- Boomers will turn 65 (SSI-full benefit retirement age) every day for the next 19 years.1 So, why not make extra mortgage payments to get the job done before retiring from your current employment? The reality is that the decision is not as cut and dry as it appears. There is a fundamental opportunity cost to consider. If you decide to put more money toward your mortgage, what could that money potentially do for you if you were to direct it elsewhere?
Really, the question to ask is: should you pay down low-interest debt, or should you invest the money into a tax-advantaged account that could potentially bring you a higher future return?
Mortgage loans are near all-time lows. As we all are aware the current interest rates on most mortgages are below 7%, in many cases below 6%, and in several cases at or below 5%! You can usually deduct mortgage interest, so if your home loan carries a 6% interest rate, your after-tax borrowing rate could end up being 5% or lower. Even for the 20%+ of American homeowners who presently find that their mortgage is underwater, the low interest rate and tax benefits still endure despite the "pain" of depreciated home values. (I talk more about this shortly.)
Ultimately, when paying your mortgage off early you are directing excess capital away from accumulation in other assets; and counting on greater value in reducing your debt than building the rest of your nest-egg. Thus, part of the answer is empirical, as in paying off a mortgage at 6% or investing the excess capital in an investment with a return greater than 6%. Another component of the answer is the emotional comfort of being debt free, particularly at a time when in most cases your earning power is diminished.
Further, it can emphatically be said that one should focus attention on a credit card or other non tax-deductible interest rate debt before going full bore at mortgage debt.
What if your house is underwater? Prepaying an underwater mortgage may seem senseless to you, or maybe you really love the house and are planning to retire at your current address. In either case, you could benefit from directing extra mortgage payment money toward one of your other goals that you need to accomplish at or during retirement, such as some account(s) with the potential for tax-deferred growth, a savings fund for health or emergency needs, or needed insurance coverage. After considering all the components of your retirement, the better move on an underwater home might be to not pay extra on your debt or adjust how much extra you are paying.
What the FED Says. In 2006, the Federal Reserve Bank of Chicago presented a white paper from three of its economists titled "The Tradeoff between Mortgage Prepayments and Tax-Deferred Retirement Savings". The study observed that 16% of American households with conventional 30-year home loans were making "discretionary prepayments" on their mortgages each year - that is, payments beyond their regular mortgage obligations. The authors concluded that almost 40% of these borrowers were "making the wrong choice." Their white paper argued that the same households could get a mean benefit of 11-17¢ more per dollar by reallocating the money used for those extra mortgage payments into a tax-deferred retirement account.2
Now as regular readers of the Foresight and my Market Commentary know I am not one who could be accused of being a fan of the Federal Reserve and its policies. Still, as a person who is very objective and agnostic in my reading and reviews of the sources of financial information, this study was well stated and poignant.
Other alternatives for your extra cash. Let's talk taxes. You save taxes on each dollar you direct into IRAs, 401(k)'s and other tax-deferred retirement oriented investment options. These dollars have the chance to grow without current taxation until you either reach your desired retirement age or age 70 ½ (when mandatory distributions must begin). Most Americans may enter a lower tax bracket in retirement, so your taxable income and federal tax rate could be lower when you withdraw the money out of that account. (of course future tax policy could change this situation).
Another potential benefit of directing more funds toward your 401(k), 403(b) or other employer sponsored retirement plan is: The company you work for may provide an employer match, and then you are able to collect "free money".
Besides the cost benefit advantages of tax-deferred retirement investing, also consider insurance needs during retirement. Most families are underinsured and the money for extra mortgage payments could be directed toward long term care insurance for baby boomers, disability coverage for younger families with 20+ years to retirement, or life insurance to provide for surviving dependents.
Always remember that once money is paid towards your mortgage debt, it is gone, and that money you accumulate in other assets can be accessible (inclusive of some possible restrictions & penalties).
Let's Think.The decision should really focus on your assumptions for retirement, as they will guide what empirical data and emotional comfort are necessary and important for you. If you are a little more conservative and prefer to have more expenses controlled during retirement, then you may lean toward paying off your mortgage before you retire. There is no doubt when you pay off a debt that you owe, you effectively get an instant return on your money for every dollar. Plus you have "comfort" in the certainty of one less future expense. So if you are tantalizingly close to paying off your house, then you may just want to go ahead and do it because you love being free and clear.
On the other hand, paying off your mortgage early while not having enough saved to meet your retirement needs is not the best choice. Once you look at the projections for your current retirement savings rate and what you will potentially need to meet your retirement goals, you may decide to direct extra money towards retirement investments. This is especially true if you tend to be more bullish/optimistic and believe there are opportunities in the market that will perform along the lines of its long-term historical averages which will provide you higher returns than the interest on your debt.
There is not a one-size-fits-all answer to this question even though many would like you to believe it. If you're unsure which direction may be most beneficial to you, perhaps now you have an enhanced framework to ask even better questions of yourself or to the qualified financial professional you work with.
Citations.
1 - http://pewresearch.org/pubs/1834/baby-boomers-old-age-downbeat-pessimism
2- chicagofed.org/digital_assets/publications/working_papers/2006/wp2006_05.pdf [8/06]
