BY JULIA ANDERSON
Retirees are told to pay off their mortgage before they leave their jobs or at least soon after. But should you? Does it make financial planning sense? Here’s my analysis of why or why not paying off your mortgage is a good move.
Pluses first. You eliminate a big monthly loan payment, which increases your monthly income. You don’t have to worry about rising interest rates, if you have a variable or adjustable-rate loan that could take a bigger bite out of your income, if the Fed raises interest rates. You increase your net worth by eliminating debt. It feels good to pay off the house loan and be debt-free as you head into retirement.
But where will the cash come from to make this move? Will it leave you “cash poor” in case you face a financial emergency such as an early retirement buyout, a major illness or accident or an unexpected need to buy a car or one for your grandchild?
Paying off a mortgage is more complicated that it might first appear. YOU WILL NEED A CALCULATOR AND POSSIBLY AT TAX ACCOUNTANT TO DECIDE WHAT’S BEST FOR YOU.
Why paying off a mortgage is NOT a good idea
With interest rates at historic lows, carrying a mortgage loan with a cheap 2.5 percent rate is not expensive. A 30-year fixed loan on $150,000 at less than 3 percent costs less than $1,000 in a monthly payment. On a $350,000 loan the monthly cost is $2,000 or less per month. It’s cheap money. You might want to put your cash to work elsewhere.
You get a deduction on your federal income tax for interest you pay annually on the loan. That reduces your taxable income. On the other hand, you no longer are making those interest payments, which will save you thousands over the life of the loan.
You might do better by investing the cash you would use to pay off the loan. Over the past 10 years, portfolios invested 60 percent in stocks and 40 percent in bonds have averaged roughly a 10 percent annualized return. With a $100,000 initial investment plus $1000 more a year invested over 10 years in stocks, your nest egg will grow to $276,905. BUT there are NO guarantees this track record will continue if interest rates go higher.
Once money is sunk into a house it is “illiquid.” In other words, you can NOT easily tap the equity in your house in an emergency. However, this could be a forced savings plan if you are not a saver.
But again, THERE ARE PLUSES: You are debt free. You eliminate a big monthly expense. You don’t have to worry about rising interest rates if you have a variable or adjustable loan. You are more financially secure without the debt. You lose the tax deduction but you gain way more income from NOT having a loan payment!!
Take These Steps Before You Decide
Understand the trade-offs between paying off the loan and eliminating your mortgage payment vs. the tax write-off benefit and/or investing your cash elsewhere for the long-term.
Run some scenarios comparing household income expense and savings, if you pay off the loan and the changes in your tax profile, if you pay off the loan. How much will you save in loan interest payments? Interest saved on a $350,000 loan even at 2.5 percent over 30 years will total nearly $148,000.
How will you use the “new” money if you eliminate the loan payment? Will you still have cash for unexpected emergencies? Get a tax professional to help you.
Look at how you would invest the cash that you might use to pay off the loan but instead invest it for the long haul. What kind of earnings can you expect over the next 10 or 15 years. Will you still have cash for emergencies? Build up an emergency fund (in cash) to cover household expenses for at least six months.
Do not tap your long-term tax advantages retirement funds – 401(k) or IRA to pay off your mortgage loan. You will need that tax-deferred nest egg for the long haul. Taking money out early undermines your compound reinvestment wealth-building strategy.
How about a compromise? Consider making “early” payments on your mortgage loan instead of an outright payoff. You can pay down the loan faster, reducing the time to pay off the loan. Invest the rest of your money a 60/40 stock-bond fund.
Don’t take an unexpected tax hit by selling investments to assemble the cash to pay off a mortgage. Those sales could bump you into a higher income tax bracket… 24 percent vs. 32 percent on taxable income (using current tax law).
Celebrate your decision!
If you pay off your mortgage, celebrate your decision. Your are debt-free, your net worth increases and your monthly income goes up. You will always wonder if you made the right call but stay focused on how good you will feel if there’s a stock market crash or interest rates go up.
Going forward: Take the “new” money in the amount of your former mortgage payment and stash it in a savings or investment account…. a PAINLESS MOVE that will build long-term wealth.
AARP - Paying off your mortgage. click here
AARP mortgage calculator. click here
WSJ “Should Retirees Pay Off Their Mortgage or Invest the Money?” click here.
Bankrate.com "Does it make sense to pay off your mortgage early? click here
Dave Ramsay: "Why Should I pay off the Mortgage?" click here
Bloomberg (For those 40 and under) “The Opportunity Costs of Paying Off Your Mortgage Early,” click here.
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I meet women all the time who face job and money transitions and who want to do them right. It’s about building confidence and taking charge of the future. This is your money. No one cares more than you do!
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