Mon, July 27, 2009
Should You Pay Off Your Mortgage Before You Retire?
Boston College’s Center for Retirement Research recently released a brief that examines whether people nearing retirement should pay down their mortgages.
The question of whether you should pay off a mortgage before you retire is one that is becoming common, though I suspect it used to be rare. Thirty years ago, mortgages were usually paid off by the time people entered retirement. But several factors have conspired to change that. Since the late 1980’s mortgage rates have generally been declining, making borrowing more attractive. House prices started taking off in the ‘80s, and during the last housing run-up in particular, homeowners eagerly
used their growing equity to fund vacations, renovations, real-estate investments, and ever-growing college tuition bills.
The Boston College study estimates that in 2007, 41% of householders aged 60 to 69 had mortgages. About half of these folks had enough liquid assets to pay off their mortgages, so the study examined the options open to such households.
If you have a 5% mortgage and you pay the principal down, you get to keep the money you would have paid out in interest; the transaction is the equivalent of getting a guaranteed yield on your investment if there’s no prepayment penalty. There are few guaranteed investment yields: Treasury bonds (held to maturity) and FDIC-insured CDs come to mind. Ignoring taxes for the moment, given a choice between paying off a 5% mortgage and getting less than that for a sure investment return, paying off the mortgage is the better deal.
What if you don’t ignore taxes? Suppose your marginal tax rate is 25% and (this is key) that you’re able to itemize deductions. A 5% mortgage only costs you 3.75% (= 5% * (1-.25)), so you’d need a guaranteed after-tax return higher than that to justify keeping the mortgage and investing the money. Unfortunately, municipal bonds aren’t really “guaranteed,” so those don’t count. Any Treasury with a term shorter than 2 years is yielding less than 1%, and 30-year Treasuries are yielding a hair under 4.6%. You’re guaranteed to get a long-term Treasury’s yield only if you own the bond for its full duration – if you sell a 30-year Treasury after only 5 years, you may not get 4.6%.
Cutting to the chase, after looking at interest rate/mortgage rate history, the Center concluded that most retirees should pay off their mortgages if they have the cash, because they can’t get a better yield for their money than the effective yield of a payoff. The only exceptions to this conclusion, in their view, are households willing to invest in risky (i.e. non-guaranteed) investments using borrowed money. If you’re willing to take a chance, you could hang on to your mortgage and put your “excess” cash in the stock market, real estate securities, or pork belly futures. One of these might give you a higher yield than the return on paying off the mortgage. On the other hand, you could end up actually losing money – that’s what makes them risky assets.
In practice, most people entering retirement aren’t inclined to roll the dice and give up a sure return. So it’s simple – everyone nearing retirement with a mortgage and cash to spare should pay off the mortgage, right? Well, not necessarily.
The study notes that about 55% of households aged 60-69 with mortgages and excess assets could have paid off their mortgages without tapping their retirement assets. But the rest would have had to spend some of their qualified accounts to payoff their mortgages. If the only assets a retiree has are qualified assets, what happens if they have an emergency?
A retiree who consumes all of his liquid assets to pay off a mortgage has much less flexibility than one who doesn’t. If a roof or a furnace needs to be replaced, the ways to cover the cost could be limited: re-mortgaging the house (potentially difficult with limited income) or getting a reverse mortgage (with lots of up-front fees). The report’s analysis explicitly ignores liquidity considerations, but in practice this could be the major concern.
Some retirees would have sufficient liquidity to handle an unexpected expense even if they pay off their mortgages. But many would probably find that their only remaining resources are their retirement accounts. Most retirees have some source of income beyond their retirement savings: Social Security, a pension, or income from rental property. A retiree might be able to accelerate a mortgage payoff without consuming liquid funds, shortening the time to pay the loan off without excessively drawing down their assets. A decision to pay off a mortgage at retirement has to be made in light of liquidity, and the best course of action will vary depending on the specifics of one’s situation.
This post has been included in the 216th Edition of the Carnival of Personal Finance.