Should You Pay Off Your Mortgage Before Retirement?

David K. MacLeod, CFP®, CFA®

Whether you’ve lived in Orange County for two years or 25 years, it’s likely you still have mortgage debt. 

That’s because our beautiful county, home to year-round golf and the magic of Disneyland, boasts a median home value of $720,000—more than 8x median household income.

This isn’t a new thing. For all the wonderful amenities Orange County has to offer, housing prices here have been significantly more expensive than the national average for decades. So you probably took on a pretty large mortgage when you purchased your home.

Perhaps you’re starting to see retirement and Social Security checks on the horizon. If you still have a mortgage, you may be wondering: “Should I plan on paying off this mortgage before retirement?”

The short answer is, yes. Although individual circumstances will vary, we generally advise being debt-free in retirement. That means your credit cards are paid off, cars are owned free and clear, and you are mortgage-free.

That said, before you decide whether to pay off your mortgage before retirement, there are some things to consider.

Income Tax Deduction

People often desire to keep their mortgage in retirement for the tax benefit. But that benefit is going away for a lot of taxpayers under the Trump tax plan passed in December 2017.

Mortgage interest is still deductible on Schedule A as an itemized deduction. For mortgages that were in place prior to December 15, 2017, interest is deductible up to principal balances of $1,000,000. For mortgages taken out since then, this limit has been lowered to $750,000.

But thanks to the recently increased standard deduction, it’s possible you won’t itemize deductions anymore starting with your 2018 tax return. If you claim the standard deduction, in effect you lose the tax benefit of homeownership.

For example, let’s consider Jane and John Smith, married 66-year-old Fullerton homeowners with a $200,000 mortgage. Assume that in 2018, the Smiths paid $10,000 state and local taxes, $8,000 of mortgage interest, and donated $6,000 to charities. They have no other potential itemized deductions.

In 2018, the Smiths won’t claim any of these deductions because their standard deduction of $26,600 (up from $15,200 in 2017) is greater than the $24,000 they could have claimed by itemizing.

The Smiths aren’t alone. The Tax Foundation expects that 90% of U.S. taxpayers will claim the standard deduction this year and get no tax break for homeownership.

Even if you do still itemize your mortgage interest, the tax bill is not cut dollar-for-dollar (as a tax credit would be). Your tax break would be based on your marginal tax rate.

House Rich, Cash Poor 

If paying off your mortgage would mean depleting your emergency fund or emptying retirement accounts, we strongly advise reconsidering. You could face steep taxes and penalties by withdrawing from retirement savings. Emptying your emergency fund would make you more vulnerable when the rainy days come.

Investment Return vs. Mortgage Rate

Thanks to decades of steadily declining interest rates and the heavy involvement of government-sponsored entities Fannie Mae and Freddie Mac in the U.S. mortgage market, 30-year fixed-rate mortgage rates are still historically low.

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If you can earn more than your mortgage by investing elsewhere, why wouldn’t you? While you’re working and contributing to an employer retirement plan, the tax savings from plan contributions make investing more attractive than paying down a mortgage. But in retirement, risk capacity is typically lower.

Another way of looking at this question is to consider what guaranteed return can be earned compared with the guaranteed savings of your mortgage rate. For example, if you have a mortgage rate of 4% and if Treasury bonds yield 3%, then you would have a higher guaranteed “return” by making additional payments toward your mortgage.

Freedom!

Numbers aside, the psychological benefit of being mortgage-free is significant. Clients who pay off their mortgage by retirement often report feeling free. Of course, there are plenty of homeownership expenses (property taxes, maintenance, insurance) that don’t go away even after the mortgage is paid off. But not having to make a payment to the bank every month can be a real weight off your shoulders.

Too Much House?

As retirement approaches, it’s a good time to re-evaluate whether your current home is right for you in the next phase of life. Often, Orange County retirees live in homes that are a lot larger than they need to live comfortably—especially after the kids move out. One way of eliminating your mortgage is to downsize and pay cash for your new home (smaller local house or out-of-state to somewhere like Boise, Idaho).

Sometimes people think of their primary residence as an investment, but we disagree. It doesn’t generate cash flow, and you always need somewhere to live. Economist Robert Shiller’s research has shown that over the past 100 years, U.S. home values have barely kept up with inflation, underperforming other asset classes such as stocks and bonds.

This doesn’t mean homeownership is unattractive—it absolutely is for other reasons. But it does make a good argument for limiting the value of your house as a percentage of your personal net worth and diversifying into asset classes that have higher expected returns.

Conclusion

It’s a worthy goal to become debt-free before retirement. But consider the points discussed in this article before deciding. If you decide you want to pay off your mortgage before retirement, we suggest making additional monthly mortgage principal payments to reach your goal.

Schedule a 15-minute discovery call with a fee-only financial advisor to discuss your personal situation.