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Mortgage or No Mortgage? That is the question…

By: Investor Solutions

By: Investor Solutions, Inc.

Should you or should you not pay off your mortgage at retirement? Sounds like a no-brainer: pay it off! Living without debt at retirement certainly seems like a comforting thought: one less worry to keep you up at night.

Unfortunately, deciding to retire debt-free or not is not such an easy task. Just like any other financial decision, many factors come into play. Here are some things you want to consider:

Diminished Cash Reserve

Unless Uncle Bob has just passed and has left you a substantial amount of cash, paying-off your mortgage entails tapping into your savings. A large portion of your funds will be reallocated to an illiquid asset. If you suddenly need that money to pay for unforeseen medical bills or any other emergency, you will be forced to sell your house. You could tap into a home equity line of credit, but then you’re back to square one. Unless you have enough liquid funds for the unexpected, it does not make sense to pay off your mortgage.

The cost of diverting investment money into your home Here’s a simple example to illustrate this point.

Let’s say Joe purchased a home at a 6.5% rate on a 30-yr mortgage. His income tax rate is 25%. The real cost of borrowing (assuming interest is deductible) is 4.8%. If Joe pays off his mortgage, he will save 4.8% in interest expenses.

Instead, he decides to place the cash in an investment portfolio. Joe is recently retired. He has a moderately aggressive investment portfolio predominantly allocated to risky investment vehicles such as stocks. He has a globally diversified portfolio with say, 60% in stocks and 40% in bonds that has averaged a 10.78% gain since 1988, according to Ibbotson & Associates. This translates into an after-tax return of 8% (assuming tax rate of 25%[1]). His investment opportunity is greater than his cost of borrowing. Advice: keep the mortgage debt.

On the other hand, if Joe lacks the strength to stomach the market’s up and downs, then his alternatives are bonds or CDs. His probability of earning a rate of return above his cost of borrowing is greatly diminished, if not zero. Advice: get rid of the mortgage.

Tax-free Compounding: This is a particularly vital consideration when the funds used to pay off the mortgage are tax-deferred in nature. The spread between the cost of borrowing and portfolio returns widens.

Let’s talk dollars: At retirement Joe has a $100,000 outstanding balance, 10 years left on his 30 year mortgage at 6.5%. Assuming again that interest is deductible, the real cost of borrowing is 4.8%. If he decides to pay off his mortgage debt, he saves approximately $36,250 in interest. If instead he leaves the $100,000 in a tax-deferred account, with the magic of compounding, in ten years his cash will be worth $278,365.

Market Risk: There is always another side to the story. So far we talked about the two types of risk of paying off a mortgage at retirement: the loss of potential return in alternative investments and the loss of liquidity. Here’s another one to consider.

Opting to invest the cash instead of paying off your mortgage exposes you to market risk (your investment value might fall). The average annual rate of return aforementioned is not guaranteed; instead it is based on historical market performance. Markets are unpredictable and cyclical in nature; this means that for some unlucky retirees their retirement period will coincide with an extended period of depressed market performance. With no other sources of income other than your investments, they run the risk of not meeting their mortgage payments and any other expenses for that matter.

It’s the same as having your mortgage paid off and deciding one day to take out a home equity line to invest in the market. Would you do that?

Your income tax rate during retirement If you are in a high income tax bracket during retirement the interest deduction can be rewarding. As you know, in the first years of a mortgage payment, the monthly payment is mostly interest rather than capital. As you pay down the principal, the interest portion of the payment grows ever smaller. For most of us, this interest is tax deductible. You should be advised that although qualified housing interest is deductible for AMT purposes, interest paid on a home equity line is not.

From a strictly emotional standpoint, the decision to retire mortgage-free is quick and simple: just do it. However, there are monetary factors that come into play in this decision, and if not properly analyzed, can be damaging to the retiree. Should you pay off your mortgage at retirement? The answer is not as simple as a yes or a no (it is worth noting, that as a financial advisor, I would be serving my interest by recommending not paying-off the mortgage). Everybody’s situation is different. Investing time into the process (rather than making snap judgement) as well as seeking professional advice is probably best when making such a decision.
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[1] Rate used for illustration purposes. Tax rate will vary depending upon asset type (long-term or short-term capital gains), type of account and/or marginal income tax rate.