Should you retire with a mortgage or pay it off?

I see this more and more often — a new retiree, or someone thinking about retiring shortly, asks me to review their retirement plan. They want to know: "Will I have enough?" After getting to know them and learning about their goals and what is important to them, I begin by reviewing their balance sheet and notice the $200,000 mortgage at 3.75 percent under the liabilities column.

When I ask them about it, people are always proud of the low rate they locked in. The problem is that you still have to pay the loan off, and that means you have these big payments to make during your retirement years.

Today I make the case for paying off your house before you retire.

Older couple looking at paperwork
Pascal Broze | ONOKY | Getty Images

So is a low rate/low payment all that matters? Cash flow is king in retirement. So is a low payment important? Yes. But how about no payment? Of course, that is ideal.

The problem is that many people never pay off their mortgage. How could this be? Isn't the American dream to own your own house? Yes, but many Americans still don't own their house; the bank does.

People refinance their mortgage in an effort to always have the lowest possible payment. However, is the lowest payment the best option for reaching financial independence? My answer is a firm no. A common mistake is paying on a 30-year loan for five years, then refinancing to a new 30-year loan with a lower interest rate. Of course, the payment will be lower due to the lower rate, but also because of the smaller loan.

I have three major problems with this strategy:

  1. You just added five more years until the mortgage is paid off if you make the minimum payment.
  2. You probably rolled your closing costs and escrow costs into the principal of the loan, so your new loan is bigger than the loan you just paid off. The next month, the old mortgage company mails you a check for the escrow amount, but instead of sending that in to pay down your mortgage, you buy a new TV or pay down some credit card debt.
  3. Your new loan is front-loaded with interest. Just as you were making progress into your amortization schedule (five years in), you took a step back with a new, 30-year amortization schedule.

Here is how the front-loaded amortization schedule works:

Beginning loan amount: $200,000
Interest rate: 4 percent
Monthly payment: $955
Term: 360 months (30-year loan)
Total repayment: $343,739 ($200,000 [principal]; $143,739 [interest paid])

First-month payment
Toward principal: $288.16
Toward interest: $666.67

Second-month payment
Toward principal: $289.12
Toward interest: $665.71

As you can see, the interest is front-loaded, and it takes a significant amount of time to start gaining traction so more of your payment goes toward what really matters — paying off the loan, not just paying interest.

So you may be thinking that financial advisors always recommend investing your money rather than paying off your loan. After all, if your portfolio is earning 8 percent and your mortgage is only 4 percent, you always come out ahead, right?

Not necessarily. And definitely not in the "lost decade" we just experienced in the stock markets. Since mortgages are so heavily front-loaded with interest, I believe it is important to try and pay extra every month to shorten the term of the loan from 30 to 15 years (or less). Don't get me wrong, I do want to see you funding your 401(k) and Roth IRA. But I believe if we work toward both goals, growing assets and paying off liabilities, we can strengthen our balance sheet and have great cash flow in retirement.

Specifically, I suggest trying to pay off the mortgage prior to retirement. But maybe your accountant tells you not to pay off the mortgage because you need the tax deduction. Have you thought this one through? If you pay $1,000 in interest, you may save $250 in taxes if you are in the 25 percent marginal tax bracket. It is nice to have the deduction of $250, but wouldn't you rather have the original $1,000 instead? Please do not keep your mortgage simply for the tax write-off. The bottom line is, you're still paying the interest.

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The rate on your mortgage is the rate if you pay every month for the full term. If you repay early, the rate is actually less, because you pay less interest. If you continuously refinance, each new mortgage is front-loaded, and that doesn't even take into account closing costs. Your rate is effectively higher than the rate you are always refinancing to get.

How about retirees with a new, 30-year mortgage? If you are getting a new mortgage, at this point paying extra on your mortgage may not be in your best interest, as it may require excess withdrawals from your portfolio.

Since cash flow is king in retirement, our objective is to minimize the outlay toward interest, so I am not recommending a 15-year payment schedule like in the example previously. A 30-year mortgage may be the best option in order to preserve your nest egg. Unfortunately, the real power to make a difference is in the years leading up to retirement.

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I strongly recommend everyone have access to a home equity line of credit, whether you ever need it or not. It is nice to have access to large amounts of cash in an emergency.

Here's the bottom line: Going against conventional financial planner wisdom, I recommend my clients do make the extra payments on their mortgage in an effort to have it paid off before retirement. Consider treating your 30-year mortgage as if it were a 15-year. Consider treating your 15-year as if it were a 10-year.

My personal strategy is to pay down the mortgage while simultaneously adding to your nest egg. Consider it an equal emphasis on growing assets and paying down liabilities for your future.

(Editor's note: This guest column originally appeared on Investopedia.)

— By Nicholas Hopwood, president of Peak Wealth Management