Should you pay off your mortgage before you retire? There's no clear-cut answer, as the strategy depends on the client's tax situation, asset and income levels, and attitudes toward debt and investment. Financial advisors discuss the pros and cons.
Retiring a mortgage reduces stress, provides peace of mind, increases cash flow and provides a significant equity cushion that can be tapped for a true emergency, such as nursing-home care, said Patrick Stark, certified financial planner and director of financial planning at R.S. Crum.
"While some people may claim that they can make 8 [percent] to 10 percent in the stock market while the mortgage may cost them only 3 [percent] to 4 percent, tread carefully," he said. "While long-term historical averages can be that high, as investors we earn our returns day by day, not in 50-year chunks.
"The market can stay irrational longer than you can stay solvent," said Stark.
In some cases, it is more tax-efficient to pay off the mortgage, said Dana Anspach, CFP and CEO of Sensible Money.
She warns against using taxable withdrawals from individual retirement accounts and 401(k) plans to make mortgage payments. Using the example of a $1,500 monthly mortgage payment, she points out that an individual would need to withdraw more than $2,000 per month in order to cover both taxes and mortgage.
"That additional withdrawal could bump you into a higher tax rate and could even cause more of your Social Security to be taxable," Anspach added. "These additional taxes are likely to be far more than any potential tax deduction you would have received on the mortgage interest."
Leon LaBrecque, JD, CFP, and managing partner and CEO of LJPR Financial Advisors, offered several financial and behavioral benefits to retiring a mortgage early:
- Having the mortgage paid off lowers your required cash flow and changes your potential asset allocation, allowing you to be a little more aggressive.
- Getting rid of an anti-asset — a liability — is like making an investment. For every dollar you pay on your principal, you're making the interest rate back because you're not paying it to someone else. For example, paying off, or down, a 4 percent mortgage makes you 4 percent with no management fee.
- Paying off your mortgage is 100 percent safe. There is zero market risk.
- Out of sight, out of mind. You aren't tempted to spend that mortgage money on other things, while you are reducing that debt.
LaBrecque also pointed out some cons to paying off one's mortgage before retirement.
- If interest rates rise, you could be paying off your 4 percent mortgage, for example, when you could get 5 percent in the bank.
- With pretax 401(k) contributions, all of your savings are tax-deductible. In contrast, using those funds to make mortgage repayments instead results in only a partial tax write-off.
- "Wounding" a mortgage, or paying it partly off, helps but doesn't change your cash flow. It is better to try to kill the mortgage and pay it off completely by retirement.
One of the top cons to paying off a mortgage early, said Stark of R.S. Crum, is not using the inflation-hedging ability offered by a fixed rate mortgage, where the bank assumes all of the risk.
"For those with sufficient assets to weather stock market volatility, using a mortgage to free up assets provides leverage to capture the higher returns that the equity markets have historically provided over the long run," he said.
There are a number of options for optimizing assets not used to retire the mortgage, said Blake Street, CFP, founding partner and CIO for Warren Street Wealth.
"For those with sufficient assets to weather stock market volatility, using a mortgage to free up assets provides leverage to capture the higher returns that the equity markets have historically provided over the long run."
"If you're more of a risk-taker and value your mortgage-interest deduction, you may be more apt to take your excess cash flow and invest it in tax-advantaged savings vehicles," he said.
For those already maxing out their 401(k) plans or IRAs, Street suggests contributing after-tax dollars above the contribution limits of their plans, if allowed. "If all of the above are off the table, you might start to build up a more liquid investment account and invest in tax-efficient assets such as municipal bonds or low-turnover mutual funds or ETFs," he said.
Michael McKevitt, CFP with Guillaume & Freckman, cautioned that using assets to pay off a mortgage at the same time reduces the amount to which one has access.
"If you were needing a large amount of assets for an unforeseen need, you've now got equity in your home and not assets," he said. "When you are retired, it can be very difficult to qualify for a loan to get the equity out of your home. That is an important risk to understand."
— By Deborah Nason, special to CNBC.com
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