Should you pay off that mortgage before retirement?

  • For many, owning their home outright provides a valuable sense of security — legitimate or not.
  • Yet paying off your mortgage may not always be the best strategy.
  • The decision depends on a number of factors, such as risk tolerance, additional assets, cash-flow needs and goals.
Carrying or paying off a mortgage in retirement depends on people's individual circumstances.
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Carrying or paying off a mortgage in retirement depends on people's individual circumstances.

Should you pay off that mortgage before heading into retirement?

For the average American, owning a home outright is a major objective in life from both a financial and a psychological perspective. However, it may not always be the best strategy.

"The question comes up all the time with clients and for most preretirees — the goal is to pay off the mortgage," said Lazetta Rainey Braxton, a certified financial planner who serves a large number of middle-income clients.

"It's a liquidity issue," added Braxton, founder and CEO of advisory firm Financial Fountains. "If most of a person's assets are in their home, they may be better off to keep paying it on a monthly basis."

As with virtually every financial consideration, carrying or paying off a mortgage in retirement depends on a person's circumstances. What are the terms of the mortgage? What are the other assets people have? What are their goals and cash-flow needs in retirement? What is their tolerance for risk?

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Before addressing the issue of a potential mortgage payoff, Braxton advises people first determine whether they can and want to stay in the home during their retirement. Is the house located where they want to live — near their children, perhaps — and is it sustainable? Or, should they be downsizing their home in retirement? When that question is satisfied, then consider the mortgage.

There are no right and wrong answers as to whether you should pay off your mortgage with a lump-sum payment before you retire. Here are five key things to consider:

How do you feel about risk? Leaving aside emotion, the question of whether to pay off a mortgage comes down to whether the after-tax return you expect to earn on the money exceeds the after-tax cost of the mortgage payments.

While many current mortgages sport interest rates below 4 percent, that is still almost twice the not entirely risk-free rate of return on the 10-year Treasury bond. If you're willing to take on more risk— likely in the form of stocks — carrying the mortgage could make sense. Keep in mind, however, that markets don't always cooperate. "Unless you have enough money to handle sequence-of-return risk, be very careful," said Braxton.

Where are the assets? If you're a conservative person with most of your assets in bank accounts and certificates of deposit, paying off the mortgage is a no-brainer. You are paying out several times more in mortgage interest than you're earning in the bank account. If the assets are in a taxable investment portfolio, the decision depends on whether you are earning more on the investments than you're paying out on the mortgage and if you want to continue taking that risk.

Do not pay off mortgages with lump-sum distributions from tax-deferred 401(k) plans or IRAs. There is a 10 percent penalty for those younger than 59½ years old; the entire withdrawn amount is taxable as income; and your marginal tax rate will likely increase if the mortgage balance is substantial.

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"When I show clients that they will need to withdraw $130,000 from their IRA to pay off a $100,000 mortgage, it's pretty sobering," said Rick Kahler, president of Kahler Financial Group.

The tax angle. The Tax Cuts and Jobs Act marginally reduces the tax advantage of having a mortgage — cutting the interest deduction to payments on the first $750,000 in loan balance, as opposed to $1 million.

For most people who itemize their tax deductions, however, mortgage interest payments are still fully deductible, meaning the after-tax cost of those payments could be substantially less. An individual in the 25 percent tax bracket with a mortgage carrying a 4 percent interest rate is paying an effective after-tax rate of 3 percent.

Because the new tax bill nearly doubled the standard deduction to $12,000 for individuals, mortgage interest payments, along with other deductible items such as medical costs and charitable donations, need to exceed that amount to make itemizing worthwhile. If you're in a lower tax bracket, the benefit of keeping a mortgage is also less. Generally speaking, the higher your marginal tax bracket and the larger your mortgage interest payments (and deductions), the greater the tax benefit of keeping the mortgage.

Are you a saver? Retirement carries risks — increased medical costs being the most obvious — and the greater risk requires that people maintain a financial cushion to deal with potential outcomes. For people with large amounts of assets, the question of paying off a mortgage may have little impact on their financial security. For the rest of us, however, it has major consequences.

"I have clients who understand the logic of keeping a mortgage in retirement but who say they'll sleep better at night if it's paid off. I don't argue with those clients." -Rick Kahler, president of Kahler Financial Group

In most cases, those who use their financial assets to pay off mortgages will have to continue contributing to their investment portfolios to make up for the withdrawal. That's not easy.

"There are a lot of people who have difficulty saving," said Kahler. Monthly mortgage payments are typically baked into people's budgets. The same discipline may be more difficult to summon when you need to beef up your diminished investment portfolio. "If people need their former monthly mortgage payments to be invested and not spent, I'll recommend not paying off the mortgage," said Kahler.

How important is it to you? For many people, owning their home outright and not having to make further payments on it in retirement gives them a very valuable sense of security — legitimate or not. Whatever the numbers underlying your financial situation, if continuing to carry a mortgage will be a big source of stress in retirement, pay it off.

"I have clients who understand the logic of keeping a mortgage in retirement but who say they'll sleep better at night if it's paid off," said Kahler. "I don't argue with those clients."

— By Andrew Osterland, special to CNBC.com

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