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?
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.