One of the questions I receive all the time, predominantly from new Relaxing Retirement members, is “should we pay off our existing mortgage”?
That’s a really good question which has no cut and dried answer to it. My answer always involves asking a lot of questions, so I thought I’d share those with you today in the hope of helping you arrive at a good answer in your unique situation.
To begin with, I find that folks ask this question for many different reasons.
One of them stems from the dogmatic belief that you should never have a mortgage in retirement! It was drilled into their minds growing up and it’s never left.
That may actually be a very good belief to carry around in the majority of situations. However, it’s certainly not an absolute as you’re about to discover.
Let’s take a look at some factors you’ll want to consider when evaluating if you should pay off an existing mortgage you have.
Factors to Consider
Factor #1: Do you have enough liquid money to pay off the mortgage? In other words, for simplicity sake, if your mortgage balance is $200,000, do you have $200,000 readily available to use?
You’d be amazed at how many ask this question when they don’t have the $200,000 readily available.
By readily available, I mean do you have to pay taxes or penalties to get at the money? For example, is all your money tied up in IRAs and/or tax deferred annuities?
If so, there’s a tax bill to pay first in order to free up the necessary money. In the example I gave, in order to free up the $200,000 to pay off the mortgage, you’d have to withdraw approximately $275,000 from your IRA. After paying roughly $75,000 in taxes, you’d have your $200,000 with which to pay off the mortgage.
For obvious reasons, this pretty much answers the question for you if all your funds are tied up in IRAs.
Factor #2: What’s the interest rate on the mortgage, and how long will that rate remain? In other words, is it an Adjustable Rate Mortgage (ARM) where the rate will increase after a certain period of time?
Let’s start with the second part of that question. If you have an ARM, the rate will adjust after a certain period of time. If that’s in a year or two, you have to make some serious assumptions about what the interest rate will be.
For the purposes of this discussion, let’s assume you know what the rate will be throughout the remaining life of the loan.
What this all comes down to is can you “earn” a higher rate of return with the funds you have set aside than the bank is charging you in interest on the loan.
For example, if your outstanding balance again is $200,000 and your mortgage interest rate is 4%, the question is “can you earn more than 4% with the $200,000 you have on the sidelines that you would use to pay off the loan”?
If CD rates were much higher than they are today, 6% for example, this would be a no-brainer. You’d keep your $200,000 in the bank CD earning 6% or $12,000, and continue making mortgage payments at 4% ($8,000 per year and declining).
To use a fancy term, this is a form of arbitrage and it’s used to make millions of dollars in the marketplace every day.
The challenge comes, however, in times like these where you can’t earn 6% on a CD. You may very well be able to earn more than 4% in a diversified portfolio in the long run. (I sure hope you can) However, there’s no guarantee. So, in essence, you’re taking a gamble one way or the other.
It then comes down to how long you have to play the game, and how strongly you feel that you can “out-earn” the mortgage interest rate over that period of time.
Factor #3: The third factor is tax deductibility. Because mortgage interest is potentially deductible, carrying a mortgage has another benefit.
The question is whether the mortgage interest is deductible for you. Mortgage interest is only deductible for mortgage amounts lower than $1 million.
Second, it’s only valuable to you if you are itemizing deductions on Schedule A. If you have virtually no deductions on your tax return, and you currently file using a Standard Deduction, the interest deduction from your mortgage is not helping you (unless the interest from the mortgage throws you over the top into using Itemized).
Another small factor, but still important, is maintaining some liquidity. If you will have to use up all of your liquid funds to pay off your mortgage, you may want to give some thought to that.
The final Factor stands alone because it’s something I’ve discussed many times with members.
I can make all of the financial and economic arguments in favor or against keeping an existing mortgage (like in the examples above). However, at the end of the day, if you have knots in your stomach, or you just can’t stand making mortgage payments, or if being “debt free” has been your lifelong goal and you have the means to pay off your mortgage, just go ahead and pay it off.
I’ve actually suggested this in many situations. I’m a big believer that you have to be able to sleep at night.
Finally, you’ll note that I’ve reserved my comments for evaluating paying off an existing mortgage. I have some thoughts about entering into a new mortgage in retirement which I’ll share with you in the next issue.