Should You Pay Off Your Mortgage?

Good Morning Relaxing Retirement Subscriber,

One of the questions I receive all the time, especially from new Relaxing Retirement members, is “should we pay off our mortgage”?

That’s a really good question which has no clear cut answer.

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 given your unique set of circumstances.

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 has 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 $225,000, do you have $225,000 readily available to use?

You’d be amazed at how many ask this question when they don’t have the $225,000 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 $225,000 to pay off the mortgage, you’d have to withdraw approximately $315,000,000 from your IRA.  After paying roughly $90,000 in taxes, you’d have your $225,000 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 is 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 going to be 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, i.e. you have a fixed rate 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 $225,000 and your mortgage interest rate is 4%, the question is “can you earn more than 4% per year with the $225,000 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 $225,000 in the bank CD earning 6% or $13,500, and continue making mortgage payments at 4% ($8,000 per year cost 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 fixed rate 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, especially over shorter durations.  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, and I emphasize the word “potentially” here given the new tax law in place now, 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 $750,000 if your mortgage originated after December 15, 2017.  If your mortgage began prior to that, interest on up to $1 million is deductible.

Second, it’s only valuable to you if you are itemizing deductions on Schedule A.  Under the new tax law, couples under age 65 are given a Standard Deduction of $24,400 automatically in 2019.  Once you’ve reached age 65, that goes up to $27,000.

What this means is that if your itemized deductions, including your mortgage interest, fall below $24,400 (or $27,000 for those age 65 and over), there is no added tax benefit to keeping an existing mortgage.

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 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 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 on my next Retirement Coach Strategy of the Week.

Stay tuned!

Committed To Your Relaxing Retirement,

Jack Phelps
The Retirement Coach

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(The content of this letter does not constitute a tax opinion. Always consult with a competent tax professional service provider for advice on tax matters specific to your situation.)