Today we’ll address a question we commonly receive from our clients — “should I pay off my mortgage early?” This question comes up with clients in many stages of life, but today we’ll look at it specifically for individuals nearing retirement. It is at this stage that most of our clients come to us with a bit of a nest egg built up, and they are wondering if they should cut into that to pay off their mortgage.
The easy answer would be to say of COURSE it is beneficial to pay off your mortgage. Who enjoys mortgage payments? To say you enjoy paying a mortgage is like saying you enjoy getting a paper cut, or going to the dentist, or eating meatloaf (that last one may just be me, but you get the point!).
The answer, unfortunately, isn’t that easy.
You see, the question is less about whether or not it is beneficial and more about opportunity costs. Is it more beneficial to use our nest egg to pay off the mortgage early, or would that money be better off invested in the market? To that point, perhaps the better question is: “What am I sacrificing by using my funds to pay off the mortgage early, and how does this fit within my overall retirement plan?”
When it may not be a good idea
Tapping into retirement accounts such as your IRA or 401(k) to pay off a mortgage is typically not a good idea. The tax and penalties that would need to be paid to liquidate some of your retirement accounts could be hefty. Remember that any money removed from a retirement account prior to age 59 and 1/2 are typically subject to a penalty. Also, depending on the account, the IRS might recognize a withdrawal as income and thus push you into a higher tax bracket for the year you remove the funds from the account. We don't advise this in most cases.
When it may be a good idea
We encourage our clients to pay off their mortgage early in several scenarios. First, remember opportunity costs. If you have a mortgage with a high interest rate, you are paying the bank quite a bit of interest every month which could be saved and invested if the mortgage was paid off. While removing money from an investment account to pay off the mortgage would reduce potential returns in the market, remember what you would save in terms of bank interest. In addition, real estate is historically an appreciating asset so your house can be viewed as an investment providing returns as well.
There is also a psychological benefit to paying off the mortgage early. Regardless of how the numbers play out, if you talk to someone who has paid off their mortgage early, you will almost universally find they will tell you it was the best decision they ever made. This is based on a feeling of financial security and relief of stress. There is no doubt that paying off the largest debt, for most families, is something you can’t put a price tag on.
Final thoughts
Paying off your mortgage is basically a transfer of assets. It doesn’t create or reduce wealth for you in and of itself. You are essentially reducing your cash / investment assets and increasing your home equity by the same amount. In other words, if you need access to that cash later on, it should be there either in the form of taking out another mortgage or by selling the home. The risks you are taking are having less liquidity and subjecting your asset to swings in the housing market. You are taking on this risk for the benefit of saving on future interest costs along with the psychological benefits and an ease on your monthly cash flow.
The bottom line is, what does your retirement plan look like? Where will your income come from? How will you cover your monthly expenses in your new lifestyle? Where do you plan to live and what do you plan to do? These are the first questions to answer, which can provide insight for the more detailed questions such as whether or not you should pay off your mortgage early.
Remember that a retirement plan must be customized on an individual basis. There are so many factors to consider, far more than we could cover in a blog post. A financial advisor can help put all of the pieces together for you and outline a detailed plan to help you achieve the retirement life you are envisioning!