Should you pay off your mortgage before retirement?

One of my long time clients paid off his mortgage early in his retirement.

But, when we met earlier this year and I congratulated him on this accomplishment, he told me that it didn’t feel as good as he was expecting.

As many of you will likely agree, becoming debt free is one of the most popular goals in retirement planning.

As our clients get closer to retirement, it’s often one of the first things they tell me they want to accomplish.

The way I see it, the psychological benefit is the main reason people love the idea.

But a mortgage is a really interesting topic, because unlike most other debts, it’s usually connected to an appreciating asset (i.e. your house).

Most of our clients, and specifically those who refinanced during the pandemic, have very reasonable interest rates on their mortgages.

I understand this is different if you bought your house over the past couple of years.

The ideas I’m about to share will still apply to you, just to a lesser degree.

So, before you make the decision to speed up your mortgage payoff, here are a few things to consider.

Refinanced during the pandemic?

If you refinanced your mortgage during the historic lows of 2020 and 2021, there’s a good chance you locked in an interest rate below 4%.

Compare that to the 6% we typically use in our financial planning projections, including for retirement planning purposes.

To put it simply, if your mortgage rate is below 6%, I would lean toward investing your extra cash instead of using it to pay off your mortgage faster.

Here’s a simple example. Let’s say you have an extra $100,000 and a 3.5% mortgage.

(Isn’t that a nice situation to be in?)

If you put that $100,000 toward your mortgage, it effectively earns you 3.5% a year in interest you no longer pay. Over 10 years, that grows to about $141,000.

If you invest it instead and it earns 6% a year, it grows to about $179,000.

That’s a difference of roughly $38,000, before taxes.

And the invested money stays much easier to access if you ever need it.

Better places for your extra cash

Are you fully maximizing your retirement account contributions?

Beyond that, are you building enough of a cushion in your brokerage or taxable accounts to complement your retirement savings?

As many of you know, pre-tax retirement contributions provide an immediate benefit.

You save on taxes in the year you contribute and your money keeps growing over time.

And it never hurts to have an extra cushion in your brokerage account just in case something comes up and you don’t want to dip into your retirement funds (and pay taxes on the withdrawal).

Assuming the funds are invested with at least some growth in mind, projecting a return of 6% or higher in the long run is reasonable and frequently beats your mortgage rate.

Mortgage interest deduction

For those of you who itemize deductions on your tax return, keeping a mortgage can lower your tax bill.

This has actually become more relevant recently.

With the state and local tax (SALT) deduction limit now at around $40,000, more people are itemizing again.

And once you itemize, your mortgage interest becomes a real tax benefit.

Keep in mind that the deduction only covers interest on up to $750,000 of mortgage debt and only on your main home and one second home.

Paying off the balance completely eliminates this potential deduction.

And just in case this point isn’t clear, the value of your home, and its potential appreciation, doesn’t depend on having a mortgage.

In the final stretch?

Timing on the loan matters as well.

If you only have five or six years left on your loan, you have already paid most of the interest.

At this stage, the vast majority of your monthly payment goes toward principal.

Paying it off faster at this point saves very little in interest.

Think of it this way. Making extra mortgage payments now is like moving money from one pocket to another.

The only problem is that your real estate “pocket” is much harder to access than your investment portfolio.

A more realistic result

Please remember that paying off a mortgage only eliminates the principal and interest part of your housing costs.

You will still need to pay property taxes and home insurance.

In high cost areas such as Maryland, Washington DC or California, these can be a significant portion of your monthly expenses.

This is exactly what surprised the client I mentioned earlier in this newsletter.

His monthly expenses changed much less than he expected after the mortgage was gone…

What does this mean for you?

There is absolutely a mental benefit to paying off your mortgage. I get it.

But the financial benefits are not always as significant as people expect, especially if your interest rate is below 6%.

Now, if your rate is over 6%, which isn’t uncommon at all, then paying it down faster is worth considering.

It’s not a one size fits all answer, so if you’re unsure about your situation, please feel free to reach out and we can talk it through.

My main goal here is to make you aware that paying off your mortgage early is not always the no-brainer some people make it out to be.