Paying off your mortgage before retirement may not be the best financial move.
Four key questions:
Can you afford to prepay your mortgage?
What will produce the greatest wealth?
When will you need your money?
How important is paying off debt to you emotionally?
Owning your home free and clear may sound awesome—no more checks to the bank, lower monthly expenses, the security and pride of knowing you own your house free and clear. In fact, for some people, paying off the mortgage may seem like a requirement before retirement.
But paying off a mortgage, particularly paying it down early, is a complex decision. Like most personal finance decisions, it's not just a math problem. There are emotional as well as financial factors to consider. What's right for one person might not be right for another.
What's right for you? Here are 4 questions to ask yourself to help decide.
1. Can you afford to prepay your mortgage?
Before you pay down your mortgage ahead of schedule, you need to make sure you aren't neglecting other important needs. For instance, if you have high interest credit cards, or higher interest short-term debt on a car, or a private student loan, you should look at paying off that debt before you consider paying off what may be a lower-interest-rate mortgage.
Also, if you have not taken full advantage of an IRA or 401(k), those savings options come with significant tax benefits, and maybe even an employer match. The tax benefits and match may make investing in these accounts more appealing than paying off low-interest rate debt, like a mortgage—particularly if you are concerned you won’t have enough funds for retirement.
2. What will produce the greatest wealth?
If your goal is to end up with as much money as possible—for instance, to leave a legacy for charity or your children, paying off your mortgage early may not make the most sense.
Financially speaking, paying off your mortgage is equivalent to a guaranteed return at your mortgage interest rate. So hypothetically, if you had $1,000 and used it to prepay a mortgage with a 3.5% interest rate, or invested it in a bond at 3.5%, the impact on your net worth would be the same either way.
Reality is a little more complex—you would likely have to pay taxes on the interest, dividends, or investments gains earned from a portfolio. Meanwhile, the interest you pay on a mortgage may be tax deductible, so the actual equivalent interest rate may be slightly different. While everyone has slightly different tax situations, the lost tax deduction should offset the tax on your investments. As a hypothetical example, assuming a 25% income tax rate, a bond that nominally pays 3.5% may return approximately 2.6% after tax. While prepaying your mortgage would provide you with 3.5% interest savings minus the benefit of a tax deduction, resulting in a savings of approximately the same 2.6%.
For an investor, this raises an interesting question: Can you earn a better return on an investment portfolio? Since 1926, the average annualized return for a balanced portfolio of 50% stocks, 40% bonds, and 10% cash, has been 7.9%. That’s far higher than most mortgages, even after accounting for taxes. For a growth portfolio (75% stocks, 20% bonds, 5% cash) the average annual return has been closer to 9%. Of course, past performance is not a guarantee of future results—the future return on an investment portfolio is uncertain. So your view of risk is important, as is your timeframe.
Let’s take a look at a hypothetical example. Say Joan is 20 years into a 30-year mortgage with an interest rate of 4.5%, an outstanding balance close to $150,000, and a monthly payment of $1,500 a month. She just finished paying off her daughter's student loans, and has an extra $500 a month of discretionary income.
If she prepays her mortgage by an additional $500 a month, she will end up saving roughly $11,000 in interest payments and pay off her loan about 3 years sooner. Saving on interest is great, but she won’t be able to claim the mortgage interest deduction on those payments that she avoided—that lost tax benefit offsets about $2,700 of savings. So in the end, she improves her financial situation by a little more than $8,200.
If she invests the $500 a month and she earns 8% a year over the same time period, she will end up with investment gains of about $14,400. After taxes, that would equal about $11,500, assuming an effective tax rate of 20%. The net effect: Compared to paying off her mortgage, investing improved her financial outcome by roughly $3,300, or roughly 40% more.
It is important to note that this hypothetical return roughly aligns with the historical performance of a balanced portfolio—but in the future actual returns could be lower, or higher. What’s more, a more conservative approach has historically earned a lower rate of return, so a risk-averse approach to investing makes the benefits of prepaying a mortgage more competitive relative to investing.