Paying Off Home Mortgage Smart For Most Retirees
In a recent column, syndicated columnist Scott Burns talked about the risks of making mortgage payments after retirement. But this left some Americans wondering: What is the alternative?
If one has a mortgage loan on the day of retirement and one pays it off, then 100 percent of that capital is now tied up in the house. So it has zero chance of earning anything. Is this analyst saying to pay off all home loans upon retirement, or sell the home and become a renter?
The answer depends on your situation.
It also depends on your income sources at retirement. You can get an idea of how the factors interrelate by considering these three examples.
THE ABUNDANT NET WORTHS: People retired with a large pension, $1 million in taxable account assets, $500,000 in tax-deferred account assets, and a home mortgage balance of $200,000 at 5.5 percent. They live in an area with high real estate taxes and a state income tax.
Their corporate pension alone is high enough that all of their Social Security benefits have been taxed well before they count any income from their retirement savings. As a result, withdrawals from IRA accounts to support mortgage payments won’t cause any additional Social Security benefits to be taxed.
In addition, their property tax, state income taxes, and charitable contributions put their itemized deductions above the standard deduction. So every dollar of interest deduction will reduce their income tax bill.
For such a couple, a home mortgage amounts to modest leverage on their personal balance sheet. They can support the mortgage without any squeeze on their personal spending. For them, mortgages can be a good thing — but they are they exceptions.
THE PRUDENTS: People retired without a company pension. They have $200,000 in taxable account assets, $500,000 in tax-deferred account assets, and a $50,000 balance on their mortgages. They elect to pay off the mortgage because much of the payment is principal, not interest.
Also, most of the interest won’t be deductible because their itemized deductions won’t be far over the standard deduction. Worse, withdrawals from their tax-deferred accounts will cause additional Social Security benefits to be taxed.
In addition, reducing their taxable account assets from $200,000 to $150,000 won’t materially reduce their financial flexibility.
While the money they take from their taxable account to pay off their first mortgage might earn more than the 5.5 percent interest they are paying, they know that getting a return of 5.5 percent is neither easy nor without risk.
THE HOUSE-POORS: People retired without a corporate pension, with $100,000 in taxable account assets, $200,000 in tax-deferred account assets, and a $100,000 balance on their mortgage loans.
Fortunately, their house is worth $400,000. If they pay off the mortgage from their taxable accounts, they will have no flexible financial assets for retirement. Every dollar taken from remaining tax-deferred financial assets will add a dollar to their taxable income. Worse, it may trigger taxes on some Social Security benefits.
Basically, having a mortgage on their house will commit them to a level of expenses that is likely to force them to make excessive withdrawals from their financial assets. It will increase the odds that they will run out of money long before they die.
The best thing the Housepoors can do is downsize.
That would allow them to put their $300,000 of equity to better use. By moving to a smaller $200,000 house, they can not only pay cash, but they can increase assets by $100,000 overall.
That way, they won’t have a mortgage payment, their home operating expenses will decrease, and their investment income will increase.
Overall, it’s a better balance for retirement.
For most approaching retirement, paying off a mortgage is the surest way to reduce cash flow requirements and bag an effective yield higher than most fixed-income mutual funds without the risk. To put the yield issue in perspective, most home mortgage rates paid by Americans average around 5-6 percent.
According to Morningstar mutual fund database, as of the end of September, there were some 3,700 fixed-income mutual funds with an average 12-month yield of 4.69 percent. Give it some thought.