If you’re approaching retirement, heading into the next chapter of your life with no more mortgage payments seems very appealing. After all, you’ve been working hard to make payments on what is likely to have been your largest monthly expense for the last 20 or 30 years.
It may feel like a significant – and maybe even emotional – life event, and it’s definitely a huge accomplishment. But does it always make sense to pay off your mortgage before you retire?
You could consider paying off your mortgage before retirement only if you have little to no other debt and have saved enough to cover emergencies for six to 24 months and to retire comfortably or, on the other end of the spectrum, you are on a limited income and really need to reduce your monthly expenses.
If you choose to take a lump sum out of a retirement savings account, it should be from a taxable account rather than a tax-deferred account like a 401(k) or an IRA. Those withdrawals could carry penalties and be taxed as ordinary income, which could get very expensive and offset any money you’re saving on your mortgage.
In addition, it may make sense to pay off your mortgage before you retire if the interest rate on the mortgage is higher than the rate of returns you expect from your investments. If, for example, your mortgage rate is 5% and your investments are earning you 4%, you may wish to clear those payments off the table. But bear in mind you then may not be able to take a deduction for mortgage interest. Depending on your circumstances, it may make more sense to get another, less expensive mortgage or refinance if lower interest rates are available.
Bottom line? Be sure to talk to a financial advisor before making any decisions.
This may surprise you, but typically the answer to “Should I pay off my mortgage before I retire?” is no, in most situations. Let’s look at some of the compelling reasons not to pay off your mortgage.
It increases your cash reserves and liquidity:
When you pay off a mortgage early, you are handing over potentially tens of thousands of dollars to your lender and you lose access to that cash and liquidity. The only way to get it back would be to sell the house – or get another mortgage.
It’s a low-cost loan:
A mortgage is one of the least expensive loans available. Do not look to pay off a 2.5% mortgage, for example, if you have credit card loans or other debt you’re still paying off at higher rates. And as a loan, your mortgage helps your credit score, so removing it from your debt report could affect your credit score.
And keep in mind you may face a penalty for paying off the mortgage early, especially if you have had it less than five years. Check with your lender if any early payment penalties would apply.
There are tax benefits:
Your mortgage interest is tax deductible. And the interest you pay on loans to buy, build or substantially improve a qualified residence (up to $750,000) is tax deductible if you itemize your deductions.
If you’re in the 35% tax bracket, every dollar you pay in mortgage interest saves you 35 cents in federal income taxes. You save on state income taxes too. Say you’re in the 32% tax bracket and you get a 3% mortgage. That loan costs you 2.04% after taxes.
Meanwhile, say you invest money and earn 3%. Long-term capital gains are commonly (at least as of time of publication) taxed at 15%, meaning your after-tax profit is 2.55%. Thus, even if your investments earn no more than what you pay for your loan, you’re still making a profit.
It can contribute to wealth creation:
Speaking of investing, this leads to an important question you need to answer before deciding whether to pay off your mortgage before you retire: What will you do with the money you save? If you have no particular plan or urgent need for it, it would most likely help you to keep your mortgage. If you plan to invest it, though, that might possibly be a better use of your money. But you will need to consider a lot of factors, including your age, risk tolerance and financial situation. Speak with a financial advisor to discuss your options.
These are just a few of the many reasons we think it is a good idea to have a mortgage in retirement. Remember, when it comes to your retirement, it’s all about wealth creation, not debt elimination. So while paying off your mortgage early may seem appealing, we believe your focus should be on creating wealth so that you can comfortably afford the cost of living in and owning your home.
Neither Edelman Financial Engines, a division of Financial Engines Advisors L.L.C., nor its affiliates offer tax or legal advice. Interested parties are strongly encouraged to seek advice from qualified tax and/or legal experts regarding the best options for your particular circumstances.