Should You Pay Off Your Mortgage Before Retirement?

Is retiring with a mortgage a good idea? Most individuals will jump through hoops to live mortgage-free, regardless of whether it makes the most sense financially. Sure, all else equal, it’s always better to reduce your expenses. But in most cases, all isn’t equal: paying off a mortgage early or forgoing one entirely typically comes at the expense of something else. Retiring with a mortgage doesn’t typically pose a financial risk, and at times it’s the best financial decision. But paying off a mortgage before retirement has upsides also. Here’s when it may – and may not – make sense to pay off a mortgage before retiring.

Paying off your mortgage early may reduce costs in retirement, but it also reduces liquidity

Using extra income or savings to pay down a mortgage faster moves your most liquid asset (cash) into a very illiquid asset (your home). In the most extreme examples, this is referred to as being “house poor.” Since being house poor is never a goal, you’ll want to consider your entire pool of resources before opting to accelerate mortgage payments.

On the flip side, not having a mortgage in retirement can be beneficial if it reduces overall lifestyle costs and how much you’ll need to draw from your portfolio in retirement. Depending on the situation, this may mean being able to retire earlier or a higher probability of not running out of money. Particularly in down markets, having relatively low fixed costs is important as you may be able to avoid forced selling to pay bills.

However, if the goal is to pay off a mortgage before retirement to spend would-be mortgage payments on other things during retirement, the math may not work out. For one, any savings from retiring home debt is a one-time savings (the interest expense). Adding new line items to a retirement budget in perpetuity, increasing by inflation each year, won’t result in a net cost savings.

Aside from that, the money isn’t there if you want to use it on something else in retirement, like a down payment on a snowbird condo or helping put your grandkids through college.

Don’t be afraid of leverage

Leverage is when your expected rate of return on an investment exceeds financing costs. If you can borrow money for less than an amount you can reasonably expect to earn by investing the funds instead, then it makes sense to keep the loan.

For example: a homeowner has a mortgage with a 3% interest rate. Their long-term average expected return is 5%. They’re using leverage to achieve a better financial outcome.

After a period of record low mortgage rates, most savvy homeowners refinanced. With an ultra-low cost of borrowing, retiring with a mortgage can be the best choice financially. Especially when in today’s rising rate environment, investors can earn over 4% annually buying a 2-year risk-free Treasury (as of 9/23/22). So at least for a time, investors don’t even need to put money in volatile equities to earn a return greater than the cost of debt. The hurdle is much higher for those getting mortgages now.

After-tax cost of borrowing and hurdle rates

With state and local taxes (SALT) now capped at $10,000 and standard deductions increasing to $25,900 for married taxpayers (plus $1,400 if over 65), fewer taxpayers benefit from itemizing deductions. Without itemizing, most charitable gifts carry no tax benefit for example. Having a mortgage interest tax deduction can tip the scale in favor of itemizing.

It’s also worth considering the after-tax cost of debt and net return on an opportunity cost investment.

Following on the earlier example:

• The net cost of a mortgage with a 3% rate is 2.28% for taxpayers in a 24% tax bracket who itemize their deductions. The cost remains 3% for those who do not itemize.
• The after-tax return on a 5% investment is 3.8% assuming short-term capital gains in a 24% tax bracket, increasing to 4.25% using a 15% long-term capital gains tax rate.

As illustrated above, the hurdle rate is pretty low for homeowners in this situation, meaning paying off a mortgage before retirement might mean leaving money on the table. The breakeven investment return to compare to someone with a 3% borrowing cost is 3.53% (assuming long-term capital gains) or 3.95% for short-term capital gains (like Treasury bonds).

Next, imagine a borrower has a much higher mortgage rate, perhaps 5%. Now the calculus changes considerably. The breakeven hurdle rate is 5.89% and 6.58% respectively. In this case, it’s probably not worth the investment risk. While this helps make the case for prioritizing paying off a mortgage, it’s still not a slam dunk.

Other factors to consider before prepaying your mortgage before retirement:

• Are you going to live in the house long enough to enjoy years of living mortgage-free?
• If you can’t pay off your mortgage, there may be little reason to pay it down Unless you have a variable-rate loan, making extra mortgage payments won’t change your monthly payment.
• As the chart earlier illustrates, rates have recently, and sharply, gone up. But there’s little reason to think mortgage rates will stay at current levels for the long run. So for borrowers with higher rates, future opportunities to refinance may cast doubts on whether free cash flow should go to paying down a mortgage today.
• Homeowners on the last legs of a mortgage may see a small and declining principal balance and be tempted to wipe it out before retiring. Before making that final transfer, recall how loan amortization works. When a new loan is issued, the interest component of the fixed payment is far greater than the amount going towards loan principal. But by the end of the loan term, this relationship reverses, and debt service costs are only a fraction of the payment.

Emotional reasons usually drive the decision to prepay a mortgage. Peace of mind may help you sleep at night (which is important), but it won’t fund a decades-long retirement. So before using extra cash or an unexpected windfall to pay off your mortgage ahead of schedule, consider the value of future flexibility. After all, goals often change over time.