Pay Off Mortgage Debt with Retirement Savings?

What are the pros and cons of paying off a mortgage, as compared to paying down one, with retirement pension savings, upon retirement?

June 8, 2012 - Answered by Al

Al's Answer:

Ideally, your mortgage would be paid off upon retirement simply because your income is likely to drop, you’ll have less flexibility to boost your employment income if necessary, and to avoid the stress of mortgage payments. But life can get in the way of such ideals!
 
Before you dip into your retirement savings, however, there are a few factors for you to consider.
 
For one, think of eliminating mortgage interest as receiving a guaranteed return equal to your after-tax mortgage rate. Are you likely to earn more, again after taxes, by instead maintaining your investments in your retirement savings account? Consider this example:
 
Let’s say your interest rate is 5%, you are in the 25% federal tax bracket, and you still are paying enough interest on your mortgage that you are itemizing your deductions. The effective rate on your mortgage is then 3.75%. Reducing it is similar to earning 3.75%.

Many financial planners will recommend that new retirees with a reasonable chance of living three or more decades in retirement spread their investments among a portfolio with different types of bonds and stocks, as well as cash, that is likely to earn more over time than 3.75%.*
 
But note the world “likely.” It’s not guaranteed. In fact, over certain stretches your investments could lose money. Some individuals may prefer the certainty of paying down their mortgage. Eliminating debt may provide more peace of mind than potentially maximizing their money.
 
Also consider liquidity: you probably want to avoid having most of your wealth tied up in your house because you want the flexibility to access your assets for major purchases or emergencies that may arise. True, once you have paid off your mortgage (or are only carrying a very small balance), you may be able to receive income through a reverse mortgage, but that comes with high fees and other drawbacks you might find unappealing. Ideally, you’d have sufficient retirement savings available to you throughout your retirement. Draining them so you can build equity in your home may severely limit your financial flexibility.
 
The bottom line? As with many financial decisions, aim for balance and diversification. If you have more in retirement savings than you are likely to ever need, consider paying off your mortgage. Start with an online calculator to determine if you might be on target.
 
If you will be dependent on your retirement savings to meet your ongoing overall expenses, consider keeping things as is so you can maintain them for as long as possible. Or, some combination of the two approaches may make sense. Consider working with an independent financial planner who can evaluate your specific situation and provide objective advice on what steps to take.

* Of course, a big wildcard is taxes; traditional retirement account withdrawals will be taxed as ordinary income and large withdrawals could push you into a higher tax bracket in which you pay at a higher rate. Plus, state taxes may apply. On the other hand, withdrawals of Roth assets could be tax-free.

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