Conventional wisdom recommends that retirees eliminate all debt, including mortgages. In fact, the common trajectory used to be that a person in his 20s or 30s would purchase a home with a 30-year mortgage, which he would finish paying in his 50s or 60s just prior to retirement.
In the 21st century, things are not so cut and dried. Many people wait until later in life to purchase homes. Rather than paying off their mortgages in a linear fashion, they periodically use refinances, second mortgages and home equity lines of credit (HELOCs) to access their home's equity, and they buy and sell homes at a faster rate than was common a generation ago. The result is that people carry much heftier mortgage balances into retirement, prompting the decision of whether to use savings to pay it off.
Paying off a mortgage prior to retirement has its pros and cons. Whether the positives outweigh the negatives, or vice versa, depends in large part on the retiree's financial situation.
The Pay-offs of Paying Off
"For most retirees, one of the most important planning tactics is to reduce fixed expenses," says investment advisor representative Jonathan Swanburg, of Tri-Star Advisors in Houston, Texas. The biggest benefit to a retiree paying off his mortgage is that doing so eliminates a monthly expense at a time when his income is likely reduced. Though exceptions exist, particularly for those with robust 401(k)s or other retirement vehicles, the average retiree brings home less money each month than he did while working. Not having to spend that money on a mortgage payment makes household budgeting easier.
Being mortgage-free also insulates a retiree from disturbances in the real estate market, such as what happened in 2008. For many retirees, finances are tenuous and stressful enough as it is; owning an underwater house because its value dropped below the mortgage balance adds to the stress. "A home that is completely paid off" also helps retirees be more flexible and able to ride out stock-market volatility, Swanburg notes. He also points out that "many retirees are better off with a standard deduction than they are if they itemize. In this situation, the retiree wouldn’t get any tax benefit to maintaining a mortgage."
When Keeping a Mortgage Makes Sense
That said, carrying a mortgage into retirement offers some advantages. For most of the 21st century, mortgage rates have been at historic lows. A retiree who locked in a mortgage rate at 5% or lower might not want to liquidate a higher-interest investment account to pay off that mortgage.
Tax benefits accrue from having a mortgage, with the interest being deductible. Carrying a debt load that is a reasonable ratio to your total assets, usually 10 to 30%, can be strategic. It allows a person to leverage someone else's money to build wealth.
And When It Doesn't
The biggest disadvantage to carrying a mortgage balance into retirement is that it obligates a retiree to make monthly payments on that debt. Moreover, these payments are required at a time when a person's monthly income is likely to be cut substantially. Compared to when he was working, a retiree often has much less money left over each month after deducting expenses, including the mortgage payment, from take-home pay.
As long as pay minus expenses is a positive figure, the retiree can survive in a typical month, but if the margin is thin, one unexpected expense can blow up his monthly budget. Eliminating the mortgage payment – the biggest monthly expense for most people – offers breathing room and peace of mind in case a medical event or car breakdown necessitates a larger-than-average cash outlay one month.
Paying off your mortgage can also protect against one of the biggest risks of recent years: finding oneself "underwater" because of owing more on a home than it is currently worth because home values have dropped. Home prices in the United States reached unprecedented heights in 2006 and 2007, after which they fell precipitously amid a brutal recession spurred by a high default rate in the subprime mortgage market. What followed was a foreclosure crisis of epic proportions. Many factors contributed, one being that a record number of homeowners found themselves underwater, at a time when they could not keep up with mortgage payments on loans that were higher than the value of their home.
A retiree on a fixed income is especially susceptible to the dangers of owning an underwater home. If money gets tight and he can no longer afford his mortgage payment, he cannot sell his home quickly to get out from under it. Negotiating a short sale with the bank can take months, and in some cases, the bank can still come after the homeowner for any deficiency balance left over. Not having a mortgage eliminates this concern; as long as the home value is greater than zero, the homeowner is never underwater.
Taking Advantage of Low Interest Rates
Low interest rates can play out two different ways, depending on the situation. Sometimes, not paying off a mortgage works to a retiree's advantage. This is particularly true for retirees who secured mortgages at the historically low rates the industry has seen during the 21st century. A retiree paying 4% interest on his mortgage is ill-advised to pay it off by liquidating an investment account that provides returns of 10%. It is better to keep both accounts as they are and enjoy the 6% spread, which is tantamount to profit for the retiree. Moreover, people retiring before 59½ incurs a penalty if they withdraw from a retirement account. This penalty can be equal to several years of mortgage interest; in this case, it makes sense to at least wait until the money can be withdrawn penalty-free.
On the other hand, a retiree who has the equivalent of his mortgage balance parked in one of today's very-low-interest savings account might come out ahead by using that money to become debt-free.
Mortgage interest is tax-deductible. The amount of benefit this feature provides a retiree, however, depends in large part on the value of the home. In low-cost areas, such as the Midwest, the tax benefits of paying mortgage interest are often negligible and even nonexistent.
Retirees in a low-cost area who are considering holding on to a mortgage for no other reason than the tax benefits may benefit more by paying it off if they have the means to do so. On the other hand, the tax benefits from mortgage interest can be huge in markets such as San Francisco, Los Angeles and San Diego, where median home prices top $500,000.
Famous advisors, such as Dave Ramsey, vilify debt as a no-exception scourge on a person's personal finances. However, for savvy people who know how to do it, carrying a reasonable debt load can provide financial advantages. The example above of the person paying 4% interest on his mortgage but receiving 10% interest on an equal sum in an investment account is a good example. Leveraging debt, when done properly, is a highly effective way to grow net worth.
Think about it. If a person borrows money at 5%, parks it in an investment vehicle earning 12% for the duration of the loan, and then pays back the principal at the end, he or she has effectively earned 7% interest on money that was not even theirs. This strategy is called arbitrage, and it is not so different from keeping a mortgage balance at a low interest rate to free up funds to invest at a higher rate.
The only caveat to strategic debt is not to get greedy and over-leverage. This is a recipe for financial catastrophe if the economic winds shift in an unfavorable direction. Most experts recommend limiting debt to no more than 30% of total assets.
The Bottom Line
Obviously, it's best to go into retirement without a mortgage and the expenses that go with it. But people approaching retirement who do have one should carefully consider the pros and cons of paying off their mortgage compared to using the money in other ways, such as in an investment account. Prospective retirees will benefit from discussing these questions with a trusted financial advisor who knows their situation.