Burdening Your Retirement With a Mortgage
Part of the rosy picture associated with retirement is the thrill of kissing that monthly mortgage payment good-bye (on the presumption you'll have paid it off by then). But don't start puckering up just yet. Lately, there has been a shift in thinking that has seen many financial planners suggest that retirees continue to carry a mortgage into and throughout retirement. Reinvest the money from your home equity, and suddenly you'll have a stream of new income, making your golden years a little more golden. This is a brilliant strategy, right?
Well, there can be some drawbacks. Carrying a mortgage in retirement can be a good idea in certain situations, but it is certainly not a one-size-fits-all solution for increasing retirement income. This article will explain the rationale behind this strategy and discuss the factors you should consider before jumping in.
You Can't Eat Your Home
The basic concept behind this strategy is "you can't eat your home": Because your residence produces no income, home equity is useless unless you borrow against it. Historically, in the long term, homes provide rates of return below those of properly diversified investment portfolios. Because home equity typically makes up a substantial portion of a retiree's net worth, it can arguably serve as a drag on income, net worth growth and overall quality of life in retirement.
So, logically, the next move would be to shift your assets from your home by taking out a mortgage and investing the money in securities that should outperform the after-tax cost of the mortgage, thereby enhancing net worth in the long run and your cash flow in the short run. Additionally, investments such as most mutual funds and exchange-traded funds are easily liquidated and can be sold piecemeal to meet extra spending needs. (To learn more, see Introduction to Money Market Mutual Funds and Advantages Of Exchange-Traded Funds.)
This all sounds great, but it's not that simple: Any time you introduce more leverage (a fancy word for debt) into your finances, there are a lot of things you need to consider. So, what are the benefits and drawbacks of this strategy?
A properly diversified investment portfolio should outperform residential real estate over the long term. Don't be fooled by real estate returns over the last decade or so. Residential real estate historically provides single digit annual rates of return, whereas diversified portfolios tend to do much better over the long term and should reasonably be expected to continue to do so in the future. Secondly, interest on mortgages are tax deductible, which can serve to minimize the cost of using this form of leverage, increasing the return on investment of the securities you buy.
Finally, from an investment point of view, a single property could be considered completely undiversified, which is bad news if it comprises a substantial portion of your net worth. Diversification is essential to maintaining not only financial stability, but peace of mind as well (see Introduction To Diversification and The Importance Of Diversification.) Remember, your retirement is supposed to be enjoyable!
Despite the potential benefits, this strategy can also have some unpleasant side effects. As mentioned before, taking out a mortgage is another form of leverage. By using this strategy, you effectively increase your total asset exposure to include not only a house but also the additional investments. Your total risk exposure is increased and your financial life becomes much more complicated. Furthermore, the income you get from your investment will fluctuate. Prolonged downward fluctuations can be scary and hard to manage. (To learn more about the importance of freeing yourself from mortgage payments entirely, read Paying Off Your Mortgage.)
Furthermore, the Tax Cuts and Jobs Act of 2017 mitigated the deductibility advantage somewhat. Taxpayers now may only deduct interest on $750,000 of qualified residence mortgage (down from $1 million). The act also suspends the deduction for interest paid on home equity loans and lines of credit, unless they are used to buy, build or substantially improve the home securing the financing.
Another important factor to keep in mind is that investment returns can be highly variable in the short term, while mortgages tend to be fixed in nature. It is reasonable to expect periods of time when your portfolio substantially underperforms the mortgage cost. This could notably erode your financial base and potentially jeopardize your future ability to keep up with payments. This variability could also compromise your peace of mind. If you become frightened during a downturn in the market, you may react by tapping into your portfolio in order to pay off the mortgage, thereby denying yourself the benefits of a recovery in your investments. If this happens, you would actually end up detracting from your net worth instead of increasing it. Do not underestimate the unsettling psychological influence of leverage, or the value of a good night's sleep in making rational investment decisions. (For further reading into emotions and investing, see When Fear And Greed Take Over and Master Your Trading Mindtraps.)
There are many objective financial factors you need to take into consideration to determine the merit of this strategy in your given financial situation. While some financial planners may issue the same advice across the board, this strategy is by no means appropriate for everyone.
The foremost consideration is determining what your total mortgage interest cost will be, as this is the hurdle your investment portfolio must overcome to be successful. The factors that affect this are very simple and include your credit worthiness and tax bracket. Of course, the better your credit, the lower your total interest cost will be. Furthermore, the higher your tax bracket, the more tax benefit you receive from the interest write off. (To get started, check out Understanding The Mortgage Payment Structure.)
Where to Begin
The first thing you need to do is talk to your loan officer and accountant to determine your total interest cost, net of the tax benefit, which will tell you how much your investment portfolio needs to earn in order to pay off the interest rate charges of your mortgage. Next, you need to approach your investment advisor to discuss beating this investment hurdle, which leads to another set of considerations.
Knowing your desired rate of return is simple enough, but whether you can reasonably achieve that rate of return or tolerate the necessary risk is another story. Generally speaking, beating your mortgage cost will require a larger allocation to equities, which can entail substantial amounts of portfolio volatility. Frankly, most retirees are probably unwilling to accept such levels of volatility, especially since they have less time to ride out the market's ups and downs.
Another factor to consider is that most financial advisors rely on historical averages to estimate a portfolio's future return. There are several issues to consider with this approach:
- Long-term expectations and short-term returns are almost never the same.
- Historical returns are based on very, very long time periods. The average retiree's investment horizon is much less than the "long term."
- You can't expect steady annual returns that resemble historical averages.
In other words, do not totally rely on return expectations. They simply serve as a guidepost for your likely returns in the future. It is wise to anticipate and consider a range of potential investment returns over various time horizons in your financial planning.
Finally, the last major consideration is determining the percentage of your total net worth your home represents. The larger the percentage of your net worth your home represents, the more important this decision becomes.
For example, if your net worth is $2 million and your home only represents $200,000 of it, this discussion is hardly worth the effort, as the net marginal gain from this strategy will minimally affect your net worth. However, if your net worth is $400,000 and $200,000 of this comes from your home, then this discussion takes on a profound meaning in your financial planning. This strategy has less of an impact, and probably less appeal, for someone who is rich than someone who is poor.
The Bottom Line
It's never a good idea to blindly accept a piece of advice, even if it comes from the mouth of a financial planner. The safety of carrying a mortgage into retirement depends on a variety of factors. This strategy is not guaranteed to succeed and can substantially complicate your financial life. Most importantly, leverage is a double-edged sword and could have dire financial consequences for a retiree.
Simply put, do not make this decision lightly and be very thoughtful before committing to it. Also, keep in mind the motivations of financial advisors – the more money you investment with them, the more money they make.
For related reading, see The Home-Equity Loan: What It Is And How It Works.