Key takeaways
- There are arguments for and against paying down a mortgage quicker to be debt free in retirement.
- The mortgage interest tax deduction may be less attractive thanks to the 2018 tax law changes.
- Investing extra money in mortgage payments nets you a risk-free return equal to the loan interest rate.
Barely 25 years ago, just a quarter of households entered retirement with a home mortgage. But times have changed. According to a recent survey by mortgage banker American Financing, 44% of 60-70-year old homeowners carry their mortgage into retirement. And 32% of them say it will take them more than eight years to pay off those debts.
Are you better off paying down your mortgage on a normal schedule to free up more money to invest into retirement accounts? Or should you get out from under the largest debt on your balance sheet as quickly as possible? The answer is: It depends. Here are a few things to keep in mind as you contemplate what’s best for you.
The mortgage interest deduction can trim your taxes
Mortgage proponents usually base their case on the income tax deduction for mortgage interest. You have to itemize your deductions to take advantage of this. But the 2018 Tax Cuts and Jobs Act (TCJA) increased the standard deduction for each filing status. So unless you have a big mortgage with hefty interest payments, it may not make sense for you to itemize deductions on your tax return just to claim the mortgage interest deduction. Check with your tax advisor to see what makes sense for your tax situation.
Even if you determine that your mortgage deduction saves you more compared to the standard deduction, the further into your mortgage you get, the less the deduction is worth because you are paying more of the principal and less in interest. Use the mortgage tax deduction calculator at Bankrate.com to see if your tax deduction is still a good value.
Mortgage payments might increase taxable withdrawals from retirement accounts
If you and your spouse will be relying on Social Security plus withdrawals from tax-deferred retirement accounts like a 403(b) plan or an IRA for retirement income, making mortgage payments may require you to withdraw more from these accounts. These withdrawals are taxable, so the more you take out, the higher your taxable income, and that can affect the taxes you owe on Social Security benefits.
Paying down a fixed rate mortgage is like getting a guaranteed return
Accelerating mortgage payments instead of investing more in a tax-deferred 403(b) plan or IRA may not be a good decision for some people, especially if the mortgage has an interest rate less than 5%, or so. Strictly as an example of how a diversified retirement portfolio might perform over a very long time period, a hypothetical investment portfolio made up 60% diversified stocks and 40% fixed income investments had an annualized return of 10.1% from 1927-2014.1
Of course, stocks and bonds carry risk, and there’s certainly no guarantee you’ll get 10% returns every year. If you have a 5% fixed rate mortgage, funneling more money into paying that off faster is like getting a guaranteed 5% investment return with no risk.
Pay down higher interest debts first
Your mortgage interest rate is likely much lower than your car loan or any credit card debt you’re carrying. Generally, it’s smarter to pay off higher interest debt first.
Unloading a mortgage can give you peace of mind
Even if the tax deduction and investment potential numbers don’t add up favorably, some people just sleep better at night if they aren’t carrying any big debts. The psychological relief many feel when they pay off their mortgage and own their home free and clear can be profound.
A paid off home can be a retirement safety net
If you need cash in retirement and you own your home, you could consider a home equity loan or a reverse mortgage.
You could have more estate planning flexibility
If you’d like to leave your house to your children, and they don’t have a lot of resources, a paid off home may give them more flexibility. An inherited home with a big mortgage could force your heirs to sell the property even if they’d rather not do so.
Crunch the numbers and listen to your gut
The decision to pay off your mortgage early and be debt free in retirement is complicated. It hinges on your financial situation, along with your emotional and psychological preferences. Even the financial experts argue both sides. Often, it’s best if you can leave emotions out of your financial decisions but peace of mind is a powerful motivator. Work with an advisor to find the financial and emotional balance that feels right for you.
1 Source: https://www.forbes.com/sites/timmaurer/2016/01/20/the-simple-diy-portfolio-that-has-beaten-the-pros/#115f9c9a7dd8; historical return data supplied by Dimensional Fund Advisors.
