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“Paying off your mortgage can eliminate a major monthly expense, save money on interest, improve your cash flow and reduce financial stress.” -Stephanie Ford, Financial Advisor
“As they say, none of us is promised tomorrow – and if you own your home free and clear, your heirs have more options.” -Wealthtender
“If you have a mortgage, your home is really the bank’s.” -Common Financial Proverb
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I recently did a financial review with a person I’ll call Taylor. I’m using Taylor because Taylor is the top “unisex” name, meaning Taylor could be either male or female. As with every person, Taylor’s case was unique. There is one aspect of Taylor’s situation though, that is a recurring thread.
That thread is Taylor’s concern about whether to pay off an existing mortgage before retirement or enter retirement with a mortgage.
Taylor is about five years away from Retirement. Taylor will soon be Medicare eligible and is near Social Security’s full retirement age. Taylor has an existing mortgage on a home and a vehicle. Taylor has had several financial setbacks, but has managed to accumulate about $300,000 in liquid assets. Taylor’s current income is around $100,000 per year.
Taylor has a vehicle mortgage of $18,000, and currently has about $70,000 equity in a home. Taylor was unsure about the amount of Social Security benefits available at full retirement age, currently single and employed. Taylor would like to work until age 70.
We started by helping Taylor identify Social Security benefits available at full retirement age, and benefits available if Taylor waited to begin Social Security benefits at age 70.
Next, I had Taylor formulate a net worth statement, including the value of vehicles and the home.
If Taylor continues to work until age 70, medical insurance would be available through Taylor’s place of employment.
One of Taylor’s biggest concerns was the outstanding mortgages. One of Taylor’s first questions concerned mortgages and whether they should be resolved before Retirement. The question of entering retirement mortgage-free is interesting because it has financial, behavioral, and emotional components. I’ll give a quick synopsis about the outcome of Taylor’s financial review at the end of the blog.
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Should Someone Enter Retirement Mortgage Free?
I first want to dive deeper into the validity of the question about entering retirement mortgage-free.
When someone asks about the validity of paying off a mortgage before retirement, what they’re actually asking is “will eliminating mortgage payments materially improve my financial position and peace of mind”.
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Let’s Talk First About Some of the Advantages of Entering Retirement Mortgage-Free
Eliminating mortgage payments will reduce a person’s “burn rate”. With no mortgage payments, expenses are reduced. This means Taylor would need to distribute less from retirement funds. It also means less financial stress because monthly mortgage payments are eliminated. For example, if Taylor’s monthly mortgage payments are $2000, Taylor will need an additional $24,000 each year to service mortgage payments.
Taylor would also be better protected against a poor sequence of returns early in retirement. A market downturn early in retirement means that funds must be removed from a portfolio that has lost value. This can severely damage a portfolio’s ability to survive. No mortgages means fewer required withdrawals from a depressed portfolio. This means better control of cash flow, and an increased rate of portfolio survival.
One of the biggest considerations is emotional. Entering retirement debt-free reduces stress. This occurs because eliminating mortgage payments simplifies finances and creates a better “income floor”, and reduces the stress of having to pay a monthly mortgage note.
Eliminating mortgages creates flexibility. Taylor could more easily delay beginning Social Security, potentially ride out market volatility more comfortably, and reduce the need to take RMD payments earlier than necessary.
But, everything’s not positive for Taylor. Eliminating mortgages before retirement has potential disadvantages that could adversely impact retirement plans.
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Retirement With a Mortgage
Taylor’s net worth statement indicated that he was constrained. Constrained means that without careful management, it would be hard for him to maintain his current lifestyle in retirement without totally depleting his portfolio. Taylor will need every available dollar to live on, and taking a significant portion of his liquid net worth to eliminate his mortgages could severely and adversely impact his Retirement plans.
Taylor’s net worth statement would not change. The mortgage debt would disappear on one side of the net worth statement and would appear as equity in Taylor‘s house and vehicle.
Liquidity matters early in retirement, and houses and vehicles are considered illiquid. They must be sold to release the equity. Paying off mortgages would mean Taylor’s position would move from more liquid to less liquid, and that could be a problem if those dollars are needed early in Retirement.
Locking up money in home equity could potentially mean that Taylor would have to take larger withdrawals from taxable retirement accounts. Withdrawals may increase his taxable income and make his financial situation precarious.
Eliminating his mortgage could mean Taylor would lose the deductibility of mortgage interest, especially if itemizing on tax forms.
There are opportunity costs associated with eliminating the debt on Taylor’s house and vehicle. The money used to eliminate the debts would be unavailable for Investment. For more information on this subject, see FUTURES IN FOCUS: OPPORTUNITY COST AND TIME VALUE IN RETIREMENT PLANNING.
Taylor is paying a note on two mortgages each month. There is a mathematical formula that determines if it would be more beneficial to pay off the mortgages or continue paying mortgages and investing the difference. Money used to eliminate the debt on the home and the vehicle would instead continue to be invested. The primary considerations are the interest rates on the loans. Retaining the mortgage and investing for appreciation would be a better approach with lower interest rates.
There is also the less obvious consideration that inflation can actually be your friend! Over time, inflation makes fixed-rate mortgage payments “cheaper” in real dollars. Paying off mortgages eliminates that advantage.
It makes sense to consider paying off mortgages if: *The mortgage rate is around 5%. *You’re within 3 to 5 years of retirement. *You value stability over growth. *Your withdrawal rate would otherwise be tight.
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It often makes sense to keep the mortgage if: *The interest rate is below 3.5%. *A person has a well-funded portfolio. *A person is comfortable with market volatility. *That person will have a conservative withdrawal rate (3-4%).
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In light of these considerations, does it make sense for Taylor to pay off existing mortgages?
Each person’s situation is different, but this is what we decided would be best for Taylor. Taylor will not eliminate mortgages. Taylor will increase payments on the vehicle debt to eliminate that note within three years. But, Taylor will not fully eliminate the vehicle note now. This allows Taylor to keep more liquid assets. Taylor will not pay off the home mortgage, but will continue making regular note payments.
Taylor’s Social Security statement indicated benefits of approximately $60,000 the first year of retirement. Benefits from Social Security are indexed for inflation. This Social Security benefit is based on Taylor working until age 70, which is his current desire.
When Taylor retires, he will sell his current home and move into a smaller home or a condo. This should release the equity in his current home after satisfying the current remaining mortgage debt. This will ease the financial strain on Taylor’s portfolio. Once this is accomplished, Taylor will be debt-free!
Taylor will maintain medical insurance through Taylor’s employment. Taylor will begin Medicare when retiring.
Most importantly, Taylor will continue to work as a consultant. Earning $2000 a month ($24,000 annually) would generate the same income as having an additional $500,000 in retirement accounts (4% X $500,000 = $20,000). For more information on this topic see RETIREMENT WORK AND ITS EFFECT ON RETIREMENT.
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Is Taylor Totally Out of the Woods?
At the end of Taylor’s Retirement review, Taylor felt much better about current retirement prospects.
Taylor understands the approximate amount of Social Security benefits available. Taylor realizes that the $60,000 provided by Social Security benefits will be far less than his current $100,000 annual income.
Taylor has a net worth statement which gives a much clearer picture of Taylor’s current financial situation.
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Taylor’s Options
*Taylor could live on the $60,000 annual projected income from Social Security. *Or, Taylor uses Social Security income as a base and supplements it with distributions from his portfolio.
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A reasonable 3 to 4% withdrawal rate from portfolio assets would add $9,000 to $12,000 in annual available cash. This would increase Taylor’s annual available cash to approximately $69,000-$72,000.
Taylor’s net worth could be increased by selling his home at Retirement, and Taylor’s annual expenses would decline as a result of eliminating mortgage payments.
Annual available cash could very easily be supplemented by part-time work, or consulting. A monthly income of $2000 would raise Taylor’s annual available cash to around $90,000.
So, there it is! By utilizing advanced planning and available options, Taylor could potentially have a retirement income of about $90,000, or about 90% of his pre-Retirement income.
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For that to happen, Taylor would have to:
- Continue working until age 70.
- Would have to eliminate mortgage debt on both home and vehicle at or before Retirement.
- Delay the beginning of Social Security benefits until age 70.
- Continue working part-time or consulting in Retirement to generate an income of approximately $2000 per month.
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Final Thoughts
As with most plans, things can go wrong!
A decline in health could mean that Taylor may not be able to work until age 70, or after age 70.
Taylor’s current job and position may not remain available until age 70, or after.
Any financial setback (such as a decline in health or a long-term health event) could severely decrease retirement funds.
Taylor may ultimately have to begin receiving Social Security benefits before age 70, which will decrease the monthly benefit.
With careful continued planning and implementation, Taylor should be fine in Retirement. But, there are many variables that I’ve described and explained here that could dramatically alter Taylor‘s retirement prospects. Being in a constrained situation where there are adequate, but not excessive funds means that if anything goes wrong the whole plan could implode.
With all this being said, Taylor feels more comfortable with retirement prospects, and now has a sense of hope that Retirement will be fruitful.
Taylor now has usable information and knowledge. This information and knowledge can help Taylor plan for retirement more insightfully.
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