On this blog, I often delve into specific practical areas of retirement stewardship. My goal is to simplify seemingly complex financial topics so that you can make sense of them for your own life. This topic is one of them.
Not long ago, a friend whose family income is somewhat seasonal asked about paying off their mortgage versus increasing their savings for retirement.
How to optimize an income surplus, assuming you are already giving at a level you desire, is an important question. As you will see, the right answer will be highly dependent on your individual situation.
House purchase decisions have major consequences
You have to live somewhere. You can rent, or you can buy. If you decide to buy a house, it will likely be the largest purchase you will ever make. How much you pay for it will have a major impact on your overall financial condition, both short and long term. Most will take out a 30-year mortgage to finance it (although I strongly recommend a 15-year mortgage if you can swing it), and the monthly payment will typically be your largest recurring expense.
Unfortunately, over the years, I have seen quite a few situations where a family’s housing expense was a disproportionately high percentage of their net income. Some had mortgage payments that were 40 percent plus of take-home pay. Such a large payment reduced the financial margin they had in their monthly cash flow, and in some cases caused it to be negative, which prevented them from giving generously and saving for retirement.
There is a school of thought that says, “Buy as much house as you can possibly afford based on what the bank is willing to loan you. That way, you’ll get maximum appreciation using someone else’s money ” (known as leverage). I think that is asking for disaster because you have no idea what the future holds. You would be wise to get a house that meets your needs and keeps your mortgage payments relatively low. A good rule of thumb is no more than 25 to 30 percent of TAKE HOME PAY (after taxes and other withholdings). If your mortgage expense is much higher than 30 percent, you are taking an unnecessary financial risk.
Benefits and disadvantages of a paid-for house versus saving for retirement
Once you have a mortgage, many financial planners and advisors tout the benefits of eventually having a paid-for house, especially as you enter retirement. I think paying off a mortgage is a worthy goal — I was able to pay mine off about seven years ago when I was in my late 50s. But saving for retirement is important too. Both increase your “earthly” net worth, but they do it in different ways.
A paid-for house maximizes your home equity (the value of your home that is unencumbered by any debt), but it is “illiquid,” meaning you can’t easily convert your equity into cash. You would have to sell the house or take out a loan against it. Home equity lines of credit or reverse mortgages are the most common ways of doing that.
The greatest benefit of not having a mortgage payment is increased cash flow, which can be great for your monthly budget. You still have to pay for taxes, insurance, utilities, and upkeep, but you had those anyway. Unless you live in a very high tax area, they should be manageable, even in retirement.
Then there is what I call the “sleep at night” factor. Many people enjoy the peace-of-mind that comes from having a paid-for house (Galatians 5:22). It’s theirs indefinitely, as long as they pay the property taxes.
Retirement savings, on the other hand, are highly liquid, subject to any tax implications, of course. These savings are necessary to ensure that you have something to live on other than Social Security when you are no longer working for a living. In retirement, at a minimum, your goal is to be debt-free and a non-borrower going forward who’s not entirely dependent on the government or others for your basic needs (Psalm 37:21).
If you’re fortunate to be a high-income person (which the U.S. Census Bureau defines as $100,000 or more a year), the simple answer to the question, “pay off the mortgage or save more for retirement?” could be to do both. But the reality is that most aren’t, and therefore can’t.
Plus, if you are a Christian, giving should always be a high priority (Deuteronomy 16:17). If you devote too much of your income to saving and paying down mortgage debt, your ability to give generously will be severely constrained.
Applying Christian stewardship principles would mean that, when it comes to a house purchase and mortgage decisions, you will be a responsible borrower and will diligently work to pay off the debt (Ecclesiastes 5:4-5). Stewardship also means wisely saving something for retirement (Proverbs 6:6-8), and of course, giving is always important (2 Corinthians 9:7).
So, ultimately, the answer will depend on your individual situation, and especially what phase of life you’re in: the accumulation phase (saving and investing for retirement), or the distribution phase (living off your savings and other income sources in retirement, or about to).
You’re in the accumulation phase
You will likely spend most of your working years saving and investing for retirement – what is called the “accumulation phase.” This period is typically age 25 to 65.
If you are in this phase of life and own a house, then you may not be saving for retirement at all. Sometimes paying a mortgage makes it tough, especially for those just starting out. Or, perhaps you are saving, but you know it’s not enough. Then there are the fortunate ones who have a mortgage but are also able to save enough for retirement and generously give, all at the same time.
You aren’t saving for retirement at all
If you’re not saving at all, the answer is clear: start saving something, even a small amount, sooner rather than later. Consider this example:
If you are 35 years old, make $50,000 a year, own a house with a 30-year mortgage, invest 12 percent of your income toward retirement ($500 per month), and it grows at 6 percent annually, you could have over $500,000 at age 65. And even if you paid nothing extra toward the mortgage, you’ll have a paid-for house when you retire.
If you start earlier, say age 25, it would be almost $1 Million! (That’s due to the “magic” of compounding.)
But what if, starting at age 35, you get a nice raise and decide to double up on your house payments instead of saving for retirement? You would pay off your mortgage in 15 years or so, by age 50 (whoop, whoop!), but will have zero saved for retirement (not sure what the opposite of “whoop” is). To play “catch up,” you’d have to invest $1,700 a month starting at age 50, which could be very tough.
Think of it this way: In the first scenario, you invest a total of $180,000 for retirement. But due to compounding, your savings grow, and you end up with a half million dollars (more if average annual returns are higher and much more if you start earlier). But in the second, you had to invest $306,000 of your hard-earned money to end up with the same amount. Bummer!
I like scenario one! Therefore, during this phase, I wouldn’t advise you to pre-pay instead of saving and investing for retirement, especially if you’re getting an employer match for your contribution of some percentage. In that case, your 401k/403b is probably going to be a better long term investment than your house.
If you’re familiar with Dave’s Ramsey’s Financial Peace “Baby Steps,” you know that paying off your mortgage AFTER you have an emergency fund in place, have taken care of all other debt, and are giving and saving for retirement, is Baby Step 6 of 7 in his plan for financial peace. Note the emphasis on AFTER.
Your priority should be paying off debt and then saving for an emergency fund so that you can continue making mortgage payments in case the unexpected should happen. So, fully fund your emergency reserves first. Save 3 to 6 months of income at a minimum, but 6 to 12 months worth is even better. (Remember, even if you pay off your mortgage, you still have to pay for utilities, taxes, insurance, etc.) After that, you should be saving at least 12 to 15 percent of your gross income for retirement. (Possibly more if you got a late start.)
You’re saving but not sure if it’s enough
But what if you’re already saving 15 percent or more? That’s a more complicated decision because multiple variables are involved.
First, if you think you might be saving enough but aren’t sure, do a quick check-up based on your age. You can use the chart in this Fidelity Investments article. In our example above, a 35-year-old making $50,000 should have about one time (1x) salary, or $50,000, saved for retirement. (At 45 years old, if you’re making $50,000 a year, you should have put away about $150,000.)
If you’re behind, you may need to bump the percentage up to 20 percent or higher instead of paying down your mortgage. (Check out “Behind in Saving for Retirement?” for more guidance.)
But if you’re on track with saving for retirement, you may be in a good position to start paying down your mortgage principal, providing you’ve taken care of any consumer and/or student loan debt and also have enough to give at the level you desire. The sooner you pay it off, the more you’ll save. That is the main reason to get a 15-year mortgage instead of a 30 year – you save big on total interest over the life of the loan, plus you get rid of your monthly payment in half the time.
If you use some excess cash to pay down a mortgage, those funds are no longer available for investment. The lower your interest rate, the less you stand to benefit through early retirement of debt.
One of the easiest ways to pay off a 30-year mortgage sooner is to make additional payments to principal. If you have more than 20 years remaining, consider refinancing to a 10 or 15-year mortgage if you can easily afford the higher payments. Downsizing is another way to go. Pay cash if you have enough equity after you sell or get a 10 or 15-year mortgage on a smaller house.
I keep recommending a 15-year mortgage because it’s a simple no muss, no fuss way to get your mortgage paid off early. It puts it on auto-pilot. If you are 45 years old and refinance to a 15-year mortgage, you can have a paid-off house by the time you are 60. That’s how I was able to do it, except toward the end I used a simple-interest home equity line of credit to supplant a small 15-year mortgage, which I quickly paid off.
Is there a higher, better use for your money?
Before I leave this section, I want to touch on one vital point. Remember, this is all about practicing good stewardship. We need to make every financial decision based on the fact that it is God’s money, not ours (Psalm 24:1).
So, if you are saving a reasonable amount for retirement and are on your way to having a paid-for house by the time you retire, then perhaps you could consider giving away some of your surplus instead of saving more for retirement or paying down your mortgage.
This is exactly what the co-authors of the excellent book, God and Money: How We Discovered True Riches at Harvard Business School, decided to do:
We understand the desire to eliminate the mortgage, but we’ve each decided to take at least 10 years to pay our homes off, even though we might be able to do it sooner. We’d rather give or save for other goals than obsess over this one. If we build up enough equity such that we’re headed toward a 10-year payoff, we’ll simply stop putting money on the mortgage and focus on other priorities. (Pg. 154)
You’re in (or nearing) the distribution phase
This phase is typically age 65 to end of life. If you’re in this phase, then paying off your mortgage can deliver lots of benefits. Retiring with Social Security and perhaps a pension, which along with a paid-off mortgage and sufficient savings that can provide you with enough money to pay your bills in retirement, will help you to retire with dignity.
Most importantly, you can reduce your living expenses at a time when your income will probably be less. (Most retirees expect to live on 70 to 80 percent of their pre-retirement income.) Plus, you can tap the equity if you need to, but I recommend that only as a last resort. And certainly not the least of the benefits is the peace of mind that comes with a paid-for house is hard to beat.
You’re retiring with a mortgage payment
If you go into retirement with a mortgage payment, and your income is less than when you were working, your mortgage will take up an even higher percentage of your income. Let’s say you were making $80,000 before retirement, but plan to live on $56,000 in retirement (70 percent of $80,000), and you will continue to make a relatively modest monthly mortgage payment of $1,500 ($18,000 per year).
Before retirement, your mortgage expense was about 22.5 percent of your gross income. But it will rise to over 32 percent in retirement. And $18,000 a year could be a significant portion of your fixed income (Social Security or company pension income). Or, it would require approximately $450,000 in retirement savings based on a 4 percent annual withdrawal rate to cover just the mortgage expense.
If you retire with a mortgage but hold retirement savings and investments that could pay off the mortgage, you might have to rely on future investment returns instead of a paycheck to pay the mortgage and other expenses. Therefore, deciding between keeping that money in long-term savings (and presumably earning some income by investing it) or using it to pay off your mortgage is a more complicated matter.
If you are considering this and are nearing retirement, you’re assuming that you can earn enough money investing in stocks and bonds and other investments to pay your mortgage payments. If your mortgage is relatively low (i.e., 25 percent or less of income), then you’re probably okay. If not, this isn’t necessarily a great bet. Plus, it becomes riskier in retirement when you can least afford to take chances with your house.
If you have non-retirement assets that could possibly be used to pay off the mortgage, that may be something to consider, but only if they are not needed to provide income in retirement.
If someone asked me if they should take out a mortgage on an unencumbered home for the sole purpose of investing the money in hopes of a higher return than what they would have to pay out in mortgage interest, I would not hesitate to say, respectfully, “are you nuts?!” If that someone is a person who is retired and no longer working, I’d add an extra exclamation point to that statement.
The liquidity problem
To be fair, there is another side to this coin. It has to do with “liquidity,” which I have mentioned before. Investopedia defines liquidity as, “…the term used to describe how easy it is to convert assets to cash. The most liquid asset, and what everything else is compared to, is cash.”
For an average household, paying off an existing mortgage with savings might convert most of their liquid assets into illiquid home equity. And freeing up cash from home equity can be challenging. In that case, I might recommend keeping the mortgage instead of having all their assets in the relatively illiquid asset of home equity if they are reasonably confident they can make the payments.
If you keep paying your mortgage, and live long enough, and don’t move, you will eventually pay off your mortgage and will have to face the illiquidity problem anyway. You can accelerate the process with a 15-year mortgage or by just making extra payments to principal each year.
Paying it off and having some illiquidity is not necessarily a bad problem to have, but if you end up with most of your earthly “wealth” tied up in home equity, it’s better to plan for that up front.
For many retirees, the most efficient solution may be downsizing, which can free up some equity and reduce monthly expenses while still enabling you to live in a house mortgage-free. Renting is another option if you don’t want to purchase another home, especially if your rent payments are less than your mortgage payments were.
Downsizing is the most common solution to free up equity, but if you’d rather not do that, a reverse mortgage is another option. But you should be cautious about what you hear from your favorite actors on TV about reverse mortgages. Reverse mortgages have gotten better, but they are still complex and come with a lot of “fine print.” Suffice it to say that it’s not income from equity per se’, but rather a slow, steady return of it, which reduces the equity in your home when you or your heirs decide to sell it.
There is no single right answer for everyone, but there is a best one
As you can see, there is much more to consider than expected savings/investment returns and mortgage interest rates when you think about paying off the mortgage. So ultimately, the “right” answer depends on what stage of life you’re in and other factors related to your overall financial situation.
Generally speaking, I think paying off a mortgage makes a LOT of sense for someone who is nearing or in retirement, assuming they have enough non-retirement savings to do so, and they can maintain adequate liquidity afterward.
Personally, I paid off my mortgage while I was still working as my goal is to enter retirement with a paid-for house. I had a 15-year mortgage and paid extra on it as I was able. But many people won’t be able to do this and should consider downsizing to reduce their housing expense in retirement while maintaining their savings reserves.
On the other hand, if your “guaranteed” income from things like Social security and pensions (which are increasingly rare, by the way) can more than cover your existing mortgage and other essential living expenses, standing pat for the time being might be okay.
What you most certainly shouldn’t do is go out and buy your “dream home” a few years before you retire if it significantly increases your monthly mortgage expense unless you know for certain you will be able to handle it in retirement. Personally, I probably still wouldn’t do that, but then I’m pretty conservative about such things. I want to keep my house expenses relatively low in retirement.
If you are younger and are fortunate to be able to save for your future and accelerate the payoff of your mortgage without using a lump sum from savings/investments to do it, then I think the best solution is also one of the simplest: Get a 15-year mortgage, especially if you are in the early stages (i.e., first 5 to 10 years) of a 30-year loan. You will need to refinance to do that, but you cut the time to pay off your mortgage by as much as half and save tons of money in interest. Do your homework before deciding you can’t afford it. You may find that your monthly payment may not be that much higher, especially if you have significantly reduced the principal amount to be refinanced.
So, I guess this all really comes down to what is best in your particular situation. Think it though, seek wise counsel, and pray. Then you’ll be in the best possible position to make the right decision.