Real estate and mortgages are very much in the news right now. The market is "hot," and long-term interest rates remain at historic lows.
Therefore, lots of people are thinking about selling—perhaps to upgrade or downsize. Others want to refinance to reduce their payments or to get access to some of their equity for improvements, maintenance, or other purposes.
Some may be thinking more about retirement and wondering whether they should pay off their mortgage or not, especially with rates so low and the stock market reaching new highs almost daily.
Debt is Bad! (Or is it?)
The Bible doesn't prohibit debt. Being in a position to lend to others is considered a blessing (Deut. 15:6). However, being a borrower is compared to being in bondage (Prov. 22:7).
So, one could reasonably conclude that while Scripture allows for debt, it should not be considered normative. And if we do borrow, we should pay it back as soon as possible (Ecc. 5:5, Rom. 13:7).
Unlike other types of loans, mortgages are secured by a physical asset (your home) that may increase in value. They are also unique in that they are long-term—often 30 years or longer. Therefore, paying them off quickly is unrealistic for most.
But you can pay them off or reduce the outstanding balance significantly by regularly making additional payments to the principal or using lump sums, such as a work bonus, tax refund, or other windfalls.
It's a No-Brainer, Right?
Debt-free living is generally good for lots of reasons, but it can be even more beneficial for those transitioning to retirement. And if you're familiar with Dave Ramsey's Financial Peace "Baby Steps," you know number six is "pay off your home early."
Paying off your home mortgage sounds like a "no brainer." But buying and selling houses, paying off mortgages, and tapping home equity are complicated financial decisions and transactions.
Plus, they aren't really "baby steps"—they're more like giant leaps. There are pros and cons, and everyone's situation is different.
And if the financial considerations aren't complicated enough, the non-financial factors can further complicate things considerably. All of this is magnified for soon-to-be retirees or those already in retirement.
In this article, I discuss the arguments for and against paying off your house. Hopefully, this will help you wisely evaluate your situation and decide what's best for you.
Reasons to Pay Off Your House
1) A paid-for house maximizes home equity and increases net worth.
As a refresher, home equity is your financial interest in a home. It can increase over time as you pay down the mortgage loan balance or its appraised market value increases.
Your net worth is all your assets minus liabilities. Home equity is an asset; a mortgage is a liability. If you increase the former by decreasing the latter, you increase your net-worth.
For example, if you bought a house for $300,000 and took out a mortgage for $240,000, you immediately had home equity of $60,000 (the amount of your down payment). If, after ten years, you paid down the remaining principal by $100,000, your equity would be $160,000. If your home has appreciated $50,000, your potential equity is $210,000.
I say "potential" because the only way to get at 100% of that equity is to sell the house for full market value or to refinance it and take all the equity out. In either case, you end up with a lot of cash in your pocket but no home equity.
Real estate markets are fickle, so the best way to build equity in your home (and increase your net worth) is to pay down the mortgage. If you make that a goal and stay in your home long enough, you will eventually pay it off.
A big reason why home equity is important is that it may be an income "wildcard" for many retirees. Some homeowners have seen an annual appreciation of between 5 and 10 percent. If they're among the 50 percent of people who haven't saved enough for retirement, most of your wealth may be home equity.
It's also possible they thought that although they haven't saved much for retirement, they were to some extent by paying down their mortgage. In a sense, they were right.
But keep in mind, $160,000 of home equity isn't the same as $160,000 in a retirement savings account. You can't live in your 401(k), and it's hard to spend home equity.
2) A paid-for house reduces expenses in retirement and, consequently, the savings required to generate the income you need to cover them.
You may view your house as an investment, but mortgage payments are an expense. Before retirement, you pay them with your after-tax income. The same is true in retirement, but your income picture may change—it could be lower.
Let's say your monthly mortgage payment (P&I) is $1,000 or $12,000/year. You'll need $12,000 in annual income plus enough to cover all other expenses to make those payments. We'll assume that income will come from savings, so we can do a quick calculation based on the "4% rule" to translate that into a required savings amount. (The so-called "4% safe withdrawal rate" says you can safely withdraw 4% of your savings in your first year of retirement and then adjust it annually to keep up with inflation.) We just divide $12,000 by 4.0%: $12,000 ÷ .04 = $300,000.
That is one of the most compelling reasons to go to retirement with a paid-for house, especially for those with limited savings. You need fewer savings to pay the bills, and you can use the money you would have spent on mortgage payments for other purposes.
One thing to keep in mind: Paying off the mortgage won't eliminate property taxes or home insurance costs. Both may go up based on inflation and property values, and assessments in your area. (Your mortgage payment statement will show you what you are paying for those things each year—they're the "T&I" in "PITI.") In other words, "P&I" will go away when you pay off the mortgage, but "T&I" will remain and may increase over time.
3) Paying off your house may be a good investment.
Some view their home as an investment, and it can be. Home values rise and fall like other assets, but they generally go up at least enough to keep up with inflation. (Sometimes much more in "hot" real estate markets and when supply is constrained like it is now in many places.)
With short-term interest rates near zero, rates on "safe" investments such as CDs and high-quality bonds are minuscule. Therefore, those with cash parked in one of these accounts may get a higher return by paying off their mortgage.
If you have a mortgage at 4% and pay it off with money that is earning only 0.5%, you get an eight times greater return on your money. (The numbers will be even better if you pay off higher-rate debt on credit cards, student loans, or other types of installment debt.)
Another way to look at this is to view mortgage debt is as a "negative bond" because you pay the interest to someone else rather than vice-versa. If you pay it off, you can then pay yourself instead of the mortgage bank.
For example, let's say you're married and have a $200,000, 30-year mortgage at 4 percent. You'll pay a total of $144,000 in interest (an average of about $4,800 per year; more in the early years and less later on) to the bank over the life of the loan. As discussed earlier, you likely will not be able to itemize your deductions to effectively reduce your interest costs.
But there is another side to this argument, which I discuss in #3 under the "Reason Not to Pay Off the House" section below.
4) Paying off debt reduces financial stress in retirement.
Carrying debt into retirement can pressure your standard of living and make your finances less stable overall. According to the Federal Reserve, the total debt burden between 1999 and 2019 for those in their 60s has risen by 471%. And, the total debt burden for people over 70 has gone up by 543%.
Other age groups have also seen large increases, but not as pronounced as those in these older age brackets.
Eliminating debts with large payments like a mortgage can improve cash flow and increase financial resilience in emergencies. It also gives you greater flexibility to spend in other areas and to save and give more.
Because a monthly mortgage payment is usually the highest monthly bill a person has, not having to pay it during times of financial challenges, especially for those on fixed incomes, can help weather times of economic turmoil.
5) Paying off the mortgage virtually eliminates foreclosure risk.
Anytime you have a mortgage, there is a possibility (however remote) that it will be foreclosed in bad economic times, as happened in the 2009-09 housing crisis, and this is a threat to many amid the Coronavirus pandemic.
People without mortgages rarely lose their homes to foreclosure, but it happens. Usually, it's because they lose their homes for relatively small amounts of unpaid back taxes or other liens.
6) Paying off your mortgage can give you peace of mind and improve the SWAN (sleep well at night) factor.
Some people want to pay off their mortgage just for peace of mind in retirement, even when mortgage rates are low, and their portfolio earns more. This highlights that the "paying off the mortgage decision" has both financial and emotional components.
These factors are unique to each person's situation. Some are just not comfortable with having debt in retirement, even if they can "afford" it. They may have an aversion to risk, a conviction against owing money, or a desire to do other things with the money going toward the mortgage payment.
That said, the more you analyze the math, the less emotional the decision may be.
Reasons Not to Pay Off Your House
1) Paying off your house eliminates your mortgage tax deduction and may make you ineligible to itemize your deductions.
The income tax deductions for home mortgage interest and property taxes have been very popular among middle-class taxpayers. Probably because, for many, next to charitable contributions, they are the largest deductions people can take. Therefore, many people factor taxes into their home purchase and payoff decisions.
The income tax deduction has been used by many to justify the largest mortgage payment they could afford. They focus on the "after-tax interest rate." Some also use the same logic to justify carrying a large mortgage in retirement to get the most house they can afford while maximizing their tax savings.
If you were already itemizing every year and take out a new mortgage, calculating your after-tax interest was simple: the interest rate, multiplied by (1 minus your marginal tax rate). In other words, your monthly interest payment minus what it saved you in taxes.
For example, for a new mortgage at 3.5% borrowed by someone in the 22% marginal tax bracket, the after-tax cost would be: .35 x (1 – .22) = .35 x .78 = .273 (2.73%). At such low current mortgage interest rates, a tax savings of .77% isn't very significant.
But in addition to low-interest rates, other things have changed.
Current tax law, which in 2021 provides for a standard deduction of $24,800 for a married couple filing jointly ($26,100 for a couple over 65), makes the mortgage interest deduction less significant unless all of your deductible expenses (the things you can itemize on Schedule A of your income taxes—mortgage interest, real estate property taxes, medical costs, and charitable expenses) add up to more than the standard deduction for your filing status.
You need to complete IRS Form 1040–Schedule A to compare the total of your itemized deductions to your standard deduction to find out which one saves you most in taxes.
Most homeowners can deduct all their mortgage interest. However, if your mortgage debt is above a certain amount, the deductible interest is proportional to your mortgage's amount that falls within the threshold. (You can learn more about these limits on the IRS website.)
As a result of the new tax law, far fewer taxpayers itemize their deductions; they take the standard deduction instead. In a situation in which you don't already itemize, you waste part of a deduction because all it's doing is bringing your itemized deductions up to the level of deduction you would have already had with the standard deduction. And it's only the amount beyond that point that's saving you any money on your taxes.
Also, suppose you've been in your house a long time and haven't recently refinanced. The amount of mortgage interest you pay every year decreases, and you pay more toward principal because of how the loan is amortized. Lower interest payments mean reduced tax savings.
Finally, your marginal tax rate may drop after you retire, which is likely if you have limited income from sources other than Social Security, making mortgage interest deductions less valuable (and your after-tax housing costs will increase accordingly).
All of this means that holding on to your mortgage to get the "tax benefits" may become irrelevant if you can't itemize or when your tax bracket may be lower in retirement.
2) Paying off your house may reduce financial liquidity and flexibility.
If you take a big chunk of cash, either from a bank account or from your investments, and use it to pay off your house, you are taking "liquid" assets (meaning they can be easily accessed and spent) and making them "illiquid" (which means they are less so).
If a lot of your net worth is in your house, there are only a few ways to "free it up":
- Sell the house and downsize (or rent).
- Take out a home equity loan or line of credit (HELOC).
- Take out a reverse mortgage.
I'm not going to go into these in detail (I have written about them before and may go more in-depth in a future article), but suffice it to say that none of them are easy or cheap.
3) You can earn a better rate on your money by investing in the stock market than you can by paying off your mortgage.
When you pay off a mortgage, you move money from one asset (cash, stocks, bonds, etc.) and move it to another (real property). Some believe that the growth of that real property will not be as great as the stock market's expected growth. Or that both will grow, but real estate will be more reliable.
Things get dicey here. Most experts say that, over a large geographic area and a long time, real estate won't appreciate much more than the rate of inflation. After all, your house is just a bunch of building materials put together by labor sitting on a piece of real estate.
But houses in some places appreciate more in value than the materials they are made of. That's because they tend to last a long time and are built on land and in neighborhoods that are becoming more scarce in those areas. Consequently, demand can be higher in some places than in others. (Compare housing costs in Boston, MA with Charlotte, NC, where I live.)
Some areas will outperform inflation and perhaps the stock market at times. But that will vary based on local conditions. Assuming your house will appreciate faster than other investment assets could be a losing proposition in many areas.
My house has appreciated an average of about 3% a year since we purchased it 14 years ago. (The number is much lower if I factor in all improvements and other costs such as mortgage payments, maintenance, taxes, insurance, etc.) That's a little higher than inflation but lower than other areas of my city and state. Compare that to an average annual return of 11% for the S&P 500 over the same period.
Of course, many of us didn't get an 11% average annual return from our investments because we didn't have 100% of our portfolio in the S&P 500. With a balanced portfolio of stocks and bonds, average returns have been closer to 8%. If you "tinkered" too much with your portfolio—perhaps selling and buying at the wrong times—your returns were probably less.
These all seem to suggest that many would be better off keeping their money in the market. But if you do, you are, in essence, leveraging your investment portfolio.
Mortgages are a low-cost form of borrowing, so you are leveraging by paying interest versus receiving the real (after-inflation) rates of return by investing in the markets. You are taking on some foreclosure risk since your home becomes collateral for the loan, and both the value of the invested assets and your house can decline during times of economic distress.
4) You don't want to use your savings to pay off your mortgage.
You may not want to use all of your savings to pay off your mortgage and then be unable to cope with other retirement expenses.
For example, if you pay it off and don't have any contingency fund for emergencies, you'll have to get a loan or open a home equity line to pay for a new roof, buy a car, or pay a hefty medical bill. You don't want to be in a situation where an unforeseen expense forces you to take on debt, negating the benefit of paying off the mortgage in the first place.
5) Using your retirement savings (or non-retirement assets that have appreciated) to make mortgage payments could trigger a taxable event.
If you withdraw $60,000 from your IRA to pay off your mortgage, you might end up with less than $50,000 after taxes. Or, if you sell stocks from a non-retirement account, you'll have to pay a capital gains tax of at least 15%. Both result in large lump-sum tax payments to the IRS.
Therefore, it might not make sense to pay off your mortgage with money from taxable accounts. It may be better to pay it off by accelerating payments to the principal using after-tax income.
6) You have lots of other debt (or a few higher-interest debts).
Before tackling your mortgage, you may want to tackle other debts first, especially the larger ones (such as student loans) or the ones with higher interest (such as credit cards).
That makes more sense than prioritizing a low-interest rate mortgage. And once you clear that other debt, you could use the money to help "snowball" your mortgage debt.
7) Don't pay off your mortgage if you aren't getting the tax benefits from saving elsewhere.
We've already discussed how, due to the new tax law, many people can't necessarily deduct mortgage interest because of the higher standard deduction. If you don't have enough deductions, you can't itemize.
However, you may be able to qualify for a tax deduction by putting money into retirement accounts. While it can be emotionally gratifying to pay off your mortgage, sometimes you can come out ahead by saving elsewhere instead of paying off your house.
By not paying off your mortgage, you can divert that money into 401(k)s, 403(b)s, and IRAs and reduce your taxes. Instead of paying off a home mortgage, you may want to consider saving more money in your retirement account or IRA.
I paid off my house over ten years ago. (It was always my goal to do so before retirement, and we were blessed to be able to do it well before I retired in 2018.) As I mentioned earlier, I could have done better keeping my money in the markets, but I tend to be risk-averse, and the SWAN factor has always been important to me.
We are now a couple of years into retirement, and we are regularly reminded of the ongoing costs of homeownership, even without a mortgage. Since our home is almost 25 years old and relatively large (over 3,000 sq. ft.), maintenance and upkeep are becoming more of an issue.
In light of that, we have been wondering what we should do. Downsize? Move to a newer but similar house? Or stay put and bite the bullet on maintenance and repairs (and maybe make a few upgrades).
You may find yourself in a similar situation. I'll discuss this in more detail in the next article, including the different financial options a retiree has.