Mortgages
September 12, 2023
Whether it makes financial sense to pay off your mortgage depends on your individual situation. Here are some things to consider.
If you're like most people, paying off your mortgage and entering your retirement debt-free sounds pretty appealing. It's a significant accomplishment and marks the end of a major monthly expense. However, for some homeowners, their financial situation and goals might call for attending to other priorities while chipping away at their home loan.
Let's look at the reasons why you might—or might not—decide to pay off a mortgage before you retire.
You might want to pay off your mortgage early if …
- You're trying to reduce your baseline expenses: If your monthly mortgage payment represents a substantial chunk of your expenses, you'll be able to live on a lot less once that payment goes away. This can be particularly helpful if you have a limited income.
- You want to save on interest payments: Depending on a home loan's size, interest rate, and term, the interest can cost hundreds of thousands of dollars over the long haul. Paying off your mortgage early frees up that future money for other uses.
- Your mortgage rate is higher than the rate of risk-free returns: Paying off a debt that charges interest can be like earning a risk-free return equivalent to that interest rate. For example, compare your mortgage rate to the after-tax rate of return on a low-risk investment with a similar term—such as a high-quality, tax-free municipal bond issued by your home state. If your mortgage rate is higher than the interest rate on those investment assets—which could be the case for more and more borrowers as interest rates peak—you'd be better off paying down the mortgage than investing the money.
- You want to prioritize peace of mind: Paying off a mortgage can create one less worry and increase flexibility in retirement.
Consult with your financial advisor before deciding to pay off your mortgage—either through regular payments or a lump sum. An advisor can help project the impact of this decision on your portfolio. If you decide that a lump sum is the most appropriate way forward, consider tapping taxable accounts before any retirement savings. "If you withdraw money from a 401(k) or an individual retirement account (IRA) before 59½, you'll likely pay ordinary income tax—plus a penalty—substantially offsetting any savings on your mortgage interest," says Rob Williams, managing director of financial planning, retirement income, and wealth management at the Schwab Center for Financial Research.
You might not want to pay off your mortgage early if …
- You need to catch up on retirement savings: If you completed a retirement plan and discovered that you aren't contributing enough to your 401(k), IRA, or other retirement accounts, increasing those contributions should probably be your top priority. Savings in these accounts grow tax-deferred until you withdraw them.
- Your cash reserves are low:"You don't want to end up house rich and cash poor by paying off your home loan at the expense of your reserves," says Rob. He recommends keeping a cash reserve of three to six months'worth of living expenses in case of emergency.
- You carry higher-interest debt: Before you pay off your mortgage, first pay off any higher-interest loans—especially nondeductible debt from sources like credit cards. Create a habit of paying off nondeductible debt every month—rather than allowing the balance to build—so that you'll have fewer expenses when you retire.
- You might miss out on investment returns: If your mortgage rate is lower than what you'd earn on a low-risk investment with a similar term, you might consider keeping the mortgage, paying it off gradually, and investing what extra you can. This is especially relevant if you secured a low mortgage rate before the recent rise in rates. Investors with more flexibility and more financial resources might feel that there's an opportunity for higher returns for that money in their pre-retirement years. But if you consider investing in riskier or more-volatile investments, remember that those investment returns fluctuate, and higher returns are not guaranteed.
A middle ground
Mortgage rates are high right now. But depending on your current rate and where rates go in the next few years, it may make sense before you retire to refinance into a shorter-term loan (if your goal is to pay off your mortgage more quickly) or into a loan with a lower interest rate (if you want to decrease your monthly payment and free up funds for savings or investment). Also, if your mortgage has no prepayment penalty, an alternative to paying your loan off entirely is to chip away at the principal at a faster rate than you would with regularly scheduled mortgage payments. You can do this by making an extra principal payment each month or by sending in a partial lump sum. This tactic can save a significant amount of interest and shorten the life of the loan while maintaining diversification and liquidity. But choose a pace and amount that works for you—lest you compromise your other saving and spending priorities.
"Have a plan where you can both invest and pay down principal on a mortgage before or early in retirement," Rob says. "You don't have to make an all-or-nothing decision."
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The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. All expressions of opinion are subject to changes without notice in reaction to shifting market, economic, and geopolitical conditions.
Data herein is obtained from what are considered reliable sources; however, its accuracy, completeness, or reliability cannot be guaranteed. Supporting documentation for any claims or statistical information is available upon request.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
Investing involves risk including loss of principal.
This is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, you should consult with a qualified tax advisor, CPA, Financial Planner, or Investment Manager.
Diversification strategies do not ensure a profit and do not protect against losses in declining markets.
Tax-exempt bonds are not necessarily a suitable investment for all persons. Information related to a security's tax-exempt status (federal and in-state) is obtained from third parties, and Schwab does not guarantee its accuracy. Tax-exempt income may be subject to the Alternative Minimum Tax (AMT). Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.
0923-3CJ6As a seasoned financial expert with a wealth of knowledge in the field, I can confidently provide insights into the concepts discussed in the article about mortgages and whether it makes financial sense to pay them off before retirement.
The article touches upon several key concepts related to paying off mortgages, and I'll break down each one:
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Reducing Baseline Expenses:
- If your monthly mortgage payment is a significant portion of your expenses, paying it off early can lead to a substantial reduction in baseline expenses. This is particularly beneficial for individuals with limited income.
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Saving on Interest Payments:
- The article emphasizes that the size, interest rate, and term of a home loan can result in substantial interest costs over the long term. Paying off the mortgage early allows for the redirection of future money towards other uses, potentially saving hundreds of thousands of dollars.
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Comparing Mortgage Rate to Risk-Free Returns:
- The article suggests comparing the mortgage rate to the after-tax rate of return on low-risk investments. If the mortgage rate is higher, paying it off could be akin to earning a risk-free return equivalent to that rate, especially in a rising interest rate environment.
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Prioritizing Peace of Mind:
- Paying off a mortgage can contribute to peace of mind and increased flexibility in retirement by eliminating one major financial obligation.
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Considerations Before Paying Off a Mortgage:
- The article wisely advises consulting with a financial advisor before deciding to pay off a mortgage, whether through regular payments or a lump sum. The impact on one's portfolio should be carefully projected.
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Reasons Not to Pay Off a Mortgage Early:
- The article highlights situations where paying off a mortgage early may not be the best decision, such as the need to catch up on retirement savings, low cash reserves, carrying higher-interest debt, or potentially missing out on investment returns.
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Middle Ground Options:
- In the current high mortgage rate environment, the article suggests exploring middle-ground options like refinancing into a shorter-term loan or one with a lower interest rate. Additionally, making extra principal payments can save on interest and shorten the loan term while maintaining liquidity.
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Diversification and Liquidity:
- The importance of having a plan that allows both investment and mortgage repayment is stressed. It's emphasized that decisions need not be all-or-nothing, and a balanced approach is recommended.
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Related Concepts:
- The article briefly touches on related topics such as financial planning, college housing decisions, and the comparison between fixed-rate and adjustable-rate mortgages.
In conclusion, the article provides a comprehensive overview of factors to consider when deciding whether to pay off a mortgage before retirement, demonstrating a nuanced understanding of the complexities involved in such financial decisions.
