Should you retire your mortgage before you retire?

Many retirees, concerned with no longer having a steady paycheck, have asked me for advice on whether to pay off their mortgage early. There is no definitive answer but here are some variables to consider when making a decision.

Your monthly mortgage payment in retirement may represent a significant portion of your monthly income. If you only have social security as an income stream, then chances are that a mortgage payment will significantly reduce the amount you will need to meet your monthly expenses. If so, then pay off the mortgage. However, be careful you don’t significantly reduce the amount of money you have available for emergencies, general expenses and discretionary spending. You don’t want to end up house-rich but cash-poor.

By paying off your mortgage now, you reduce interest rate risk, especially in a rising rate environment. Naturally, there are several factors at play here. How long and how much debt remains on your mortgage will be a crucial factor. If you have an adjustable rate mortgage and rates double over the next five years then it makes sense to pay off the loan or at least convert to a fixed-rate mortgage.

On the other hand, if you took advantage of the low interest rate environment over the last few years and re-financed, you might now have a thirty-year fixed rate mortgage with an interest rate of 3-5%. In that case, it may make sense to keep the mortgage. Why?

If, as many predict, interest rates do rise substantially in the years to come, your borrowing cost on that fixed mortgage will look like a very good deal.

Retirees must also understand the opportunity costs of paying a large lump sum out of your retirement savings to be free of that mortgage. While being debt-free may feel good, could there be other investments that might provide a better return?

Let’s go back to the retiree who refinanced and now has a 30-year fixed at 5%. If interest rates do rise from here sometime down the road, that retiree has the opportunity of taking advantage of those higher rates. Theoretically, he could invest that lump sum money into a safe U.S. Treasury bond yielding 6 or 7%, maybe more.

While he waits for rates to rise, there is always the stock market. Stocks have averaged a 7% return historically for well over the past 100 years. He could invest the money in a group of dividend stocks, which would not only generate him income but also price appreciation.  In long-term bull markets like today’s, the average return on equities has been much, much more.

Of course, each individual’s situation is different. Paying off the last $100,000 of a mortgage out of a retirement nest egg of $1 million is much different from someone who only has saved $300,000. As always, the mortgage interest rate you are paying is critical to the equation. There are also alternatives. If there is no prepayment penalty, you can always pay down the principal faster or simply double your overall monthly payment.