It’s one of the big questions facing people who’ve owned their homes for a while but haven’t fully paid them off: With retirement approaching, does it make sense to pay off my mortgage early?
“I think it’s sexy to want to live mortgage-free,” says Jonathan Pont, a New York City financial planner and board member of the Financial Planning Association of New York. “Especially for people who are looking at retirement, and saying: ‘Wouldn’t it be great to have one less X hundred or X thousand mortgage payment a month.’ But you need to look before you jump.”
Pont suggests asking yourself three questions as you make the decision:
1. What are your future plans? If you’re expecting to sell your home within the next few years, then continuing to make mortgage payments each month is less of a concern than if you’re expecting to stay there for another decade or longer. (Next Avenue has an article by former U.S. Secretary of Housing and Urban Development Henry Cisneros on why cities need to do more to help their residents age in place.)
You should also take estate planning into account when deciding whether to pay off your mortgage early, notes Pont. If your aim is to pass your home to your child upon your death, you have an incentive to eliminate the mortgage soon. That way, your son or daughter won’t be saddled with mortgage payments on the house.
Another consideration: Do you expect your income to drop once you retire? If so, your mortgage interest deduction will likely become less valuable to you, so there will be less of a tax advantage to your mortgage payments then.
Just keep in mind that the percentage of your mortgage payment going toward interest shrinks each year and is much smaller in the last few years of a 30-year mortgage than in the early years. That means your mortgage interest deduction shrinks year by year, too, so the amount you’ll lose in annual mortgage write-offs by paying off your mortgage in its final years will be much less than if you had paid off the mortgage years earlier when interest was a bigger chunk of your payments. For instance, on a new $200,000, 30-year, 4 percent, fixed-rate mortgage, your interest in year one might total $7,936 but in year 28 it would amount to $1,105, according to hsh.com.
2. How much money would I save overall by paying off the mortgage early? That’s a fairly easy number to calculate if you’ve got a 30-year-fixed mortgage, Pont notes. Websites, like hsh.com, have mortgage amortization calculators that will generate a table of your future interest expenses year by year.
If you have a 30-year, 5 percent fixed-rate mortgage with $200,000 and nine years left to go (original balance: $471,700), you’d save $53,000 in interest by paying off the loan now.
Before you write a check, though, see if your lender would charge a prepayment penalty. That’s unlikely for a 30-year fixed loan that you’ve had for decades, but if you refinanced into an adjustable rate mortgage in the past several years, a prepayment penalty may be hidden in your paperwork. If there were a penalty, it would likely be just a few thousand dollars, so the interest savings minus the penalty would still represent a significant savings.
Martin Lo, a financial planner in Parkville, Md., notes that on “a financial and emotional level,” a mortgage payoff offers a predictable return, too. “If you pay off a loan that was charging 4 percent, you just earned 4 percent,” he notes.
But you’ll need to be disciplined about the cash you’ll save from paying off the mortgage, Lo says. “People swear up and down that if they have money to pay off loans, they will ‘invest the difference.’ But most folks spend the difference.” The best way to keep your spending from escalating is to automatically transfer each month from your checking to savings account the money you would’ve paid for the mortgage.
3. Where is the money for the payoff going to come from? Don’t dip into savings to eliminate your mortgage unless you already have an emergency fund equal to three to six months’ of expenses, Pont says. You don’t want to find yourself in a financial bind from a mortgage payoff and unable to cover essential expenses. It may be smarter to sell your home and move to a cheaper place with a less expensive mortgage.
If you plan to sell one of your investments to eliminate the loan, figure out whether you’ll owe capital gains taxes as a result. If so, be sure you’ll have enough cash on hand for the tax bill.
After You've Answered the Questions
Once you have the answers to those three questions in your head, it’ll be easier to decide whether to pay off your mortgage.
Say, for example, you plan to stay in your house for another few years and could save $50,000 in interest by paying off your 4.8 percent fixed-rate loan. If you have $50,000 sitting in the bank earning less than 1 percent, the answer is pretty easy: Pay it off.
If you’d need to scrape together the $50,000 by selling your dividend-earning stocks yielding 6 percent or so, the answer changes. Then you’ll have to decide whether it’s worth liquidating the higher-yielding investment and possibly owing capital gains taxes in exchange for a lower, but certain return.