Should Retirees Pay Off Their Mortgage?

Not long ago a key part of every retirement plan was paying off the mortgage. I’m told that a popular ritual was the mortgage-burning party, though I have never been to one.

Now, it seems that fewer retirees consider paying down the mortgage to be important. To the contrary, maintaining a substantial mortgage frequently is touted as a sound financial planning strategy. Some financial planners recommend maintaining the largest and longest mortgage possible throughout your life. When the mortgage balance begins to shrink or the home equity soars, they say refinance with a higher balance.

Anecdotes in the media indicate that more retirees are using debt to buy larger or more expensive homes or are tapping home equity to travel and buy things.

The data show that retiree debt isn’t as widespread as the headlines would have one believe, but the number of retirees with outstanding mortgages is growing. Today, 39% of those over 65 have mortgages compared to 28% who had the loans 16 years ago. Among all homeowners, about 25% have no mortgage debt, and another 28% say they expect their mortgages to be paid in full within 10 years. So, it appears that at least half of future retirees plan to have no mortgage in retirement.

Which group should you be in? Is a mortgage-free retirement for you, or should you leverage home equity to enhance the standard of living of your retirement years?

Advocates of always having a mortgage point out that a home is a consumer item with high holding costs: taxes, insurance, and upkeep. The equity in the home might or might not appreciate, depending on where the home is, but it does not generate immediate cash. The equity sits there while you spend money to maintain it.

Instead of having equity tied up in the home, put it to work so that over time it pays for the house’s holding costs. Home equity should be a working asset, not something that is stored away, they say. When home equity is put to work, net worth increases.

Under the long mortgage strategy, you maximize net worth by having a large mortgage at all times.

But the debt must be used wisely. Borrow against your home equity, and use the loan proceeds to buy a diversified portfolio of growth investments. Over the long term, the portfolio will appreciate.

For the strategy to work, the portfolio must appreciate at a greater rate than the mortgage interest rate. It won’t appreciate every year, but over the long term it should exceed the mortgage rate. Keep in mind that the mortgage interest should be deductible, so the after-tax rate on the mortgage is less than the stated rate.

It is a logical argument, and it is easy to develop numbers that make a compelling case for carrying a large mortgage at any age.

For example, Max Profits takes a $100,000 home equity loan against his house. He pays 6% interest with a 30-year amortization, resulting in a monthly payment of about $600. He invests the loan proceeds in a portfolio that he expects to earn 8% annually. After one year, he has paid $5,967 in interest. With monthly compounding, the portfolio has earned $8,300 after one year. That puts Max ahead from the start.

If Max keeps the strategy in place for 30 years, he pays $100,000 in principal and $115,838 in interest on the mortgage. His investment fund grows to over $1,000,000. The strategy clearly is a winner from this perspective.

This example assumes Max takes just one mortgage. In the long, long mortgage strategy, Max should refinance the mortgage and put more money into the investment portfolio as home equity rises due to appreciation and mortgage principal payments. That would increase the investment fund.

After 20 years, the combination of mortgage payments and appreciation might give Max enough equity that he can refinance the mortgage so that he now has a $200,000 loan. The original mortgage balance is down to about $60,000. Max uses that amount to pay off the first mortgage, adds $140,000 to the investment portfolio, and begins making payments on the $200,000 portfolio.

Yet, the case for a large mortgage involves some assumptions and conditions. Those assumptions and conditions are reasons why carrying a large mortgage through retirement is not for everyone.

• You need income to make the mortgage payments. The investment portfolio purchased with the loan proceeds will generate income and gains to offset the mortgage and the cost of home ownership. But the portfolio needs to compound for years for the program to work. Cash to make the mortgage payments must come from other sources, at least until the portfolio has compounded for some years. 

  Some advisors recommend using the loan proceeds to purchase income-producing investments with higher yields than the mortgage rate. The investment income is used to make the mortgage payments, and the excess income compounds in the portfolio.

  Yet, investments with a higher after-tax yield than the mortgage are tough to find, and they carry a fair amount of risk, perhaps more risk than a diversified portfolio of growth investments. In addition, the investment portfolio won’t compound to nearly as large an amount as when the full return is allowed compound.

• A mortgage decreases flexibility. A portion of your income is committed to the mortgage each month. If you lose a job in the pre-retirement years or your retirement income takes a hit, the mortgage still has to be paid. 

  The counterargument is that in times of severe financial distress, the investment portfolio can be liquidated and the proceeds used to pay the mortgage and any other expenses that arise. That might not always work. The investment portfolio isn’t guaranteed to always be worth as much as the loan balance, especially after taxes on the appreciation are considered.

• Don’t forget about taxes. The mortgage interest payments likely are deductible. But home equity loan interest is deductible only if the outstanding balance of the loan is no more than $100,000. Also, mortgage deductions might be disallowed under the Alternative Minimum Tax.
  That is only one side of the tax equation. The investment earnings probably also are taxable. The tax rate on the investment earnings will depend on whether you earn dividends, long-term capital gains, short-term gains, or interest. The after-tax returns need to exceed the after-tax mortgage rate. 

• The mortgage generally should be fixed rate. Some people try to maximize the benefits of the strategy by taking out a variable rate loan, because it carries the lowest interest rate at the start. But when mortgage rates ratchet up, the returns on the investment portfolio might not follow suit. A rise in mortgage rates also means that more income is needed to make the mortgage payments. An adjustable rate mortgage might be a good idea if you plan to live in the home for less than five years and have a comfortable gap between current income and the mortgage payments. In other circumstances, it carries a lot of risk. 

• A long-term perspective is required. An investment that historically earns more than the mortgage interest rate will be volatile. Stocks, real estate, and commodities are the most likely choices for the portfolio. Each of these investments has its ups and downs. The down periods can last for years. Diversification can reduce the fluctuations but does not guarantee positive returns every year. 

  The Max Profits example assumed a steady 8% annualized return. More than likely, a portfolio that earns 8% annualized over the long term is likely to have many years with returns that are either higher or lower than 8% by wide margins.

  Someone implementing this strategy must stick with the program when the investment portfolio is losing value, even if the value declines below the mortgage balance. This strategy is not for someone who would lose sleep during periods when things are not going as planned.

  Before undertaking this strategy, consider how you would feel today if you had taken out a big home equity loan in 2000 and invested it in an S&P 500 Index fund. You would have paid interest the last five years and only now would be getting the investment balance back to its starting level. In fact, you probably would have paid a few taxes on dividends from the portfolio that would further reduce the fund.

• The strategy only works if the mortgage proceeds are invested. The homeowner must resist the urge to spend all or part of the mortgage proceeds instead of investing it. 

• Peace of mind is important to many retirees. Not having to worry about a mortgage payment has an emotional benefit that increases satisfaction in retirement. 

• In retirement, home equity always can be tapped when needed through either a home equity loan or a reverse mortgage. But if there is a financial emergency in retirement when a large mortgage is carried, a reverse mortgage is not an option. Instead, the investment account must be large enough that at least part of it can be liquidated to pay the expense. But the mortgage payments still would have to be paid. The alternative would be to liquidate the portfolio to pay the mortgage, then take out a reverse mortgage. 

  The earlier example does not tell the full story. If Max is able to pay $600 monthly for a mortgage, that means he has enough cash flow to skip the mortgage and put $600 monthly into an investment portfolio. If he earns 8% on that account, after 30 years he will have almost $900,000. That compares favorably with the compounded amount from taking a home equity loan and investing the proceeds, and he will own the home free and clear the entire time.

• Of course, your heirs will not inherit the home. They will inherit the investment portfolio after paying the outstanding mortgage.
  There are many variables that can be changed in the examples, and the new assumptions will make the mortgage strategy seem more or less attractive. 

The big mortgage strategy is not for everyone. The assumptions used to compare the options must be selected with care. And the non-financial aspects must be given as much consideration as the numbers.