Ready For Retirement
Ready For Retirement
3 Key Factors to Consider Before Paying Your Mortgage Off in Retirement
Connor plans to retire soon and wonders if he should pay off his mortgage of $300,000 or invest those funds, especially since he has a low interest rate. James gives a detailed response and reveals why there is no one-size-fits-all answer. When it comes to having a mortgage in retirement, math and spreadsheets can help with part of the question, but emotions and personal values should be considered too.
Questions answered:
Should you pay off your mortgage as you head into retirement, especially if you secured a low interest rate mortgage in recent years?
How should you weigh the financial benefits of investing available funds versus the emotional peace of mind of being debt-free in retirement?
Timestamps:
0:00 - Connor’s question
1:36 - An example scenario
4:51 - Interest rates
6:22 - Tax considerations
9:13 - Tax-adjusted mortgage interest rate
12:13 - Sequence of returns
15:27 - Peace of mind
17:07 - Conclusion
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Welcome back to another episode of Ready for Retirement. On today's show, we're going to talk about whether or not you should pay off your mortgage as you head into retirement. And before you jump to an immediate conclusion, keep in mind that this very much depends upon when you got your mortgage, when you took out that mortgage, because this answer is going to be very different for someone who took out their mortgage today, for example, versus maybe someone who took it out a few years ago, simply due to the rapid changes we've experienced in interest rates over the past few years and the potentially rapid change to interest rates we may experience in the future. There's a lot to uncover with this specific topic. All ahead on today's episode of Ready for Retirement.
Speaker 1:This is another episode of Ready for Retirement. I'm your host, james Canole, and I'm here to teach you how to get the most out of life with your money. And now on to the episode. This show is based on a listener question and this question comes from Connor. Connor says Hi, james, I love your podcast and I've been learning a lot.
Speaker 1:Here's my question that I would assume others would have a similar scenario I would like to be in a position to retire, even if I don't, when I'm age 57. I recently financed my home in late 2020, when the rates were super low and my interest rate is 2.75%. So I'll have another 22 years of mortgage payments once I do retire, assuming I don't pay it off. I could pay it off now and the balance is $332,000, but I think it would be better to invest, because the tax benefits of having a mortgage and I should be able to earn more on the money if it's invested. What do you think, connor? Well, connor, thank you very much for that question. I do think a lot of people have similar questions and that is one of the big things of do you pay off a mortgage as you go into your retirement? And here's a really unique thing for many of you.
Speaker 1:Listening is for those of you who financed or refinanced your property in 2020 or thereabouts, like Connor did. There's a dramatic difference between where interest rates are today and where interest rates were at that time. So I'm going to use Conor's situation as an example. I don't actually know Conor's exact monthly payment principal and interest payment nor do I know the initial mortgage balance when he took it out, but just for the sake of an example to illustrate what I'm going to talk about in the rest of the episode.
Speaker 1:I'm going to assume that someone today takes out a mortgage of $332,000, which is the remaining balance on Connor's mortgage and I'm going to assume a 2.75% interest rate on that mortgage for 30 years with no additional payments made. What that would result in is a monthly principal and interest payment of $1,355 per month. So let's assume that you take out that mortgage today. Now, of course, today you're not going to be able to get an interest rate of 2.75% like you could have a few years ago. And the thing that has changed significantly since a few years ago, on top of mortgage interest rates, is also savings interest rates. Where four to five years ago, savings accounts were paying practically nothing, today you can find savings accounts high yield savings accounts paying 5% or more.
Speaker 1:So with that, here's something that's unique about people's situation like Connor. Assume that he has that $332,000 that Connor has in cash and he says look, I can either pay off my mortgage or I can invest this. Let's not even assume that he invests it, but let's simply assume that he puts that $332,000 into a high yield savings account that's paying 5%, and let's assume that he continues to receive that 5% for the next 30 years? Not a guarantee, probably even unlikely, because the thing with high yield savings accounts is that interest rate is going to fluctuate based upon whatever the Fed funds rate is or the baseline rate is. So I'm going to assume for this illustration that he receives 5% for the next 30 years, but very unlikely in the grand scheme of things. That will fluctuate as things go up and down.
Speaker 1:So here's what we're looking at. Let's assume that Conor puts that $332,000 that he has in cash today into a high yield savings account, paying 5%, and he pulls $1,355 per month from that savings account to make his monthly mortgage payment. So what he's doing is, instead of paying off the mortgage, he's putting that money to work, earning that 5% and just pulling the minimum amount needed each month to make the monthly payment. Here's the thing At the end of that 30 year time period, connor would have his mortgage paid off and he would still have $355,000 in his savings account, which is more than he initially started with. He started with $332,000 in his savings account. So what he effectively did is he paid off his mortgage and he still had a balance left over that he was able to do that with, and when we take a step back and look at the math, this makes sense. If you look at the math, 5% on $332,000 is $16,600 per year. Assuming he had that 5% every single year going forward, the annual mortgage payment is $16,260. So, in other words, in Connor's specific situation, the interest payment alone covered the mortgage payment, with a little bit left over that continued to build up in the savings account.
Speaker 1:So that's what's really unique for those of you who refinanced or just initially financed a property or a mortgage in a year like 2020, when interest rates were very low, and then in recent years, we've had interest rates spike, meaning you can now put your cash to work and earn a much higher rate than you could have a few short years ago. So here's the general principles that you need to look at, not just Connor, but everyone who's contemplating this same question of should I pay my mortgage off going into retirement? There is the math side of things that you need to consider, and we'll walk through that, and then there's the emotional side of things, and we'll need to consider that as well. In the math part, some of these things are known and some of these things are unknown, and it's not just as simple as saying, well, what's the interest rate on your mortgage and what's the interest rate you might expect to earn in your investments. That's where we want to start, though, on the math side, you do generally want to look at your interest rate versus what you could earn on an investment. One thing to keep in mind is that, due to how mortgages are amortized and the timing of various things, it's not always a perfect comparison, but it's a great place to start of look at what's the interest rate on the mortgage. What interest rate do I think I could get on my investments and start there.
Speaker 1:So, to go back to Connor's point earlier, his mortgage rate from 2020 is 2.75. Could he invest and do better over the lifetime of his mortgage? Probably, no guarantee, like we looked at, even a high yield savings account today could pay more than he's paying on his mortgage interest rate. Now, for those of you that are getting mortgages in this year say 2024, your interest rate might be 6.5% 7% somewhere thereabouts. So could you get more than 6.5% to 7% on your money if you invested it as compared to what you'd be paying on the mortgage? Maybe, but also maybe not. The higher that mortgage interest rate is, the lower the possibility or the lower the probability that you'll be able to outpace that in terms of the returns you might be able to get on your investments going forward. Here's the thing, though and Connor brought this up a little bit you shouldn't just look at the interest rate by itself.
Speaker 1:You also need to factor in tax consequences. Now for Connor, I'd be interested to see is he actually able to deduct his mortgage interest? Based upon a mortgage balance of $332,000 and an interest rate of 2.75%, he's paying approximately $9,000 per year in interest right now, and that amount will actually continue to go down as the mortgage payment gets paid down. So it's a tax benefit only if Connor's itemizing, meaning if he adds up his mortgage interest plus state and local taxes, capped at 10,000 per year, plus any charitable giving plus anything else like that. So if Connor is itemizing his taxes, he is getting a benefit for that mortgage interest rate. If he's just taking the standard deduction, then that mortgage interest really isn't helping him. Nor is it helping any of you if you're paying mortgage interest but you're not itemizing your deductions. More on that in a little bit.
Speaker 1:So what you do need to look at, though, is when you look at your starting mortgage rate. Let's say that you take out a mortgage today and use round numbers, you're paying 7% on your mortgage. What you're going to ask yourself, if you're in a position like Connor, is should I make extra payments or pay down my mortgage, or should I invest money as opposed to trying to pay this mortgage off early Now? The starting point, the starting threshold, is that 7%. If you can invest and get more than 7%, maybe it makes more sense to invest. If you can't, maybe it makes more sense to pay off the mortgage. That's the starting point. But where we need to go from there is we need to understand what's the tax adjusted mortgage rate. Here's what I mean by that.
Speaker 1:Let's assume you are itemizing. You're taking your mortgage interest plus charitable giving, plus state and local taxes plus anything else. If you add all that up and it exceeds the standard deduction, you're going to itemize your deductions. So let's assume that you're in a position where you're doing that. And let's also assume that you're in a very high income tax bracket. Let's just assume you're in the highest income tax bracket At the federal level. That's 37%. Well, if you're able to itemize every dollar of mortgage interest that you pay and your mortgage interest rate is 7%, your tax adjusted interest rate is closer to 4.4%. What I'm doing there is I'm simply saying, yes, you're paying 7% to the bank, but part of that you're able to offset on your tax return in the form of an itemized deduction. So now what you're looking at is 4.4% as the threshold that you need to exceed. Obviously, the lower the tax bracket that you're in, the less that mortgage interest actually helps you because you're not in those higher rates. If, for example, you're in the 10% tax bracket and you're paying 7% on your mortgage and you're itemizing your deductions, well, now your mortgage interest rate or your tax adjusted mortgage rate is closer to 6.3%. So as you do this, that should be the number that you're looking at is what's the net cost to you of that interest? Because there's a cost that you pay the bank, which is the interest rate itself, but then there's a potential tax savings if you're itemizing.
Speaker 1:Now, as a quick aside, I'm going to get a little bit more detailed here. But even if you itemize, you're not necessarily getting every single dollar of mortgage interest paid helping you. Here's an example. Let's assume that you're single in 2024. You have a standard deduction of $14,600. Let's assume that you have property taxes of exactly $4,600 and you don't have any state income taxes. So 4,600 is how much you can deduct for state and local taxes. Let's assume that you have no state income taxes. Like I said, let's assume they have zero and charitable giving.
Speaker 1:And let's assume that you have mortgage interest of $20,000, no other deductions. Well, if you look at this, your total deductions are $24,600. That's the $20,000 in mortgage interest plus the $4,600 in property taxes. So you do itemize. You're itemizing there because the itemized deduction exceeds the standard deduction. But the first $10,000 of mortgage interest that you pay really isn't helping you because that first $10,000 is just bringing you back to where the standard deduction would take you by itself. Then the remaining 10,000 is what you're actually getting in a benefit. So a little bit more detailed there.
Speaker 1:But all this to say is if you're really trying to get detailed, don't just look at do you itemize or not itemize. But even if you do itemize, what amount of mortgage interest is actually exceeding the standard deduction? What amount are you getting to itemize that you wouldn't otherwise be able to take as a deduction if you were to take the standard? So really the logic here is just saying what is the net cost you're paying to your mortgage? And again, the net cost is the amount that you're paying to the bank in the form of mortgage interest, minus any potential tax deductions that you're getting for doing that. So what that's going to get you is what we'll call the tax adjusted mortgage interest rate. I don't think that's an official term or anything, but just something that I'm going to call it here on this podcast episode. So that's where you start.
Speaker 1:So let's assume let's go back to that example you have a 7% mortgage interest rate because you take that money out today, or you take that mortgage out today, you're in a high tax bracket, income tax bracket. You are itemizing so effectively, that's a 4.4% rate, the tax adjusted interest rate that you're paying. Now what we need to look at is what rate of return could you get on your investments? The same way we looked at the tax adjusted mortgage interest rate, you also have to look at the tax adjusted rate of return that you could get on your investments. Part of this comes down to what type of an investment are you investing in. Is it paying dividends? Is it paying long-term capital gains? Is it paying interest, and where are you doing the extra investing? So, for example, if you have an extra thousand dollars a month and you're trying to say, should I use this to pay down mortgage interest or should I use this to invest, the analysis is going to be different if you put that thousand dollars a month into, say, a Roth IRA or 401k versus if you put that thousand dollars a month into a brokerage account versus a traditional IRA, simply because all those things have different tax impacts. So a few different scenarios here to consider, but I'm not going to go through it all the way, as much as I'm going to say consider your tax adjusted mortgage interest rate and then compare that to the tax adjusted investment returns that you could get as an alternative.
Speaker 1:Once you've done that, that's the first part of what we'll call the math part of this equation. That's the known aspect of you know what your mortgage interest rate is and you don't know exactly what investment return you're going to get, but you know the investment return required to exceed that interest rate when you consider taxes and making adjustments for that. Now, some of this math stuff to use a technical term is known and that's what we just looked at, and some of it is unknown. So what are the unknown components of this that purely come down to a math equation? Well, it's sequence of returns. Here's how sequence of returns ties into this equation.
Speaker 1:Let's assume that you knew for certain that you're going to retire, you're going to carry a mortgage into your retirement and you knew that you could get 7% per year over the next 30 years on your investments. You have some way of looking into the future and you know that in retrospect you could earn 7%. So you look at that and say, okay, I could earn 7% and maybe have a mortgage interest rate of 5%. So I'm going to invest my money instead of paying down my mortgage because I know that over the next 30 years I'm going to get a. But what happens when you do average that 7% over 30 years, but say the first five to 10 years of retirement? You get horrible returns. You get negative returns in the market or very flat returns in the market.
Speaker 1:What does that mean? Well, what it means is you have higher expenses going into retirement because you have that mortgage and you haven't paid the mortgage off and you have poor returns on your investments. Now this is not a good combination, because those higher expenses from your mortgage means you need to pull more money in most cases from your investments to pay that mortgage. So it doesn't matter if those investments would have earned 7% had they stayed fully invested for 30 years. If they don't stay invested for 30 years, you're not gonna get that. And the way they're not gonna stay invested is because when the market's dropping no-transcript.
Speaker 1:So this is something that's still very much part of the math component of this decision of paying off a mortgage versus not paying off a mortgage. But it's completely unknown because you don't know exactly what the market's going to do next year, the following year, the year after, for the first number of years into your retirement. Now, on the flip side, if the market does even better than average returns in the first five to 10 years, then the equation comes out even better for you. So if you get, say, 12%, 13% on average those first five years, well then, not paying the mortgage off leads to an even better outcome for you than if you would simply average 7% every single year for the opposite reason, or the inverse reason that we just discussed. Now, when people are making this decision, it's usually not to say, okay, well, what if we get great returns.
Speaker 1:A lot of people want to know what's the downside of not paying off the mortgage. So we're more focused on that downside and downside protection, which is you don't pay it off. Maybe you do get great returns over time, but the first few years are sub-average or sub-optimal and that ends up costing you over time. Now, to an extent, there's some ways of helping to protect against this by making sure your portfolio is invested the right way having a good mix of growth funds, conservative funds, things like that. But that is still a big part of this that we cannot underestimate is what sequence of returns are you going to get going into retirement? So that's the math side of this. If you can figure that stuff out, you can look at spreadsheets to come up with an answer. When you're considering the math side of things, the things that a spreadsheet is not going to do for you, the things that math isn't going to do for you is give you that peace of mind, the emotional component of paying off a mortgage. One way you can think about this is, if you're considering, do I pay off my mortgage or not, ask yourself what would it feel like to have a mortgage in retirement. Envision that Some people don't even bat an eye when they think about this.
Speaker 1:To them, having an extra payment in retirement is no big deal and it's just part of their plan. As long as they have enough money to cover it, they're totally good having that mortgage in retirement. Other people they cannot conceive of having a mortgage, let alone any debt in retirement To them. It blows their mind that anyone would even consider retiring with a mortgage. So these are not necessarily math problems that these people are solving, as much as that's kind of part of their internal belief system or core things that is most important to them and just having no debt, being mortgage free, as part of what's going to allow them not just to be able to retire financially but even emotionally, knowing that there's not that extra drain on their portfolio because they have to continue making a mortgage payment.
Speaker 1:So, as you're considering this, yes, look at the numbers, look at the math, run them and see what makes most sense. But then ask yourself what would it feel like to have a mortgage in retirement? And, on the inverse, what would it feel like not to have a mortgage in retirement? Would you feel significantly better? Would that feel like a huge weight is off your shoulders. If that was the case, if that's the case, if you would feel that tremendous sense of relief by not having the mortgage, then I'm not going to say don't consider the math, but maybe weigh it a little less heavily in your overall decision criteria as compared to the emotional component of this, the peace of mind component of this, because a big part of financial planning is not just optimizing the spreadsheet numbers, but it's doing what's going to give you most peace of mind, the most confidence, while still, of course, allowing you to accomplish the goals that you have. So, as we start to wrap up today's episode, those are the things we want to be mindful of.
Speaker 1:Connor, I really appreciate that question of low interest rate mortgage. Should I invest, should I not invest? There's tax components, there's math components, there's emotional components to this and hopefully that was helpful to consider as you're trying to make the decision for you of what makes sense as you go into retirement. So that is it for today's episode. Thank you, as always, for listening.
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Speaker 1:That's it for today. Thank you for listening and I'll see you all next time. Hey everyone, it's me. Again. For the disclaimer, please be smart about this. Before doing anything, please be sure to consult with your tax planner or financial planner. Nothing in this podcast should be construed as investment, tax, legal or other financial advice. It is for informational purposes only. Thank you for listening to another episode of the Ready for Retirement podcast. If you want to see how Root Financial can help you implement the techniques I discussed in this podcast, then go to rootfinancialpartnerscom and click start here, where you can schedule a call with one of our advisors. We work with clients all over the country and we love the opportunity to speak with you about your goals and how we might be able to help and please remember, nothing we discuss in this podcast is intended to serve as advice. You should always consult a financial, legal or tax professional who's familiar with your unique circumstances before making any financial decisions.
