There are many approaches to handling debt and that holds true for what is often our largest debt – a residential mortgage on a primary home. Although we usually are not considering paying off a mortgage when we enter into the transaction – after all fifteen or thirty years seems a long way off – that question may arise at some point in the future.
When one is starting out, it is common to use a mortgage to fund the majority of the cost of a home. This is usually because the buyer does not often have enough cash on hand to purchase a home outright. This does not necessarily mean that the buyer is without significant assets – a qualified retirement plan may be a repository of substantial value but may not be easily or cheaply accessible, particularly for younger buyers. Other non-liquid assets may also be available and these, along with prospective earning power, can provide the necessary security for the loan.
As we age, however, we tend to build up some additional liquidity in our investment portfolio and retirement savings while at the same time we are gaining equity in our residence as we service the mortgage. There may be a windfall such as an inheritance, proceeds of a sale of stock or a business, or even perhaps winnings such as in a lottery. At some point in time, these changes can spur us to consider whether to pay off the remaining mortgage balance entirely. Another option that is beyond the scope of this discussion is the refinancing of a mortgage which is an altogether different step to take.
There are several relevant questions or factors to consider when you are thinking about paying off a mortgage.
Perhaps the primary question is whether your money is better off invested while you continue with the mortgage or if some assets would be better used to pay off that mortgage. A way to evaluate this is to examine the rate of interest paid on the mortgage and compare it to the anticipated return on your investment of the money. A higher rate mortgage might nudge one towards paying off the balance if it is assumed the funds would not grow at a better rate if invested. A lower rate mortgage provides a better likelihood that the money earned on an investment would outpace the cost of servicing the mortgage.
The impact of paying off a mortgage on the resources remaining for funding retirement goals, as well as other current goals if not near retirement, is also worth thinking about. Available funds invested for the mid to long term may perform well and help to provide for a more comfortable retirement. If they are instead expended on satisfying a mortgage, then those funds no longer will be able to help fund other goals. That leaves one dependent on saving the difference (the mortgage payment) to replenish the asset base. Not everyone is suited to that approach as funding other goals and spending that money no longer needed for a mortgage can be very tempting.
A related factor to consider would be the friction or cost of freeing up the money to pay off the mortgage balance. For example, income tax would be due on most IRA or other qualified plan withdrawals, together with the ten percent penalty when applicable. Selling holdings in an investment portfolio could result in long term gain or perhaps short term gain. Other friction might include trading costs or broker fees. Don’t forget that some investments come with restrictions as to when you can liquidate them – certificates of deposit, for example, must be held to maturity date or some interest may be forfeited while restricted stock may prohibit the sale of sufficient shares to fund the planned pay off.
The ever present income tax may have additional implications when you are pondering the mortgage pay off. Particularly while you are working but also potentially during retirement, itemized deductions can make a difference in one’s tax liability, especially when the interest paid together with property taxes and other items will exceed the available standard deduction. The fact that gain realized on the sale of the property is protected from income taxation, to some extent, may have little influence on the decision whether to pay off the mortgage.
Another consideration is your comfort level with the current situation with your mortgage. Not to be confused with inertia, the idea is to understand whether you are comfortable with having and managing debt. For many of us, this is the normal situation and carries no hesitation, using the mortgage as tool to obtain a home and depend on income as opposed to assets to service that mortgage. On the other hand, some folks are debt-averse and would prefer to have no debt so as to minimize their monthly expenditures. The absence of debt may also allow for additional savings or perhaps choosing to apply income to make other expenditures such as travel, gifting and more. A related aspect here might be a desire for some to reduce spending on a mortgage as income drops with retirement.
There are many factors and nuances that may come into play once you start thinking about what to do with your mortgage. When there are options, it is best to understand and examine them in order to make the right decision for you. A financial adviser can be very helpful in this process, showing how the choices affect your other goals and planning.
George Chamberlin & Mentor RIA Consulting © 2018