When it pays to have a mortgage in retirement—and when it doesn’t

Higher interest rates have changed the math on what was recently a straightforward decision, advisers say.

  • By Anne Tergesen,
  • The Wall Street Journal
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Quit your mortgage before you quit working.

So goes the standard advice for those nearing retirement, but that might not be feasible for retirees who bought or refinanced homes later in life.

Those who can afford to pay off their mortgages might find there is now a case for keeping their loans in retirement. Thanks to higher interest rates, investing savings in bonds instead of paying down principal could return enough to cover more than the cost of the monthly mortgage interest.

“A year ago, the math was really compelling in favor of paying off a mortgage early,” said Allan Roth, a financial planner in Colorado Springs, Colo. But with bond yields significantly higher today, the decision “is a much closer call,” he said.

Americans now are much more likely to carry mortgage debt into retirement than prior generations, as demonstrated by three of the four retirees The Wall Street Journal profiled last week. According to the Federal Reserve, nearly 38% of those ages 65 to 74 had mortgages or home-equity lines of credit on a primary residence in 2019, the latest year for which data is available. That is up from 22% in 1989.

When interest rates were low, many homeowners refinanced into new 30-year loans. For many older borrowers, those refis have extended loan terms far into retirement, said Craig Copeland, director of wealth benefits research at the nonprofit Employee Benefit Research Institute.

“If you had a mortgage at 7% or 8% and could refinance it down to 2%, why wouldn’t you do that?” he said.

Many retirees cannot afford to pay off their mortgage in a lump sum or feel they are better off giving priority to other goals. Lots of people prefer keeping an extra cash cushion in a bank or a brokerage account, rather than using it to pay off a mortgage, since home equity can be difficult and expensive to tap in emergencies.

For those with the capacity to pay off a mortgage, here are factors to consider:

Two rates to compare

If you can afford to pay off your mortgage now, the key calculation is to compare your mortgage rate with the yield on an ultra-low-risk investment, such as a Treasury note or bond, says Mr. Roth. The goal is to see if you can earn enough in interest after taxes to cover your continued mortgage interest.

Consider someone with a $100,000 mortgage that charges a 3% interest rate. By paying off that mortgage, the homeowner would save 3% a year, earning a guaranteed 3% return.

That person could also use the $100,000 to buy a short-term Treasury note, which would bring a slightly higher guaranteed return of about 3.49% in interest.

“If bonds are paying more, then buy the bond and enjoy the extra money,” said Burt Hutchinson, an adviser in Wilmington, Del.

What about investing the $100,000 in stocks to aim for an even higher return to cover your mortgage payments and generate a bigger profit? Since 1926, U.S. stocks have delivered an average annual return of about 7% after inflation, according to Morningstar Inc.—far higher than the interest rate many home borrowers are paying on their mortgages these days.

But that 7% return is far from guaranteed. So far this year, the S&P 500 (.SPX) is down about 16.8% through Sept. 1. And from the end of 1965 to the end of 1981, the annualized return on the S&P 500 was about 1.8% without dividends.

That illustrates the risks of such a strategy. “It’s not for the risk averse,” said Elliot Dole, an adviser in St. Louis.

Consider the tax impact

Taxes can change the math on the decision to pay off a mortgage, generally in favor of paying off the debt.

Since the 2017 tax overhaul, which significantly raised the standard deduction, far fewer homeowners have taken a tax deduction for their home-mortgage interest payments.

Those who do should reduce the cost of their mortgage to reflect that tax benefit when deciding whether to pay off the mortgage, said Mr. Roth.

If the homeowner above with a 3% rate on a $100,000 mortgage receives a home-mortgage interest tax deduction, the cost of that 3% mortgage falls to 2.34% after the tax benefit is factored in. (This assumes the homeowner is in a 22% tax bracket.)

The homeowner must compare the 2.34% after-tax cost of the mortgage with the after-tax return he or she could earn on a Treasury note. Someone in the 22% tax bracket would forfeit 22% of the note’s 3.49% in interest to taxes. That leaves an after-tax return of 2.7%, according to Mr. Roth.

Because the bond’s 2.7% after-tax return exceeds the mortgage’s 2.34% after-tax cost, the strategy of buying bonds to pay the mortgage remains the more profitable choice, said Mr. Roth.

However, if the homeowner doesn’t receive the full tax benefit from taking the deduction, the bond’s 2.7% after-tax return falls short of covering the 3% mortgage. As a result, the taxpayer can get a higher return by paying off the mortgage.

How paying off the mortgage can affect liquidity

If you pay off a 3% mortgage only to discover you need to tap your home equity in retirement, you may have regrets.

Retirees with substantial assets but little income can have trouble qualifying for a new mortgage, said Mr. Dole. One retired client of Mr. Dole’s was recently turned down for a mortgage on her primary residence and had to sell assets to meet her cash needs.

Compared with other forms of housing debt, including home-equity loans and reverse mortgages, retaining a primary mortgage “can be a low-cost way to fill funding gaps,” said Mr. Dole.

Even when the math is favorable, some retirees may still feel more comfortable paying off the loan as soon as possible. Eliminating it can bring peace of mind and a sense of accomplishment, said Kevin Lao, an adviser in Jacksonville, Fla.

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