Take a Mortgage Into Retirement, or Pay it Off?
October 4, 2010

Seniors approaching retirement with a mortgage balance and financial assets are faced with the question of whether or not they should liquidate assets to pay off the mortgage. With income declining at retirement, the mortgage payment becomes more of a strain. Yet liquidating assets to repay the mortgage reduces the income being generated by the assets, and leaves the borrower with less to liquidate later on when needs may be even greater.

This is not the first time I have written about this topic, see Preparing For Retirement by Reducing the Payment, but the world has changed, and so have some of my perspectives. The earlier article focused on reducing the payment and never squarely confronted the core problem, which is that we don’t know how much money we will need to support our lifestyle in retirement because we don’t know how long we will live. The only foolproof solution to that problem is to accumulate more wealth than we can possibly outlive, but most seniors can’t manage that. For all the others, the question of whether or not to pay off the mortgage looms large.

 The Case For Paying Off the Mortgage

My general view is that for most seniors, paying off the mortgage (or paying it down by enough to reduce the payment significantly) is a prudent move. The major reason is that for most borrowers, their mortgage interest rate exceeds the rate they can earn with a reasonable degree of safety on their assets. Paying off a 5% mortgage is an investment that yields 5% with no risk, so if you can do it by liquidating assets yielding 2%, you increase your wealth.

A feature of the post-crisis financial landscape that reinforce the case for paying down the mortgage balance is that the returns available on low-risk investments today are lower than they have been at any time since the 1930s. While some seniors may have opportunities to earn high returns on their assets – in a family business, for example -- the great majority can’t earn a return above their mortgage rate without taking excessive risks.

Paying Off the Entire Balance

Some seniors have enough liquid assets to repay their entire mortgage loan balance. This is a one-time investment decision that is irrevocable, which means that the borrower must anticipate what the return will be on the assets that would be liquidated if they were held instead. If the judgment is that the return would be below the mortgage rate, the proper move is to liquidate them and pay off the mortgage.

To help deal with this problem, I developed a spreadsheet which allows a borrower to enter any scenario for future interest rates, and compare his wealth in every future month in the two cases: where he liquidates his assets to repay the mortgage at the outset, and where he retains both the mortgage and the assets. The spreadsheet is titled Payoff Versus Hold. 

In comparing the return on mortgage repayment with the return on alternative investments that are taxable, it doesn't matter whether the comparison is made before-tax or after-tax. If mortgage repayment earns the higher return before-tax, it also earns the higher return after-tax. If income on the alternative investment is not taxable, however, returns should be compared after-tax.

Paying Off With Excess Cash Flow

Some borrowers facing retirement don’t want to deplete their cash by an amount sufficient to pay off their entire balance, but they will have excess cash flow for a period which they can allocate to mortgage repayment. The borrower in this situation confronts a new investment decision every month, Adding their excess cash flow to the mortgage payment is prudent if the mortgage rate is higher than the return that can be earned on newly acquired financial assets.

One of the foolish ideas that I hear about from readers is that seniors should set up a special account into which they deposit their excess income until such time as they have enough to pay off the mortgage. This is foolish because it leaves money behind. For example, John has a $100,000 balance on his 5% mortgage with 15 years to go. If he makes additional payments of $500 a month, the balance of his mortgage is paid down to zero in 94 months. If he puts the $500 in an account paying 2%, after 94 months his account is worth only $50,661 while his mortgage balance is $57, 223!

A Reverse Mortgage Can Play a Key Role as a Backstop

The case for paying down the mortgage balance is strengthened by the emergence of reverse mortgages as a legitimate and tested product for seniors. I noted above that the core challenge facing all but wealthy seniors is in assuring that they will have sufficient income over the remaining period of their lives, regardless of how long that turns out to be. Reverse mortgages can play a key role in reducing uncertainty about that. Paying off the existing mortgage clears the way for a reverse mortgage in the future.

Suppose Mary retires at 65 with a mortgage and significant financial assets. She pays off the mortgage and lives on the assets, without any certainty about how long they will last. The reverse mortgage is a backstop if she is still alive when her assets run out. The reverse mortgage allows her to borrow against her house without incurring any repayment obligation as long as she resides there. The longer she lives, the more likely it is that she will deplete her financial assets, but the larger the amount she will be able to draw on a reverse mortgage. Her draw increases because her life expectancy declines as she gets older. In addition, appreciation in the value of her home may also increase the amounts she can draw on a reverse mortgage.

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