Check out our video on this topic here!
In today’s blog, we’re going to discuss the pros and cons of paying off your mortgage before you retire. The answer to this question isn’t always black and white but there are certain steps you can take to better understand which method may be best for you.
So let’s take a closer look at what’s really at stake.
For many people that we speak to who are nearing retirement, the idea of being debt-free is incredibly appealing.
Most times, they have a strong belief that paying off your mortgage is the ultimate sign of financial security.
No more monthly payments and no more debt hanging over your head makes it sound like it could be the perfect way to enter your next chapter with confidence.
And while the emotional relief could feel comforting, this sense of security could also come with a hidden price which is the opportunity cost of lost compounding growth.
When you put every extra dollar toward your mortgage, you’re tying up your money in your home rather than keeping it accessible or putting it to work in the market.
Now picture this, you reach retirement, completely debt free, and then a sudden expense leaves you scrambling because you used your liquidity to turbocharge your mortgage payments.
In some cases, this could leave one opting to borrow money or even having to sell investments to create the necessary cash.
And this is where the concept of opportunity cost can become critical.
Every time you pay extra on your mortgage instead of investing, you’re making a tradeoff.
So let’s put this in perspective- Historically, the S&P 500 has returned over 8% per year on average while many mortgages in recent years have carried rates between 3% and 6%.
If your mortgage rate is at the lower end of that range, the money you use to pay it off early can be viewed almost like earning you a “return” equal to your mortgage interest rate—say, 4%.
But if you invest that same money in the stock market, you could potentially see annual returns closer to 8%.A quick disclaimer here is that past performance does not guarantee future results!
And over time, this difference could have the ability to compound.
A caveat that we find of importance to recognize is that the desire to be debt-free may not just be a rational calculation, but also a deeply emotional decision.
Knowing that your home is paid off could bring one a feeling of safety and confidence which can be hard to ignore.
But the fact that locking your wealth up in your house could make it hard to access, especially in the event of an emergency, is something that should not be overlooked.
The next factor we take into consideration when moving through this process is how your mortgage interest rate could potentially influence your financial strategy as you approach retirement.
This single figure can help to determine whether your money works harder by eliminating debt or by investing.
Being that investment returns are never guaranteed, and the markets can move in cycles, we need to be aware that downturns can happen.
So, when we walk through this process, we are taking into account one’s risk tolerance and time horizon among other things.
For someone uncomfortable with market swings or who is closer to retirement, they may prefer the certainty of paying off a higher-rate mortgage, even if that means missing out on some potential gains.
While for others, especially those who have built up an emergency fund or have a longer term outlook, investing while carrying a low-rate mortgage may feel more comfortable.
One of the biggest factors in this process is flexibility.
For example, if you have investments that provide liquidity, meaning you can access them in the event of an unexpected expense arising, you might find yourself more nimble as opposed to having cash tied up in an illiquid asset like a home.
Ultimately, although not a perfect framework every time, we find that matching your mortgage rate against what you think your investments could earn, can provide a framework in making the decision.
And as we build out the decision making process, there’s another layer that can sometimes be overlooked.
The timing of my payments—whether in the early years or nearing the end of your loan, can make a big difference in how much one might benefit from paying off the mortgage or not.
Why does this matter you might ask?
Mortgages are structured through a process called amortization, which controls how each monthly payment is divided between interest and principal.
In the earlier years of a 30-year mortgage, the majority of the payments tend to go toward interest, while a smaller portion reduces the actual loan balance.
And over time, this ratio typically gradually shifts so by the later years, the majority of the payment is applied to the principal, while a smaller portion covers interest.
In other words, putting extra money into your mortgage in the early years could potentially put a significant dent in the total interest you’ll pay over the life of the loan.
By year 20 though, that same extra payment might only save a fraction of what it would have earlier.
The bottom line is that this difference in impact can cause your strategy and thinking to adapt as your mortgage progresses.
It’s also important to be aware of the fine print in your mortgage agreement being that some loans could include prepayment penalties which are essentially fees for paying off your mortgage ahead of schedule.
And although this decision might seem like an overwhelming fork in the road, in our mind, it doesn’t always make sense to choose just one path at the potential expense of the other.
You may find comfort in an approach where the goals are both debt reduction and wealth building and the plan could include intentionally splitting your extra resources between your mortgage and your investments.
An example might look something like this. If you were to receive a bonus or inheritance, you might allocate half toward additional mortgage payments and the other half to your investment portfolio.
This method could help you make steady progress on your loan while also adding to your investments in hopes of long-term growth over time.
Another tactic to consider is making biweekly mortgage payments instead of monthly so by dividing your monthly payment in half and paying every two weeks, you end up making the equivalent of an extra full payment each year.
Over the life of your mortgage, you could cut years off your loan term and potentially save a significant amount in interest.
At the same time, maintaining regular contributions to an investment account could keep your money working with the potential for compounding returns.
One of the key determinations we speak about with clients is having a solid financial foundation before dividing the extra cash.
Eliminating things like high-interest debts, such as credit cards or personal loans, in addition to making sure your emergency fund is flush can bring confidence to your overall strategy.
Wrapping things up here, if being debt-free allows you to feel more at ease and enjoy life, that could be a valid consideration to pay off the mortgage in full. The key is to weigh this emotional benefit against the objective financial trade-offs, rather than letting it overshadow all other factors.
When weighing whether to pay off the mortgage or invest, here are three steps we take into consideration.
First, compare the mortgage interest rate to the returns you might expect from your investments.
Second, consider where you are in your mortgage term and how much liquidity you might need for unexpected expenses.
And third, find a balance between debt reduction and investing that matches your long-term goals and comfort with risk.
The Final Word:
As always, working with your team of trusted professionals could help you make an informed decision. Your situations is different than everyone else’s and the emotional feeling of be comfortable either with or without the mortgage debt should always be a big factor of consideration.
Thanks for reading!
Disclaimer:
Rockline Wealth Management (RWM) is a registered investment adviser located in Islip Terrace, NY. RWM is registered with the U.S. Securities and Exchange Commission. Registration of an investment adviser does not imply any specific level of skill or training and does not constitute an endorsement of the firm by the Commission.
Rockline Wealth Management does not offer tax or legal services. The information in this material is not intended as tax or legal advice. Please consult legal or tax professionals for specific information regarding your individual situation.
All information presented is believed to be factual at the date of publication. This blog should not be viewed as advice for any individual and is intended for general informational purposes only.
All investment strategies have the potential for profit or loss. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment or strategy will be suitable or profitable for a client's investment portfolio.
Asset allocation and diversification do not ensure or guarantee better performance and cannot eliminate the risk of investment losses. The opinions expressed and material provided are for general information and should not be considered a solicitation of financial advice or for the purchase or sale of any security.
Real-life and fictional examples given in this blog should not be viewed as guaranteed outcomes when investing. Past performance is not indicative of future results and every individual’s investment circumstances are different. Individuals should consult their financial professional before implementing their investment plan.
Certain information contained herein constitutes “forward-looking statements,” which can be identified by the use of forward-looking terminology such as “may,” “will,” “should,” “expect,” “anticipate,” “project,” “estimate,” “intend,” “continue,” or “believe,” or the negatives thereof or other variations thereon or comparable terminology. Due to various risks and uncertainties, actual events, results or actual performance may differ materially from those reflected or contemplated in such forward-looking statements. Nothing contained herein may be relied upon as a guarantee, promise, assurance or a representation as to the future.