Episode 15: Should I Pay Off My Mortgage Before I Retire?

John Bever |

Did you know that paying off your mortgage before you retire might not always be your best move?

In this episode of The Year You Retire, Jim Uren and John Bever delve into the hot topic of whether to pay off your mortgage before retiring. They discuss the advantages of being mortgage-free, such as potential interest savings and improved cash flow, but also emphasize the liquidity risk and misunderstood historical fears associated with mortgages. They discuss the importance of considering individual financial goals, risk tolerance, and overall liquidity when making this decision. They also touch on the tax advantage of having a mortgage and strategies for paying off mortgages early.

If you want to be better prepared for the year you retire, this episode provides valuable insights into the considerations individuals should weigh when deciding whether to pay off their mortgage.  Remember, there's no one-size-fits-all answer and your own circumstances should be carefully evaluated. If you're nearing retirement and own a home, this episode offers valuable insight into the decisions that lie ahead. 

In this episode, you will:

  • Learn the unusual perks of mortgage in the U.S. compared to other countries.
  • Discover the pros and cons of an early mortgage payoff.
  • Learn the potential tax advantages of keeping your mortgage in place.
  • Explore effective strategies if you choose to pay off your mortgage early.
  • Learn the personality type that might be best suited to a 15-year mortgage.

The key moments in this episode are:

00:00:42 – Topic Introduction

00:04:37 - Pros and Cons of Paying Off Your Mortgage Early

00:07:41 - Impact on Portfolio and Sequence of Return Risk

00:10:55 - Historical Fear of Mortgages and Current Market Conditions

00:15:19 - Importance of Liquidity and Unexpected Expenses

00:19:32 - Tax Implications of Paying Off Mortgage

00:21:09 - Factors to Consider in Paying Off Mortgage

00:23:48 - Ways to Pay Off Mortgage Early

00:25:55 - Final Tips and Considerations

00:27:50 – Coming Up on Our Next Episode


Show Transcript

Jim Uren: This is The Year You Retire podcast for people who want their first year of retirement to be right on the money. Your hosts are me, Jim Uren and John Bever, CERTIFIED FINANCIAL PLANNER™ professionals with Phase 3 Advisory Services. Retirement is one of the happiest times of life, but getting the most out of it requires you to be properly prepared.

Listen along as we explore the financial topics, tips, and strategies that will help you make your first year of retirement your best year yet. Now let's get planning.

John Bever: Welcome to episode 15 of The Year You Retire podcast. Today, we'll be delving into one of life's biggest financial decisions. Should you pay off your mortgage before you retire? Dave Ramsey of course says “yes”, but other financial experts say “no.” Who is right? In this episode, we'll tackle this often controversial topic and explore the key factors you need to consider when deciding whether or not to pay it off early or not or to maintain your mortgage into retirement.

Hey, Jim, good to see you today.

Jim Uren: Good to see you, John. I'm excited for this topic because this is something we're often, often asked about.

John Bever: Yeah, I would say, more often than not, I'm asked about this, especially as people approach retirement, how should they handle the mortgage? And as more people are carrying mortgages into retirement, this is a big topic.

Jim Uren: Absolutely.  It effects that vast majority of people so it's worth listening to.

Before we hop into the big issue, though, John, we know we'd like to start with our trivia. Our first trivia question today is…

In 1934, Congress created the Federal Housing Authority, or FHA. At that time, most mortgage loan terms allow you to borrow what percentage of your home's market value? In other words, prior to the FHA stepping, in a typical mortgage, how much of the home's value could you actually borrow? Was it…

  1. 70%?
  2. 60%?
  3. 50%?

Well, the answer is C 50%, which of course means that you could only borrow half the value of your home. If you had a 50% down payment.

So you had a 50% down payment was standard back then. And to make matters worse, the repayment schedule was typically spread over just three to five years after which the remainder of the mortgage was due in full. So quite challenging to get a mortgage back then.

John Bever: This is interesting because going into the 1929 crash, you could borrow 90% against your stock portfolio and it looks like you could only borrow 50% against your home. How interesting that is.

All right. Well, at the same time in history, what percent of households were living in a home that they owned rather than renting? Owners versus renters. What was the percent of owners?

  1. 10%
  2. 20%
  3. 30%

The answer is 10%, Jim. We were primarily a nation of renters at the time. We had a lot of stock debt out there going into the 1929 crash, but not a lot of homeowners, isn't that interesting?

Today, however, household ownership has grown from that 10%, I think currently to about 66%, is that right, Jim?

Jim Uren: Yes. That's a huge increase, right? And that is in large part due to the government backed mortgage market because of FHA mortgages as well as the creation of Fannie Mae and later Freddie Mac. Fannie Mae and Freddie Mac, of course, buy mortgages from banks and other lending institutions in the U.S., which of course allows those organizations to then use the money they get back to loan out again to other homebuyers and that helps make mortgages a little bit easier for all of us to get now compared to about a hundred years ago.  For which I'm thankful.

John Bever: Yes, definitely.

Well, then for those 66% of people that actually own their home, the question is, “Should you pay off your mortgage before you retire?”

Jim Uren: And the answer of course is, once again, it depends. It depends on a variety of factors of what your specific goals are when it comes to your finances. Now there are a number of advantages to paying off the mortgage, but there's also a number of disadvantages to paying off your mortgage early.  And you really should have a full understanding of both the pros and the cons before deciding which approach is best for you.

So we're going to start first with some of the advantages of paying off the mortgage early so that it might be gone before you retire. Now John, why don't you share with us one of the first benefits? What is the first big advantage of paying off the mortgage early?

John Bever: The big one is interest savings.  And this is the one we see advertised all over the place.  Make extra payments and reduce the term of your mortgage. 

So let’s take an example of a $400,000 loan.  A 30-year fixed rate loan. Current interest rates are 7%.  So the interest cost over the life of that loan would be about $558,000.  More than the mortgage itself. $558,000 in interest over 30 years. An extra $500 per month payment pays off the mortgage in 19 years and three months, just a little over 19 years. So you go from about 30 years down to a little under 20 years and brings down the interest paid over the life of the loan to $328,000. That is a savings of $230,000 of interest just by making an extra $500 per month payment.

So this idea of making extra principal payments is a good idea. It is one of the benefits of paying off your mortgage early. And the nice thing is that's a guaranteed rate of return. That's 7% percent mortgage that's locked in for life.  Might have a chance to refinance at a lower rate, might not, but every $500 you put into that mortgage principle, it's saving you 7%.

It's the same idea as earning 7% on the other side. So it's a guaranteed rate of return. Rarely can we see guaranteed rates that high.

Jim Uren: Yes, absolutely. And that is an important factor when you're thinking about paying off the mortgage.

And that leads into another big advantage of paying off the mortgage, which of course, is improved cash flow. Obviously once your mortgage is paid off, that's a big expense that you no longer need in your budget.  Which of course can free up cash flow to help cover other retirement expenses or spending goals.  And it can simply lower, therefore, the amount of money that you need to withdraw from your portfolio every month.

So if you're not going to redeploy that savings into extra spending, you could just withdraw less from your portfolio every month.  And the less money that you're taking out of your portfolio, of course, means you're more likely that your portfolio will be able to provide you with regular income for the rest of your life.

Now we've talked about the concept of sequence of return risk on previous podcast.  To put it simply, it's just the risk that you experience negative market returns in the early years of retirement.  Negative returns in those early years of retirement are much more damaging than when the negative returns are experienced in the later years of retirement.

And that's just because when returns are negative, you do have to sell extra shares of your particular investment in order to generate the same amount of cash withdrawals from your portfolio. And that means you have fewer shares in your portfolio that can increase in price as the markets recover.

Now, if your mortgage is paid off and you can withdraw less from your portfolio, especially in those early years of retirement, that does help protect you from that sequence of return risk that we've talked about, which of course therefore, can help your portfolio last longer.

John Bever: Yes, very important consideration especially depending on the size of the mortgage and the size of the portfolio.

So paying off the mortgage early though, has another advantage, Jim. And that is PMI. So you can eliminate PMI faster if you were paying PMI on the mortgage. So can you talk to us about that?

Jim Uren: So PMI, if you don't put enough of a down payment on your home purchase, the lender may require the mortgage insurance or PMI, which just protects the lender should you be unable to pay. And so if you have that, when you take out your mortgage, obviously the faster you pay it off, usually the faster you can get rid of PMI, because they'll usually remove that once you have enough equity in your home. So that's another advantage potentially of paying off the mortgage faster.

The other big benefit, and this is perhaps for some, the biggest benefit of all.  It's really the psychological benefit of having paid off the mortgage. You know, some people are just wired to pay off the mortgage early because they have an aversion to debt.

These are likely the Dave Ramsey types out there. But they find that owning their home free and clear is a rewarding financial goal in and of itself regardless of some of the benefits they might receive by using some of that excess cash flow in other ways.

But, there also seems to be this, I like to call it a historical fear of mortgages, because we kind of have this idea that banks can call the mortgage and take our homes away.  And there's certainly some truth to that because if you don't make your mortgage payment, obviously the bank can foreclose on your home.

However, beyond that, there seems to be this fear that banks could call your mortgage at any time and ask you to pay off the remaining balance all at once. Or that a bank might increase your monthly payment.  And that's typically because many, many years ago, mortgage borrowers did not have this kind of legal protection that we enjoy now.

And maybe you grew up hearing horror stories of homes lost during the Great Depression. And the moral of the story, of course, was always to pay off your mortgage early and not have to worry about that fear. 

But the truth is today, as long as you pay your monthly payments on time, the lender has almost no legal way to call your loan and require you to pay off that remaining balance early. So a lot of those kind of historic fears that we hear about are much more unfounded today.  Not as big of a worry as long as you can pay your monthly payment on your mortgage.

John Bever: Right.  And think about this, if you have the money to pay off your mortgage then you have that money available to you to make your monthly payments. So, if the question is, do I pay off my mortgage early or not, then really, this is really not an issue because you have the money already there in your portfolio that you can draw on if you need to make a payment. Because maybe for some reason your Social Security payment didn't show up in your checkbook that week. Or the pension plan had to be redone as has happened with some of the corporate pensions over the years when the companies actually go through a bankruptcy reorganization.

So, consider that too, is are you looking at making a decision of paying off the mortgage early with funds that you have or stretching it into retirement?

But one thing that's interesting, this takes me back to my first mortgage.  My first mortgage was a variable rate mortgage.  And there was some risk there that my payment was going to go up. And that’s still the case today with variable rate mortgages.  And fortunately, the mortgage was taken out during a period of time where interest rates kept falling and falling and falling.  So fortunately our mortgage rate kept falling and falling and falling. 

Now, we are in a period of time right now where we may be seeing variable rate mortgages increasing on the interest rate side. We are perhaps in an inflationary cycle where it's the up cycle at this point in time. So that'll be something to consider if you're looking at a variable rate mortgage.  Be sure again, to talk with your advisors, your tax professional and your mortgage lender to make sure you have a thorough understanding of that mortgage. 

Jim Uren: Yes, because obviously, if you do have that variable rate, that is one advantage of paying off the mortgage is you don't have that risk, right, of those rates going up. Now, today, the vast majority of people do choose a 30-year fixed loan and of course that locks in your interest rate for 30 years.

Now most of us here don't realize actually how lucky we are in the U.S. to be able to take out a home loan with an interest rate that is fixed for 30 years.  That is not typical in most other, even developed countries.

Canada, for example, our neighbor to the North, you can get a 30-year mortgage, but typically that interest rate can still reset every five years. That's typical.  So, you know, five years into your mortgage, you could see your mortgage payment jumps substantially if rates go up.  Which, of course, unfortunately is exactly what has happened in the last couple of years. So there's a lot of folks who have seen their actual principal and interest payment of their home jump up quite a bit from what it has been the first several years of their mortgage. So we're very lucky here in the U. S.

Now let's discuss though, John, some of the disadvantages of paying off your mortgage early.  Can you talk about, you alluded to this just a little bit ago, but the liquidity risk.  Because if you make extra payments towards your mortgage, that unfortunately doesn't lower the next payment due.  So tell us about the liquidity risk.

John Bever: Right. No. When you make extra payments on your mortgage, what's actually happening is it's shortening the length of your mortgage, but it's not changing your payment amount that is due every month. So when you make that extra payment, you no longer have that money in your bank account, in your portfolio.  Now it's in your house and in your house, it is illiquid. You can't get it that. You can't just write a check against your house equity.

So you have to think about the liquidity features and how much money you really have in your portfolio.  Should you be taking extra money and putting it towards the mortgage, especially given the fact that it doesn't decrease your monthly obligation on that mortgage?

And remember, if you're escrowing for taxes, or even if you're not, property taxes go up.  Although mortgage payments are fixed on a 30-year fixed, your insurance and your cost of operating the house and your property taxes that goes up every year in an inflationary environment. So you want to make sure that you have the liquidity that you need should something happen.

You have that unexpected repair. You have all the appliances go out in one year, the luck of the draw. So that is one of the big disadvantages of paying the mortgage off early is you just may be reducing your liquidity.

Jim Uren: Yeah, and that's important because as you said, John, liquidity is something that can be essential in any good financial plan. And so you got to be careful.

There's a couple more disadvantages. One I'm just going to mention briefly is that some mortgages do have a prepayment penalty where they charge you a fee if you want to pay it off early. That's pretty rare nowadays, but it's certainly something that you want to just double check to make sure that it wouldn't apply to you if you're going to be accelerating your mortgage payments and paying it off early.

So probably though, the biggest reason that most experts cite for not paying off the mortgage early is that it can lower your potential net worth. “Now, how can that be?,” you might ask. Obviously paying off the mortgage early means lower interest costs, which of course would improve your overall net worth. I mean, John gave you that example earlier, and that's true. However, that comparison is typically only evaluating options A and B meaning pay off, make extra payments to the mortgage or not make extra payments to the mortgage.  And when you compare those, yes, making extra payments to the mortgage always puts you in a better financial situation.

However, in the real world, there are lots of other options that you have for that extra money that you could be putting towards your mortgage and paying it off early. So, for example, if you are paying an extra $500 a month towards your mortgage principle, the question really becomes what is the best use of that extra $500?  Certainly it saves you interest if you pay down your mortgage faster, but there may be other options that would allow you to build your net worth faster.

So for example, John discussed the example of a 7% mortgage rate on a 30-year fixed mortgage, where you paid an extra $500 a month, and that would end up saving you $328,000 of interest in the loan.  And the loan would be paid off just after 19 years. So you'd be 10 years earlier. Great.

But if you did that, at the end of the 19 years, you wouldn't have any extra savings. Your mortgage would be gone and you'd have better cash flow, you’d own nothing on the mortgage, which is great, but there's no extra savings.

But what if you could invest instead? Instead of taking that extra $500 and paying towards the mortgage, what if you could invest it in an investment that ended up returning you a 10% rate of return that compounded monthly? Well, at the end of 19 years, if you had not made any extra payments toward the mortgage, you would still owe about $227,000. However, the investment account where you put that extra $500 a month would be worth $341,000. So if you paid off the mortgage at that point, if that's what you decided to do, you'd also have no mortgage, but you'd also have an extra $114,000 sitting in your account.

So there's an example where your net worth could be significantly higher by not putting that extra $500 towards the mortgage, but actually building it up in something other than the mortgage, where it might earn a higher rate of return.

Now, of course, there is a rare investment account today that would pay you a guaranteed 10% rate of return compounded monthly.  So the wisdom of this approach will certainly vary based on your particular circumstances.  But you can at least understand the concept of alternative uses for your extra cash each month.

John Bever: Jim, I think I got one of those emails the other day that had that 10% guaranteed, in quotes, rate of return.

Jim Uren: In quotes. Yeah, be careful of those.

John Bever: That's not what you're talking about, right, Jim?

Jim Uren: No, no, no, no.

But John, there's also another potential downside of paying off the mortgage early and that's related to taxes. Can you explain that?

John Bever: Yeah. Unfortunately, this is something that is certain, right? So we know that we will continue to have taxes going forward. So there's a tax advantage to having a mortgage. And that is that you get to take the interest every year that you've paid on the mortgage. That interest gets listed on your tax return under itemized deductions.

And so that reduces your income dollar for dollar, assuming you're able to itemize. So that's actually the most important thing to understand is are you an itemizer or are you not? Are you just taking advantage of the standard deduction because your itemized deductions aren't large enough or are you actually able to itemize?

And so that is a big advantage because that actually reduces the interest rate, effective interest rate, that you're paying. If you are in a 25% tax bracket and you're able to reduce that 7% mortgage by one quarter because of the tax savings that reduces the cost of the mortgage and is one of the things to consider in not paying off your mortgage early.

So Jim, what are some of the other factors that should be considered if someone is going to pay off their mortgage early, not just the tax piece? Because some people can't itemize, right? Some people just have the standard deduction.

Jim Uren: Right, right. And if you do itemize, the government's helping subsidize your mortgage, which is nice. So that's one of the things to consider.

But yeah, we've discussed a lot of the pros and the cons of paying off the mortgage, but where the rubber meets the road, you have to look at a few factors.

Certainly the first consideration we've talked about is liquidity. If you've got little to no emergency savings or other options for accessing cash when needed, then making extra mortgage payments is typically not recommended. Of course, if you have lots of excess liquidity, you may feel more comfortable paying off your mortgage early.

Second, a big, big factor is your current mortgage interest rate. Now, if you've got a low mortgage rate, let's say in the 3% range, then it's more likely that you could earn a better rate of return on your excess cash flow than you would paying down your mortgage early. For example, at the time of this recording, FDIC insured CDs are paying well above a 3% interest rate. So beating a 3% mortgage rate would not be difficult.

However, if your mortgage rate is in the 7 or 8% range, that is a much more difficult rate to beat with other investment options. And of course it certainly would require a significant amount of risk to try and do so. So if your mortgage rate is on the higher end, then it makes more sense to pay extra monthly mortgage payments to get that mortgage paid off early. So the rate of interest rate that you're paying on your mortgage is a big factor.

And of course, don't forget, as John mentioned, if you're claiming a tax deduction on your mortgage interest, you need to calculate your true after-tax interest rate so that you can compare accurately all of the options that you have with the excess cash flow that you have to work with every month.

Third factor to consider, of course, is any other debt that you have. If you've got a car loan, a personal loan, any other kind of debt, you may be better off paying down that debt first before you start putting extra payments towards your mortgage.

For example, if your mortgage rate is 5% and you have an auto loan at 7%, well, you're probably better off making extra payments toward the auto loan first, because that's going to help you save more on interest. And of course, auto loans are never tax deductible where the mortgage may be.

Also, of course, if you have any debt that is at a variable rate, we kind of talked about this with mortgages, but any other debt you have at a variable rate, you may also want to pay that down first to minimize the risk that the interest rate could go higher down the road and jack up your monthly payment.

John Bever: Right. So if someone decides that they want to pay off their mortgage early before they retire, what are some of the ways that they can do that?

Jim Uren: So if you know from the very start that you want to pay off your mortgage early, and you've got enough cash flow and liquidity to be comfortable doing so, you may want to just consider a 15-year mortgage right out of the gate. Of course, it does require a higher minimum payment. But it does mean that the loan will be paid off in 15 years instead of 30. And the other perk is that a 15-year mortgage generally has a lower interest rate than a 30-year mortgage, which of course is an added advantage.

Now, another option is just simply to pay a higher amount than what is due each month, you know, by sending in extra payments, um, each month, or just whenever you get extra cash flow, just to write an extra check to your mortgage company. Either approach will certainly get the mortgage paid off faster.

Another option, of course, is you could potentially refinance your mortgage if you qualify for a lower interest rate today compared to when you took out the original mortgage. Now that's quite unlikely at the present moment, because interest rates have jumped substantially in the last couple years. But if you do find yourself in a situation where you can refinance to a lower rate, you could potentially maintain the same payment and get your mortgage paid off faster.

Final option would be to switch your payments from monthly to bi-weekly. A lot of lenders offer this. It's just basically what it sounds like. Instead of making your monthly mortgage payment, you make a lower payment, about half that rate, every other week. Now this results basically in extra money being paid toward the mortgage every year, which also gets the mortgage paid off much faster. This works particularly well if you're in a job where you get paid every two weeks rather than twice a month.

So those are some options if you do want to pay down your mortgage faster. And so John, that pretty much wraps up our answer to the question of, “Should I pay off my mortgage before I retire?” Any closing comments? Anything else you would add, John, when people are considering this question?

John Bever: Yeah. So you want to make sure that when you make that extra payment, it actually gets credited to your principal. Depending on the bank and how they do their processes, sometimes they'll actually consider that your next month's payment. Some of them may automatically put it towards escrow. So you want to make sure that you clearly identify when you're making that payment, that it is to go towards principal repayment. That's a very important step.

And another thing is, sometimes it's not a bad idea to have that 30-year mortgage for the flexibilities you mentioned. You can always make extra payments along the way. But especially if you have variable income and you may go through a period of time with low income, you may want to have that flexibility of a lower payment on a 30-year mortgage. And then when you get those large bonuses or big income, you can make extra principal payments towards the mortgage at that point in time. So I find flexibility is really important for many, many cases.

One thing that I do like about the shorter term mortgage, it's great for those people that have a hard time with discipline. So that's going to be paid off in 15 years. That is done. It's set in stone. They can't change it. So for people that may have a hard time with discipline in their finances, a 15-year mortgage might make sense.

Jim Uren: Excellent points. Confirms this idea that it's not a one size fits all. So it really depends on your circumstance. The idea that everyone should pay off their mortgage as quickly as possible I don't think is good financial advice.  Though it may be for some people.

Hopefully this has been informative for our listeners. Before we jump into our final gratitude segment though, John, can you tell us what we are going to be covering on our very next podcast episode?

John Bever: Yes. We're going to be talking about an exciting subject. RMDs and QCDs. What does that mean? Required minimum distributions out of your retirement account, which have to start, I'm going to not give it away, but by certain ages, that seems to be changing. 

Qualified charitable distributions, which is a way of using your retirement account to actually make a donation to charity. And that would be your IRA and a way to avoid some taxes on that. So we're going to be covering the planning opportunities. Do you want to start early? What are the ages that you have to start these distributions? How to delay your required minimum distribution. And even how to avoid paying tax on your required minimum distribution.

And wait, there's much more, just like Mr. Ronco.

Jim Uren: We'll look forward to that. Yes, your reward for getting older in the U.S. is that the IRS wants to make sure you pay more in taxes. So we'll talk about how that works in our next episode. And what are some of the things you might do to help minimize that tax hit. So that's an important episode for anyone getting ready for that year you retire. So be sure to follow or subscribe to this podcast so you don't miss that episode.

Also for show notes or a transcript of this episode, you can go to our website at phase3advisory.com/podcast. That's phase3advisory.com/podcast.

John, what are you thankful for today?

John Bever: I tell you all this talk about mortgages and homes. I'm very thankful for our home and actually the series of events that got us here because I'm a weekend rehabber. And, so really ultimately what I'm saying, I'm thankful for my wife because she has been patient through construction, house after house. Love our homes, but also love my wife who has been so patient through this whole process.

Jim Uren: That's great. I am thankful for our oldest son, Micah.  He will be graduating soon from Illinois State University with a major in cybersecurity. And Jenn and I are very proud of all the work he's done to get to this point. And we're looking forward to attending the upcoming graduation ceremony and celebrating his accomplishments with our entire family.

So that will be, for us, two kids through school, three more to go. But, we're very proud of him.

John Bever: I've got two down and I'm done.

Jim Uren: Yeah, we've got three to go.

Well, thank you all for listening to this episode of the year you retire podcast. We hope you found it helpful and informative and if so, we'd appreciate it if you could share your favorite episode with a friend.

It can be a great way to help them be better prepared for the year they retire. Thanks again. Don't miss our next episode.

Disclosure: The views expressed in this podcast are not necessarily the opinions of Phase 3 Advisory Services or Osaic Wealth and should not be construed directly or indirectly as an offer to buy or sell any securities or services mentioned herein.  Unless otherwise specified, show guests are not securities licensed or affiliated with Phase 3 Advisory Services or Osaic Wealth.   Investing is subject to risks, including loss of principal invested. Past performance is not a guarantee of future results.

No strategy can assure profit nor protect against loss. Please note that individual situations can vary. Therefore, the information should only be relied upon when coordinated with individual professional advice.  Securities offered through Osaic Wealth, Inc. member FINRA/SIPC.  Additional investment. and insurance advisory services offered through Phase 3 Advisory Services Limited, a Registered Investment Advisor.

Osaic Wealth is separately owned and other entities and or marketing names, products or services referenced here are independent of Osaic Wealth. Phase 3 Advisory Services is located at 1110 West Lake Cook Road, Suite 265 in Buffalo Grove, Illinois 60089. Our phone number is 847-520-5545. For additional information, visit our website at phase3advisory.com.