You’ve probably wondered about it at least once. When your budget finds an extra dollar, is it better put to use paying down the mortgage or invested into the retirement nest egg? It’s time to end the debate. Pay off the damn mortgage.
Set Your Budget Free
My preference is for a client’s mortgage to be paid off by the time they’re ready to retire. When you’re on a fixed income for the rest of your life, reducing fixed costs, so there is more room for discretionary spending, frees your budget so you can better pursue passions, interests, hobbies, etc.
For some insight, we turn to the CPI-E, the Bureau of Labor and Statistics (BLS) measure of consumer spending for those over the age of 62. The data tells us that retirees spend the most money, up to 45% of total income, on housing-related expenses. A mortgage payment can easily be $1,000 per month or more. It doesn’t take much to spend another $1,000 per month on health care, often the next biggest expense. There goes your Social Security.
If you’re looking forward to travel, vacations, spoiling grandchildren and other frivolities, you’re going to want as few expenses as possible. Do yourself a favor and make a plan to have the mortgage paid off by retirement, if possible.
What Tax Deduction?
The most common objection we hear when suggesting the mortgage be paid down is lamentation over the potential loss of the Mortgage Interest Deduction. People get really excited about this deduction, which is entirely understandable – who doesn’t love something that helps lower taxes? But the savings is mostly illusory. Here’s why:
BLS data tells us that married couples around age 55 carry an average mortgage balance of $150,000. Assume the mortgage is at 4% interest and the couple is in the 25% tax bracket. They’re going to pay the bank $6,000 in interest this year ($150,000 x 4%) which translates into a tax deduction of $1,500 ($6,000 x 25%). Is it a good deal to pay $6,000 in order to save $1,500? Ask a 6-year-old to give you $6 in return for $1.50, and if the kid has any smarts he’ll deliver a kick to your shin.
But it gets worse. The deduction is only valuable in the amount that it exceeds your standard deduction ($12,600 for married couples in 2016) since it only applies if you itemize deductions. Assuming our couple has $15,000 in total itemized deductions, the real value of the mortgage interest deduction is now just $600 ($15,000-$12,600) x 25%).
Better Safe Than Sorry
But might it be better to invest those extra dollars as opposed to paying down the mortgage? After all, the market is capable of delivering big rates of return. But given the uncertainty of the market, the risk probably isn’t worth it.
Put additional tax advantages aside and assume our couple has ample savings for emergencies, job loss, etc. A dollar going into the investment portfolio would be at risk, but paying down the mortgage in our last example amounts to a guaranteed rate of return of 4%.
Turning down a guaranteed 4% is tough to do when investing has been so volatile. If we’re going to take any risk with the money, an investor would expect some kind of excess return over a risk-free alternative. This is known as the risk premium and is commonly accepted to be about 5%.
An investment portfolio would need to deliver a 9% rate of return (4% + 5%) to justify risking the money as opposed to using it to pay down the mortgage. In the short term, with the stock market breaching all-time highs and being eight years beyond the last major market correction, it’s hard to imagine 9% rates of return in the intermediate term.
Consider the following: Right now, would you take out a $150,000 loan at 4% interest and use the proceeds to invest in the market? Of course not; if the market crashed, you might be left with $75,000 invested but still owe the bank the full $150,000 plus interest. In other words, gambling in lieu of a sure thing is best left to those who can afford to lose. For those nearing retirement, reducing risk is often the key to success.
Keep it simple. Knowing the tax savings component isn’t exactly what it’s cracked up to be, we find that our clients prefer a plan that sets them up for less debt in retirement with less volatility along the way.
Information provided should not be considered as tax advice from Arcadia Financial Group, LLC or its representatives. Please consult with your tax professional.