Paying a mortgage has become the norm for American families today. In fact, according to a recent ‘Retirement and Mortgages’ survey by American Financing, about 44% of Americans age 60 to 70 have a mortgage when they retire, and many say they may never pay it off. Nearly 63% of all homeowners have a mortgage balance on their home per ‘US Census Bureau, 2017 American Community Survey. 1-year Estimates’.
How does the mortgage on your home fit into your overall financial plan, and should you be considering paying it off early?
First, it’s important to note that you should be saving and investing enough money in your long-term accounts to build wealth for retirement. You can do this by evaluating how much income you expect to need and how you plan to generate that retirement income. Usually, this is 15% or more of your household income.
This would include:
- contributing at least 5% to your TSP and receiving agency matching contributions
- funding an investment account
- building emergency savings
- planning to continue service for FERS pension benefits, etc.
Once you feel you are on track, it’s time to create your strategy.
Let’s get started by examining a few reasons in favor of a pay-down strategy.
Reduced Tax Advantages
Many of the tax benefits of owning a home and mortgage have been significantly reduced with the Tax Reform Act of 2018. The standard deduction for 2019 is $12,200 filing single, and $24,400 married filing jointly, these higher limits are allowing fewer people to itemize expenses.
The good news is that you may not need to itemize, but it also negates the value of the mortgage interest deduction. Beginning in 2018 mortgage interest is only deductible on qualified loans up to $750,000. However, if you originated your loan before Dec 15, 2017, the previous limit of $1M still applies.
The Trouble Years
In the OPM report titled Retirement Age & Trend Analysis of the Executive Branch, the document provides an analysis from 2015-2017 showing the average age for federal retirement is now close to 62 years old.
Bridging the retirement income gap between your federal retirement and full retirement age for Social Security benefits (66+) can be tricky. The ‘trouble years’ as we like to call them have certain challenges and present difficult choices related to producing income.
Questions arise such as: Do I take Social Security early or tap my TSP or other investment accounts for the needed income?
To further cloud the picture, the FERS supplement (if applicable to you) is only available until age 62 while the FERS pension multiplier increases from 1% to 1.1% at age 62 for employees with 20 years of creditable service.
Housing is often the largest household expense for families, with mortgage debt making up the majority share. Reducing this expense may create extra breathing room in the monthly budget and potentially change your need for income.
Looking at it another way, it might be considered creating an income stream. Ultimately we are seeking to create flexibly and allow more choice when it comes to timing our exit from the workforce.
Take Robin and John for example, who were evaluating retiring at 62 with 10 years to go. Their projections were falling short of being able to retire comfortably at 62 without having to tap into Social Security early. By restructuring their budget to include additional savings directed at paying off the mortgage to coincide with age 62 the confidence level changed dramatically and they are now working toward having the flexibility to retire on their own terms.
Maintaining Debt In Favor of Other Investments
Carrying mortgage debt in order to fund other investments creates leverage on your balance sheet. While equity markets may carry a risk premium in the form of higher potential returns, they also carry a lot more risk and there is no guarantee of return on your investment.
To illustrate, when we look at measuring risk and volatility, the 3-year standard deviation on the S&P 500 is more than 10% and the 10-year standard deviation is over 14%. You can compare this with no volatility on mortgage payoff returns. This becomes much more important to consider as you get closer to retirement and may need to access your investments for retirement income.
Many will argue for putting the extra money to work in potentially higher-yielding investments with interest rates currently at historic lows, but the risk is a personal preference and many prefer balance and diversification; remember you may already be contributing 15% or more toward your investments. Paying down your mortgage will provide a guaranteed return in the form of saved interest, and mortgage returns are non-correlated to the stock market.
Mortgage Pay-Down Strategy
How does it work?
Establish An Ideal Payoff Date
When do you want to have your house paid for?
If you currently own a 30-year mortgage it doesn’t mean that you can’t pay it as a 15 or 20-year loan. When determining a payoff date many people will look for milestones such as turning a specific age or a significant occurrence such as retirement.
Once you determine your goal, use this date to determine how much extra you need to pay to meet the payoff date. Whether it is possible or not will be based on your available cash flow, but it’s still a great exercise to work through, and may help determine how much of your additional monthly investments to use toward the goal.
Perhaps you’ll find a balance that allows you to contribute to your mortgage payoff and put extra into your investments simultaneously.
Make Extra Payments
Early in a 30-year mortgage term, your payments will consist of mostly interest; if you have a 15-year loan, this shifts more in your favor toward principal, but your payments still contain a significant amount of interest.
Making additional payments on the principal early in the term makes a big difference in either scenario. In case you were wondering, making one extra payment per year on a 30-year mortgage can reduce the life of the loan by 5 to 6 years.
We recommend keeping things simple – if you’re more of a routine person, add extra to your payment. If you like to do things in bunches, make an extra payment once or twice a year.
Also, consider the following strategies:
- Apply annual pay increases towards your mortgage
- Increase your monthly payments to pay the additional principal
- Round up – simply increase your payment to the next round number
- Avoid tapping retirement funds
What Not to Do
Generally, it’s not a good idea to withdraw from a TSP or an IRA to pay off a mortgage. If you withdraw before you turn 59½, you may incur taxes and early-payment penalties. Even if you wait, the tax hit of taking a large distribution from a retirement plan could potentially push you into a higher tax bracket further and significantly reduce the value of your investment.
What are your goals for retirement income and how do you plan to meet them? If you’d like to discuss your plan, I welcome you to schedule an introductory call.
District Financial Advisors, Justin Holtz and LPL Financial are not affiliated with or endorsed by the Federal Government. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. All investing involves risk including loss of principal. No strategy assures success or protects against loss. This is a hypothetical example and is not representative of any specific situation. Your results will vary. The hypothetical rates of return used do not reflect the deduction of fees and charges inherent to investing.