Summary/TL;DR
Since most retirees have locked in their mortgages at historically low interest rates, have already been paying their home debt down for at least a decade, and have the opportunity to earn compound interest in the stock market (as opposed to the simple interest they are charged on their loan), the desire to pay one’s home off before its maturity, while understandable, is often ill-advised. And for those who are simply wanting to rid themselves of the regular monthly payment, refinancing their traditional mortgage into a reverse mortgage is often a far better option than paying off the debt early.
Introduction
Wondering if paying off one’s home “early” in order to reduce retirement expenses is a natural and common question that many retirees will ask themselves. It’s also a question that everybody has an (usually quite passionate) opinion about, which can leave one confused when looking for personal guidance. Needless to say, this common question typically has a quite straightforward answer. Today’s post explores why this objective, while understandable, is often misguided.
What’s The Point?
The key is to understand that the primary benefit of paying off debt early is to save interest on the note. If, on the other hand, you’re able to put the additional amount you would pay on the loan into an investment vehicle that is likely to grow to an amount that exceeds the amount of interest you would save, then you’re worse off putting those funds towards the loan instead of in the investment.
With interest rates having been forced to historical lows over the past couple of decades, most retirees were able to lock in their long-term debt with exceptionally small interest payments. This fact, coupled with some basic characteristics of mortgage debt in general, form the basis for understanding why paying off your home “early” is rarely a good idea.
Loan Amortization Basics
The first reason for this is that it doesn’t consider the way that mortgages are amortized. In short, you pay far more interest at the beginning of the loan than you do at the end because your equity balance increases with every monthly payment. Consider, for example, a couple who takes out a $400,000 30-yr mortgage at a 4% interest rate. In the first 10 years of the loan, they would pay $144,295 in interest, which ends up being about half of the interest owed on the loan over its total lifetime.
Considering that almost everyone who is thinking about paying off their mortgage before retiring has already been making payments for many years, this fact suggests that they are far beyond a point in their loan amortization schedule where they would stand to benefit by way of saving interest. All that paying their loan off early is doing is transferring equity from their investment portfolio to their home.
To better illustrate, assume that both members of the couple above are 50 years old, plan on retiring in 10 years, and are 10 years into their mortgage (meaning it was originated when they were 40). Having their loan paid off by the time they retire requires an additional $1,285 to be put towards their monthly payment. But because they have started to pay down their loan “late”, this strategy would only save them $75,558 in interest despite costing them about $154,000 in additional payments.
Compound Interest vs Simple Interest
Another common mistake is to assume that you have to find an investment whose return can reliably exceed the interest rate on your mortgage in order for it to be “worth keeping”. This ignores the fact that the interest on a mortgage is “simple” interest, while the return earned on an investment is often “compound” interest.
Let’s assume the same basic facts as the example discussed above, except this time the couple has a 6.00% interest rate on their mortgage. Over the life of their loan, they would pay $463,353 in interest. Recognizing the facts discussed about loan amortization (in addition to the consideration that they now have a “high” interest rate), they decide to put an additional $465/mo towards their loan beginning with their very first payment in order to have their home paid off in time for their retirement.
Despite costing them $111,135 in extra monthly payments, this strategy would save them $175,013 in interest over the next 240 payments. But what if they had saved this $465/mo into a stock account? What rate of return would they have to earn over the same period to have $175,013 saved up, effectively “breaking even” with their strategy of putting extra towards their loan? The most common answer would be, “anything over 6.0%”, but the actual answer is 4.30% - an all but guaranteed minimum return if they invested in stocks. This is because the earnings accumulated on the savings in their brokerage account participates in additional earnings in the future, which is a simple definition of compound growth. Paying extra towards their mortgage does not compound in the same way, as interest is charged simply on the outstanding loan balance.
Another Way To Get Rid of Monthly Payments
Finally, for retirees who want to pay their debt off simply for the sake of the psychological comfort that having little to no monthly obligations brings, refinancing their traditional mortgage into a reverse mortgage is arguably a better way to accomplish this goal.
The pros, cons, and history of the reverse mortgage program in the United States is a potential topic for a future post. For now, just know that rolling your current mortgage over into a reverse mortgage line of credit (known as a Home Equity Conversion Mortgage, or HECM) is an entirely legitimate decision if it is done correctly and guided by a professional. Contrary to what you might read or hear on the internet about reverse mortgages, a lot of research has been done by financial planning professionals on their potential for improving retirement planning outcomes. The general consensus amongst researchers is that, when used and managed properly, they are a safe and reliable tool for retirees.
When a traditional mortgage is rolled over into a HECM, monthly payments become optional. In fact, depending on the amount of equity you have in your home, the bank might even pay you monthly income out of your equity. Any unpaid principal and interest are added to your HECM line of credit which, due to the non-recourse aspect of reverse mortgages, cannot force you into foreclosure as long as you continue to live in your home, pay homeowner’s insurance, property taxes, and keep up with maintenance, all of which are things you would do if you kept your traditional mortgage anyway. Upon your death, the loan balance becomes due and your heirs will simply sell your home and pocket whatever is remaining, which, again, is exactly what they would do if you had kept your traditional mortgage. If the loan balance exceeds the value of your home at the time of your passing, your heirs can simply give the home to the bank through a deed in lieu of foreclosure, owing nothing additional out of pocket.
Conclusion
While it’s more often than not a better decision to keep low interest debt, it’s not always the right thing to do. There are certainly circumstances in which paying off your home “early” can be a smart financial decision, and the only way you can really be sure is to review your circumstances with a qualified professional. At the very least, one can conclude that paying off your mortgage before retirement is often a misguided, albeit understandable, objective.
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