The benefits of a mortgage-free retirement
Retirement is often likened to "financial independence." However, as pointed out in a USA Today story last week, many retirees are finding themselves very dependent, very despondent, and, well, screwed. These are retirees with mortgages they can no longer afford. Pretty sad stuff.
Of course, this wouldn't be a problem if these folks owned their homes outright before they retired, but that's not the case for many (if not most) retirees. For years, the standard advice has been to keep a mortgage so you could have more money to invest. After all, if you're paying 6% on your tax-advantaged mortgage and earning 10% in your tax-advantaged 401(k), why pay off the debt?
Well, now that we no longer take that 10% average annual return in stocks as a G-given right (insert the "G" of your choice -- God, Greenspan, Geithner, GM, GE, Gumby) it's time to question the wisdom of maintaining a mortgage and investing the extra cash.
For someone like me -- who is almost 40, won't retire until age 70 if ever, and can personally stand a lot of volatility and market uncertainty -- I think it still makes sense to invest rather than make extra mortgage payments. But for more conservative investors or those closer to retirement, paying off the mortgage might be the better bet. This is especially true if their surplus funds are going into "safe" investments, such as CDs or Treasuries, which are just paying 1% to 4% these days.
What's the "return" on paying off the mortgage? At the high end, it's the rate on your mortgage -- that's if you don't itemize and therefore don't deduct mortgage interest when you file your tax return. Because the majority of taxpayers don't itemize, and with the rates on most existing mortgages landing from 5% to 7%, the "return" on paying off the mortgage looks pretty good. And remember, paying off debt is a guaranteed return.
What's the return if you do deduct mortgage interest? Here's the simple rule of thumb: Turn your tax bracket into a decimal and subtract it from 1, then multiply that number by your mortgage rate. For example, someone in the 25% tax bracket with a 6% mortgage rate would earn an after-tax return of 4.5%.
That's the simple version. Keep in mind that the return will vary depending on how much your itemized deductions exceed the standard deduction (in 2009, $5,700 for single filers and $11,400 for couples). And remember, the amount of interest you pay declines every year because the principal portion of mortgage payments increases each year. Clearly, it takes some spreadsheet wizardry and unearthing of mortgage papers to figure out the actual after-tax return of paying down your mortgage. Suffice it to say that it lands somewhere between our rule-of-thumb rate and your mortgage rate.
Here's the other benefit of paying off the mortgage before kissing off the boss: You'll have lower expenses in retirement, so you'll need less income. In a country with progressive taxation (like the U.S.), lower income results in a smaller tax bill. It also means that less of your Social Security benefit may be subject to taxes. So you're lowering your retirement expenses in all kinds of ways.
In my Rule Your Retirement service, I published an article last year that showed how a couple, both aged 65, could have retirement income of $40,000 and still pay no taxes. However, if they then needed more income -- perhaps because they had a mortgage -- then they'd have to withdraw more from their traditional IRAs, which would then begin to be taxed. Like every hypothetical, a real-life person's situation would differ, depending on the sources of retirement income and deductions. But the point remains: The more you need to spend in retirement, the more you may need to tap your savings, which could raise your tax bill.
Finally, a debt-free retirement allows for true "financial independence," so that when the economy turns south, you don't have banks banging on your door and trying to kick you out of your home. That independence is something the people profiled in that USA Today article wish they had right now.