This is a significant question for the approximately 30% of homeowners over 65 who have a mortgage, including, in my experience, high-net-worth homeowners with jumbo mortgages.
As in all financial planning, deciding whether to repay your mortgage depends on your retirement expectations, your outlook for the financial markets and the amount of assets that you wish to leave to heirs. The smart management of outstanding mortgage payments is critical, even for high-net-worth homeowners.
To decide whether it is best to pay off a mortgage, you should first calculate its after-tax cost.
For example, assume you have a mortgage rate of 4% and are in a relatively high bracket of 35%. The after-tax cost of your mortgage will be 2.6%. This is arrived at by multiplying your mortgage rate by your bracket (4% x 35% = 1.4%) and then subtracting the result from your mortgage rate (4%-1.4% = 2.6%).
If you owe more than $1 million in mortgage debt going into retirement, your after-tax cost is even higher, because debt in excess of $1 million is not deductible (for married filing jointly).
You now know your
hurdle rate of return, which is the minimum investment return required to exceed the mortgage's after-tax cost. In today's rate environment, you need to assume a fairly large degree of investment risk to beat a seemingly low hurdle return of 2.6%.
Recently interest rates on the 10-year treasury were around 2.3%. (Rates, of course, can change frequently.) With stocks at or near all-time highs, even after the recent bout of volatility, it is reasonable to expect lower than historical returns in the near future.
For our projections, let's assume an 8% stock return over time (many project less). If you had a 50/50 bond stock mix in retirement, your expected rate of return would be 50% x 2.3% for bonds + 50% x 8% for stocks, which would add up to 5.15%.
However, your expected return is also subject to taxes. If we use the assumptions above for an investor in the 35% tax bracket, stocks would provide a 3.4% return after a 15% capital gain tax was applied and bonds would generate a 0.75% return once the 35% income tax was levied. Your 4.15% after-tax return in this case leaves very little cushion to exceed the aforementioned hurdle rate.
Keep in mind that this tax example pertains only to federal taxes. For many people, the tax bite could be somewhat higher.
In sum, taxes increase the challenge of exceeding your hurdle rate of return. You might reasonably ask if the extra return you might achieve is worth the risk and aggravation. In our example, it may be more expedient to simply pay down the mortgage. In general, you should take risk when the potential reward is ample and shun risk when the reward is small.
Some investors may argue that it sounds pretty doable for investments to yield more than the hurdle rate in our example, given an investment horizon that could well exceed a decade. However, this is far from a guarantee. In the period from 1968-1982, stocks did basically nothing for more than 13 years. More recently, in the “lost decade” of January 2000 to December 2009, the S&P 500 total return was negative-9.1%, which would not have allowed you to clear even a modest hurdle rate.
SEQUENCE-OF-RETURNS RISK
Paying off a mortgage as you near retirement also can provide some protection against sequence-of-returns risk.
Sequence-of-returns risk alludes to the significant impact that the timing of future returns can have on your savings.
For example, Retiree A and Retiree B have the exact same rate of returns over the course of their retirement, including the same number and degree of down years. However, they experience these returns in a different sequence. Retiree A suffers his most severe down year during the first year of retirement, while Retiree B encounters the same decline in the fifth year. Everything else being equal, Retiree B will fare far better than Retiree A over time, simply because her negative year occurred later.
Homeowners who eliminate mortgage payments before entering retirement can better withstand a decline in savings during a market correction or bear market. Since your retirement expenses are lower without a mortgage, you are not as vulnerable if your investment portfolio yields less.
The biggest reason to pay off your mortgage in retirement is peace of mind. Repaying your mortgage is a guarantee. Investment projections are always subject to the whims of uncertainty.
Have a question you want answered by a professional financial adviser? Email us here.
John Rocco is a financial adviser with Morgan Stanley Global Wealth Management in New York.
