One of the most common questions we get from clients is whether they should pay off their mortgage as they near retirement. Like so many questions, the answer is “it depends.” But that doesn’t mean it has to be difficult to determine the right answer. We believe in using a simple methodology we call the Debt Decision Meter™ in order to evaluate this decision.
Crunching the Numbers
To determine the appropriate answer for your situation, you can start by considering just four variables:
- Your Current Mortgage Balance
- Your Current Mortgage Payment (Principal & Interest Only)
- A Sustainable Withdrawal Rate from Your Portfolio (4% is a good rule of thumb – click here for more explanation)
- When You Plan to Retire
Here is the calculation we recommend to help make this debt decision:
- Annual Mortgage Payment (P&I) Divided By Sustainable Withdrawal Rate
- Is the answer (above) greater than or less than your mortgage balance?
- If it is greater than your mortgage balance, then you should pay off the mortgage.
- If it is less than your mortgage balance, then you should keep your mortgage.
A Hypothetical Example
Let’s assume you have a $350,000 balance on your home mortgage. You are paying $1,800 per month in principal and interest or $21,600 per year. Assume a 4% sustainable withdrawal rate and that you will be retiring at this end of this year.
- $21,600/0.04 = $540,000
- $540,000 > $350,000 so it makes sense to pay off the mortgage
Why are we recommending paying off the mortgage in this case? It all comes down to cash flow, and we believe “cash flow is king” in retirement. Based on our 4% withdrawal rate assumption, you would need $540,000 in order to create enough cash flow to make the $21,600 of annual mortgage payments. In other words, “the break-even point” for paying it off would be a mortgage balance of $540,000. Since you only need $350,000 to eliminate this ongoing cash flow requirement, you would come out ahead by paying it off.
Please keep in mind that, while this calculation is a great starting point, it is not necessarily the final answer. The decision as to whether to maintain a mortgage or pay it off is always contingent on some non-financial considerations. Most importantly, how do you feel about having debt? If being completely debt-free is a major priority for you and something that will feel as though a great burden or debt (pun intended) has been lifted, then you may want to do it regardless.
Additionally, you’ll need to consider your liquidity available to pay off the mortgage. If most of your assets are in qualified retirement accounts like a 401(k) or IRA, it may not make as much sense to draw down those accounts in order to pay off your mortgage as it would if the money were available in bank accounts or non-retirement investments.
There are also income tax considerations to take into account. Generally speaking, taxes are less important than cash flow considerations when it comes to this particular question, but nonetheless there are cases where the tax advantages of maintaining a mortgage can make it worthwhile to keep it. Therefore, it is always wise to incorporate the perspective of a tax advisor into the decision.
Want to do your own calculation? Use our calculator below: