When it pays to have a mortgage in retirement — and when it doesn’t

Pay off your mortgage before you stop working.

So the standard advice applies to those approaching retirement, but this may not be feasible for retirees who bought or refinanced homes later in life.

Those who can afford to pay off their mortgages may find that there is now a chance to keep their loans in retirement. Thanks to higher interest rates, investing savings in bonds instead of paying off principal could earn enough to more than cover the cost of monthly mortgage interest.

“A year ago, the math was really compelling in favor of paying off a mortgage early,” said Allan Roth, a financial planner in Colorado Springs, Colo. ” he said.

Americans are now far more likely to retire with mortgage debt than previous generations, as three out of four retirees profiled by the Wall Street Journal last week showed. According to the Federal Reserve, nearly 38 percent of those ages 65 to 74 had mortgages or home lines of credit on a primary residence in 2019, the latest year for which data is available. This is up from 22% in 1989.

When interest rates were low, many homeowners refinanced into new 30-year loans. For many older borrowers, these refis have extended loan terms well into retirement, said Craig Copeland, director of estate benefits research at the nonprofit Employee Benefit Research Institute.

“If you had a mortgage at 7% or 8% and you could refinance it at 2%, why wouldn’t you do that?” he said.

Many retirees cannot afford to pay off their mortgage in one lump sum or feel it is better to prioritize other goals. Many people prefer to keep an extra cash cushion in a bank or brokerage account, rather than use it to pay off a mortgage, since home equity can be difficult and expensive to tap into in emergencies.

For those who have the ability to pay off a mortgage, you need to consider the following factors:

Two prices to compare

If you can afford to pay off your mortgage now, the key calculation is to compare your mortgage rate to the return on an ultra-low-risk investment like a Treasury bond or bond, Mr. Roth says. The goal is to see if you can earn enough after-tax interest to cover your ongoing mortgage interest.

Consider someone with a $100,000 mortgage charging 3% interest. By paying off this mortgage, the homeowner would save 3% per year, earning a guaranteed 3% return.

That person could also use the $100,000 to buy a short-term bond, which would yield a slightly higher guaranteed return of about 3.49% in interest.

“If bonds pay more, then buy the bond and enjoy the extra money,” said Burt Hutchinson, a consultant in Wilmington, Del.

What about investing $100,000 in stocks to target an even higher return to cover your mortgage payments and generate more profit? Since 1926, U.S. stocks have returned an average annual return of about 7% after inflation, according to Morningstar Inc.

—Much higher than the rate many home borrowers are paying on their home loans these days.

But that 7% return is far from guaranteed. So far this year, the S&P 500 is down about 16.8% through September 1. And from the end of 1965 to the end of 1981, the S&P 500’s annual return was about 1.8% ex-dividend.

This shows the dangers of such a strategy. “It’s not about the risks,” said Elliott Dole, a consultant in St. Louis.

Consider the tax implications

Taxes can change the math on the decision to pay off a mortgage, generally in favor of paying down debt.

Since the 2017 tax overhaul, which significantly increased the standard deduction, far fewer homeowners have received a tax deduction for home mortgage interest payments.

Those who do will have to reduce the cost of their mortgage to reflect that tax benefit when deciding whether to pay off the mortgage, Mr. Roth said.

If the above homeowner with a 3% interest rate on a $100,000 mortgage gets a home mortgage interest tax credit, the cost of that 3% mortgage drops to 2.34% after the tax benefit is factored in. (This assumes the homeowner is in the 22% tax bracket.)

The homeowner must compare the 2.34% after-tax cost of the mortgage to the after-tax return he could earn on a Treasury bill. Someone in the 22% tax bracket would lose 22% of the 3.49% note in interest taxes. That leaves an after-tax return of 2.7%, according to Mr. Roth.

Because the bond’s 2.7% after-tax yield exceeds the 2.34% after-tax cost of the mortgage, the strategy of buying bonds to pay off the mortgage remains the most profitable option, Mr. Roth said.

However, if the homeowner doesn’t get the full tax benefit of taking the deduction, the 2.7% after-tax bond return falls short of covering the 3% mortgage. As a result, the taxpayer can get a higher return by paying off the mortgage.

Despite predictions of a cooling housing market in 2022, US home prices are still hitting record highs, even as mortgage rates have risen in recent months. The WSJ’s Dion Rabouin explains what’s driving demand, evidence of a slowdown on the horizon and what it could mean for the economy. Composite photo: Ryan Trefes

How paying off your mortgage can affect liquidity

If you pay off a 3% mortgage only to find you have to tap into your retirement equity, you may have regrets.

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Is it worth carrying a mortgage into retirement? Why or why not? Join the discussion below.

Retirees with significant assets but little income may have trouble qualifying for a new mortgage, Mr. Dole said. A retired client of Mr. Dole’s was recently turned down for a mortgage on her primary residence and had to sell assets to meet her cash needs.

Compared to other forms of mortgage debt, including home equity loans and reverse mortgages, maintaining a primary mortgage “can be a low-cost way to fill in the financing gaps,” Mr. Dole said.

Even when the math is favorable, some retirees may feel more comfortable paying off the loan as soon as possible. Eliminating it can bring peace and a sense of accomplishment, said Kevin Lao, a counselor in Jacksonville, Florida.

Write to Anne Tergesen at anne.tergesen@wsj.com

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