Pay Off the House or Keep the Mortgage?

EDITOR'S NOTE: This article was originally published in the December 2011 issue of Kiplinger's Retirement Report. To subscribe, click here.

More retirees than ever are still making mortgage payments. If you're one of them, you're likely pondering this question: Should I pay off the loan, or not? Throw in historically low interest rates and the decision gets a little harder.

Anna Vassilian, 70, who lives in Houston, refinanced her mortgage last year, dropping the interest rate by a percentage point. Her mortgage balance of $48,000 now carries a 4.25% rate with a 15-year term.

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But with her savings earning less than 1%, Vassilian says she is thinking of paying off the debt. Half of the payoff would come from taxable savings and the other half from her IRA. "People my age are entitled to have peace of mind," she says.

Homeowners in Vassilian's position should view a mortgage payoff as an investment, says Jack Guttentag, a professor of finance emeritus at the Wharton School of the University of Pennsylvania. Paying off a mortgage with a 5% interest rate, he says, is like getting a 5% return. "You can't earn 5% with no risk in today's market," he says. But if you earn more on your investments than the rate on your mortgage, it makes sense to keep your cash invested.

On Guttentag's Web site, www.mtgprofessor.com, you can plug in numbers on a spreadsheet to decide the better option. (Click on "Elderly Home Owner," and then click "Mortgage Prepayment as Investment.")

Say you have eight years left on a $75,000 mortgage with a 5% rate, and you assume your investments will grow 3% a year for two years and then jump to 7% a year. According to Guttentag's tool, in the first 59 months your wealth would be greater if you paid off the mortgage. But after 59 months your wealth would be greater if you kept the mortgage. The bottom line: Don't pay off the mortgage if you expect interest rates to rise and you expect to live a long time.

Peace of mind, though, can play a big part in the payoff decision. Kelly Campbell, principal of Campbell Wealth Management, in Alexandria, Va., says that having a mortgage in retirement "makes people feel uncomfortable." He advises clients to try to pay the mortgage off before retiring. Before you write a check to a mortgage company, mull these factors.

Liquidity. Review your other assets and income streams. You don't want to restrict your cash flow, especially during an emergency. "Most people going into retirement need to be careful of giving up liquidity," says Wayne Copelin, founder of Copelin Financial Advisors, in Sugar Land, Tex.

Also, it may be wise to pay off other debts first. The interest rates on those debts, such as an auto loan, are likely to be higher, and the interest isn't tax-deductible.

Asset location. Avoid using assets in a traditional IRA or 401(k). You have to pay Uncle Sam when you pull money out of a tax-deferred account. For someone in the 28% tax bracket, withdrawing $50,000 to pay off the mortgage would result in a $14,000 tax tab.

A large IRA withdrawal might also force you into a higher tax bracket. If that $50,000 withdrawal, plus other taxable income, pushes you into the 35% bracket, you would owe $17,500 in taxes on the withdrawal. Older IRA owners, though, could accelerate the mortgage payoff if they don't need their required distributions for other expenses.

Interest deduction. If you're far along in your mortgage, most payments may be going to principal, leaving little interest to deduct. And with the additional standard deduction for taxpayers age 65 and older, you may find it's no longer worth itemizing.

Cut costs. If a mortgage payoff is not feasible, consider refinancing, especially if you can beat your current rate by a percentage point or more. Because of the upfront fees, don't refinance if you plan to sell your home within a few years.

For now, Vassilian expects to cut her total interest costs by paying off her mortgage faster. She has been adding $150 a month to her required $350 mortgage payment.