Should a Widow Pay Off Her Mortgage?
For some people who lose their spouse, it could make perfect sense. For others, not so much. Here's how to judge what could be a prudent approach in this stressful and confusing time.
Susan, a referral from a colleague, is a recent widow. She called and wanted to know my thoughts on using her late husband's life insurance proceeds to pay off their mortgage.
On the surface this seems like a reasonable idea, however, I didn't want Susan to make a quick decision she may regret later. We met to review the pros and cons of her idea, including a special rule on the home sale exclusion amounts for widows. Here's what we discussed:
Reasons to pay off the mortgage
There are times when it makes sense to pay off a mortgage after a spouse passes away, here are six examples:
1. The surviving spouse wants to stay in the house and doesn't plan on moving.
If a client wants to stay in the house, paying off the mortgage can provide peace of mind. However, it's not a good idea to pay off a mortgage if that leaves the widow or widower house rich and cash poor. It's best to ensure there is enough left over for living expenses. Also, if the surviving spouse plans on staying in the house, the house may need updating or improvements. It's a good idea to keep some money on the side for renovations.
One caveat is if the homeowner is at the age of possibly needing long-term care. If that is the case, perhaps it's best not to pay off the mortgage but keep the money in a safe, conservative and liquid account. This money is then earmarked for purchasing a future residence in a community or skilled nursing care facility. The last thing I want a client to do is pay off the mortgage then in two years need to sell to move in with a family member or need to move into an assisted living facility, the risk being that the real estate market may not be favorable at that point.
2. There are plenty of other assets available.
If the client has sufficient other assets and paying off the mortgage does not leave him or her cash poor, then paying off the mortgage can seem like a reasonable idea. A better approach to analyzing this scenario is to run retirement cash flow projections so the surviving spouse sees the numbers for him or herself. I ran two scenarios to show Susan the impact that paying off or not paying off the mortgage would have on her future balance sheet.
I also showed Susan the impact that varying rates of return can have her on her nest egg in both scenarios. We call this a Monte Carlo simulation. The Monte Carlo runs her situation through about a thousand different iterations of the stock market and gives a probability of success. I showed her how different rates of return on her investment portfolio could impact her decision. All in all, retirement projections and a Monte Carlo simulation are a nice way for the client to see the numbers for him or herself and can help provide a framework to make an educated decision.
3. The surviving spouse is financially conservative.
If the surviving spouse is ultra-conservative and doesn't want anything to do with the stock market, then the most conservative option is paying off the mortgage — assuming again, the client has an emergency cash fund at hand and can meet his or her monthly bills with other assets or income like Social Security.
4. The mortgage is an adjustable rate mortgage.
If the client has an adjustable rate mortgage, rather than waiting for the rate to reset at a potentially higher level and incur refinancing costs, paying off the mortgage can make sense.
5. It makes sense from an income tax perspective.
Though I don't advocate a widow or widower keeping a mortgage for a tax write-off, it helps to understand how paying off the mortgage will affect his or her income taxes. If the standard deduction (which for 2019 is $24,400 for married couples filing jointly) is larger than the client's itemized deductions, then paying off the mortgage may make more sense from an income tax perspective. Keep in mind, the surviving spouse is eligible to file jointly in the tax year their spouse passed away as the IRS considers you married for the entire year. Filing jointly means you have two standard deductions instead of one.
6. Peace of mind.
Emotional desires usually trump logical choices. If paying off the mortgage provides peace of mind and helps the client worry less and sleep better, that is a very persuasive argument for paying off the mortgage.
There are also reasons to keep the mortgage
1. A surviving spouse is confident he or she can earn a higher return on his/her portfolio than the mortgage interest rate.
For a more market savvy or sophisticated investor who understands the risks and rewards of investing and is confident he or she can earn a rate of return higher than the mortgage interest rate, then investing the money versus paying off the mortgage can make sense. In my research, one doesn't have to earn much more than a mortgage rate, usually 1.5% more. The downside is obviously if the stock market craters, then the client is left with a smaller portfolio and still has a mortgage payment to make, not an ideal scenario.
2. The homeowner may decide to relocate or downsize.
If the surviving spouse plans to move, it may be too risky to pay down the mortgage. Paying off the mortgage yet planning to move in the near future can backfire if real estate values drop. The equity can evaporate. In this case, it's best to leave the money in a bank account, CD or short-term Treasury bill.
If a widow or widower does decide to sell, he or she needs to be aware of the capital gains exclusion rules for selling a house. According to the IRS, "If you sell your home within two years of the death of your spouse and you haven’t remarried at the time of the sale, then you may include any time when your late spouse owned and lived in the home, even if without you, to meet the ownership and residence requirements."
Equally important, a single widow or widower can increase his or her home sale exclusion amount from $250,000 to $500,000 if he or she meets certain criteria, such as selling the home within two years of the spouse passing. This may be extremely valuable for the surviving spouse who wants to sell the house but may incur a large capital gain. See IRS publication 523 (2018) or speak to a qualified tax adviser or financial planner. It's also important to understand if the house "stepped up in value." If there was a full step up in value on the date of death, and not much of a taxable gain, then the capital gain exclusion amounts may be a moot point if immediately selling.
3. Liquidity is a concern.
If the client uses up his or her cash to pay off the mortgage, that is a risky proposition if something goes wrong. A surviving spouse may want to consider having at least a year's worth of expenses readily available for home repairs or other emergencies. Looking at the cash outflows for the past three to six months can help in developing a budget and a spending plan.
A compromise: It doesn't have to be an all-or-nothing decision
1. Take a wait-and-see approach.
The surviving spouse may want to stay liquid for the time being until his or her housing situation is clearer. Then he or she can use the money to purchase a new house or pay down the existing mortgage if moving is not an option. This is a conservative and safe choice.
2. Pay down some of the loan and refinance or recast the mortgage.
Recasting a loan involves making a sizable payment, then asking the mortgage company to recast — or reset — the loan payment based on the new balance. For example, if a surviving spouse has a 30-year mortgage with a $300,000 balance at 5%, he or she may choose to make a one-time payment of $50,000 and keep the rest of the money in cash, then ask the mortgage company to recast the loan. The loan payment is now based on a 30-year $250,000 loan at 5%, which will mean a lower monthly payment going forward.
3. Invest the money conservatively to increase liquidity, but have it ready to pay off the mortgage if need be.
One doesn't have to invest to beat the mortgage rate, but rather earn a return that keeps pace or close with the mortgage rate. For example, owning a bond that pays interest comparable to the mortgage rate. If an investor can do this, then he or she can maintain liquidity and keep the opportunity cost of owning the mortgage low. Most intermediate bonds can come close to earning what mortgage interest rates cost. One can also build a laddered bond strategy, buying short-term and intermediate-term bonds to achieve a blended rate of return with less risk than owning all intermediate bonds. Doing this allows the client to maintain their liquidity and have the peace of mind knowing the mortgage can be paid off at a moment's notice if need be. The client should be made aware bonds can lose value if interest rates go up. If that is a concern, owning short-term bonds to maturity may make more sense.
What Susan decided to do
In the end, Susan decided to take a wait-and-see approach. She wanted to see how things would go this upcoming year and hold off on making any big decisions till then. From our discussion, she is also now aware of the two-year window for using the $500,000 home sale exclusion. This proved extremely helpful for her, given how long they had the house, their low basis in the property and only half the value of the house had a step up in value when her husband passed since they owned it joint tenants in common with a 50% ownership each.
To provide income and liquidity, we also built a portfolio of high-quality short-term Treasury bonds and municipal bonds for Susan. Municipal bonds provide tax-free interest, which is unlike a CD where the interest is fully taxable. Municipal bonds are not FDIC insured like CDs, but the ones we bought were AAA rated. Unlike a CD too, there are no withdrawal penalties with bonds, so her money was not locked up for a long time. Though if she sold prior to the bond maturing, she may lose value if she sold the bond for less than it is worth, an important consideration and reason you have to ensure the bonds are not too long in duration or maturity.
For now, she enjoys the extra liquidity, the security of the Treasury bonds, and the tax-free interest from the municipal bonds. Susan said it best when she called me and said she appreciates the extra liquidity and the bond income but also the peace of mind knowing she has the money available to pay off the mortgage at a moment's notice. All this gives her the best of both worlds.
Investment advisory and financial planning services are offered through Summit Financial, LLC, an SEC Registered Investment Adviser, 4 Campus Drive, Parsippany, NJ 07054. Tel. 973-285-3600 Fax. 973-285-3666. This material is for your information and guidance and is not intended as legal or tax advice. Legal and/or tax counsel should be consulted before any action is taken.
About the Author
CFP®, Summit Financial, LLC
Michael Aloi is a CERTIFIED FINANCIAL PLANNER™ Practitioner and Accredited Wealth Management Advisor℠ with Summit Financial, LLC. With 21 years of experience, Michael specializes in working with executives, professionals and retirees. Since he joined Summit Financial, LLC, Michael has built a process that emphasizes the integration of various facets of financial planning. Supported by a team of in-house estate and income tax specialists, Michael offers his clients coordinated solutions to scattered problems.
Investment advisory and financial planning services are offered through Summit Financial LLC, an SEC Registered Investment Adviser, 4 Campus Drive, Parsippany, NJ 07054. Tel. 973-285-3600 Fax. 973-285-3666. This material is for your information and guidance and is not intended as legal or tax advice. Clients should make all decisions regarding the tax and legal implications of their investments and plans after consulting with their independent tax or legal advisers. Individual investor portfolios must be constructed based on the individual’s financial resources, investment goals, risk tolerance, investment time horizon, tax situation and other relevant factors. Past performance is not a guarantee of future results. The views and opinions expressed in this article are solely those of the author and should not be attributed to Summit Financial LLC. Links to third-party websites are provided for your convenience and informational purposes only. Summit is not responsible for the information contained on third-party websites. The Summit financial planning design team admitted attorneys and/or CPAs, who act exclusively in a non-representative capacity with respect to Summit’s clients. Neither they nor Summit provide tax or legal advice to clients. Any tax statements contained herein were not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal, state or local taxes.