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Should we pay off our mortgage?

Keith Gumbinger

Q: We have chance to pay off the remaining balance on our mortgage. Should we do this? We are retired, living on annuities and Social Security.

A: Whether you should pay off your mortgage or not sounds like a simple problem with an easy answer. After all, who wouldn't want to own their home free and clear?

The truth is that it's a much more complex issue than it might seem on the surface.

Retiring your mortgage: Asking questions

Just because you can do a thing doesn't mean you should, and there's a difference between wanting to do something and needing to do something. The first question you'll want to answer is "What's the reason or need to pay off my mortgage now?"

For many homeowners, there probably isn't a need to pay off their mortgage, but rather a want, such as the peace of mind not having a mortgage is said to bring. As well, an often-cited goal for folks is to approach or enter retirement age mortgage free, but this may be unrealistic for many homeowners to accomplish.

It may be that your wish is to leave your home to your heirs unencumbered by debts they would need to pay off to take possession of the home, but remember that your remaining mortgage balance will shrink naturally over time as you continue to make payments. Even if there is some amount remaining at a future point, there may be options for your heirs to cover any outstanding debts, including using their own funds or cash you may bequeath to them. There are even likely to be financing options available, such as taking a new mortgage or a home equity loan or line of credit to pay off what remains of your mortgage if they so desire.

The second question that needs to be considered is "How many years of payments remain on my mortgage?"

Payments on an older mortgage may be comprised nearly entirely of principal, so interest savings you achieve by paying off the mortgage may not be all that compelling. As such, it may be better to commit the funds you would use to pay off the loan to something else. It may even be possible to earn greater returns on those funds than the amount of interest you are paying on the loan's remaining balance, too.

On a 30-year fixed-rate mortgage with a 4.5% interest rate, the percentage of a payment that goes to principal and interest is equally balanced at payment number 176, just shy of the halfway mark. By the time there are only six years remaining on the loan, the principal-to-interest ratio has changed to 3-to-1 in favor of principal, so there's little interest savings to be had by paying off the loan, as you've already paid 94% of the total interest scheduled to be paid at that point. Note that a higher or lower interest rate affects the timing of these ratio changes, so use an amortization calculator to run the numbers for your situation.

Next would be "How large is the remaining loan balance I want to pay off?" While this is related to how many months of payments remain, there can be a considerable difference between loosing funds to pay off a remaining balance of $25,000 as compared to one of $250,000. The larger amount may produce more pronounced changes in your cash-flow or tax situations than the smaller amount would.

You'll also need to consider whether or not you have been itemizing deductions on your tax returns. If you have been, no longer paying mortgage interest will remove what can be a sizable component of an itemized return, so paying off your mortgage could change your taxable income picture.

Which brings us to the next question that needs answering, namely: "Where are the funds to retire my mortgage coming from?" If, for example, you will need to sell or liquidate stock holdings, doing so might incur fees or have tax implications, so you'll need to weigh any transaction costs against any savings or cash-flow improvements paying off your mortgage might bring.

This is especially true for any tax implications you may generate by selling holdings; you may incur capital gains taxes that will need to be paid. Because of this, it's possible that will need to sell additional holdings to generate the cash to cover these tax costs (or come up with funds to cover any fees or taxes from other liquid accounts). These factors can change your financial picture beyond the amount needed to pay off the loan.

Pulling funds from retirement assets like a 401(k) or traditional IRA to pay off your mortgage before you have reached 59-1/2 years of age will trigger penalties of up to 10% of the amount drawn and also produce a higher tax bill, as the amount you pull out will be included in your gross income for that tax year.

Even if they aren't coming from a place that will create cost or tax implications, committing those funds can have "opportunity cost", where you won't have them available if a need or better use for them should arise. "Opportunities" can be anything from a chance at a new investment with higher returns to something as mundane as having funds readily available to replace a car that is no longer viable.

Which brings up the next point: Using other assets to pay off your mortgage can mean a loss of financial liquidity. Paying off your mortgage isn't merely a case of shifting assets from one place to another. You can take assets that are highly liquid (cash, CDs, etc.) or fairly liquid (stocks, bonds) and add them to an asset that is highly illiquid -- your home.

Once those liquid funds are trapped in your home, you'll need to either sell the home to release them or take a loan or line of credit against the home as collateral, which can incur upfront, recurring and interest costs.

More important perhaps is that if you find you need those funds, there is no guarantee that a lender will make you a loan or line of credit, or in a amount you may need, or at a price you can afford. Be aware that there have been times when lenders have completely stopped making second-lien home equity loans and lines of credit, so there is a chance that you may not be able to secure access to your equity at any price.

You may also need to consider the cash-flow implications of the changes you make to your income and debt profile, too. Yes, you will no longer have a monthly mortgage payment to be made, but any assets you liquidate to use to retire your mortgage can no longer generate income or dividends to help bolster your income, either. Don't forget to subtract any loss of income you may incur from the amount of mortgage payment you're no longer required to make. Not having to make a $500 monthly mortgage payment is actually only a $400 improvement in cash flow if selling assets means $100 less in dividends each month.

Which brings up an additional point: If you have funds that are available to use to retire your mortgage, could these funds be used more productively elsewhere? Depending on your situation, this could include things like paying off credit card debt or funding long-term care insurance among a range of other things. Section 4 of HSH's Guide to Prepaying Your Mortgage covers this in greater detail. Certainly, it may be possible to put those funds to better use in a new or different investments to broaden your holdings, build more asset strength or even create a new cash stream that you can use to accelerate the amortization on your loan. You get to keep your original asset and may be able to pay off your mortgage more quickly, too.

If the goal of paying off your mortgage is simply to no longer have to make mortgage payments, one method you might consider is to take our a reverse or Home Equity Conversion Mortgage, or HECM. An HECM will replace your forward mortgage that requires making monthly payments with a reverse mortgage that doesn't. The loan balance and any accrued interest and fees don't need to be paid back until the last borrower no longer occupies the home. These can be complex products to understand and aren't without costs of their own, but a great place to start your education is by reading HSH's comprehensive Guide to Home Equity Conversion Mortgages and Reverse Mortgages.

These are only some of the considerations of which you need to be aware when you make what can be considerable changes to your debt, asset and income profile. You should check with your investment and tax advisors before you consider locking up available money into your home.

Paying off your mortgage early can be a good idea and could bring you a range of benefits. That said, while you might save interest cost by retiring your mortgage, attain greater financial peace of mind, or even improve your debt structure, you'll need to also consider that you may have a difficult or costly process getting access to new funds should you need it. For many homeowners, if you are managing your finances comfortably at the moment there may be no compelling reason or need to change the structure of your debts and assets.

Ask the expert
Keith Gumbinger
Keith Gumbinger
Mortgage Expert
Vice President, HSH.com
About Keith: Mortgage market observer and analyst with 35 years experience... (more)
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