Should I Pay Off My Mortgage?

Should I Pay Off My Mortgage?
Written by Publishing Team

If you have a question like this, submit it. I will address case studies that have educational value.

“I am eager to make the mortgage payments because, with the current standard discount, there is no advantage in claiming interest on the mortgage.

“My wife and I are retired. I am 72, with my pension along with Social Security, and have $850,000 in an IRA account. I have a mortgage balance of $134,000. To get that after taxes, I had to hand out 185,000 dollars, which would obviously reduce my wallet significantly.

“Is this a good move? The ROI with Fidelity was 10-15 percent per year with a 60/40 mix of stock and bond funds.”

Michael, Missouri

Readers send inquiries like these. I will answer questions that clarify difficult tax and investment decisions.

My answer to Missourian:

good movement? probably. Retirees must pay off their mortgages. You are fortunate to be in a position to do so.

For many people, no doubt you listed, it turns out that getting a mortgage to get into a house was a good decision. But we have to break up the home ownership. The mortgaged house is two things, the origin and the opponents. Owning a home is a good investment. Getting a mortgage is a bad investment. The retiree’s goal should be to get a home without a mortgage.

40% of your IRA in bond funds means you’re a lender. If the funds track the US bond market, a large portion of your savings will be lent, at low rates, to the US Treasury. This part of your portfolio earns 2% at best. The mortgage may cost you 3% or more.

Borrowing at 3% for lending at 2% is a bad idea.

There are two things that cause people like you to hesitate before putting money into an IRA to pay off a debt: the taxes they owe and the return of the IRA they missed.

Yes, withdrawing an IRA means writing a check to the tax collector. You’re likely to be in the 27.4% (state and federal combined) bracket, so you’ll owe $51,000 on a $185,000 withdrawal.

But taxes on this money are inevitable. If you’re over 59-1/2 (the cap to avoid penalties) and don’t expect your tax bracket to go down, putting off the inevitable doesn’t make you any better off. If the IRA is growing, so will the tax bills.

The math becomes clearer if you rethink what an IRA is. When you see an $850,000 asset, I see something different. I see you as a custodian for an account that has two beneficiaries. You are sitting on $617,000 that belongs to you and also on $233,000 that actually belongs to the tax collectors.

See what growth does to this account. If, for example, you manage to double the portfolio in Fidelity, then the account will contain $1.7 million. Of this amount, $1,234,000 will belong to you and $466,000 will belong to the tax officers. You doubled your money and you doubled the government money.

In fact, what you have is not an $850,000 asset, but a $617,000 asset that is all you own and grows tax-free.

So, what do you sacrifice when you make a big distribution? Assuming you take it out of the bond portion of your portfolio, you lose up to 2% pre-tax return, and thanks to the wonders of IRAs, you lose the same 2% after-tax.

And what do you gain from tearing up the mortgage? You get a guaranteed 3% return before taxes. Thanks to the wonders of a standard deduction, you’re not taking interest and a 3% mortgage costs the same as 3% after taxes. So getting rid of the mortgage earns you 3%.

that is it. Paying off the mortgage costs you 2% surcharge and earns you 3% surcharge. It’s a winning move. The winner will still be, albeit more modestly, if the tax rules change and you go back to deducting interest.

Now, let’s tackle the other reason people stick with 3% mortgages, which is that they invest money to earn 10% or 15%. This is a wrong comparison. Higher returns come from risky assets like stocks. A mortgage is a sure obligation (you can’t avoid debt), so it should be compared to a sure asset (a loan to the US Treasury).

The apple-to-apples comparison comes into sharper focus when I assume that the entirety of the $185,000 withdrawn comes from low-risk bonds. In this first stage of your financial transformation, equity funds are unaffected.

Now you can take a look at what’s left and see a Fidelity account with a high equity ratio. Is this customization too high? Maybe and maybe not. But this is a separate discussion.

Selling bonds to pay off a mortgage leaves you in a better position no matter what happens to the stock market. Meanwhile, whether you have a lot of money in the stock market is an independent decision that should not affect your thinking about a mortgage.

Unlike the comparison between 2% and 3%, determining the correct level of risk for a 72-year-old is not a question with a clear answer. Pulling money out of stocks may lower the expected return but it might be wise anyway. What are the costs of living and how are they covered by pensions and social insurances? Will your retirement survive the stock market crash with the portfolio you have now? Talk to your wealth advisor about this.

Whatever you do, don’t compare the stock market returns of 10% versus 3% of mortgages.

I said, above, that the mortgage payment probably good move. Now here are some things to be careful about.

First, your tax bracket. You may need to break your $185,000 distribution into thirds, and distribute it over 2022-2024, to avoid being kicked out of a federal rate of 22% to 24%.

Next, make your plans for the near term. Are you likely to move to Texas or Florida? If so, hold off on overdistribution until you are out of the reach of Missouri’s 5.4% tax.

Finally, your end game. Is there a good chance a dwindling IRA will dry up while you’re still healthy enough to live independently? Would you, at this point, be against moving – to a rented house or a smaller house – in order to get some cash? And can you, for survival, use a reverse mortgage to cover your monthly expenses? If this outcome is a possibility, and if your current mortgage has a lot of years to run, you should probably stick with it. Its terms are much better than anything you get on a reverse mortgage in the future.

Do you have a financial situation like this? Send a description to the address listed on my resume. Include first name and residence status. Include enough details to create a useful analysis. Messages will be edited for clarity and brevity; Only some will be selected; The answers are intended to be educational and not a substitute for professional advice.


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