That Darn Mortgage

Should I pay off my mortgage before retiring? This is a common question for folks planning to retire, and for others who would prefer to not have any debt. While I've written about this previously, the recent tax law created some new wrinkles to consider.

I'm a firm believer that there's no one right answer to questions like this. What's right should always be based on one's own situation. But the new higher standard deduction will crowd out the ability for many to see their mortgage as a tool to save on taxes. For these folks, starting this year, owing money on their house could seem to have no benefit.

Understandably, many will want to simply be done with having a mortgage and will try to pay it off as soon as possible. But is this the best financial decision?

Here's an explanation of one of the ways I think about this question.

Relative Interest –

Assume your mortgage is at 4.5% per year for 30 years and you find out you can't deduct your interest. If you could deduct the interest, you'd reduce this number by your highest marginal tax bracket. But since we're assuming no deduction, your interest expense is just 4.5%

Now assume you want to get rid of this debt. Where will you get the money from? Maybe you have a lump sum sitting in cash and are wondering what to do with it. Or, maybe you need to sell investments.

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If from investments, you'd want to compare your mortgage rate to a reasonable expected return from a balanced portfolio, say 6%. This means you'd be selling an asset earning 6% to pay off a debt costing you 4.5%.

In this simplified example, the psychological benefits of having no mortgage would come at an opportunity cost of 1.5% potential return per year compounded over how long, twenty years? If so, the opportunity cost could be worth almost $70,000 on a hypothetical $200,000 mortgage payoff! Is that worth it? It depends.

You could be more analytical and compare your mortgage interest to the bond market instead of a balanced portfolio. This looks better on paper because the bond market is expected to earn maybe 3.5%, obviously less than your 4.5% mortgage. That makes the math straightforward, right? Take from the lower-yielding asset to pay off the more expensive debt. But since most of us own more than just bonds, the thought process gets more complicated.

Let's say you have a $500,000 investment portfolio with 60% (or $300,000) in stocks and 40% (or $200,000) in bonds. You could be selective and take from your bonds to pay off your mortgage. Simple, right? Maybe even enticing given the low return environment for bonds.

But for this to work you'll likely need to maintain your exposure to stocks, which is now 100% of your portfolio. You could think of this as still having a balanced portfolio with the 40% now in your house without a mortgage payment as sort of a bond proxy. The interest income you'd give up from the bonds would be replaced by not having to pay interest on your mortgage. Okay so far?

The issue is that what you'd see in your account statement is 100% stocks. When the stock market is up, you'd be happy because you'd get all the gains. When the market is down you'd get all the downside too because you sold your conservative bonds to pay off your mortgage. You might be trading the psychological benefits of not having a mortgage for more worries about the stock market. This greater downside risk, and a host of others, makes this more of an academic exercise, but it's still an important thought process.

I'm a big proponent of paying off all debt prior to retiring, or at least as early in retirement as possible. There are many benefits to doing so but it's not always possible or practicable. Nonetheless, it's important to go through a deliberative process before making large financial decisions like paying off your mortgage, even though it might seem like the new tax law is forcing your hand.

The following excerpts from a recent Wall Street Journal article (emphasis mine) are helpful to understand the dynamics:

For 2017, 32 million tax filers got a mortgage-interest deduction. For 2018, that number will drop to 14 million. Americans' total savings from this break are also expected to fall sharply this year, from nearly $60 billion for 2017 to $25 billion for 2018, according to Congress's Joint Committee on Taxation.

These landmark shifts are the result of the tax overhaul's direct and indirect changes to the longstanding provision allowing filers to deduct home-mortgage interest on Schedule A. These changes are set to expire at the end of 2025.

As a result, current and future mortgage holders need to consider their options, which range from paying part or all their debt to sitting tight.

Some homeowners are already reducing their debt. Ken Walsh, an engineer who lives outside Baltimore with his family, says he used a windfall to pay off the remaining $500,000 mortgage on his home in January.

When the tax overhaul passed, Mr. Walsh knew that he and his wife would no longer get an interest deduction, even after their 2.6% adjustable-rate loan reset higher this year.

"It was a perfect storm, so we decided to pay off the loan," he says.

Mr. Walsh's move may not make sense for everyone. Here's what to consider for your analysis.

For many people, two revisions to non-mortgage provisions will have the biggest effects on their mortgage-interest deductions.

One is the near-doubling of the "standard deduction" to $12,000 for most single filers and $24,000 for most married couples. As a result, millions of filers will no longer benefit from breaking out mortgage interest and other deductions on Schedule A.

The other key change is the cap on deducting more than $10,000 of state and local income or sales and property taxes, known as SALT. This limit is per tax return, not per person.

These changes will hit many married couples with mortgages harder than singles. Here's why: For 2017, a couple needed write-offs greater than $12,700 to benefit from listing deductions on Schedule A. Now these write-offs have to exceed $24,000.

Many couples won't make it over this new hurdle on mortgage interest and SALT alone. According to the Mortgage Bankers Association, the first-year interest on a 30-year mortgage of $320,000 (the average) at the current rate of 4.8% is about $15,250. Interest payments are smaller if the loan is older or the interest rate is lower.

The new threshold is lower for single filers, as each can also deduct SALT up to $10,000. Their standard deduction is now $12,000, so many will only need more than $2,000 of mortgage interest, charity donations and the like to benefit from listing them on Schedule A.

Even for taxpayers who can still deduct mortgage interest, the expansion of the standard deduction means the value of this write-off will typically be lower than in the past.

Following the tax overhaul, most home buyers can deduct only the interest on total mortgage debt up to $750,000 for up to two homes. This limit won't be an issue for most buyers, but some will be affected.

There's a "grandfather" exception: Most homeowners with existing debt up to $1 million on up to two homes before the tax overhaul can continue to deduct their interest.

The rules also changed for home-equity loans. To get an interest deduction, the taxpayer must use the debt to buy, build or improve a home. There's no write-off if it's used for another purpose, such as paying tuition.

For homeowners with a shrinking or vanishing interest deduction, here's the key question: Is the after-tax return on an ultra-low-risk investment lower than your after-tax mortgage rate? If it is, consider paying down the mortgage if you can.

Even if paying down a mortgage makes financial sense, it means restricting access to funds. So consider whether they'll be needed in an emergency, and what the rate on a (non-deductible) personal loan would be. You need to be able to sleep at night.

Have questions? Ask me. I can help.

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