With mortgage rates averaging less than 5% for the past five years—and 2015 set to become year No. 6 in that trend—there’s never been a better time to carry a mortgage into retirement, right?
Not so fast.
While it’s an appealing idea to hold onto a predictable monthly mortgage payment and plow into retirement savings the money that would otherwise go to a home-loan payoff—the thinking is that you come out ahead if you can earn more in the markets than you’re paying to borrow the money—some say that even at ultralow interest rates, it often makes more sense for people to pay off their mortgage before they retire.
One reason for that is the challenge of getting a decent return given the stock market’s current gyrations and potentially weaker-than-normal returns in the future. Read: The ‘new normal’ for markets: Everything stinks.
You also need to consider the what the Federal Reserve’s decision to raise interest rates means for your long-term and retirement investments. After almost a decade of holding the benchmark federal-funds rate near zero, the Federal Reserve raised the interest rate to a range of 0.25% to 0.5%. The board of directors also raised the discount rate to 1% from 0.75%.
In the short term, there’s a chance for ongoing volatility in both the bond and stock markets. But as a retirement investor, you’re focused on the long term, right? And as a long-term investor, the key rule is: Don’t panic. That rule holds even for those in or near retirement.
That said, these days you wouldn’t need the financial markets to yield much to top the cost of money borrowed to buy a home. In all but one of the first nine months of 2015, the average rate on the 30-year-fixed mortgage was less than 4% (the exception was July’s 4.05% rate). From 2010 through 2014, the annual rate averaged less than 5%, according to data from Freddie Mac. (See the data)
So why not hold onto that low-rate mortgage and try to make a higher return on your money by investing it? In a word: certainty.
“Do we know that markets are guaranteed or what’s going to happen? No. We don’t have a clue. They giveth and they taketh away,” said Michael Falk, CFA, a partner at Focus Consulting and chief strategist on a global hedge fund. Falk spoke at a recent panel event hosted by MarketWatch in New York.
The title of the MarketWatch event was “Rate Quake: How to manage retirement investments in a rising-interest-rate environment.” See the full special report.
Falk was joined by Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research, and Joseph M. Jennings, Jr., wealth director and senior vice president at PNC Wealth Management.
“What do we know about liabilities? You have to pay every month to repay that debt,” he said. In general, those on the verge of retirement should “strategize to get rid of as much debt as possible,” Falk said.
He admits it’s not always a popular idea. “I usually irritate people when I talk about [how] the liability side of the equation is more important than the asset side of the equation for retirees,” Falk said.
By “liabilities” he means more than mortgage debt. For example, near-retirees and retirees should consider selling all but one car, he said. “The capitalized cost of the average car is upward of $500 a month,” Falk said. “If you start to reduce your liabilities, now you’ve got a much higher degree of control over your spending. If you have a higher degree of control over your spending, you’re less dependent on markets, so they can’t be as disruptive in your financial plan.”
He’s not alone in that thinking. “Generally, the goal is to get your debt down as much as you possibly can, even at the expense of investing, particularly if you’re getting very close to retirement,” said Schwab’s Jones.
“You want to get that debt off the balance sheet as quickly as you can, so that you are freed up to invest,” Jones said. “We do have a generation that’s going into retirement with more debt than in the past. I think that’s going to be a big challenge.”
In a follow-up email interview, Falk said the decision of whether to carry a mortgage into retirement will vary widely depending on individual circumstances, including, among many other things, whether the mortgage still offers deductible interest and whether the retiree plans to downsize eventually (in which case, perhaps consider doing it sooner than later, Falk suggests).
It’s not only about the money
Don’t forget that the question of whether to pay off the mortgage or invest the money goes beyond a purely financial calculation. It’s “as much philosophical as it is financial,” said Jennings, from PNC Wealth Management.
“Many retirees aspire to start their retirement debt-free, which is a commendable goal. Not having a mortgage in retirement can be a significant benefit,” Jennings said in a follow-up email. “It liberates cash flow for other ventures, such as travel, hobbies, etc., and it simplifies one’s finances.” Plus, given that many retirees downsize soon after retiring, it’s a “very achievable” goal, Jennings said.
The psychological benefits of entering retirement debt-free shouldn’t be ignored. Forty percent of retirees said that paying off their mortgage was one of the best financial decisions they ever made, according to a survey in 2013.
But if you set aside the psychological benefits of paying off that debt, on a purely financial basis it might make sense to hold the home loan, Jennings said. “If your mortgage rate is 3.5% or 4% and you believe you can earn 6% to 7% consistently on your investments, maintaining a mortgage for a period may make sense for individuals who are willing to take that risk,” Jennings said.
Of course, taxes come into play, on both mortgages and investments. If you’re far enough along on your home loan such that your mortgage-interest tax deduction isn’t worth much, and you plan to invest the money through a tax-qualified account such as a Roth IRA rather than a taxable account, that may skew the numbers in favor of investing over paying down the mortgage—assuming you’re fairly certain about your market returns.
“Market returns may not live up to expectations,” Jennings said. Also, he added, “This approach may only make sense in early retirement. As retirees near the middle and late stages of retirement and their investment returns and expectations become more conservative, continuing to hold a mortgage simply may not be advisable from a cash-flow perspective.”
Certainly, consider taking a long look at the debt side of your balance sheet before you retire. “You want to try to match your assets and your liabilities,” Falk said during the panel discussion.
Divide your spending into what is fixed—bills you must pay—and what is aspirational, he suggested. Then, figure out what portion of fixed expenses will be covered by Social Security benefits. If your fixed expenses are greater than your Social Security benefit, “use laddered bonds, use annuity contracts [to] cover your fixed expenditures,” Falk said.
“If you do that, it doesn’t matter where interest rates go … because whatever you need to spend is covered, guaranteed, for as long as you live. Then with the rest of your assets, invest it any way you want and risk doesn’t have to matter to you anymore,” he said.
Jones agreed. “The first thing you do is cover your near-term expenses” with cash on hand, she said. Also, look to a bond ladder or possibly an annuity. After that, she said, “You have the riskier investments, where you can withstand the volatility because you don’t need the money for a long period.”