DR 108: Should You Pay Off Your Mortgage or Invest for Retirement?

Imagine you’ve just inherited some money. The amount just happens to match the outstanding balance on your mortgage. Now you have a decision. Do you pay off the mortgage or invest the money for retirement. That’s the question facing a podcast listener named Shelly. Here is her email to me:

Great job on your podcasts. I started listening over the summer and they are great. You thoroughly go over a topic and are good about discussing the pros and cons. I really did not pay as much attention to mutual fund costs before but I do now after you explained about how this will impact my returns. My average for the mutual funds I own is 75 basis points, which I learned using the Morningstar tool which was free through T. Rowe Price, which is not awful, but I know I can do better.

I have a question that perhaps might be a topic for a podcast. I am anticipating an inheritance in the near future of about $150,000. This amount is roughly the remaining balance on my mortgage. What are the pros and cons to paying off your mortgage instead of investing the money for retirement? I’m currently behind where I should be for my retirement savings so I’m tempted to use the money to turbo-charge savings for retirement. Yet the idea of paying off the house is pretty tempting. I live in a high cost of living area and my husband and I are not planning to stay in our home long-term, maybe a maximum of seven more years. We have equity in the house and we can probably take it and pay cash for a condo or townhome into another part of the country. I am 51 and my husband is 56. And I do not plan to retire until 68. Any thoughts on where one should put a windfall?

This is the kind of personal finance question that doesn’t have one right answer. Many popular financial personalities believe their approach to this type of question is the only reasonable approach. Ironically, some of these financial gurus insist the right answer is to pay off the mortgage, while others insist the right answer is to invest the money. I don’t think about personal finance that way in most cases.

There are certainly times when there’s really just one answer. There are cases where you might be considering a course of action and it’s just a really bad idea. But in cases like this, I don’t think there is just one right answer. Instead, here are 10 factors worth considering if you are facing this or a similar financial decision.

Listen to this article:

1. Calculate your monthly home payment after your mortgage is paid off. This may seem odd. Once you pay off the mortgage, there is no mortgage payment. True enough. But you still have monthly payments that you must make even after you’ve paid off your mortgage. In fact, there are three of them. If you’re ahead of me on this, you may be thinking of two of them, but there are actually three, and here’s what they are.

The first one is homeowners insurance. Even when you’ve paid your mortgage off, you’re still going to have to pay for homeowners insurance.

The second one is real estate taxes. You’re going to still pay those real estate taxes. Like homeowner’s insurance, they are likely part of your mortgage payment. But once the mortgage is paid off, you’ll be responsible for making these payments directly to your insurance company.

The third one is a bit different. Once you pay off your mortgage, assuming you itemize your deductions on your taxes, you no longer have the deduction on the interest portion of your mortgage payment. The result is you’ll pay more in income tax each year.

One easy, although not perfectly precise way to calculate the increased tax liability, is to figure out what your interest payments were last year and multiply that by your marginal tax rate. That will give you a rough idea.

Understanding this cash flow is an important first step so you have a sense as to exactly what the benefit will be if you decide to pay off the mortgage. If, in this case, you take $150,000 to pay off your mortgage, step one probably won’t answer the question for you in and of itself. But I can tell you that I did this about a year ago, and I was surprised with just how much we’d continue to pay each month after we retired the mortgage. Certainly paying off our mortgage would save us a lot of money each month, but it wasn’t quite as much as I thought it would be when I added back in these costs.

2. Consider your current cash flow needs. What does your current budget look like? Are you strapped for cash each month or do you have money left over to save and invest? Do you have other debts such as car loans or student debt?

The current cash flow could have a big impact on your decision. If you’re living month-to-month and maybe even going into a little bit more debt and the mortgage payment is really a burden for you, that might counsel towards paying off the mortgage. One of the things you need to do here is to be very, very honest with yourself. If you’re having cash flow issues, is it because of the mortgage or is it because you’re spending money in other areas where you shouldn’t be spending? On the other hand, if your cash flow is great and you don’t need the extra money you’d generate by paying off your mortgage, then that might counsel in favor of not paying off the mortgage.

3. Consider other financial goals. Paying off the mortgage and saving for retirement are two very important financial goals. But they aren’t the only important financial goals. As a result, the decision shouldn’t be made in isolation from everything else that’s going on in your life. And Shelly is looking at this the right way because she’s looking at her current age, how long she wants to work, when she’s going to retire, and even where they’re going to live during retirement. The key is to identify all of your financial goals, and then evaluate where best to use the money.

4. How long you plan to live in the house. Are you going to move in a few years or stay in your home well into retirement? The answer to that question won't make it clear whether you should pay off the mortgage. Even those that plan to move in a few years might be wise to retire the mortgage now. But your plans will bring into focus other financial priorities. For example, if you plan to stay in your home into retirement, you know exactly what you need to do to be debt-free by the time you retire. Depending on your total financial picture, that may suggest using the inheritance to pay off the mortgage.

5. The interest rate on your mortgage. The lower the rate, the more advantageous it will be to use the money to invest for retirement.

6. Your risk tolerance. There are two important ways to consider risk here. The first is the risk of investing in the market. Paying off the mortgage offers a guaranteed return on your investment. Investing in the stock market for retirement, in contrast, comes with the potential of significant loss, at least in the short term. How would you react to a 30 percent loss of that investment? To put that into perspective, a $150,000 investment in a diversified portfolio could easily fall to $100,000 in a single year.

The second type of risk tolerance question is, does the fact that you have a mortgage keep you up at night? I think for a lot of people, there’s just a good sense of security and accomplishment for paying off your mortgage. This will probably show my age but I remember an episode of All in the Family that aired on March 8, 1975, where Archie and Edith paid off their home and burned the mortgage to celebrate. If your mortgage is keeping you up at night, that’s an important consideration to factor in as to what’s best for you.

7. Consider what you’ll do with the money if you don’t pay off the mortgage? What will you do with the money if you don’t pay off the mortgage? Shelly would save for retirement, which is a critical goal. Others may intend to use the money for other purposes, such as starting a business. The key is to evaluate how you would use the money if you didn’t pay off the mortgage. As part of this analysis, keep in mind that a perfectly valid option is to use the money for multiple purposes. One might, for example, put $75,000 toward the mortgage and $75,000 toward retirement.

8. Consider what you’ll do with the extra cash flow if you do pay off the mortgage. What would you do with your extra cash flow on a monthly basis if you do pay off the mortgage? This is particularly important for those who are not good at managing their money. What’s interesting here is that many who aren’t great at handling small amounts of money might be very good at handling lump sums of money. For those who will likely blow the extra cash flow, they may be better off keeping the mortgage as a forced way to save.

9. Consider whether you are prepared for the unexpected? A key to financial planning is flexibility. That's really all an emergency fund is--the flexibility to handle the unexpected. If your finances have little in the way of flexibility, paying off the mortgage may be less than ideal. On the other hand, if you have no other debt, a healthy emergency fund, and plenty of monthly cash flow, retiring the mortgage may be more sensible.

10. Consider the decision in the context of all of your finances. And that leads us to the final consideration. This decision should be made in the context of your entire financial picture. Do you have an emergency fund? What are your spending patterns? Do you have other debts?

In answering these questions, I think it’s important to take a holistic view. I might have a different answer for someone who’s got no emergency fund and hasn’t saved anything for retirement. There would be different concerns to deal with as compared to someone who has 6 months in an emergency fund and maybe is a little behind in the retirement savings but still has a good amount saved. Then again, someone whose spending patterns give them a lot of flexibility in their monthly budget versus someone who maybe has no flexibility or is, in fact, spending more than they make. You have to consider these other finances.

You may have all kinds of other factors that you would take into account. Or maybe you just think it’s easy and there’s just one answer, and it’s this. In any case, I’d be happy to hear from you, shoot me an email at dr@doughroller.net and let me know what you think.