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March 03, 2011

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deegee

I had paid off my mortgage about 10 years before I Early Retired, and about 3 years before I began seriously planning my ER.

When I had the money to pay down (and off) the mortgage, I considered 2 items: (1) The net interest I would be paying based on interest rate on the mortgage, a 1-year ARM whose rate had been rising from 6% to 8% in recent years (this was a more costly co-op loan in the 1990s), (2) The rate of return on whatever money I would be using to pay down (and off) the mortgage - most of it was from a muni bond fund (paying in the 4%-5% range like your CD) but some came from a mixed-asset mutual fund which had grown so I would be taking some of winnings "off the table" to pay it down.

The tipping point for me was realizing that paying off the mortgage would not cost me as much as I thought because I would move from the itemized deduction to the standard deduction on my state income taxes, thereby retaining an equivalent deduction on my state income taxes as before.

Your interest rate, already low compared to mine, was dropping, which made keeping the mortgage a good move. If mine had been that low (which it never was) and was dropping (which it never did once I had refinanced it down from nearly 11% to 6%), I would have kept the loan and not taken money out of a muni bond fund to pay it off.

We basically did the same analysis but did the opposite based on our own situations.

Retired Syd

@deegee: Actually, you bring up an other excellent consideration which I missed-rebalancing. In your case, paying off the mortgage helped you to keep your overall asset allocation in balance (by taking out some of the "winnings" off the table and moving them to effectively bonds (your mortgage), guaranteeing a 6-8% (or more) rate of return.

Again, kind of my same decision process but the opposite since my "winnings" at the time were actually losses, so rebalancing in my case was to keep the money in equities to maintain the asset allocation when stocks had fallen so far.

Thanks for adding that great point to the discussion.

dgpcolorado

I have long known that having a mortgage — at a low interest rate — was good financial planning: better to have $100K in the bank or invested where I can get at it, than no mortgage and no money. However, after I retired I no longer qualified for a mortgage because my income was too tiny (and I didn't have an old mortgage because I moved and built a new house). Nevermind that I would have more than 50% equity in the house or that I had assets that could pay off the amount I wanted to borrow several times over. I could only get a high interest "no doc" loan, which irritated me no end.

So I have no mortgage. It really is very convenient to have housing expenses that consist of just property taxes (very low in my state), insurance, and utilities. And the standard deduction makes the Schedule A mortgage interest deduction almost worthless anyway. But there is all that "dead money" tied up in my house, so I am paying for the convenience.

Still, after surviving two bear markets since I retired, perhaps it is better that I didn't succeed in taking some equity out of my house and invest it...

By the way, back in 2000 TIPS were paying more than 4% real (plus inflation, of course). I bought some back in 1999 (2028 maturity) at about 3.6% real (I also have a lot of Series I Savings Bonds at 3% real). That was back in the days when they were new and few people understood them. It is unlikely that we will ever see those TIPS rates again, sad to say.

Retired Syd

@dgpcolorado: I've often wondered about that, if I paid off the remaining mortgage, how hard would it be to borrow that out in a pinch. I suspect hard without a job, even, as you say with a ton of equity in the house. No income, no loan.

Here where I live, most of us are still itemizing (property taxes are pretty high and usually get you over the hump), so the deduction is still worth a little something.

But of course I don't under appreciate the sense of well-being that comes with having that paid off either . . .

dgpcolorado

Syd,

No income, no mortgage, simple as that. I believe it is because mortgages are sold to the bond market, usually through Fannie and Freddie, and they need to fit the standard form. If local banks were to keep mortgages in their portfolios, as happened in the "olden days" they might be more inclined to look at wealth instead of income. But it just doesn't work like that anymore. There isn't any box on the application that says "living comfortably on savings because I'm thrifty".

In the case of someone who planned to move as soon as he/she retired, it might be possible to build or buy the retirement house before leaving work, but that means two mortgages and it might be difficult to qualify unless one has a high income (which I never did: I was earning in the mid $40s before I retired).

Anyway, building the new house first wasn't an option for me because I retired on impulse several months after being downsized. I was doing my taxes and I happened to come across a quirk in the tax law that allowed me to take money out of my IRAs without penalty faster than I thought possible (SEPP using an amortization formula instead of the IRS tables). Some quick calculations showed that I could make it and that my nest egg would likely last until I reached Social Security age, using conservative projections. That was January 30, 1999, a happy day! Two weeks later site preparation work started on my lot and the following month I moved here so I could declutter my old house for sale. To say I was ready and eager to get on with my early retirement would be putting it mildly...

Hence my need to just enjoy the convenience of having no mortgage, even though it is poor financial planning. I didn't realize that it wasn't possible to get a mortgage at a good interest rate based on assets rather than income because it makes no sense. Still doesn't.

So, keep your low interest mortgage while you can!

Rick

I fully understand the arguments for and against mortgage debt. Personally, we decided in our early 30s that we are more comfortable with no debt, and consider the no debt decision part of our asset diversification. It works for us. Like a lot of financial and life choices though, I don't think it's one size fits all; although I think I can make a pretty good case against most consumer related debt. Enjoy the weekend ... if you can remember what day it is :-)

Sightings

I agree a lot of whether or not you want to keep a mortgage after retirement depends on your emotional/psychological point of view. Some people just don't like to be in debt.

I've got a small, leftover adj. mortgage at 3.75% that seems like cheap money -- until you look at a CD paying 1.5%, and then 3.75% suddenly doesn't seem so cheap!

Since I can't decide what to do, I've just done nothing.

Executioner

The standard analysis of "Investing versus Eliminating a Mortgage" involves a comparison of the mortgage rate against potential rates of return from other investments. I don't think it's appropriate for most people to compare mortgage rates against equity market returns because they represent different asset types, with very different risk characteristics. Mortgages should be compared against other types of debt investments: CDs, government bonds, and the like. This consideration is especially important if the mortgage is held on a primary residence, where the risk of a losing investment jeopardizes the home -- and if mortgage payments cannot be made, then the homeowner must choose between involuntarily liquidating other assets or selling the home itself.

Consider that widely-published rates of return for stock markets are very long-term averages, spanning the length of a human life or longer. Mortgage terms are comparatively shorter, and someone on the verge of retirement would presumably not be embarking on a 30-year mortgage. For shorter time periods (ten or five years), the likelihood that stock market returns will exceed (or even meet) the guaranteed return of the mortgage becomes smaller. Would it have made more sense to pay off a ten-year mortgage or invested in the stock market between 2000 and 2009? How about between 2001 and 2005? Or 2005 and 2010?

If the situation was different, and you had no mortgage, would you take out a home equity loan and invest the proceeds in the stock market? If so, I would argue that your risk profile puts you firmly in the "aggressive growth" or "speculative" category. I would guess that most retirees (even "early" ones) would describe their own investment objectives more conservatively, and therefore the strategy above would not be appropriate. Therefore it makes no sense to me that a mortgage should be held when it could be eliminated unless the investor has very aggressive risk tolerances.

I completely agree that if you can find a guaranteed (fixed & insured) rate of return from an investment (like the CD described in your example) then it makes sense to keep the mortgage and take advantage of the spread. But for me, this would be the only situation where it would make sense to keep the mortgage if sufficient funds were available to pay it off. And I don't think this situation occurs frequently enough to suggest a meaningful investment strategy.

I also strongly believe that anyone considering (early) retirement should have the mortgage paid off well in advance of the retirement date -- something to be addressed during the planning phase. Without a regular income, mandatory mortgage payments are an unnecessary drain on cash flow.

Retired Syd

@Executioner: It's very true that generally you would compare your alternative uses with the more fixed investments. However, practically speaking, if you are liquidating the fixed portion of your assets to pay off the mortagage, you will need to re-balance your assets to get them back in whack with your target allocations, which would probably mean selling some stocks to put back in your bonds/cash.

Similarly, if you use all or most your cash to pay off the mortgage, you might be in a tight bind as well (being required to liquidate stock funds over the coming years while they are at potentially low prices) just to live, so liquidity is still a very important consideration, irrespective of rates of return on alternative investments. As you point out, it's very hard to get that money back if you need it (once you've paid down the mortgage) -- perhaps requiring you to sell the home itself, the same problem you have if you can't make the mortgage payments.

As far as the aggressiveness of a retiree's portfolio, someone retiring in her 40's will need at least 50% of her assets in equities to make it through possibly a 50 year stretch. (If you are using the 3% rule, you'd need a nest egg of 33 times your annual expenses, historically you would not be able to achieve these results with a 100% bond portfolio).

There is room in a retirees portfolio for a speculative category, in my case I agree this mortgage could sort of be considered a speculative category (although at 3% how speculative is that really?) Since I'm talking about a number that only represents 5% of my net assets, it's really not a very risky bet--certainly in line with what financial advisors would recommend for a speculative category. Certainly a different consideration than if it represented 50% of assets, although I can't see how that person would even be able to consider retiring with those facts.

@Sightings: Your decision will be much easier if it winds up adjusting upward significantly, then I'll be right there with you paying it off.

Retired Syd

P.S. It's probably worth mentioning also that my mortgage payment represents about 6% of my annual living expenses. I think that puts the risk argument in a little bit better perspective. As a point of reference, that is the same dollar amount as my annual vacation expense, something that could definitely be given up in tight times in favor of the mortgage.

jojo

thank you for your input. I just discovered your blog. I think it is wonderful that you are able to retire so young. My husband and I are looking to take the big plunge in 21 months. Can't wait.
My question to you and your husband since you retire so young, how do you handle health insurance? Do you budget that as part of your expenses?

Retired Syd

@jojo: Sorry for the delay responding to your comment, but it inspired my post today over at U.S. News: http://money.usnews.com/money/blogs/On-Retirement/2011/04/13/how-to-find-health-insurance-in-retirement

invest in stocks

Investing in stocks is one of the largest ways that people look to make residual income when it comes to investments.

Avril Copperfield

Mortgage payments should be protected from the suddenly rise and fall of inflation rates. If these are protected through a security or insurance program, interest rates will remain the same despite of the market flow.

Gmac Home Loans

Behind the argument for not paying off your mortgage is the reasoning that you could invest the extra money and earn a higher return, while keeping your money more liquid. That may have been a good reason in the past but the rate of return on investing now is more questionable, compared to the fact that every dollar paid to reduce a mortgage balance provides a guaranteed return equal to the interest rate on the mortgage.

Richelle Jelsma

I don't know how many retirees have outstanding mortgage responsibilities, but I think it has been a frequent issue among them. It would be wise for them to start a new business or make profit from a hobby to repay the remaining expenses faster.

Randy Robinson

Ultimately, it's up to the person to decide whether he should pay off the mortgage or be patient. Both have pros and risks. Still, it can be a wise idea to invest that money to increase your funds and budget.

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