The proposition is essentially this:
"I bet that I can earn enough money investing in stocks and bonds to equal my mortgage payments and, further, to provide enough profit in excess of those payments to adequately reward me for exposing my home to greater foreclosure risk."History shows this isn't a great bet, that it certainly isn't easy money, and that it becomes a worse bet after retirement.
So, everyone should rush to pay off the mortgage, right?
If a wealthy client asked me if she should take out a mortgage on an unencumbered home for the sole purpose of leveraging her stock portfolio, I would not hesitate to say, "Absolutely not." Had she already retired, there is an even stronger case for forgoing a mortgage.
On the other hand, for a less wealthy household, paying off an existing mortgage might convert most of her liquid assets into illiquid home equity. Freeing up cash from home equity can be challenging. (A fixed rate mortgage, it should be noted, is a temporary solution to that problem.) Maybe I would recommend keeping the mortgage.
But, maybe I wouldn't.
Lawrence Kotlikoff, who built E$Planner, says that he has analyzed many mortgage payoff scenarios and he most often sees an improvement to the household's standard of living, though not always. This is more of a cash flow than a profitability analysis and I would see what consumption smoothing says about the client's finances before making that recommendation.
Regardless, many retirees will eventually pay off their mortgage and have to face the illiquidity problem. They may find that most of their wealth is tied up in home equity. Better to plan for it up front. The most effective solution may be downsizing or relocating. It may not be a mortgage issue, at all.
Should you pre-pay the mortgage instead of investing? I wouldn't advise my son to pre-pay instead of investing in a 401(k). The amount of money we need to save to retire comfortably is so large that investing in risky assets is the only realistic way to get there. Pre-paying the mortgage is too conservative an approach. You have to take the risk. But, once you feel that you have saved enough for retirement, or you actually retire, you no longer need that risk.
After you retire, however, if you hold investments that could pay off the mortgage, you're relying on future stock returns instead of a paycheck to pay the mortgage and that's riskier. You're betting your home that you will succeed in exchange for a net expected return that is lower than your expected portfolio return by the amount of your mortgage. Your net expected return will be sharply lower than that of your portfolio return, but your risk will be the same1.
As sustainable withdrawal rates studies showed, the higher the spending rate from your portfolio, the greater your risk of outliving your savings. Paying off the mortgage will probably reduce your withdrawal rate and thereby decrease your risk of depleting your savings. (I'll go into this "lifestyle leverage" in greater detail in a future post.)
Taxation may also be a consideration, though frequently a second-order problem after retirement. Consider taxes part of the calculation, not a certain justification for keeping a mortgage.
Lastly, there is a risk tolerance issue to consider. While many retirees will be comfortable with a higher withdrawal rate and more exposure to foreclosure risk, many will not. To quote a recent commenter on this blog,
"I am SO glad, now that I am retired, that we didn't load up on mortgage debt that we'd now have to service. Our house got paid off 6 years ago and wow, does that make a difference in retirement security. "As you can see, there is significantly more to consider than expected portfolio returns and current mortgage rates when you consider paying off the mortgage. I would want to answer the following questions:
- Will paying off the mortgage significantly improve my standard of living? (Calculate with E$Planner.)
- Will I have adequate liquid assets after paying it off?
- What is my foreclosure risk before and after a payoff?
- What is my portfolio withdrawal rate and risk of portfolio failure before and after payoff?
- Will I sleep better knowing my home is paid off?
- What are the tax implications of paying off the mortgage and of not doing so?
- If I am still accumulating retirement savings, will paying off the mortgage leave me with too little market risk to achieve my goals?
If you're very wealthy, paying off the mortgage seems like a no-brainer. If you insist on portfolio leverage, open a margin account.
If you can't afford to pay it off, I suppose that's a no-brainer, too.
It's always the group in between that has the tough call. Investing the mortgage may not be the best bet, but sometimes it's the best bet on the table.
1 Mathematically, we are subtracting a constant mortgage payment from a random variable representing our portfolio return. That random variable might have an expected return of 8% and a standard deviation of 12%, for example. The result of the subtraction is another random variable with an expected return of 8% minus the annual mortgage payment, but the standard deviation (risk) of the initial portfolio return random variable will remain unchanged. Lower return, same risk.