Key Takeaways
It’s always better to pay off high interest debt before paying off low-interest debt.
If you have a low fixed-rate mortgage, there may be much better uses of your money than making extra principal payments – even if you’re retired.
Mortgage interest remains deductible for most homeowners and there could be college financial aid reductions if you have too much home equity.
I recently met with a working couple in their early 60s who had been making extra mortgage payments over the past several years. They were very financially responsible and didn’t have much debt other than their mortgage. They had a low 3.5% fixed rate mortgage and wanted to have the house paid off before retiring in a few years. Their kids were grown and finished with school, so they didn’t need the extra money for tuition or a college savings plan. I wasn’t aware of the extra payments at first, until it came up when we were doing our comprehensive planning for them.
Conventional wisdom is that you don’t want to enter retirement with a mortgage or other big debts hanging over your head. After all, you’ll no longer be earning a paycheck and there’s the psychological satisfaction of owning your home outright, which is often one of the largest assets for many people. But more and more people, including the very affluent, are retiring with a mortgage on their primary home. Between 1989 and 2016, the share of homeowners aged 65 to 79 with mortgage debt more than doubled, from 17% to 43%, with a median balance of $77,000, according to a report by the Harvard Joint Center for Housing Studies. And a 2022 study from American Financing found that nearly half (44%) of 60- to 70-year-old homeowners bring their mortgage into retirement. With interest rates so high these days, I told the couple to stop making extra principal payment to pay down a 3.5% mortgage when we can get that money invested or do something better with that cash flow to get a higher return. For instance, they could be taking the $2,000 to $4,000 a month for extra mortgage principal payments and instead put it into a low-risk type investment like a short-term Treasury that’s paying close to 5.5%. By doing so, they are engaging in an "arbitrage opportunity". In that they are getting an additional 2% return by simply investing this money instead of paying down their debt. All in a risk-free instrument!
Alternatively, they could use that extra money to pay down credit card balances, home equity lines, car loans, or student loans in which the interest rate is much higher than the 3.5% they’re paying on their mortgage. In addition, if the couple has large short-term expenses coming up there are great investments to earn a little extra yield in the short-term with very minimal risk. This includes things like money market account or high yield savings account. In previous years, these types of accounts would get you a very minimal return and typically weren't worth the hassle. But now, you are rewarded for making the effort.
When interest rates were low, as they had been for the past 15 years, some people would make extra mortgage payments to build up equity in their homes. In the future, if needed, it enabled them to borrow against the equity in their homes via a credit line or home equity line of credit (HELOC). This type of loan would allow them to do renovations or supplement other needs and was easy to budget for when interest rates were 3%. But now the rate on those lines has reached 8% to 10%, it doesn’t become as great a strategy as it once was.
Finally, the interest on your primary mortgage – one of the biggest annual expenses most people have – is deductible for those who itemize their deductions. By paying off your mortgage early, you minimize that interest deduction. Also, for those facing a college expense, a little-known trap that most elite colleges won’t tell you about is that the amount of equity you have built up in your home counts against you when applying for financial aid. The FAFSA form that all colleges require doesn’t ask about your home equity. But, if your child is applying to one of 300 or so highly selective schools that require the College Scholarship Service (CSS) form in addition to FAFSA, you’ll need to disclose a lot more about your financial situation than W-2 income. And that includes home equity.
Conclusion
I know it may seem counter-intuitive not to pay off your mortgage as soon as possible. But in these extraordinary times, paying off high interest debt before low-interest debt makes more sense than ever.
If you or someone close to you has concerns about mortgages or other long-term debt heading into retirement, please don’t hesitate to reach out. We’ve helped many clients like you in similar situations.
RYAN A. DUNN, CFP®, is a Wealth Manager at Novi Wealth