Overpay Your Mortgage Or Save More For Retirement Here’s What To Know
Becoming a homeowner is an accomplishment to be proud of â but taking on a mortgage can feel like a heavy burden to bear. So itâs natural to want to pay it off as soon as possible by putting any extra funds in your budget toward overpaying your monthly mortgage.
But is that a smart financial move? Overpaying your mortgage to chip away at your principal is not a bad thing, but it could be coming at the expense of other goals â especially retirement. If you have extra money to put toward a goal and are weighing whether to pay off your mortgage or save more for retirement, here are some things to consider.
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One option is to keep working and postpone retirement until youve paid it off, says Coles.
‘If you are well enough, have no caring responsibilities, and work is available, working longer until your mortgage is repaid is going to be a sensible option for many people.’
She also suggests downsizing as soon as you retire in order to get rid of a mortgage burden.
‘This can solve the problem, but do the maths if youre planning this approach, because you may not free up as much as youre expecting.
‘You also need to be prepared to move out of the family home, which can be easier in theory than in practice.’
Use other savings
Paying your mortgage off using savings and investments can offer peace of mind but its not always a good idea, warns Coles.
‘During your retirement you will be spending down the savings and investments youve built up over a lifetime, so you may not want to wipe them out on day one.’
You can also use your pension tax-free lump sum to pay off your mortgage, but again Coles stresses this needs to be considered carefully.
‘You may need the pot to generate an income you can live off, so dipping into it could leave you struggling throughout retirement.’
‘If you can remortgage to a lower interest rate, more of your monthly payments go towards repaying the loan,’ says Coles.
You could also consider switching to a retirement interest only mortgage.
When Paying Off Your Mortgage May Not Make Sense
- You have to withdraw money from tax-advantaged retirement plans such as your 403, 401 or IRA. This withdrawal would be considered a distribution by the IRS and could push you into a higher tax bracket.
- Withdrawing the funds puts your retirement savings at risk or forces you to make drastic changes in your lifestyle.
- You carry other debt with higher interest rates and fewer tax advantages. You may benefit from tackling other debt before paying off your mortgage.
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What Are The Benefits Of Paying Off Your Mortgage Early
Whether you make an overpayment or remortgage to a more competitive deal, youll reduce the remaining size of the mortgage.
This will reduce the amount of interest left to be paid, and – if you keep your monthly repayments the same – it will shorten the length of the mortgage too.
- You have a £100,000 mortgage
- It has a 15 year term and charges 3% interest
- You make a £5,000 overpayment and keep monthly payments the same
- The remaining interest is reduced by £2,717
- The remaining mortgage term is reduced by 11 months
Getting A Loan For Your Home Is Not The Same As Getting One For Retirement
While taking out a loan to purchase your home offers financial benefits, borrowing money to fund your retirement is less straightforward, and should be carefully considered before doing so. And while you can use your home equity as a financial cushion in the form of a loan, âa house isnât a liquid asset, and if the housing market should tumble, you might not be able to access the money you need,â Raess says.
If youâre trying to pay off your mortgage principal faster without sacrificing your retirement savings, check to see if you qualify to refinance at a lower rate. It may also be worth it to take a closer look at your budget: Are there more funds that you can free up to use toward both your retirement and mortgage pay off goals? Often, revisiting your budget as well as any changes to your income â such as a pay raise or bigger-than-expected bonus â can help you find extra dollars to put toward your financial goals.
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When To Continue Making Mortgage Payments
Monthly mortgage payments make sense for retirees who can do it comfortably without sacrificing their standard of living. It’s often a good choice for retirees or those just about to retire who are in a high-income bracket, have a low-interest mortgage , and benefit from tax-deductible interest. This is particularly true if paying off a mortgage would mean not having a savings cushion for unexpected costs or emergencies such as medical expenses.
Continuing to make monthly mortgage payments makes sense for retirees who can do it comfortably and benefit from the tax deduction.
If you’re retiring within the next few years and have the funds to pay off your mortgage, it may make sense for you to do so, particularly if those funds are in a low-interest savings account. Again, this works best for those who have a well-funded retirement account and are still left with substantial savings for unexpected expenses and emergencies.
Paying off a mortgage ahead of retirement also makes sense if monthly payments will be too high to afford on a reduced fixed income. Entering retirement years without monthly mortgage payments also means you wont have to withdraw funds from your retirement account to pay for them.
Should Retirees Pay Off Their Mortgage?
Stop Digging The Debt Hole
Its essential to stop racking up debt when you stop working. That might sound obvious, but its not always so clear for some retirees, says Paul Miller, a New York-based CPA.
Many people think that when they retire, their expenses go down, but they tend to increase, says Miller, owner of Miller & Company, LLP. Retirees want to do things that cost money, like travel. Some people buy a dream retirement home, when they should be downsizing, Miller says.
When youre on a fixed income in retirement, take extra care not to add more debt. Thats especially true of high-interest debt, like credit card debt. If you hope to get free of what you owe, that means living well within your means so you have resources to pay down existing debt while eschewing more.
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Use A Reverse Mortgage To Pay Mortgage Debt
Another way to tap home equity without incurring another monthly debt payment is a reverse mortgage. This tool can be used by people aged 62 and over to borrow against their home equity, and payments arent required until the borrower sells the house, moves or dies.
If youre not ready to give up ownership in your home, you might consider a reverse mortgage home equity line of credit, which makes that money available if you need it in case of emergency. Reverse mortgages have a checkered past, but new regulations have cleaned up the industry, to a degree. Still, proceed with caution.
If their retirement plan is tight already, which is the case for many, a retiree can monetize their home by replacing their mortgage with a reverse mortgage, says Chen. The benefit is that they would free themselves from monthly payments without depleting their retirement assets.
Given Current Rates Could Cashing Out Your 401 To Pay Off Your Mortgage Make You A Bundle
Cashing out your 401 and using the proceeds to pay off your mortgage lets you borrow at a low rate and invest at a high rate and do so at no risk. Yes, your 2020 taxes will increase, but there will likely still be a large net gain. The fact that your 401 is invested in stocks doesnt matter. Once you adjust for the risk, investing in stock is no different from investing in todays low yielding long-term Treasury bonds. I.e., on a risk-adjusted basis, stocks are now yielding a very low return.
Arbitrage is when you can sell an apple for $3.00 and buy an identical apple for $1.00. The transaction nets you $2.00. Thanks to the extraordinary upheaval in financial markets from Covid-19, there’s a significant arbitrage opportunity available for millions of homeowners. It entails withdrawing funds from retirement accounts to pay off all or part of one’s mortgage.
Ideally, one would withdraw the requisite funds from Roth IRA accounts, since withdrawals from these accounts aren’t taxable. But given today’s mortgage and long-term government bond rates, the arbitrage can work even if you need to withdraw from a 401 or similar taxable account. It can even work if you have to pay the 10 percent penalty on making withdrawals prior to age 59.
Here’s a hypothetical example based on my software company’s MaxiFi Planner software.
The answer is a whopping $98,002, which almost fully makes up for Jack’s loss of earnings this year.
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Should Retirees Pay Off Their Mortgage
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Eric is currently a duly licensed Independent Insurance Broker licensed in Life, Health, Property, and Casualty insurance. He has worked more than 13 years in both public and private accounting jobs and more than four years licensed as an insurance producer. His background in tax accounting has served as a solid base supporting his current book of business.
Paying off the mortgage after 30 years, followed by retirement, used to be a rite of passage for many. This scenario is no longer the norm: Baby Boomers, Americans born between 1946 and 1965, are carrying more mortgage debt than earlier generations at this life stage and are less likely than generations before to own their homes at retirement age, according to research from Fannie Mae’s Economic and Strategic Research Group.
Whether it makes financial sense for retirees or those nearing retirement to pay off their mortgage depends on factors such as income, mortgage size, savings, and the tax advantage of being able to deduct mortgage interest.
Ask One Final Question: Invest Or Pay It Off
When you’ve taken the steps above, the big question remains: What should you do with any spare cash? The answer comes down to your individual preference. Some people like to feel the security of having no outstanding debt on their home. That’s certainly got some psychological value. However, there are other alternatives.
Excess cash could get plowed into the stock market in a balanced portfolio of securities. Stocks have typically outperformed cash and bonds over long periods. Case in point: the S& P 500 returned more than 10% annually since 1926. That’s far higher than the 4% cost of a home loan. Of course, there have been periods when stocks dropped precipitously, such as in 2008, 1987 and 1929. But for those who have a time horizon to see their investments grow in decades rather than months or years, stocks might be a financially favorable alternative to paying off a home loan.
That might seem like a lot of steps to go through.
The trick to tackling the larger task is to write down a list of all debts and their interest costs and then start paying down those with the highest rates first. As each debt is paid off, move to the next highest cost loan, and so on. Soon enough you’ll get to the point when you can decide whether investing in the market is preferable to eliminating the home loan.
Looking for additional advice? Connect with a financial advisor at First Horizon Advisors for guidance.
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When Paying Off Your Mortgage May Make Sense
- You have substantial retirement savings, especially if the funds youd be withdrawing are in a taxable account and are not earning much interest.
- Youre downsizing. If youre planning to sell your home for a smaller one, you can apply the equity to your new home, resulting in a modest mortgage or perhaps no mortgage.
- You place a high value on being debt-free, and are able to achieve that goal at a reasonable cost.
Your mortgage is a factor in your retirement income plan and can affect your quality of life.
Dont Try To Fix Mistakes With Bigger Mistakes
Some people end up in retirement and realize they havent saved nearly enough, then make rash decisions in an effort to make up for lost time. That can be catastrophic, Miller warns.
People become day traders. They do things outside their normal personality and they jeopardize their retirement, Miller warns. Hes seen plenty of cases where one spouse doesnt tell the other about these risky steps until things really go south. And most often, its irreparable at that point, he says.
If you havent saved enough for retirement, look for ways to maximize your available retirement funds. That could mean working longer to delay taking Social Security, which offers you larger monthly payments the longer you defer it, or
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Guidelines For Conservative Investors
Retirees and those approaching retirement typically take a more conservative approach to investing. They often limit their exposure to risky equities and have a larger percentage of assets allocated to fixed income investments and cash. As a result, retirees and the risk-averse may benefit more from paying off their mortgage early, Fidelity found. Here are Fidelitys guidelines for investors with conservative investment portfolios:
Asset allocation: 20% stock / 50% bonds / 30% cash Pay off your mortgage early if your interest rate exceeds 2.875%
Asset allocation: 30/50/20 Pay off your mortgage early if your interest rate exceeds 3.250%
Asset allocation: 45/40/15 Pay off your mortgage early if your interest rate exceeds 3.625%
How Much Will A Prepayment Penalty Cost Me
Generally, mortgage lenders are prohibited from imposing prepayment penalties on most home loans under the Dodd-Frank Act.
If your mortgage is the exception to the rule, a prepayment penalty can only be assessed in the first three years. Its capped at 2 percent in years one and two, and 1 percent in year three. So, if your outstanding loan balance in year two is $295,000 and you pay your mortgage off, the lender could charge a prepayment penalty of up to $5,900.
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Strategies To Pay Off Or Reduce Your Mortgage
You can use a few strategies to pay off a mortgage early or at least reduce your payments before retirement. Making biweekly payments instead of monthly ones, for instance, means that over a year you’ll make 13 payments instead of 12.
You can also refinance your mortgage if doing so would help shorten the loan and lower your interest rate. Although it could be helpful in the long run, refinancing could also hurt your net worth. Remember, a mortgage new or old is a liability to your household, subtracted from a households assets.
If you have a larger home, another option is downsizing by selling your home. If you structure the sale correctly, you might be able to buy a smaller home outright with the profit from the sale, leaving you mortgage-free. However, the pitfalls include overestimating the worth of your current home, underestimating the cost of a new home, ignoring the tax implications of the deal, and overlooking closing costs.
Although paying off a mortgage and owning a home outright before retiring can provide peace of mind, it’s not the best choice for everyone. If you’re a retiree and or a few years away from retirement, it’s best to consult a financial advisor and have them carefully examine your circumstances to help you make the right choice.
Carefully Consider Home Equity Loans Or Debt Consolidation Loans
Pooling some of your debts to get a lower interest rate can work in some special circumstances. This is especially true if you have untapped equity in your home and can use it for a low-interest home equity loan.
The trouble is this strategy includes all the risks of borrowing money to fix a spending problem. Depending on your particular situation, you may end up violating tip #2: Dont try to fix mistakes with bigger mistakes.
Home equity loans or debt consolidation loans can make a lot of sense for a one-time surprise medical bills, for example. But if the underlying spending/income mismatch isnt fixed, youre just causing more debt headaches down the line.
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Using Home Equity To Start A Business
The United States is home to many of the most successful entrepreneurs in the world, producing a steady stream of new businesses and entrepreneurs every month. According to the U.S. Census Bureau, applications for new businesses totaled more than 420,000 in April 2022 alone.
However, as many entrepreneurs will tell you, the road to self-employment can be very challenging. One of the many challenges that new entrepreneurs face is how to raise money to finance their business. Traditional options include small business loans, personal savings, or loans from friends and family. But with home prices rising substantially in recent years, many entrepreneurs may be tempted to look at home equity as a source of business financing.
How To Pay Off Your Mortgage Early
If paying off your mortgage early is right for you, here are some strategies to do it:
- Make biweekly payments. One way to get started with making extra mortgage payments is to set up a biweekly schedule. This amounts to making a full extra monthly payment each year and can reduce the time spent with a mortgage. Starting with biweekly payments can help you get ahead on your mortgage while allowing you to keep working toward other financial goals.
- Make extra mortgage payments each year. Similar to making biweekly payments, you can simply make an extra mortgage payment once a year, or pay an additional amount each month on top of what you already pay. Be sure to coordinate with your lender so that these extra funds are allocated to the principal.
- Refinance to a mortgage with a shorter term. If you stand to get a lower interest rate, refinancing to a 15-year mortgage means youll pay off the loan sooner. Keep in mind that even with a lower rate, you could be paying more each month, since your payments are now spread out over a shorter period of time.
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