Should I Pay Off my Mortgage?

A Reader posted this question which we thought might be good to answer as others probably have the similar questions.

Q: We have a mortgage worth $167,000 on a house that we’ve owned for 21 years. We’ve refinanced our loan twice, and now have a 30-year mortgage at 6.125% that we took out in 2006.

My husband and I are now about 6 – 8  years from retirement, and we are trying to figure out the best use of our money. We have enough to pay off the mortgage without dipping into our IRAs, and we’d sleep better if we didn’t have a mortgage hanging over our heads. Is this a good idea?

A: Given the economy’s continuing weakness, the fact that you have cash that’s not tied up in IRAs and how close you both are to retirement, I think it might be good idea to pay off your mortgage.

Here’s why it might make sense: You generally should always try to get the best return possible on your money with the least amount of risk. So you shouldn’t keep the loan unless you can find another investment that, before taxes, can reliably earn more than the 6.125% that you’re currently paying on it. With the stock market still volatile and certificates of deposit and other relatively safe investments paying less than the rate of inflation, I wouldn’t count on that.

What’s more, paying off a mortgage loan is almost risk-free—no matter what happens to the general economy, you’ll be left with an asset that you can live in or rent out.

A downside is that you’ll lose the mortgage interest tax deduction if you pay off your loan. But as a new report from the National Association of Home Builders points out, those benefits largely go to those buyers who are younger than 45, who typically have the largest mortgages and the most itemized expenses.  Also, the standard deduction has continued to increase so you may not even have enough deductions that allow you to itemize.

One of the biggest drawbacks is that you are moving your liquid cash into an illiquid investment.  So this part really depends on what other cash outside of your retirement funds do you have.  In today’s economy I would argue that you should have at least 12 months living expenses set aside after paying of the mortgage.

One other item you might want to consider if you are going to pay off the mortgage is putting an equity line against the property.  If for some reason you needed to access those illiquid funds invested in the house you could tap the equity line.  Equity lines are cheap and you are only charged interest on them if you carry a balance.  Furthermore you should use the savings from not having to make a mortgage payment to boost your savings.

Meanwhile, if you pay off the loan, you’ll have plenty of company. According to the latest American Community Survey released by the U.S. Census, there are approximately 50.7 million owner-occupied homes with a mortgage in 2009, compared to about 51.6 million in 2008. Folks are paying off second mortgages and home equity lines of credit, too. Those have dropped to about 12.1 million in 2009 from roughly 13.3 million the year before.

Of course, you do have other options. You can refinance your relatively expensive current loan to today’s lower interest rates—but doing so might incur a few thousand dollars in closing costs. Or, while you are both still working, you could simply add extra principal payments to your current mortgage and pay it off more quickly.

But if you pay off your mortgage completely, you’ll not only sleep soundly, you’ll be in a position to get a reverse mortgage should you need to tap into your home’s equity at a later date. The way reverse mortgages are structured, the older you are when you take out a reverse mortgage, the more you’ll be able to withdraw while still remaining in your home, since your life expectancy declines with each passing year. That’s a good fallback should you outlive the funds you manage to put away before retirement.  Reverse mortgage are not cheap so you should investigate these when and if you decide you might need one.