Should I Pay Off My Mortgage Before Retiring Early?

If life went according to the official plan, most of us never need to ask ourselves whether to pay off our home mortgage before retiring. That’s because banks normally do not extend mortgages or home loans (for our primary residences) beyond the age of retirement. So by retirement age, we will be debt free and have one less worry in retirement. But what if life did not go according to this plan? And we are the lucky few who are financially independent and can retire early (i.e. FIRE)? Should we pay off the home mortgage before retiring early? Or should we keep it? And risk having another risk or expense or worry during retirement?

This is not as uncommon as we might imagine. Suppose at the age of 35 we took out a 30 year mortgage to purchase our dream and forever home. Fast forward 15 years, at the age of 50, we realise that we have enough to FIRE. But the mortgage still has 15 years to go, with about 60% of the principal left to pay. Or, if we made early repayments along the way, there may be 40% to 50% of the principal left. Should we pay off the mortgage before retiring? Or should we keep it for the next 15 years in retirement?

What if we do not keep up with our mortgage payments during retirement?

Why we may want to pay off the home mortgage before retiring

Most people who are ready for, or on their way to FIRE will be fully cognisant of how judicious use of leverage can help accumulate their nest egg faster. Having a mortgage or a home loan is probably the most common form of leverage. And we know that it is better not to pay it off as fast as possible, but instead invest spare cash towards FIRE. Especially in the past decade when interest and mortgage rates have been low, it is straightforward to see that keeping a mortgage at a low rate of interest and investing at a higher expected return (e.g. in stocks) will help accumulate wealth faster.

But having a mortgage in early retirement is a different matter. For a start, there’ll be no more regular income to meet the mortgage repayments. Now, these payments now will have to made from the investment portfolio. This clearly restricts the amount of leeway a early retiree has to reduce expenses during market downturns in order to weather Sequence of Returns Risk. What reasons are there for wanting to pay off the mortgage before retirement?

1. Suppose the early retiree uses the 4 percent rule to drawdown on investments to pay for expenses during retirement. If the remaining mortgage principal is $500,000, and the yearly mortgage payments amount to roughly $45,000 (at a rate of 2%), this means that 25X this amount, or $1.1 million is needed to support these payments. Alternatively, you can pay off the mortgage for $500,000. So it is cheaper to pay off the mortgage than to keep it in retirement
2. To some extent, the mortgage is a short position in bonds. Suppose that the early retiree would like to keep a balanced allocation in the early years of retirement to help manage Sequence of Returns Risk, say 80% in stocks and 20% in bonds. Adding the mortgage to this means that the total allocation to bonds goes down by the amount of the mortgage, which is a portfolio more heavily in stocks. And which may end up exacerbating Sequence of Returns Risk instead!
3. To add on to point 2, while it is possible to add more bonds to the portfolio to offset the short position of the mortgage, in practice, it is quite silly to do so when bond yields are lower than the mortgage rate, which they are in general

The effects of keeping a mortgage (or a short bond position) on Sequence of Returns Risk has been discussed by ERN here. The mortgage turns the portfolio into a leveraged stock portfolio, and while this means that on average, the retirement portfolio can sustain a higher withdrawal rate, at the 5th and 10th percentile Safe Withdrawal Rate, it will perform worse than the tradition 80:20 portfolio.

Effect of Keeping a Mortgage on Safe Withdrawal Rates (Source: ERN)

Why we may want to keep the home mortgage in retirement

But the arguments above are not cast in stone, and there are also reasons why it may be worthwhile to keep, rather than pay off a mortgage in early retirement. Let’s start by re-examining some of the arguments made above for paying off the mortgage before retiring and whether they hold water:

Needing 25X the mortgage payment in assets compared to paying off the mortgage

Using the 4 percent rule, the cost of keeping the mortgage in retirement seems far higher than paying it off. But that is an incorrect use of the 4 percent rule. Why? Now, the 4 percent rule applies for retirement expenses which rise with inflation over time. Clearly the mortgage payments do not, and they do not go on forever either. In the earlier example, for a 30 year mortgage of which 15 years are left at the point of retirement, all we need to do is a stream of roughly constant payments over 15 years.

In fact, if we have a deposit or a bond fund, paying around 3% a year, we only need to put aside 110% of the mortgage principal outstanding to cover the payments over the remaining 15 years. This means putting $550,000 aside to be gradually withdrawn and run down over 15 years to repay the mortgage. And it is not much higher than the $500,000 of principal (not including prepayment penalties) outstanding before retirement. But that is not all!

Maintaining the liquidity of the retirement portfolio

Choosing to keep the mortgage in retirement rather than paying it off by maintaining about 110% of the principal outstanding also allows us to keep our retirement assets liquid, which may come in handy during the first few years of retirement when we may be subject to Sequence of Returns Risk. Note that when we are halfway through a mortgage, about 75% of the payments made monthly are to repay principal, with only about 25% going towards the interest. This means that the mortgage repayments are essentially transforming liquid financial assets into illiquid housing wealth. And when we are living off our investments, more liquidity is always better than less!

However, note that this is technical rather than true liquidity we are talking about (Hat tip to Wade Pfau). “Technical” liquidity refers to having liquid assets, but which we earmark for the purpose of supporting expenses in retirement. “True” liquidity would be unencumbered assets, which are over and above that which is needed to support expenses. Regardless, having technical liquidity is still beneficial if the need to prepay some expenses, or make investments to take advantage of a market downturn arises.

To be fair, a better way to maintain this liquidity through housing wealth would be to take out a reverse mortgage instead (see here). But where such products are not easily or cheaply available, the best way to monetise housing wealth and maintain liquidity of assets is by keeping the mortgage in retirement.

Using the mortgage as a short bond position to control portfolio asset allocation

One of the potential problems of keeping a mortgage in retirement is that it is a short bond position, which may end up inadvertantly leveraging the portfolio into a higher than desired stock allocation. However, the reverse can also be true, that the retirement portfolio has a much higher allocation to bonds than desired. How can this come about?

Firstly, we often encourage retirees and early retirees in particular to purchase an annuity. Or even better, a deferred annuity. Having a guaranteed and possibly Cost-of-Living adjusted stream of income in the later stages of retirement is a good hedge against the retirement portfolio never fully recovering from Sequence of Returns Risk in the early years, and hence having insufficient assets to support expenses in the later years. For retirees in Singapore, this would be CPF LIFE. In the US, it would be Social Security. Elsewhere, it might be state pensions. And it is not unusual to find that the value of these annuities be up to 20% or 30% of the value of the retirement portfolio. Meaning that there is an additional 20% or so additional allocation to bonds in the total wealth of the retiree.

CPF LIFE as a deferred annuity

Secondly, an early retiree may find that there are certain retirement accounts which are inaccessible to him or her until a later, official retirement date. And the assets in these accounts may be bonds or cash. For Singapore early retirees, this would be the CPF savings over and above the minimum sum (which goes into CPF LIFE) and which are not accessible until the age of 55. Given the prevalence of the people aiming for early retirement to get to at least $1 million in their CPF before retirement, they may end up having a bond allocation far in excess of what would be optimal.

And thirdly, some retirement drawdown strategies for managing Sequence of Returns Risk revolve around bucketing strategies. These are also known as Time Segmentation approaches. These advocate keeping 5 or even 6 years of expenses in cash of bonds, which will be drawn down over the first few years of retirement, hence shielding the retiree from having to sell any stocks in a market downturn. Again, the net effect of adopting such strategies may be to have a bond allocation that is too high to be optimal in the long run.

Time segmentation or bucketing strategies

Once again, a reverse mortgage may be a better and more precise way to put on a short bond position to balance out these distortions in the bond allocation within the retirement portfolio. However, until such products become widely available, keeping a mortgage in retirement may the next best alternative.

Should I Pay Off My Mortgage before Retiring Early?

So it turns out that the answer to the question of “Should I pay off my mortgage before retiring?” is a fairly complex one. It definitely is not as straightforward as saying that “Since a portfolio of stocks and bonds has higher returns than the mortgage, I should keep the mortgage and invest“. Rather, the argument for paying off the mortgage is that it can worsen Sequence of Returns Risk, leads to reduced flexibility for reducing retirement spending, and ultimately require a lower Safe Withdrawal Rate.

But most early retirees have wealth stashed across a multitude of assets beyond just their investment portfolios. Such as deferred annuities and untouchable retirement accounts, which may push the bond allocation across total wealth a level which is too high. Also, strategies to mitigate or manage Sequence of Returns Risk may require an inordinate allocation to bonds which may ultimately hurt the longer term growth of the retirement assets. In these cases, keeping the mortgage can help to adjust the bonds allocation.

Managing Sequence of Returns Risk using more than just spending flexibility and a lower Safe Withdrawal Rate will probably be the way to go in the future. Approaches like using deferred annuities and time segmentation will be more common. Therefore, keeping a mortgage in retirement is still going to be a viable alternative.

References

Early Retirement Now (2019). The Ultimate Guide to Safe Withdrawal Rates – Part 21: Why we will not have a mortgage in early retirement

Kitces.com (2013). Is A Reverse Mortgage Better Than Keeping A Traditional Amortizing Mortgage In Retirement?

Wade D Pfau (2021). Retirement Planning Guidebook: Navigating the Important Decisions for Retirement Success (The Retirement Researcher’s Guide)

Other articles you may find diverting

What’s the Value of my Leasehold Condominium (1)? Revisiting Mr Bala’s Table

What’s the Value of my Leasehold Condominium (2)? Is freehold better or leasehold?

What’s the Value of my Leasehold HDB (3)? Dealing with HDB Lease Decay

Do Property Market Cooling Measures Work? Why ABSD does not work

What Really Drives HDB Resale Flat Prices in Singapore?

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