By David K. MacLeod, CFP®, CFA

Whether you’ve lived in Orange County for 2 years or 25 years, you probably still have a mortgage.

That’s because our beautiful county, home to year-round golf and the magic of Disneyland, boasts a median home value of $1,200,000 – more than 10 times the median household income in the county.

This isn’t a new thing. For all the wonderful amenities Orange County has to offer, housing prices here have been significantly more expensive than the national average for decades. So, you probably took on a pretty large mortgage when you purchased your home.

Perhaps you’re starting to see retirement and Social Security checks on the horizon. If you still have a mortgage, you may be wondering: “Should I plan on paying off this mortgage before retirement?”

The short answer is, yes. Although individual circumstances will vary, we generally advise being debt free in retirement. That means your credit cards are paid off, cars are owned free and clear, and you are mortgage free.

That said, before you decide whether to pay off your mortgage before retirement, there are some things to consider.

Income Tax Deduction

People often desire to keep their mortgage in retirement for the tax benefit. But only 1 out of 9 tax returns claim itemized deductions. That means 8 out of 9 taxpayers see no tax benefit from paying mortgage interest.

Mortgage interest is deductible on Schedule A as an itemized deduction. For mortgages that were in place prior to December 2017, interest is deductible on a principal mortgage balance of up to $1,000,000. For mortgages taken out after that date, the limit is $750,000. Other common itemized deductions include medical expenses, state and local taxes, and charitable donations.

When a taxpayer’s itemized deductions are less than their standard deduction in any given year, they simply take the standard deduction. If you claim the standard deduction, you don’t get a tax benefit from homeownership.

The IRS increases the standard deduction annually for inflation. For this reason, it’s possible you could claim the standard deduction this year even if you have always claimed itemized deductions in the past.

As an example, let’s consider Jane and John Smith, married 66-year-old Fullerton homeowners with a remaining $200,000 mortgage balance. In 2024, the Smiths will pay $10,000 in state and local taxes, $8,000 in mortgage interest, and they will donate $8,000 to charity. They will have no other itemized deductions this year to claim.

In 2024, the Smith’s won’t claim any of these deductions because the standard deduction that applies to them of $35,400 is greater than the $26,000 they could claim by itemizing deductions.

Approximately 89% of taxpayers are expected to claim the standard deduction this year and get no tax break for homeownership.

Also note that even if you do itemize your mortgage interest, your tax bill is not reduced dollar-for-dollar (as a tax credit would be). Your tax break would be based on your marginal tax rate.

House Rich, Cash Poor?

If paying off your mortgage would mean depleting your emergency fund or emptying retirement accounts, we strongly advise reconsidering. You could face steep taxes and penalties by withdrawing from retirement savings. Emptying your emergency fund would make you more vulnerable when the rainy days come.

Investment Return vs Mortgage Rate

If you refinanced your fixed rate mortgage in 2020 or 2021 you locked in a historically low interest rate.

If you can earn more than your mortgage by investing elsewhere, why wouldn’t you? While you’re working and contributing to an employer retirement plan, the tax savings from plan contributions make investing more attractive than paying down a mortgage.

Another way of looking at this question is to consider what guaranteed return can be earned compared with your guaranteed fixed mortgage rate. For example, if you have a mortgage fixed at 3.5% and Treasury bonds earn 5% interest, then you would have a higher guaranteed “return” by saving and investing. Many people in this situation choose to save toward a “mortgage payoff” brokerage account until it makes sense to pay off their mortgage in a lump sum.

Freedom!

Numbers aside, the psychological benefit of being debt free is significant. Clients who pay off their mortgage before retirement often report feeling free. Of course, there are plenty of homeownership expenses that don’t go away even after the mortgage is paid off (property taxes, maintenance, insurance). But not having to make a payment to the bank every month can be a real weight off your shoulders.

Too much house?

As retirement approaches, it’s a good time to re-evaluate whether your current home is right for you in the next phase of life. Often, Orange County retirees live in homes that are a lot larger than they need to live comfortably – especially after the kids move out. One way of eliminating your mortgage is to downsize and pay cash for a new home. Some find a smaller local home or move to a more affordable state such as Arizona, Florida, or Nevada.

Sometimes people think of their primary residence as an investment, but we disagree. It doesn’t generate cash flow and you always need somewhere to live. Economist Robert Shiller’s research has shown that over the past 100 years, U.S. home values have kept up with inflation but underperform other asset classes such as stocks and corporate bonds.

This doesn’t mean home ownership is unattractive – it absolutely is for other reasons. It just makes a good argument for limiting the value of your house as a percentage of your personal net worth and to diversify into other asset classes that have higher expected returns.

Conclusion

It’s a worthy goal to become totally debt free before retirement. Consider the points discussed in this article before deciding. If you decide you want to pay off your mortgage before retirement, we suggest start making additional monthly mortgage principal payments to reach your goal or saving toward a mortgage payoff account that can safely earn more than your fixed mortgage rate.

Please do not hesitate to call if you have questions or want to schedule a meeting.