Our friend, Mortgage Mandy, is 55 years old and wants to retire in ten years. However, she recently refinanced her mortgage. While she’s happy with her lower payments, her recent refi put her on track to make payments for 20 years after she plans to retire. Should she pay off her mortgage when she retires? Or should she continue to pay her mortgage in retirement?
Will she be better off one way or the other? Be sure to read until the end; the answer may surprise you.
For simplicity, we’ll continue to use the same assumptions we’ve made in prior blog posts from this year. Inflation will be 3% and our expected portfolio returns are 7%. Because Mandy’s mortgage will end during her retirement, and since they will not increase with inflation, we’ll need something more nuanced than the 4% Rule. Instead, we’ll be using a Monte Carlo analysis to examine this case.
A Monte Carlo analysis is simply a statistical modeling technique that uses multiple variables to determine a potential outcome. In our case, we place probabilities around all the assumptions we make for Mandy and model her retirement a thousand times. The higher the number of successful trials, the better the odds that Mandy has a good retirement.
For Mandy’s details, let’s assume she earns $150,000 per year, saves 10% of that in her 401(k), has a 3% match, and saves another 5% to her after-tax investment account.
We’ll also say that she has $500,000 saved in her 401(k) with another $150,000 saved in her brokerage account. Her home is worth $350,000 and her $250,000 mortgage was just refinanced with a 30-year fixed at 2.75%. I still can’t believe how low interest rates are these days.
If we assume that Mandy spends everything after she saves, pays her mortgage, and pays taxes, we end up with pre-retirement expenses of $7,696 per month.
In retirement, let’s assume she spends 80% of that, bringing her retirement living expenses to $6,157 per month. Remember, these expenses do not include the principal and interest of her mortgage payments.
While some people may spend much less than 80% of their pre-retirement expenses, this is a good place for us to start to examine this mortgage question.
Option 1: Keep the Mortgage in Retirement
Assuming Mandy retires in 10 years at age 65, she would still need to pay the remaining principal and interest on her current mortgage. That ends up being $12,247 per year for 20 years.
If we run our Monte Carlo analysis for this scenario, we find that Mandy has a 69% probability of not running out of money in retirement. That’s not great, but it’s not terrible either. If her probability is too high, she’s not enjoying the money she’s worked so hard to save. If it’s too low, she risks running out of money in retirement.
Option 2: Pay Down the Mortgage at Retirement
The second option that Mandy’s considering is to pay off her mortgage when she retires in 10 years. According to the amortization schedule, her remaining balance will be approximately $188,000. If she pays it off, that reduces her retirement portfolio. However, it also means that she’ll spend $12,247 per year less for the next twenty years.
So how does that affect her Monte Carlo probabilities? Surprisingly, it reduces them. She’ll now have a 62% probability of success – 7% lower than had she continued to pay her mortgage in retirement.
Should Mandy Keep Her Mortgage?
Of course, this is a simplified case. In real life, there would likely be more variables around Mandy’s changes in spending, life expectancy, and other financial goals such as car purchases, vacations, and nursing home care.
However, given the current low-interest-rate environment, paying off the mortgage isn’t the no-brainer that you might assume. If we continue to see higher-than-average inflation, having a fixed mortgage effectively means that your housing payments decrease in real terms over time.
I’m not advocating that everyone keeps their mortgage in retirement. It’s a personal choice with lots of variables at play. However, at some point, you have to do the math rather than assume.
If you need help determining if you should pay off your mortgage at retirement, then click here to set up a quick, complimentary introduction call to see if Prana Wealth is a good fit. We do still have the capacity to take on new clients.
As a fee-only financial advisor in Atlanta, we can (and do) work virtually with clients all across the U.S. and we’re here to help you when you’re ready.