One of the hallmarks of the American dream is homeownership. We have an entire regulatory and tax structure along with government-sponsored entities to support home ownership through the standardized 30-year fixed rate mortgage. In this environment, it’s possible to purchase a home with a 20% down payment (sometimes less) while committing to 30 years of payments at relatively low-interest rates. But how does a mortgage fit into a financial plan? In short, makes decisions about mortgage terms and purchase price should with an eye toward paying off the mortgage by the beginning of retirement.
In the United States, the 30-year fixed rate mortgage, along with other benefits, encourages home ownership through low down payments and low monthly payments. These monthly payments combine with steady price appreciation to store the bulk of the wealth for most Americans. I’ll enter the rent vs. buy and rental property vs. stock market debates in later posts, but in this post, I want to explain why not having a mortgage is key to financial independence and retirement.
One of the criteria I use to define financial independence is having spending flexibility, particularly the ability to reduce spending when the economy and/or financial markets are doing poorly. Reducing investment account withdrawals during tough times allows us to keep more of our investments working for us to then sell during periods of strong returns. We can use several techniques to overcome this challenge, but the most effective method is reducing spending for a period of time.
Owing any sort of debt puts a floor under spending flexibility, the most limiting of which is a mortgage, especially if the payment is large relative to our monthly income. If we don’t make the payment, the bank forecloses on the house. In a 2008 scenario, making the payments would force us to liquidate twice as many shares of our investments compared to other years, reducing future living standards. Retirees in their 60s may be able to apply social security and annuity income to offset their fixed living costs, assuming the monthly payment is sufficient. The challenge is much greater for those who retire early and depend entirely on their own investments.
Given that many Americans desire to own their home, it’s important to consider how a mortgage payment may affect other financial goals. Once an individual or family enters the 30s, a 30-year mortgage starts to bump into traditional retirement ages. With subsequent trade-ups to larger homes, the payment may increase, and the payoff date moves into retirement ages. Therefore, I encourage people to consider any home purchase decisions from the perspective of their overall financial plan. More importantly, they should to plan to pay off their mortgage before leaving work for good.
We can rid ourselves of mortgage debt a few different ways. First, take out a mortgage whose term will allow you to pay it off entirely before retirement. If retirement is 15 years away, take out a 15-year mortgage. An additional benefit is a lower interest rate. A 15-year mortgage locks us into a higher minimum payment, though. A better route is to take out that 30-year mortgage but make extra principal payments to complete the payoff by retirement. The third option is to downsize the home in retirement. For someone who owns a home or property with significant equity, it’s possible to downsize, using the equity to purchase a smaller home.
Some may disagree with my approach. One could make a rational argument that a home and property store wealth, but don’t grow it and that it’s better to make minimum mortgage payments and invest as much as possible. That argument is historically and theoretically correct. Real estate prices tend to rise with inflation except where geography and local laws limit supply (like the Bay Area and the northeast, among others). Investments in stocks and bonds outperform homeownership in generating long-term wealth.
Theory is one thing, but sometimes it’s difficult to put theory into practice. For one, the approach of investing instead of paying off a mortgage makes sense when we look at hundreds or thousands of scenarios, most of which support investing. In practice, though, an individual or family has only one shot at retirement; they don’t get to come back in a hundred years and try again if it doesn’t work out this time. As such, people are subject to the market conditions that will occur during retirement, and we don’t know what those will be.
Lacking a mortgage and other debts during retirement provides additional flexibility to cut spending should market or economic conditions warrant, allowing us to hold those investments which should provide strong future returns. Being secure in their home will help people avoid panic selling, the activity which is the most detrimental to investment growth and financial security.
Another, more recent development for homeowners in retirement is the reverse mortgage. While sometimes expensive and not for every situation, a reverse mortgage could allow retirees to tap into their home equity as a fallback. Owning the home free and clear helps facilitate this process and allow retirees to maximize the cash received from a reverse mortgage.
Command & Signal
Continuing the theme of my post discussing Good Debt vs. Bad Debt, having a mortgage is not always wrong, but it is not always right, either. Paying off a mortgage before retirement does not apply to everyone in every situation. Indeed, that achievement may not even be possible for some people. However, I continue to advocate minimizing debt in retirement to maximize financial flexibility and security.
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