August 25, 2022

This question, posed recently to the Quora web site, elicited some 40 answers from Quora’s roster of “experts”, of which I am one. Most answers fell into one of two categories. One group said “yes” – based mainly on the diverse (and mostly non-verifiable) benefits of being out of debt. The second said “it depends” – based mainly on the relationship between the interest rate being paid on the mortgage and the rate being earned on the financial assets that would be used to repay the mortgage. I was in the second group, but I appended my answer with a warning that the question deserves much greater thought than any of the experts, including me, had given it. This article is a response to that challenge.

What Is the Objective?

A retirement plan has two possible objectives. The objective that applies to every case is having enough spendable funds to meet anticipated needs. A second objective, relevant only to some retirees, is to leave an adequate estate. For this group, the answer to whether or not to repay the mortgage, and if so, how to do it, is very likely to differ from that of retirees concerned only with spendable funds.

Options and Complexity

To determine whether or not to repay a mortgage at retirement, one must compare a retirement plan that involves retaining the mortgage against a plan that pays it off. Both plans have multiple options, which complicates the issue enormously. This explains why the prevailing opinions of “experts,” including mine, are based on simplistic rules of thumb that are unreliable. My good fortune is to work with Allan Redstone, whose mastery of spreadsheet-based analytics has enabled us to sort out the intricacies of the multiple options that are involved.

Option to Retain the Mortgage

If the decision is not to pay off the mortgage, the retiree’s plan can follow two paths. One path is to follow the so-called 4% rule where the retiree draws 4% of his financial assets every year adjusted for inflation. The alternative is to purchase a deferred annuity, dividing the assets between the annuity cost and spendable fund draws during the deferment period.

I compare these options for a 62-year-old woman with a $100,000 mortgage balance at 4% and monthly payment of $850 on a house worth $400,000. She has financial assets of $250,000 earning 6%. These features are typical of millions of “house-rich/income poor” homeowners.

The comparison is shown on Charts 1a and 1b. The deferred annuity option generates more spendable funds but a lower estate value than the 4% rule option. This finding holds over a wide range of asset yields and deferment periods. (Note, the jump in spendable funds at age 74 reflects the cessation of the mortgage payment.)

Note: Spendable funds are calculated to rise 2% a year. The deferment period is 10 years, and the annuity has a cash refund option in the event of early death.

Paying Off the Existing Mortgage by Liquidating Financial Assets

The mortgage can be paid off using the retiree’s financial assets, or by drawing enough for that purpose from a HECM reverse mortgage. These are considered in turn.

In the case where the mortgage is paid off with financial assets, the retiree must decide whether the remaining financial assets are drawn as spendable funds following the 4% disbursement rule, or used to purchase a deferred annuity with the remainder providing spendable funds during the disbursement period.

These options are shown in Charts 2a and 2b for the retiree identified above. The deferred annuity case provides more spendable funds but less estate value. This holds over a wide range of asset yields and annuity deferment periods.

Note: Spendable funds are calculated to rise 2% a year. The deferment period is 10 years, and the annuity has a cash refund option in the event of early death.

Paying Off the Existing Mortgage With a HECM Reverse Mortgage

Instead of liquidating assets to pay off the mortgage, the retiree can take out a HECM reverse mortgage. While this replaces the existing mortgage with a new mortgage, the new mortgage carries no repayment obligation so long as the retiree lives in the house that secures the mortgage.

The balance of the credit line the retiree receives on her HECM, after repayment of the existing mortgage, can be used in 2 ways. One way is to convert it to a HECM tenure payment, which provides a constant monthly payment so long as she lives in her house. The alternative is to use part of it to purchase a deferred annuity, with the balance drawn as spendable funds during the deferment period. The combination of the credit line available after repayment of the old mortgage plus the retiree’s financial assets cover the one-time payment for the annuity and monthly draws on the credit line during the deferment period. This option provides more spendable funds but lower estate values.

Note: Spendable funds are calculated to rise 2% a year. The deferment period is 10 years, and the annuity has a cash refund option in the event of early death.

Comparing Mortgage Payoff Versus Mortgage Retention

For retirees focused mainly on spendable funds, which is the case for most retirees of limited means, the best option is to pay off the existing mortgage with a HECM reverse mortgage, and purchase a deferred annuity. As shown in Charts 4a and 4b, this payoff option provides significantly more spendable funds than the mortgage retention option. For estate values, however, the patterns are reversed.

An interesting sidelight is that in both the payoff and the retention cases, the deferred annuity option generates more spendable funds than the 4% rule option.

Implications For Retirees

The best option for homeowners entering retirement with a mortgage, who are concerned about having sufficient spendable funds during their remaining years, is to pay off the mortgage with a combination HECM/deferred annuity. The retirees draw a credit line under the HECM; they use part of their financial assets to purchase a deferred annuity and the balance plus the HECM credit line to provide spendable funds during the deferment period. As an example, the 62-year-old woman referred to earlier would pay $189,462 for a 10-year deferred annuity, then draw $1,175 a month rising by 2% a year. The payment would be $1,432 in year 10 when the annuity kicks in.

Implementation

The data in this article were drawn from a spreadsheet developed by my colleague Allan Redstone. I nudged him unmercifully to make it simple enough that any homeowning retiree not in dementia could use it to assess their own unique situation. The spreadsheet can be accessed at Should You Pay Off Your Mortgage at Retirement?

But a word of caution. Implementation that involves paying off the existing mortgage with a combination HECM/deferred annuity requires involvement in two extremely imperfect markets. In both markets, the spread between the best prices and the worst prices is large enough to make a significant difference in the retiree’s spendable funds. Retirees accessing these markets on their own in order to duplicate what they have found using the spreadsheet are almost certain to be disappointed.

The spreadsheet is based on the best prices in both markets drawn from a network of HECM lenders and an annuity pricing model that simulates the best pricing available. Retirees accessing these markets on their own in order to duplicate what they have found using the spreadsheet are almost certain to be disappointed. You can avoid that risk by consulting an advisor.

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There is no cost to consult an advisor who has access to the best competitive prices on HECM reverse mortgages and annuities, who can also provide guidance on options you may not have considered.