Preparing For Retirement by Reducing the Payment

July 16, 2007, Rewritten January 23, 2009, Reviewed September 27, 2010

Many borrowers approaching retirement with a significant mortgage balance are concerned that their income will drop when they stop working, but their mortgage payment will not. If they have a nest egg as well, they wonder how best to use it to avoid a disruption in their life.

"I am 58 and just purchased the home in which my wife and I plan to spend the rest of our lives. I am feeling very insecure. The payment is affordable now, but I plan to retire in 7 years and my income will drop. At that point, my property taxes will almost certainly be higher as well.

I fear that when I retire, the mortgage payment will become a major strain on my finances. I would like to get it down to about half of what it is now. What is the best way to do that? I have free assets equal to about half of the loan balance."

Reducing the Mortgage Payment at Retirement

In assessing this growing problem, I will start by assuming that you don't need to get the payment down until you retire. The challenge is to formulate the best game plan now for getting the payment down then.

Step one is to determine whether or not you can profitably refinance in today's market. For example, if your existing rate is 5.5% and you can refinance at 5% with little cost, do it. The lower rate will reduce your payment immediately, and 7 years later your loan balance will be lower.

Step two is to compare your mortgage rate (the existing rate if you don’t refinance, the new rate if you do) with the rate you expect to earn on your nest egg over the next 7 years. If the mortgage rate is higher, liquidate the nest egg and use the proceeds to pay down the loan balance.

If you have a fixed-rate mortgage (FRM), your payment will not change but you will amortize more quickly. At the end of 7 years, you will be wealthier, where wealth is measured by the nest egg less the loan balance.

For example, assume the balance is $100,000 on your 6% mortgage and the payment is $700. Your nest egg is now $50,000 and earns 3%. If you do nothing, your loan balance after 7 years will be $79, 185 and your nest egg will be worth $61,668, so your net worth will be negative $17,517. If you liquidate the nest egg to pay down the balance to $50,000, the balance after 7 years will be $3167. You are better off by $14,350.

If you have an adjustable rate mortgage (ARM), there is a caveat. When the rate is adjusted following the halving of the loan balance, a new payment is calculated that will pay off the loan over the original schedule. To come out ahead over the 7 years, therefore, you must continue to make the payment you made before the rate adjustment. See Can I Pay Off an Adjustable Rate Mortgage Early?

If your nest egg earns a return higher than your mortgage rate, stay put. Your wealth when you retire will be larger than if you use it to pay down the balance now. If your nest egg earns 7%, for example, it will be worth $81,500 in 7 years, large enough to completely pay off the loan balance of $79,185.

Reducing the Mortgage Payment Now

If you need to get the payment down now rather than when you retire, liquidate your nest egg to pay down the balance. In this case, having an ARM is an advantage, because the payment will drop with the next rate adjustment. Of course, after 7 years you will still have a loan balance and no nest egg, but that is the price of taking the payment reduction early.

If you have an FRM, paying down the balance will shorten the term but not reduce the payment. There are two ways to get the payment down on an FRM. One is to request a contract modification from the lender after you make the large balance reduction. Some lenders will do it for a fee. If you pay off half the balance and the rate and term remain the same, the payment would fall by half as well.

However, there can be no assurance that the lender will be willing or able to modify the loan. Your mortgage could be sitting in a pool of mortgages that are the collateral for a mortgage security, in which case a modification probably would not be possible

The second way to get the payment down on an FRM is to refinance the loan. On a refinance, a new lower payment would be calculated on the new lower balance. This could be good or bad, depending on the interest rate on the existing loan relative to what is available to you in the market on new loans. If you have to convert a low-rate loan into a high-rate loan in order to get the payment down, reconsider whether it is worth it.

Note: Readers should also look at Take a Mortgage into Retirement, or Pay if Off.

In or near retirement? The Professor’s Retirement Funds Integrator (RFI) might enhance your life during retirement.

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