While many assume that people will have lower expenses in retirement, in reality, most retirees and near-retirees hold both household debt in the form of a mortgage as well as some consumer debt, according to a recent Forbes article.
But this household debt “presents both a threat and an opportunity to soon-to-be retirees and retirees,” Jamie Hopkins writes in his article, which focuses on the feasibility of prepaying an existing mortgage as a retirement investment option.
According to the Social Security Administration, 80% of near-retirees hold debt with a mean of roughly $150,000 — more than $100,000 of which represents housing debt.
While paying off the mortgage is not the only option — as some retirees downsize early in retirement or tap into reverse mortgages to generate income or reduce expenses — it was viewed as the most comfortable option for most retirees, according to a research report from the Society of Actuaries (SOA), cited in the Forbes article.
“During focus groups conducted by the Society of Actuaries, we noticed many retirees were not comfortable with using a reverse mortgage, but instead showed a great deal of pride in owning a home,” said Cindy Levering, a retired pension actuary and member of the SOA’s Committee on Post-Retirement Needs and Risks.
Levering also noted that people wanted to maintain the value of their home and continue living there as long as possible in retirement. And one way to do so is to prepay the principal on the mortgage.
Prepayment of the principal on a fixed-rate mortgage works like an investment in an individual’s investment portfolio.
For example, if a homeowner has a fixed-rate mortgage at 4.5%, then all payments that prepay that principal (without early payment charges) have the same effect on the homeowner’s wealth as if the money were invested in an investment that promised 4.5% returns.
As such, prepayment of a fixed-rate mortgage is similar to investing in a risk-free rate of return asset, as there is no default risk associated with the investment and no interest rate risk.
Prepayment of a fixed-rate mortgage could help lower the overall risk level of an individual’s investment portfolio if the person is highly invested in growth stocks and does not feel comfortable investing in bonds at the current low rates.
Doing so will also help to reduce future expenses, increase one’s equity in the home and support a sense of pride created when someone pays off their home. In addition, it adds a layer of housing security as the home is paid off and owned by the homeowner — clear of any lender restrictions — more rapidly than it would have been under the set mortgage payment schedule.
However, pre-retirees should remember that unpaid property taxes and other debts could still threaten the value and the financial security that the home represents.
The prepayment of a mortgage does have its place in retirement planning, but the strategy is “very sensitive to each person’s personal situation, financial assets and mortgage features,” Levering says.
A person’s risk tolerance, their expected investment returns, the impact of taxes and any prepayment penalties inside of the mortgage agreement must be carefully considered before embarking on a mortgage prepayment strategy.
“To unearth the true benefits of this strategy one must take a comprehensive look at the individual’s financial situation,” Forbes writes.
To read the full article, click here.
Written by Emily Study