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Ask Dr. Don

Paying off the mortgage in retirement

Dear Dr. Don,
I am a homeowner whose only mortgage is a 20-year fixed home equity loan of $110,000 at 6.24 percent. I am one year into the loan, with 19 left to go. I have $250,000 in savings outside of my IRA and a 401(k) plan, so I do have funds to pay off the loan.

The loan interest and property taxes (property tax is $6,000 a year) are currently my only write-offs at tax time. I would like to know if it makes sense to keep paying loan interest just to have the write-offs or should I pay off the home equity loan, lose the write-off and not pay that 6.24 percent interest for the next 20 years? I'm in a 25-percent tax bracket, retired on a pension and 53 years old.
Thanks for your advice,
Bob Bungalow

Dear Bob,
The tax deduction on your mortgage isn't reason enough to hold on to the mortgage. The mortgage interest deduction lowers the effective rate on your mortgage from 6.24 percent to 4.68 percent (6.24 percent x [1 - 0.25]). Being able to use the mortgage interest deduction on your state and local taxes would further reduce the effective interest rate on your mortgage.

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What kind of after-tax yield are you getting on your $250,000 in savings? If you're earning 2 percent after-tax on your savings, and paying an effective 4.68 percent on your mortgage, then paying off your mortgage gives you an increased return of 2.68 percent.

What I don't like about paying off your mortgage is the reduced financial flexibility. You'll free up an extra $800 in your monthly budget, but will have reduced your savings by 44 percent. Where's that $800 going to go? If you're planning to funnel it back into your savings then I'm more amenable to you paying off your mortgage than if the $800 is going to be spent on travel, wine, women and song.

If you pay off the mortgage and change your mind later, you'll have a harder time getting a new loan in retirement than when you were working. With an expected increase in interest rates on the horizon you may be able to improve the return on your savings so it's closer to the effective rate on your mortgage.

Maintaining financial flexibility in your 50s will help ensure that you continue to have financial options in your 60s and 70s.

-- Posted: June 9, 2004

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