Keep the mortgage or pay off the house?

Mortgage burnings used to be a ritual that families hoped to be lucky enough to perform. But times have changed. Now, growing older and

retiring still includes another ritual: paying monthly on a mortgage.

As they head down the road toward retirement, many people are asking themselves: Should I use part of my nest egg to pay off the mortgage and gain a sense of security? Or should I leave my nest egg intact where it’s earning interest and let my mortgage continue to provide me with a tax deduction?

If you decide to keep your mortgage in retirement, you won’t be alone.

In 2004, 32 percent of households headed by someone age 65 to 74 were carrying home mortgage debt, and nearly 20 percent of households headed by those 75 and older had a mortgage, according to the triennial Federal Reserve Survey of Consumer Finances conducted in 2004.

About 25 percent of those of any age who considered themselves retired had a mortgage.

Is carrying a mortgage into the sunset something most people should seek to avoid? Or does holding onto a mortgage make financial sense, especially when rates are low and it is possible to earn a large enough return on money invested to pay the mortgage and still have a significant gain.

The answer isn’t a slam-dunk. The right decision depends wholly on your personal financial situation.

Keep the mortgage?

Here are some things to consider as you look ahead to retirement and the possibility of also retiring your mortgage.

Tax is the biggest bugaboo

  1. Your mortgage’s tax benefit
  2. Social Security and taxes
  3. Don’t mess with your 401(k)
  4. Don’t mess with your 401(k), part II
  5. The pros of paying off your mortgage.

Your mortgage’s tax benefit

An income tax deduction for homeownership is sacred in Americans’ minds, but often the deduction doesn’t add up to much. The financial advisers who tout its value probably live in expensive areas and own pricey houses, while the rest of us aren’t so lucky.

Sure, mortgage interest and property taxes are tax-deductible, but the amount of interest and taxes typically paid on a median-priced home in the U.S. results in unimpressive tax benefits. If you live in the Midwest, are in the 25 percent tax bracket and you have 20 percent equity in your median-priced home, there are possibly no tax benefits at all.

Uncle Sam’s standard deduction of $10,700 in 2007 for a married couple filing jointly — available whether you own a home or not — exceeds the value of the mortgage interest and tax deductions from the very first day of homeownership.

In 2006, the national median home sales price was $222,000. With a 20 percent equity stake and a 30-year mortgage loan at 6 percent, in the first year, the tax benefit is an estimated $1,195. The value of the deduction for a couple in the 25 percent tax bracket declines every year, until it in the 13th year, it’s worth a grand total of $3.

In lower-priced areas, it gets worse. Married taxpayers in Akron, Ohio, who own a regional median-price house worth $110,200, mortgaged with 20 percent equity, and who are in the 25 percent tax bracket would receive zero tax benefits from day one.

The picture changes dramatically for a single homeowner with a house in San Francisco, where the median price is $733,400. In the first year of a home purchase, for which he puts down 3 percent, the tax benefit would be worth $17,632. If that homeowner in the 33 percent tax bracket were to hold on to his home for 30 years, the cumulative deduction would be worth $444,403. A pretty good deal.

Analyze your own situation using Dallas Morning News reporter Scott Burns’ calculator. You may find that paying off your mortgage is a very smart tax move, since you get the standard deduction no matter what.

Social Security and taxes

If, after retirement, you will be relying on a mix of Social Security and savings from an IRA or 401(k) for income, reducing the number of pretax dollars you have to spend is startlingly important.

Social Security benefits become taxable for a married couple filing jointly when one-half of their total Social Security benefit added to all their other income is greater than $32,000 — or $25,000 for a single individual.

In 2007, a couple getting the average Social Security benefit receives $20,556. Half of that is $10,278. That means they can withdraw about $19,500 from tax-advantaged savings for a total income of $40,000 and pay few, if any, federal taxes at all, in part because Social Security remains tax free and the couple gets extra standard deductions for being older than 65.

In many parts of the country that’s a comfortable income — particularly for people who own their home free and clear. Add a mortgage to the equation and the picture changes significantly.

If this couple has a monthly $1,000 mortgage payment and opts to pay it by pulling savings out of a 401(k) or other tax-advantaged account, they’ll not only pay taxes on Social Security, they’ll also be taxed on the money they withdraw from their 401(k). Altogether, they would need to withdraw $39,000 from the account to cover the extra mortgage payments and taxes, which increases their tax bill from nearly zero to about $4,000.

If this couple, who could otherwise live comfortably on $40,000, happens to withdraw another $6,000 from their 401(k)s for a total of $45,000, then their taxable Social Security and income will likely push them into the 25-percent tax bracket, raising what they’ll pay in taxes to about $5,700.

“Between Social Security and an untaxed nest egg, people are thrown into a position where all of their withdrawals and the majority of their Social Security is taxable. The longer people can defer touching their untaxed nest egg, the better off they are,” says Sheryl Garrett, founder of the Garrett Planning Network, based in Shawnee Mission, Kansas.

Don’t mess with your 401(k)

If, in order to pay off your mortgage, you have to reduce or stop contributing to your 401(k), you’re likely not making a good decision.

In a recent research report, economists posed this question: “If I have extra money for savings, should it go toward retirement or paying down my mortgage?”

They examined the tax advantages of itemizing deductions, typical mortgage rates and savings interest rates on retirement accounts. After analyzing those variables, the economists concluded, “About 38 percent of U.S. households that are accelerating their mortgage payments instead of saving in tax-deferred accounts are making the wrong choice.”

One of three authors of the report, Clemens Sialm, an assistant professor of finance at the University of Michigan, says his conclusions are actually more dramatic than they appear. He says the number of people who should be saving instead of paying off the mortgage is closer to 60 percent because the economists relied on very conservative investment returns to calculate their findings and didn’t take into account employer matches.

Sialm says anyone with an employer match who is accelerating payment on his mortgage at the expense of maxing out his tax-advantaged retirement account is almost certainly making a mistake.

“The typical match is 50 percent of the first 6 percent saved. That means if you save 6 percent of income, you get 3 percent additional saving, effectively a 50 percent return on your investment. Forgoing that is a costly mistake,” Sialm says.

Don’t mess with your 401(k), part II&nsbp

Taking out a lump sum from your 401(k) to pay off a mortgage is a particularly bad idea.

A couple with $50,000 in taxable income who pulls $100,000 out of their 401(k) plans to pay off the mortgage plus enough to pay off the additional taxes will reduce their 401(k) savings by at least $135,000. That’s assuming they are older than 59½ so there are no penalties.

Withdrawing from a retirement plan to pay down a mortgage when the retirement plan is 100 percent taxable upon distribution is a lousy idea, says Robert Fragasso, president of The Fragasso Group in Pittsburgh.

“That money is taxed at the individual’s highest bracket. You’re paying an exorbitant cost to free up money.”

The pros of paying off your mortgage
All that said, it’s not a bad idea to pay off your mortgage prematurely. If you can swing adding an extra payment every month toward the principal without sacrificing your retirement savings, that might be the ideal approach. Use Bankrate’s mortgage calculator to determine how making extra payments to the principal can shorten the term of your mortgage.

You can get more from a reverse mortgage. If a reverse mortgage is your financial fallback position and you owe money on the property, you must take at least that amount as a lump sum advance at closing and use it to pay off your debt at that time. Therefore, having a paid-off mortgage increases the amount of cash available to you in a single lump sum, credit line or monthly advance.

You leave more to your heirs. If you want to leave the house to your children or someone else who doesn’t have a lot of resources, do them a favor and pay off the mortgage. Otherwise, they maybe faced with selling the house whether they want to or not.

You protect yourself from suit. In many states, if you’re sued, your home is exempt from judgment. Owning your home outright also can provide some protection from bankruptcy. “One hopes sheltering assets in your home will never pay off, but it’s something to consider,” says Garrett.

Make a sure bet. Gillette Edmunds, author of “Retire on the House,” a book about real estate investing, pooh-poohs the notion that it is smarter to keep a mortgage and invest at a higher interest rate. “The problem is that mortgage interest is a sure thing and the investment isn’t,” he says. “You could lose everything you invested and still have to pay the mortgage.”

Peace of mind. For many people, paying off the mortgage has intangible advantages. “You would never believe how fabulous and freeing it feels to pay off a mortgage,” Garrett says. “The psychological benefits are enormous.”

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