Beyond the Numbers Blog series: Planning for Financial Peace of Mind
At its core, financial analysis, and therefore some aspects of wealth planning, is all about the numbers. Utilizing spreadsheets, projections, knowledge of tax laws, historical assumptions, and many other empirical datapoints is foundational in constructing a solid wealth plan. But life is not a spreadsheet. Done well, we believe wealth planning involves weighing the objective calculations against the critical subjective factors of many life decisions. And it is not uncommon for the subjective to trump the objective as it is so difficult to put a price or a numeric value on a feeling. Realizing this, we believe it is our role as advisors to help clients balance these factors and make well-informed decisions by “doing the math” and then subjugating the numbers to the broader, and more important, real-life context of what really matters to a family. By no means does this discount the importance of financial analysis. Instead, it is recognizing the proper role for the numbers as just one factor, not the only factor, to help make the decision.
So this month we begin a series of articles that analyze many decisions clients face that require balancing the objective reality of financial analysis with the subjective value of helping clients sleep at night. We believe this integration is where the art of planning goes well beyond the science of finance. And while Google, and now ChatGPT (and other AI engines), can certainly retrieve and formulate data efficiently, they can’t look a person in the eye, read body language, notice tears welling up, or integrate family history to ensure financial decisions are aligned with a family’s core values.
Beyond the Numbers: Should We Pay off the Mortgage Before or In Retirement?
A home is much more than just another line-item on the family balance sheet. Countless family memories, years of sweat equity and personalized renovations often make this “house” a home and a sanctuary. For many people nearing retirement or in retirement, it is quite common for them to still have a mortgage on their primary residence. Most often, the home was purchased several years ago, the mortgage rate is relatively low (compared to today’s rates), and the family has ample cash flow to service the loan until maturity. But for many clients, the idea of a paid-off home seems to drive a particularly strong sense of peace, well beyond not having that automatic payment pulled every month. The knowledge that no matter what happens with the investment portfolio or the economy, no one can take away the “roof over their head” holds a particularly strong sense of meaning and security, which should not be discounted by any means.
But if a family can earn more in their investment portfolio than the funds needed to pay off the home, should they? And what about the risk of illiquidity when funds to payoff the mortgage are “trapped” in the house? In short, how much would this feeling of satisfaction and peace of a paid-off home, actually cost? And is it worth it?
Running the Numbers: How Much Would the “Feeling” Cost?
From a financial standpoint, paying off a mortgage is, at its core, an arbitrage strategy as if the homeowner does NOT pay off the mortgage, the investment gains on the un-spent balance could outpace the payments one is making each month. So, much of the result depends on assumptions for investment growth over time and the rate of the mortgage. This also ignores variable rate mortgages, which makes it almost impossible to analyze given one would also have to correctly estimate future interest rates. At our disposal are tools to help analyze this and make an informed decision. And the data needed to evaluate this decision include the following:
Factors to Consider
- Terms of loan (interest rate, term (in years), fixed or variable, number of payments remaining)
- Available liquidity and other assets
- Investment portfolio / market assumptions for liquid funds
- Taxes (assume deductibility of mortgage interest isn’t available due to standard deduction, assume some capital gains taxes to generate proceeds to pay off mortgage)
- Save or spend the payments if paid off?
Case Study:
A good example is almost always more illustrative than facts, figures, and bullet points. So, let’s consider the following example. A recently retired couple with $3.5 million in liquid assets, of which $1,000,000 is in a taxable joint account, have always had a goal of not having a mortgage in retirement. But how much would that cost them?
Here’s their situation:
- Clients are recently retired and can service the loan from savings and other income
- Original Mortgage: $560,000 from 1/1/2005
- 30-year fixed rate mortgage at 5.5% (they never refinanced when they should have!)
- 10 years remaining on mortgage with balance of $272,307
- Estimated long term, investment returns is 8.0% annually
- Liquidating investments to payoff mortgage would cost them an extra $15,000 in capital gains taxes
Factoring all this data, we can calculate how much it would “cost” by comparing the three scenarios.
- Continue to service the loan for 10 years until it’s paid off.
- Pay off the remaining mortgage using after-tax funds in the joint account and SPEND the funds they would have spent on the mortgage payments over the next 10 years on increasing their lifestyle, charity, or enjoyment.
- Pay off the mortgage using after-tax funds in the joint account and SAVE the funds they would have spent on the mortgage payments and invest them back into the joint account.
The result? At the end of 10 years, paying off the mortgage and spending the payments would cost them only about $21,600 MORE than the mortgage payoff. So, they would be only $21,600 “poorer” (but would have enjoyed the spending) over 10 years, and they would have peace of mind knowing their house was paid off.
If they were very diligent, they could pay off the mortgage and then save (and invest) the payments they would have made. This would result in their joint account growing to almost $2,000,000, which is about $530,000 higher than it would have been had they not paid off the mortgage.
Putting this in context: If the goal is the “feeling” of paying of the mortgage and the net worth does not decline too much, is it worth the satisfaction of paying off the home? This is where the conversation and the true wealth planning begins.
Final Note and Recommendation
As with any complicated analysis, details matter and assumptions can skew the answer either way. So, it is critically important to work with a team to ensure accurate calculations and the wisdom of prudent assumptions. To that end, below is a brief summary of the advantages and disadvantages of paying off a mortgage early. As a planning note, we highly recommend clients who do pay off their home early soon after securing a home equity line of credit. This provides emergency liquidity and partially offsets the disadvantage of the loss in liquidity. While it may cost an annual fee to maintain (assuming the credit line is not used), there is peace of mind in having this liquidity “insurance.”
Advantages
- Peace of mind knowing the home is “paid off”
- Absence of interest payments
- Possibility for minimal loss in net worth
- Less concern with “market crashes” on investment portfolio
- Simplified process on future sale of the home
Disadvantages
- No Peace of mind with the “paid off” home
- Loss of liquidity on funds used to pay down mortgage
- Loss in net worth could be larger with very strong investment portfolio returns
- Potential capital gains tax headwind if securities to sell to generate proceeds for payoff are very low basis
Paying off a home might not be the optimal financial decision, and there are many variables involved in analyzing the data. By using reasonable assumptions and a well-thought-out plan, the numeric disadvantages, when put in proper context, could be far outweighed by the advantages of peace of mind and contentment.
Disclaimer: The case study is provided solely to illustrate Johnson Investment Counsel’s approach in providing financial planning and portfolio management services and implementing successful solutions for its clients. This case study is not indicative of future successful solutions for prospective clients. Market conditions and individual clients’ situations may differ substantially from the case illustrated herein.