Should You Use Savings to Pay Off a Mortgage or Invest for Retirement?
Thursday, September 8, 2016
A lot of people wonder what the best use of their savings prior to retirement is: to pay down their mortgage faster or to invest. While the question may be straightforward, the answer is less so and depends a lot on which stage of your career you’re in.
The accumulation stage is all about earning. While you’re in this stage of you’re career, your income should be greater than your expenses, ideally by quite a lot. But this isn’t necessarily a green light to pay of your mortgage. There are a few things to consider before you decide what to do with your savings.
1. Feather your nest first. You might hear that paying down your mortgage is the best thing you can do for financial security because regardless of what happens with your career you’ll always have a place to live and you can borrow against the value of your home. But in reality, the first step towards financial security should be an emergency fund of easy-to-access cash.
Traditional advice is to have between 3 and 9 months of basic expenses saved before investing, paying down your mortgage, or spending your extra cash. How do you decide whether you need 3, 6, or 9 months worth of savings? Consider how hard it would be to replace your income. If you’re in an industry with plenty of available positions that would pay more or less what you’re making now, 3 months should be enough. On average, it can take 6 months to find a new, comparable job, so that amount is generally safe for most careers. If you’re in a very specialized position and it would be difficult to find another job with similar pay and benefits, you should sock away at least 9 months worth of savings.
2. What does your company offer? The next step in your financial security plan should be to max out any matching program that your company offers otherwise you’re simply ignoring free money month after month.
3. Next consider the interest rates. While the stock market can certainly be volatile, smart investing can be a better use of your extra money. If you can earn more from your investments (to be on the safe side, say a 5% annualized return on average), than you could save by paying down a mortgage with an interest rate of 4%, then it makes sense to put your money into investments. If your interest rate on your mortgage is higher, you may be better off making extra payments.
4. Finally, don’t forget about taxes. Your tax savings can reduce your mortgage interest rate. For example, if your mortgage rate is 4%, that puts you in the 25% tax bracket, which allows for deducting all of the mortgage interest you pay in a year. So, your mortgage interest rate is really only 3%. If you’re investing in a tax-advantaged account, you can treat the earnings as tax-free.
After retirement, when your income is coming from investments rather than a paycheck, it makes more sense to pay off your mortgage.
If there’s one thing we’ve learned about the stock market, it’s that it is volatile. What if during your retirement the stock market is in a low point, returning far below average?
When you’re withdrawing money from your investments during retirement, if you aren’t careful, you can end up depleting your account long before your death. A growing number of retirement experts recommend withdrawing a maximum of 3% to safeguard depleting your accounts.
In which case, you can probably save more in mortgage payments by paying off your mortgage during early retirement than you would earn in income by having that same amount of money invested. The tax benefits of keeping a mortgage later in life all but evaporate because most of your later payments are principal vs. deductible interest and you may be in a lower tax bracket in retirement. For those reasons, you’ll probably want to plan to pay off your mortgage before or soon after your retirement date.
Another factor in all of this is how you plan for your retirement. Today there’s no reason to be subject to the volatility of the market when you can secure your retirement with a plan that only rises, never dips. Your money grows tax-free, is distributed tax-free, and can be passed on to the next generation tax-free. And what if you want to retire early? A smart plan ensures that you aren’t subject to age restrictions.
If you’re interested in learning more about how to retire smart, give our office a call today. There is never a charge for consultations or advice.