Mortgage math: Why it may not pay to pay off the house

The mortgage-burning party has long been an exhilarating rite of retirement. But these days more and more retirees are carrying mortgage debt for years after they leave work. During the real estate boom of the last decade, many older individuals bought bigger houses or relied on cash-out refinancing to tap equity.

As the recession threatens economic security, that old-fashioned question -- Should I pay off the mortgage now, or continue with monthly payments perhaps well into my seventies? -- is back in vogue. There's no simple answer for everyone. Living free of debt has its emotional rewards, but you'll need to cast a cold eye on the financial pros and cons.

To pay off a mortgage, you'll have to come up with a lump sum, probably from your portfolio. The basic rule of thumb holds that you should usually keep your mortgage if your after-tax interest rate is lower than the expected after-tax returns from your investments. (The after-tax rate accounts for the savings you get from deducting the mortgage interest on your tax return.) To the extent your investment income enjoys the lower capital-gains rate, the real cost of cashing in investments to pay off deductible debt rises.

A bear market presents another disadvantage for the payoff strategy, says Dianne Nolin, first vice-president of Spire Investment Partners, in McLean, Va. "You will be transforming a not-permanent loss to a permanent loss," she says. "You'll lose all opportunity for the upside."

Richard Arzaga, chief executive officer of Cornerstone Wealth Management, in San Ramon, Calif., agrees, based on an analysis of the last nine bull- and bear-market cycles. He calculates that if a homeowner withdrew $100,000 from a diversified portfolio during the average bear market to pay off a 6% loan, the homeowner would have saved $50,528 in interest by the end of the 82 months of the bear-bull cycle. However, a homeowner who stayed in the market would have gained $86,000 in profits by the end of the cycle. "Historically, it has paid to stomach the volatility of the bear-bull cycle rather than paying down 6% debt," he says.

Other Considerations

Paying off a 6% mortgage could make sense if you have a lot of cash in money-market funds earning 1% or 2% a year, but make sure you have enough in cash reserves to pay for living expenses for several years. "You cannot tie up all your money in the house," says Nolin. Also, set aside money for large medical bills and other unexpected expenses.

Don't assume you can pay off the mortgage and then tap a home-equity line of credit if you need money later. Lines of credit are tough to get now and may carry a higher rate than your current mortgage. In a crunch, you can take out a reverse mortgage, but such a loan comes with high fees.

If you're convinced it's time to pay off your mortgage, try to find the cash in a taxable account. Funding the payoff with a big 401(k) or IRA withdrawal could push you into a higher tax bracket.

An alternative route to a mortgage-free lifestyle is to downsize to a less-expensive house that you buy with the proceeds from the sale of your current home. Or you could take the middle ground: Boost the amount you're paying on the mortgage each month. The extra money will go toward reducing principal and reducing future interest payments -- and speeding up the date for that mortgage-burning party.

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