Should you pay off your mortgage before retiring?

This is something that Dave Ramsey gets a lot of flak for. He recommends that once people are saving 15% of their income for retirement, that they focus their remaining cash flows on paying off their houses. Even when their mortgage is a 4% or lower.

Why does he recommend this?

Well, he evidently did a study a while back about people who have achieved financial independence, and nearly every retiree who had a million dollars or more of net worth had two things in common. One, was a paid off house. The other was a well-funded 401k or workplace retirement plan.

If you'd asked 25-year-old me, he would have told you never to pay off your house. Mortgage debt was so "cheap" in his view compared with the opportunity costs. After all, at that time you could borrow money at around 4.5% on a house, whereas stocks looked poised to deliver 10-12%. The "smart" thing, really, would be to refinance your house periodically to free up more money to invest in stocks.

While I get where he was coming from. I think that's a bad idea today. Especially for people approaching retirement. The biggest reason for this comes from portfolio withdrawal rates. The research varies in details, but it pretty consistently agrees that the long-term safe withdrawal rate from a portfolio is about 4% of its value each year, adjusted for inflation.

And you might think, that's not so bad! A 4.5% interest rate, vs a 4% withdrawal rate, all while your stock portfolio is growing about 4% a year!

But that ignores principal. Which is significant, even on a 30 year mortgage. A 4.5% mortgage on a $500,000 mortgage works out to about $2533/month. That's $30,401 a year, or a 6% portfolio withdrawal rate on the $500,000. That's on the high side of sustainable. Not good.

It gets even worse with higher interest rates. For instance, where rates sit currently around 6.75%, that monthly payment becomes $3243, or $38,916 annually. That's a 7.78% withdrawal rate on the funds taken out to pay your mortgage. Not good.

So, if possible, it can make a lot of sense to get rid of your housing payments before going into retirement. It removes a huge line item from your list of expenses and gives you a lot more flexibility. That said, if you don't have enough liquid to pay it off completely (or within the first 5-10 years of retirement), paying it off urgently may not be as good of an idea. If unexpected bills come up, you don't want to have to arrange an emergency cash-out refinance of your house. Consult an advisor for your own situation.

But does this make sense for younger people?

Since younger people have so much time for their money to grow, and can cover mortgage payments out of their paychecks, surely they should play the arbitrage game. Right? No. I still think that's a bad idea. It's one of those things that sounds smart, but is actually dumb (my 25 year old self was a master of ideas like this). I can't say exactly why it won't work in your case, but when I look at my wealthiest clients near retirement age, they all have a paid off house and no debt. My least wealthy clients, by contrast, still have mortgage balances remaining. You might argue that I am confusing cause and effect, but I don't really think so.

Consider what happens when two different couples move houses. One couple is called "the Savers," and the other is called "the Spenders." The Savers have no debt, live frugally, and are putting extra money towards their house. The Spenders, however, have a couple car loans, and a HELOC from when they last remodeled. They make no extra mortgage payments. When the Savers move, they take all of the equity from their old home, and put it into the new place. When the Spenders move, they take the proceeds, pay off the HELOC and car loans, set aside some cash for upgrades, and then put the rest towards the house.

Now, in the moment, everything the Spenders are doing feels justifiable. Why have higher interest auto loans, which are not tax deductible, when you could have lower interest house payments, that you can write off on your taxes? And why not do a remodel, which will make the house so much nicer and help it hold its value? These are rationalizations.

Fast forward and eventually you'll hit a point in time when the Savers have no mortgage, and the Spenders do. Without realizing it, the Spenders were living far beyond their means, while the Savers were living well within theirs. Hence, the Savers own their home outright, can retire sooner, and enjoy greater financial flexibility, and the Spenders cannot.

Did I cheat with this example? Yes and no. Yes, I gave the Spenders higher expenses, and I gave the Savers lower expenses. In a strictly mathematical analysis, you'd look at my "case study" and conclude I'm full of horse manure. That'd be like me racing Usain Bolt in the 100 meter sprint with a 50 meter head start. But this story isn't about how to optimize every dollar for maximum return. That objective is irrelevant because the Spenders are unwilling to live that way. Otherwise they wouldn't do the remodels, buy as many new cars, or as nice of cars... This illustration is about how to become wealthy. Live as the Savers do, and you will almost inevitably become wealthy. Live as the Spenders do, and you almost inevitably will not.