For a retiree with a mortgage, what's the best option? Use your accumulated savings and investments to pay off the mortgage and live debt-free? Or to hang onto those savings and investments to provide liquidity and earnings, while continuing to pay down the mortgage as usual?

According to a new report from the Center for Retirement Research at Boston College, for most retirees it's definitely the former: pay off the mortgage instead of chasing investment returns. The reasoning, in essence, is that retirees are unlikely to find safe investments that pay them a rate of return equal to the interest rate on their mortgage. And paying down a mortgage, notes report author Anthony Webb, is essentially the same as having an ultra-safe investment that pays that same rate of return.

Offers better return than investments

For example, Webb compares making payments on a 30-year mortgage with a historically low interest rate of 5.0 percent to earning interest on a short-term deposit paying 3.0 percent. Even adjusting for tax consequences, the savings from paying down the mortgage would exceed the earnings from the investment.

Even longer-term investments, which pay higher rates, are unlikely to help, because interest rates on 30-year mortgages typically exceed those on 30-year Treasury bonds, which offer some of the highest safe returns available.

"It is unlikely that many retired households will be able to earn a return on risk-free investments, such as bank certificates of deposit, Treasury bills, and Treasury bonds, that will exceed the cost of their mortgage," Webb wrote.

Investments in the stock market, which many retirees hope will provide a rate of return far exceeding the interest rate on their mortgage, also present a degree of risk, Webb notes. He cites figures that from 1925-2006, stocks yielded an average return of only 7.1 percent - which is comparable to what the going rate on mortgages has been for much of the past 10 years, though he doesn't make that point explicitly.

Can still get same exposure to stocks

Noting that most retirees like to have a mix of stocks and safe investments, Webb argues that you can get the same risk exposure by paying off your mortgage and putting the same amount in stocks that you would have if you'd kept a mix of stocks and bonds.

For example, if a retiree has $200,000 to invest and wants to put $50,000 in stocks, they can still do that regardless of whether they use $100,000 to pay off a mortgage or put that $100,000 into bonds - the risk exposure is the same.

The only way to come out ahead, he notes, is to put most of one's investments in stocks - a highly risky strategy for retirees.

The short report (four pages of text, plus endnotes) still makes for some heavy reading, especially for those unaccustomed to number-crunching. Webb touches on whether to draw upon taxable or tax-advantaged accounts first in paying down a mortgage, coming down in favor of the former.

Liquidity may not help

He also dismisses the "liquidity" argument that many make for not paying down a mortgage in retirement, arguing that if you ever do need to draw on that liquidity, your situation would only be worsened by having to make mortgage payments as well.

One thing the study completely ignores is the whole question of reverse mortgages - borrowing against the equity in one's home to provide immediate or long-term income in retirement. However, because homeowners in a reverse mortgage are no longer actually putting money into the home, the issue is probably outside the scope of the report.

Published on July 23, 2009