Feds nearing retirement: Is it always a good idea to pay off that mortgage?

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Federal employees have family and professional lives. They also have financial lives. Today we’re inaugurating a monthly talk with a man who has long experience in federal financial management and investment strategies. He was a regular on our show Your Turn hosted by the late Mike Causey. Now he’ll be a monthly guest here on the Federal Drive with Tom Temin.  We welcome certified financial planner Art Stein.

Interview transcript: 

Tom Temin: And it’s good to have your voice continue with us and your expertise. Today, I wanted to ask you about the issue of approaching retirement or maybe not approaching retirement or maybe already in retirement, the issue comes up of whether to retire that mortgage, because it seems like golly, my monthly payments will go down and the house will be paid off. It’s a psychological relief. Is it really a good financial strategy?

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Art Stein: Okay. Well, Tom, thank you very much. Yeah, people feel like they want to pay off their debts, especially as they approach retirement when they’re in retirement. I understand that. But we look at it as a, you know, what is the financial advantages and disadvantages of doing that. And I think something that people don’t think about is that, you know, paying off your mortgage early means you’re increasing the amount of home equity that you have, home equity being the difference between the value of the home, and the amount you owe on your mortgage. And home equity has a 0% rate of return, it does not earn any interest, dividends, or capital gains would only go up if the house increases in price. But that’s not a rate of return. Really, home equity is equivalent to a savings account with a 0% interest rate. And if you put another $100,000 in that savings account, then it’s going to be worth more but no one would say well gee, the savings account earns money, it didn’t, doesn’t earn any money, because we said it has a 0% rate of return. Home equity is the same way, no rate of return. And it means that that’s a lot of money to have with a 0% rate of return.

Tom Temin: Let me just challenge you for a moment on that. Because if the value of a home is going up, and pretty much everywhere in the country, they are, how does that not translate to a return on investment or return on the savings?

Art Stein: It’s just like putting extra money in a savings account, it doesn’t have a rate of return. You have to think about it like well, if the home doesn’t go up in value, then the home equity doesn’t and the home can be considered an investment. But home equity, an investment where you might have, hopefully, you’re going to have an increase in value, you’re going to have an investment return if you want to think of it that way. But not the home equity.

Tom Temin: All right, then on the other hand, by not paying it off, you’re paying interest. So it’s a cost.

Art Stein: Absolutely. But think about this. The interest that you pay, every year, the actual value of that interest goes down, you know, if you’re a federal employee, your salary is going up. If you’re an annuitant, if you’re retired, you annuity is going up and your mortgage isn’t going up. And also mortgages. They leave consumers, they leave mortgage holders with great flexibility. Because if interest rates go up, like they have just recently, people with low interest rate mortgage, they just keep them and they’re happy. If interest rates go down, you can refinance your mortgage at a lower rate. I mean, that’s the type of flexibility leaving a mortgage holder in the driver’s seat that you don’t have with many other types of financial instruments or investments.

Tom Temin: We’re speaking with certified financial planner Art Stein. And then there’s also the tax implications of having your mortgage payments, the interest part of that.

Art Stein: Yeah, some of that is tax deductible. And you know, that’s certainly very helpful. But to me, the key thing is where’s the money coming from to pay off the mortgage early, like maybe every month, you’re putting in an extra $300 in payments? Well, every month, you could just make a $300 investment. You could put it in an extra $300 in the TSP if you haven’t maxed out, you could put it in Series I savings bonds and get a current interest rate of 9.6%. You could put it in the stock market, do dollar cost averaging and you’re going to end up I think with a lot more funds available to spend because let’s face it, home equity is not easy to spend. If you want to take money out of your home equity to spend you either have to get another mortgage, or you have to take out a loan which is kind of the equivalent or you have to sell the house So, you know, I mean, I had a client who wanted to pay off his mortgage, I explained this to him, he felt very strongly emotionally didn’t want to do that. So that was fine. He took a couple of 100,000 out of investments, another 100,000 out of his emergency funds, paid it off. And a year later, his daughter got married. He needed $75,000 to pay for the wedding. We had to sell even more investments to pay for the wedding. And you know, if he hadn’t paid off his mortgage, he would have that money.

Tom Temin: Right. Or he could say to the daughter, there’s a better instrument for you called the E.L.O.P.E.

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Art Stein: Yes. The E.L.O.P.E. – the elope. Very important financial instrument for some people.

Tom Temin: And I guess, too, if you have, say, the cash like this man did to pour into the house to pay it off. You could also pour it all into those high percentage bonds he mentioned.

Art Stein: Yeah. There’s a limit on how many I Series savings bonds you can buy. But you could put some in there, you could put some in CDs, you could put some into investments like stock funds and bond funds, and give yourself a more diversified portfolio that’s going to grow faster over time, probably, then your home equity because your house isn’t going to go up fast enough. Historically, homes have not increased at as high a rate as the stock market has. I mean, I just think it leaves you in a better diversified position, more easily able to pay for investment needs not met by your annuity and Social Security.

Tom Temin: It’s almost as if the inflation has created a new era of CDs, they haven’t exactly come back. But some of these high yield short term instruments you mentioned, they weren’t around a few years ago.

Art Stein: All of a sudden bank accounts are paying higher rates of return. CDs are paying higher rates of return bond funds are paying higher rates of return. But Tom, we have to keep in mind, you know that retirement, it’s all about generating the income you need to spend to supplement your annuity and Social Security. And especially FERS employees, they do have a cost of living adjustment. But anytime inflation is more than 2%  it doesn’t fully compensate them for the inflation. So the purchasing power of their FERS annuity is decreasing over time and Social Security, of course, as a full cost of living adjustment. It means that FERS employees are very likely to need money, either in the beginning or subsequently from their investments. That’s why the TSP is so important.

Tom Temin: 
Right. And I wanted to ask you to while we have you, just to clarify, under the FERS system, how big is your annuity relative to what your salary was? And what percentage of Social Security do you get, what portion of it relative to if you’d been in the private sector?

Art Stein: Well the annuity, you know is approximately 1% for each year you worked, it’s not exactly that. Social Security, you know, it’s just going to depend. But a key part of financial planning is of course calculating or having your human resources calculate the annuity that you’re going to receive, getting on the Social Security website, finding out how much social security you’re going to receive, and comparing it to what your expenses are going to be in retirement. And for many people, their expenses are going to be higher than their guaranteed income, they need to start taking money out of their investments for most feds their key investment is a Thrift Savings Plan. And the question is, are they able to afford to retire when they want to, if they need to take a small amount out of their investments, say less than three or 4%? You know, they look pretty good. If they all you know, if they needed to take 10% out of their investments. I mean, that’s risky, unless they’re, you know, like in their 80s but they’re like 62 or when they want to retire and they’re going to need 7, 8% from their investments. I’d say that’s a risky strategy.

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Tom Temin: But in the meantime don’t worry, don’t have that psychological attachment to the idea of burning the mortgage I guess that’s that’s an image in the American mind.

Art Stein: Absolutely. The mortgage party, you burn the mortgage, tell the banker to go to hell. And you know you’re free but we’re not free from inflation. We’re not free from the need to have supplemental investments.

Tom Temin: Art Stein is a certified financial planner from Bethesda, Maryland.

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