I recently spoke to a financial advisor about a client’s retirement plan that I wanted to share with you.  The situation is such that the client is getting ready to retire and he was looking at ways to reduce his expenses to ensure that his retirement income and his retirement accounts would be setup in a way that he would be able to meet all his financial obligations and still be able to have some fun in retirement. 

As we started to dive into this client’s financial picture, it was clear that this client’s income was going to be less in retirement since he was not going to be receiving a pension and he was only going to be receiving social security income.  Additionally, this client had done a very good job of saving and had a significant amount of money saved in his portfolio and he also owns a home with a lot of home equity.

As we started to investigate this client’s situation, the financial advisor told me that the client decided to pay off his mortgage to eliminate the mortgage payment which was just under $2,000 per month as that was his largest monthly expense.  It was at that moment that I raised the question, why would someone do that?  The financial advisor then simply said that was the simple solution to reduce his monthly expenses.  I then asked to clarify, so you are saying that the client took $400,000 out of his portfolio which was producing a solid 6% return on investment (which is over $24,671 annually), to save less than $24,000 of annual expenses?  Plus, the $400,000 in the portfolio is not only producing a decent rate of return but when the client took out the money to pay off the mortgage, he was forced to pay over $50,000 in taxes, which means he needed to pull out over $450,000 from his portfolio.

So, I got back to the basic question, why would someone take hundreds of thousands of dollars (in this case it was $450,000) out of their portfolio to pay off a mortgage?  I realized at that point it was just the simple solution, it was like hitting the “easy” button”.  However, after doing the math and running the numbers, the simple solution was not the best solution.  The reality is that the money was producing a better rate of return in the portfolio annually than the mortgage was even costing the client each year.  Additionally, if the client really wanted to reduce expenses in retirement, it would have been just as easy and achieved the same goal by utilizing a Home Equity Conversion Mortgage (HECM).  The client could have gotten a HECM to payoff the mortgage and eliminate his need for making a mortgage payment (you are still required to pay the property taxes, homeowner’s insurance and maintain the home) and this would have not only reduced his monthly expenses but it would have allowed him to keep the $450,000 in his portfolio, continuing to earn a return on his investment and not have to pay the $50K in taxes.  

Is this a little more complicated than just paying off the mortgage?  Maybe, but it would create a far better financial outcome for this client as the client would have had more money in his portfolio to use in retirement.  Now this client simply has more equity, which he cannot use in retirement and less cash.  However, if this client wants to get a HECM now, he still can which will allow his access to some of the equity in his home and convert the equity back to cash.  It is also important to note that this is just an illustration and this same math could be applied to a situation with a lesser mortgage balance as well and achieve a similar outcome.