What’s better: rent or buy? Should you consider your mortgage part of your net worth? Should you pay off your mortgage to retire faster?
The debate continues in the FIRE (Financial Independence, Retire Early) community of bloggers as to whether one should consider your home an asset or an expense. Should it be included in your net worth calculations or not? Should you bother paying off your mortgage or just carry the expense in retirement? Is it better to rent and invest the difference or buy a house? And on it goes. I think I can simplify the matter with a bit of basic math.
First, you have to live somewhere. So, you must factor housing costs into your financial independence equation whether renting or owning. Given most people spend 20-30% of their total living expenses on housing, getting rid of this expense by paying off your mortgage will reduce your fixed living expenses in perpetuity. Yes, you’ll still need to pay maintenance, taxes and insurance, so it won’t be a net zero expense for living. But you can get a big chunk of your monthly expenses down simply by paying off your mortgage.
Consider that you can pay off your home in 30 years (or 23 if you make one extra mortgage payment a year). That means you’ll have 30 to 50 years of living, depending on how long you live, without a mortgage expense. Obviously, any expense that you can permanently eliminate makes it easier to retire sooner because you’ll need less invested.
According to Darrow Kirkpatrick of Can I Retire?, the average upper middle-class retired couple needs an income of $75,000 a year if they have a mortgage or rent payment and $54,000 a year if mortgage-free. Based on the 4% Rule, you need to have $1,875,000 invested to generate a $75,000 annual income, but only $1,350,000 to generate an income of $54,000 a year. (I’m not including Social Security or any pension income you might have). That is an extra $525,000! Given the average house costs $250,000, you’d be better off paying for the house than having to save an extra $275,000.
Let’s say you have a $250,000 mortgage and pay 3.75% fixed for 30 years. Your monthly payment would be $1,157 a month. If you were to retire early without having paid off your home, you’d need 300 times the monthly expense ($347,100) invested to cover that monthly payment until it is paid off. That means you’d need $97,100 more invested than the mortgage itself! So it clearly makes sense from a mathematical standpoint to pay off that mortgage and eliminate that expense permanently. There are no rules here, you can do what you want, but it helps to make the optimal decision by knowing the figures.
Any expense you have now that you plan to have in retirement means you need 300 times that amount invested to pay for it in perpetuity. For example, your monthly gym expense of $50, needs $15,000 (300 X $50) invested. Your daily cup of coffee needs $23,400 invested ($2.60 x 30 =$78 a month X 300). These are the sorts of calculations that make it much easier to decide to go down the route of frugality as you start weighing the cost versus the benefit.
“Hmm…if I gave up that daily cup of coffee, I could retire two years sooner. But hey, I love my coffee so that would be worth saving up that extra $23,400.” It makes it much easier to cut costs when you know how much they actually require in terms of years of labor to maintain in perpetuity. Given housing is the major part of most household budgets, reducing it to the minimum makes a lot of sense. But wait, there is more to it than that.
By paying off your home, you remove interest rate risk — the risk that rates will go up should you need to remortgage or refinance at some point in the future. In the UK, there are no fixed 30-year mortgages. So all the interest rate risk is borne entirely by the homeowners, not the banks. The longest you can lock in a mortgage rate in the UK is for 10 years. Then, if you need to refinance at that time, you’ll have to do so at the current rates, which might be higher, lower or the same. Given rates are currently at ridiculously low levels, the risk may be that they are higher in the future.
If rates go from 2% to 4%, you’d be doubling your monthly interest payments, which you may not be able to afford. This could mean that you end up in foreclosure as the bank repossesses your home. Pay off your mortgage and you won’t care what is happening to mortgage interest rates. You won’t need to worry about being repossessed. One less thing to worry about in retirement!
The other risk you reduce by owning a home is inflation. Inflation has the power to destroy the lifestyle of retirees living on a fixed income. Your stock portfolio may not keep up with inflation. Bonds get eaten alive in inflationary times, so they definitely won’t save you. So what can a retiree do about the risk of inflation? Reduce the risk as much as you can by owning your own home. If you rent, rents will continue to go up with inflation. If you own your home, you’ve stabilized your housing expense as much as possible. Yes, you’ll still face the rising costs of maintenance. However, that will be more manageable than keeping up with rising rents, especially if you are on a fixed income. Remember, any expense that you can permanently eliminate will reduce the risk of inflation destroying your lifestyle.
Another benefit of paying off your mortgage is that your annual expenses will be that much lower (typically 20 to 30%). That may put you into a lower tax bracket, thus reducing the amount of taxes you’d pay in retirement.
Let’s not forget peace of mind. Most people can easily cut discretionary expenses in tough times. But your mortgage and rent payments are not so easy to cut. By eliminating this expense, you give yourself more flexibility in your spending since housing is a non-discretionary expense. While it might be fun in your 20’s to live in a camper van, you probably won’t think it much fun to raise a family or retire in one.
Then, there is the peace of mind that comes from knowing you have a Plan B, should all else fail. You can use your home equity to fall back on if a completely unexpected, huge expense appears (often a medical or home care expense). If your investments fail you, then you have your home equity to draw down on. You could get a reverse mortgage or sell your home and buy a fixed annuity for lifetime income. You could rent out rooms in your home to lodgers if you need extra income. If you rent, you have no such emergency asset to draw upon.
Given all of the above, it seems obvious that paying off your mortgage before you retire makes a whole lot of sense both from a financial standpoint and from a peace of mind standpoint. On the financial side, you’ll need a whole lot less money to retire (less invested and less in taxes to pay). On the peace of mind side, you’ve eliminated two risks that plague a person on a fixed income (interest rate risk and inflation).
I hope that helps resolve this ongoing debate. Yes, your home equity is definitely an asset and should be included on your net worth statement. And yes, you should pay off that mortgage. That said, I know retirees who rent and love it. To each his/her/their own!