The February 2010 issue of Better Homes and Garden printed a question from a reader nearing retirement. They owed $100,000 on their home and had a retirement nest egg of $200,000. She asked if they should pay off the house or keep the money and invest it in a diversified portfolio of stocks and bonds.
The answer the editors of the financial section of the magazine was that they probably should pay off the mortgage. Specifically, since guaranteed investments do not return at the current rate of the mortgage interest, they actually get a better "rate of return" by paying off the mortgage.
This answer should be examined more fully before jumping to conclusions. First, what other income does the couple have and will they receive cost of living adjustments on the benefit? If this is all the money that they have, the first issue they'll have to tackle is how to pay their monthly living expenses. Even without the mortgage, if they draw the standard 4% (considered by many to be a sustainable withdrawal rate) they'll have to live on $4,000 per year! Expending 50% of their cash into their home could result in a cash crisis early in their retirement, forcing them to consider a costly reverse mortgage sooner than later.
Secondly, since the mortgage costs are tax deductible, the simple subtraction (5-6% mortgage - 2-3% bond interest = 2-3% savings by pre-paying the mortgage) doesn't work. It's probably close to a wash depending on the couple's total monthly income.
Third, I was concerned reading the question that this lump sum was in a retirement account. If it's in a 401K or a TSP account, any money you take out is taxable as ordinary income. That could artificially push you into a much higher tax bracket and take as much as 33% of the money off the top.
Finally, the person asking the question doesn't say how long she and her husband are planning on staying in the house. If she's ready to move from Michigan to Florida in the next couple of years, it's probably a much better idea to bank the money now than to tie it up in the MI house.
Now, all this said, I am not arguing that it's never a good plan to prepay the mortgage and own your home. Actually I think it's a great idea, but it has to fit into your overall financial plan. It's a great way to manage a cash flow situation on a fixed income, but not when this amounts to 50% of your total net worth. I'd be much happier with it if was about 25-30% of the net worth.
If you're a military member planning on retiring after 20-30 years of service and making work optional, having a paid-for house is almost a necessity, but it should be something that you've worked for over 10-15 years, not as a lump sum right at the end.