As you approach retirement, you may have a big mortgage balance hanging over your head. The average 60-something household has about $243,000 in outstanding mortgage debt. Paying off those loans may be a smart move for a lot of soon-to-be retirees.

A mortgage is a fixed-income asset you sold

Most people diversify their portfolios by allocating some of their investments to stocks and the rest to fixed-income investments like bonds. A mortgage is a fixed-income asset. There's a whole market for mortgage-backed securities, which are basically just bundles of mortgage loans.

If you have a mortgage balance, it's kind of like selling a mortgage short. In other words, it's a negative fixed-income asset.

Houses in a suburban neighborhood.

Image source: Getty Images.

As such, you should adjust your portfolio to account for the mortgage balance as a counter to your bond and other fixed-income asset allocation. For example, let's say you want to maintain a 60/40 split between stocks and fixed income in a $1,000,000 portfolio with a $200,000 mortgage balance. You'd need $480,000 of stocks and $520,000 of fixed-income assets in your investment portfolio to produce a net 60/40 split. That's because the fixed-income allocation is reduced by your $200,000 mortgage balance.

If you're comfortable doing the math and accounting for the counterweight of a mortgage on your fixed-income assets, then perhaps holding onto a mortgage in retirement will work out for you. But you also need to consider whether holding the mortgage is the best use of your money.

What's the return on paying down a mortgage?

2020 and 2021 offered an opportune time for many people to refinance their current loans. Many people saw their mortgage rates drop below 3% when they refinanced during that period. With today's inflation rates, those mortgages have negative real interest rates. In other words, paying the minimum on that debt is a good idea because it increases your purchasing power long term.

Generally speaking, investors with a long time horizon might consider leveraging their mortgage in order to invest more in stocks. Stocks have greater expected returns over the long run, but generate more volatility in a portfolio. Young investors can typically handle that increased volatility, which is increased by maintaining a large mortgage balance. In the long run, it can produce a bigger nest egg to retire on.

But retirees are looking to live on their portfolio, and capital preservation becomes more important as you approach retirement and go through the first few years of living on your investments. And since a mortgage can have a meaningful impact on portfolio decisions like how much to allocate to bonds, a retiree should compare the expected value of paying down a mortgage to buying bonds.

For a mortgage, the calculation is simple. If you take the standard deduction on your taxes, the return is the interest rate of the mortgage.

Determining a return expectation for investing in bonds takes a little bit of guesswork. Historically, though, Treasury bonds have merely kept up with inflation while providing a counterbalance to stocks. Going forward, investors shouldn't expect much more than inflation-matching returns from Treasuries.

The Fed expects to get inflation back down to about 2.3% by 2024. Most mortgages have an interest rate above that number. So, by paying down the mortgage, you'll get a guaranteed positive real return, which might outperform Treasury bonds in your portfolio. (If you're very bullish on bonds, however, you may want to leverage your mortgage to keep more money in the asset class.)

You can often get a better long-term real return by selling bonds and paying off your mortgage.

Important real-life considerations

There are some important factors that may sway the balance in favor of continuing to slowly pay down your mortgage throughout retirement.

There are probably some tax implications to selling assets in your portfolio to pay off your loan. If a substantial part of your portfolio is in a tax-advantaged retirement account, you could incur a very high tax bill to pay off your mortgage in one big chunk. Or if you have assets with a lot unrealized capital gains, it could be more advantageous to spread the sale of those securities out over multiple years.

The bond market is currently in one of its worst years for investor returns ever. It may sting to sell when your investment is down 10% to 20%, but investors should always be looking at expected returns going forward. If you believe the market is poised to rebound sharply and outperform, you may want to keep your mortgage in order to hold more bonds. But if you don't believe bonds will exceed their historical real returns in the medium to long run, paying down the mortgage makes a lot of sense.

You don't have to pay off the mortgage all at once. Perhaps your mortgage payoff plan heading into retirement is merely allocating the portion of your retirement savings contributions that would go toward bonds toward your mortgage instead. That way you can hold your current assets without selling, incurring no tax consequences.

Retirees who have enough deductions to itemize on their tax returns may also receive fewer benefits from paying down their mortgage. The interest rate needs to be reduced by the tax deduction from paying mortgage interest, so be sure to factor that into your calculations.

Paying down your mortgage will simplify your retirement planning. Not only will it make it easier to manage a balanced retirement portfolio, it'll also ensure your expenses remain consistent throughout retirement. You won't have a big line item dropping off midway through retirement once you pay down the loan organically. So, not only can it make sense mathematically, it can make planning more practical as well.