How much debt should you carry into retirement? Is one type of debt better than another? How can you develop a transition plan for your debt as part of your retirement planning?
These are all important questions that are not often considered during the pre-retirement years when there is so much focus on saving, investment choices and rates of return. However, the answers are critical to your long-term planning and your ability to meet your retirement goals.
Debt reduction and elimination should receive as much attention as your savings rate and investment choices.
Types of Debt
Secured debt is generally backed by an asset that a lender can reclaim, such as a car, home or boat. It generally costs less to obtain than unsecured debt, which is used to purchase goods or services (groceries, fuel, clothing, entertainment). Because it is unlikely that a lender will reclaim these items, the lender has more risk and charges a higher interest rate. These loans may also incur an even a higher interest rate as a penalty if a monthly payment is missed.
Revolving debt (credit cards, equity loans) can be paid down, then re-borrowed. This can lead to a much higher cost than the original purchase price because the balance may never be fully paid.
Installment debt is generally paid off at a fixed rate over a pre-determined period of time (car loan, mortgage).
The biggest problem with unsecured consumer debt is that it typically carries a high interest rate and requires a small principal payment on a monthly basis. As a result, it can take many years to pay off the balance. For example, if you make a $5,000 purchase on a credit card that charges 18 percent interest and requires a 3 percent monthly principal payment, it will take more than 16 years and about $9,000 to pay off the purchase, assuming that the minimum payment is being made. During that time, the item purchased may have declined in value (an appliance) or been consumed altogether (a dinner out, a vacation). You can end up paying several times the value of an item before it is paid off and find yourself in a position to replace the item, which begins the cycle all over again.
Debts to Pay Before Retirement
There are several types of debt that you should focus on in pre-retirement years:
• Consumer debt of any kind, including revolving unsecured credit cards and secured installments, such as loans for cars and boats.
• Home revolving secured debt, particularly if it has a variable interest rate or was used to purchase consumable items.
• Excess installment mortgage debt that has a high interest rate or is not tax deductible because it is over the $1.1 million limit.
Paying it off can dramatically reduce your cost of living both before and after retirement. A couple of other reasons to consider paying off the debt:
1. Increased positive cash flow produced at the end of the payments can be directed to other savings vehicles, one of which can be a cash account earmarked to make future purchases (and allow you to avoid the debt cycle).
2. Interest paid on consumer debt is not generally tax deductible, further increasing its cost.
Elimination of debt reduces the cash flow required to maintain your lifestyle in retirement. This brings about two additional potential benefits: You may need to accumulate fewer assets for retirement because your required cash flow has been reduced. And you may be able to reduce the level of risk and volatility you select for your long-term assets if you either require less cash flow or less total
asset accumulation.
Strategies
There are several potential strategies for debt reduction:
• Reduce participation in 401(k) plans to the minimum required to get the maximum match from your employer. Use the extra after-tax cash flow to accelerate debt payments. This will produce a rate of return that is attractive by saving interest on the loan and still allow you to work toward your long-term goals.
In the credit card example above, if the extra-tax income is used to increase principal payment on the 18 percent debt from 3 percent to 6 percent, the payoff will take only 7 years versus 16, and the amount of money saved would be about $3,100. This represents a significant savings.
• Reduce consumption where possible and earmark the savings for debt service.
• Allocate bonuses or tax refunds to debt service.
• Allocate a portion of pay raises to pay debt. This can be effective as you are not accustomed to having that money in your consumable cash flow yet.
• Re-finance high-interest revolving consumer debt to an installment home equity line. An equity line may have a lower interest rate, and the interest may be tax deductible as well. You can earmark the payments on the consolidated debt to increase principal payments on the equity loan and eliminate it as quickly as possible.
• Shop for lower interest rates on your credit, which can result in a significant savings.
It is highly beneficial to pay for all consumer debt prior to retirement. It will save a significant amount of money and make it easier to achieve a comfortable retirement.
With respect to mortgage debt, it is considered better debt to have because it generally carries a much lower interest rate that is generally fixed, the interest is generally tax deductible, and it is associated with an asset likely to appreciate over time—your home.
Despite these facts, it is still desirable to reduce this debt. However, this answer is less clear because of the nature of the loan contract and the fact that it can be used as a deduction against income that is likely to continue to be taxable well into retirement (such as 401(k) distributions or pension payments).
How to reduce debt and which choices to make should be part of a well-coordinated, comprehensive plan. You should look at all aspects of your long-term strategies to be sure they are all working in a coordinated way to deliver the greatest amount of after-tax money with the lowest amount of cost and risk.
Joseph H. Guyton, CLU, AEP, is principal of the Guyton Group, a financial planning firm in Portsmouth. He can be reached at 603-766-9200. For more information, visit guytongroup.net.
Current Issue - May 2024