Should I get out of debt before I retire? It’s one of the more common questions we get when we meet with people getting closer to retirement.
Misconceptions About Mortgages
The most common liability on a balance sheet we see is a mortgage when asked if someone should get out of debt before they retire. For a long time, it was almost taboo to retire and still be making a mortgage payment. However, the interest rate on mortgages issued within the last decade aren’t the same rates your parents might have had as they approached retirement.
If you took out a mortgage in the early 1980s, chances are good that your mortgage interest rate was as high as 18.5% (this was the average rate in October 1981, according to Freddie Mac). That’s about what the average credit card interest rate is today! In 2018, the average mortgage interest rate was a much more palatable 4.54%. And if you’ve refinanced sometime in the last 7-8 years, chances are you have a rate in the 3’s.
Using Investments or Savings to Pay Down Debt Before You Retire
We also regularly get asked if someone should use investments or savings to get out of debt before they retire. When you consider whether or not you should take a withdrawal from an investment account or a savings account to pay down debt, you need to consider something called opportunity cost, which is the loss of potential gain from other alternatives when one alternative is chosen.
Opportunity Cost
Let’s say, hypothetically, you’ve got a mortgage with a rate around 4%, locked in for the next 20 years, at which point the mortgage will be paid off. You plan to retire in 5 years, and would really like to not have to make a mortgage payment once you retire. You have more than enough money sitting in an old 401(k) or IRA to pay off the mortgage, and for the sake of this hypothetical scenario, let’s assume that you are over the age of 59 1/2, and therefore not subject to any early withdrawal penalties. Your investments in the account are divided into 50% US stocks, and 50% US bonds. If you were to expect a return on your investments similar to the average annual return since 1926 for a similar portfolio, you’d expect an average annual return of 8.4%.
Option A) Take a withdrawal from your investments with a potential return of 8.4% to pay off a debt that is costing you 4%. Your opportunity cost is 4.4% (the long-term average return you are giving up). In addition, any amount you withdrawal is likely subject to be taxed as ordinary income.
Option B) Continue to make the regularly scheduled mortgage payments.
This is obviously an over-simplified example, but the rational decision would be to take Option B should you decide to use investments or savings to get out of debt before you retire.
Should I Get Out of Credit Card Debt Before I Retire?
Now, if let’s say we’re dealing with credit card debt instead of a mortgage. The interest rate on the revolving credit card balance is 15%. Prioritizing paying this debt off before retirement sounds much more reasonable when considering the opportunity cost. Paying off credit card debt to help you get out of debt before you retire is a good decision.
Tax Efficiency and Debt
There was a luncheon recently hosted by the Financial Planning Association in Kansas City, which featured Greg Geisler, is a professor of accounting at Indiana University, as the keynote speaker. He is a CPA who also holds a PhD. One of the topics he spoke about was the most tax-efficient order to invest and pay down debts. This order needs to be adjusted based on each person’s individual goals and risk tolerance, but paying off high-interest debt was one of the highest priority items. In fact, paying off moderate interest rate debt was still ahead of making a contribution to a taxable brokerage account. Interestingly enough, paying off low-interest rate debt was not on the list at all.
So, Should I Get Out of Debt Before I Retire?
There’s no clear rule of thumb for the question of whether or not you should pay off debt. It does depend on several factors. Consider your opportunity cost, any tax implications, and your cash flow projections in retirement, among other things.
As always, our advisors would be happy to sit down and analyze a debt-payoff strategy with you, customized to your comprehensive financial plan. You can schedule a complimentary consultation below or give us a call at 913-393-1000 to request a meeting with a financial planner.
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The views expressed represent the opinion of Modern Wealth Management an SEC Registered Investment Advisor. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Modern Wealth Management does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.