Pay Off Debt or Continue Owing in Retirement?

Paying off the mortgage used to be part of the American dream and a prerequisite to retirement. Then, times changed. Debt management and the use of leverage spread from businesses to personal finance. It was not unusual for people to enter retirement with mortgages and other debt with no plans to become debt free. Some did not hesitate to increase debt during retirement.

Now, the pendulum seems to be swinging the other way. The financial crisis and economic downturn are causing Americans in general to deleverage. They are reducing debt and increasing saving.

What is the best approach? Should you try to pay off the mortgage as soon as possible or use debt as a financial tool?

The first factor to consider is subjective. Some people are not comfortable with debt, especially in retirement when they no longer have steady working income. They want to be debt free as soon as they can and will sleep soundly knowing that they do not owe substantial sums to anyone. If that describes you, paying off the mortgage probably should be a priority even if the numbers we will discuss shortly show it might be better to carry some debt.

Another factor to consider is the level of your cash or liquid asset reserves. Emergencies arise from time to time. Everyone should have cash or liquid assets to be drawn from in case of unplanned expense such as medical expenses or home repairs. It could be risky to use part of your emergency cash reserves to pay off the mortgage. Shortly after the mortgage is paid, there might be an unexpected need for cash. Alternatively, it might be possible to set up a home equity line of credit to be tapped for such emergencies. Before paying off a mortgage, consider how any emergency needs would be covered.

Once those factors are considered, take a hardnosed look at the numbers.

Someone considering paying a mortgage has a source of funds from which to make the payment. The question is: What is the best use of that money?

First, estimate the rate of return you expect to earn from investing that money over the remaining term of the mortgage. A conservative investor might estimate a return of 3% or so from money market funds, certificates of deposit, or conservative bonds. Other investors might estimate a higher return, and aggressive investors might project a return of 7% or more annually. Then, apply your tax rate to the investment return to arrive at the after-tax rate of return.

Next, verify the interest rate on the mortgage. If you itemize deductions, the mortgage interest will be deductible, so determine the after-tax interest rate. The after-tax rate will be less than the stated rate on the mortgage because of the deduction. (Most lenders will provide an estimate of how each future payment will be divided between interest and principal. As a mortgage gets older, more of each payment is applied to principal and less is interest.)

If the after-tax investment return exceeds the after-tax interest rate on the mortgage, you are better off keeping the mortgage and leaving your money invested. You are earning more income on your capital than the mortgage is costing, so it is better to keep the cash invested and pay the mortgage over time.

If the situation is reversed with the mortgage interest rate exceeding the investment return after tax considerations, the best use of the money is to pay the mortgage. You are earning less than the mortgage is costing you, so your wealth is increased over time by paying the mortgage and saving the interest payments.

Example. Suppose your mortgage has an interest rate of 6% and your combined federal and state income tax rate is 40%. The after-tax interest rate is 3.6%. Tax-exempt bonds yield more than that. Investment grade corporate bonds yield around 7%, which is 4.2% after taxes. If you invest the money in either of those vehicles, you are better off doing that and instead of paying down the mortgage. The same would be true if you plan to invest in a diversified portfolio or even primarily in stocks and expect to earn more than 3.6% annually after taxes. Keep in mind, however, that for these investments the rate of return is not guaranteed over the life of the mortgage, and there is a risk of losing principal.

If you invest in money market funds, certificates of deposit, or treasury bonds you probably will be earning less than 3.6% after taxes. Also, if you are bearish about stocks for the duration of the mortgage, you probably are anticipating a return less than 3.6% annually. In those cases, the better use of your capital is to pay the mortgage.

Suppose you already own a home debt free and are considering how to pay for repairs or improvements. Your choices are to take money from the portfolio or borrow against the home. The same analysis should be done. Compare the mortgage interest rate with the portfolio's investment return to decide on the best use of your money.

There are other factors for some people to consider.

If you still are working, the best use of income might be to maximize the contributions to your 401(k), or at least contribute enough to receive the full employer matching contribution. Taxes are deferred on the income contributed to the 401(k), as are taxes on the account's earnings. To the extent the employer makes a matching contribution, the rate of return on the 401(k) contributions is very high.

If the wealth that would be used to pay the mortgage is not in cash or near-cash, transactions might be needed to convert it to cash. Those transactions could trigger taxes. Selling stocks or mutual funds could trigger capital gains taxes, while withdrawals from annuities or IRAs would be taxed at ordinary income rates. The transactions also might push you into a higher tax bracket or even trigger the alternative minimum tax. In effect, you would need a greater amount than the mortgage balance to pay off the mortgage, because of the taxes incurred. The interest rate on the mortgage would have to be substantially higher than your investment return to justify taking the extra money from investments to pay the mortgage and the taxes.

Are the wealthy smarter than other people about using debt? Data from before the crisis show that the percentage of older Americans with mortgages is rising, and wealthy Americans have a disproportionate share of the nation's debt. This could be an indication of what financial advisors call strategic debt—using debt as a tool to increase net worth.

Strategic debt works like this. Suppose you have $500,000 of investments. You want to buy a home for $500,000. You could pay cash for the home and be debt free. Or you could make a down payment of $100,000 and take a mortgage of $400,000. Then, you own a $400,000 investment portfolio and a $500,000 house, controlling $900,000 of assets. The strategy works as long as income is high enough to pay the mortgage and is smart when the portfolio’s return is at least as high as the mortgage interest rate.

But a further probe into the data also shows that a lot of the debt among the wealthy probably is incurred to maintain a lifestyle people really cannot afford. The top 1% by wealth owe much less debt than those just below them on the wealth scale. It appears that a lot of the debt is not so much strategic as it is to stretch a lifestyle to keep up with even wealthier people.

One final factor to consider is prepayment penalties. Some states prohibit them, but in others penalties can be imposed on principal prepayments. This is another cost to factor into the equation.

Deciding whether to keep or eliminate debt is a simple exercise, requiring a few simple calculations. There are web sites that help make the calculations, such as www.mtgprofessor.com.

 

Bob Carlson is editor of the monthly newsletter Retirement Watch and the web site www.RetirementWatch.com. He also is author of the books The New Rules of Retirement and Invest Like a Fox…Not Like a Hedgehog.





Posted 08-21-2009 10:13 AM by Bob Carlson