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Should You Be Debt-Free in Retirement?

Last update on: Mar 17 2020

Should you try to be debt-free in retirement?

For a long time it was taken for granted that people wanted to be debt-free in retirement. People even held mortgage-burning parties and paid cash for everything purchased in retirement. Now, more people
see no reason to avoid debt simply because they’re retired. There are financial advisors who advocate debt as a valuable financial management tool for retirees.

The near-zero interest rates we experienced following the financial crisis were a big incentive for retirees to take on or continue debt. But rates are rising now, and the equation is changing a bit.

There are two perspectives to consider when considering whether or not to have debt in retirement.

The first perspective is the mathematical one.

The analysis from this perspective is fairly clear cut, but still has some fuzziness. You compare the after-tax return you would receive from investing your money to the after-tax interest rate on the debt. It is important to be sure the tax effects are considered on both sides. It is not unusual to see an analysis that
considers the tax effects of one side but not the other.

When your after-tax investment return is higher than the after-tax cost of borrowing, then it makes sense to keep your money invested and carry the debt. On the other hand, if the after-tax returns on
your money are lower than the after-tax cost of the debt, then the smart move is to use the money to pay the debt.

The reason there’s still some fuzziness to this discussion, is you have to choose the investment rate of return to use. Most analyses use the long-term expected return from the portfolio or from specific assets. Under that approach, the numbers usually show it makes sense to have some debt.

Many economists disagree with that approach. Paying debt is risk free, they say. When you pay the debt, the obligation and the payments are gone. The results won’t change over time with different circumstances.

But your investment return will vary over time. The portfolio could decline significantly shortly after you decide to stay invested instead of paying the debt. The annualized return for your portfolio could stay below the long-term average for a number of years.

Many economists say because paying the debt is risk free, you need to compare the after-tax risk-free rate of return you could earn from treasury bonds or similar investments to the after-tax cost of the
debt. When you do that, it usually makes sense to minimize debt.

You can read a full discussion of this approach here:https://crr.bc.edu/briefs/ should-you-carry-a-mortgage-into-retirement/

The second perspective is the emotional or subjective one.

Some people derive a lot of comfort, or psychic income, knowing that they aren’t in debt. Not having debt means fewer mandatory monthly expenses. If income declines or unexpected expenses arise, they have more flexibility than if they were in debt. They also know home equity is available to be tapped in an emergency.

On the other hand, when markets are doing well, some people are comforted by the extra gains earned by having more money in the markets instead of having used it to eliminate debt. It’s also a comfort
to know they always can sell some investments to pay the debt or other expenses.

But it’s a different story when markets decline. A bear market can be less unnerving when you have fewer assets in the market to lose value and know you aren’t encumbered by debt.

Consider these different scenarios and decide where you are on the emotional scale. Then, balance the mathematical and emotional perspectives to decide on the amount of debt you want to carry in retirement.

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