In What to Do if You Cannot Afford to Retire we laid out five separate strategies to help you create at least a comfortable semi-retirement. The five strategies included saving money, getting out of debt, selling your home, continuing to work, and adjusting your expectations. We?ve already done deeper dives on saving money (no matter what) and selling your home. Today I want to focus on paying off debt before retirement.
Welcome to the Age of the Indebted Retiree
That debt of all types has been on the rise in the US in the past few decades is an accepted fact. Less well-known is that increasing debt levels are also common to both retirees and near retirees. The following chart tells the story:
(Source: Employee Benefit Research Institute Debt of the Elderly and Near Elderly, 1992 – 2013)
The chart shows that debt increased among three groups age 55 and older:
- For ages of 55 to 64, debt increased from 71.4% of households in 1992, to 78.5% in 2013.
- Among those 65 to 74, it increased from 51.5% to 66.4%.
- Finally, for those 75 and older, it increased from 31.9% to 41.3%.
Figures only run through 2013 but we should suspect that they?ve only increased since. Debt levels tend to increase during economic expansions, and then contract in recessions. Since the economy has been mildly improving since 2013, an increase seems like a reasonable assumption.
The point is however, where getting out of debt was once a primary retirement goal, attitudes are changing. I believe there are two reasons why this is happening:
- The cost of living is rising relentlessly, even higher than the official rate of inflation. People are borrowing to make up the difference.
- The average person today has a much more benign view of debt than was the case 25 years ago.
Debt has largely replaced cash as the primary method of payment. In various buying decisions, from widescreen TVs to college educations, it?s simply assumed that debt will be part of the equation. But debt that?s comfortably tolerated during the working years can become an unsustainable burden in retirement.
Why Paying Off Debt Before Retirement is More Important than Ever
It?s ironic that debt levels are increasing among the retired and near retired, given the rising difficulties with the whole concept of retirement. Traditional defined benefit pension plans are fast becoming extinct, and the vast majority of people have little or no retirement savings.
Here are just a few reasons why paying off debt for retirement is more important than ever:
Paying off debt improves cash flow better than investing. Paying off $10,000 in credit card debt with a $200 monthly payment will improve your finances more than investing the same amount in the stock market. The historic average return on the S&P 500 from 1928 to 2016 is about 10%. That will generate an annual cash flow of $1,000. That?s a lot less than the $2,400 in monthly payments you?ll save by paying off your credit cards.
Lowering your cost of living. The often unspoken ?other half? of retirement planning is lowering your cost of living to fit within your income. By paying off your debts, you lower your cost of living, often substantially. The lower cost of living means that less income is needed.
Increasing your mobility. Debt limits your freedom of movement. You can?t quit a job because you have debt. You can?t make a geographic move because you have debt. Helping a family member in need is impossible, because you have debt. When debt is paid off, you?re free to do whatever you want. I think that?s one of the aspects of retirement that people really look forward to.
Freeing up cash flow to create more retirement savings. If you can pay off debt before you retire, you?ll have that much more to put into savings once the debt is paid.
Now let?s look at each type of debt individually.
Credit Card Debt
When I was in the mortgage business, the saying was once a Visa, always a Visa. There?s a reason why they call credit cards ?revolving debt?. The principal portion of the monthly payment is typically borrowed back the following month or shortly thereafter.
Do you see what a trap that is? Sure, you may intend to pay off your credit cards, but it never seems to work out that way. That?s because credit cards are not designed to be paid off.
The big problem with credit cards is psychological. You become emotionally attached to the benefit that it provides ? mainly, cash when you have no cash. It means that you don?t have to say no to yourself or someone else.
That’s addictive. And that?s the problem!
If you spent a lifetime caring credit card debt, it won?t be as easy to suddenly given up once you reach retirement. Credit card debt is a lifestyle as much is anything else. Unless you purge them from your life, they?ll always hang around. And always but you in the butt at the worst possible time.
Payoff strategies. Credit cards are hard to pay off because it?s so easy to run them up again. The easiest strategy is to set a flat payment amount that you will pay until the card is fully paid. If you owe $10,000 on credit cards with an average interest rate of 15%, and you make a monthly payment of $250, the cards will be paid off and 56 months. Use a credit card calculator to help you figure this out.
Of course, you?ll need to put cards away and not add additional charges to the current balances. That?s the emotional part of the pay off, and it?s not always easy.
I?m really on the fence about car loans. It?s always best to not owe any money on your car. There are definite risks to car loans that most people never think about. But on the other hand, the accountant in me sees the virtue in spreading the cost of a high-priced asset over several years.
An auto loan isn?t the worst type of debt to carry into retirement. If your income can handle the payment, it can be better to spread out the cost, rather than withdrawing a big chunk of your savings. This is particularly true of savings are limited.
But if you do carry a car loan into the retirement years, don?t get carried away. There are some good practices to keep in mind:
- Make sure the payment doesn?t exceed 10% of your monthly income. Less is even better.
- Keep the loan term to not more than five years. At that point, you?ll start to have car repair bills. You don?t need to have a car payment at the same time.
- Don?t trade the car in for a new one every five years. Your transportation needs should decline as you age.
- Make the largest down payment you can. That will minimize the car payment.
Payoff strategies. It really depends on where you are with the loan. If you?ve recently taken a $30,000 loan, you won?t want to pay that out of savings if they?re limited. But you might if you say, have $10,000 remaining with a $400 a month payment. Removing that payment will significantly increase your cash flow. Then plan to keep the car for a few more years. You can get around the repair cost issue by hooking up with a good backyard mechanic.
If you don?t have your mortgage paid off by the time you retire, you?ll probably just have to find a way to live at peace with it. It?s very difficult to pay off a 30-year loan in just a few years. Worse, most people get so comfortable having a mortgage that they make little progress paying it off. Multiple refi?s keep setting the clock back to year one. It?s no longer unusual for people in their 60s having mortgages with 15 to 20 or more years remaining on them.
If you have that many years remaining, you won?t be able to pay it off on a lower retirement income. If there are lower-cost places to live, that option should be considered.
Mortgage strategies. Options can include either moving to a lower-cost rental situation, or selling your current house and trading down to a less expensive one.
In the case of moving to a rental situation, it can make a lot of sense if your payment will be substantially reduced. For example, if you?re lowering your house from $1,500 per month, down to $1,000, it?s certainly worth considering.
There are potentially additional benefits as well:
- Once you retire, the tax benefits of homeownership aren?t as generous as you think.
- By moving to a rental situation, you won?t have the expense of property repairs and maintenance.
- By selling your home and moving to a rental, you can use any equity from the sale to increase your retirement savings.
- Renting will provide you with more mobility, should you decide that you want or need to move in the future.
Downsizing to a less expensive home can work well if you have enough equity to purchase a house that won?t require a mortgage at all.
Student Loan Debt
This one?s gotta go. It?s unsecured debt ? just like a credit card ? but there is virtually no option to default on it. Most can?t even be discharged in bankruptcy. In case you weren?t aware of it before, 15% of your Social Security benefit can be garnished for an unpaid federal student loan debt. That?s in addition to the potential to garnish your bank account. This is serious stuff.
In most cases, it won?t be a would-be retiree?s own student loan debt in question. It would almost certainly be a cosigner situation for the debt of one of their children. But you should know that should your child default on a student loan for any reason, the lender can come after you personally. That?s the whole idea of adding a cosigner to the loan.
For that reason, student loan debt should be eliminated before retiring. Even if your child has been faithfully making the payment for years, a divorce, loss of a job, or a medical emergency could change that situation quickly. At that point, you?d be on the hook.
Payoff strategies. If the debt can?t be paid off, the next best strategy is to get a cosigner release. This is possible on many student loans, though your child would need to qualify for the new loan based on their own financial resources.
But just because a cosigner release is available, doesn?t mean that it will be granted. When a lender releases a cosigner, their security on the loan is instantly weaker. For that reason, release is not automatic. But it?s always worth a try.
Final Thoughts on Paying Off Debt Before Retirement
I hope I?ve succeeded in making the case that it?s necessary to pay off debt before retirement, as well as what the consequences are for not doing so. Most discussions of retirement planning gloss over this issue, as though getting out of debt is assumed. In today?s economy, that?s an increasingly weak assumption.
One of the fundamental problems with debt in 21st century America is that it?s much easier to get into it then it is to get out of it. But when retirement comes around, it takes on a whole new dimension.
If income and retirement assets will be limited, lowering your cost of living will become infinitely more important. Paying off debt will be a critical part of that effort. The last thing you need to be doing is carrying debts from your working years into your retirement years. For this reason, paying off debt before retirement should be given equal priority with saving money. Not the least of which because saving money becomes so much more doable once debt is out of the picture.
What are your thoughts about paying off debt before retirement? I know it?s a complicated subject because everyone?s situation is different. What strategies can you offer that would help someone make it happen? What strategies are you using yourself?