You might be surprised how many people have questions about debt.
For most people at or near retirement, reducing debt should be a primary goal. Comprehending the mathematics of debt, as well as the decision points, should help better understand a particular situation.
While mortgages may differ from other types of debt because of their potential tax deductibility, the math of any loan type is essentially the same.
Also, keep in mind that credit card interest is usually the worst type of debt because it tends to have the highest interest rate.
Why is debt so important?
For most retirees, the paycheck stops and they are then required to provide their own monthly spending money to replace it.
You may have Social Security, and possibly a pension, to fund day-to-day needs. If those are not enough, you will need either part-time work or income from your portfolio to offset your needs.
Any debt payments must come out of this very valuable cash flow. Hence, the less debt the better when you enter retirement.
MATHEMATICS OF DEBT
Let’s put debt in simple terms.
If you have a debt of $50,000 with a 4 percent interest rate, you would owe roughly $2,000 per year of interest, or $166.67 per month, and that is without paying down principal. If you want to pay that loan off in 15 years, you would owe $369.84 per month.
Note that some loans have variable rates, which increase or decrease with overall interest rates. If rates rise, you could pay more interest.
INVEST OR PAY OFF?
A frequently asked question is whether it makes more sense to invest one’s money or instead pay off debt.
Evaluating the example above, for anyone to invest his money rather than pay off the debt, there has to be some expectation to earn a rate greater than 4 percent. In most economic conditions, you cannot go to a bank and get more interest on an account greater than the interest you pay on a loan. Banks could never stay in business that way.
More likely, you would have to invest your money in some other variable type of investment.
Here, however, there are no guarantees. In some cases, your account could be worth more down the road, and in other cases less.
WHAT COULD GO WRONG?
Your time horizon is very important. If it is very short, paying off debt might make more sense.
More importantly, you need to consider what happens if things go wrong.
What if your account value drops dramatically in the near term? Will you be able to stick with your plan?
This investor behavior is extremely important to understand. Human beings are wired to behave negatively when they face this type of adversity.
Ask yourself whether it is worth the risk of entering retirement with any debt or creating a plan to pay it off beforehand.
The same holds true with the question of investing vs. paying off debt. You need to have an objective viewpoint of your existing situation, as well as your experience.
Ask yourself, what if things don’t go as expected early in retirement?
Bad outcomes and bad decisions can adversely affect long-term retirement. Understanding how that might affect your personal situation ahead of time is extremely important.
The best time to evaluate this is now. If you are unable to look at your situation objectively, seek help.
Either way, think conservatively in the hope of avoiding a big mistake.
Paul Marrella is a wealth manager at Marrella Financial Group LLC in Wyomissing, public speaker and author of “What Now? The Widow’s Guide to Financial Independence.” He focuses on providing wealth management and retirement income solutions to successful families in southeastern Pennsylvania and can be reached at www.marrella.com or 610-655-9700.