Debt Management in Retirement

| March 14, 2017
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Wealth Management

Remember the book "Rich Dad, Poor Dad?".  It described in great detail the actions of managing money that appear diligent but actually can hurt the outcome of increasing a person's net worth.  Among the greatest of these are in the area of debt management.

A common sense myth is the idea that a retired person needs to pay off all debt before retirement.  That is a classic "Poor Dad" approach.  Debt, like any other financial product, has a proper and necessary use, and best methods for disposition.  I am going to submit a financial truth that Solitude shares with each client:

"Consumer debt should be eliminated quickly, minimized in all cases, and generally reserved for automobiles alone.  Fixed Rate Mortgages are completely different.  They must be viewed as a function of their effect on net worth, and should rarely have an accelerated rate of payoff regardless of age."

If that sounds in contradiction to your instinctive feelings - EXCELLENT!  You are normal.  Debt creates feelings of being controlled and stifled freedom.  But we manage money on facts and knowledge - not feeling alone.  Let's talk about a few simple examples and why we can help you make a difference in the area of debt management as you retire.

Most Americans buy a home worth about 1/2 of their total net worth. So let's say we are on the last day of the retirement race, age 65.  We have $200,000 in the bank, $300,000 in our 401k, and because we refinanced here and there and moved a few times, we still have a mortgage.  Our $250,000 house was refinanced about 5 years ago. We paid $50,000 down and now owe $170,000.  So what do our two cash flow statements look like?

With the mortgage:Without the mortgage:
Expenses:$3000/month$3000/month
Mortgage:$1000/month$0/month
Total Need:$4000/month$3000/month

Looks like we should pay off the mortgage to save $1000 a month. Right? Not so fast. From what? Fairy dust? We are robbing Peter to pay Paul. Let's look at the balance sheet:

 With the mortgage:Without the mortgage: ($170,000 from savings to payoff)
 Assets:Assets:
  House: $250,000 House: $250,000
  401k: $300,000 401k: $300,000
  Savings: $200,000 Savings: $30,000
 Liabilities:Liabilities:
  Mortgage: ($170,000) Mortgage: ($0)
NET WORTH:$580,000$580,000

There is absolutely no difference on the balance sheet, regardless of the favorable cash flow statement.  Let's not kid ourselves that having $170,000 less in savings INSTANTLY is not going to impact the retirement lifestyle.  The first year's $36,000 of retirement expenses will cause a draw on the 401k and taxes, next year even more so as the cash savings are wiped out.  The loan payoff will not "engineer" a solution for the problem of buying a house near retirement.   It is not that there is no difference between the two choices.  There is, just a different one than the expense reduction one so quickly chosen. So put on your thinking cap - what is the only difference between the two futures?


It is the cost of the capital, as measured by the interest schedule in money (buying power per dollar) terms.  It must be compared to the opportunity costs of the payoff (a fancy way of asking if there is a smarter investment with all of that payoff cash).  The cost of interest charge (which is NOT the same as the total interest paid) is the ONLY thing that is saved between the two and that is not directly on either one.  The cost of the interest must be measured in money terms using inflation and taxes, which is why the amount in dollars cannot be used.  At the end of a 30-year mortgage, each dollar is worth about 1/3 of what it was worth at the beginning of the term.  That is calculated using the long-term rate of inflation over 30 years (3.74% to the 30th power, which yields just over 3).  That means it will take 3 dollars to buy what 1 bought at the beginning of the term.  Surprising, isn't it, how much the dollars drop in buying power over time?

Not remembering inflation and cash flow effects leads to the incorrect conclusion: "Throwing cash at a tax advantaged, longer term, moderate interest rate loan like a mortgage makes sense because of all the future interest you save"  Not true. If you do that you are generally spending high value non-deflated dollars to prevent owing future deflated dollars.  As FIXED mortgages have the tailwind of inflation to make them "easier" to pay in money terms over time, that is rarely a good idea.  So let's look at how we would measure the costs of this mortgage in money terms (buying power) using inflation and taxes.

Recent interest rates are about 4% for 30-year mortgages.  If the rate of inflation is 2% and we are in the 25% tax bracket saving an additional 1% (one fourth of the interest rate as that amount is written off on Schedule A of our tax return) the cost of the capital is about 1%.  Provided at least 1% can be earned by payoff cash kept outside of the mortgage, carrying the mortgage is the better choice.  In plain English, the cost of the capital is about 1% or $1700 per year.  That is the amount the buying power is reduced each year by THE CHOICE to accept $170,000 of debt on a $380,000 balance sheet.  So if you buy a laddered bond portfolio with a 2% payout ratio - you have DOUBLED your return on capital.  Think of how well $100,000 of dividend securities and $70,000 in laddered CDs would look.  You could improve ROIC by a factor of 6 or 7!

What if the interest rate is 8%?  8% minus CPI inflation of 2% minus one fourth for taxes lops off another 2% yields a cost of capital of 4%.  That is a tougher bar to get over by reinvesting the savings, but certainly would be expected by a moderate allocation to equities.  At 12%, even a 3% inflation rate still leaves us at 12 - 3 - (12/4) = 6%.  This is the first rate, tax bracket, and CPI where payoff may be the better choice.  As each of those factors (rate, CPI, tax bracket) change, the cost of carrying the debt will have to be weighed against the opportunity cost of paying off the debt.  Finally all of this relates to fixed mortgages.  HELOCs or other variable mortgage products must be viewed with greater risk in times of rising rates.  Retiring these forms of debt can be more helpful to be sure.

Finance is about choices.  Optimizing them improves outcomes.  Rather than pay off the fixed mortgage EARLY (remember it is amortizing and getting smaller every month!) we would rather see Roth and 401k contributions, Roth conversion taxes, or improvements to taxable investments over a mortgage payoff.  When it comes to collateralized debt, choose carefully the terms.  Then plan to (as my brother once said) make each and every of the "360 EASY payments"!  Making the debt go down faster looks like progress but it gets in the way of buying the REAL money creators: Securities.

Please note that I am using todays slightly below average rate of inflation that is about 2% as measured by the consumer price index.  If inflation picks up again to it's more normal 3%+ the cost of capital will rapidly go to zero.  In a high inflation environment, it will literally create value for the mortgagee!  I once read a book (Successful Investing in an Age of Envy - Dr. Gary North) about hyperinflation in central Europe between the great wars.  A potato farmer bought a farm worth YEARS of his crops.  As inflation devalued the currency of the debt terms, he was able to pay off the farm just a year later with one potato crop.  The author notes that if he would have waited few month months, a single potato would have retired the note!  Remember that story the next time you are tempted to throw CURRENCY against a fixed mortgage.  As currencies always devalue (sometimes heavily), patiently making payments is a superior outcome to rapid payoff to hedge inflation risks.

Debt is paid in currencies, and they lose value through relentless inflation, created ON PURPOSE by governments so we will not hoard cash but spend it.  Early mortgage payoff (versus another method of saving) puts you on the wrong side of financial history. Your choice of the debt late in life can be managed, but not by a clumsy attempt make it go away.

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