A question we often hear is whether one needs debt in retirement. More particular, the question is whether one should pay off their mortgage by the time they retire or even earlier. There are differing views on this question. Indeed, there are many benefits and reasons to be free of a mortgage. However, we will also look at some potential benefits of having a mortgage in retirement as well as ways to use debt strategically in retirement to provide various financial benefits.
Clearly, not relying on high interest debt in retirement – or, generally, any other times, is a no-brainer. If you are relying on credit card debt in retirement, then you need to circle the wagons and figure out a game plan to pay off such high interest debt. We call that debt “bad debt”, and we are not fans of it at most points in your life – especially at retirement. But, what about “good debt”. I classify good debt as low-interest rate debt that can help you meet some of your life goals that are well within your financial capabilities or that low-interest rate debt that can help you make wise investments. In some cases, the good debt may even be tax deductible. That is the kind of debt we will address in this article.
Of course, there are some in the financial world such as those in the financial entertainment space that suggest that all debt is bad and should be paid off as rapidly as possible. This kind of advice has served many people favorably and there are various advantages to this viewpoint. However, I do believe that good debt can lead to better financial outcomes for certain people in the right circumstances, and not using good debt or paying off good debt in a rapid manner may actually be disadvantageous in certain situations.
So, we will talk about good debt in light of our belief that in the right circumstances good debt can be beneficial. But, how should good debt be looked at as one approaches retirement?
We talk to many near retirees – say anywhere from 1 month to 12 years from retirement – and one of their number one goals is to be debt-free by the time they reach retirement. They want to be debt free for either financial or non-financial reasons.
Certainly, there are benefits of paying off debt in retirement. The peace of mind of knowing that you do not have to pay the lender when you are retired – when you are no longer receiving a paycheck from work – can be significant. The idea that your expenses are reduced when your income is reduced can provide a peace of mind. Also, knowing that you own your home free and clear without having to worry about the bank taking back your home if you were unable to pay the mortgage can clear up some headspace. Indeed, the peace of mind that one receives from being debt free should not be underestimated.
There may be financial benefits of paying off debt in retirement, as well. Often times, people automatically assume that paying off debt is the better financial decision. The thinking is that if I don’t have to pay interest on the debt, I am saving money and thus I am better off financially. This is not necessarily the case because you need to look at what you are losing if you pay off the debt. You are losing the opportunity to have the amount that you used to pay off your debt be invested and theoretically grow. In a simplistic manner, the question can be summarized as follows: can you earn more on your investments on an after-tax basis than the cost of debt you incur on an after-tax basis?
Looking at the financial arbitrage question in more detail, we can see that it is often not an easy question to answer. From the interest rate perspective, that is a bit easier to figure out. If the rate is a fixed interest rate, then the cost is that rate. Then, you need to see if you get any tax deductions on the interest. If we are talking about a mortgage, then you may or may not be getting a tax deduction. As you know, you generally have to take itemized deductions on Schedule A to take the home interest deduction. If your standard deduction is higher than the itemized deductions, then you won’t take itemized deductions and you effectively won’t get a tax deduction for your home mortgage interest. If your fixed interest rate is 3.5%, then the cost of that debt is 3.5%.
If, however, you do itemize deductions, then you need to do a bit more analysis to figure out what your true tax benefit is on the interest. It’s not as simple as saying if your marginal tax rate is 24%, then the cost of debt is the interest rate times the marginal tax rate, or (1 – 24%), for example. This is because to determine the true value of your tax benefit you need to know how much your itemized deductions exceeded the standard deduction as a result of the interest expense. If the standard deduction was $24,800 and your itemized deductions were $25,000, that means that the interest expense really only gave you a $200 more deduction than what the standard deduction provided. And, you then apply your marginal tax rate to that delta to determine your tax benefit. In this example, you effectively don’t get much of a tax break at all and the cost of debt is still near 3.5%. The higher your other itemized deductions like state and local taxes and charitable contributions – those are the most common – the greater likelihood that you may be getting a tax benefit from your mortgage interest. Of course, the higher your marginal income tax bracket, the greater the benefit. In some cases, perhaps the original cost of debt of 3.5% is reduced to 2.5% for those in higher tax brackets to 3.1% for those in 12% tax bracket. Again, it varies by individual and the tax break may vary by year based on what is going on with your individual tax situation and the tax laws at that time.
This analysis is a bit harder today because we don’t know what future tax laws will be. Indeed, we never know exactly what future tax laws will be. In today’s environment, the higher standard deduction is scheduled to be reduced to its previous lower amount in 2026 unless Congress takes action before then. If the standard deduction is reduced, that means that many of us will likely get a larger tax benefit from our home mortgage interest deduction.
So, to determine the after-tax cost of debt can be somewhat complicated. That is why it is important to analyze your financial situation over a long-term basis to get a more accurate picture of the true cost of debt in your situation.
So, once we have analyzed the cost of debt, we need to compare that to an expected rate of return on your money. What is the opportunity cost on the money that you would otherwise have used to pay down debt – either by prepaying the mortgage gradually or paying it down in one lump sum at retirement or some other date. Coming up with the right expected return is not simple either, and this arguably should vary based on your circumstances. To determine the proper expected return, you need to ask yourself how the money would otherwise be invested. If you are paying your mortgage out of cash flow, or if your extra payments are otherwise coming out of your surplus cash flow such as salary, then this would tend to suggest that your asset allocation would not be impacted by the decision to pay down debt. In that case, one could argue that the applicable rate of return to use is what your portfolio overall would produce. So, if you had a 60/40 portfolio, perhaps a 6% rate of return would be used and you then have to apply income taxes to this rate of return. Of course, that rate of return is made up of a combination of return components that are taxed differently. Interest income is generally subject to ordinary income tax rates, dividends and capital gains are taxed at capital gains tax rates, and unrealized gains or appreciation are not taxed currently but at some point in the future. So, coming up with a tax rate can be part art and part science, but perhaps the after-tax rate of return is around 5% if the rate of return was 6%. You would then compare the after-tax rate of return of 5% with the after-tax cost of debt of 3.5%, for example, and see what the better use of your money is. If you feel like you can earn significantly more on your investments than the debt is costing you, then perhaps the financial benefits outweigh the sleep-at-night factor of having paid this debt down.
In some cases, for those that are more years from retirement, then the applicable rate might even be higher – for example, if one were invested in all equities based on their time horizon. Keep in mind that it is impossible to estimate what the rate of return is in the long-term let alone the short-term. That is one reason many people prefer to pay down the debt – there is no guarantee that the expected return could be achieved. Whereas, when you pay down fixed interest rate debt, you are effectively guaranteeing a cost savings equal to the fixed interest rate.
Now, 6% may not be the right expected rate of return number to assume. If you don’t have many years left on your mortgage – say less than 10 years – and you are using your portfolio to pay this mortgage down, then arguably the rate of return should be lower than what a long-term portfolio could be expected to return. I suppose it depends on how one manages the portfolio. In our case at Oasis Wealth, we use the matched bucket approach and we try to generally have 7 to 10 years of cash flow needs met with fixed income instruments that mature at the right time. This means that if we are paying the mortgage out of the portfolio, the proper rate of return to assume is the equivalent fixed income portfolio. So, if the mortgage interest rate is 3.5% and we are paying the mortgage out of the portfolio, then, all else equal, we probably want to pay down that mortgage because we are not going to earn returns higher than 3.5% with fixed income in today’s environment. In that case, it is arguably more beneficial to pay down the debt. And, this is what we often see for those at retirement or a few years after retirement. They don’t have a significant mortgage balance, and they are reliant on the portfolio to pay down the mortgage. Thus, it may very well make financial sense to pay down the debt around retirement.
However, this analysis ignores other factors that could come into play. Debt can be used for tax planning as well. When one is still working and has say five to 15 years from retirement, they may be tempted to pay down the debt faster than what the amortization schedule indicates. We talked about the need to evaluate what kind of return one could otherwise get with their money. If they otherwise could use those funds to save to tax-favored assets, whether it is saving to tax-deferred assets or saving more in a tax-free asset such as a Health Savings Account or Roth type of retirement plan, then perhaps the returns are arguably greater than merely saving to a taxable investment account.
Mortgage debt can also be used strategically to help fund education. Perhaps you need to fund your children’s college education as retirement nears. Rather than taking out school loans that often come with a much higher interest rate, you might be better off paying the mortgage according to the amortization schedule and using the funds that you were going to use to pay off the mortgage for your children’s college. So, a mortgage may provide for more cost-effective financing for college education.
And, there could be some other large tax benefits of not paying off your debt in retirement. I refer to this as using debt as a tool for cash management to provide for implementing potentially beneficial tax strategies. At Oasis Wealth, we work with many near retirees and recent retirees and some of these strategies can be significant if implemented correctly and if the individual’s financial situation is amenable to these strategies. The tax strategies I am referring to are Roth IRA conversions, capital gains minimization at retirement, and health insurance premium subsidies.
We won’t go over these strategies in detail, but keeping your mortgage – or even taking out a mortgage near retirement – can help preserve some of your cash or taxable investments to help maintain your lifestyle in a tax-beneficial manner while allowing you to strategically implement some of these tax strategies. These strategies often work best if you can minimize your income during those years of implementation. That means if you can minimize having to pull from your tax-deferred assets or delaying taking money from Social Security, then these strategies can be more effective. You still need to look at the other factors we mentioned – the sleep-at-night factor and the financial arbitrage question – but these other benefits should not be ignored.
I did want to transition to a similar topic and that is the use of a Home Equity Line as a tool leading up to and through retirement. Similar to a mortgage, a Home Equity Line can be used to help meet financial goals or to help with tax planning. We generally don’t advocate using a Home Equity Line to purchase toys such as boats, but it can provide some short-term liquidity for two purposes.
First, a Home Equity Line can be used to provide some additional tax planning as we discussed earlier. Using proceeds from a home equity line are generally not taxable, and thus can be used in years in which you need to keep your taxable income low to implement various tax planning strategies. Second, the HEL can be used as an alternative source of funds to meet your living expenses in the case of a market decline or additional emergency fund need. At Oasis Wealth, we use fixed income instruments to tie to the retiree’s cash flow needs (the “Matched Bucket”), while generally devoting the rest of the portfolio to an all-stock portfolio (the “Growth Bucket”). Having access to the HEL may be able to provide more runway in the Matched Bucket in the case of extreme downturns in the market, allowing the investor to give the Growth Bucket more time to recover. The costs of the HEL need to be evaluated in relation to the benefits, but there are some low-cost options in the marketplace if one is willing to shop around.
A mortgage may also be used as a tool to help the retiree maintain one’s standard of living over the long-term. Effectively, you are using the equity in your home longer. I am generally not a fan of having to rely on using your home equity to meet your expenses in retirement, but it may need to be a fallback in some situations. While different than a regular mortgage, a reverse mortgage may be a decent use of home equity in one’s later retirement years. There are some disadvantages with a reverse mortgage so that is why I always caution certain individuals from paying down their debt too early in retirement – it may be better off to use a standard mortgage rather than the reverse mortgage. We won’t go into detail on this article, but those are a couple of additional ways to use debt in retirement.
So, there are indeed many factors to consider and it is hard to evaluate your situation on a single year basis. You really need to understand your overall financial and tax situation to make the most informed decision using a variety of tools or help. That is why we are a big fan of financial modeling – or, projecting out your cash flow, income tax, and net worth situation over a number of years. While you can do the analysis using some calculators, the most efficient way – and the least likely for human error – is to do scenario analysis on your situation. One scenario would be paying down the debt, and the other scenario would not be paying down the debt or some variation of the two. And you can see the various tradeoffs and tax implications of the various scenarios. Again, the financial analysis should not control the decision, but you can look at the financial benefits of one strategy and weigh that with the peace-of-mind factor.
The online retirement calculators are obviously not great tools for this type of analysis. If you are ambitious like many engineers we consult with, you might develop your own Excel spreadsheet to provide this analysis. This obviously takes hours and hours to develop, but I know some of you out there enjoy working with spreadsheets and you consider this a fun hobby (or it may be your main hobby). Others might want to buy more sophisticated financial modeling tools that can run $1,500 to $4,000 per year. Or, you can retain a financial planner that has an investment and tax background that works with retirees on these unique issues. The difference in making the right decision on paying off debt or using it as a tool to implement other strategies can run into the hundreds of thousands of dollars in many cases.
Thus, deciding whether to pay down debt leading up to and at retirement should be based on both non-financial and financial concerns. Even if the financial analysis suggests that keeping debt may be favorable for your situation, you may nevertheless want that peace of mind of knowing that your debt is paid off near retirement. I encourage you to take a holistic picture of your situation and take a multi-year view of your cash flow, do some analysis, and take action in deciding whether to pay down debt. The more actions you take – armed with the right knowledge and proper analysis -- will free you up to focus on the life-fulfilling aspects of retirement.
If you or someone you know is facing important issues such as this as they are nearing retirement, we at Oasis Wealth would be happy to have an initial discussion to see how our financial modeling and holistic planning and investment services can provide peace of mind and dollar saving recommendations.