Unconventional Financial Advice for Retirees
The debt load for older Americans is growing bigger. According to the Employee Benefit Research Institute, about two-thirds of US households headed by someone age 55 or older had debt in 2013, up from about half in 1992. But that’s not necessarily a bad thing, and in many cases, it may be a good thing.
Conventional wisdom holds that debt drags people down, especially approaching retirement or in retirement when monthly payments on loans might seem like a particular burden for people on fixed incomes. Of course, loans with high interest rates, such as credit card debt, should be paid down as soon as possible. But certain types of debt can be beneficial—assuming that a retiree understands the risks and takes certain precautions.
Two smart ways you might be able to put debt to very good use in your retirement…
KEEP THE MORTGAGE
Paying off a mortgage as you approach or enter retirement may seem like a positive step—but for many home owners, it can instead prove to be a negative move.
Reason: Paying off your mortgage reduces your liquidity. If you pay it off before you are required to, you may unnecessarily shrink the pool of assets that you have for other purposes. That might leave you in a more precarious—or at least restrictive—financial position than you realize. True, you could take out a home-equity line of credit (HELOC) and plan to borrow against the equity in your home if you ever need cash fast—but home equity sometimes dries up when it’s needed most. Many lenders suddenly canceled or significantly reduced HELOCs during the last economic downturn, for example.
There also are potential tax disadvantages to paying off a mortgage and then, at some point, borrowing against the value of the home. While interest on a primary mortgage is almost always tax-deductible, the interest on a home-equity loan or line of credit sometimes is not. If you are subject to the Alternative Minimum Tax, for example, the money you borrow is deductible only if the money is spent on home improvements.
Furthermore, having a mortgage costs less than you might think, especially when you include tax breaks. Consider this: Most mortgages have an interest rate of 3.5% to 5% these days. You might think that paying off the mortgage, and so no longer having to pay interest on it, is the equivalent of putting the same amount of money in an investment that generates the same amount of interest income. But the interest you pay on the mortgage is tax-deductible. As a result, if your mortgage rate is between 3.5% and 5%, you likely are paying just 2% to 3% on an after-tax basis, assuming that your federal tax bracket is 25% or higher and that you pay significant state income taxes.
Helpful: If your mortgage rate is above 5%, consider refinancing. If you still are working and expect to retire soon, try to refinance before you leave the workforce. That’s because retirees often lack sufficient income to qualify for attractive mortgage terms.
Another tax advantage of keeping a mortgage: If you are not paying mortgage interest, there’s a good chance it will not make sense for you to itemize your tax deductions—which means that you might not be able to deduct things such as gifts to charity and medical expenses either.
Exceptions: Paying down your mortgage could be a smart move if your mortgage rate is well above 5% and you do not qualify for attractive refinance terms…or if your rate is well above 5% and your mortgage balance is below $50,000—with small loan balances, refinancing does not provide enough upside to justify its fees and hassles.
BORROW AGAINST INVESTMENTS
Do you plan to buy an RV and roam the country in retirement? Or maybe you would like to take an entire summer and tour Europe. Most retirees would either dip into their savings to finance large expenses such as these or perhaps take out a bank loan (or, worse, use credit card debt). You might be better off obtaining a “securities-based loan” instead. This type of loan uses your investment portfolio as collateral.
Securities-based loans are similar to the better-known margin loans, but…
- Unlike with margin loans, the money borrowed can be used for purposes other than increasing your investments.
- You might choose to obtain this type of loan from a financial institution other than one that handles your investments, perhaps to get a better rate or because yours does not even offer it.
- The interest rate can be very low—often just 2% to 3%. With rates that low, retirees could reasonably conclude that they are better off taking out the loan rather than withdrawing money from their savings. As long as investments return more than the 2% to 3% paid on the loan, the borrower comes out ahead.
Financing a major purchase with a securities-based loan can help with tax planning—it might mean that you can put off selling those securities and being hit with a capital gains tax bill until a year in which you are in a lower tax bracket. It also preserves your financial flexibility—unlike most car loans and personal loans, these have no required monthly loan payments.
Helpful: Lenders often specify that securities-based loans not be used to purchase additional securities, but there’s a way around this—use the loan to pay other expenses, then use the money you would have used to pay those expenses to purchase additional securities. But take care—borrowing money to increase the amount you invest also increases the amount you could lose.
Caution: Securities-based loans are subject to “collateral calls” similar to the margin calls you might face with margin loans. That means that if the value of the assets used as collateral falls significantly due to losses or withdrawals, the borrower might be required to quickly add cash or other assets to the account. If the borrower cannot do this, shares might be liquidated to cover the cost of the loan. The best way to avoid this risk is to borrow no more than half of the amount the lender says you can borrow based on the size and composition of your portfolio—ideally even less.