Tips for Managing Debt in Retirement

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. More and more older adults are carrying debt into retirement. Joining me to share some tips on how pre-retirees and retirees should approach their debt is Tim Steffen. He is director of advanced planning for Baird Private Wealth Management.

Tim, thank you so much for being here.

Tim Steffen: Thanks for having me again.

Benz: We've seen data that more and more retirees are carrying debt into retirement. Let's talk about that cohort specifically, and let's talk about how they should manage their balance sheets. If they have some sort of high-interest credit card debt, for example, on their books, I would guess the old rule of thumb about paying that off before you deploy your money anywhere else is sound advice here as well?

Steffen: If you've got several different types of debt out there, you want to line them up on what's the most expensive to the least expensive taking into account tax considerations. Credit card debt, nondeductible, usually the highest rate by far. That's the first one to go. Then you look at other things like home equity loans, mortgages, auto loans, student loans perhaps. You line those up in terms of what's the gross rate, what's the after-tax benefit, and pay those off in order of highest rate to lowest rate.

There's other people who would suggest maybe paying off the smallest loans first just to get that psychological benefit of making a loan go away. I understand that, but I'm still in favor of paying off the most expensive ones first.

Benz: The math doesn't really add up even though the psychological benefit might be there.

Steffen: Right.

Benz: Increasingly, parents are taking loans on behalf of their kids, too. We've seen some data on that front. How should parents approach that?

Steffen: Either borrowing money on behalf of your kids or co-signing loans, which is essentially the same thing. If you co-sign a loan, that's your loan effectively. It can be done. Just be careful with it. If you're loaning money, then taking the loan yourself and turn out making a separate loan to your kids, make sure you've got that well-documented. The stated interest rate, an amortization schedule, a collateral, all that kind of stuff to make it look legitimate in the IRS's eyes, so it doesn't look like a gift.

Benz: The big topic I want to discuss is mortgages, and as people approach retirement or get into retirement, how they should manage their mortgages. Should they prepay their mortgages versus investing in the market? What are some key things that people should think about?

Steffen: The old rule of thumb had always been, you don't want to retire until the mortgage is paid off. It's your biggest monthly expense in all likelihood. Having that off your income statement every month when you don't have a fixed income coming in is kind of a big deal. It used to be, you don't retire until the mortgage is paid. We're seeing a little bit less of that now. As you said, more retirees are having mortgages. As long as they can manage the income side of that, it's just an added expense during retirement as a part of your monthly planning. As long as you plan for that heading into retirement, a mortgage in and of itself isn't a bad thing.

Benz: Does it matter whether I intend to stay in my house or not? How should that fit into the mix?

Steffen: That's all part of the larger planning. If you don't intend to stay in the home long term, just paying your normal monthly payment might be about is all you want to do. If you do intend to make this long-term home, maybe you've already done the downsize thing, and this is the home you intend to spend the rest of your life in, it might not hurt to pay a little bit extra on the loan even just to get it paid off sooner. Leave less for your heirs, for example, if you don't pay it off before you pass. That can be an advantage too as well.

Benz: Home equity lines of credit, you say that's actually something that people should think about lining up before they retire. Why is that?

Steffen: If you are heading into retirement and maybe you've used your available cash to pay off your mortgage because you just didn't want that debt. You've just figured I am going to sleep better at night in retirement knowing I don't have the mortgage. You use your cash to pay that off. Now, if there is some sort of an emergency that happens in retirement--whether it's a medical emergency, a major home repair or something along those lines where you need access to cash--it maybe harder for you to get access to debt or something like that during retirement. The bank is going to look at you as maybe not a good credit risk. You don't have an income stream coming in anymore. What we are encouraging folks to do is, as you head into retirement, if you don't have one already, at least apply for a home equity line of credit. Get it up and running. You don't have to pay on it. You maybe pay some closing costs upfront …

Benz: Maintenance fees possibly.

Steffen: Yeah, an annual maintenance fee. But until you start drawing on it, there's no interest expense, it doesn't cost you anything other than those annual expenses. Have the line available to you. It's going to be a lot easier to get while you're working than it is after you retire.

Benz: The advantage of the home equity line of credit versus, say, other forms of borrowing that I might need to do in a pinch, why is that beneficial?

Steffen: Under current law, you can deduct the interest on a home equity loan up to $100,000. As long as you don't borrow more than that, the interest would be deductible under current tax law. That may change under some of the reform proposals that have been bandied about. But as it stands today, that would be deductible.

If you were to take a loan on an investment portfolio, for example, a margin loan, and you use the loan proceeds for something other than purchasing other investments--so you use it to repair the house or to go on a vacation or buy a car--that interest would not be deductible. It's a common misconception from folks who have margin loans. They just assume, well, if a loan is secure by my investments, the interest is deductible. It's not exactly true. It's really more, what were the proceeds of the loan used for. That determines the deductibility.

Benz: Important topic. Thank you so much for being here to discuss it with us.

Steffen: Thanks, Christine.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.