The Value of Debt in Retirement

[photoguy]

I just skimmed through the thread and didn't see this mentioned but with respect to a mortgage I would prefer to have one not so that I can invest the money at higher expected return, but to preserve the walk-away option.

E.g. you buy a house in california and it gets leveled by an earthquake but since you have a mortgage you can just walk away. Alternatively, one of my co-workers had his house in florida fall into a limestone sinkhole.

 

[daylatedollarshort]

I just skimmed through the thread and didn't see this mentioned but with respect to a mortgage I would prefer to have one not so that I can invest the money at higher expected return, but to preserve the walk-away option.

E.g. you buy a house in california and it gets leveled by an earthquake but since you have a mortgage you can just walk away. Alternatively, one of my co-workers had his house in florida fall into a limestone sinkhole.

Good consideration, though I do not think all mortgages in California are non-recourse. It depends on factors like refinancing and when the refinancing occurred since the laws have changed over time.

But overall I agree that is another important aspect to consider, especially in states with natural disasters that may not be covered by homeowner's insurance.

 

[Niuatoputapu]

I agree it has been a good discussion, and I agree the answer is "it depends".

We are close to retirement with 27 years left on a 30 year/10 year ARM refinanced mortgage (California). Over the past ten years, we had a choice to either pay down the mortgage or max out our Roth IRAs, and we chose the latter. Now happily have Roth balances that are greater than the remaining mortgage, and will pay 2.875% mortgage interest for another 7 years while hoping the Roth investments return better. Odds are 50/50 we'll stay in the house after 7 years, but if we do, we'll deal with the adjusted rate when it happens.

 

[Golden sunsets]

This sounds like the advice Ric Edelman has been giving for years. And the opposite advice of what Dave Ramsey tells his millions of followers daily. Whatever helps you sleep at night is the right answer. But liquidity is a must if you do payoff your mortgage sooner than later. Dave Ramsey tells people daily to pay off their mortgage as they head into retirement and these people are using a huge chunk of their overall retirement nest egg to do it. Thats just irresponsible. I get the whole "slave to the lender" thing but a well funded diversified portfolio will outperform a 3% mortgage and will also provide a retirement paycheck to make the house payment.

We paid off our mortgage before retirement the old fashioned way, one payment at a time, through our working careers. Despite three moves and three home sales and purchases our intentions were always to manage our mortgage so that the money borrowed decreased over time as our home equity increased culminating in a mortgage burning party just prior to retirement. That is not being irresponsible. Would you have advised us to then remortgage that home and invest the money in the market just as we retired?

 

[Pilot2013]

We paid off our mortgage before retirement the old fashioned way, one payment at a time, through our working careers. Despite three moves and three home sales and purchases our intentions were always to manage our mortgage so that the money borrowed decreased over time as our home equity increased culminating in a mortgage burning party just prior to retirement. That is not being irresponsible. Would you have advised us to then remortgage that home and invest the money in the market just as we retired?

I'm not sure if others have stated, as a strategy, to "take a mortgage" at retirement to use as investment for retirement funding. Certainly, paying off your mortgage as you also fund your retirement, would not be irresponsible but would be the choice option IMHO. I think the poster that made the irresponsible statement was referring to paying mortgage off in lieu of retirement funding, or worse, pulling LIMITED retirement funds to pay it off. Note the LIMITED. If you have several million $'s and decide to pull $300k to pay off mortgage, have at it.

I am interested in the author's thoughts on debt as part of personal finance strategy. Interested, but not necessarily buying in....

 

[MildlyEccentric]

To illustrate a point, I gave two scenarios to FIRECalc.

#1 - $30,000 spending a year, Portfolio $300,000, 10 year horizon, no mortgage.

#2 - $35,729 spending a year, Portfolio $400,000, 10 year horizon, $100,000 mortgage.

The second scenario is essentially the same as the first with the addition of a $100,000 30 year mortgage at 4%. The annual payments (P+I) for the $100,00 mortgage would be $5,729.

This is intended as a simulation for someone who wants to retire 10 years early. After the 10 years, they receive a pension/social security which would more than cover their expenses (including the mortgage). The higher spending in scenario 2 is the cost of the mortgage. The higher portfolio in scenario 2 is the extra money they would have in their portfolio because they didn't pay off the mortgage.

In scenario #1 with no mortgage, 30 cycles failed, for a success rate of 77.6%.

In scenario #2 with a mortgage, 17 cycles failed, for a success rate of 87.3%.

This illustrates how a mortgage might help someone who is attempting to bridge the "no income" period leading up to full retirement. By holding onto the mortgage, the chances of successfully surviving the period of no income
might be increased significantly.

 

[Pilot2013]

To illustrate a point, I gave two scenarios to FIRECalc.

#1 - $30,000 spending a year, Portfolio $300,000, 10 year horizon, no mortgage.

#2 - $35,729 spending a year, Portfolio $400,000, 10 year horizon, $100,000 mortgage.

The second scenario is essentially the same as the first with the addition of a $100,000 30 year mortgage at 4%. The annual payments (P+I) for the $100,00 mortgage would be $5,729.

This is intended as a simulation for someone who wants to retire 10 years early. After the 10 years, they receive a pension/social security which would more than cover their expenses (including the mortgage). The higher spending in scenario 2 is the cost of the mortgage. The higher portfolio in scenario 2 is the extra money they would have in their portfolio because they didn't pay off the mortgage.

In scenario #1 with no mortgage, 30 cycles failed, for a success rate of 77.6%.

In scenario #2 with a mortgage, 17 cycles failed, for a success rate of 87.3%.

This illustrates how a mortgage might help someone who is attempting to bridge the "no income" period leading up to full retirement. By holding onto the mortgage, the chances of successfully surviving the period of no income
might be increased significantly.

Interesting. Dependent on where their "pre full retirement" income is coming from, that interest might help out as well (although admittedly, not in the case you provides as Std Deduction would likely exceed Itemization.

 

[pb4uski]

To illustrate a point, I gave two scenarios to FIRECalc.

#1 - $30,000 spending a year, Portfolio $300,000, 10 year horizon, no mortgage.

#2 - $35,729 spending a year, Portfolio $400,000, 10 year horizon, $100,000 mortgage.

The second scenario is essentially the same as the first with the addition of a $100,000 30 year mortgage at 4%. The annual payments (P+I) for the $100,00 mortgage would be $5,729.....

I think a firecalc simulation is a useful way to assess it but I think your 10 year time horizon is a suboptimal way to model it. If one has a mortgage, what I would do is a full retirement projection including the annual mortgage payments as a off-chart expenses offset by a non-COLA "pension" of equal amount when the mortgage payments end. Then compare that to an alternative that omits the mortgage payments and "pension" and reduces the assets by the mortgage balance.

It is important to include the mortgage payments as an off-chart spending and offsetting pension because if they are included in living expenses they last for the entire projection period and get increased for inflation every year, which is contrary to having a fixed mortgage payment.

 

[ERD50]

To illustrate a point, I gave two scenarios to FIRECalc.

#1 - $30,000 spending a year, Portfolio $300,000, 10 year horizon, no mortgage.

#2 - $35,729 spending a year, Portfolio $400,000, 10 year horizon, $100,000 mortgage.

The second scenario is essentially the same as the first with the addition of a $100,000 30 year mortgage at 4%. The annual payments (P+I) for the $100,00 mortgage would be $5,729.

....

A couple points - did you enter the mortgage 'off chart spending' and 'not inflation adjusted'? If you just change spending on the first page, it will increase the mortgage payment with inflation, which is not what happens with a fixed mortgage.

If you run the scenario less than 30 years with a 30 year mortgage, you never see the benefit of the mortgage term ending.

That said, these historical reports may not be all that great for evaluating mortgage payoffs - there were many times in history when a low rate mortgage would not be available, so it may be artificial to use a 3-4% rate when rates were really 10%.

edit/add - ooops, cross-posted with pb4uski!

-ERD50

 

[pb4uski]

....That said, these historical reports may not be all that great for evaluating mortgage payoffs - there were many times in history when a low rate mortgage would not be available, so it may be artificial to use a 3-4% rate when rates were really 10%. ...

Good point that I had forgot about.

 

[Running_Man]

The article proposes that an individual with a million dollar portfolio should have $500,000 in debt and if that was put on a house you would now have additional 500K after tax assets and $27,788 annually of additional cash payments to bank to fund. The suggestion in the articles is a proposal of financial optimization, which is both good and bad.

There are many points where this would be an advantage:
1. Increases after tax assets to provide flexibility on before tax withdrawals and lower taxable income in those cases.
2. Advantages for Affordable Care Act in minimizing health care costs.
3. Tax deductibility of interest could leave more room to potentially increase Roth conversions
4. Funds could be used to forestall taking of Social Security to age 70, bridging the 62 to age 70 gap.
5. Average market performance will provide a portfolio growing at quite a bountiful pace.

But there are also pitfalls:
1. Major market fall early on could immediately make this an untenable situation as with a 40% fall in portfolio value a portfolio that was originally 4% withdrawals without debt becomes 4.5% with debt. This means with a 40% fall in portfolio in a major bear market withdrawal becomes 7.5% in the debt portfolio versus the 6.6% in the non-debt portfolio - before tax effecting tax benefits. In order to equalize risk you need to find $7,500 in cash tax benefits.

2. If a married couple and one becomes very ill the protection afforded by having assets sheltered in a home for eligibility of Medicare upon needing long term nursing care is lost and the need for insurance to offset is compelling. That is a cost that should be included in the equation as well.

3. It would tend to incentivize investors to stay in a more expensive house than they otherwise might keep. If you have a house valued at 600K a 500K mortgage could be viewed as optimizing the portfolio. Likewise though considering selling and moving to a lower cost or smaller home at 300K house would also likely provide a tax free 300K for investing as well and provide many or even more (lower property taxes, utilities etc) of the same benefits at far lower risk (portfolio withdrawal in this case drops to 3.07 percent when you add 300K to a million dollar financial portfolio).

4. It is simply an unfortunate fact that as one ages the ability to be swindled increases, as the cognitive ability to recognize bad characters decreases over time. If the more financially astute spouse dies first the survivor is much more susceptible to losing everything. There are no corporate treasurers monitoring this debt plan.

5. The amazing ability of some people to overspend as long as there is money in the bank, and we have seen many threads on these boards on this topic could be enabled by increasing debt. Have to be sure the household CFO has proper cost controls in place.

Overall I do agree that taking the debt especially with present interest rates would probably maximize the estate value upon death of the owners. I think the younger a retiree is the more sense it would make to hold the debt ratio as proposed. I personally view the increasing risks as to become more important than tax benefits for those over age 70.

 

[sengsational]

I don't think this is an issue that can be individually financially optimized with a maxim, generic article or emotions. There are many factors to consider including but not limited to taxes, retirement income sources, tax brackets, local appreciation rates, historic interest rates and ACA credits. We run everything in the RIP and our own spreadsheets. Even future RMDs might be impacted by having a mortgage or not in the pre-70 years. I could never do all the calculations in my head. I always get surprising results when I run all the numbers.

For me, it's easy to see that paying off the mortgage would harm my ability to spend while staying short of the cliff. The value of the subsidy is much more than the interest I'm paying. Not only is not paying off the mortgage a no-brainer, but also getting a HELOC to extend the subsidy another year or two is on the horizon.

 

[Pilot2013]

I think any analysis I would make pertaining to this would be "bridge" time between ER and FRA or even pulling SS at 70. By those times, I think I would want mortgage gone.

As for the "assets sheltered by a home" and medicare for long term care, that's a big question mark. My MIL (who unfortunately just passed away), was struggling with dementia. They were swindled by some attorney in OH (that has since been disbarred) into putting their ~$200k house into an irrevocable trust to "protect" it from long term care costs. They have/had VERY little cash assets, guvm't pensions. Finding Long Term Care that will start off with Medicare is next to impossible. All of them (decent, private ones) want some duration of paid care and then when exhausted will turn to Medicare. It was a nightmare.

The attorney that scared my MIL into this crazy Irrevocable Trust deserved to be disbarred!

 

[daylatedollarshort]

For me, it's easy to see that paying off the mortgage would harm my ability to spend while staying short of the cliff. The value of the subsidy is much more than the interest I'm paying. Not only is not paying off the mortgage a no-brainer, but also getting a HELOC to extend the subsidy another year or two is on the horizon.

+1. It is a no brainer for us with a cliff for both ACA credits and college financial aid. Plus we have to watch not just our taxable income but what the kids earn from internships and summer jobs, so it helps to have the after tax money to stay under the cliffs.

We make more in financial aid and tax credits than we pay in mortgage interest.

 

[Clone]

I am living this discussion right now. We are going to take a mortgage on a house. I will need to make a decision as follows:

Do I pull money from my investment accounts to pay off the mortgage? (This would take several years so as to not jump into the 33% tax bracket)

or do I maintain a mortgage?

Income (Pension, rental income, 2nd career or SS) exceeds expected living expenses (and keeps me planted firmly in the 25 - 28% incremental tax bracket.

The effective interest rate on the mortgage would be 2.7% if I take a 30 year, or 2% if I take a 15 year. (Given that the interest is tax deductible).

Thus, if my portfolio returns greater than 3%, I am money ahead to pay off the mortgage on the monthly schedule.

If the market were to drop significantly, and stay there, then I would lament that I had not pulled my money out of the market.

I suppose I really need to understand MRDs better. I could be setting myself up to get locked into a higher tax bracket when they kick in. Anybody have some good reference sites that explain MRDs? I am already pulling an MRD from an inherited IRA, so I assume it is a similar equation? If the MRDs put me into the 33% bracket, then I probably need to pull money from the market each year right up to the edge of the 33% bracket. That would go against the mortgage.

First world problems...

 

[daylatedollarshort]

I suppose I really need to understand MRDs better. I could be setting myself up to get locked into a higher tax bracket when they kick in. Anybody have some good reference sites that explain MRDs? I am already pulling an MRD from an inherited IRA, so I assume it is a similar equation? If the MRDs put me into the 33% bracket, then I probably need to pull money from the market each year right up to the edge of the 33% bracket. That would go against the mortgage.

First world problems...

I don't have a perfect solution but using the Fidelity RIP and looking at the year by year cash flow and tax details with and without a mortgage payment is helpful. We have more savings and less in the house if we downsize and don't have a mortgage, but interestingly our overall net worth in our particular circumstances didn't change too much either way. I was surprised that downsizing didn't come out ahead more.

 

[harley]

The attorney that scared my MIL into this crazy Irrevocable Trust deserved to be disbarred!

I think the word you were looking for was "horsewhipped".

 

[MildlyEccentric]

A couple points - did you enter the mortgage 'off chart spending' and 'not inflation adjusted'? If you just change spending on the first page, it will increase the mortgage payment with inflation, which is not what happens with a fixed mortgage.
-ERD50

I did not run the mortgage payment off chart. If I rerun scenario #2 with the mortgage payment off chart and not inflation adjusted the results are as follows:

Scenario #1 with no mortgage is unchanged. 30 cycles failed, for a success rate of 77.6%.

In scenario #2 with a mortgage, 10 cycles failed, for a success rate of 92.5% which is about a 5% improvement over the original run.

So, maintaining a mortgage improves the chance of successfully spanning the ten years of early retirement by about 15% over prepaying the mortgage (in this test case).

YMMV

 

[imoldernu]

What Running_Man said: +1

 

[Meadbh]

I have a couple of mortgages on rental properties. Currently they are slightly cash flow positive, but generate any tax liability because of depreciation. I bought them with a view to generating an income stream later on. If I do nothing, and the 4.1-4.2% interest rates on the mortgages stay the same, both properties will be paid for within 9 years. While the current mortgage rates seem "high", they represent a blend downwards from the original rates, which were very competitive at the start of the term.

I have been looking for high yielding fixed income investments for my spare cash. Right now, paying down some principal on those mortgages is better than anything else I can find. I recently chopped a couple of years off the payback period of one of them.

So I would say yes, debt can be a useful tool in retirement. Like any other tool, it needs to be carefully used.