Tuesday, November 24, 2009

Should you be DEBT-FREE?

There are many websites, books, seminars and financial gurus out there who promote the idea of being debt-free. Is this a good idea or not? Should you structure your entire financial planning to focus on reducing debt, or increasing savings?

The answer, like much in life, is "it depends". It depends on your income, marital status, age, and your goals and plans. Debt can be, at some points in your life, necessary. But there does reach a point where you should be out of debt, or at least have your debts reduced.

We are born without debt, and die the same way. It is the middle part of life where it gets tricky.

Acquiring debt should be something that is carefully thought out -with a strategy that goes beyond "I can afford the monthly payments". As I have noted before, the monthly payment approach to finances is fraught with peril, particularly when monthly income declines or evaporates.

But should you be debt-free? The financial advisers seem split on this.

The debt-free advisers (which I subscribe to more) point out that when you are retired, you don't want to have the need for a steady cash flow to pay for housing, transportation, and other living expenses. If you can "pay as you go" then you can save your capital for major expenses such as illnesses or assisted living. At some point in life, if you live long enough, you may need to enter assisted living, and have a "paid for" house to sell may make the difference between spending your final years in comfort, or in the State home.

The have-debt advisers (whcih I subscribe to less) argue that having some debt is a good thing, as there is an "opportunity cost" to paying down debt. For example, paying down your mortgage early (doubling payments, switching to a 15-year payoff, etc.) may save you a lot of money in interest payments. However since mortgage interest is relatively low (5% at the time of this writing) and you do get a tax deduction for such interest, it may be a better bet to put that extra money into savings, specifically your 401(k) where it may earn better than 5% in returns and also provide a tax deduction.

So which advisers are right? Should you be debt-free or have some debt? Is it better to pay down debt or use that money to invest?

Well, both are right, in my opinion.

In my view, as an overall goal in life, one should strive to be debt-free by the time of retirement - no car payments, no credit card payments, no mortgage payments. Granted, when starting out in life, it may be necessary to borrow money for student loans, to buy that first car (secondhand, hopefully, using your credit union) and to buy your home. Debt, to some extant, cannot be totally avoided. The key is to minimize debt and avoid "stupid debt" such as credit card debt, consumer financing, and the debt for things you don't really need or can buy secondhand for cash (hot tubs, pool tables, jet skiis, etc.).

By age 40, you should have paid off your student loans, and be in a situation where you don't have car payments anymore. It can be done, if you work toward it. At that point in life, you should have only mortgage debt, which is interest-deductible. During that last 20-25 years toward retirement, retiring this debt as well should be the goal.

By paying down high-interest rate debts first, you are saving the largest chunk of money. Not taking on additional debts (car payments, credit card debt, etc.) is the second step. Eventually, the only debt you should have is home mortgage debt.

Now granted, it is true that you might do better "in the market" investing money rather than paying down debt. However, as we age, we should put more money into safer investments. One rule of thumb (and I generally dislike rules of thumb, but I like this one) is that as you age, the percentage of investments in "safe" investments should reflect your age.

Thus, at age 25, 25% should be in insured accounts or safe bonds. At age 50 - 50%. At age 75 - 75%, etc. One safe investment, in my opinion, is the home you live in, provided you did not overpay for it in one of these bubbles. Now that the dust has settled in the Real Estate market, people are starting to pull back from their earlier panic modes and realizing that in the majority of the country, Real Estate prices are about where they were in 2005 or so. That means that the last few years of "crazy" gains are gone. But over the long haul, Real Estate has been a safe investment for most folks.

Real Estate prices may fluctuate over time, but a home you lived in for 10, 15, or 20 years is not going to drop to zero in value any time soon. Chances are, it will hold its value and gradually increase over time. Owning Real Estate outright is not a bad idea, when you are retired.

So yes, paying down Mortgage debt as you approach retirement is a good idea, as it will significantly decrease your cash-flow needs in retirement, and provide you with a "safe" place to live and a relatively safe investment.

Paying down mortgage debt when you are young, on the other hand, may make less sense, particularly if you are carrying higher-interest-rate debts such as car loans or credit card debt. It also may make less sense if you are not making the full contribution to your 401(k). Even with the current downturn in the market, the returns on most 401(k) accounts have exceeded 5%, often 10%. With the tax deductions available, the effective rate of return is even higher. Putting money aside when you are young has the additional effect of allow you to use TIME as your friend, as money compounding in interest over time will add up to a tidy sum by the time you are retired.

In addition, you will need money when you are retired. If you pay off your mortgage early, you will need to put even more money into retirement accounts, to make up for the lost time in investing. You can't eat a house. If you retire with a "paid for" house and no cash, life will be tough.

My personal goal is to be debt free before I am 60. In that manner, I can live a relaxing retirement, not having to worry about making money to pay for mortgage payments, car payments or other monthly expenses. By limiting my cash-flow needs, I will have a flexible retirement and be able to do things without having to run through my retirement capital.

1 comment:

  1. Update July 2013: Well, by selling the vacation home, the antique tractor, two boats, a jeep, and three cars, we did it. We are debt-free at age 53, not age 60, as I postulated in this posting.

    It turns out, after I analyzed my finances, that I could have been debt-free all along, "but for" my "need" to have lots of toys and bling. Granted, they were fun, but they required a monthly cash flow in the thousands and thousands of dollars (mortgage payments, taxes, insurance, upkeep, etc.).

    So now we are debt-free, and I can tell you, it is a pretty liberating feeling. I don't "need" to work anymore, if I don't want to. Or maybe just a little bit to pay my taxes.

    Retirement looks a lot rosier now! And sooner!


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