Clients often express a strong desire to pay down debt, especially when they have accumulated assets or inherited assets that can be used to do so. And while this is a commendable instinct, it is not always the right thing to do. "What, you say, isn't paying off debt the surefire route to financial success?" Not necessarily, and here's why.
Let's start with a few caveats. I'm assuming that the debt we are considering paying off is relatively low interest. By that I mean under 5% and tax deductible, like a home mortgage or home equity line of credit (HELOC). (For more, see: To Invest or to Reduce Debt, That's The Question.)
Higher interest, non-deductible debt should rank as a high priority for elimination. Lower interest, tax deductible debt is more strategic, both from a tax standpoint and from an interest rate hedging standpoint. Here are two situations which I've encountered where I don't believe that paying down such low-interest, deductible debt makes sense.
Betty says now that she is retired she wants to pay off her $150,000, 4%, 30-year mortgage with 13 years left on it. Her parents lived in retirement debt free and she thinks that she should too.
Betty has $250,000 saved outside her retirement plan so she figures that she'll use that money to extinguish the debt. Plus, with the mortgage paid off, she'll have $1,700 (her monthly payment) more to spend. She'll feel better and will have more cash flow. But will she be better off?
First, let’s examine her real after tax savings. The mortgage payment consists of three parts:
- Interest: $500/month
- Principal: $734/month
- Escrow for taxes: $400/month
The real savings is $500/month before taxes and after taxes it is $400/month (20% taxes). (For more, see: Should You Tap into Savings to Pay Off Debt?)
But here's the rub. If after she pays off her mortgage (and feels more relaxed about her cash flow), she spends more than $400/month (her true savings), she will be worse off in the long run.
And, in my experience, that's exactly what she will do. She will feel "freed" from the debt, and will over estimate her savings. In 13 years, she'll have nothing to show from the lowered cash flow, whereas even if she earned zero interest on her invested assets she would have the $150,000 still intact.
Puzzled? The upshot is that we always have to factor in our behavior when we make financial decisions. In this case, your behavior after you pay off debt is tremendously important in determining if you are better off.
Brian also wants to live debt free in retirement for some of the same reasons as Betty. He has the same $150,000 mortgage at 4%, but all his savings are in a qualified retirement account.
Brian wants to withdraw enough from his retirement account so that he can avoid the $1,700/month payment. While he may suffer from the same over estimation of savings, he's also got a big tax problem.
Brian would be better off leaving the $150,000 invested in his retirement account and withdrawing an amount equal to the interest payment because a large lump-sum withdrawal would incur a big upfront tax cost.
In order to withdraw enough to payoff $150,000, Brian would need a $200,000 withdrawal ($50,000 in taxes to pay). The $50,000 that goes to the government could be working for Brian in his retirement account.
If he left the $200,000 in the retirement account and earned 3% (less than 4%, because the $50,000 is working for him), he could withdraw the $500/month earned from the retirement account and use it to pay the interest part of his mortgage.
If instinct tells you to pay off debt make sure you evaluate all the details, including your behavior, before making the decision. (For more, see: When Paying Down Debt Doesn't Make Sense.)