I’ve seen some disturbing data points recently:
- 78 percent of American workers report living paycheck to paycheck. This became very visible during the recent government shutdown.
- 40 percent of Americans said they couldn’t cover a $400 unexpected expense without going into debt. That number jumps to 60 percent for a $1,000 expense.
- A record 7 million Americans are 3 months delinquent on their car loans.
- In 2018, student loan debt hit $1.46 trillion and $166 billion of that is seriously delinquent. Both record highs.
- People in their 60s with student loans owe an average of $33,800 in student debt. They owe $86 billion total which is a 161% increase since 2010.
- People over 60 owed $615 billion in credit cards, auto loans, personal loans and student loans as of 2017. That’s an 84% increase since 2010 and the biggest increase of any age group.
- The percentage of bankruptcy filers older than 65 is higher than it’s ever been.
Whatever the reasons, we’re spending too much, saving too little and living on the bleeding edge of financial insecurity. Sure, everyone on Facebook looks like they’re #LivingTheirBestLife, but peer behind the curtains and there’s trouble. To make matters worse, all of this is happening at a point in time when the economy is in relatively good shape, unemployment is at multidecade lows and the stock market is near all-time highs. What happens if/when we have another recession?
I’m going to spend the next several posts discussing these worrisome trends and talking about how you can overhaul your expenses, save more and improve your retirement security. Today, however, I’m just giving you a friendly reminder. The general idea behind retirement is to reach a point of financial independence where work is optional. If you’re not on track for financial independence, you’re doing it wrong. Stay tuned over the next few weeks and I’ll give you some practical ideas on how to get there.
Hardly a week goes by that I’m not asked the question: “Should I pay off my mortgage before I retire?” The answer, of course, depends. On math. On your situation. On your personal preferences. Let’s look through some of the key variables to consider and then I’ll tell you what I’m doing with my house (spoiler alert: I’m a big proponent of retiring debt free) and give you some tips on how to retire your mortgage early, should you choose to do so.
Variables to consider
Interest rate. What is the interest rate on your mortgage? If you buy a $250,000 home and have a 30-year mortgage at a rate of 4%, you’ll pay $179,674 in interest over the life of that loan. That same loan at 6% would cost $289,595 in interest, about $110,000 more. The higher your interest rate, all else being equal, the more incentive there is to pay it off sooner.
Other debt. Mortgage rates are typically lower than rates on other forms of debt like credit cards or car loans. If you look strictly at the math, it makes sense to pay off your higher interest rate loans first. If you carry a credit card balance or car debt, focus on those first. Once those are gone, you can target your mortgage.
Investment alternatives. Your house is an investment. Whether you use available cash to pay it off will partly depend on the other investment opportunities you have for that available cash. If your mortgage is 4%, but you have another investment opportunity that yields 8%, it might make sense to hold off on the house and invest the cash at the higher rate. Just keep in mind that paying off your house offers a guaranteed return (the interest disappears), while alternative investments likely do not.
Income sources in retirement. Think about your income sources in retirement. Social Security. Pension. Income from your investments. Add that up and then compare it to your retirement budget. Is there enough there to easily service your mortgage without limiting your other plans for retirement? If so, carrying a mortgage in retirement might not be a burden. If not, it might make sense to pay it off early.
Nest egg. Are you on track with your retirement savings? Are you maxing out your 401k and IRA contributions each year? If not, focus on those things first and then, if you still have some extra cash, consider paying down your house second.
Peace of mind. The decision to pay off your house isn’t entirely numbers based. I’ve had plenty of clients who could justify carrying a mortgage, but they paid it off anyway because they wanted the peace of mind of being debt free. I’ve never had a single client tell me that they regret the decision to pay off their house.
How long will you live there? Do you plan on downsizing to a different house or moving somewhere else in retirement? If you only plan on being in your current house for a few more years, it might not make sense to pay it off. If you plan on being there for a while, however, owning it outright would probably be best.
Tax considerations: Many people argue against paying off your house because of the “tax benefit.” Recent changes to the standard deduction make this argument less compelling, but even before then, I think this argument didn’t hold water. Consider a person in the 20% tax bracket who paid $10,000 in interest and got a $2,000 deduction. They paid $10,000 to get $2,000. Better to pay it off, spend a little more on taxes and save the $10,000 in interest.
What I’m doing and why.
As you’ve probably guessed (both from this article and others I’ve written on debt), I’m paying my house off early. I thought through the math, but to be honest, that was secondary. The three primary drivers of my decision are:
- Peace of mind: I sleep better when I’m debt free.
- Security: Debt adds risk and reduces cash flow. Both are bad for retirees.
- Priorities: According to the Employee Benefits Research Institute, the average retiree spends 40-45% of their budget on housing. I have other plans for that money! (For more, read The benefits of an extravagantly modest lifestyle)
A few tips to pay it off early.
Below are a few strategies I use:
- Set a goal and re-run the amortization schedule: If you have 7 years until retirement and want to have the house paid off by then, re-run your loan amortization for 7 years and figure out how much extra you need to pay each month to reach your goal.
- Make it automatic: Once you know how much you need to pay each month, make it automatic. Saving in your 401k is easy because it automatically comes out of your paycheck. Set up your extra principal payments to do the same thing.
- Refinance: Rates are still historically low. If you haven’t refinanced in a while, call your bank to see if it would make sense. Just don’t refinance into another 30-year loan. Keep the payback period as short as possible so more of your payments go to principal.
- Stop escrowing: This is more of a mental trick. When I started paying off my house early, I got discouraged each month at how much of my payments went to taxes, insurance and interest. So I called the bank and asked them to stop escrowing. Yes, I still need to pay my taxes and insurance, but now those bills come separately. Most of my payments go to principal and I’m forced to save extra to cover the taxes and insurance.
- For more ideas, read How (and why) to retire debt free and Your biggest retirement expense (and how to get rid of it).
In life, we often have the option to do things the easy way or the hard way. We can choose between the wide and narrow roads. Paradoxically, choosing the easy way out often leads to a hard life while choosing the hard way often leads to an easy life.
Narrow, difficult decisions that require discipline and sacrifice usually pay off by leading us into a place where the road is wide and our options are plentiful. On the other hand, taking the wide, easy path often ends up funneling you down a narrower and narrower chute until all good options are gone and all that is left are painful consequences. In short:
Easy choices, hard life. Hard choices, easy life.
Nowhere is this more true than with our finances. We all stand at a fork in the road when making decisions on things like debt, saving, investing and giving. Path A is wide and well worn. Reach for that credit card. Try to keep up with the Joneses. Feed those desires. The other path, as Robert Frost might say, seems a bit grassy and in wont of wear. Live within your means. Give generously. Save for the future. Steward those resources wisely.
Perhaps not surprisingly, my advice on finances (and pretty much everything else) encourages you to take the road less traveled. Sure, doing so will be difficult and take discipline, but it will ultimately lead you to a place of peace, security and comfort.
Every year the flu kills about 36,000 people in the United States. Those who die typically have an immune system that is already compromised in some way, such as by age or illness. In other words, it’s not necessarily the strength of the flu that is so dangerous, but the weakness of some immune systems.
In the same way that the flu virus can disproportionately affect those with weakened immune systems, a financial virus can disproportionately affect those with compromised financial health. The virus could be something as simple as an unexpected car repair or something a bit more serious like a market crash, job loss, divorce, disability, illness or unexpected death. How well you’re able to respond to those things depends on how financially healthy you are and how well you’ve immunized yourself against those threats.
Some people are fragile and at risk. Others are financially resilient. The closer you get to retirement, the more resilient you want to be so that something unexpected doesn’t derail decades of planning. Below are five things that, financially speaking, will either make you weak or strong, depending on how you handle them.
How much you owe. There are many tell-tale signs of a person who is financially fragile and having too much debt is often the most obvious. When you take on debt, you are bringing future consumption to the present. That gives creditors a legal claim on your future earnings, which reduces your cash flow, increases the risk that you will run out of money and limits what you can afford to do. Get rid of your debt, however, and not only will you be more financially resilient, but you can also retire sooner. Unfortunately, years of low interest rates have encouraged exactly the opposite behavior. What’s a good level of debt for a retiree? Shoot for zero.
How much you spend. If you live at or above your means, you are financially fragile. That’s true whether you make $50,000 per year of $500,000. Here’s the good news. Most of the people reading this likely have the ability to live significantly below their means. What if you spent 10% to 50% less than you made every year? Would that give you a certain resilience? You wouldn’t be worried about an unexpected car repair, I can tell you that much. So take a stand against lifestyle inflation. Just because you will earn more money this year than you did last year doesn’t mean you have to spend it. Set a lifestyle cap and save the rest.
How much you’ve saved. If you spend less than you make, you’re able to save. That savings not only protects you in the short term (i.e. emergency fund), but it allows you the financial freedom to live the life you want to live in the long run (i.e. retirement). In other words, savings is the secret sauce in both security and independence. How much should you have saved by now? This article will give you a rough idea.
How well you’ve planned. Most people don’t have a plan for retirement. They don’t know what they want to do, how much it will cost or whether or not they are on track to save enough to pay for it. Not surprisingly, that creates a great deal of anxiety, uncertainty and—you guessed it—financial frailty. If you are among the 88% of people who don’t have a written plan, your retirement will probably fall far short of what it could be.
A plan can also help inoculate you against bad decisions. Sometimes a financial virus takes the form of fear and uncertainty. When we’re scared, we tend to make unwise and irrational decisions. To navigate those waters, it’s good to have a North Star. The wind can blow and the seas can rage, but when you look up, it will be there. A detailed retirement plan can act as that North Star. If you have a long-term plan—you know where you are, where you want to be and how you’re going to get there—you can inoculate yourself against short-term fear and uncertainty. When you have context and you understand the big picture, you’re less likely to be blown off course or panic and make a mistake. For help with creating a plan, check out my Ideal Retirement Design Guide or touch base with me if you want some one-on-one help.
How well you’ve prepared for the unexpected. What if something happened to you or your spouse? Would that derail your finances? Are your legal and financial affairs in order? Life is unexpected. The more “What if?” planning you do, the more resilient you will be in the face of tragedy. Here are two articles and a guide that can help:
That’s five ways to boost your immunity, harden your defenses and make yourself more financially resilient. But they only work if you take action. Modern medicine has given us many miracle vaccines, but they only work if you take them. So too, financial vaccines are either contagion or cure, depending on what you do with them.
The current bull market is 9 years old. That’s the second longest on record and it has people wondering how much further it can go. That question has taken on added urgency given the recent volatility, rising interest rates and political uncertainty. Markets lost ground in February (the first losing month in over a year) and they’re on track to close lower in March as well. Is this the beginning of something bigger? Should you make changes to your portfolio or otherwise prepare for a deeper downturn? I’ll share my thoughts below.
Keep Things in Perspective
First of all, I think it’s good to keep things in perspective. Yes, there have been some scary drops recently. In February, the Dow had its two biggest point drops ever. The S&P 500 had four of its largest drops ever. On a percentage basis, however, those drops didn’t even crack the top 20. Still, when the daily loss has a comma, it’s disconcerting. Just try to remember that pullbacks are natural and healthy, especially after the outsized gains we’ve had over the last several years. At the beginning of this bull market (the end of the Great Recession) the Dow was below 7,000 and the S&P was below 700. Now, even after the recent selling, they’re around 24,000 and 2,600 respectively.
Watch the Fundamentals
Warren Buffett has famously said that in the short-term the market is a voting machine, but in the long-term it’s a weighing machine. In other words, fundamentals matter more than feelings. How do the fundamentals look? In a word, strong. GDP and corporate earnings are growing at the fastest pace in years. The tax cuts will boost profits even more. Job creation continues to surprise on the upside. Unemployment is low. Consumer sentiment and consumer spending are very strong. Interest rates are still relatively low. Most signs point to a healthy and growing economy.
3 Key Risks
While most indicators are positive, that doesn’t mean that investors should be complacent. The bullish case is always strongest right before it’s not. And even if the fundamentals stay strong, you can still get some nasty price corrections. What are the key risks?
I see three primary risks right now: 1) Valuations, 2) Interest Rates, and 3) Political/Geopolitical risks. Because of the strong economy, stocks have been going up and valuations are at the upper end of their historical range. Markets are priced for perfection. What if we don’t get it? To quote John Mauldin, an economist I follow, “the consequences of a mistake are growing.” Or what if the Fed raises rates too aggressively? That could tip the economy into recession. And the uncertainty in Washington is not helping. If we get into a trade war with China or the Mueller investigation finds serious wrongdoing, markets will not react positively.
How to Protect Yourself
I said earlier that pullbacks are healthy. What do I mean by that? Economist Hyman Minsky had a theory that stability leads to instability. In other words, when the economy and markets are good, it encourages more and more risk taking. People start to focus on reward and ignoring risk. They invest too aggressively. They take on too much debt. They save less. They get complacent. And then a shock hits the system, losses start to build and people panic. The bottom falls out. That sudden instability is referred to as a Minsky Moment. The longer the period of stability, the greater the likelihood that people are making decisions that will eventually lead to serious instability. Periodic corrections are healthy because they keep people from straying too far from home.
Which brings me to the question at the beginning of this article. Should you prepare for a deeper downturn? The answer, of course, depends. During this 9-year bull market, how far have you strayed or drifted from your appropriate investment and retirement strategy? How can you tell? Here are 7 areas to look at closely.
Risk Tolerance. The longer a bull market goes, the less people worry about (or even think about) risk. That’s a problem, because the economy and markets usually revert to the mean. What would mean reversion look like now? We’ve gotten a taste of it over the last several weeks. After years of rising markets, they start to fall. After years of almost non-existent volatility, it spikes. After a decade of historically low interest rates, they start to climb. If the market dropped 20-30% this year, how would that impact your portfolio? Could you (would you) just ride it out? If not, you should probably dial back your risk.
Asset Allocation. The two primary ways to manage risk are through diversification and asset allocation. Look at your portfolio. Do you have any outsized positions? Is your stock/bond balance appropriate given your risk tolerance? Has your allocation drifted or changed over the years? Review your portfolio and align your asset allocation with your risk tolerance.
Time Horizon. All of this is a bigger deal if you’re at or near retirement. You have less to worry about the longer you have to go. Even after the 57% peak to trough drop in 2008-09 the markets fully recovered within about 4 years. Those who rode it out did fine. Could you ride out another major downturn? If you’re already retired, maybe not. At the very least you’re 9 years closer to retirement than you were during the last serious pullback. And even if you have time, sharp drops can cause you to make mistakes and do the wrong thing at the wrong time, so see points 1 and 2 again. Make sure you understand your risk tolerance and that your allocation is aligned with that.
Spending. Most people have lifestyle bloat as they get older. As income grows, so do expenses. Bigger paychecks mean better houses, cars, vacations, wardrobes and gadgets. That’s not necessarily bad, but the longer good times persist, the closer we tend to push our spending to the outer limits. That makes a person financially fragile. It can cause stress, limit your options and force you to make compromises in life. You control your spending. Beware of bloat. The more you live below your means, the more financially resilient you will be. And when you splurge on things or add expenses, do your best to make that spending discretionary rather than fixed. That way you can dial back if your income drops or the economy heads into recession. See this article on how to use dynamic spending to make your money last.
Debt. One of the characteristics of long bull markets is that people load up on debt. The boom years make them more comfortable borrowing for cars, houses and credit cards. Having debt adds risk and reduces cash flow, two things that are especially troublesome for a person at or near retirement. If you want to be better positioned to weather a financial storm, get rid of debt.
Saving. The average savings rate in 2015 was 7.19%. In 2016 it fell to 5.98%. Last year it fell to 3.74%. Care to guess which direction it will move in 2018? This is what Minsky was talking about. Stability leads to instability. People become complacent. They save less, which means they have less of a buffer, which means they’re less able to weather a storm.
Cash. It’s always a good idea to have a portion of your portfolio in cash or short-term securities. That way, if markets drop and a good investment opportunity presents itself, you’ll have some dry powder to invest. Or, if you’re already retired and taking distributions from your portfolio, you can pull your distributions from your cash rather than selling your stocks into a declining market.
Will the markets drop further? Who knows. The risk is certainly there. The important thing is to focus on the things you can control and make sure that if we get another downturn, it won’t derail your plans.
The amount of debt in the world is staggering.
- Auto loans recently passed $1 trillion for the first time and the average car loan is the highest it’s ever been, recently surpassing $30,000.
- Student debt stands at about $1.4 trillion.
- Mortgage debt is about $14 trillion.
- More than 30% of households carry a balance on their credit cards. Those that do have an average balance of $16,000
- The top 2,000 non-financial companies have $6.64 trillion in debt, $2.81 trillion of which they’ve added in the last five years.
- The U.S. public debt has nearly doubled since the 2008 financial crisis, ballooning from $10 trillion to more than $19 trillion.
- 20 years ago China had $500 billion in public and private and debt. Ten years ago that number stood at $3.5 trillion. Today it is more than $35 trillion.
More than the amount of debt, however, is just how much of it has been added since the 2008 financial crisis. After experiencing a debt induced financial Armageddon, you’d think individuals, companies and governments would be hesitant to go down that road again. Not so. Record low rates have fueled trillions (with a “T” like the Titanic) in new debt. It’s like eating until you’re sick at a buffet and then deciding that the next logical step is to grab a new plate and see how many cheese enchiladas and Mini BBQ Brisket sandwiches you can fit on it.
And just like binging at the buffet is likely to end badly, binging on debt will usually end in a combination of regret and real world consequences. How is all this debt affecting us and our ability to reach our retirement goals?
It’s causing stress. A recent survey of adults with student loan debt showed that people would go to some pretty extreme lengths to get rid of that debt. Nearly 57% would take a punch from Mike Tyson. More than 40% would give up a year of life expectancy. Almost 7% said they’d be willing to cut off their own pinky finger. Think about that. A not insignificant percentage of the borrowers polled would be willing to die sooner or hack off body parts if they could turn back time and get out from under their debt. Living with excessive debt is stressful.
It’s making us financially fragile. A recent Federal Reserve survey found that 47% of Americans could not cover an unexpected $400 expense without borrowing or selling something. In other words, half the country is stretched so thin that they couldn’t afford a car repair or a new pair of glasses without some sort of payment plan. There are likely many reasons for this state of affairs, but one is most assuredly debt. In other words, we need to go into debt to fund new purchases because all of our income is already being used to pay for the debts from our old purchases.
It’s limiting our ability to save for retirement. Each year the Employee Benefits Research Institute (EBRI) conducts a Retirement Confidence Survey to see how people are doing when it comes to saving for retirement. In the most recent survey, nearly a third of respondents reported having less than $1,000 saved so far. Two-thirds have less than $50,000 saved. You don’t need to be a financial genius to know that $1,000 is not enough to fund a 20 or 30 year retirement. Even $50,000 would only get you a year or two at best. Why aren’t we saving more? Again, one reason is debt. If most of your current money is being used to pay for past purchases, you won’t have much left over for future savings.
It’s exposing retirees to market risk. Even if you are near retirement and you have no debt, you may still be at risk from debt indirectly. That’s because, with interest rates so low, many retirees have been forced to move further up the risk spectrum to get any sort of yield on their investments. It used to be that you could put your money in a risk-free money market and earn 3%. Now those same investments pay 0%. Super safe bonds don’t yield much better, so many investors are shifting more of their portfolio to lower quality bonds or dividend paying stocks. That works fine while markets are rising, but if we get another debt shock and borrowers can’t repay, then markets could tumble and many investors may find that they took on too much risk in their search for yield.
How much debt is ok?
To be sure, not all debt is bad. Debt can be a useful tool when it’s used to purchase an asset or invest in a project that helps us to generate income and pay back the debt. That said, in order to retire comfortably, the typical person needs to move from a place of low savings and high debt early in their career to a place of high savings and low debt later in their career.
What should that gradual reduction look like? To help people track their progress, researcher Charles Farrell devised a Debt to Income Ratio and then established benchmarks for different age groups. According to Farrell, your debt (e.g. mortgage, car loans, credit cards, etc.) divided by your income should be 1.25 at 40, .75 at 50, .20 at 60 and zero at retirement.
Retiring debt free used to be the rule rather than the exception. Unfortunately, that is no longer the case. In fact, a recent study by the Employee Benefits Research Institute showed that 65 percent of American families with a head of household age 65-74 had debt. The age group with one of the biggest spikes in debt was 75 and older.
That’s troubling because debt adds risk and reduces cash flow, two things that can derail your retirement. It is inherently limiting at a time when most hope for greater independence and opportunity. It increases uncertainty at a time when most people want security. So make a plan to gradually eliminate your debt and you will greatly increase your odds of having freedom, flexibility and peace of mind during retirement.