Q: Should I be debt-free before I retire?

There’s no doubt that not having any debt can give you a certain sense of freedom. When you don’t owe anything to anybody, the money you have is yours to do with as you wish—a great retirement dream scenario. But as we all know from experience, reality can be a bit different.

In an ideal world, none of us would have any debt—ever. And we’d certainly pay off our mortgages, credit cards, and car loans before we retire. But that’s not always possible. And sometimes, it’s not even the best thing to do. As I discussed a bit in My Top Ten Recommendations on page 3, debt isn’t necessarily negative. In fact, in the financial world there’s a common distinction made between “good debt” and “bad debt.” But you have to know the difference. And to keep debt from ruining your plans, you also have to figure out how much debt you can comfortably handle on your retirement income. Here are some ways to go about it.

Put Your Debt in Perspective

Debt that creates opportunities can actually work for you. If it’s also low cost and has tax advantages, so much the better. For instance, with mortgages or home equity lines of credit, you’re borrowing to own a potentially appreciating asset. On top of that, home loans may be tax-deductible. So they fall into the category of good debt.

On the other hand, there’s nothing positive about debt that’s high cost, isn’t tax-deductible, and is taken to buy an asset that will likely depreciate. Things like credit card debt and car loans fall into the “bad debt” category. The image of taking on high monthly payments for a new car that decreases in value the minute you drive it off the lot is probably one of the clearest examples of debt that works against you.

What should you do? If the ideal scenario of being debt-free is out of reach, your practical goal should be to pay down any bad debt while keeping the good debt working for you.

Fact: The average debt held by families headed by individuals 55 and older stood at $75,082 in 2010, up more than $1,300 from 2007, according to Federal Reserve data crunched by the Employee Benefit Research Institute.

How Much Debt Can You Afford? The 28/36 Rule

28%—An industry rule of thumb suggests that no more than 28 percent of your pretax household income should go to servicing home debt (principal, interest, taxes, and insurance).
36%—No more than 36 percent of your pretax income should go to all debt: your home debt plus credit card debt and auto loans.

As you look ahead, I think you should be even more conservative. While these percentages may be manageable when you’re working, I suggest keeping debt much lower in retirement.

Safe Debt Guidelines Housing Debt: 28% of Pre-Tax Income | All Debt: 36% of Pre-Tax Income

Prioritize Your Payments

Don’t try to tackle all your debt at once. You’ll likely just become frustrated and discouraged. Instead, prioritize.

If you have credit card debt, that’s your first priority. Make a list of your credit cards and balances, from the highest-interest card to the lowest. Focus on highest-interest debt first, increasing the payment if you can, while continuing to at least make minimum payments on the rest. Work your way down until everything is paid off. And give yourself a pat on the back as you eliminate one debt after another.

Another way to approach multiple credit card debts is to consolidate them on a low-interest card and pay the maximum that you can afford each month. But be very wary of loan consolidation offers. While some are legitimate, others have up-front fees and hidden costs.

Behind the Scenes: What Credit Card Debt Really Costs You

When you want that new top-of-the-line flat-screen TV, it’s easy to whip out the plastic and figure you’ll pay it off over time. But when you stop to calculate what that single purchase can cost you if you don’t pay it off right away, the numbers could make you think again before you buy. Here are three eye-opening scenarios:

Cost of TV: $5,000; interest rate: 14%

Make the minimum payment each month (usually interest plus 1%) and it will take you 264 months (22 years!) to pay it off. During that time you’ll pay $5,333.30 in interest, more than doubling the original cost of the TV.
Make a fixed monthly payment of $200 and it will take you 30 months to pay if off with $946.23 in interest.
Up your monthly payment to $500 and you’ll have your TV paid off in 11 months and pay only $348.12 in interest.

Of course the best scenario of all is to pay cash to avoid any interest charges. The numbers speak for themselves!

Caution: Once you’ve finally paid off your credit card debt, keep your guard up! It’s way too easy to fall back into bad habits and run up your balances again.

Don’t Let Debt Payments Derail Your Savings

Paying down debt and saving for retirement doesn’t have to be an either/or proposition. The two can work together. Once again, you have to prioritize. Here’s what I recommend:

Save enough in your retirement accounts to capture the entire employer match.
Pay off high-interest consumer debt.
Create an emergency fund to cover necessary expenses for a minimum of three to six months.
Save more for retirement.

After that, prioritize other savings and debt reduction goals according to your own situation.

And Finally, Assess Your Mortgage

For most of us, our mortgage is probably our largest debt. And eliminating your monthly mortgage payment before you retire is a worthy goal. But deciding whether to pay off your mortgage is more difficult because there can be a psychological as well as a financial aspect to your decision.

The financial side is pretty straightforward. First, what’s the interest rate? Is it adjustable or fixed? Next, factor in tax deductibility.

Example: Let’s say that you have a 5% fixed loan and your combined federal/state income tax bracket is 30%. Assuming your mortgage interest is fully tax-deductible, your mortgage is really costing you only 3.5%. On the one hand, paying it off is equivalent to a risk-free 3.5% return on an investment. If you’re happy with that return, pay off the mortgage. If you think that you can earn more from another investment, then it probably makes sense to keep it.

Note: As you reach the end of your mortgage term, you’re paying less interest and more principal. Only the interest portion is tax-deductible.

Smart Move: If you have a high interest rate mortgage or an adjustable mortgage, think about refinancing to a lower, fixed rate. You might also consider a shorter term (say fifteen years), which will carry a lower interest rate.

On the psychological side, you need to weigh the value of having more money in the bank (or in your portfolio) versus being mortgage-free. Only you know which will ultimately give you more peace of mind. It could also be a matter of proportion. For example, if you have a $250,000 portfolio and a $100,000 mortgage, it’s probably not prudent to deplete your assets by 40 percent to pay it off. But if you have $1 million in assets, paying off a $100,000 mortgage is more reasonable.

Finally, you can always decide to split the difference—pay off half your mortgage and refinance the rest. It all depends on what you can handle on your retirement income and what makes you feel the most secure.

Smart Move: One way to pay down your mortgage more quickly is to make additional annual payments. Even one extra payment a year can cut significant dollars off your debt and time off your mortgage.

When Does It Make Sense to Prepay Your Mortgage?

If you have the money to prepay your mortgage in a lump sum, consider these points before writing that big check:

After-tax opportunity cost. Consider the after-tax cost of money. As I mentioned in the example, a 5% mortgage loan actually costs you only 3.5% on an after-tax basis if you have a combined marginal income tax bracket of 30% (assuming full deductibility). Can you do as well or better with an alternative use of your money—risk-free?
Liquidity preference. If you have a low-rate mortgage, you might prefer to keep this money liquid. It might also be a question of keeping your money diversified.
Income tax considerations. Remember, you can deduct the interest on mortgage debt of up to $1.1 million (in 2013) on your primary and/or secondary residence for purchase or capital improvement. Once you’ve paid off the original mortgage, you’ll be limited to the $100,000 home equity debt ceiling unless you make capital improvements or buy another home.
Psychological considerations. Does your desire to be debt-free trump these other considerations? If so, put your peace of mind first and make the big payment.

Smart Move: If you own your home and don’t already have a home equity line of credit (HELOC), consider opening one now. You’re much less likely to qualify when you don’t have a regular income, and it can be a great backup in case of an emergency. Plus, you can deduct the interest on up to $100,000 of home equity debt used for any purpose. So it could also be a tax-deductible way to consolidate your higher interest loans.

Part II: Getting Closer: Transitioning into Retirement, Question 13