Key takeaways
- When you reduce your debt interest payments, you’re essentially increasing your income.
- Consider paying down debt when the interest rates on your debts are higher than your investment returns.
- Carrying a credit card balance can be costly especially if your interest rates are high.
- If you’re overwhelmed by debt, get help from a reputable credit counselor.
Many people in previous generations tended to head into retirement virtually debt-free. Home mortgages were paid off, and credit cards weren’t typically used for day-to-day living expenses the way they are now. Today, it’s not uncommon for people to enter retirement with substantial debt.
Mortgages, for example, are one of the largest and most common types of debt for Americans, and an increasing number of older owners still carry a balance on their loan. According to the Federal Reserve’s 2019 Survey of Consumer Finances, 37.6% of households headed by those age 65 to 74 had a mortgage on their primary residence. Among those 75 and older, 27.7% were still making mortgage payments, compared with just 6.3% 20 years ago.
It just makes good financial sense to reduce debt as much as possible before retiring, especially because retirement income from pensions and savings may be lower than working income, and pension payments are fixed.
Of course, that can be easier said than done. Let’s talk about two types of debt you can focus on now to help drastically reduce your financial obligations before you retire.
Start by tackling the two biggest types of personal debt
Simply put, less debt in retirement means more money in your pocket. You can effectively boost your fixed retirement income by reducing or eliminating the interest payments on mortgages, credit cards, car loans, student loans and other debts. Every dollar you allocated toward a debt is one less dollar you have for day-to-day living expenses or for investing.
For many pre-retirees, two of the biggest debt monsters are credit cards and a home mortgage. Here are a few tips to help you cut them down as much as possible.
How to eliminate high interest-rate credit card balances
Carrying balances on your plastic? That’s probably your most expensive debt from an interest rate perspective. According to creditcards.com, the national average credit card interest rate was around 16.14% in June 2021, but interest rates can vary widely. Consumers with less-than-ideal credit scores will be offered rates on the higher end, while those with stellar credit ratings may get much lower rates.
Many experts suggest paying down your highest interest card balances first. On the other hand, debt guru Dave Ramsey recommends generating more debt payment momentum by paying down your smallest balance first, then progressing to the next smallest balance, in what he calls “the debt snowball method.” The idea is to knock off a few small debts, one at a time, to get quick results and feel a sense of accomplishment that will encourage you to keep paying down your debt. Take the payoff route that feels best to you.
Another tactic is to transfer high-interest card balances to a card with a low or zero promotional interest rate. Card companies routinely send out promotional offers like this in an effort to sign up new cardholders. Be sure you do the math to make sure you can pay off the transferred balance before the promotional period ends or you else could find yourself right back on the high interest-rate merry-go-round.
Avoid using the card for additional purchases while paying off your transferred balance because your payments will first go to the lowest rate balance before being applied to the new purchase balance. That move could inadvertently increase your interest payments by a lot over time.
How to pay off your home mortgage
Mortgage interest up to the first $750,000 is still tax deductible. Interest on a home equity loan or home equity line of credit (HELOC) is deductible only if the money is used to buy, build or substantially improve your home that secures the loan.
Because of that tax deduction, some people feel like mortgage debt isn’t so bad. But it’s only deductible if you itemize deductions on your tax return. If your deductible expenses are less than the standard deduction, it doesn’t make sense to itemize just to claim the mortgage interest deduction.
Besides, 30-year mortgages are weighted toward paying more interest in the first 15 to 20 years of payments. If you’re 20 years or more into your mortgage payoff, more of your payments will be non-deductible principal rather than deductible interest.
Your mortgage interest rate is likely higher than the rates available in 2021 on certificates of deposit (CDs) or money market investments. That means using money to accelerate mortgage payments instead of investing it may be a net win.
Seeing your debt payments dwindle certainly can provide a sense of emotional relief, but aim to pay off what you can comfortably afford. Don’t be tempted to pull money out of your retirement savings to pay down your mortgage. You’ll end up owing taxes on the withdrawal and, if you’re under age 55, a 10% penalty. Plus, that money no longer has the opportunity to grow tax-deferred in your investment accounts.
Another option is to sell your home and either buy a smaller and/or less expensive home outright, or to rent. Although renting does set you up with a perpetual monthly expense, you’ll eliminate the costs of home maintenance, homeowners insurance and property taxes. (Renters insurance, to cover your belongings, is still a good idea though.)
Create your pre-retirement debt pay-down plan
Maintaining your lifestyle in retirement depends on generating sufficient income from any pensions and savings. But nothing erodes your income like having lots of debt.
If you don’t have a lot of debt now, you may be able to zero your balances before you retire without too much strain. However, if you have substantial debt, be methodical in your pay-down approach:
- Chip away. Much like saving for retirement, making small debt payments is better than nothing at all. It may take you longer, but you’ll know you’re making progress.
- Cut expenses. Eliminate some discretionary expenses, and use the found money to pay off those credit cards—and then avoid putting new charges on the cards that you can’t pay off right away.
- Retire later. If you need more time to get your debts under control, consider collecting your paychecks for a little while longer while you take the steps outlined above.
- Get help. If you’re still overwhelmed, work with a debt restructuring counselor who can help you develop a schedule for repayment through a debt management plan. You can find a list of reputable credit counselors through the National Foundation for Credit Counseling. Learn more about selecting a credit counselor from the Consumer Financial Protection Bureau.
