A key question that soon-to-be retirees often face is whether or not to eliminate a debt before retirement. Generally, we would love to see all our clients enter their retirements debt free. However, there could be some instances where making monthly debt payments is not necessarily a bad thing (i.e., zero-percent financing on a car). Sometimes the answer is clear and obvious, other times we are faced with a bit of a grey area. In any situation, our goal is always to help our clients make unemotional and informed decisions, and today we highlight how we empower them to do so.
Over the past several Atheneum articles, we have been discussing a powerful financial planning tool that we put to work for our clients at Ballast – the Monte Carlo simulation. This software allows us to statistically quantify how multiple variables affect our clients’ ability to achieve their financial goals. In this situation, we are going to compare making mortgage payments during retirement years vs. making a large lump-sum payment to completely pay off a mortgage before retirement begins.
For the sake of discussion, let’s take a look at our hypothetical clients, Husband and Wife. Husband and Wife are each 60 years old and they plan to retire at age 68. Their annual household gross income is $130,000 ($65,000 each), they each have a 401(k) plan with $500,000 of assets ($1 million total), and another taxable joint investment account of $275,000.
Husband and Wife each max out their 401(k) contributions ($19,500 + $6,500 catch-up because they are over age 50) and receive an employer contribution as well (100% up to 3%, which here equates to $1,950). They also make a point to put away another $500 each month ($6,000/year) into their taxable joint investment account.
Husband and Wife are willing to live more frugally in their final working years and aggressively save to really enjoy themselves during their retirements – their goal is to save enough to live on $8,000 per month in retirement. To add to their retirement enjoyment, they’ve just purchased a quaint $250,000 condo in their favorite getaway town. They put 20% down and have a 30-year fixed mortgage at 6%.
So here we are: eight years from retirement with a brand new $200,000 mortgage debt which requires $1,200 monthly payments ($14,400 annually). The question is, what is better – to pay the relatively “small” monthly mortgage payments starting now and continuing well into retirement years, or take a sizeable chunk out of their taxable joint account this close to retirement to completely pay off the debt?
If they pay off the mortgage with a lump-sum, Husband and Wife have agreed – consistent with their aggressive saving strategy – to save the would-be-mortgage-payment of $1,200 per month into their taxable joint account each year until they retire. Under either scenario, monthly payments or lump-sum payoff, their potential outcome is not bad. In fact, per the Monte Carlo simulation, their probabilities of success under the either plan are nearly identical.
This is a great example of one of the “grey areas” in financial planning where there is not a clear-cut right or wrong answer. In these situations, we look to other factors to help our clients make better decisions. If the clients are more conservative in nature, we would typically recommend making the lump-sum payment. Yes, Husband and Wife would have to make a relatively substantial reduction to their retirement portfolio, but they would also significantly reduce their required income need in retirement. By reducing their required income need, it allows Husband and Wife to have more control over how and when to withdraw from their portfolio. If the markets are selling off, it may allow the couple to temporarily reduce spending or delay a vacation/purchase to a more favorable market environment. The fewer “payments” that a retiree is required to make (i.e., a monthly mortgage payment) during retirement, the better.
Each situation is different and in general, constantly evolving. No one can predict the future (and we don’t claim to either), but by using the Monte Carlo tool we can statistically analyze whether our clients are headed down the right path towards achieving their retirement goals, and confidently advise on potential realistic outcomes. When situations arise where there is not an obvious answer, we will use the analytics as a starting point and then dive into the grey area factors to try to come to the best decision. If you think that you or anyone in your life could benefit from a Monte Carlo analysis, please do not hesitate to contact our office – it would be our pleasure to help.