If not carefully managed, debt can shackle a retiree, but if carefully managed, debt can also be a powerful financial tool. You can make it work in your favor throughout retirement.
However, if you want to make the most of debt advantages, and minimize debt advantages, you need to understand exactly how debt works, and how it’s relevant to your retirement.
If you’re feeling overwhelmed about the idea of managing your own retirement, don’t worry; managing debt leading up to and during your retirement is easier than you might think.
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The Downsides of Debt
Most people understand that it’s beneficial to pay off your debts as early as possible. The sooner you pay off your credit card, the sooner the credit card company will stop annoying you with reminders. However, there are also several potential downsides you need to be aware of:
Interest rates on loans generally apply to both the principal and interest you’ve generated in the past. For example, if you take out a $1,000 loan with a 10% interest rate, your first round of interest will put your principal at $1,100.
Your next round of compound interest (if you don’t make payments) will be $1,210 – meaning you’ve generated $110 of interest instead of just $100. This may not seem like a big deal, and during the first few rounds of compounding, it’s not. Given enough time, though, compound interest can multiply your debts and put you in a worse financial position.
Credit and Financial Restrictions
Holding massive amounts of debt can impact your credit and impose you with financial restrictions. The lower your debt to income ratio is, the better, and having too much debt can skew this ratio in the opposite direction, ultimately weakening your credit score and making it harder for you to qualify for certain loans.
If you need to purchase a new house and move to a new city, or if you need another type of loan, you may not be able to qualify.
You’re personally responsible for any debts you take on as an individual. Depending on the nature of the loan, the lender may be able to seize your assets in order to make up for the outstanding principal.
For example, if you’re making $500 monthly payments on a loan, and you fail to make this payment several months in a row, your bank may be legally entitled to take your personal possessions to cover the balance – including your home.
Keep in mind that some types of debts will transfer to your spouse upon your death. If you’re trying to plan a bright future for yourself, your spouse, and your children as well, you need to think about the long-term impact your debts may have.
Understanding these downsides can help you minimize them with your debt management strategies.
The Potential Benefits of Debt
Most people talk about debt as a negative concept, but there are some potential benefits of debt, if you know how to manage it correctly.
One of the greatest strengths of debt as a financial tool is its ability to confer financial leverage upon you. Essentially, this means being able to invest more money than you currently have available. This is easiest to understand in the context of buying a house, since it’s the norm to take out a loan to buy a house.
If you could only buy a house from your own personal savings, you might be severely limited on what type of house you can buy. If you can take out a loan, you might be able to multiply your purchasing power many times over, thereby increasing your potential return on investment. Since you can often buy a house for as little as 5% down, this is one potential strategy for quickly accumulating wealth.
Building and Maintaining Credit
Having debt is also valuable for building and maintaining credit. As an older adult nearing retirement, you probably already have a sound credit score, and you’ll probably be making fewer decisions for which your credit score is relevant. However, it’s still a good idea to have some kinds of debt and make regular payments to keep your credit score high and keep your accounts active.
Access to More Capital
Taking on debt also provides you with more access to capital that you can use for other applications. For example, you might have $25,000 to buy a new car, but if you only make a $5,000 down payment and take out a loan for $20,000, you can use the $20,000 you saved to invest in stocks, bonds, or real estate, thus increasing your potential return. This is especially valuable if you want to grow your existing principal.
An Inflation Hedge
Debt can be a good thing in periods of high price inflation. Inflation essentially weakens the buying power of the dollar (or other currencies). If you owe a lender $100,000, and the value of a dollar sharply declines, you’ll effectively owe your lender less money.
This is a risky game to play, since no one can predict exactly how or when inflation will manifest, but if you’re concerned about rates of inflation in the future, this could be a valuable hedge in your portfolio.
Good Debts vs. Bad Debts
There are good debts and bad debts, based on the proportion of advantages and disadvantages that they generally provide to people. Bad debts are debts that financially hurt you, while good debts can actually benefit you, but how can you tell the difference?
Due to the power of compound interest, the interest rate of your debt plays a massive role in whether the debt is good or bad. If you’ve obtained a mortgage recently, you might enjoy an interest rate of less than 4% – which is almost negligible. Conversely, some credit cards have rates of 25% or more, compounded in short intervals. The lower the interest rate is, the better.
Terms and Conditions
You also need to think about the terms and conditions of the loan. Is the interest rate fixed or variable? Fixed rates tend to be better. Is there a penalty for early payment? If so, you’re incentivized to keep the debt. Is the debt secured or unsecured? What minimum payments are due?
Reason for the Debt
Some debts are considered good debts, as they allow you to acquire something that gives you a financial advantage. For example, student loans are sometimes considered good debt. They grant you an education that you can use to increase your lifetime earnings many times over.
Mortgages are often considered good debt. Owning a house is usually better than renting – and it gives you a way to put your money toward a valuable long term investment.
Position in Your Portfolio
Good debts can quickly turn into bad debts if they’re improperly managed or if they become a bad fit in your portfolio. It’s important not to become overleveraged – in other words, taking on more debt than you can reasonably handle.
Effective Debt Management for Retirees
What actionable strategies can you use to manage debt effectively as you begin approaching retirement?
Take inventory of your debts before retiring.
Preferably long before you retire, you should take a moment to take inventory of all your debts. What are your standing loans? How much of an outstanding principle do you have for each of them? What interest rates apply to those debts and what are your monthly payments?
Once you have a better understanding of the fixed income you’re receiving, you’ll be able to put this in a much better context – and organize your debts more effectively.
Pay off bad debts as quickly as you can.
There’s a good chance that at least some of your debts are bad debts. They have high interest rates and little functionality for your financial future.
It’s a good idea to pay off these bad debts as quickly as you can, especially if you can do this before you retire. Doing so will free up more cash for you on a monthly basis and reduce your risk of being overleveraged.
Save an emergency fund.
Similarly, it’s important to avoid taking on new bad debts in retirement. If your income is $3,000 per month, and this month’s expenses are $3,500, you might be tempted to put that extra $500 on a credit card.
However, it’s much better to tackle these unexpected surprises with the help of an emergency fund. Therefore, saving up an emergency fund should be one of your top priorities as a new retiree. You should have at least a few thousand dollars set aside so you can avoid taking on new bad debt.
Scrutinize new potential debts carefully.
Before taking on any debt, including good debts like home loans, you should scrutinize those debts carefully. Make sure you fully understand all the terms and conditions that apply to these debts and comprehend how this will influence your financial standing and overall portfolio. Never take on more than you can effectively manage.
If you have many bad debts, or if you’re struggling to pay off your debts consistently, consider consolidating. Loan consolidation isn’t the right strategy for everyone, and there are some ways that it can go wrong. If all you’re doing is grouping your debts together under one umbrella with a lower interest rate and better terms, it’s an absolute win.
Similarly, you may consider refinancing. If you bought your house or another significant asset many years ago, there’s a chance that today’s interest rates are significantly lower. Refinancing could put you in a much better overall position – and help you free up cash at the same time.
Speak to a credit counselor if you’re struggling.
If you feel like you’re drowning in debt during retirement and nothing you do is making a dent, consider speaking to a credit counselor or financial advisor directly. They may be able to provide you with resources and guidance. Ask for ways to reduce your debts or negotiate with your creditors.
Try not to tap into your retirement savings.
For the most part, you should avoid dipping into your retirement savings to pay off your debts. These savings exist to fund your entire retirement, so delving into them prematurely or in excess can backfire. Instead, try to make do with what you have. Or you might choose to establish a new line of income to supplement your debt payment efforts.
Be wary of over-leveraging.
Finally, be wary of over-leveraging yourself. If your debt to income ratio gets too high, you’ll be in a position of extreme financial risk.
Debt in retirement is a complicated financial topic. It has the power to be destructive, but it can also give you many financial advantages. What’s important is that you have a thorough understanding of how debt works. Understand the role of debt in your current investment portfolio and personal finance structure. Learn how to manage debt in a way that secures advantages without weakening your financial position. There’s still more you can learn, but this article should give you an excellent start.
Article by Deanna Ritchie, Due
About the Author
Deanna Ritchie is a financial editor at Due. She has a degree in English Literature. She has written 1000+ articles on getting out of debt and mastering your finances. She has edited over 40,000 articles in her life. She has a passion for helping writers inspire others through their words. Deanna has also been an editor at Entrepreneur Magazine and ReadWrite.