Good Debt, Bad Debt – The Framework for Optimal Retirement Finances

On This Episode:

This show tackles the crucial topic of debt management, particularly as it relates to retirement planning. The core focus centers on differentiating between "good" and "bad" debt, making informed decisions about paying off or retaining existing debt, taking on new debt or using assets to stay debt free, and why, in most cases, it makes sense to go into retirement debt-free.

Not all debt is "bad". While high-interest consumer debt (e.g., credit card debt) is almost universally disadvantageous due to its high cost (average credit interest rate (APR), is currently around 24.33%)1, "good" debt can serve as a practical convenience or a strategic financial tool. Examples include bridge loans for real estate transactions or taking on debt when an investment portfolio's projected returns exceed the borrowing cost.

The fundamental principle of debt evaluation involves a straightforward mathematical comparison: weigh the interest rate of the debt against the inflation adjusted (real) expected return of an investment portfolio. If a portfolio is expected to generate returns higher than the debt's cost, holding the debt and investing available cash might be financially beneficial. Conversely, if the debt's interest rate surpasses expected investment returns, paying it off can be viewed as a "guaranteed return" by eliminating that interest expense.

Affordability is another critical element. While lenders might approve significant loan amounts because they don’t assume any cash flow is saved for other goals like retirement. We prefer to follow the more conservative rule of thumb, like the 28/36 rule (28% of gross income for housing debt, 36% for total debt), to ensure that you flexibility in your cash flow to save for other objectives. That said, a holistic financial plan is the best way to determine what is truly affordable given your personal savings and spending objectives.

We believe that most people should aim to enter retirement debt-free. This is because retirement portfolios are typically more conservatively balanced (with a mix of stocks and bonds) to stabilize returns, generate income, and protect capital, which generally results in lower expected returns compared a higher risk, higher expected return portfolio that is more common during the wealth accumulation phase. Carrying fixed debt obligations into retirement, especially during market downturns, can necessitate selling assets at a loss and create considerable financial stress.

However, exceptions do exist. Individuals with substantial guaranteed income (such as pensions and Social Security) that comfortably cover both living expenses and debt payments may find it manageable to carry debt in retirement. Tax implications, particularly when large sums are withdrawn from tax-deferred accounts, also significantly influence the strategic approach to debt repayment.

Ultimately, the decision to carry or pay off debt is highly individualized and depends on unique circumstances, including risk tolerance, time horizon, and comprehensive financial objectives. While financial optimization is often sought, the peace of mind gained from being debt-free can sometimes outweigh purely theoretical financial advantages. A detailed financial plan is crucial for navigating these complexities and making choices that align with both financial well-being and personal comfort.

 

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