Essay Nine: Retire Mortgage Debt or Accumulate in Your 401(k) Plan?

9 Oct

Essay Nine: Mortgage Debt and 401(k)

Assets in Retirement

Increasingly, many Americans nearing the end of their work life find they have a large mortgage and must choose between paying off the mortgage or contributing more funds to their 401(k) plan. A large number of financial advisors advise their clients to increase 401(k) contributions rather than pay off their mortgage.

My view is that it is essential for people nearing retirement to eliminate their mortgage debt even if this goal requires some reduction in 401(k) contributions.   I have two reasons for this view.   First, as noted and explained in the previous section 401(k) plans are not capable of mitigating the impact of market down turns at the end of a career or during retirement.   Intuitively, a person with no debt is much better able to withstand market downturns than a person with a mortgage.   The Wall Street analysts always say don’t sell on a panic the market will come back.   Well retirees with a large mortgage often have no choice but to sell.

Second, the financial risk considerations interact with another factor, the tax treatment of 401(k) plans. During working years mortgage interest and 401(k) contributions reduce income tax burdens.   During retirement a person with a large mortgage payment and most financial assets inside a 401(k) plan will pay more in tax than a person without a mortgage.

All disbursements from a 401(k) plan are fully taxed at the ordinary income tax rate.   A person with no mortgage disburses enough to cover discretionary expenses and taxes   A person with a mortgage must disburse enough to cover discretionary expenses, the mortgage and taxes.

The disbursement to cover the mortgage leads to additional taxes because all disbursement from the 401(k) plan is taxed. MOREOVER, THE DISBURSEMENT ON FUNDS USED TO COVER THE TAX ON THE 401(K) DISBURSEMENT IS ALSO TAXED.

Part of Social Security is taxed for people with income over a certain threshold. A quick way to find out if part of Social Security benefit is taxable is to compare your income to the threshold for your filing status — $25,000 for filing status single and $32,000 for filing status married.

Higher disbursements from the 401(k) plan can increase your adjusted gross income beyond the threshold and increase the amount of the Social Security benefit subject to tax.   Of course any 401(k) disbursement used to pay the income tax is also taxed.

So let’s take a household with all financial assets in their 401(k) plan with a $30,000 annual mortgage.   This monthly mortgage is $2,500, not huge.   Let’s assume that the person has to pay around $1,000 more in tax on Social Security benefits because of the additional disbursement to pay down the mortgage. A first order approximation of the amount of additional tax needed because of the additional $31,000 disbursement is $31,000 x the marginal tax rate for the taxpayer.   For most filers the marginal tax rate would be around 25 percent in 2014.

So the taxpayer with the mortgage and the additional tax burden because of the additional 401(k) disbursement will probably disburse $39,000 more per year from their 401(k) plan.

This analysis puts a whole new wrinkle on the question how much money does one have to save in their 401(k) to have a secure retirement.   The answer is much more if you have not paid off your mortgage.

Note that the disbursement to cover the unpaid mortgage must occur whether the market falls or rises.

Many people who choose to add to their 401(k) plan rather than pay off their mortgage prior to retirement are going to have sell their home and downsize. Downsizing may make sense but most people don’t want to downsize until they are fairly old.

Some people who end up selling their home may choose to rent rather than buy a new home.   The main risk of choosing to rent throughout retirement is that home prices and rents may rise.   This exacerbates longevity risk.

Downsizing should be a choice not an outcome from a failed financial plan or worse the result of financial advisors putting their interests over your interests

Concluding thoughts on mortgage debt in retirement: An increasing number of households are retiring prior to their mortgage being entirely paid off. Surprisingly, the existence of a mortgage in retirement is often consistent with a financial plan developed by a financial planner.   Many financial analysts and planners advise their clients to increase savings in their 401(k) plan rather than retire their mortgage.

These financial planners are not being upfront with their clients.   Retirees with mortgage debt and all or most financial assets in a 401(k) plan are at the whim of the market and have a substantial tax obligation.   The advice that put people in this position is in my view a form of malpractice.

Appendix to Essay on Mortgage Debt and 401(k) Assets in Retirement

The issue of whether to pay off a mortgage or contribute to a 401(k) plan for an older worker is related to the issue of mortgage choice, especially for older homebuyers.   The following question addresses the interaction between mortgage choice and 401(k) investment strategy for an older worker.

Question:   A 50 year-old person is buying a house and must choose between a 15-year mortgage and a 30-year mortgage.   The mortgage choice will impact how much money the person can contribute to his or her 401(k) plan.

The person makes $80,000 per year. The initial mortgage balance is $400,000.   The person’s 401(k) balance at age 50 is $200,000. The 30-year FRM rate is 3.9 percent and the 15-year FRM rate is 3.1 percent.

Discuss the advantages and disadvantages of two strategies (1) taking the 30-year FRM and investing 15% of salary in the 401(k) plan and (2) taking the 15-year FRM and investing 5% of salary in the 401(k) plan.


Let’s start with a reiteration of mortgage choice issues a subject previously broached in essay four.

Observations and Thoughts on Mortgage Choice Issues:

  • The monthly payment on the 30-year FRM is nearly $900 less than the monthly payment on the 15-year FRM. The higher mortgage payment on the 15-year FRM will all else equal require the person who chooses the 15-year FRM to make a smaller 401(k) contribution than the person who chooses the 30-year FRM.
  • After 15 years the 15-year FRM is completely paid off.   The remaining loan balance on the 15-year FRM is around $257,000.
  • Note that gains from the quicker pay down on the 15-year mortgage are not dependent on market fluctuations.   The gain from debt reduction occurs regardless of whether the market is up or down and regardless of when bear or bull makers occur.
Analysis of 15-Year Versus 30-Year FRM
  30-Year 15-Year
Mortgage 0.039 0.031
Term 360 180
Loan Balance 400000 400000
Payment -$1,886 -$2,781
Future Value $256,799 $0.00


Observations and Thoughts on Two 401(k) Contribution Strategies:

As noted in essay eight, the final 401(k) balance after 15 years depends on both the rate of return of the market and the sequence of the returns in the market.   Outcomes are presented for two market scenarios.   The first involves 7% returns for the entire 15-year period.   The second involves 7% returns for 10 years followed by -4% returns for 5 years.

  • The difference in the final 401(k) balances (high contribution minus low contribution) under the 15-year bull market scenario is around $211,000.
  • The difference in the final 401(k) balance (high contribution minus low contribution) under the 10-year bull and 5-year bear scenario is around $131,000
Analysis of Different 401(K) Contribution Strategies
5% Contribution Rate 15% Contribution Rate Difference
7.0% Return for 15 Years $675,442 $886,752 $211,309
7.0% Return for 10 years followed by -4.0% return for 5 years $394,339 $525,090 $130,751

The initial balance in the 401(k) plan for both scenarios is $200,000.


Additional insights on the tradeoff between 401(k) contributions and mortgage retirement:


  • The 30-year mortgage/high 401(k) contribution strategy results in major tax savings during working years compare to the 15-year mortgage/low 401(k) strategy.   All mortgage interest is tax deductible and the 401(k) contribution is not taxed.
  • The 15-year mortgage/low 401(k) contribution strategy results in major tax savings during retirement compared to the 30-year mortgage/high 401(k) strategy.   The previous example in this section demonstrated exposures for the person with mortgage debt in retirement when the person is dependent on 401(k) disbursements.   Remember all disbursements from a conventional 401(k) plan including disbursement used to pay the mortgage and disbursements used to pay taxes are fully taxed at ordinary income rates.   By contrast, the money gained from paying off the mortgage and most capital gains on owner-occupied real estate is not taxed.
  • Financial risks associated with a bull market persist through retirement as long as the saver allocates 401(k) assets into equity.


All nine essays on debt and your retirement can be purchased at Kindle, Ibooks or Nook.

The description of nine essays is at the post below.


Nine Essays on Debt and Your Retirement

5 Oct

My book nine essay on debt and retirement is now available on Kindle, Ibooks, and Nook.   The introduction to this book is presented below. 


Most financial advisors, bankers and realtors that you will interact with during your life time stress the importance of asset purchases and are generally oblivious to issues pertaining to controlling the amount you borrow and will ultimately repay to your creditors. Financial firms want you to contribute to your 401(k) plan as soon as you get out of school, even if you have extensive credit card or student debt and lack a basic fund for emergencies.   Realtors and bankers want you to buy a house with a 30-year mortgage, (assuming you qualify for the mortgage) even if you have credit card debt and student loans and even if it is highly likely that you will have to relocate within a decade.

Realtors and bankers will never advise you to delay purchasing a home until the student loan is paid down or to delay a home purchase until you can qualify with a 15-year rather than a 30-year mortgage. Realtors and bankers will never tell you to stay in your current home for a few more years in order to build up equity for the second home.

Financial advisors and brokers will seldom if ever recommend that you reduce your contributions to a 401(k) plan in order to more quickly pay off credit card debt, obtain a 15-year mortgage instead of a 30-year mortgage, more quickly eliminate student loans or use funds to reduce debt and improve your credit score. Realtors, bankers, financial advisors and brokers are united in their view that the best ways to reduce taxes is to leverage yourself up with a big mortgage and plow a lot of money into your 401(k) plan and if you have extra left over buy stocks. However, delaying loan repayments in order to fund a 401(k) can lead to higher interest rates and hundreds of thousands in additional debt payments over the course of a lifetime.

In past generations, it has not been unusual for a person or a household to buy 3 or more houses during their lifetime.   Typically, each house was purchased with a 30-year mortgage.   Often the house would be sold or the mortgage refinanced in 5 to10 years.    As a result, many workers nearing retirement have a substantial mortgage. Interestingly, many financial advisors advocate 401(k) accumulation over mortgage reduction for older workers.

A financial formula that leads to match of a risky 401(k) asset filled with equities and a mortgage debt at retirement is not a viable strategy.  The value of the 401(k) plan fluctuates with the market.   The retiree with a mortgage and a 401(k) plan must make additional disbursements to cover both the mortgage and the tax on the additional disbursement.  Most individuals with substantial mortgage debt in retirement will have to sell their home and downsize if most of their financial assets are in 401(k) plans, even if returns on assets in the 401(k) plan are reasonably high.

Estimates of the proportion of workers who will likely have inadequate retirement income will range from 50 percent to 70 percent. Some articles on the adequacy of retirement income:

The financial plan used by the baby boom generation has failed. Moreover, financial challenges are even more daunting for the new generation of workers.

  • First, the current generation starts their career with substantially more debt than previous generations.  The average student loan for all age groups has gone from around $15,000 in 2005 to around $29,000 in 2015.

  • Second, the current generation is having a slow start to their career.   Labor force participation has been down and unemployment up for the younger cohort of workers, especially during and after the last recession. It is possible that older workers remaining in the workforce have displaced younger workers.   Also, it appears likely that the new cohort of workers are more likely to switch jobs more frequently during their career.
  • Third, the current generation lacks secure defined benefit plans and is even more heavily dependent on 401(k) plans and IRAs, which fluctuate in value with the market. The percent of workers who have a defined benefit plan that provides annuity income at retirement has fallen from around 38 percent in 1980 to around 20 percent in 2008.

The view espoused and outlined in the essays published here is that debt management will have a more important impact on your financial security and your retirement than asset acquisition.   The advice obtained from the interdependent essays in this book differs from the advice that you will get from your realtor, broker or mortgage lender.

The first essay describes and critiques a rent versus buy calculator displayed at the web site   The calculator uses input on house and renting costs and taxes to calculate the number of years it would take for a house purchase to be less expensive than renting.   The model is useful but has several limitations. First, the model assumes constant house appreciation and does not measure the risk or variability associated with this forecast. Second, the user of the model needs to consider the likelihood that he or she will have to move prior to recouping their investment. Third, the model does not allow the user to consider advantages associated with delaying a house purchase in order to repay student loans and credit card debt.

The second and third essays examine the impact of student debt and credit card debt on the ability of a person to qualify for a mortgage and estimated costs incurred when borrowers restructure student debt in order to qualify for a mortgage. The example in the second essay involves a person with a very large student loan. The example in the third essay involves a person with a substantial student loan and additional credit card debt. The essays consider the costs and benefits associated with increasing the maturity of the student loan from 10 years to 20 years in order to purchase a home.  We also consider the potential advantages of more rapid debt reduction even if this goal requires a delay in the home purchase or a reduction in 401(k) contributions.

An appendix to the second essay provides a description and assessment of the Income Based Replacement (IBR).   The IBR program allows eligible borrowers to link student loan payments to household income and provides for the eventual forgiveness of student loans.

The fourth essay provides background information on the choice between the 15-year FRM and a 30-year FRM.   There are advantages and disadvantages associated with both 15-year and 30-year mortgages.   The 30-year mortgage has a lower payment, which allows the borrower to take out a larger mortgage or make additional payment to her 401(k) plan.   The tax deductibility of mortgage income combined with the fact that interest on 30-year mortgages early in the life of the mortgage makes up the lion share of mortgage payments further reduces the cost of 30-year FRM mortgage payments relative to the cost of 15-year FRM payments.

However, housing equity growth is excruciatingly slow for 30-year mortgage. There are several risks and costs associated with the slower growth rate for house equity.   First, the borrower with a 15-year mortgage will have less equity and may not be able to refinance their mortgage should interest rates fall.   Second, the increase likelihood of negative equity may make it difficult to sell the home.   (The homeowner with negative equity would have to pay the difference between the mortgage and the house price at the time the house is sold.)   Most importantly, the lack of housing equity becomes a major problem in retirement especially for retirees who use fully taxed 401(k) disbursements to fund consumption and mortgage payments.

The fifth essay examines how mortgage choice and housing or mortgage holding period impact lifetime house equity growth when people buy multiple houses in their lifetime and the down payment for the second home come from proceeds obtained from the sale of the first home.   The results presented in this essay indicate that people who use 15-year mortgages and who have a long holding period for their home and mortgage will retire with substantial house equity and with no mortgage obligation. By contrast, people who use 30-year FRMs and have short holding periods will retire with little housing equity and substantial mortgage debt.

The sixth essay considers issues related to the use of adjustable rate mortgages (ARMs).   The lower interest rate on ARMS can reduce initial payments. However, in virtually all instances payments will increase substantially once interest rates reset even if the general interest rate environment remains stable.   The numbers presented in this essay strongly indicate that consumers should shun ARMs with interest rate reset periods less than 5 years.

Essay seven examines issues pertaining to subprime mortgages, especially mortgages with penalties against prepayment.   The essay critiques the claim that prepayment penalties can be good for risky borrowers. My analysis suggests that risks associated with subprime mortgages far exceed the lower possible interest rate.   The endorsement of these products by prominent academic economists strikes me as evidence of a perspectival bias in favor of the needs of the financial services industry and against the interests of the consumer.

Essay eight examines the role played by 401(k) plans and Individual Retirement Accounts.   Most financial advisors emphasize a key to a secure retirement is the early and continued investment of equity inside 401(k) plans. However, many economists and financial analysts now recognize that the adoption of 401(k) plans has increased the number of workers who will have inadequate resources in retirement.   There is wide disagreement over whether the failure of 401(k) plans stems from inadequate participations and bad decisions by workers or the shortcomings of plans.

In my view, these explanations are not mutually exclusive. My analysis found that even households who aggressively contribute to 401(k) plans and make astute investments often come up short if there is a market downturn near the end of a career. Moreover, it is often the case that highly leveraged household will be better off paying off debt than contributing funds to a 401(k) plan.

Essay nine was prompted by the view held by several financial advisors that people nearing the end of their career should emphasize accumulation of assets in their 401(k) plan even if this approach requires them to hold a mortgage during retirement. The analysis presented here documents two important reasons why the elimination of a mortgage prior to retirement should be the top objective.   First, people in retirement with mortgage debt who are reliant on 401(k) disbursement for cash will pay much more in taxes during retirement than retirees who have paid off their mortgage.   Second, the household who keep debt and builds up their 401(k) balance is exposed to substantially more financial risk than households who pay off their mortgage. The discussion of the tradeoff between paying off the mortgage and building up 401(k) assets for workers nearing retirement is intertwined with the issue of choosing between a 15-year and 30-year FRM, the issue discussed in essay five.

The paper concludes with a brief summary of my concerns discussed in the essays. My worldview is pessimistic.   I am concerned that self-interested financial professionals are giving their clients inappropriate advice. Moreover, tax incentives too often encourage asset accumulation over debt reduction.   People who fail to aggressively pay off their loans and remain in the market may eventually find the same fate as the player in the gambler’s ruin game.

Concluding Thoughts:

The interdependent essays in this book attempt to motivate an alternative path towards financial security for the current generation of workers.   The advice presented here differs sharply from the advice that you will receive from your realtor and your financial advisors or lenders.

The realtor’s job is to persuade you to buy or sell your home.   My advise for the person starting her career is to rent rather than buy a home if you have substantial student or consumer debt or will likely have to sell a house in order to relocate for career reasons. Do not extend the term of your student loan to 20 years in order to purchase a house. Do not take out an ARM that resets in less than 5 years or a subprime mortgage in order to obtain a lower interest rates.   The risk of these products is too great. Remember that mortgage debt is detrimental in retirement so in order to pay off your mortgage you will have to stay in your home, use a 15-year mortgage and refrain from borrowing with second mortgages or home equity lines.

Your financial advisor’s job is to persuade you to invest in a 401(k) plan under all circumstances.   401(k) plans have many good features and should be part of your retirement plan.   However, your earnings are fungible and limited.   People starting their careers with large amounts of student debt or consumer loans and a shaky credit rating must consider the tradeoff between debt reduction and 401(k) contributions. Your financial advisor will tell you that you should never refuse the employer match to a 401(k) plan or take out a 401(k) loan. It is not difficult to come up with examples where this is bad advice.

Your financial advisor and your mortgage lender are both likely to argue that adding money to your 401(k) near the end of your career is more important than paying off your mortgage. The analysis presented here indicates this strategy will make you worse off than one emphasizing the elimination of all mortgage debt prior to retirement.

The traditional approach to financial planning – buy houses with 30-year mortgages and throw money into the market through 401(k) plans does not work. Instead the new generation of savers needs to focus on debt reduction and growth in housing equity even if this approach delays the purchase of your dream house and decreases investments in 401(k) plans.

Link to Nine Essays on Debt and Your Retirement in Kindle


Book is also available through Nook and Ibooks.



Tip 4c: 401(k) loans are a viable option for people drowning in debt.

3 Jun

Tip 4c: 401(k) loans are a viable option If you are drowning in credit card debt or faced with default on student loan debt, homelessness or some other existential emergency. I don’t recommend the use of 401(k) loans for routine borrowing needs. Also, be reluctant to take out a 401(k) loan if you are likely to leave your current employment.

Background: Suze Orman lists taking out a loan from your 401(k) plan as one of the things you should never do with your money.

Missing a student loan payment is also on the list.   She does not mention what to do if the only way to avoid a missed student loan payment is to borrow from your 401(k) plan.

Suze Orman makes a good point that 401(k) assets are protected from bankruptcy.   If bankruptcy is unavoidable don’t borrow from your 401(k) plan!!!!!!!   However, if bankruptcy is avoidable or not a practical option a 401(k) loan needs to be considered. (Bankruptcy may not be a practical option for people with student loans because student debt is not forgiven in bankruptcy.)

An Example: One of the things I have learned in life is that one should rarely if ever use the word never.   Consider a person with 10 credit cards, a total of $20,000 in credit card loans, at a high interest rate.   This person is drowning.   He won’t qualify for a personal consolidation loan at a reasonable rate. If she stops charging immediately it will take at least 5 years to pay off these credit card loans.   Direct costs include both interest and annual fees.

The credit rating for this person is probably already in the toilet and as a result the person will have a hard time borrowing for a car or a house at a reasonable interest rate in the next five or ten years.   These problems might have been avoided if the person had limited contributions to the 401(k) plan and instead had focused on debt management.

Past is past.   One must now consider the pluses and the minuses of using a 401(k) loan to repay the credit card debt.

The money is taken out of the 401(k) plan to repay the loan.   However, money is returned to the 401(k) plan once the loan is repaid.   So what then is the cost of the 401(k) loan to your 401(k) account IF THE FULL LOAN IS REPAID?

The impact of the 401(k) loan on the eventual balance in the 401(k) account depends on the allocation of assets in the account and the return of assets over the period of the loan.   If your 401(k) assets are in stocks and the market skyrockets you will lose out. If your 401(k) assets are in stocks and the market craters, your decision to borrow really worked out. If your 401(k) assets are in government bonds then the return on the loan you repay will be roughly the same as the bond investment.   Since returns on bonds and 401(k) loans are similar it may make sense for the person with a 401(k) loan to allocate more assets towards stocks.

Asset allocation inside a 401(k) plan is a complex issue in its own right and is address in other tips.   My point here is that loans from 401(k) plans are a viable option if you are drowning in credit card debt or are facing some sort or existential emergency.

There is financial risk associated with failure to repay 401(k) loans. The part of the 401(k) loan that is not repaid is subject to federal and state income tax and a federal tax penalty.    The person with a 401(k) loan who loses his job or takes a new one will generally have to either repay the loan in full when leaving his current position or pay the tax and penalty.   For this reason, people who are likely to leave their current position for any reason should probably not take out a 401(k) loan.

You need to actively weigh the likelihood of leaving your current employment situation prior to taking out a 401(k) loan.   Be especially cautious about taking out a 401(k) loan if you are actively looking for a new job or if a spouse is actively looking in another city.

People who have a 401(k) loan and leave their place of employment generally have 60 days to repay the loan in full or take a tax hit.     Some have argued that a person with a 40l(k) loan who is leaving his employment should borrow in order to repay the loan.

One wonders why a person drowning in debt with no liquidity faced with existential emergencies has chosen to fund his non-liquid retirement account rather than avoid debt.

Tip Four A: Place a high priority on reducing the total number of open credit cards.

1 Jun

Tip Four A: People with multiple credit cards need to consider factors in addition to interest rates when devising a strategy to repay credit card debt.  These factors include annual fees, the likelihood of missed payments, the size of the balance on the card, and minimum payments.

Discussion: Intuitively it seems reasonable to pay off cards with higher interest rates prior to paying off cards with lower interest rates.   However, there are other costs both direct and indirect of having multiple credit cards.

The most obvious direct cost is the annual fee.   A $50 annual is not unusual.  It can easily take five years to fully pay a maxed out card when making only the minimum payment. Fees for a person with 10 maxed-out cards would add to $5,000 over the life of the card.

A person with multiple cards will be highly prone to missing some payments.   Missed payments will cause the person’s credit rating to fall apart and will lead to prolonged future high borrowing costs or even inability to qualify for a mortgage.   (You probably don’t have to worry about lack of access to high-interest rate consumer loans or payday loans.   Your friendly bank and neighborhood crack dealer will always be there for you!)

People with too many credit lines and/or problems making payments on time will not qualify for a loan that will allow them to consolidate their credit card debt at a lower interest rate. The person drowning in credit card debt with multiple cards may have to cut or even eliminate contributions to their 401(k) plan in order to make payments on time.

So consider a person with 10 credit cards drowning in debt.   Nine of them have a 14% interest rate. Each of the nine have a $1,000 balance and each requires a minimum payment equal to 4.0 percent of the current balance.   The tenth card has a $11,000 balance with a 18 percent interest rate. The minimum payment on the tenth card is 4.0 percent of the loan balance.   Should this person apply all extra payments to the high-interest high-balance card or apply extra payments to smaller-balance cards in sequence.

The debtor could minimize interest payments by targeting the $11,000 card with the 18 percent interest rate.   However, this strategy would result in the debtor paying the full $5,000 in card fees over 5 years.

Alternatively, the debtor could concentrate all extra payments on each $1,000 card in sequence. The small-card sequential payment strategy would result in the debtor retiring 2 cards the first year, 3 cards the second year and 4 cards the third year. This strategy reduces card fees by $3,500.

The larger savings are likely to stem from the improvement in the credit score.    The mere existence of an excessive number of open maxed-out credit lines will lead to a low credit score. A person with 10 maxed-out credit cards is highly likely to miss payments and end up with a terrible credit score.   This will be catastrophic.

The sequential payment strategy targeting the smallest cards with large minimum payments is the strategy that is more likely to prevent this impending disaster.

Tip Three: Paying only the minimum due on a credit card is often highly costly.

27 May

Tip Three: Paying only the minimum due on a credit card is often highly costly.

Large credit card balances will cause you stress, ruin your credit rating, and will cause you to pay a large amount of interest over the life time of the loan unless you aggressively pay down the loan. A number of articles have concluded that paying the minimum balance on your credit cards is likely to lead to the deterioration of your credit score.

Paying only the minimum is not a good tactic.

Credit card minimum payments vary across companies or cards.  Card balances appear to be going up and can be changed arbitrarily by banks.

A typical credit card may have a minimum amount due of around 2 percent to 3.5 percent of the balance of the card. I have estimated the life of the loan for a credit card with 2 percent minimum monthly payment and a 3.5 percent minimum monthly payment.

My calculation of the amount of time it takes to repay a credit card loan assumes an interest rate of 15 percent.   The balance on the card should be irrelevant to the duration of repayment because the minimum payment is a percent of the total balance. (Higher balances are obviously associated with higher payments and more interest over the life of the loan.)

I found that it takes around 79 months to repay the card with a 2 percent monthly payment and 36 months to repay the card with a 35 percent loan.

Total payments on a $1,000 debt will be $1,580 (79x $20) for the 2 percent minimum and $1,260 (36x $35) for the 3.5 percent minimum payment balance.

Payment summaries for two credit cards
Minimum payment


Number of


Total payments over

life of loan

2.0% 79 $1,580
3.5% 36 $1,260

Calculations are based on a $1,000 credit card with a 15 percent interest rate.

Appendix:   How did I get these numbers?

I calculated the payment on a $1,000 loan with a 15 percent interest rates for loan durations ranging from 1 to 140.   The payment function gives us the payment that will lead to $0 balance once payments are finished.   A 2.0 percent payment on a $1,000 loan is equal to a monthly payment of $20.  Note that at for a period of 79 months the payment function is equal to $19.99. A 3.5 percent payment on a $1,000 loan leads to a payment of $35 per month.   Note that for a period of 36 months the payment function falls below $35.

Hence a 2.0 percent minimum payment loan should entail 79 monthly payments while a 3.5 percent minimum payment loans should entail around 36 monthly payments.


The impact of months of payments on payment level
Interest Rate months Balance Payment
0.15 1 1000 -$1,012.50
0.15 2 1000 -$509.39
0.15 3 1000 -$341.70
0.15 4 1000 -$257.86
0.15 5 1000 -$207.56
0.15 6 1000 -$174.03
0.15 7 1000 -$150.09
0.15 8 1000 -$132.13
0.15 9 1000 -$118.17
0.15 10 1000 -$107.00
0.15 11 1000 -$97.87
0.15 12 1000 -$90.26
0.15 13 1000 -$83.82
0.15 14 1000 -$78.31
0.15 15 1000 -$73.53
0.15 16 1000 -$69.35
0.15 17 1000 -$65.66
0.15 18 1000 -$62.38
0.15 19 1000 -$59.46
0.15 20 1000 -$56.82
0.15 21 1000 -$54.44
0.15 22 1000 -$52.27
0.15 23 1000 -$50.30
0.15 24 1000 -$48.49
0.15 25 1000 -$46.82
0.15 26 1000 -$45.29
0.15 27 1000 -$43.87
0.15 28 1000 -$42.55
0.15 29 1000 -$41.32
0.15 30 1000 -$40.18
0.15 31 1000 -$39.11
0.15 32 1000 -$38.11
0.15 33 1000 -$37.17
0.15 34 1000 -$36.28
0.15 35 1000 -$35.45
0.15 36 1000 -$34.67
0.15 37 1000 -$33.92
0.15 38 1000 -$33.22
0.15 39 1000 -$32.55
0.15 40 1000 -$31.92
0.15 41 1000 -$31.32
0.15 42 1000 -$30.75
0.15 43 1000 -$30.20
0.15 44 1000 -$29.69
0.15 45 1000 -$29.19
0.15 46 1000 -$28.72
0.15 47 1000 -$28.26
0.15 48 1000 -$27.83
0.15 49 1000 -$27.42
0.15 50 1000 -$27.02
0.15 51 1000 -$26.64
0.15 52 1000 -$26.27
0.15 53 1000 -$25.92
0.15 54 1000 -$25.58
0.15 55 1000 -$25.25
0.15 56 1000 -$24.94
0.15 57 1000 -$24.63
0.15 58 1000 -$24.34
0.15 59 1000 -$24.06
0.15 60 1000 -$23.79
0.15 61 1000 -$23.53
0.15 62 1000 -$23.27
0.15 63 1000 -$23.03
0.15 64 1000 -$22.79
0.15 65 1000 -$22.56
0.15 66 1000 -$22.34
0.15 67 1000 -$22.13
0.15 68 1000 -$21.92
0.15 69 1000 -$21.72
0.15 70 1000 -$21.52
0.15 71 1000 -$21.33
0.15 72 1000 -$21.15
0.15 73 1000 -$20.97
0.15 74 1000 -$20.79
0.15 75 1000 -$20.62
0.15 76 1000 -$20.46
0.15 77 1000 -$20.30
0.15 78 1000 -$20.14
0.15 79 1000 -$19.99
0.15 80 1000 -$19.85
0.15 81 1000 -$19.70
0.15 82 1000 -$19.56
0.15 83 1000 -$19.43
0.15 84 1000 -$19.30
0.15 85 1000 -$19.17
0.15 86 1000 -$19.04
0.15 87 1000 -$18.92
0.15 88 1000 -$18.80
0.15 89 1000 -$18.68
0.15 90 1000 -$18.57
0.15 91 1000 -$18.46
0.15 92 1000 -$18.35
0.15 93 1000 -$18.25
0.15 94 1000 -$18.14
0.15 95 1000 -$18.04
0.15 96 1000 -$17.95
0.15 97 1000 -$17.85
0.15 98 1000 -$17.76
0.15 99 1000 -$17.66
0.15 100 1000 -$17.57
0.15 101 1000 -$17.49
0.15 102 1000 -$17.40
0.15 103 1000 -$17.32
0.15 104 1000 -$17.24
0.15 105 1000 -$17.15
0.15 106 1000 -$17.08
0.15 107 1000 -$17.00
0.15 108 1000 -$16.92
0.15 109 1000 -$16.85
0.15 110 1000 -$16.78
0.15 111 1000 -$16.71
0.15 112 1000 -$16.64
0.15 113 1000 -$16.57
0.15 114 1000 -$16.50
0.15 115 1000 -$16.44
0.15 116 1000 -$16.38
0.15 117 1000 -$16.31
0.15 118 1000 -$16.25
0.15 119 1000 -$16.19
0.15 120 1000 -$16.13
0.15 121 1000 -$16.08
0.15 122 1000 -$16.02
0.15 123 1000 -$15.96
0.15 124 1000 -$15.91
0.15 125 1000 -$15.86
0.15 126 1000 -$15.80
0.15 127 1000 -$15.75
0.15 128 1000 -$15.70
0.15 129 1000 -$15.65
0.15 130 1000 -$15.60
0.15 131 1000 -$15.56
0.15 132 1000 -$15.51
0.15 133 1000 -$15.46
0.15 134 1000 -$15.42
0.15 135 1000 -$15.37
0.15 136 1000 -$15.33
0.15 137 1000 -$15.29
0.15 138 1000 -$15.25
0.15 139 1000 -$15.20
0.15 140 1000 -$15.16


Tip Number One: Make Living With Little Debt a Priority

14 May

Tip Number One:  Make Living With Little Debt a Priority

Households need to limit the amount of their debt they pay over their lifetime even if this goal requires them to delay home purchases and 401(k) contributions.


For many households, financial planning involves around two goals — (1) purchase a home and (2) save for retirement.   The advice they receive in this process from their realtor and their retirement advisor is unambiguous.

The realtor almost always tells the potential homebuyer that house prices are going up.   The realtor with the loan officer generally advises the use of a 30-year mortgage over a 15-year mortgage because often the use of a 15-year mortgage would require that the person purchase a smaller home or wait until they have a larger down payment.

Financial advisors stress the importance of placing money in a 401(k) plan. The financial advisor generally recommends that people start placing money in their 401(k) plan as soon as they start their career and always take the full employer match. Often the financial advisor will recommend that you make the fully allowable contribution to your 401(k).

People who follow the financial game plan of buying a home and contributing to their 401(k) plan right after college instead of paying off debt are likely to fall in a debt trap where they work for the bank their entire life.

Consider a person finishes school with $80,000 in student loans and $20,000 in credit cards. He makes home purchases and 401(k) contributions a priority over debt reductions.   After taking out the student loan and the credit cards he continues consuming and borrowing often on less than favorable terms.   Over the course of his lifetime he buys three homes with 30 years mortgages and five cars all on credit. The loan history for a hypothetical person is presented below.

Lifetime Loans for a Hypothetical Borrower
Debt Type Amount Interest Rate Maturity of Loan in Months Years Loan Held
Credit Card $20,000 12.00% 120 120
Student Debt $80,000 7.00% 240 240
Mortgage 1 $100,000 5.00% 360 96
Mortgage 2 $250,000 5.00% 360 96
Mortgage 3 $500,000 5.00% 360 360
Car Loan 1 $5,000 7.00% 60 60
Car Loan 2 $10,000 7.00% 60 60
Car Loan 3 $15,000 7.00% 60 60
Car Loan 4 $20,000 7.00% 60 60
Car Loan 5 $20,000 7.00% 60 60

How much does this person pay in interest over his lifetime?

Lifetime Interest for the Hypothetical Borrower
Debt Type Cumulative Interest over the life of the loan
Credit Cards $14,092
Student Debt -$67,994
Mortgage 1 -$36,818
Mortgage 2 -$92,044
Mortgage 3 -$462,269
Car Loan 1 -$906
Car Loan 2 -$1,812
Car Loan 3 -$2,718
Car Loan 4 -$3,624
Car Loan 5 -$3,624
Total -$657,716

This is not an atypical situation.   Paying over $600,000 to banks in the form of interest over the course of a lifetime is plain CRAZY! The household who pays over $600,000 to the bank in a lifetime is essentially a slave.

In order to avoid this debt trap people must pay off credit card debt ASAP, accelerate payments on their student loans and take out a 15-year FRM rather than a 30-year FRM.   This can only be accomplished by delaying home purchases and by reducing investments in financial assets.   For most households, the debt reduction strategy will necessitate some reduction in 401(k) contributions.

People need to reduce the amount of debt they pay banks over the course of their lifetime.   The can do this by getting rid of credit card debt as quickly as possible, accelerating payments on their student loans, delaying purchase of homes, and using a 15-year FRM rather than a 30-year FRM.

This is heresy for many financial advisors who stress always taking full advantage of employer matching contributions.   Most likely these financial advisors were never in a situation with poor job prospects, low liquidity and spiraling debt.

The situation presented here is not a worse case scenario.   Many households fail to quickly reduce their credit card debt will have their credit rating deteriorate.   A poor credit rating will impact job prospects, insurance costs, and even the ability to rent an apartment.

My first tip is a general one. People need to make debt containment a priority over other financial goals including home purchases and contributions to 401(k) plans.

Tip Two: Getting rid of credit cards is a higher priority than 401(k) employer matches.

14 May

Tip Two: People with large credit card balances and/or multiple credit card accounts need to make retirement of credit card debt their highest priority even if this strategy results in them foregoing employer-matching contributions to their 401(k) plan.

Analysis:   Let’s take a person with $20,000 in credit card debt scattered over 8 cards with an average interest rate of 15 percent. This person is paying $3,000 in interest per year. The person has around $100 in her checking account, a large student loan, a car loan and nontrivial rent.   This person is living paycheck to pay check.

The financial advisor sees that the person works for a firm a 401(k) plan that offers 100% match on 5 percentage points of their contribution.   The person makes $75,000 a year.   This amounts to $3750 per year of essentially free money.   The financial advisor says you are crazy to not take the $3,750 in free money.

Is the financial advisor right?

Short Answer is NO!!!!!!!!!

Reasons why the financial advisor is wrong:

  • With eight credit card payments, one student loan, and one car loan this person is highly likely to miss some mandatory payments. I suspect that a person with this level of debt and this number of accounts will screw up at least once a month and probably a lot more. The direct costs of the missed or late payments will result in late fees from the creditor and possibly a bounced check fee.   The indirect cost of a late fee is a deteriorating credit rating, which leads to higher borrowing costs. Late or missed payment is one of the most important determinants of a person’s credit score and cost of credit.
  • The article linked below has an example discussing the impact of good credit on mortgage costs on a $200,000 loan.   The person with good credit (760 or above) will pay around 3.8 percent on a mortgage.   The person with less than stellar credit (score of 650) will get a mortgage with a 4.9% interest rate.   This amounts to around $125 per month on a $200,000 loan.

  • The same article linked above suggests that the difference in credit card interest rates for a person with good and bad credit could be around 15 percentage points with the bad-credit person paying 30 percent interest.  Not to worry though. In actuality. a person with credit so poor that he or she will have a 30 percent credit card interest rate is likely headed for bankruptcy.
  • This person could lose his or her job for any variety of reasons.   Perhaps the job is a bad fit. Perhaps the person’s boss is an asshole. Perhaps there is a layoff.   Money in a 401(k) plan needs to be withdrawn in this situation. Withdrawals prior to age 59 ½ incur a 10% tax penalty.

Concluding thoughts: The financial advisor that recommends highly leveraged young people take the employer match in a 401(k) plan is out of touch with the realities facing today’s generation of young adults.   The best-case scenario for the highly leveraged young adult who focuses on retirement planning rather than debt containment is a lifetime of excessive debt payments.   The more immediate scenario is a destroyed credit rating leading to higher interest rates and possibly even bankruptcy.

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