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 www.realtor.com. 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.
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.