Saturday, April 15, 2006

A debt free retirement?

The second of the critical assumptions in the retirement planning exercise is that a person should have no debt on retirement.

While there is a very meaningful distinction between "good" debt and "bad" debt, the way in which debt is viewed and used needs reexamination once a person leaves full time paid employment. My view is that it is undesirable to have debt once retirement has commenced.

The main reason for not having debt in retirement is safety. Debt needs to be serviced. Interest needs to be paid or it will accrue and compound, increasing the amount owed. Lenders generally expect to get their principle back as well. There are usually two ways in which debt can be repaid. The first is from investment income (e.g. a loan used to purchase an investment propety could be serviced using rental income from the property). The second is from earned income (e.g. a mortgage used to finance the purchase a home would typically be serviced from salary).

If you have been relying on your salary to meet the mortgage payments, the obvious question is where the money will come from to continue meeting payments once the salary stops hitting the bank account each month?

Even if you have been using passive income to service the debt, when you stop working you lose the security of having an alternative means of making payment should there be any disruption to the passive income or, alternatively, if the cost of servicing the loan increases when interest rates rise. People who financed property purchases using floating rate loans (or loans that would move to a floating rate after an initial fixed period) have recently been subjected to rising interest rates (including the traineeinvestor).

Another question to ask is whether the lender will be willing to leave the loan outstanding when you stop working? For most of us, our earned income is one of the things which the bank or other lender will take into consideration when deciding whether or not to grant the loan in the first place. The fine print in the typical loan documentation will often contain a clause giving the bank the right to demand repayment at any time if it thinks that the security of the loan is in doubt - even if the loan was originally granted for a fixed term.

The last consideration is less tangible but still important. People worry about debt just as much as they do about other bills. Why burden your retirement with unnecessary anxiety and stress?

One exception to the undesirability of debt on retirement is the reverse mortgage. Although reverse mortgages have their place in the tool kit of retirement financing they are generally best left as a form of insurance against the unexpected.

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