Tip 11a: Paying off the mortgage is more important than padding your 401(k) prior to retirement.

6 Jun

Tip 11a: Paying off the mortgage prior to retirement is more important than padding the 401(k) plan.

Older workers are allowed to make additional contributions to their 401(k) plan.   Many financial advisors advocate full use of these make-up contributions even if this results in their clients keeping a mortgage in retirement.

Many of the articles below suggest it is okay to keep a mortgage in retirement.

http://www.forbes.com/sites/nancyanderson/2014/01/03/7-reasons-not-to-pay-off-your-mortgage-before-you-retire/

http://www.kiplinger.com/article/real-estate/T040-C000-S002-should-you-pay-off-your-mortgage-before-you-retire.html

http://www.washingtonpost.com/news/get-there/wp/2015/03/26/the-case-for-not-paying-off-your-mortgage-by-retirement/

http://www.foxbusiness.com/personal-finance/2014/06/18/maybe-shouldnt-pay-off-your-mortgage-before-retirement/

http://business.time.com/2013/05/28/the-new-retirement-why-you-dont-have-to-pay-off-your-mortgage/

http://online.wsj.com/ad/article/privatewealthretirement-mortgage

http://www.schwab.com/public/schwab/nn/articles/Should-You-Pay-Off-Your-Mortgage-Early-Before-You-Retire

http://www.principal.com/planningcenter/retirementplanning/nearingretirement/retirementnews/mortgagequestion.htm 

Let me be clear about my view.

For the overwhelming majority of households, keeping a mortgage in retirement is a huge mistake. The problems associated with keeping a mortgage in retirement are especially pronounced for a household with most of its financial assets in a 401(k) account.   The entire disbursement from a 401(k) account is taxed at ordinary income tax rates.   A retired person with all assets in his 401(k) plan must make larger withdrawals to cover the additional expense of the mortgage and the additional tax on the additional withdrawal.

Analysis: Let’s consider two people both 15 years away from retirement. One takes out a 15-year mortgage and pays off the mortgage on the day he retires.   The other takes out a 30-year mortgage, makes a smaller mortgage payment and invests more in a 401(k) plan.   Possible results after 15 years might look as follows.

The 401(k) Strategy Versus the Mortgage Payoff Strategy

– Possible Outcomes

Person A Person B
House Value $600,000 $600,000
Original Mortgage Value $540,000 $540,000
Term of Mortgage 30 15
Mortgage Payment -$2,578.04 -$3,994.31
Mortgage Balance at Retirement $348,531.12 $0.00
Equity in House $251,468.88 $600,000.00
401(k) Balance in Retirement $800,000 $400,000
Net Worth $1,051,468.88 $1,000,000.00

Observations on the possible outcomes from the two strategies:

  • If the person continues to live in his house after retirement he must take a disbursement from the 401(k) of around $31,000 to cover the cost of the mortgage.   The person will also have to disburse additional funds to cover the cost of tax on the additional funds.   My guess is that this person has a marginal tax rate of at least 0.30 for federal and state taxes.   This would result in total disbursement of around $44,000 ($31,000/0.7).   If my numbers are accurate the net worth advantage stemming from the 401(k) investment strategy is almost entirely wiped out after one year.
  • Is this comparison realistic? Possible yes and possibly no. If returns at retirement are low (think 2009) I have probably overstated the value of the 401(k) maximization strategy. If market returns are robust the person may have a larger 401(k) balance and net worth. But if the person who adopts a 401(k) maximization strategy plans to stay in the house he has to either pay the mortgage for15 more years or pay the mortgage off. The person in my example is not going to be able to stay in the house and continue to pay down the mortgage for 15 years unless the person had phenomenal returns on her 401(k) plan assets.   However, in order to get high returns a person needs to take risk and allocate assets towards stocks rather than fixed-income assets.   This person is both old and retired and should be avoiding rather than embracing risk.
  • A person with all financial assets in his 401(k) plan will find immediately paying off the mortgage expensive.   This person will have to withdrawal $348 plus the tax on the $348.   If done in one tax year the marginal tax rate for federal and state taxes combined could easily be 0.45.   Perhaps the mortgage payments could be spread out over two or three years but even then early payment of a mortgage from 401(k) assets is expensive.
  • Many retired people with high levels of 401(k) assets and a high mortgage are likely to end up selling their house and buying a smaller one with whatever cash left over when they payoff their mortgage. Certainly, Person A in this example would be wise to quickly consider downsizing.

Concluding thoughts: Financial advisors do a very good job pointing out the tax advantages of 401(k) contributions during working years.   However, the retiree with a disproportionate amount of assets in his 401(k) plan has a very large potential tax obligation.   The tax bill in retirement is larger for people who must continue to pay off their mortgage. Perversely, the tax obligations of older people who are reliant of 401(k) assets increases in years they have large expenditures because of a financial or health emergency.

It is not surprising that financial advisors and bankers would favor 401(k) investments over mortgage pay downs.  401(k) fees are basically a percent of assets under management.   A higher level of 401(k) assets is associated with higher revenue and profit for fund managers. Mortgage interest received by investors and bank profits will fall if people pay cash for houses or payout their mortgage quickly.   Financial advice is often more closely aligned towards the interests of the financial advisor than the client.

Tip One: Avoid the debt trap at all costs

13 May

 

Tip Number One:  

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.

Analysis:

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.

Can the Survey of Consumer Finances be used to study student debt?

3 Dec

Some Thoughts on the use of the Survey of Consumer Finances (SCF) to study Student Debt

A recent Federal Reserve Bulletin article provided some interesting statistics on student debt. This post summarizes the numbers in the FRB article and discusses the limitations of the use of SCF to study issues related to student loans.

http://www.federalreserve.gov/pubs/bulletin/2014/pdf/scf14.pdf

Summary on Student Loan Analysis in the FRB article:

The analysis in the FRB article on student debt pertains to “young” households defined as households where the head of household was younger than 40 at the time of the survey.

The main student debt results reported in this study are as follows:

  • Percent of young households with student debt went from 22.4 in 2001 to 38.8 percent in 2013.
  • Conditional student debt mean went from $16,900 to $29,800.
  • Conditional median student debt went from $10,500 to $16,800

The Distribution of Student Debt Balances for the Young Household Population is as follows:

Distribution of Student Debt Balances Reported in FRB Article
2001 SCF 2013 SCF Diff.
Less than $25,000 78.2 64.2 -14
Between $25,000 and $50,000 15.6 17.1 1.5
Between $50,000 and $100,000 5.6 13.2 7.6
Over $100,000 0.6 5.6 5
100 100.1 0.1

Numbers in table above are taken form pie charts in Figure B of page 26 of the FRB study.

  • Share of student debt held by young households went up for households making less than $30,000 from around 12 percent to somewhere in the mid 20 percent. The share of student debt held by people making $30,000 to $60,000 per year went down from around 40 percent to around 28 percent.   The share of student debt held by individuals with households making more than $60,000 went up slightly to approach 50 percent.
  • Around 70 percent of families with student debt had one member of the household with a bachelors degree or higher.
  • Young families with student debt pay around 3.8 percent of their household on student loan repayments. One reason why this number is so low is that some households can defer payment on student loans for a variety of reasons.

Comment One: Other studies which examined large databases of recent graduates have reported much larger student debt burdens the FRB study.

Stats in Brief U.S Department of Education

http://nces.ed.gov/pubs2014/2014011.pdf

  • This paper found that the percent of BA degree recipients in public 4-year institutions with a repayment burden greater than 12 percent of income rose from 14 percent in 2001 to 26 percent in 2009.
  • In private non-profit institutions this number went from 25 percent to 39 percent.

Amazingly, this increase in payment burdens occurred during a period of modest interest rates.

Comment Two: The under-40-household population is too broad to be useful to study the impact of the rapid increase in student debt mentioned in comment one. A person who was 40 has likely been repaying their undergraduate loans for 18 years and their graduate loans for at least 10.   These older “young” households were not affected by the recent increase in student debt.

Perhaps this issue could be addressed with the chart below but the sample size of the SCF is a significant limitation.

Student Debt Burdens
Age 2001 SCF 2013 SCF
<-30
31 to 39
>=40

Comment Three: The sample size of groups of households on the SCF defined by different levels of education, age, income and other issue is very small.   The SCF covers the entire population with 4568 cases from a general survey and 1458 cases from an IRS sample of high-income households.   Since higher income households tend to be older I suspect that the IRS sample under sampled the young households that are the focus of this study.   (I can’t answer this issue authoritatively.   Readers interested in this issue need to contact the FRB staff.)

If 30% of the SCF households are under 40 the incidence of student debt numbers are based on a sample of around 1,800. Around 38.8 percent of the population has a student loan the mean and median loan figures are based on a sample size of around 700 or less.   Around 28 percent of people over 25 have a BA degree.   But the number of households with a BA might be a bit lower because of a marriage effect.   Hence, there may be around 200 households in the sample with student debt and a BA.   Less than half of these households have a household head under age 30.

Around 20 percent of students go to the more expensive private non-profit institutions.  Hence I expect the SCF sample contains at most 40 households with people who went to some private school.   It is likely around 10 people in this survey have student debt over $100,000.

The SCF sample sizes are small. The results are likely very imprecise.   I suspect micro data on student loans would provide a more accurate view of student debt in America.

Comment Four: The Survey of Consumer Finances contains a lot of information on household assets, debts and decisions. It would be useful to categorize young households on the basis of their amount of student debt and look at the impact of student debt on financial decisions and outcomes.     One categorization would involve households with no student debt, <$30,000, $30,001 to $75,0000, and greater than $75,000. I am interested in how these household differ and on the changes in these groups in several variables including — home ownership, credit card interest and consumer debt totals interest rates on different types of loans, contributions to 401(k) plans and IRAs.

Student debt is likely to impede the growth of wealth for households through two channels — delayed home purchases and reduced 401(k) contributions.

 

http://dailymathproblem.blogspot.com/2014/11/wealth-inequality-and-student-debt.html

 

Again, the sample size of the SCF limits the amount of information, which might be obtained from this exercise.

Comment Five: The report states that “highly educated families continue to hold the majority of education debt in 2013.   Nearly three fourths of education debt is held by families where one member has a BA degree or higher.”

It is a misnomer to call a person with a BA degree highly educated. A BA degree is now required for a lot of entry level jobs that did not formerly require a college education.   Also, the unemployment rate and underemployment rate for current College grads are around 8.5 percent and 16.8 percent respectively.

http://www.slate.com/blogs/moneybox/2014/05/08/unemployment_and_the_class_of_2014_how_bad_is_the_job_market_for_new_college.html

Concluding Thoughts:. The SCF is not the most useful source of evidence on this topic.   Some additional tabulation based on SCF data might prove interesting but researchers interested in student debt issues should consider other sources of data.

Reprint of seven ways to provide student loan debt relief

27 Nov

The National Association of Student Financial Aid Administrators originally published this article.   I am grateful to them for allowing me to reprint it here.

The original link for the article is here.

 

 

Seven Ways to Provide Student Loan Debt Relief

The current generation of students is leaving school with more debt than any previous generation. While postsecondary education remains a good investment for the average student loan borrower, some borrowers will never be able to repay their student loans in full. Moreover, current bankruptcy law and procedures make it very difficult for borrowers with student debt to ever obtain a fresh financial start.

At the federal level, there is some interest in policies that might alleviate student loan debt burdens. The desire to provide student debt relief to borrowers is tempered by concern about the cost to taxpayers when this government guaranteed debt isn’t fully repaid. In my view, it is possible to provide a modest level of student debt relief to borrowers without imposing substantial costs on taxpayers. This could be accomplished by modifying the Income Based Replacement (IBR) Loan Program and through changes to the bankruptcy code.

The IBR program, enacted in 2009, provides four benefits to student loan borrowers.

1.     Reduction in student loan payments when household income is low in relation to qualified student debt,

2.     Reduction in interest payments when IBR payments do not cover interest due,

3.     Limits on the capitalization of interest for loans in deferment or forbearance, and

4.     Forgiveness of a remaining loan balance 25 years after the student loan enters repayment.

In addition, some student loan borrowers who maintain payments through the IBR program will be able to utilize public loan forgiveness programs

The primary purpose of the IBR program is to prevent borrowers from defaulting on their student loan when their household income is low compared to qualified student loan debt. Only student loan borrowers with chronically low levels of household income can receive some debt forgiveness. Borrowers who receive lower payments through the IBR program will often pay more on their loan than if they remain in the standard 10-year payment plan.

The IBR program is complex and does not offer assistance to many overextended student loan borrowers. First, the IBR program does not cover PLUS loans made to parents, private loans, or consolidated loans that include a parent PLUS loan or a private student loan. The decision to consolidate 10-year loans into a 20-year loan could also make borrowers ineligible for the IBR program. To fully benefit from the IBR program, borrowers need to be aware of IBR rules long before they are aware that they will need IBR, when they are borrowing or consolidating federal student loans.

Second, the IBR program often provides little or no relief to a household that has high levels of both consumer debt and student loans. The IBR program is especially complex for married households.  A single person who qualifies for the reduced IBR loan payment could lose this benefit if he or she marries someone with high levels of consumer debt, even if household debt-to-income ratios increased after marriage. Married individuals could choose to file separate tax returns to take advantage of the IBR program, but that decision usually results in a larger tax obligation.

It is impossible to modify the IBR program to account for consumer debt without creating an incentive for additional borrowing.  Borrowers with high levels of student debt and consumer loans might seek relief in bankruptcy courts.  However, current bankruptcy laws and procedures offer little relief for borrowers with student loan debt.

There are two ways debtors can seek student loan debt relief in bankruptcy. First, the debtor could petition the court for a complete or partial discharge of student debt. Second, in a Chapter 13 bankruptcy the debtor could petition the court for a payment plan that favors the repayment of student loans over the repayment of other unsecured loans. Neither remedy is easily obtained.

To discharge student debt in bankruptcy, the borrower must prove that he or she has an “undue hardship.” Most courts require that the borrower show a “certainty of hopelessness” for his or her financial situation over the repayment term of the loan. A certainty for hopelessness is extremely difficult to demonstrate because there is some probability circumstances will improve, even for individuals in extremely dire circumstances. An August 31, 2012, New York Times article describing the petition of a legally blind, unemployed man illustrated the hurdles a student loan borrower must clear in order to have student debt discharged in bankruptcy.

Any proposal that makes it easy to discharge government guaranteed student loans in bankruptcy entails some additional cost to the taxpayer. However, it is easy to envision a less stringent student loan discharge rule that does not significantly increase taxpayer costs. Such a rule would rely on objective criteria rather than the subjective “undue hardship” concept. For example, student loan discharge could be limited to individuals with incomes near poverty level, contingent on participation in the IBR program, favor individuals with medical problems, and allow for partial, rather than full, loan cancellation.

Two other aspects of the bankruptcy code have a substantial impact on financial outcomes for student loan borrowers in bankruptcy and for the government agencies that hold or guarantee student debt.  First, financial outcomes are affected by the rules governing whether a debtor can obtain a Chapter 7 bankruptcy or a Chapter 13 bankruptcy.  Second, financial outcomes are affected by the rules governing repayment of student debt and other unsecured consumer loans under a Chapter 13 repayment plan.

Under a Chapter 7 bankruptcy, the bankruptcy court will immediately discharge most unsecured consumer loans. In a Chapter 13 bankruptcy plan, debtors must file repayment plans with the bankruptcy court. The repayment plan determines how much debtors can repay creditors and the amount received by each creditor. Prior to the 2005 bankruptcy law, debtors could choose to either file under Chapter 7 or Chapter 13. The 2005 bankruptcy law created a means test that required many individuals with incomes over the household median to file Chapter 13 rather than Chapter 7.

When student loans are dismissed under Chapter 7 bankruptcy, the borrower gets an immediate fresh start and can use all the newly available funds for the repayment of student debt. A borrower who obtained a deferment prior to bankruptcy can immediately renew payments on his or her student loan. By contrast, when borrowers are placed into a Chapter 13 repayment plan, the amount allocated to the payment of student loans might not even cover interest and, in many circumstances, the debtor will leave bankruptcy with a substantial student debt intact.

Student loan borrowers in Chapter 13 can petition the bankruptcy court to allocate a greater amount of their payment plan to the repayment of student loans and a lower amount to the repayment of other unsecured credit card debt. However, most courts tend to favor a payment plan that does not discriminate against any class of unsecured creditors. As a result, many student loan debtors emerge from the bankruptcy process five years older with a substantial amount of unpaid student loans. Many individuals experience decreases in income and have fewer job prospects after age 50. A delay in repayment of student loans caused by a forced entry into a Chapter 7 bankruptcy plan will increase financial exposure to taxpayers, increase student loan default rates, and decrease collection rates.

A revision of Chapter 13 bankruptcy rules that gives priority to student debt payments over other unsecured debt payments in bankruptcy would provide student loan debtors with a fresh financial start and would ultimately reduce taxpayer losses. Unsecured creditors would still enjoy greater collection rights than existed prior to the 2005 bankruptcy law.

Under current law, very little debt relief is offered to overextended student loan borrowers experiencing substantial economic hardship. Several policy changes might provide modest debt relief to these borrowers, maintain strong incentives against default, and protect taxpayer interests.  These policies include:

·      Allowing married couples to obtain IBR debt reduction without having to actually file separate tax returns,

·      Making PLUS loans to parents and consolidated student loans with a PLUS loan eligible for the IBR loan program,

·      Allowing private student loans to be discharged in bankruptcy,

·      Basing the decision to discharge student loans in bankruptcy on objective criteria pertaining to the economic status of the bankruptcy applicant rather than the subjective “undue hardship”  concept,

·      Allowing for quicker loan forgiveness under the IBR program for individuals in dire economic circumstances,

·      Repealing or modify the Chapter 13 means test, 

·      Providing priority to student debt over other unsecured loans in Chapter 13.

The goal of debt forgiveness policies inside and outside of bankruptcy is to balance two competing objectives: providing overextended borrowers a fresh start, and fair treatment towards creditors. The pendulum may have swung too close to the creditor, especially with regard to the treatment of student debt.

The author is a retired economist who worked in the Office of Economic Policy of the U.S. Treasury from 1988 to 2012. He publishes a blog www.economicmemos.com

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