If you are like many working adults, you may be dreaming about a time when you can wake up each morning of the week when you feel like rolling out of bed and enjoying the entire day on your own terms. Retirement can seem blissful, but before you reach the point to make this monumental transition in your life, you need to properly prepare your finances. Unless you are incredibly wealthy, you likely need to prepare a retirement budget so that you can live well within your means. A common rule of thumb that many potential retirees follow is to pay off their top three types of debts before leaving the workforce. With a closer look at what these debts are and why you should pay them off, you can take proper steps to prepare yourself fully to live on a scaled back retirement budget.
Your Home Mortgage
If you are like most homeowners, your mortgage payment is one of the most significant debts that you pay each month. You understandably need a shelter in retirement, but when your mortgage is paid off, you can live in that shelter with minimal cost. Remember that you will still be responsible for your property taxes and home insurance premium with your mortgage is paid off.
Having this very large expense removed from your budget can help you in more ways than you might think. Consider if your mortgage payment is $2,000 per month, and your total expenses including the mortgage payment are $4,000 per month. With your mortgage paid off, you could essentially live on half of the money that you otherwise would need. You could stretch your nest egg longer, or you could potentially retire earlier.
If you cannot afford to pay off your current mortgage within a reasonably amount of time, there is another option available. You could sell your existing home, and you could use the equity to buy a smaller home in a more affordable market. By doing so, you may be able to pay cash for the home and own it free and clear.
As beneficial as paying off your mortgage may be, remember that you will give up the mortgage interest deduction when your loan is paid off. You can, however, still deduct property taxes on your federal income tax return. This will impact your total tax liability each year going forward, so you should plan accordingly.
Your Car Loan
Your car loan is another expense that deserves a closer look as well. Many married retirees downsize to a single vehicle in retirement, and this step alone could save you money on loan payments and insurance costs. However, a car loan payment may easily range from $300 to $600 per month for most drivers. While this payment is not as significant as your mortgage payment may be, you can see that it is still a very large expense that will take money out of your retirement accounts unnecessarily. It also could strain your budget in retirement so that you live less comfortably or enjoy less financial freedom.
Remember that your retirement account balance will continue to increase in value over the years based on the existing value of your investments. When you withdraw more of your funds to make your car payment each month, you are decreasing the growth potential of your retirement account going forward. In this way, your $500 per month car payment is actually costing you far more than $500. It is costing you $500 plus all of the future growth that the money would have earned in the years to come.
More than that, you also are straining your budget unnecessarily. Using the example above, if you pay off your $2,000 mortgage and your $500 car loan, your $4,000 per month expense total will decrease to only $1,500. This difference is truly substantial and even life-changing in many cases.
Your Credit Cards
A final debt that you should strive to pay off as soon as possible is credit card debt. Credit card debt is unsecured, and it is associated with a high interest rate and a revolving term. While you may want to keep one credit card account open for a true emergency situation when you need to make a quick and unexpected payment, carrying balances on credit cards simply eats up your money unnecessarily. With a $300 per month credit card payment, $100 or more may be used to pay the previous month’s interest. Over the course of a year, the interest charges that you pay on a single credit card can be substantial. This payment is another form of wasted money that otherwise could have been used more efficiently.
As is the case with a car loan and a mortgage, the money that you draw out of your retirement account now to pay interest charges is money that will not increase in value over time while sitting in your retirement account. When you look at your finances in this way, you can see that it is in your best interest to pay off as many debts as possible before retirement. By doing so, you can keep more money in your retirement account for a longer period of time to maximize growth. You can also live more comfortably with a minimized budget.
When you minimize your regular expenses in your retirement budget to the bare minimum, you will only pay for insurance, utilities, food, gas and a few other essential items. Some people are even able to live entirely on Social Security income when they reduce expenses as much as possible. Others may only have to draw a small amount of money out of a retirement account each month, or they may be able to live on residual income from other investments. As you can see, paying off these three typically large debts can have a profound impact on your financial future, and it can potentially set you up to enjoy more freedom and a relaxed lifestyle in your retirement years.