There are many reasons why you might be deciding on whether to use debt or investments in retirement.
As in there is something you want or need to pay for and the choice is:
1. Do you use your savings and investments to pay out? OR
2. Do you take out a loan and repay this loan using your savings and investments over time?
In this article I’ll go through some examples of why you might still use debt in retirement, what’s going to give you the best net result and also what you need to think about.
Why you might use debt or investments in retirement
It seems odd to talk about debt in retirement as hopefully you have paid off most if not all of your debt by the time you retire.
You might have spent years paying off your mortgage and it was such a great feeling when it was finally gone. So why would you want to take out a brand new loan and have to worry about repayments all over again?
When we talk about using debt or investments in retirement we are talking about a large expense.
Some examples could include:
- Buying a new home – Perhaps replacing your property with something more expensive, buying a holiday home or an investment property.
- Buying a new car – Something you may need to do every few years to ensure you feel safe and your car is reliable on the road
- Gifting money to your children – Perhaps they could really do with a lump sum now rather than waiting for their inheritance. This could be for a house deposit, wedding or a new car themselves.
- Medical expense – Since Covid, reports are the NHS is pretty stretched. Maybe you would prefer to pay the cost of private care if you had a significant medical issue.
I’ve recently been talking to a client who has quite a large property portfolio. He is retired and has 4 children. He would like to start helping his children financially by helping them with their own house deposits.
None of his investment properties have mortgages so he is wondering whether he should take out a mortgage on one or two of his investment properties and then gift the money to his children or does he gift them money from his other savings?
A big reason why you might be considering using debt or investments at this moment in time is because we are living in a world of low interest rates. Which means debt is cheap.
Funnily enough, now might actually be the perfect time to use debt rather than your savings or investments as not only are interests low, they are likely to go up sooner rather than later plus we have high inflation at the moment.
High inflation and low debt interest rates means your debt is actually declining over time in real terms.
But just because debt is cheap does not mean it’s a clear cut decision to use debt over investments. Taking on debt involves risk. There is a mathematical answer to the debt or investments question and then there is an emotional one.
What you need to consider when deciding whether to use debt or investments in retirement
Let’s look at an example.
Ian wants to help his daughter buy her first home. He wants to gift her £25,000.
He wants to know whether he should take a lump sum out of his pension using his ‘tax free cash’ option or take out a loan, gift the money straight to his daughter and then pay off the loan over time using monthly withdrawals from his pension.
Option 1) Ian takes out a £25,000 tax free lump sum from his pension and gifts it to his daughter.
His pension is down £25,000 but there are no further payments to be made.
Option 2) Ian takes out a £25,000 monthly repayment loan over 5 years at an interest of 3%. We will assume his pension investment returns are 6% per annum.
His monthly loan repayments will be £449.22. So this is the amount he will take out of his pension each month.
At the end of the 5 years Ian will have paid off his loan and would still have £2,232.44 left over from the original £25,000 invested in his pension that was ringfenced for his daughter.
Therefore Ian is £2,232.44 better off if he chose to use debt rather than investments. Looking at it another way, the £25,000 gift has only cost Ian £22,767.56.
However if we reverse the debt interest and investment return the picture is quite different.
Option 1) Ian takes out a £25,000 tax free lump sum from his pension and gifts it to his daughter.
His pension is still down £25,000 and there are still no further payments to be made as before.
Option 2) Ian takes out a £25,000 monthly repayment loan over 5 years at an interest of 6%. We will assume his pension investment returns are 3% per annum.
His monthly loan repayments will be £483.32.
At this rate of withdrawals and the investment returns he is getting, Ian’s original £25,000 ringfenced in the pension is not enough to support the loan repayments over the term and he therefore needs to pay an additional £2,233.68 to clear the debt.
This means he is worse off as the £25,000 gift has now cost him £27,233.68.
Please note these examples don’t include fees or inflation outcomes which could impact the end result.
So from a mathematical point of view, if the interest rate on the debt is lower than the investment returns you get, using debt could be a good idea.
But of course this all depends on whether you can fix either option.
It’s more likely that you can fix your debt interest rate but when it comes to investment returns, it is impossible to predict what will happen. We could enter a period of market declines at the point you take out your debt which means you could be net worst off by some margin.
So taking on debt instead of using your investments is the more risky option.
You also need to consider what would happen if there was a change in your circumstances. Perhaps you needed more money for your own day to day living and therefore there isn’t the money left to pay off the debt.
Using debt does have other benefits though.
For example it may allow you to unlock the value of your home (via an equity release loan) so that you can either enjoy a more comfortable style of living in retirement or gift money to your children.
Taking on debt and gifting the money could allow you to protect your house from new long term care funding and may save your children some Inheritance Tax on your death.
Whilst you can do the maths, when it comes to using debt or investments in retirement the biggest factor will be how it makes you feel.
There is no point being better off at the end of the loan term if during the repayment period you were worried and it stopped you doing other things in retirement.
Remember life is too short.
If you want to understand your retirement position and to know whether you have enough then please schedule a no obligation free 15-minute call.
Risk warning:
Stock market linked investments and any income from them, can fall as well as rise and is not guaranteed. Any figures quoted are for illustrative purposes and should not be taken as a forecast or guarantee. Past performance should not be seen as an indication of future returns and clients may get back less than they have invested.
