Tag Archives: mortgage

Am I Better Off Investing or Paying Down Debt?

Emergency Fund vs. Paying Off Debt - Which should you contribute to first?This is the fourth installment in our series on how individual investors can assess their financial health.

A common dilemma in personal finance is whether to use funds to pay down debt faster or to invest more. The question crops up in various forms:

 

  • Should I pay off all credit card debt or make smaller payments while saving more for retirement?
  • Should I pay extra on my mortgage or invest in securities?
  • Should I pay down my student loans faster or invest more?

Financial health requires both savings and control over debt. But when these two goals seem to be in conflict, what’s the best way to balance them? Consider these six ways to prioritize.

  1. Make sure you get your employer match. If you’re lucky enough to have an employer that matches your contributions to the workplace 401(k) plan, your first priority is to maximize the employer match. It’s too good to pass up. Contribute any less than what’s matched, and you’re refusing the offer of free money.
  2. Tackle costly credit card debt. Once you are saving enough to secure your entire employer match, you can focus on paying down debts faster. The goal is to pay off all credit card debt as quickly as possible. The interest rates on credit card debt are typically so high that nothing else you do with your money is likely to be as profitable.
  3. Beef up your emergency fund. When you’re beyond the hurdle of credit card debt, consider building out your emergency fund.  If you don’t have sufficient emergency savings to cover a serious car repair, a trip to the emergency room or other not-so-infrequent disasters, this is the next focus.
  4. Save enough in retirement accounts. Assuming you have no credit card debt and decent emergency savings, you can move on to the next set of priorities. If you are saving less than 10% of your pretax income in retirement accounts, ramping up your contributions is probably a better bet than paying extra on your student or auto loans or mortgage. Contributions to retirement accounts are tax advantaged, and it is almost impossible to catch up if you delay retirement savings.
  5. Decide whether to save more or pay down your mortgage. Only when you have no credit card debt, a healthy emergency fund, and you’re saving at least 10% of your pretax income should you consider making additional investments or speeding up your mortgage payments.

But when you compare the cost of having a mortgage to the possible returns from investing elsewhere, don’t forget the tax deduction on mortgage interest. Because of that deduction, your effective (after-tax) interest rate on your mortgage is lower than your actual mortgage rate. There are handy online calculators that can quickly calculate the effective interest rate on your mortgage, accounting for tax benefits.

If you are confident that you can invest at a rate of return that’s at least as high as your effective mortgage rate, you may want to hang on to the mortgage and invest more.  Over the past few years, many consumers have taken out mortgages with effective interest rates of 3% or less.  At this level of interest, there are investment alternatives that make more sense.

Also remember that extra principle payments come with liquidity risk. That is, if you need a source of cash, it may be easier to sell a security investment. To take cash out on your mortgage, you will have to refinance or open a line of credit.  Either of these may come with a higher cost than your current mortgage, not to mention origination fees.

  1. Decide whether to save more or pay down college debts. If your income is below $75,000 per year ($155,000 for a couple filing jointly), some or all of the interest that you pay on college loans may be tax deductible. So the effective rate of interest on your college loans may be lower than the actual rate. Take that into account when you compare your loan interest with potential investment earnings.

An additional consideration may be whether a parent or grandparent cosigned your student loans.  If you become disabled or die—or you’re simply unemployed for a long period of time, your consignors may have to pay your college loans.  That risk may make it worthwhile to pay off college loans faster.

Accounting for Uncertainty

If you could be sure that you’ll never lose your job and that you’ll always be able to open a low-cost line of credit, the decision to pay off debts would be much easier.  But you have to look beyond comparing interest rates on debt to the expected returns from investments. You have to consider that credit may not always be available at today’s rates.

With mortgage rates as low as they are now, paying down a mortgage does not look like the most attractive choice. Once you’ve paid off all high-cost revolving credit (e.g. credit cards), have a solid emergency fund, and you’re saving 10% of your income in retirement accounts, however, it’s worth considering paying down college debts.

Putting non-retirement money into risky investments like stocks before you have accomplished the milestones listed above makes your overall financial situation more risky.  Whether or not this is too much risk depends on you.

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Am I Saving Enough to Reach My Goals?

This is the second installment in our series on how individual investors can assess their financial health.

Am I saving enough to reach my goals?The starting point for any discussion of a household’s financial health is to evaluate current savings and savings rates in the context of financial goals.  The three largest expenses that most families will face are buying a home, paying for college, and providing income in retirement. Setting specific savings targets and timelines is a key step in increasing your ability to meet these goals.

To determine whether you are saving enough to pay for one or more of these goals, consider the following factors:

  • Expected total cost of goal
  • When the money is needed
  • Current amount saved for the goal
  • Expected annual rate of saving towards the goal
  • How much risk to take in investing to meet the goal

Retirement

A good first step for estimating how much you’ll need for retirement—and how you’re doing so far—is to try Morningstar’s Retirement Savings Calculator.  This tool uses a range of sensible assumptions (which you can read about in the study from which it was developed) to estimate whether you are saving enough to retire.  The study accounts for the fact that Social Security represents a different fraction of retirement income for households at different income levels and assumes that investments are consistent with those of target date mutual funds.  The calculator scales income from your current age forward, based on historical average rates of wage growth.

Are you saving enough for retirement?

The calculations assume that you will need 80% of your pre-retirement income after subtracting retirement contributions, and that you will retire at age 65.  The estimated future returns for the asset allocations are provided by Ibbotson, a well-regarded research firm (and wholly owned subsidiary of Morningstar).

The final output of this model is a projected savings rate that is required for you to meet the target amounts of income.  If this is less than you currently save, you are ahead of the game.

College

There are enormous variations in what a college education costs, depending on whether your child goes to a public or private institution and whether those who choose public schools stay in-state.  There is also a trend towards spending two years at a community college before transferring to a larger comprehensive university.    estimates that the average annual all-in cost of attending a public four-year university is $23,000 per year, while the cost of attending a private four-year university averages $45,000 per year.  This includes tuition, room, board, books and other incidentals.  It is worth noting, however, that the all-in cost of private universities are often far above $45,000 per year.  The University of Chicago has an all-in cost of $64,000 per year.  Yale comes in at $58,500.

Every college and university has information on current costs to attend, as well as a calculator that estimates how much financial aid you can expect to be given, based on your income and assets.  There are a variety of ways to reduce the out-of-pocket cost of college including work-study, cooperative education programs, and ROTC.  There are also scholarships, of course.

College tuition and fees have been rising at about 4% per year beyond inflation for the past three decades.  With inflation currently at about 2%, the expected annual increase in college costs is 6%.

To be conservative, assume that money invested today in a moderate mix of stocks and bonds will just keep up with inflation in college costs.  Vanguard’s Moderate Growth 529 plan investment option has returned an average of 6.9% per year since inception in 2002 and 6.4% per year over the past ten years.  In other words, $23,000 invested today will probably pay for a year at a public four-year university in the future.  You can invest more aggressively to achieve higher returns, but taking more risk also introduces an increased exposure to market declines.

Using the simple assumption that money invested today in a moderately risky 529 plan or other account is likely to just keep pace with cost inflation makes it easy to figure out how you are doing in terms of saving.  If you plan to pay the cost of your child’s four-year in-state education and you have $46,000 invested towards this goal, you are halfway there.

Buying a Home

A house is a major financial commitment—one of the most significant that most people make.  Unlike retirement or education, there is an alternative that provides the same key benefits: renting.

For people who decide to buy, a key issue is how much to save for a down payment.  The amount that a lender will require depends on your income, credit score, and other debts.  Zillow.com provides a nice overview, along with an interactive calculator of down payment requirements. This tool can help estimate how all of the factors associated with obtaining a mortgage can vary with the down payment.

In general, the goal is to have a down payment ranging from 5% to 20% of what you plan to spend on a home.  By experimenting with the calculator at Zillow, you can determine how much house you can afford and how much you will need to put down.  A down payment of 20% or more is the most cost-effective route because smaller down payments require that you buy mortgage insurance, which adds to the monthly payment.

There are several alternatives for investing a down payment fund.  The primary consideration, however, is whether you are willing to adjust your timeframe based on how the market performs.  If you are committed to buying a house within one to three years, you really cannot afford to take on much risk.  If you are looking at a timeframe of five years or more—or if you hope to buy in one to three years but you are comfortable delaying if market returns are poor—you can afford to take more risk.  There is no single answer for everyone.

If you are investing only in low-risk assets, however, estimating how much you need to save each month for a required down payment is straightforward enough, because the current expected rate of return on safe assets is close to zero.

 

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How Am I Doing? An 8-Point Financial Checklist

How am I doing?A question that nags at many people is whether they are on track financially.  Even an average financial life can seem remarkably complex.  How does anyone know whether he or she is doing the right things?  A range of studies on how people manage their money suggests that many, if not the majority, are making choices that look decidedly sub-optimal.  Americans don’t save enough money and when they do save and invest, they often make basic mistakes that substantially reduce their returns.  More than 60% of self-directed investors have portfolios with inappropriate risk levels.  Almost three quarters of Americans have little or no emergency savings.  The solution to these problems starts with an assessment of where you are and where you need to be.

The key, as Einstein once said, is to make things as simple as possible but no simpler.  In an attempt to provide a checklist that’s in line with this edict, I offer the following questions that each person or family needs to be able to answer.

The first three questions focus on consumption and saving:

  1. Am I saving enough for to meet personal goals such as retirement, college education, and home ownership?
  2. Am I saving enough for contingencies such as a job loss or an emergency?
  3. Am I investing when I should be paying down debt instead, or vice-versa?

The next five questions deal with how you invest the money that you save:

  1. Is my portfolio at the right risk level?
  2. Am I effectively diversified?
  3. Am I aware of how much am I paying in expenses?
  4. Are my financial decisions tax efficient?
  5. Should I hire an investment advisor?

Anyone who can answer all eight of these questions satisfactorily has a strong basis for assessing whether he or she is on track. Odds are there are more than a few questions here that most of us either don’t have the answer to or know that we are not addressing very well.

Part of what makes answering these questions challenging is that the experiences of previous generations are often of limited relevance, especially when it comes to life’s three biggest expenditures: retirement, college, and housing.

For example, older people who have traditional pensions that guarantee a lifetime of income in retirement simply didn’t need to worry about choosing how much they had to save to support themselves during retirement.

The cost of educating children has also changed, increasing much faster than inflation or, more crucially, household income.  For many in the older generation, college was simply not a consideration. It has become the norm, however, and borrowing to pay for college is now the second largest form of debt in America, surpassed only by home mortgages.  Children and, more often their parents, must grapple with the question of how much they can or should pay for a college education, along with the related question of whether a higher-ranked college is worth the premium cost.

The third of the big three expenses that most families face is housing costs. Following the Second World War, home buyers benefitted from an historic housing boom.  Their children, the Baby Boomers, have also seen home prices increase substantially over most of their working careers.  Even with the huge decline in the housing crash, many Boomer home owners have done quite well with real estate.    Younger generations (X, Y, and Millenials), by contrast, have experienced enormous volatility in housing prices and must also plan for more uncertainty in their earnings.  And of course, what you decide you can afford to spend on a home has implications for every other aspect of your financial life.

In addition to facing major expenses without a roadmap provided by previous generations, we also need to plan for the major known expenses of everyday life. It’s critically important to determine how much to keep in liquid emergency savings and how to choose whether to use any additional available funds to pay down debts or to invest.  There are general guidelines to answering these questions and we will explore these in a number of future posts.

The second set of questions is easier to answer than the first.  These are all questions about how to effectively invest savings to meet future needs.  Risk, diversification, expenses, and tax exposure can be benchmarked against professional standards of practice.

What can become troubling, however, is that experts disagree about the best approach to addressing a number of these factors.  When in doubt, simplicity and low cost are typically the best choices.  Investors could do far worse than investing in a small number of low-cost index funds and choosing the percentages to stocks and bonds based on their age using something like the ‘age in bonds’ rule.  There are many ways to try for better returns at a given risk level, and some make far more sense than others.  Even Warren Buffett, arguably the most successful investor in the world, endorses a simple low-cost index fund strategy.  Upcoming posts will provide a number of straightforward standards for addressing these questions.

Investors who find these questions  too burdensome or time consuming to deal with may wish to spend some time on the eighth and final question: whether they should hire an investment advisor to guide them.  Investors may ultimately choose to manage their own finances, search out a human advisor, or use an online computer-driven advisory service.

While financial planning can seem complex and intimidating, our series of blog posts on the key issues, as outlined in the eight questions above, will provide a framework by which individuals can effectively take control and manage their financial affairs.

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One Advisor’s Approach to Income Investing

Guest post by Contributing Editor, John Graves.

Editor’s Note:  John Graves has been an independent financial advisor for 26 years. He is one of the two owners of The Renaissance Group, a Registered Investment Advisor based in Ventura, CA.  John’s book, The 7% Solution: You Can Afford  a Comfortable Retirement, was published in 2012.  When I read this book, I was impressed with John’s approach and thinking and I recommend it as a good read.  I contacted John and asked if he would consider contributing to this blog.  After we bounced around some possible topics, he sent me the following piece that describes his process for designing income plans for retirees.  Continue reading

What is Your Pension Really Worth?

Last week, we posted an article from Michael Lewitt, Vice President and Portfolio Manager at Cumberland Advisors called “The Pension Dilemma” that talked about how America’s largest pension fund, the California Public Employees Retirement Systems (CALPERS) reported an abysmal 1% return on its investments for the past year (ending June 30, 2012).

CALPERS has been in the news lately for several reasons:

  1. The California state pension is a bellwether for other state-run retirement systems across the U.S. that are also forced to face one of the most challenging periods in history: low interest rates, volatile markets and slow economic growth.
  2. CALPERS missed their own internal targets by more than 7.2% and then blamed their underperformance partly on picks made by individual investment managers (which CALPERS declined to name).
  3. The CALPERS underperformance has shaken the confidence that many investors have in their own pension funds.

What Does This Means for the Average Investor?

Retirement planning is a passion for us here at the Portfolioist. Yes, go ahead and laugh at the use of the word “passion” if you must—but that’s how we truly feel—especially in these turbulent economic times. Continue reading

The Collapse of the American Net Worth

Many of you are painfully aware of how many friends or family members are out of work, now under-employed, or who have lost their homes. Geoff Considine, a leading contributor to the Portfolioist, provides his take on what we’re calling the “collapse” in household net worth, starting with a recently published report released from the Federal Reserve called the “Survey of Consumer Finances” (SCF).

This study, performed every three years, provides an analysis of household income and wealth across America, and the results will astound you. The SCF is well-worth reading if you want to get a handle on the state of Americans’ finances—especially if you want to see how those same finances have changed dramatically in just three short years. Continue reading

Are We Hard-Wired To Make Bad Financial Choices?

Proper financial planning that provides for our financial needs in retirement is perhaps the prototypical example of willful blindness. We all know that most people have not saved enough to provide for a sustainable long-term income in retirement. The core issue here is that we (as a society and as individuals) are making consistently bad financial decisions that affect our futures, beginning with how we pay for Continue reading