Invest For Retirement Or Pay Off House Early?
March 26, 2009 – 9:48 amI received the following question from a reader this week and would like to share my response. If you have other recommendations please post them in a comment!
“My wife and I are reevaluating what we should be doing with the extra income we currently have. Considering how our IRA’s are in the tank and have been for about a year now and I don’t see that changing anytime in the next few years we are thinking it would be best to do two things and I wanted your opinion.
1. Change our IRA accounts to be in bond heavy funds with much lower risk (currently they are all in S&P 500). Keep in mind…were only talking 4k…but it used to be around 7k and I don’t want to see it drop more.
2. Take all our extra monies and pay down our house. We are thinking this would be wise for multiple reasons.
First and foremost is we are thinking we can get the house paid off in 7 years and this would free up this income completely and save us around 80k over the long haul. We also like the idea of being in less debt. I love the idea of eventually owning my home and then focusing on helping others and helping my retirement fund. Now we wouldn’t necessarily pay down the house only for 7 years but for the next year or two until the market looks better. Then we would invest and pay down the house.”
My Recommendations were as follows:
To a large extent I think this decision is a personal one, and I don’t think you can go wrong by trying to pay off your home early. I’d be happy to discuss this with you any time you would like at your convenience, and I like to bounce ideas off of others before making a decision. I’m not a professional financial adviser, but I’m happy to tell you what I would do.
It sounds like your main concerns are:
- your IRA is losing money
- you think you can time the market and invest later when things are better
- I can only assume you’re a bit worried about the economy (jobs) and family financial well-being and don’t want to throw more money into investments that go down.
Based on these assumptions I would do the following:
- I would make sure my emergency fund is completely and fully funded. Whether that’s 3 months, 6 months, or 2 years is up to you to decide.
- I would continue to contribute something to the IRA regularly. Even $10/month is something, and compounding will help you over time. It will also help you develop good habits if you don’t already have them.
- If you want to put the rest of your money towards your home for a couple years I’m fine with that, and it will help you sleep a little easier at night.
- I would adjust your asset allocation in your IRA to include some stocks and some bonds. The truth is that everyone else has already had the idea you’re proposing of moving everything to bonds, which raises the price of bonds (and drops the yield). Therefore when the market turns around those who bought into the bond market recently could see some big losses as well. You’ll need to decide what that split is, but it could be 50/50 stocks bonds or even 40/60 if you wish to be conservative.
- If you REALLY want to make sure your account value goes up consistently please recognize that you will need to purchase individual bonds directly (or CD’s) and hold them to maturity as opposed to buying a bond mutual fund. It’s less likely that bonds alone over the long term will beat inflation much (meaning you’ll lose real spending power), but it is a choice. Bond mutual funds go up and down in value on a daily basis due to supply and demand, so you can lose money on your bond fund as easily as you can on your stock fund. Holding an individual bond to maturity assures that you’ll get your interest and principle back unless the company or nation defaults on the bond. I don’t recommend picking individual bonds yourself, but I just wanted to make sure you understood this. Also please do NOT be fooled into thinking the great bond performance from last year will continue going forward. It might, or it might not. No one knows.
- Try to forget about your IRA. It doesn’t matter what it was worth. What matters is you have over $4,000 saved which is more than many Americans. It needs to stay in that account until you’re almost 60, and 30 years from now it will be worth more than it is now. We’ve had 10 year periods in the stock market with no growth, but we’ve never had a 30 year period with no growth.
- Take any unexpected funds, like tax refunds, raises, etc, and put some of that in your IRA.
Here are a few other thoughts if I haven’t put you to sleep already:
- First of all let me state that I’m risk averse in general, and I too want to own my home outright. I have not, however, decided to completely stop my retirement savings plan to make this happen. The market is down and it stinks. I also accept that it could continue to go down for quite some time or could reverse today. No one knows.
- Markets go up and they go down, and it’s not uncommon to have one pretty bad year out of every three in the stock market. It has been proven that market timing is not consistently possible, so although I too would like to wait for the market to “improve” before investing it’s unlikely either of us will know when that occurs. It’s also a fun fact that missing the top 10-15 market days a year will pretty much wipe out all of your investment returns for the year. Therefore even if you’re right 90% of the time you’re still likely to miss out on good returns.
- I’m a big fan of the (Dave Ramsey) baby steps as you know, and their order is well thought out in my opinion. If you don’t think you’ll be able to get to saving 15% for retirement for a very, very long time though it could make sense to start saving for college and/or start paying more on your home, depending on your goals.
- If you’re looking for more stable portfolio growth, a 100% stock allocation is probably not appropriate for you. A mix of stocks and bonds would have smoothed out some of the bumps, but still won’t guarantee growth every year. I do applaud you if you’re using a low-cost S&P 500 index fund. I’m not entirely against using actively managed funds, but for average investors like you and me index funds are a great way go. History has shown very few active funds outperform index funds in the long run, mostly due to the added cost of MBA’s to run the funds.
- Since the decision you’re trying to make is a personal one, and you need to decide what you really, really want. From a purely financial perspective you’re likely to be better off continuing to investing in the stock market in the very long term. You have fixed (hopefully) house payments at a reasonably low interest rate and your house in Texas probably won’t appreciate a ton year over year. Therefore, in the long term (10+ years), it’s likely stock investments will outperform the appreciation and savings of paying down your house.
- You didn’t mention if your IRA is a traditional or Roth. As young as you both are a Roth would probably be a better choice. And in a pinch you can remove your original contributions without penalty at any time. I wouldn’t necessarily recommend doing this unless the need was dire, but this ability can turn your Roth into a backup emergency fund.
- I don’t know what company your IRA is with, but you should check to make sure they’re not charging you stupid annual fees and that the fund(s) you’re in actually are low-cost index funds (if that’s what you’re trying to invest in). The cost of a mutual fund is listed as the “expense ratio”, and for a good index fund it should be at 0.40 or less (i.e. 4 tenths of one percent). Great index funds are closer to 0.2 or lower depending on the amount you invest.
- I don’t know if you use the “months of expenses” or “months of income” approach, but I would also think through what expenses you could cut if you needed to look for a new job or had a major unexpected expense arise. As for my wife and I, one months of expenses would last us about 1.5 months if we had to cut everything back (cable, gym membership, go to one car, etc…). Knowing that number, in my opinion, is important.
Did I miss anything, or do you have a similar or differing opinion?
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