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Retirement savings and debt

Chris Farrell Sep 25, 2008

Question: I have a SEP plan. I make quarterly contributions. I commit a % for the year. At the end of the year if I have extra I contribute more. My question is would I be better off putting the extra into paying off my car? Or just putting it in savings? I am sticking to my quarterly contributions but it is hard when by the next quarter it has “vanished”. I am looking at retiring in 15 years. My spouse has a 401K, company pension and separate investments. Would it be better for him to not contribute at this time to the separate investments and work towards paying off the house? He is looking at retiring in about 11 years. Elizabeth, Indianapolis, IN

Answer: I’m glad that that you aren’t just looking at your retirement portfolio. It’s really easy to get caught up in the downward gyrations of the bear market in stocks and the abrupt shifts in market interest rates. (Imagine, the yield on the 3 month T-bill went briefly negative last wee. That’s right, less than 0%.) It’s good to keep funding it too.

When it comes to managing household finances, the main message of the past year has been get household finances in good shape by spending less and paying down debt. That’s why I like your thought of taking that extra cash in this tumultuous environment and putting it toward eliminating the car loan.

However, I’d recommend that your spouse continue to save for retirement, too, as well as build up household savings rather than take dramatic steps to pay off the mortgage early.

Of course, in the heart of most (all?) homeowners burns an intense desire to say goodbye to the bank for the last time and own a home free and clear. There are advantages to accelerating mortgage payments. You can get a good return on your money, especially in this market. Let’s say your mortgage rate is 6%. In that case, by paying down your mortgage early you’ll earn the equivalent of a simple 6% rate of return on your money. If your rate is 5%, the return is 5%. (This simple example doesn’t take into account taxes and other factors.) You’ll save thousands and thousands of dollars in interest payments. And it’s important for most people to be debt free when they enter their elder years–and that’s what you want.

That said, here’s why I’m cautious about getting too aggressive with mortgage payments. My basic problem is that most people end up putting too much of their financial eggs in one basket — a home. That’s another way of saying that your financial health is now increasingly dependent on how one asset performs and, as we are witnessing right now, home prices can go down as well as up. Diversification pays.

For me, the key is building up a well-diversified portfolio of cash, stocks, bonds, commercial real estate, commodities, and international equities–even in a market like this one. I especially like investing in Treasury Inflation Protected Securities (TIPS) and I-bonds. Both of these default-free securities sold by the federal government will protect you against the ravages of inflation. The value of your home shrinks as a percent of your net worth over time. Once you’ve built up a well diversified portfolio, then pay off the mortgage by all means.

A sensible way to shorten the life of your mortgage without taking drastic action is to make an extra monthly payment a year. By writing 13 monthly mortgage checks instead of 12 you’ll pay off that loan faster. Just be sure to tell the bank in writing to put that extra payment toward principal.

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