Ask Money

Savings strategies after locking in a low rate

Chris Farrell May 11, 2012

Question: My husband and I just refinanced our house at a great rate (15-year fixed mortgage at 2.875 percent). Our house payment is low and we can afford to pay more each month. Would the best use of our money be to pay down the principal on this low-interest loan or put extra away for retirement or for our children’s college fund? We have two young children and are in our late 20s/early 30s. Thanks for your help! Katie, Helena, MT

Answer: That is a great rate you got on your 15-year mortgage. I love it. Now, you really can’t go wrong with any of the options you’re considering. All will increase your savings. However, if you aren’t maximizing contributions into retirement savings plans, I would put that at the top of my list. You’re young and it’s sensible to harness the power of time.  

For example, take an insight from a recent academic paper by a group of scholars from the Center for Retirement Research at Boston College, How Important is Asset Allocation to Financial Security in Retirement? As in most academic papers, they make a number of assumptions and run through multiple scenarios. One set of figures was intriguing. For the median earner with a 401(k) planning to retire at Age 65, starting to save at Age 25 rather than Age 45 cuts the required savings rate for adequate retirement income by about two-thirds. Starting at Age 35 rather than 45 still reduces the required savings rate to maintain living standards in retirement by about 40 percent.  

The Employee Benefits Research Institute research shows that many people participating in a 401(k) are saving between 7 percent and 10 percent of their income. The research suggests these workers should be setting aside 15 percent to improve their odds of achieving a financially secure retirement. By the way, the 15 percent is the same savings rate recommended by the Center for Retirement Research paper for someone starting at age 25 and retiring at 65.  

OK, that’s one perspective to consider. Another idea I always like to propose is to look at (1) the uncertainty of your income and jobs, and (2) some goals and dreams for the next 10 years. Would it be sensible to take the extra cash flow and put it into safe savings so that you build up your emergency-and-opportunity fund? If you like this approach, I would have the money automatically transferred from your checking account into your savings accounts. Put your savings on autopilot.  

Of course, we all feel a lot of pressure to put money aside for college. It’s expensive and getting more costly by the year. It wouldn’t hurt to put some money into, say, a 529 college savings plan. You can open most 529s with as little as $25 to $35. I would put a greater priority for now on some other savings strategies, and once they’re in place and up and running, I would then turn to think more about college savings.

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