Should I Pay Off My Mortgage Early?

I have heard this question three times in the past month, so I thought it must be on the minds of at least a few more of you. The answer isn't as easy as you might think. There is no denying that it feels great to get any debt paid off early, especially one that could be taking up 20% to 40% of your monthly budget. When a client comes to me wanting to put a little extra money toward getting rid of her mortgage, I am happy to support the effort. But I do ask clients to consider this list of questions. Depending on your answers, you might want to leave the mortgage alone and focus on something else.

1. Do you have a good, fixed-rate mortgage at a low interest rate?

The home buying process is confusing enough that a lot of people walk out of it not sure what sort of mortgage they actually have. If that's you, go check your documents right now. A fixed rate mortgage means that your required monthly payments will stay exactly as they are throughout the life of the loan, and that's great. Any sort of variable rate mortgage, on the other hand, could bring some nasty surprises. Your variable rate mortgage payments will go up if interest rates go up (and they probably will). If that happens just at the moment when you are trying to get costs under control, your mortgage could become a very painful thorn in your side.

By all means, pay off a variable rate mortgage as soon as you can. But if you've got a nice, predictable, fixed-rate mortgage, ask a few more questions...

2. Do you have other debts?

Your mortgage is what we call a "secured loan," meaning that if you don't make your payments, the lender can claim something of value (your home, in this case) to pay off that debt. When lenders write a secured loan, they don't mind charging you a lower interest rate. A car loan is also secured, but let's face it—it's a lot harder to collect value from a used car than a house. And that is why your mortgage is probably the best interest rate you are ever going to get on a loan that isn't from your mother.

This means that your other debts—credit cards and car loans, for instance—are likely to have higher interest rates than whatever you are paying on that mortgage. Mathematically speaking, you want to pay those down first. As you get the loan with the highest interest rate paid off, shift that payment to the next highest and so on. The mortgage will probably be last on this list. [One caveat: student loans are often secured by the federal government and may not follow this pattern, so check your interest rates first!]

3. Do you need to be putting more money away for the long-term?

This one is not always obvious, but think about it—if you are investing money for a child's college tuition or your retirement or anything else that might be more than 10 years out, you are probably planning to get an average return of at least 5% to 8% per year on the money you are investing. If your mortgage is at 3%, then putting the extra $100 a moth toward paying off the mortgage will save you money at a rate of  3%. But if your investment plans go reasonably, you might be giving up 6% or 8% in returns in order to get that 3%.

As you've probably figured by now, the comparison isn't perfect. You are just about guaranteed to save that 3%, whereas investment returns are never, ever guaranteed (no matter how great your investment strategy). But if your targets and strategy are reasonable and you are investing for the long-term, it's a very good bet that your investments will out-perform the savings you got from paying down that mortgage.

4. How much is your tax deduction doing for you?

You probably know that if you live in the home you own you are getting a tax deduction. What fewer people know is that the deduction is actually for the interest you are paying on that mortgage. In fact, in the early years of your mortgage what you are paying is almost entirely interest. To help you visualize that, I found the handy image below from a website called "Financial Tips":

Mortgage-Amortization

In fact, mortgages work through "amortization," which means that the bank builds in the interest payments in a particular way. Specifically, your payments go mostly toward interest (in yellow) throughout the first years of your loan repayment. As you can see from this chart, the balance of your payments does not shift toward the actual principal (in red) until you are more than half-way through paying off the loans. (By the way, this is why you want to make absolutely sure your lender applies any early or extra payments to principal!)

Alright, so you are only getting the homeowner's tax deduction on that yellow stuff. Why do you care? Because tax planning is a strategy game. Being able to take the mortgage deduction during a period when your income is higher (especially if it is just over the line of one of the tax brackets) can mean a significant tax savings. So, in getting rid of your mortgage payments faster, you might be getting rid of a key part of your tax savings strategy.

So, should I pay off my mortgage early?

After you've gone through list, you might find that paying off your mortgage doesn't make sense from a mathematical point of view. But there is still one more question to ask. The fact is that, just as we perform better on exams when we feel confident, we tend to handle all of our financial decisions better when we feel good about the steps we're taking. As I've said to more than one client recently, if paying off that mortgage means that you feel more "on top of" everything else, that might be reason enough.

How Much Money Should I Have Before I Need Advice?

I get this question all of the time. And I understand why. The whole "investment" thing, heck, even the financial planning concept, seems designed for people who aren't worried about whether they'll have to wait until next month to fix the muffler on the aging Honda. Actually, though, this is the wrong question. The right question isn't about how much money you have; it's about how much time you have to grow it. Let me explain...

Imagine a woman who's doing quite well for herself. She's got a good career, saves up a little money every month, and just received a big bonus at work. All of the sudden, she has $120,000 in her bank account. Does she need investment advice? Well, maybe not. Let's say now that what she really wants to do is to buy a house in her favorite neighborhood with her savings. Since she lives in the Boston area, that's going to be about $650,000 (no, really). And she wants to do this within the next 3 years.

This would be a great time for her to pay for a financial plan—she's going to want to think about how the mortgage terms play with her other financial goals, taxes, retirement savings, etc... But if she plans to put all of her money into real estate within the next few years, actual investment advice is pointless. The best she can do is probably an FDIC insured bank account with some sort of interest rate (better yet, at her local credit union to set herself up for more favorable mortgage terms).

Sure, she could put the money in the stock market or into bonds or other investments for the next few years, but no financial advisor worth her salt would recommend it. Why? Because investment in securities (stocks, bonds, funds, private businesses, etc...) works well for the long-term. In the short-term, though, investments are a lot more risky and a lot less likely to be worth the hassle and expense. If the market or business is "down" when the perfect property comes up, she's out of luck.

Now imagine another scenario. Like the first woman, this other woman is on the right track after overcoming some difficulties. She's got nothing in the bank, yet, aside from some emergency funds (and we don't ever want to invest those!). On the other hand, she wants to start putting money away for sometime down the road. She's only going to be able to put aside $50 a month for right now. But she has no intention of touching that money for the next 8 to 10 years, at least. Does she need investment advice? Absolutely.

Thanks to all sorts of affordable investments and investment accounts, she's got a ton of choices in terms of where her money goes. Maybe she needs some sort of tax deferred retirement account. Maybe she'd be better off not deferring the taxes. Maybe she needs one well-managed fund, but which kind of fund works best? How can she avoid unnecessary fees? Sure, she is starting small, but the choices she makes now will have a big impact on how that money grows—or doesn't.

So, don't ask yourself (or your local advisor) how much money do you need before you should get investment advice. Ask yourself what your time frame is for that money. If you've got it for 2-5 years, you should probably be shopping for good deals at your local credit union or bank. If you feel confident that you won't be touching it for at least 5, or better yet, 10 years, it doesn't matter what you've got—it's time to become an investor.

Three Ways To Give Yourself A Break In 2106

'Tis the season to start with all of those self-improving resolutions. Aargh. If you're like me, you are still fighting off the sugar crash from an overdose of green and red frosted products and wondering if your house will ever look the same again after a trail of visiting family. So, I'm scrapping the financial resolutions and focusing on finding the easy path. Here are a few ways to put in less effort around your finances.

Open a spending account

That's right, a spending account. For years (generations?) wise people have been hammering away at us to have a savings account in which we diligently put 10% of our pay every week or two so that we can (somewhat magically) become tycoons in our old age. In actuality, it's pretty good advice. But there are two problems. For one, most of us would be hard pressed to reach tycoon status on our annual pay. And that fabulous .06% interest rate the banks are paying these days can make the savings process can be a little demoralizing in the short-term. Worse yet, it is really, really hard for a lot of us to find an "extra" 10% of our income.

If this sounds familiar, flip the advice on its head. Have your paychecks deposited into your regular account as usual. If you don't already, use online bill pay to have all of you fixed expenses paid automatically (that's your rent/mortgage, monthly subscriptions, health insurance premiums, car or transport payments, memberships and monthly credit card payments). Then put in one more automatic payment—a monthly amount that goes every pay period from your regular account to your new spending account. The spending account will be for anything you want to buy until the next pay check. Some of these are necessary expenses, like groceries. But all of the rest should be for fun stuff—entertainment, nights out, new clothes, gifts for friends, comic books, flowers—whatever makes your day better. And better yet, you can spend every dime of the money in that account. Because the amount you put in for auto-transfer to your spending account left a little extra that wasn't needed for the fixed expenses I mentioned earlier. That little extra just accumulates as savings in your account, growing a little more every week while you aren't looking.

The great thing about this system is that the savings happens without you paying any attention to it. And the spending account is just that—a license to buy whatever the heck you want to get between paychecks—guilt and mathematics-free.

It does happen, though, that we hit times when saving is just not possible. And that brings me to point #2...

The experts are a bunch of jerks

In the enthusiastic crusade to get us all to save for retirement, financial experts, banks, employers and nosy family members have bombarded us with frantic messages about how our failure to be "responsible" with our money will end in cat food and a home under a bridge. Unfortunately, all this advice tends to overlook the fact that in real life, people have good years and bad years. In good years, you really should be putting aside some money, whether it's for retirement, a new house, a new business or just a rainy day. But unless you are very fortunate (and probably had a little parental help with stuff early on), you are going to have some bad years, too. These are the years when medical crises hit, when you or another family finds yourselves between jobs, or maybe just when you are starting out and your paycheck is too crappy to cover much more than ramen noodles and bed in your parents' basement. That doesn't make you financially irresponsible. It just makes you busy with life.

So, ignore the stories about people who socked aways thousands of dollars by eating from trash bins after closing time. If you are that person, you don't need financial advice anyway, but you might look into a good health plan. Recognize that some years are savings years and some are spending years. If you are in one of those years, decrease the amount you are putting aside or eliminate the savings altogether. Measure your financial progress instead in terms of career growth, or personal growth, or just getting back on your feet. After all, those things are all just as important, if not more so, than building your retirement account. Now mark your calendar to check every 6 months to review your situation. When things are looking up financially, it's time to start the savings again, but feel free to start small. And until it is that time, give yourself a break.

Stop expecting to know everything

The whole point of this blog is to help people understand and feel more comfortable with financial issues. As a former professor, I love it when people decide to really dig in and teach themselves more about the financial world and their own investments. But it does take a lot of work and time. Financial questions involve rapidly changing tax regulations, new investment types, new investing laws and constantly renamed and re-jiggered products. That means that unless you are dedicating regular time to reading and research, it's going to be hard to keep up. And that's true even for people who are in related fields like law and banking. If you are interested in the field or just committed to doing it yourself, that's great. But if don't want to spend your evenings learning about index funds, who can blame you?

For those of you who don't want to put in the time, stop feeling guilty and hire an expert. As self-serving as it might sound coming from a financial advisor, the cost of having someone qualified go over your financial situation and goals with you is almost always a tiny fraction of the extra money you can earn, save, or make by following professional advice. This is just as true for those of us in who work for a living as it is for the mega-rich we usually think of as having financial advisors. And let's face it, there's a lot more at stake for us.

Skip the stock brokers and the insurance agents and look for an RIA rep, or at least a CFP, who is focused on planning, as opposed to focused on selling you a particular investment or account. Ask how much a plan costs and what that process involves. A good plan will finish with something in writing you can take away, but should also involve more than one conversation with you to really understand your resources, your debts, your concerns and you goals. All good planners offer a free initial consult—use it, and don't be afraid to keep shopping until you find someone with whom you feel good about working.

And once you've got the pieces of your plan set up for the year, your savings or non-savings strategy in place, and your spending account on auto-pay, treat yourself to one more sugar cookie before you embark on any of those fitness resolutions.

Should I keep putting money in this investment? Dollar-Cost Averaging and Time

I got a great question yesterday about the difference between saving and investing. Everyone knows that we are supposed to regularly save money. Most of us who follow a set savings plan have our banks set aside a little bit monthly or from each paycheck just to make sure this is happening. But putting money aside in a savings account is not the same as regularly investing it in a stock, bond or fund. We all know the difference matters. So here are a few things to think about when you are trying to decide where, exactly, the money goes.

Dollar-cost averaging.

This is the auto-pilot of investing, which makes it one of my favorite techniques to recommend to new investors. The old "buy low, sell high" investment advice suggests that you should be analyzing the market every time you buy more units of your favorite stock, bonds or fund—not so realistic if you are putting money aside monthly and don't plan to give up your job for day trading.

Fortunately, dollar cost averaging studies show that you actually do well over time by choosing your fund and buying into it at a regular interval, regardless of the price that day. Some months, you will pay more as the price goes up. Other months, though, you will hit those bargain moments when the price is temporarily down. And in between, you usually take advantage of the general growth in the market.

If you could predict the future, you could always get the lower prices, but since none of us (even the experts) are really good at those short-term predictions, statistics show you are better off to not even try. With this in mind, use the settings in your investment account to automatically invest your monthly savings in a good fund. And don't forget the automatic dividend reinvestment setting, too. We love studies that tell us to do less work.

Volatility and your investment account.

Let's say that you already have money in the investment account and want to keep adding but know that the college tuition bill or house down payment will be coming your way in a few years. This is when you start thinking about volatility.

Volatility is the measure of how often and how dramatically the value of a particular investment tends to change. A mutual fund with high volatility will drop and soar in price regularly. We don't have a crystal ball, but we know that the value of bonds tends not to move very fast while company stocks tend to be volatile. For this reason, financial planners recommend that you start putting more of your money in bonds as you get closer to the time when you need it. After all, you don't want one of those price drops to hit just when the tuition bill comes due.

If you don't have a financial planner to help you figure this out, try creating your own simple version of one—pair a cheap, blended stock fund with a government bond fund. As you get closer to when you need your money, put more into the bond fund. (For more on how to choose a fund, check out this earlier post). Or, you could use a "Target Date Fund."  Target date fund managers assign each fund a target year when the investor expects to start drawing out money. The fund manager gradually shifts the investments as it gets closer to that year. Target date funds and blended funds are only a rough approximation of your needs, but they can be a cheap and viable way to manage things yourself.

Bank Accounts verses Investment Accounts

Almost all of the investment advice you will see on the internet assumes you are going to leave that money in your investment account for a long period of time—preferably 10 years or more. Why? Because we are betting that the economy and its markets will continue to grow bigger over time. The majority of investment professionals have developed their strategies to take advantage of just that fact. On the other hand, we are all pretty much positive that the market's growth is not going to be smooth and easy. In other words, we expect a few dips and crashes along the way. That's where your time problem comes in. If you need that money out in 2 years, you may get hit with the crash but not had time to benefit from the growth. It's a good way to lose some of your hard-earned money.

There are cases in which you are better off to use an investment account than a bank account even if you only plan to put the money in something very safe. College savings accounts and retirement accounts offer tax advantages over regular bank accounts. But if you aren't looking for the tax deferral and you are just putting the money away for a few years, don't overlook your bank. I find that local banks and credit unions often offer you better interest rates on savings accounts and CD's (Certificates of Deposit), so you can squeeze just a little bit more out of that savings.

Follow the plan

The single most important factor in determining you success as an investor is making a plan and sticking to it. Choose your strategy and your investment allocation first. And then let all of those auto-deposit and auto-invest features work for you. I firmly believe that paying for a financial plan at this stage is a bargain for just about anyone. But if you are willing to put in some time and do a little research, you can do this yourself. Ready to start? Begin with this How To Start Investing: Basics for Doing It Yourself.