Question:
I am nearing retirement and will rely exclusively on savings for my retirement needs. I have generally kept all my investments in equities, with money required for the next 10-12 years in liquid investments. In a recent portfolio review, it was suggested that I consider investing between 20% and 30% of my portfolio into a bond fund like Vanguard Total Bond Market Index Fund to balance the portfolio and provide “safer” growth. The adviser correctly pointed out that I would have been better off in a bond fund over the last 10 years, rather than in a total U.S. equities market index fund. Of course, the interest rate picture over the last 10 years has been stable or falling.
I am concerned about an intermediate bond fund in a rising interest rate environment, which I believe may be coming. I am also concerned that so many people have gone into bond funds in the last few years to get better returns, if there is a big outflow of capital from these funds in the coming years, this could further impact bond fund manager’s abilities to get acceptable returns. Additionally, ultra short term bond fund returns don’t seem large enough to use as an investment vehicle for funds not required for the next 10 years. What is your position on the use of bond funds as an investment vehicle for monies not required for the next 10-12 years?
Answer:
It appears you have been following our Ten Year Rule, keeping money you need in liquid investments. Your adviser is also correct in saying that in the past 10 years, you would have made more invested in a bond fund as interest rates dropped from 16% to 2%. If you think interest rates will fall from 2% to -14%, then yes, a bond fund is the place to be. However, interest rates are more likely to increase, and in that case, you will lose money. When interest rates fall, the value of the bond increases. If you have a bond paying a 16% coupon and interest rates drop to 8%, that bond increases in value.
Since your adviser suggested the Vanguard Total Bond Market Index Fund, your adviser is not likely commission driven. It is a widely respected bond fund with low costs. It is also not leveraged, thus it will provide you the safer growth for your liquidity needs. Some bond funds will use leverage to offset expenses, leveraging up to 50%.
Some advisers will suggest you need a certain percentage of assets in fixed investments, which is fine. We prefer to run cash flow projections so only money you need for liquidity in the next 10 years is in an investment that is as close to guaranteed as you can get. With a bond fund, you have no maturity date. If you buy a $1,000 bond today, in 10 years you know you will get your $1,000 returned. With a bond fund, in 10 years, you do not know what it will be worth when you need the money.
Considering interest rates right now, we suggest you consider CDs and avoid money markets or intermediate-term bond funds. One-year Treasurys pay 0.14% while a six-month CD can be around 0.25. With a 10-year Treasury, you are only getting 2%. We do not feel that you’re getting paid enough to take on the interest rate risk.
Question:
I have heard your reasoning behind the idea of not paying off the mortgage early, and it was eye-opening and I can see your point. I’ve been particularly swayed by the scenario that you could be 18 years into a mortgage and become disabled or lose your job, and then, you’d be “house rich” but need cash to live and cannot refinance or obtain a second mortgage because you are not employed. Does this argument make the most sense for younger people, who have not yet accumulated a nest egg, or for people 22 years into a 30-year mortgage? I was explaining this to my daughter, who is soon to finish professional school and start practice. Her question was: Does this apply to student loans too?
Answer:
We believe you should borrow for your home as long as you can because it is a tax deductible expense. As for student loans, you may be able to deduct interest you pay on a qualified student loan. Generally, the amount you may deduct is the lesser of $2,500 or the amount of interest you actually paid.
Consider the typical furniture offer: You can pay cash for your sofa today, or you can pay for your sofa over four years without interest. Well of course, you would rather pay over four years. The situation is similar to a 30-year fixed mortgage at 3.75%. The tax deductibility of the interest makes this rate even better.
As you point out, by paying off your mortgage early, you could be “house rich.” If you prefer, you can make the payments you would make on a 15-year mortgage while still holding a 30-year mortgage. For example, if your payment is $1,500 on a 30-year mortgage, or $2,400 on a 15-year mortgage, you could obtain a 30-year mortgage, and pay the $2,400 monthly payment. If you were to get injured or lose your job, you could lower your payment to $1,500. If you are locked into a $2,400 a month payment, you cannot go down from that.
Additionally, every dollar that is not paying a mortgage can be invested into a tax deductible investment, such as a 401(k) or IRA.
If you are married with young children, how much are you really able to save? If you have a 30-year mortgage at 6%, you could be better off refinancing at less than 4%, and then investing the difference in your 401(k). Not only will you still get the tax deduction on the interest paid on the mortgage, but you will benefit from the tax deferred growth of your 401(k). Additionally, you may also benefit from an employer match to your 401(k) contribution. If you were to become sick or disabled, you would also be able to borrow from your 401(k) for the emergency.
At Henssler Financial we believe you should Live Ready, which includes taking advantage of tax deductible borrowing when your mortgage is concerned. If you have questions regarding your financial planning, the experts at Henssler Financial will be glad to help. You may call us at 770-429-9166 or e-mail at experts@henssler.com.
Disclosures:
All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing.
