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SApr 30, 2008

Same Fund Family but Less Risk

Scott Burns

Q. I'm semiretired, married, with no children. We own our home. I'm 62, have no pension. Our total savings is $95,000 in Vanguard Target Retirement 2010 fund in an IRA. I just moved it there about six months ago. In the last year or two my IRA account has stopped growing. I'm thinking of pulling it and putting it in a CD or something that will give me guaranteed growth.What do you think?---T.H., by email from DeSoto, TX

A. The last year, particularly the last 6 months, have shaken the confidence of all investors. Your fund choice, however, is fundamentally a very good one. The Vanguard Target Retirement 2010 fund (ticker: VTENX) is only about 55 percent equities. It also has a very low annual expense ratio, only 0.20 percent. While a move to CDs would eliminate your risk of loss, it would also reduce your long-term investment return and expose you to an eventual loss of purchasing power. That’s not something you want to risk at age 62.

If you want to reduce your equity risk, you can easily do so within the Vanguard fund family. Target Retirement 2005 fund (ticker: VTOV) has only 43 percent equities (according to the Morningstar database) and an expense ratio that is very slightly lower, 0.19 percent. You might also consider moving to Vanguard Wellesley (ticker: VWINX). It has only 36 percent equities and an expense ratio of 0.25 percent. In the first quarter of this year, Target 2010, Target 2005 and Wellesley provided returns of minus 4.08 percent, minus 2.50 percent and minus 1.74 percent, respectively. You can get current performance data on these funds by visiting the Morningstar website, www.morningstar.com.

Why this site rather than the Vanguard website? The Morningstar website has a standardized format and provides performance percentile rankings against comparable funds. In the event you decide to look beyond Vanguard, Morningstar will be a good place to start.

Q. My wife and I want to pay our mortgage biweekly--- instead of monthly--- with a personal check. The lender insists, however, that we make a monthly payment or a biweekly electronic bank draft. We want to reduce the total interest payment on our 30-year fixed-rate mortgage. Can we get our way, or does the lender have absolute power over the frequency and method of payment? Would we save more over the long run making two payments each month or a 13th monthly payment? When making an extra payment, should it be applied to the principal or escrow?---R. N., by email

A. Mortgage service companies are set up to handle monthly payments. Handling more payments costs them money. The many “services” that offer to save you interest by giving you a biweekly payment don’t actually make 26 payments a year. They hold your money and make the equivalent of 13 payments in a year.

Virtually all of the interest savings from a biweekly mortgage plan comes from making the additional principal payment. It does NOT come from making 26 payments.

The easy and cost-free way to get the effect of a biweekly mortgage payment plan is to divide your monthly mortgage payment by 12 and add that amount to your regular monthly payment. Most mortgage payment slips now provide a specific line for you to indicate that you are making an additional principal payment.

Let me give you some concrete figures. If you were to borrow $100,000 at 6 percent for 30 years, your monthly mortgage payment would be $599.55 and you would pay your mortgage lender $215,838 over the next 30 years. If you take the same annual payment, $7,194.60 a year, but deliver it in 26 equal payments of $276.72, you’ll pay the mortgage off in 778.9 payments, or a total of $215,543. So you will save only $295 over nearly 30 years by changing the frequency of your payments.

That figures out to an interest saving of 38 cents a payment, so you’d best make the payment electronically rather than buying stamps that cost 42 cents today…

As I have pointed out many times, the “magic” of a biweekly mortgage is entirely bogus. What saves you interest is making additional principal payments. You can do that by simply adding some money to your regular monthly payment.

Now, let’s start with the same mortgage payment of $599.55 and add $49.96 a month ($599.55 divided by 12), so we are making the equivalent of a 13th payment every year. If we do that, the mortgage will be paid off in 294.5 payments. We’ll have paid the lender $191,283.82. That means the additional principal payment will save us $24,554.37 in interest over the 24.5 years we’ll make payments. And we’ll avoid 5.5 years of payments.

Virtually everyone gets offers for biweekly mortgage payment plans when they take out a mortgage or refinance a mortgage. You should, in my opinion, treat them as what they are: junk mail.

Filed Under: Financial Planning, Q&A (from print)