---J.J. by e-mail from Dallas
A. Simplify the portfolio, reduce the price volatility of what you hold, and own some fixed income securities that will mature as you start making withdrawals. Specifically, unless you have a passionate interest in individual stocks, I'd eliminate your individual stock holdings and replace them with broad stock indices. After that I'd work on keeping the mutual fund population to a number you can follow easily. For most people that will be five or six.
Finally, you should start buying safe fixed income securities that will mature in four years or more. Suppose, for instance, that you intend to withdraw $10,000 four years from now. You can be assured of having that amount of money ready for you by replacing a fixed income fund (or a stock fund if you don't have any fixed income investments in your SEP) with a 4-year Treasury obligation. Make five such investments, each maturing in a different year, and you'll have the cash you need. More important, you'll have avoided the need to sell any securities to meet your income needs. In a down market, that would be great portfolio protection.
Q. I recently bought a house in Dallas for $285,000 with a 90 percent mortgage at 4.75 percent. It's a 7/1 ARM so the payments will be about $1,300 a month for the next 7 years. Shortly after that I inherited a house. If sold, it could net me about the same as the sale price of the house I just bought!
If I invested the yield on the sold house in a portfolio of no-load, low-cost funds such as Vanguard's Wellington fund (10 year record about 12 percent a year) and assume an average return of 9 to10 percent on the portfolio, would I be better off to (a) pay off the mortgage in full with the sold house proceeds or (b) invest the proceeds as mentioned for at least the first seven years? The joker in the deck, of course, is what the portfolio will do in 7 years. What is your view?
---D.J., by e-mail from Dallas
A. Viewed casually, this is a no-brainer. As long as the expected investment return is substantially higher than the mortgage interest rate, you are likely to be better off investing the money than paying off the mortgage. Unfortunately, the casual view understates the actual risks you face. Let me explain.
If you pay off the mortgage you will no longer have an obligation of $1,300 a month. Invested at 4 percent those payments would accumulate to $116,000 in 7 years: $145,000 at 10 percent. The monthly commitments for 84 months would have the built-in security of dollar cost averaging. That means you would buy more shares when prices were down, fewer when they were up. On the disadvantage side, you would lose about $7,000 of net tax deductions ($17,000 for mortgage interest and taxes less the $10,000 standard deduction on a joint return). Also, any investment income would be taxable.
If you hold the mortgage and invest the cash, a $285,000 investment could grow to $525,000 in 7 years, a taxable gain of $235,000. That's way better than what you could accumulate in a monthly investment plan.
But something has been forgotten. To make an apples-to-apples comparison, you need to withdraw $1,300 a month from your investment to make the mortgage payment. This means you will be doing dollar cost averaging in reverse. You'll be selling more shares when prices are down and fewer when prices are up. Worse, you'll be withdrawing at a rate of 5.6 percent a year.
If we have volatile stock and bond markets and rising interest rates dampen future returns, your expected gain could disappear. Indeed, it could even turn into a loss. Over the last 5 and 10 years, Vanguard Wellington fund has returned 9.61 and 11.79 percent annually, respectively. It has also been in the top 10 percent of all balanced funds over the same period. The average balanced fund had a return of 3.08 percent over the last 5 years and 8.70 percent over the last 10 years. Less than one balanced fund in five had an annualized return greater than the 5.6 percent you'd be withdrawing every year.
This isn't a no-brainer. It isn't a slam-dunk, either.
What you do depends very much on your age and the security of your earned income. If you are young and securely employed, I'd roll the dice and take the risk of volatility and debt. If you are close to retirement, you should take the safer route--- paying off the mortgage and increasing your savings. You might be "leaving money on the table" but you could also be avoiding significant remorse.
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