Life is full of tough decisions. Should you move far from your family to take that promotion? Should Bowser have that expensive and risky operation, or is it time to say goodbye? Should you send little Susie to private school? Do you want the chocolate cake or some rice pudding for dessert? (Fortunately, there are some easy decisions, too: Should you play hide and seek with your nephews? Should you marry this person whom you just can't live without?)
On our Living Below Your Means discussion board the other day, I ran across a wonderful discussion about someone trying to make a decision. (I'll excerpt it below, but you can read the whole thing via a painless free 30-day trial of our entire Fool Community.) It began with a question from Fool Community member pottsch, who wondered whether it would be smarter to invest about $12,000 per year in two Roth IRAs, one 403(b) retirement account, a college savings account, and a general investing account . or to use that money to pay off a mortgage in seven years. (The monthly payment was $1,000, and the fixed interest rate was 5.125%.)
As I read the question, some answers began forming in my head, but I soon was reminded about the power of numbers. Fellow denizens of the board had already offered more than a dozen responses, and they had already said what I would have said, plus a lot more. A few responses I'd have taken issue with, but again, others had already done so.
Below is an abbreviated version of the conversation, with some commentary from me added in.
First response
DeltaOne81 was the first to respond: "The market, long-term, has returned 10% to 11% annually, before taxes. [Extra payments made toward your mortgage principal] will give you a fixed, guaranteed return of 5.125%, before taxes -- after the tax advantage is taken out, in the 25% bracket, we're talking about 3.8%. So you can get yourself a guaranteed after-tax return of 3.8% by paying off your mortgage. Not at all bad for an after-tax guaranteed return, but not great, either. Or you can put it in the market and probably, on average, get a much better return, but who knows over the next seven years. There's your choice -- risk versus reward options. No one can answer that for sure but you."
He added: "One thing's for sure -- it doesn't make much sense to invest in any 'safe' investments right now (CDs, etc.), unless they're returning more than 5.125%. One more thing to consider -- those retirement vehicles often have maximum contributions. If you don't contribute to them now, you will never be able to make it up later."
These are all excellent points. We've tackled this topic before in Fooldom, and we've explained that when your interest rate is relatively low, as it is for many mortgages and student loans, it's often best to not pay off the loan early. The interest payments you'll ultimately save yourself from paying later won't be worth as much as you can hope to make investing elsewhere, such as in the stock market. (Plus, mortgage interest is tax-deductible, so there's a bit of an upside there, too.)
More responses
RiverCityFool chimed in with some additional good points. The original post had referred to funds for general investing as "mad money." Warning against thinking about it in those terms, RiverCityFool advocated taking a long-term view instead. That's very sensible. A short-term mentality can be very dangerous in investing, since no one really knows what the market or any given stock will do in the short run -- but in the long run, things tend to rise. RiverCityFool also pointed out that if the money is all applied to the mortgage, that's focusing an investment on just one asset, which can be risky, whereas spreading it out across several retirement accounts adds valuable diversification.
Mark12547 then asked about the fees for the investment accounts being considered. He noted that a 403(b) plan he was in charged 2.55% per year, plus a withdrawal fee. Ouch. The importance of examining fees is a great point. As I explained in an earlier article, some brokerages are charging hefty fees, which can really shrink your returns.
Permit me to quote myself here: "According to [Consumer Reports'] Money Adviser, Charles Schwab (NYSE:SCH), a major player, requires at least $25,000 in assets or two trades per year -- otherwise, customers can expect to be charged a whopping $160 per year. . T. Rowe Price (NASDAQ:TROW) requires a minimum of $10,000 or two trades per year, or it charges an annual $25 fee. Wells Fargo's (NYSE:WFC) WellsTrade unit requires a minimum of $20,000 or two trades per six months -- otherwise, expect a $60 fee. TD Waterhouse, a unit of Toronto-Dominion Bank (NYSE:TD) that is merging with Ameritrade (NASDAQ:AMTD) . sports no maintenance fees." (Our Broker Center's handy comparison table can help you find a better brokerage for yourself.) [I later heard from the folks at Schwab, who noted, "Schwab has eliminated account service fees you reference. We now have a very competitive minimum balance requirement of $2,500 for brokerage accounts, and charge just $30 if you drop below that in any quarter."]
Then board member gebinr returned to another critical point raised earlier: Since there are annual limits to retirement plan contributions, you can't easily make up for them later. "Once the year is gone," this member wrote, "you cannot contribute anymore and lose the compounding capability of the early years. . The longer you can have money compound, the larger the final pot becomes."
Controversy
Of course, not every discussion on our boards flows smoothly with all participants in agreement. Community member joelxwil drew fire when he disparaged index fund investing: "Remember that the S&P 500 has had a 40% drawdown, and if you had bought [an S&P 500 index fund] five years ago, you would be down 7%, even with distributions reinvested."
Them's fighting words in Fooldom! I was ready to fire back with some contrary thoughts, but I saw that others had beaten me to it. RiverCityFool returned to say that "if you'd bought [the S&P 500 index fund] (at the October 1995 high of $55.63) or 15 years ago (at the October 1990 high of $30.22), you'd be pretty happy with its current price of $113.20. If you've got a long timeline for your investing (i.e., more than five years) and not so much time to research and select individual stocks, index fund investing makes a lot of sense, especially if you reinvest dividends and dollar-cost-average." Amen.
I'll pause here to point out that you can turbocharge your index investing by adding some investments on the side. We can help by recommending some individual stocks or funds with great track records and potential. Test-drive one of our investing newsletters for free -- or perhaps read about their impressive performance first.
To the above, community member joelxwil also weighed in against index funds: "None of this stuff is really complicated. Buying an index fund is just plain dumb. The fact is that if you, as an individual investor, cannot beat the S&P 500, then you are really making a number of mistakes." This advice made me shake my head. After all, thousands of highly educated, very well-paid mutual fund managers fail to beat the S&P 500 each year. It's not so easy.
Invest in a broad-market index fund such as the Vanguard S&P 500 Index Fund (FUND:VFINX) or the Vanguard Total Stock Market (FUND:VTSMX), and you'll instantly be invested in gobs of great American companies, such as Wal-Mart, ExxonMobil, General Electric, Dell, Microsoft, and Procter & Gamble.
The big picture
Community member warrl then raised a critical point I hadn't thought of yet: "You don't mention any debt other than the mortgage. If you have, say, credit card debt, I'd favor doing the low-introductory-rate dance while building up enough cash that when the music stops, it's the credit-card companies that are left with no chair."
Learn about the credit industry and how to get out of debt by visiting our Credit Center. And in the meantime, you can read the entire discussion for much more detail than what I've offered here.
If you're in the market for a new home or new mortgage, we also invite you to drop by our Home Center for lots of guidance. If you'd like a little help with your retirement planning, take advantage of a free trial of our Rule Your Retirement newsletter. It arrives each month, is readable in a single sitting, and is chock-full of motivation and practical recommendations. It can help you pave the way to a comfy and secure retirement.
Dell and Charles Schwab are Motley Fool Stock Advisor recommendations. Four of T. Rowe Price's mutual funds have been recommended by our Motley Fool Champion Funds newsletter service.
Selena Maranjian 's favorite discussion boards include Book Club , Eclectic Library, and Card & Board Games. She owns shares of Wal-Mart and Microsoft. For more about Selena, view her bio and her profile. You might also be interested in these books she has written or co-written: The Motley Fool Money Guide and The Motley Fool Investment Guide for Teens . The Motley Fool is Fools writing for Fools.
