abcInvesting Blogs

January 2008

January 31, 2008

Contribute to Your 401k or Build Up a Savings Account?

Financial planning sages have long advised families to have an emergency fund, often suggesting it total six months of income. Although that is a high hurdle for most families, the logic of a rainy day fund is strong.

Let’s consider your risks. If you car’s transmission blew up tomorrow, would you be able to get to work? If your son broke his arm while trying to climb a tree, would you be able to pay the deductibles and co-pays required by your medical insurance? If you suddenly lost your job, would your family have food on the table and a roof over its head until you found work?

If the answer is “no” to any of these questions, you have a problem. But the answer may not be “no” even if you don’t have much savings. First, let’s look at the degree of risk you face. If your car is still under warranty, you have less risk than if you’re driving a well-used car. You have less risk if your health plan requires only minimal cash payments or if you work for a healthy company in a stable industry.

Even with significant risk, there are alternatives to six months of income in the bank. Your credit cards offer a last line of defense against temporary emergencies. Notice the key point of that sentence: The credit card should be a last line of defense, not a routine way of funding vacations and retail therapy. Let’s say that you follow our best practices for credit cards and pay the balance off in full every month. Then you have a good bit of credit available when your car gets sick. If your credit limit is low, ask for an increase; you can often get a higher credit limit just for asking if you have a good credit history.

But suppose that you don’t have much available credit on your plastic, and you have normal risk of financial difficulties. Then you need to get a savings account.

In most 401k plans, you can borrow money from your own 401k. That provides another layer of protection from the devilish transmission or the unexpected medical expense, but it does not help at all in the event that you lose your job. In fact, you may have to repay any loans to your 401k immediately if you lose your job. If you can’t pay off the loans, the money you borrowed is considered a distribution. You owe tax on it, as well as a ten percent early distribution penalty. All of this would happen at a time when you are least able to pay extra taxes. (See the chapter on loans for more details.)

The bottom line on loans is that they add a layer of protection. If your job is very secure, then the layer of protection is thick. If your job is at risk, then it’s a thin layer. Don’t count on it. And while hardship withdrawals could also be an option, they have tax consequences and are limited in use. (See the chapter on that subject for details.)

The worst part about the idea of building up a savings account first is that you can’t just ignore the 401k in the hopes that someday you’ll build up a savings account. You need to make a definite plan to build up that savings account. Allocate all available cash for the next six months to the savings account. Decide on a fixed amount you’ll add to savings out of every paycheck. Put the money into a separate account, not your routine checking account. Cut expenses to the bone. Every payday, put money into the savings account before spending it on other things.

January 24, 2008

Contribute to Your 401k or Pay Down Your Mortgage?

Would you like to pay off your mortgage? Some people can shrug off six figures of debt, but other people feel a weight on their shoulders. They want to burn the mortgage and be debt free. Good for you if you are one of them, but…

Unfortunately, making extra payments on your mortgage should be a lower priority than funding your retirement plan.

Making extra payments on the mortgage to pay down the balance due does not add to your flexibility should you lose a job or have an unexpected bill. This is a weird thing about mortgages: No matter how much extra you paid in the past, you still have to make your monthly payment in full. (There is one type of mortgage, called an “Option ARM,” that does allow a lower payment in some cases.)

Assume your mortgage payment is $1,000 a month, but for each of the past six months you’ve been paying $1,500. You’ve sent in a total of $3,000 more than your required payment. Don’t you think you should be able to skip one, or two, or even three payments? Well, you can’t. You are legally obligated to keep making that $1,000 monthly payment. So paying down the mortgage does not provide you with flexibility.

One way to think of paying off debt is that you earn a return equal to the interest rate on the debt. What should you do if you have an extra $1,000 lying around? If you put it in a certificate of deposit at the bank you might earn five percent interest. If you pay down your credit card balance, you might earn 18 percent interest. You’re not technically earning interest, but avoiding interest is just the same.

Now back to your mortgage payment. It is probably the lowest interest rate debt you have. Because there’s equity in your home, lenders have given you an interest rate not much higher than the best borrowers in the world have. You don’t earn very much by paying off the mortgage. In fact, you’re very likely to earn a higher total return in your 401k account than you pay in mortgage interest.

January 23, 2008

Contribute to Your 401k or Pay Off the Car Loan?

Should you pay off that car loan before starting contributions to your 401k plan? To answer that, let’s begin with a simpler question. Suppose you lend your brother $100 at eight percent interest and borrow $100 from your sister at eight percent interest. When the two loans are paid off, will you be better or worse off than when you started? Obviously, you’ll be in exactly the same position. To be better off, you need to charge your brother a higher interest rate than you pay your sister. So the simple starting point for the car loan question is whether the total return on your 401k will be higher or lower than the interest rate you’re paying on your car loan.

Over the last few years, banks have been charging between six and eight percent interest on car loans. (We don’t count financing arranged by dealers, because they often grant lower interest rates in exchange for a higher price on the car.) The investment returns on your 401k are not so simple to calculate, unless your employer offers to match your contribution. If the employer matches even a little of your contribution, then your 401k will earn far more than the interest you pay on your car loan.

If there is no match from your employer, a rough long run average for a well diversified investment fund is roughly eight percent a year. Car loans, on average, cost a little less than what you can earn in your 401k. In other words, you’re better off leaving the car loan in place and contributing to your 401k.

However, the difference in interest between the two choices is small enough that other factors can be considered. For instance, if you have a very strong urge to be debt-free and if you are definitely going to stay out of debt after the car is paid off, then it’s not such a bad idea. However, most people will find it easier to discipline their spending if they contribute to the 401k rather than making extra payments on their car.

The decision is up to you, but in most cases, you’ll be better off contributing to your 401k rather than paying off your car loan early.

January 16, 2008

Contribute to Your 401k or Pay Off Your Credit Card?

Assume for the sake of argument that you have a credit card that charges a fairly high interest rate. Herein is the most extreme question that arises about contributing to a 401k or paying off debt: Should you pay off the card first, or contribute to the 401k first?

Let’s describe the happy case where you pay off the credit card first. You put all of your discretionary income to work paying off the credit card tab and avoid adding any more credit card debt. You get out from under the 18 percent (or whatever) interest rate you had been paying on the debt. Now that you are used to living on less money, it’s easy to contribute to your 401k.

Now consider the unhappy case: You don’t contribute to the 401k, and you still rack up credit card debt. This leaves you with high debt and no retirement savings, the worst of all worlds.

So what should you do? First, let’s look at how you incurred the debt. Let’s say that your debt was relatively small, but then you had a major unavoidable expense, like a large medical bill, or the car you use to get to work needs a major repair. You don’t have a behavioral problem—you simply need to dig yourself out of some bad luck. Okay, delay contribution to your 401k, but put yourself on a firm schedule to pay down the credit card debt by a specific date. And keep to that schedule.

Now let’s look at the harder case: You racked up a large credit card debt simply because you spent too much. Not once or twice, but over and over again. Clothes, sporting goods, and vacations have all added up over a period of years to a large credit card bill. You really need to change your behavior. If your behavior is not going to change, at least fund your 401k so that you’ll have a retirement account, even though you are wasting thousands of dollars paying a high interest rate.

However, I’d prefer to see you work on the behavior. Here are some steps that frequently help. First, figure out where you are spending money. Use Quicken or another computer program to track expenses.

Second, create a belt-tightening budget. This is a two-step process. The initial step is to create an extremely severe budget, which eliminates all luxuries, frills and recreation. The next step is to add back in a little money for the luxuries and recreation that are most valuable to you. For instance, most married couples should get out of the house without the kids every week or two, so you might add enough for a date—a cheap date, though.

Some people find it hard to avoid using credit cards for impulse buying, but they want to keep a credit card handy for emergencies. Here’s the solution: Put the credit card in a zip-lock bag filled with water and drop the bag in the freezer. You have to thaw the bag to use the card, giving yourself some cool-down time. A simpler version is to keep your emergency credit card in your wallet, but wrapped in paper, taped shut. That may create enough of a bother that it prevents impulse buys.

The hard numbers show that paying off a high interest rate debt before contributing to your 401k makes sense, but only if you follow through by paying off the debt and then getting started with your 401k. If you can’t do that, contribute to the 401k and accept that you’ll be in debt for a longer time.

January 9, 2008

401k Automatic Enrollment: Good But Not Enough

The latest research shows that automatic enrollment in 401k plans is getting more people to participate, but at too low a contribution rate to be able to retire comfortably. The problem seems to be that some people who would have enrolled at a higher contribution rate instead just accept the default contribution percentage under auto enrollment. As a result, they are contributing far too little.

If you are an employee who was automatically enrolled, thank your employee for getting you started. Then sit down and figure out how much you need to contribute. I'd like to see your contribution, plus your employer's match, up to ten percent of your income. If you are over 40 and don't already have substantial retirement savings, then max out your 401k contribution. Either that or find a nice brand of dog food you can enjoy in your old age.

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