I asked Daniel Nentl, Senior Partner of Ironwood Financial, a few investing questions to help guide you if you’re in debt. Many of the questions asked came from One Paycheck at a Time readers. Should you refinance your house to get out of debt? How does a 401k loan work? Does it make sense to take out a home equity loan to make ends meet?
Daniel did an excellent job of answering these questions for us. If you have more questions for Daniel, please send us your comments and we'll be sure to get the questions to him for you.
The challenge here is which we should do first; pay off a car loan at 7%, build cash at 4%, pay off a Home Equity Line of Credit (HELOC) at 8% or increase our 401k contributions.
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Griffiths:
If a person is looking to consolidate their household debt of credit cards, they have a few options. They could try to find one credit card with a reasonable interest rate and transfer their debt to this card. If the person is a homeowner, they might be able to get a home equity loan or refinance their house and take cash out to pay their debt. Another option might be to take a loan against their 401k, especially if they’re not a home owner or able to get a low interest credit card.
How does a 401k loan work and how does the interest rates compare to other alternatives? Are there finance charges? And, would you advise this as a viable option to someone looking to become debt free.
Nentl:
A few items to consider, consolidating debt is a wonderful idea, however a slippery slope. One must consider the discipline needed to not drive up those areas that now have available credit. That being assumed – if I had to rate the options based on my person preference as a financial professional;
- Consolidate to one reasonable credit card, and then attack this card. Why? Because you aren’t taking your debt and spreading out payments over 30 years – i.e. mortgage refinance.
- Home Equity Loan, in theory the interest you pay is only deductible if you are using the home equity for home improvements; however I have noticed most CPA’s still deduct this interest. That being said the net interest rate is very favorable. The monthly obligation is usually spread over a longer period so the payment is lower. This with good discipline could allow a person to build up cash/emergency reserves. Note on this idea, if your home is short term hold – this could work against you if the real estate prices shrink.
- Take a loan against a 401(k) – the old saying is very true – you can’t take a loan for retirement. That being said sometimes it is nice to be your own banker, meaning paying yourself the interest instead of a bank. This idea works well unless the investment markets go up like the past 4 years, then paying your self your own interest was a poor idea compared to the opportunity cost of how the money would have performed in most markets. How it works, most companies allow a minimum loan of $500 up to a maximum loan of $50,000, with a caveat of a maximum of 50% of the account value. The interest is usually within current prevailing interest rates and has to be paid back with in 5 years, usually by pay roll deduction. So the payment could be stiff – imagine a $40,000 car loan. There is no credit check, however there could be fees. Taking a loan against your 401 (k) is a bad idea if you are planning on switching jobs in the next couple of years or could be laid off.
Griffiths:
Many employers are now matching employee contributions into the company’s 401k (or 403B) program. For example, an employer may offer to match $0.50 for every dollar an employee invests in the 401k up to 3%. If the employee earns $50,000 per year and contributes exactly 3% of their income, or $1500, the employer contribution is $750. The 50% return on your investment would be really hard to beat.
The 401k employer contribution may only eligible after a specific waiting period, also known as a vesting period, determined by the employer. As a result, it’s entirely possible you may never even work at the company long enough to earn the contribution benefit. In some cases, I have seen that vesting can take six years. So, even though a 50% return on your investment sounds like a great idea, it isn’t something you can always count on.
When you’re in debt and your 401k portfolio is making a 7-10% return but your credit cards have a 15% interest rate, does it really make sense to make 401k contributions or other investments?
Nentl:
This is a tricky one, if you have ever seen a compounding chart the longer the money is working for you the better of you will be. However, you are correct in a generic world where you are earning 7-10% and you are paying 15%, reality is in both situations your money is working for you. So the idea should be simple, which would you rather have, a guaranteed 15% or a not-guaranteed 7-10%. In other words you pay off your high interest debt; because reality is over the long haul you will not come close to a 15% rate of return in the stock or bond market. You will do it here and again, but over a 10 year average – everything reverts back to its mean and in the market that’s 8-10%.
Now if you are working for a stable company and you think you will be working there for awhile, I still would want to see someone put the minimum amount of money into their 401k to get the company match, even with a six year vesting schedule, after two years you are 20% vested on a guaranteed 50% growth rate, in other words 10% of it is yours, now if you get a 6% return on your investments, you have now beat the rate of return you are paying on your high interest debt.
Another concept is the ‘pay your self first’ idea of saving. To you use the previous example, a person making $50,000, putting in 3% to get the company match. 3% equals a net take home affect of $100 per month that is out of sight out of mind and building towards a very difficult task - retirement
Griffiths:
I think that Americans have heard the message from financial advisors, plan now for your retirement. Oftentimes what happens is an employer hands the employee a 401k booklet and points them to the financial institution’s website that is managing the company’s 401k. Very little help is offered as to how to set up a portfolio. To a novice, knowing what mutual funds or bonds to invest in is overwhelming. These self-directed employee accounts just don’t seem to be very intuitive. What do you suggest?
Nentl:
There is nothing that can take the place of experience, but how do we get it. The first problem is the plain truth that some people have a simple dislike of all things financial. The workbooks that are given nowadays to 401k participants, however not friendly are set up to help those that want to learn how to build a portfolio. They are actually workbooks that ask a series of questions that all have a point system associated then upon completion the calculation will actually tell you how to invest. Then once you have had the account awhile and you check on it monthly or quarterly you will gain that needed investment experience. That being said, reality is, as long as you’re in the appropriate position to save in your company sponsored plan and you are going to continue to save, you almost can’t mess it up. If you have more than 10 years to retirement and you put at least 60% to stocks and the rest to either bonds or cash – you will have a nice average annual rate of return. The biggest mistake you can make is simply to build your portfolio using what was the best performing funds over the past year.
Griffiths:
What is meant by risk tolerance?
Nentl:
A better association might be called your ‘threshold for losses.’ Risk tolerance is used to associate an investor's ability to handle declines in the value of his/her portfolio. The old cliché nothing ventured nothing gained is somewhat true. But financial planning is not a science; there are many ways to accomplish the same goal. True financial planning should be about minimizing stress. Some people lose sleep if their portfolio would lose 5%, so if someone says you have to take risk to make money, they are not taking into account the very very important aspects the role emotions take in holistic financial planning.
Griffiths:
What other advice do you have for people who are trying to strike a balance between getting out of debt and investing?
Nentl:
I use the 9% percent rule with some disclaimers. If you have debt that you are paying more than 9%, you should direct most disposable income towards the goal of paying those higher interest rate debts off. As mentioned earlier, I believe we should take advantage of a company sponsored retirement plan up to the company match, but then all money should be sent to the money that is borrowed at more than 9%. Upon paying off those debts then only then should a person increase their 401k contributions. Of course this starts the next balancing act of building emergency cash reserves (usually 3-6 months of fixed expenses). The challenge here is which we should do first; pay off a car loan at 7%, build cash at 4%, pay off a Home Equity Line of Credit (HELOC) at 8% or increase our 401k contributions. I would not worry about the car loan and pay it for the hopefully not more than 5 years (and actually keep the car that long); I would split disposable income towards equally increasing the 401k and attacking the HELOC and not build cash reserves. Should you fall on hard times, paying money towards your HELOC is like building cash, but it’s earning far better than 4%.
Griffiths:
If a person has worked hard to get out and stay out of debt, is now making the maximum contribution allowed to their 401k, do they need to try to save even more money for their retirement? I realize that different people need different amounts to live on because of their lifestyle, but is there a guideline you might suggest?
Nentl:
There really isn’t a specific rule about how much a person will need for retirement. The 401k websites will tell you need ‘X”, which is usually more than you need, but I am for more than less. Once you are maxing out your 401(k) there are some generic rules of thumb. A person really needs to make sure they have;
- Emergency reserves set a side.
- Enough disability and life insurance (nobody likes insurance unless you need it).
- all of their debt in the correct places
But after that; enjoy. Life is short. I personally like to;
- save to taxable accounts for more liquid money
- diversify in rental real estate properties.
Griffiths:
I read an article recently published by AXA Financial which said, “The U.S. leads the world in saving for retirement according to a global retirement survey by AXA Equitable, an AXA Group company. U.S. workers save on average $696 a month for retirement, more than double the amount saved by workers in Germany, Italy and France, and nearly 10 times the amount saved by workers in China. Eight of 10 working Americans surveyed have already started saving for retirement.”
Because the U.S. doesn’t have a lot of the same government subsidized retirement programs as other developed nations, it would stand to reason that the U.S. citizens are smart to save more than people in other countries. At what age would you recommend people begin investing?
Nentl:
As soon as you can
Griffiths:
If a person is looking to engage a financial advisor, how do they find someone who is qualified?
Nentl:
First and foremost you have to realize that with the right advisor you meet with that person in person, on the phone or via email many times a year. You need to trust and like that person as a person. Look for a truly independent advisor that that doesn’t have any relationships with a specific company i.e. a big insurance company. You really want to know that the advisor is going to hear your goals and then build your plan, not have the solution before he hears your goals. Ask for referrals of other clients in a similar situation. Don’t be in a hurry, interview a few advisors.
Daniel Nentl, CFS, CSA, is a Senior Partner of Ironwood Financial. Dan specializes in working with retired investors. He focuses on portfolio management and helping investors increase the efficiency of their portfolios through reducing hidden expenses and by using modern portfolio theory to lower portfolio volatility. He has taught Retirement Planning to thousands of seniors throughout Arizona, Minnesota, Iowa and Wisconsin. Daniel can be reached at 888.271.4646, www.ironwoodfinancial.com.
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