Many investors today are fretting over the increasing price of the stock market. That’s natural given the two big market crashes we’ve seen since the year 2000. Both were preceded by giddy markets that seemed disconnected from real economic growth. So what are you to do if you’re worried?
Well, you’ve probably heard the argument that you should just keep investing right through market declines, and that’s generally good advice, although you need to have the stomach for it. And if you don’t, then think about doing something else with your money that also advances your ability to retire.
Fundamentally, if you want to retire, there are two things you need to do: increase assets and decrease liabilities. You increase assets by investing. You decrease liabilities by paying down debts. But the difference is that building assets through investing carries some uncertainties. You can never be sure what’s going to happen to your money, which is what may have you feeling uncomfortable these days.
But reducing debt doesn’t carry any uncertainty. If you pay it down, you’ve paid it down, plus you’ve reduced the amount of interest you’ll owe in the future on that debt. There’s a clear double benefit to paying down debt. It’s a winning strategy regardless of the level of the stock market.
For most people, their primary debt is their mortgage. If you plan on retiring, it’s good to be mortgage free once you no longer have a steady paycheck. You’ll need to pay it off at some point, so there’s no problem with accelerating that process. Plus, it will provide you with a much better return than parking the money in a savings account these days.
Here’s an example. Let’s say you have $100,000 you could apply to paying down your mortgage or putting in a savings account. With a savings account, we’ll be generous and assume you could earn 1 percent on your money. Now, let’s assume your mortgage rate is 4 percent. Instead of putting the funds in your savings account, assume you use the money to pay off $100,000 on your mortgage balance. You’ll save yourself $4,000 of interest over the next year, which is higher than the $1,000 of interest you might have received in a savings account.
If you have a lump sum to use, the benefits are pretty easy to see. Maybe you don’t have a lump sum, but could pay extra principal on your mortgage every month. The benefits are the same, it’s just that the change is smaller and happens over time. For instance, assume you have a $200,000, 30-year, 4 percent mortgage that’s in its fifth year. By putting down an extra $200 a month, you’d pay off the mortgage six-and-a-half years early and save over $30,000 of interest payments.
Most mortgages allow for penalty-free prepayments in either lump sums or monthly. If you’re interested in reducing your mortgage debt, contact your lender. They can help you with either a lump sum or monthly increase to the amount of principal you pay.
The same math applies to other debts, like credit cards. If your card carries an interest rate of 12 percent, every time you pay down principal, your return on that money is 12 percent because you are saving yourself from having to pay the 12 percent interest. Compared to what you might earn from investing that money in stocks, you can see how reducing debt is just as important as building assets, particularly high-interest debt.
When markets are expensive, it’s alright to feel apprehensive. But one danger is to sit in cash and wait for the next correction to invest. It’s possible the market may not correct and continue to move forward for years. And if your money isn’t working for you, you’ll fall that much further behind in preparing for retirement.
So consider reducing debts when you aren’t comfortable with the investment side of your retirement plans. It keeps you moving forward and offers a solid return on your money.
Charlie Farrell is chief executive of Northstar Investment Advisors LLC. He is the author of “Your Money Ratios: 8 Simple Tools for Financial Security.” This column is for information and education purposes only.
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