Hugh F. Doherty, DDS, CFP
Invest or prepay the mortgage?
Situation: You hold a 6.25 percent, $120,000 mortgage. You also have $750 left over each month. Question: What is the best use of the $750? Prepaying the mortgage or investing it in a stock mutual fund?
Assuming you could earn a 10 percent average annual return from your investments over the next decade - the average long-term results for common stocks - investing beats prepaying. An extra $750 per month would enable you to retire a 30-year, $120,000 mortgage in just eight years and eight months. After that amount of time, here`s how the numbers work out:
- If you prepaid: You would have a $120,000 paid-off home loan. However, you would have lost an estimated $7,571 in tax savings from mortgage-interest deductions that you could have claimed if you had followed a normal loan payment schedule, so subtract that amount. Net value: $112,429.
- If you invested: Your fund would be worth $107,863 (assuming a 7.2 percent after-tax return), plus you would have paid $14,548 toward principal with your mortgage payments. Net value: $122,411.
So investing wins by $9,982. With the fund, you have liquidity, but you also have not lost the opportunity to use the "Eighth Wonder of the World" - the "Magic of Compound Interest."
However, if emotions enter the equation and paying down debt and safety are important, then, by all means, consider prepayment.
How much emergency cash Is enough?
Not everyone needs a big, rainy-day umbrella. The age-old rule of thumb says to keep a cash reserve for emergencies to cover three to six months` expenses. Some financial planners even recommend a six- to 12-month cushion. But do you really need to tie up half a year`s wages in a low-yielding bank certificate of deposit or money-market account before you start saving toward long-term goals? Probably not.
Too many doctors keep as much as $70,000 in a bank money-market account yielding a paltry 2 percent to 3 percent per year. This is best described as "Sleeping Money." "I am just a conservative-cash kind of person," says one doctor. With that amount, they had enough to cover 14 months of bills and expenses, if they lost both of their primary sources of income.
The doctor should put the money to work, using a "layered" approach to having enough for emergency funds. Keep $10,000 in a bank money-market account yielding 5 percent and another $10,000 in a short-term bond fund yielding 5.3 percent. Invest the rest in a mutual fund portfolio. With the $10,000 in cash, the doctor was just as comfortable as with the $70,000. He or she probably will earn about $3,000 more on savings this year than last year.
This doesn`t mean everyone should plow all savings into the stock market. It does mean you must understand that "you make money with your money." As a saver, you should strike a balance between a realistic assessment of rainy-day demands and the need to invest for the long term.
The new rules
Some rainy-day money is a must. But how much you need depends on your age, health, job outlook - and your borrowing power in an emergency. It may be enough to be able to cover three to six months of expenses with a combination of cash and credit. With a paid-off house or a low balance on your home, you would have plenty of low-cost borrowing power to secure a home-equity credit line from your bank. If necessary, you also could borrow money against any securities you have. You can easily borrow against assets to cover the unexpected emergency.
Don`t forget REITS
The turnaround in commercial real estate makes Real Estate Investment Trusts (REITs) - pools of properties that trade like stocks - an attractive investment for the years ahead. "The fundamentals are quite exciting with the real estate recovery still in a relatively early stage," says Cohen & Steers Realty Shares, a mutual fund that invests in REITs.
REITs look undervalued on three counts:
1.) In many, the liquidation or value of the properties in the pool exceeds the total market value of the stock.
2.) Price-to-cash flow multiples are historically low.
3.) Dividends, averaging about 8 percent, also should rise, thanks to higher rents and revenue growth.
For now, rising interest rates could draw money into other income-oriented investments and keep a lid on REITs, but over three years, you could expect an annual total return of 14 percent or more in a strong economy and 11 percent in a mild recession.
A lesson from Peter Lynch Money Course
Here`s a lesson from Lynch 101 that I never turn down a chance to repeat. No investor can expect to be an expert in hundreds of stocks, but it is possible to become an expert in four or five that are easy to follow and monitor their progress. Then you can buy more shares when the opportunity arises.
Hugh F. Doherty, DDS, CFP, is a national lecturer, financial advisor to the health-care profession and CEO of Doctor`s Financial Network. For personal financial consultations or to have Dr. Doherty speak to your study club or dental society, call (800) 544-9653.