Personal Finance Q&A: We Answer Your Questions

by the Schwab Center for Financial Research
March 10, 2009

Each month, we receive thousands of questions from Schwab clients. Here, we tackle the top questions on personal finance, with answers and guidance that we believe will address some of your most pressing concerns.

If you have a question that doesn't appear below, we have more Q&As on timely topics in the box at right. If you have a question that we haven't already addressed, you can submit it using the Editor Feedback form at right—we may include it when we add new questions and answers.

To talk to a Schwab investment professional about your particular circumstances, please call 800-435-4000.

On personal finance

I have a 6% fixed-rate mortgage with a $50,000 balance. I also have CDs maturing at this time. Would you recommend paying off the mortgage, adding to my existing investments, or a combination of both?
Would it ever make sense to sell my relatively safe municipal bonds to pay off a mortgage? I'm early in retirement and I'm concerned about retaining my residence should everything really go south.
What's considered a healthy ratio of debt to net worth?
How many months' worth of easily accessible cash should I have?
As a college student, how can I balance investing with paying off debts?
I'm getting married soon. Are there any adjustments I should make to my investing?
What are some common investment strategies for college savings?

I have a 6% fixed-rate mortgage with a $50,000 balance. I also have CDs maturing at this time. Would you recommend paying off the mortgage, adding to my existing investments, or a combination of both?
The decision to prepay your mortgage depends on a number of factors, including:

After-tax opportunity cost. Number crunchers might choose to focus solely on the after-tax cost of money. For example, a 6% mortgage loan would actually cost 3.6% on an after-tax basis if you have a combined federal/state marginal income tax bracket of 40% (assumes full deductibility). If you could net 3.6% or better putting that money to work elsewhere instead of paying off your mortgage, you'd come out ahead. But don't forget about risk: Prepaying a mortgage is a risk-free proposition.
Liquidity preference. Even if you can't do as well or better with an alternative use of the money, you might prefer to have the cash on hand instead of using it to pay off a low-rate mortgage prematurely. Diversification could play a role here, as well—would you rather commit more money to your principal residence, or invest it elsewhere?
Income tax considerations. You can deduct the interest on up to $1 million of mortgage debt used to purchase a home or make capital improvements. Once you've paid off your original mortgage, you'll be limited to deducting the interest on up to $100,000 of home equity line of credit (HELOC) debt—unless you take out another mortgage to make capital improvements or buy another home.
Psychological considerations. For some folks, a strong desire to be debt-free may override other factors. In that case, opportunity costs and income taxes take a back seat.

For more, see "Managing Your Mortgage."

Would it ever make sense to sell my relatively safe municipal bonds to pay off a mortgage? I'm early in retirement and I'm concerned about retaining my residence should everything really go south.
Like the previous question, this decision depends on a number of factors, not the least of which is your mortgage rate and the yield on your bonds. For example, if your mortgage rate is 5.5% and you're in a combined 40% marginal federal/state income tax bracket, then the after-tax cost is 3.3% (assuming full deductibility).

Is the yield-to-maturity (based on both coupon and return of principal over the remaining life of your bond) on your munis at least 3.3%? Even if it isn't, the benefits of diversification and a preference for liquidity might lead you to keep some "relatively safe" investments on hand just in case. On the other side of the argument, paying off a mortgage is a risk-free proposition.

If the bonds are of high quality and not at risk of default, keep in mind that there's no rush. You can always pay off the mortgage at a later date if it makes sense to do so. Meanwhile, you could continue to make your mortgage payments as normal knowing that your mortgage is essentially covered by your bond stash.

What's considered a healthy ratio of debt to net worth?
The best way to measure personal debt is to calculate the percentage of your pretax income that goes toward making your total debt payments.

As a guideline, consider the following ranges:

Below 30%—great!
30% to 36%—OK
36% to 40%—borderline
More than 40%—red flag, especially if you're carrying a lot of variable-rate debt and your income doesn't keep up with rising rates.

There's also an industry rule of thumb called the 28/36rule. The first number means no more than 28% of your pretax household income should go toward your home-related debt costs, including your mortgage and/or home equity line of credit (principal and interest), property taxes and insurance. The second number means no more than 36% of your pretax income should go toward all your debt payments—home-related debt plus credit cards, auto loans and so on.

If you can manage the payments, then the right debt level for you hinges on how much you're paying for the use of the borrowed money, and what you plan to do with it.

For more, see "Borrowing Smart."

How many months' worth of easily accessible cash should I have?
If you're still working, we suggest setting aside enough cash to cover your essential living expenses for at least three months. To learn more, read "Building an Emergency Fund."

If you're retired, we suggest keeping one year's worth of living expenses in cash.

As a college student, how can I balance investing with paying off debts?
Your first priority should be to pay off your high-cost, nondeductible debt, such as credit cards, car loans and so on (this doesn't necessarily include paying off your student loans—interest on those is tax deductible, within certain limits). Then, make sure you pay off your credit card balances each month in full.

If you're a part-time student working full time, make sure you have an adequate emergency fund.

At this point, you can think about investing. For more, see "Get Smart About Savings" and "Schwab's Investing Principles: Becoming a Successful Investor."

I'm getting married soon. Are there any adjustments I should make to my investing?
Ideally, you and your spouse can view your financial decisions as a team. Spend some time discussing your long-term hopes and dreams, such as home ownership, college for the kids, charitable pursuits, retirement goals and so on.

Beyond that, there are a number of nuts-and-bolts decisions you need to make. For more, read "On the Road to Financial Bliss" and "Cash Flow Planning for Life."

What are some common investment strategies for college savings?
Many people open a Coverdell Education Savings Account (if eligible) and/or a 529 college savings plan—special tax-advantaged accounts designed to help you save for your children's or grandchildren's education.

The next step is to implement a prudent investment plan that's appropriate for your risk tolerance and the time horizon.

Consider the following general guidelines, but also keep in mind that with the Schwab 529 Plan, you can choose an automatic, age-based savings track that will lower the level of risk in the account as the child gets closer to college.

18 years before college

Open the account of your choice and contribute money every month, perhaps by signing up for an automatic investment plan. Contribute extra money whenever possible.
Consider investing the money in stocks or mutual funds for long-term growth (if appropriate given your tolerance for risk).

8 to 10 years before college

Has anything changed in your life? A new baby? A better-paying job? Consider these changes and recalculate your needs.
If you haven't yet opened an account, consider doing so right away. You may want to make an investment in a 529 plan, which allows much larger lump sum contributions and may help provide a chance to make up for lost time.
Contribute any windfall money to your college savings account.

1 to 2 years before college

Figure out your expected family contribution, a number that financial aid officers use to help evaluate your child's eligibility for financial aid.
Look into your options for financial aid and scholarships.
Reassess the risk level in your accounts. As college approaches, consider moving the money into less risky investments, such as shorter-term bonds and money market funds.

For more information, see:

Important Disclosures

Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing. Past performance is no guarantee of future results, and your investment value and return will fluctuate such that shares, when redeemed, may be worth more or less than original cost.

An investment in a money market fund is neither insured nor guaranteed by the FDIC or any other government agency. Although the fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in the fund. Please note that bank deposits are FDIC insured up to $250,000 while nonbank independent products have no such guarantees.

Before investing in a 529 College Savings Plan, carefully consider the plan's investment objectives, risks, charges and expenses. This information and more about the plans can be found in the Schwab 529 Guide and Participation Agreement available from Charles Schwab & Co., Inc., and should be read carefully before investing. If you are not a Kansas taxpayer, consider before investing whether your or the beneficiary's home state offers a 529 plan that provides its taxpayers with state tax and other benefits not available through this plan. As with any investment, it is possible to lose money by investing in this plan.

The Schwab 529 College Savings Plan is available through Charles Schwab & Co., Inc., and is managed by American Century Investment Management, Inc. The Plan was created by the Kansas State Legislature under the provisions of Section 529 of the Internal Revenue Code and is administered by Kansas State Treasurer. Notice: Accounts established under the Schwab 529 Plan and their earnings are neither insured nor guaranteed by the State of Kansas, the Kansas State Treasurer, American Century Investments or Charles Schwab & Co., Inc. Accounts established under the Schwab 529 Plan are domiciled at American Century Investments and not Schwab.

American Century Investments® receives remuneration from fund companies, including PIMCO Funds, American Beacon Funds, Metropolitan West Asset Management, and Baron Funds® for recordkeeping, shareholder services and other administrative services associated with funds held in the Schwab 529 Plan portfolios.

Fixed-income investments are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, corporate events, tax ramifications and other factors.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets. Periodic investment plans do not ensure a profit and do not protect against losses in declining markets.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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