The financial crisis has torpedoed the retirement planning of many seniors.
Those foolish enough to have followed the advice of investment advisers who preached that homeowners should convert all their home equity into investments now find that their home equity is negative because of declining home prices. At the same time, the value of common stock they purchased by mortgaging their houses to the hilt is probably way down because of the sharp decline in stock prices.
This seems pretty questionable advice - maybe some really had an objective rather than making commission off of the investment. But we assume many just saw it as a means to gain commissions from the home equity line and then another commission for the stock transactions. Hopefully there will be some investigations into these activities.
Lets take a look at some of the guidelines regarding future investments that were dispensed -
· The core principle is that repaying a mortgage is an investment: The yield on mortgage repayment is the mortgage interest rate. Repaying a 6 percent mortgage yields 6 percent, the same return as acquiring a 6 percent bond. Note: Bonds and mortgages have different interest compounding periods, which affects their "effective return," but not by enough to worry about.
· Before-tax and after-tax returns: In comparing the return on mortgage repayment with the return on alternative investments that are taxable, it doesn't matter whether the comparison is made before-tax or after-tax. If you are comparing repayment of a 6 percent mortgage with acquisition of a 5 percent bond, for example, the before-tax comparison is 6 percent vs. 5 percent. The after-tax comparison, assuming the borrower is in the 40 percent tax bracket, is 3.6 percent vs. 3 percent. If mortgage repayment earns the higher return before-tax, it also earns the higher return after-tax. If income on the alternative investment is not taxable, however, returns should be compared after-tax.
· The investment decision: In general, borrowers should repay their mortgage when their mortgage rate is higher than the return on alternative investments of comparable risk. Because mortgage repayment carries no risk, the safest application of this rule would limit alternative investments to government securities, insured deposits and other federally guaranteed assets. The returns available on such assets would usually be below the mortgage rate.
· Allocating excess cash flows: Borrowers are faced with two types of mortgage repayment decisions. In one, they invest excess cash each month over an indefinite future period. They should allocate excess cash flow to mortgage repayment if the mortgage rate is higher than the return, adjusted for risk that can be earned that month on newly acquired financial assets. The owner confronts a new investment decision every month.
· Liquidating assets to repay the mortgage: Many seniors are faced with a different type of decision -- whether to liquidate financial assets to repay the entire mortgage loan balance. In making a one-time investment decision that is irrevocable, the borrower can't adjust to future changes in the investment rate. He has to look ahead and anticipate what these changes might be and how long he will be around.
While the article is written to seniors, the advice can be applicable to people of all ages. Comparing the yields - investing in a 3% CD versus paying off a 6% mortgage. Comparing the before and after tax rates to know which investment is better. Evaluating the risks of various investments. Lots of good advice for anyone who still has any equity or other funds left.