by Archie M. Richards, Jr., CFP^®
October 21, 2002

Katharine writes, "I am a retired teacher with a monthly net income of $3,500. My condominium is worth $210,000. I have a 30-year mortgage of $100,000 with interest of 6.375 percent; it has 27 years left. I lease a car for $500 a month and have $80,000 in savings. Two questions: Should I switch to an adjustable-rate mortgage? And what should I do with my savings account?"

I would keep your mortgage, Katharine. Short term, I expect interest rates to rise. If this occurs, you could then obtain an adjustable-rate mortgage. Thereafter, I expect rates to decline significantly.

Car leasing is convenient, but it's actually a loan incorporating an interest rate of about 6.25 percent. In the long run, paying cash for a good second hand car would probably be cheaper. Also, when you need to change cars again, you'll have something of value to sell. With the lease, you'll have nothing.

Between the mortgage and the car lease, you're paying interest of about 6.3 percent. But a bank savings account earns only about 1.3 percent. In effect, you're probably losing something like 5 percent a year (6.3 less 1.3). Five percent of $80,000 is $4,000. Each year, you're heaving $4,000 out the window.

I myself would invest the entire $80,000 in an asset allocation program (see www.archierichards.com). But if you find investing everything up front too nerve-racking, here's an alternative:

Keep a few thousand in savings for emergencies. Terminate the car lease and buy a good second hand car for cash. Also pay off as much of the mortgage as you can. This should save something like $800 a month.

Cutting debt also cuts risk. Given your lower level of risk, invest your monthly savings into an asset allocation program. Use automatic investing. Each month, the mutual funds withdraw the amount you request directly from your bank account.

No doubt you'd need to spend the savings at some point. But if you don't, and the $800 a month grows at 9 percent a year, it would be worth $534,000 in 20 years, $1.4 million in 30 years, and $3.7 million in 40 years. Yes, 40 years; incredible medical breakthroughs are coming.

Wenhao writes, "Your columns point to index funds as the best way to engage in asset allocation. But a recent article by Morningstar said that in small and international markets, managed funds beat index funds and are the better choice. What's your opinion?"

For relatively short periods, Wenhao, you can always find managed funds specializing in certain kinds of stocks that outstrip index funds. But with most stock groups, index funds beat managed funds most of the time.

Here's why. Index funds don't need stock research. They just buy and hold the stocks that are included in the index being tracked. This lowers costs. Also, the publishers of indexes are slow to change the stocks counted in the indexes. Therefore, index funds buy and sell infrequently. This reduces capital gains taxes.

Let's say the index funds perform no better than managed funds. But they have lower costs. The index funds win.

Remember that Morningstar doesn't make money from investing. It makes money by selling its publication. Morningstar wants readers. If it told readers to just buy and hold index funds, people would drop their subscriptions, and the company would go out of business. To keep readers interested, Morningstar and most other investment publications try to spot the latest investment trends.

The trouble is, jumping on the latest trends doesn't generate good investment results. By the time a trend becomes obvious enough to act on it, it's likely to reverse. Also, continually moving money around from one investment to another raises both transaction and tax costs.

Just buy index funds and rebalance every 13 months. Otherwise (except for a certain newspaper column I happen to favor), forget about your investments.