Swapping Debt: Home Equity for Credit Cards

Question of the week:With rates generally low right now, I'm thinking about taking out a home equity loan to pay off some credit card debt. Do you think that's a good idea? --Walter B.

Dear Walter,

You have plenty of company. According to the Consumer Bankers Association, debt consolidation is the most common use of home equity loans and lines of credit. Borrowing against your home equity to consolidate consumer debt is a fairly common scenario. When we asked the Armchair Millionaire community about their experiences doing this, we got two distinctly different kinds of responses. Here are two examples:

Go for it. "I took out a home equity loan at a low, fixed, rate and used it to pay off a higher fixed rate graduate school loan. Not only am I paying less interest, I can now I can deduct it all." --Erin

Stay away. "Good friends of mine got a home equity loan and consolidated all their credit card bills, which they couldn't afford in the first place. Within six weeks, they had charged the cards back up, putting them in even further over their heads." --David

As you can see from these two very different experiences, whether borrowing against your home to pay off other debt is a good idea depends entirely on you. If you stick with a disciplined program for paying off the debt and refrain from adding more credit card debt, it can be a great help, saving you hundreds or even thousands in interest and often giving you a tax deduction, to boot.

On the other hand, if you end up simply running up more credit card debt, it can be downright dangerous, putting your home at risk if you're unable to pay. I would suggest tapping home equity to pay down credit cards only when you're willing to make concrete changes in your spending habits and stop incurring additional debt.

If you do choose to make the plunge and take out that loan, use my checklist to do so wisely.

The Armchair Millionaire's Checklist for Tapping Your Home Equity

• Know the differences. There are two different types of home equity instruments:

  • A home equity loan is for a fixed amount, usually has a fixed interest rate, and has a set term, typically 10 to 15 years. It is generally the best kind if you need a lump sum at one time (like to pay off all your credit cards) and don't anticipate needing to borrow beyond that.

  • A home equity line of credit allows you to write checks at any time during the life of the loan for any amount up to your credit limit. It will generally have a variable interest rate, and the amount of your monthly payments will vary according to the current interest rate and how much of the credit you have used. The loan must be repaid in full, or renewed, when it expires. A line of credit would be more appropriate when you need the money over time and want the flexibility to borrow exactly what you want, when you want.

• Don't get in over your head. In many states, it's possible to borrow an amount greater than the value of your home. Steer clear of these loans-they will make it very hard to sell your home and generally create a hole that's difficult to climb out of.

• Watch costs. Just like first mortgages, home equity loans and lines of credit carry some significant fees, including closing costs, points, application and processing fees, and a charge for an appraisal. These costs can vary significantly from lender to lender, so shop around. A "no closing costs" loan is not necessarily the best deal. Those savings could be more than offset if the loan has a higher interest rate.

THE BOTTOM LINE: There's an old adage that says you can never borrow your way out of debt. Whether that's true, however, is entirely up to you. If you're considering using home equity to pay off consumer debt, make sure you have a plan in place in advance for not getting in deeper.

Cracking the Retirement Nest Egg

Question of the week:I'm three years away from retiring and starting to look at my options for safely withdrawing money from my portfolio for living expenses. How do you suggest I go about it? --Early Retiree in KC

Dear KC,

As you're probably discovering, drawing a regular income out of your portfolio during retirement can be even more complicated than growing the portfolio in the first place.

It's a balancing act. You need to use your capital to generate income while simultaneously preserving that principal so that it lasts as long as you need it. When we asked members of the Armchair Millionaire community how they plan to tap their retirement accounts for income, we received a range of responses:

CDs. "Starting at age 59 1/2, I'll take 2 percent out my retirement accounts each year and place into a 5-year CD. The first one is due at 65, then the next one at 66, and so on. It will take at least 50 years, or until I am 115, to go through all the money. I'll supplement this with payouts from a fixed-income fund." --Joe M.

Bonds. "Our portfolio is mostly in U.S. Treasury and Agency bonds. We'll spend 3 percent of the portfolio per year to supplement pension income. Social Security is a nice addition, but not an essential element of our retirement. This plan will provide us with 115% of our pre-retirement income." --Allen and Kay

A blend of CDs, bonds and money markets. "I'll have a mix of stocks and bonds. Three years before retirement, I'll start monthly transfers of one-half percent of the portfolio to cash-short-term bonds, CDs and money markets. So long as the portfolio averages six percent annual returns (below the long-term average), I can maintain or improve my lifestyle, plus have something left for the children or charity." --Mike

As you can see, there is no single correct way to construct a retirement portfolio. But every sound approach does have one critical ingredient: good planning. My checklist will guide you when making your own plan.

The Armchair Millionaire's Checklist for Tapping Retirement Funds

• Run the numbers. Figure out precisely how much income you'll need each month. Look closely at your current expenses and how they might change once you stop working. While some people may need less income than during their working years, I suggest that you plan on being able to generate at least 100 percent of your pre-retirement income.

• Get professional advice. Counsel from a financial planner at this stage can be worth its weight in gold. A good advisor will be able to recommend an appropriate asset allocation, income vehicles and tax-minimizing strategies. He or she can also do some long-term projections to help ensure that your portfolio lasts as long as needed.

• Find the right balance between safety and growth. While a portfolio made up entirely of fixed income investments (such as bonds, CDs or money markets) might feel "safe," it actually has the risk of your principal being eroded away by inflation. At the same time, if you're entirely in stocks, you risk the ups and downs of the market. The key is finding a balance that offers a reasonable return and still allows you to sleep well at night.

• Think long term. Depending on the age you retire, plan on making your portfolio last 30, 40 or even 50 years. While retirees are naturally more skittish of the market's short-term volatility, keep in mind that funding your retirement is still a long-term objective. Stick with your plan, and don't be swayed by short-term market moves.

THE BOTTOM LINE: After a lifetime of working, you deserve to be able to retire on your own terms. Take an active role in your success through careful planning, discipline, a balanced portfolio and a long-term outlook.

What's So Great About Index Funds?

Question of the week:I've been hearing a lot lately about the benefits of index funds and they sound interesting, but I hesitate to invest in them because they will never beat the market. Why should I settle for just average returns?
--Douglas R.

Dear Douglas,

You've asked a great question that often comes up for people considering index funds. First, let's define exactly what we're talking about.

An index is simply a list of stocks. A well-known example is the S&P 500, made up of 500 of the largest companies in the U.S. An index fund seeks to do nothing more than match the performance of its index, which it does by either owning every stock in the index, or a representative sampling of it. By its very makeup, an index fund will never outperform its index. In contrast, actively managed funds seek to beat the performance of the market by selecting stocks that their managers believe will have above-average returns.

So why would anyone settle for average? It's because the "average" of index funds is actually better than the performance of most actively managed funds. According to The Vanguard Group, a leading provider of index mutual funds, the S&P 500 index outperformed 72 percent of large-cap, actively managed funds in 2001. And looking back over a longer time frame at the ten years ending December 31, 2000, the average low-cost index fund beat out the average stock fund by a half a percentage point each year.

In addition to superior long-term performance, index funds have other important advantages. Armchair Millionaire community members weigh in with some of them:

Low expenses. "Investing in index funds is the most effective tool for maximizing returns while maintaining very low expenses." --Reuben

Minimized taxes. "There's nothing more tax efficient than an index fund. Since indexes don't change that often, funds don't sell that often, which minimizes capital gains." --Polly T.

Simplicity. "I've switched mostly to index funds because of their simplicity. Now I can concentrate on my real work and just rebalance my portfolio quarterly." --Harry SW

Use my checklist to construct a solid, common sense portfolio with index funds.

The Armchair Millionaire's Checklist for an Index Fund Portfolio

• Cover the market. Use index funds to invest in every part of the stock market. An S&P 500 index fund will cover the large companies, a Russell 2000 index fund will cover the small companies, and an EAFE index fund will cover the major international stocks. I invest one-third of my own portfolio in each of these indexes.

• Explore the niches. Once you have the base of your portfolio established with funds of the major indexes, consider spicing it up a bit with one or two index funds that specialize in one sector or industry.

• Invest regularly. Most fund families will allow you to make automatic monthly or quarterly investments drawn directly from your bank account. Doing so will make investing easy and give you the benefits of dollar cost averaging--take advantage of it.

• Rebalance periodically. Since each index will have a different rate of return, keep your eye on your target asset allocation (the percentage of your portfolio that each index represents) and rebalance your portfolio as necessary.

THE BOTTOM LINE: In any given year, some actively managed funds will outperform their index. But the chances of the same fund beating the market year after year are extremely small. Use index funds to achieve market returns, with low fees and low taxes.

No Need For Social Security

Question of the week:I'm starting to seriously save for retirement and am looking at all my different options. I'm wondering about Social Security--do you think it's reasonable for me to plan on it for any part of my retirement income? Dear Gen Y, We recently asked members of the Armchair Millionaire community about the role that Social Security plays in their retirement plans, and got a range of responses: It will be essential. "My retirement is made up of bond funds, stock funds, annuities and Social Security. I look at these as the four legs on my retirement stool. --Joe G. It won't be there at all. "I plan on zero Social security benefits. At 26, we are already maxing out our Roth IRAs and 401(k) plans, so we will be fine when we retire." --Trevor It will just be it gravy. "I am not counting on Social Security for any of my retirement. If I get anything, I will consider it a bonus." --Michael H. Even the Social Security Administration says that your Social Security benefit should be only one of three parts to your retirement savings formula, along with a pension and personal savings. For the growing number of us not covered by a company pension, that leaves just Social Security and savings. And if you're skeptical of ever receiving any significant Social Security benefit, you should plan on taking care of all of your retirement yourself. But this really isn't bad news. With the myriad options of retirement savings vehicles now available, funding retirement all on your own is within easy reach. My checklist has the steps to get you started. The Armchair Millionaire's Checklist for an Abundant Retirement Make a plan. Start with a clear understanding of exactly how much you'll need, when you'll need it, how much you'll need to save, and how to invest it all. You may find the services of a financial advisor especially useful when planning your retirement savings program and assessing your future needs. Defer your taxes. The best deal Uncle Sam has going is retirement savings tax-deferral. Simply put, when you use a retirement account like a 401(k) or IRA you can often deduct your contribution and you won't have to pay taxes on the growth of that money until you withdraw it. (In the case of the Roth IRA, your contribution is not tax-deductible, but your money will grow tax-free forever.) Deferring your taxes in this way can add hundreds of thousands of dollars to your nest egg by the time you retire. Don't look a gift horse in the mouth. Every type of retirement account has some kind of limit on the amount you're allowed to contribute each year. Do yourself a favor: Contribute the maximum allowed, or at least as much as you possibly can. Capture compounding returns. Over time, the thing that will make up the lion's share of your retirement savings will not be what you've contributed, but the returns (and the returns on your returns) on your contribution. So whenever you invest for the long term, make sure that you have all your interest and dividends automatically reinvested. THE BOTTOM LINE: Stashing away the entire amount that you'll need for the golden years seems like a daunting task, but it's one you can easily whittle down to size. By starting immediately and saving regularly into retirement accounts, the fate of Social Security will become something you just don't need to worry about.

Getting the Best Car Deal

Question of the week:I'm ready to upgrade my old clunker to something much classier, but am dreading the whole process. I'm not even sure if I should buy or lease. How can I make sure I'm getting the best deal? --BMW Fan

Dear BMW,

Buying from a dealer, buying from a private owner, paying cash, financing or leasing-as you know, there are many options. Here is what has worked--and hasn't worked--in the Armchair Millionaire community:

Buy quality used. "We buy cars that are two to four years old because they offer the best value. We use the Blue Book--available at libraries--to determine the exact value of the car so that we don't over pay." --Mike

Buy direct from the owner. "I search the classified ads because buying from private owners usually means that you get a better history of the car. Private owners also seem more willing to negotiate price." --Norris

If you have to have a new car every couple of years for personal or business reasons, don't drive more than 15,000 miles a year, and can't stand the thought of having to deal with selling your used car, you might consider leasing.

Lease it. "I lease because I want a reliable car for family trips and a new car every three years. I figured I'd have a payment anyway, so why not lower it through leasing?" --Andy

Be warned. "I just got out of a lease--what a mistake it was! I'm going to end up owing $1,500 for what they called 'excessive wear and tear.'" --Mitch

If you do choose to go ahead and buy, use my checklist of common sense tactics for ensuring that you get the best possible offer.

The Armchair Millionaire's Checklist for Dealing With Dealers

• Know the price. Start your negotiations from the price on the factory invoice, not from the manufacturer's suggested retail price (also called the "sticker price"). There are Web sites that will help you find out the factory invoice on the car, such as Edmunds.com and consumerreports.org. While the factory invoice is often not the dealers' real cost--they usually pay less after incentives from the factory--it can serve as a good reference point for comparing different dealers' offers.

• Beware of hidden charges. "Floor charges," "dealer preparation charges" and "document preparation charges" are all ways for dealers to sneak in a bit of additional profit on each car. Do not pay them.

• Think twice about buying an extended warranty. Many new cars are very reliable these days and come with their own manufacturer's warranty, so this is one high-cost item you could easily skip.

• Don't assume that the dealer will offer the best financing deal. Check with local banks, your credit union, and on the Internet for loans that offer the best terms and interest rate. And get pre-approved for a loan before you start to shop. That way, if the dealer wants your financing business, he'll have to beat the deal you already have.

THE BOTTOM LINE: Everyone loves getting a new set of wheels, but many become so enamored of that shiny chrome that they may abandon good common sense in the process. Use smart strategies for sticking to your price. Over the last five years, the World Wide Web has turned the tables on car dealers. A little information gives you a lot of leverage.