Where should I put money I need in 5 years?

[Goldy]

I was always one to pay extra on my debt but now that the highest interest rate on our debt is a mere 2.2% I am starting to think that I should invest instead of paying extra on the debt.

With that said, can anyone recommend something to invest in from Vanguard? 5 years isn't all that long so I am leaning towards something with a bit less risk but I would like to make ~5+% interest. What do you think about the bond market?

Thanks for your help and let me know if I forgot to mention something important.

[disneysteve]

If you need the money in 5 years, that really isn't a long enough time to ride out any market downturns so you want to avoid stocks. As for bonds, though they've been on a great run in recent years, that won't necessarily continue, especially if interest rates creep up.

Looking at Vanguard specifically, VBTLX has 1, 5, and 10 year returns of 7.37, 6.94, and 5.63% respectively. Obviously there is no guarantee that in the next 5 years returns will stay that high but if you are looking for a low-cost diversified bond fund, that's a good choice.

You could dabble a bit in stocks to try and capture some market upside but I probably wouldn't go more than perhaps 20% into stocks and you could do something simple like Vanguard's Total Stock Market Index.

[dczech09]

The issue with bonds is that interest rates are low. So when they inevitibly go up, bond prices will go down. This will only affect you if the bond funds you are in are actively managed.

Maybe you could look into some ETFs or mutual funds that hold bonds and don't trade them. If you could find one, that would be good. As long as the fund does not actively manage their bond investments, then the interest rate situation will not affect you.

Another option is to maybe consider a Real Estate Investment Trust (REIT). The only issues with this is that it is a real estate investment that you would be making, and who knows where real estate will go. For me, my REIT has does well, but who knows what will happen in the next few years.

I agree with DS that 5 years may not be long enough for stocks. You could certainly put a portion of your money into some stock funds. I would avoid international stocks, emerging markets, and individual stocks though.

[Goldy]

Thanks guys. One question about bonds. I have heard people say before that as interest rates go up the bonds will go down. Is it possible to actually lose money investing in bonds or do you just make a smaller gain?

I looked at some of the vanguard bonds and was amazed at how many different ones there were. How do you choose?

[disneysteve]

Thanks guys. One question about bonds. I have heard people say before that as interest rates go up the bonds will go down. Is it possible to actually lose money investing in bonds or do you just make a smaller gain?

I looked at some of the vanguard bonds and was amazed at how many different ones there were. How do you choose?

If you purchase an individual bond and hold it until maturity, what happens to interest rates is of no concern. The bond will continue to pay the stated rate and you'll get back your principal plus collect interest for the term of the bond. The only "loss" you might experience is lost opportunity if you own a bond paying 3% and newer issues are now paying 4%, for example.

If you invest in a bond fund (or ETF) however, you are purchasing a basket of bonds and what is held in that basket can change over time as the managers buy and sell bonds on the open market. The value of each of those bonds is affected by interest rates so the share price of the fund can go up or down. You could lose money. Generally, the lowest risk is with bond funds with the shortest average duration, so a short-term fund will be less impacted by a rate increase than an intermediate or long-term fund.

[dczech09]

Bond investing can be pretty complicated. Yes, you can absolutely lose money. I will give you an example.

Let's say you buy a $1,000 10 year bond with a 5% interest rate. You buy the bond for the $1,000 face value.

Then 2 years later, market interest rates rise to 8%. You decide that you want to sell the bond.

So, your bond carrying a 5% interest rate in a 8% market is obviously worth less. If you want to sell it, you will have to be willing to settle for less.

FV= $1,000
Pmt= $50/12
I/Y= 8%/12
N= 96
PV= $823.15

So if you sold the bond, you would get $823.15.

Over the two years passed, you would have got $50 per year for interest, which equals $100.

So you would have spent $1,000 for the bond, but only got $923.15 after selling.

Please note that this is a completely hypothetical situation. But it definitely shows that yes you could certainly lose money investing in bonds.

Like I said before, the interest rate risk only applies if you buy and sell bonds, or the mutual fund that you invest in buys and sells bonds.

If you were to buy that 5% bond and hold it until maturity, you would get 5% per year and then get your $1,000 back at the end of the bond's life. So your end result in that scenario is simply a 5% return per year.

I know this stuff can be complicated, so please let me know if something confuses you and I will elaborate

[kv968]

Looking at Vanguard specifically, VBTLX has 1, 5, and 10 year returns of 7.37, 6.94, and 5.63% respectively. Obviously there is no guarantee that in the next 5 years returns will stay that high but if you are looking for a low-cost diversified bond fund, that's a good choice.

I'll have to disagree with you on this one Steve.

That fund has a duration of 14+ yrs. and a maturity of 24 yrs. IMO, that's way too much risk to be taking on a 5 year investment that only yields 3.8%.

[disneysteve]

I'll have to disagree with you on this one Steve.

That fund has a duration of 14+ yrs. and a maturity of 24 yrs. IMO, that's way too much risk to be taking on a 5 year investment that only yields 3.8%.

Point taken. I hadn't looked at the average maturity.

[kv968]

Thanks guys. One question about bonds. I have heard people say before that as interest rates go up the bonds will go down. Is it possible to actually lose money investing in bonds or do you just make a smaller gain?

I looked at some of the vanguard bonds and was amazed at how many different ones there were. How do you choose?

The biggest risk you're most likely to face with bonds and bond funds is interest rate risk. A quick way to see how sensitive a bond fund is to changing interest rates is to look at the fund's average duration. What that shows is the approximate amount the fund will rise or fall when interest rates change. Although it's quoted in years, it's used as a percentage.

For example, Vanguard's Intermediate-Bond Fund (VBILX) has a duration of 6.4 yrs. If interest rates were to rise 1%, the fund would lose approximately 6.4%. Conversely, if interest rates rose 1%, the fund would increase 6.4%. Vanguard's Long-Term Bond Fund (VBTLX) has a duration of 14 yrs. which means it could fluctuate 14% for every 1% interest rates move. That's why I had to disagree with Steve in that I think that's too much risk for the time frame and the yield you'd be getting.

For the most part, the longer the holding period of the fund, the higher the duration.

[Goldy]

The biggest risk you're most likely to face with bonds and bond funds is interest rate risk. A quick way to see how sensitive a bond fund is to changing interest rates is to look at the fund's average duration. What that shows is the approximate amount the fund will rise or fall when interest rates change. Although it's quoted in years, it's used as a percentage.

For example, Vanguard's Intermediate-Bond Fund (VBILX) has a duration of 6.4 yrs. If interest rates were to rise 1%, the fund would lose approximately 6.4%. Conversely, if interest rates rose 1%, the fund would increase 6.4%. Vanguard's Long-Term Bond Fund (VBTLX) has a duration of 14 yrs. which means it could fluctuate 14% for every 1% interest rates move. That's why I had to disagree with Steve in that I think that's too much risk for the time frame and the yield you'd be getting.

For the most part, the longer the holding period of the fund, the higher the duration.

I had no idea bonds were potentially so volitile. Would bonds really lose 6.4% by a 1% interest rate increase? Simply paying down the debt is looking better than I had previosuly thought.

[disneysteve]

I'll have to disagree with you on this one Steve.

That fund has a duration of 14+ yrs. and a maturity of 24 yrs. IMO, that's way too much risk to be taking on a 5 year investment that only yields 3.8%.

Wait a second. I just checked and those numbers aren't correct for VBTLX.

Average maturity is 7.1 years.
Average duration is 5.1 years.

You were looking at VBLTX.

[dczech09]

I had no idea bonds were potentially so volitile. Would bonds really lose 6.4% by a 1% interest rate increase? Simply paying down the debt is looking better than I had previosuly thought.

There are many studies out there that show that bonds carry almost as much risk as stocks, but generally a lower average annual return. This is why people like Dave Ramsey do not like bonds.

Bonds carry a completely different type of risk than stocks. Interest rate risk applies as we have shown. There is also the risk that the borrowing business can not fulfill their obligation to bondholders.

In my example I did earlier, the market interest rates increased 3%. The bond value dropped by over 17% total!

Bonds can be a good asset in a well diversified portfolio due to its stability. But that stability is dependent on that bond being held until maturity. The real issue with bond funds is that the fund managers have a tendency to trade and turnover the portfolio a lot in order to try to avoid losses. That of course turns into a self-fulfilling prophecy

[Goldy]

Well my lending club account is looking better and better for a short term investment. Looks like I am going go need to give this more thought that I had initially anticipated.

What would you guys do with money you might need in 5 years?

[disneysteve]

What would you guys do with money you might need in 5 years?

Buy a CD. Take a look at I Bond rates. Or just park it in the highest yielding money market account I could find.

[MonkeyMama]

Buy a CD. Take a look at I Bond rates. Or just park it in the highest yielding money market account I could find.

Agreed.

The only thing beyond cash (CD/high yield savings - both FDIC-insured) that I would consider for the "short term" is something like Treasury Bonds. Bonds bought directly - not a bond mutual fund.

Personally, we have decided in this low interest rate environment that paying down our 4% mortgage makes more sense than most any other option (better than investing short-term money in bonds). I think you'd likely be better paying off your 2.2% interest debt - a similar conclusion. You can always re-evaluate as interest rates rise. This is not the decision I Would make a few years ago, but it just is what it is with these interest rates.