Archive for April, 2008

Is it wrong to stop paying your mortgage?

Published on April 29, 2008 in Uncategorized. 0 Comments

Lately it seems there has been a lot of talk about the rise in mortgage foreclosures. Specifically I have seen a lot of authors question the ethics of letting your home go into foreclosure, especially if you have the means to pay for it. So I thought I would chime in with my own opinion.

Enough people have decided to give their home back to the bank that a new term (jingle mail) has been used to describe the process. There are two main reasons someone would stop paying the mortgage on their house. The first is that they just can’t afford it anymore. This is likely to happen when someone has an adjustable rate mortgage reset, which hits them with a higher interest rate.

The other reason someone might decide to stop paying their mortgage is that their home is no longer valuable to them. This could occur because of a huge drop in equity, or because the cost of renting is significantly lower than the cost of the mortgage. This is usually when the decision to let a home go into foreclosure generates controversy. Many people believe that it is wrong to back out on your debts and that you should do everything that you can to pay. I disagree.

I think that if letting your home go into foreclosure is the financially smart move, than that is the move to make. Someone who decides to stop paying their mortgage is not taking the easy way out. Having a foreclosure on your credit report is a major ding. They will be paying higher interest rates on other debt for a long time. But if the savings of not paying for a home that has gone down significantly in value outweighs those risks, then why not do it?

When you decide to borrow money for a home, the bank lends you money with the agreement that if you stop paying your mortgage, they take your house. Look at it from the bank’s point of view. If you were truly unable to pay your mortgage they might feel bad for you, but they would still take your home from you. It’s the best financial decision for the bank. So why should any borrow feel remorse about sending the keys back to the bank if that’s the best financial decision for them?

This is by no means the last time you will see this topic come up, in my blog, in other blogs, or in the financial press. I have a feeling that for the next two years or more we are going to see a wave of foreclosures that this country has never seen. It will be interesting to see how the popular opinion of debt repayment changes as more and more folks back out of debt the promised to pay.

Planning for retirement part 2 - Choosing investments

Published on April 24, 2008 in Financial Basics and Retirement. 0 Comments

This is Part 2 of the Retirement Planning series. In Part 1 we covered what a retirement account is and some of the basic account types available.
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One of the more confusing things about retirement accounts is choosing where your money will go. After reading this post you should have a better idea of what you’re looking at when you are picking investments for your account.

Side note: this post is mostly in regards to mutual fund investments. If you are investing in individual company stocks with your IRA then you probably have a different approach to investing, and may find this article less useful.

Asset Allocation

At the broadest level, a mutual fund will cover one of the major asset classes: stocks, bonds, commodities, and real estate. Each asset class has it’s own risk and return characteristics that you should keep in mind when investing. The general rule of thumb is that riskier investments have higher returns, and that the longer your investment horizon the riskier your investments should be. The thinking behind this is that a longer time horizon gives you a larger chance to realize the higher returns.

Bonds are generally considered to be the least risky investment, but also the lowest returning. Stocks have historically had higher returns than bonds, but have higher swings up and down. Commodities, such as gold or crude oil, have the most risk, but can also exhibit large price swings. Real estate can be anywhere on the scale due to its unique characteristics. Most 401(k)s will have many stock fund options, a few bond options, and a money market (cash) fund. Commodity and Real Estate funds will be available for IRA accounts through a company like Vanguard or Fidelity.

When choosing investments for your retirement account you should consider the time until you retire. A person in their 20’s may decide that they want to have only risky investments with no low risk investments, with the hope to maximize their return potential. Someone closer to retirement may want to have more money in cash, bonds, and dividend paying stock funds, and less in risky investments so they don’t risk money they will need in a short timeframe.

Asset Allocation At Another Level

Once you’ve decided on the appropriate percentage of your account to allocate to stocks, bonds, and other investments, it’s time to break the allocation down further.

Company stocks are categorized into market capitalization groups. Capitalization is a fancy word for the size of the company. This means that based on size, a company’s stock will fall into micro cap, small cap, mid cap, or large cap. Market cap is calculated as the share price times the number of shares outstanding. To capture a broad range of stocks you should choose a fund from each of these groups to include in your stock portion.

In addition to capitalization, stock funds can be broken up into domestic and foreign. Foreign stock funds will have names like Euro-Pacific or Emerging Market. For now I think it’s important to diversify into foreign companies, especially considering the slide of the U.S. dollar.

Bond funds often have many types available as well. The most common types include total bond funds, high-yield bonds (called junk bonds by most), and government bonds. Again, each type of fund will have it’s pros and cons. High-yield bonds will have higher yields (obviously), but they will exhibit higher price swings similar to stocks. Government bonds will usually have lower rates, but should have less risk since their cash flows are backed by government agencies. A total bond fund will cover a range of all bond types.

Expense Ratios

While you can’t control the returns of your investments, you can do your best to minimize losses. The two biggest return robbers are taxes and expenses. Since retirement accounts are non-taxable, you have already eliminated the first issue. The second, expenses, is a little tougher to control for.

An expense ratio is the amount of money that the fund charges to manage your money. If the ratio is 1% then the fund will keep 1% of your money every year. It doesn’t sound like much, but over the long term any amount will hurt your returns due to the effects of compound interest.

Typically index funds will have the lowest expense ratios. Actively managed accounts run by a portfolio manager will have much higher expense ratios. It’s up to you to determine whether you think the expense is worth it. I personally try to stay with index funds as much as possible, due to both expenses and my belief that most managers cannot beat the market consistently (a topic for another post).

What About Lifecycle Funds?

One of the newest products of the mutual fund industry is the lifecycle fund. These types of funds give you an easy way to diversify, especially if you only have one account and all of your money is in that one lifecycle fund. A lifecycle fund will typically invest your money in a mix of stocks, bonds, and cash, depending on what year you specify for your retirement. As the retirement date approaches the ratio of cash and bond investments increases, and the amount of money in stocks goes down.

Sounds great, right? The downside to these funds is they generally have higher expense ratios than if you simply invested in a stock and bond fund yourself and handled the rebalancing yourself every year. The lifecycle fund options in my wife’s 401(k) had expense ratios around 1%, fairly high considering the index fund options all had ratios under 0.5%.

How Should I Pick Funds?

The absolute worst way you could choose funds is to pick the ones with the highest historical returns. Instead you should consider the advice above. A typical 401(k) plan or IRA mutual fund list will have funds that fall in the categories we just talked about. Start by thinking about your investment timeline and choosing the appropriate risk level. Decide what percentage you would like to devote to equities, what percentage to bonds, and what percentage to devote to cash. If they are available, also decide if you will contribute to a commodities or real estate fund.

Once you’ve determined a percentage to devote to stocks, decide what percentage will be domestic, and what percentage will be foreign. Choose ONE fund for each of the asset classes. For example choose one small cap fund, one mid cap fund, and one large cap fund. As I said before, if index funds are available I recommend choosing them. But you may decide another fund offers better prospects.

Do the same thing for your bond allocation. Determine an amount to put into high-yield, government, or any other bond funds that are available. Try to mix it up between high risk and low risk, just like you did with the stock funds.

You’re done!

If you follow these steps you should be able to create a diversified portfolio that covers a broad spectrum of investments. You should also have a better understanding of what is going on with your portfolio when you see month to month fluctuations. I realize this is an incredibly broad topic to cover, enough that an entire book has been written about it. But this should be enough for you to look at the funds available to you and determine what class they fall into. Next week will be part 3 of the retirement series, so keep on the lookout!

The relationship between interest rates and home prices

Published on April 22, 2008 in Interest Rates and Real Estate. 0 Comments

We were watching Ghostbusters a few nights ago (awesome, I know), and in the beginning of the movie Dan Aykroyd mentioned the interest rate on a home mortgage-19%- ouch! That was in 1984, near the end of Paul Volcker’s infamous term at the Fed.

Can you imagine what would happen if interest rates went that high again? Affordability would plummet. Suppose for example you could afford $3,000 a month for a mortgage payment. At 6% annual interest you could afford a $500,000 mortgage. If interest rates rose to 16% you could only afford $223,000. Saying that is a HUGE drop is an understatement, that’s over a 50% reduction.

Seeing that makes you wonder why people say real estate prices always go up, doesn’t it? In 1980 and 1981 the federal funds rate was as high as 20%. In 2003 the same rate hit 1%. Think of that past example in reverse, with a few additional assumptions. Suppose there is a 4% spread on the federal funds rate, so that in 1980 mortgage rates were around 24%, and in 2003 rates were around 5%. Now assume that there was about 2% inflation every year from 1980 to 2003. That would mean that a $1,900 payment in 1980 would be equal to a $3,000 payment in 2003.

So in 1980, with a $1,900 payment and a 24% interest rate, you would be able to afford a house worth a little under $95,000. Flash forward to 2003. After huge cuts in interest rates you can now find a 30 year fixed mortgage for 5%, and due to annual pay raises of 2% thanks to inflation you can now afford a $3,000 payment. Now you can afford much more house, about $559,000 worth. So for no other reason than inflation and huge rate cuts courtesy of Alan Greenspan, the price of that $95,000 home skyrocketed 488% over 23 years to $559,000.

This brings me to two points.

First, anyone that says a slowdown in the mortgage market was unpredictable is an idiot failed to observe this simple relationship. Once rates hit historic lows, especially with Fed Funds at 1%, they had nowhere to go but up. Propaganda from the folks at the NAR and investment ‘gurus’ like Robert Kiyosaki led people to believe that real estate prices always went up. Sayings like “buy land, they don’t make it anymore” became popular, even though building new homes and condos wasn’t particularly difficult in most areas. Flipping houses was the new stock market speculation, and the eventual downturn was inevitable. Easy credit amplified the problem further.

The second point is that home prices will continue to fall from their current levels. Mortgage rates will likely continue to rise. Huge increases in foreclosures will help to drive property values down. Add to that a tightening economy due to increasing inflation, higher fuel costs, higher food costs, a weakening dollar, and lower consumer confidence in the housing market, and things don’t look so good for housing, do they? Oh, and don’t forget that easy credit is now turning the other direction.

I don’t think it’s a good time to buy, no matter what anyone wants you to believe. Statistics saying that homes are a good way to build wealth through equity are simply misrepresenting the mathematical relationship between interest rates and home values, and may not hold up in the future.

If you are considering purchasing a home, think about the difference between the mortgage payment and what rent on a comparable place would be. Don’t forget to include the monthly cost of insurance, property taxes, HOA fees and melaruse. If there is a large difference, you are probably better off renting a comparable place at a lower monthly payment and saving the differece. Do this long enough and you can save a substantial amount of money. If rents eventually come in line with mortgages and it makes sense to buy, you now have money saved for a larger down payment. Maybe even enough to make a 15 year mortgage affordable, giving you a lower interest rate and a shorter time frame to pay everything off.

Don’t believe the hype that renting is paying someone else’s mortgage. The first few years of your mortgage you will be paying much more in interest that you would pay for rent. This is definitely a topic that I want to cover more in the future.

If you would like to learn a little of the math behind this you can check out annuity payments math at wikipedia. And check out Microsoft’s page on time value of money functions to get an idea of how to calculate the numbers I have above.

As always please leave any questions in the comments or shoot me an email!

Progressive using military service to determine insurance rates

Published on April 20, 2008 in Uncategorized. 0 Comments

This is just a quick post for my friends from the Marine Corps.

The Consumerist has a post up regarding Progressive Auto Insurance and veterans. They point out that Progressive might be charging higher rates to veterans based on recent military service. I assume that they wouldn’t mind charging higher rates for active military members as well.

Just something to look out for if you have insurance with Progressive, or are thinking about getting insurance with them. Also don’t forget that you can cancel your insurance and switch companies at anytime, you are never locked in.

Using tools to reach your financial goals

Published on April 18, 2008 in Uncategorized. 0 Comments

One of my favorite flash games right now is called magic pen. The goal of the game is to use various mechanical tools to get a ball to the flag. The first few levels are fairly easy, but the later ones require some thought, and sometimes brut force.

Once you’ve played that game for a little bit and are more familiar with using wedges, levers, and planes head over the The Wisdom Journal and read this post from Ron on 6 simple financial tools. He outlines how these simple tools (and a few others) relate to personal finance.

Personal finance isn’t tough, but consistency and patience are. Just like the magic pen game, getting to the goal is just a matter of using the right tools in the right places.

Saving versus spending - striking the right balance

Published on April 17, 2008 in Buying Stuff, Debt and Saving Money. 0 Comments

By far the most difficult part of getting out of debt is not incurring more debt. A while back I started an extra savings account to save for new gadgets, namely a new dSLR camera. But every time I save a decent amount of money in the account I decide that I would rather put that money onto my credit card to pay it down further. It has been great for paying off debt, but not so great for me actually getting a camera. So far I have been patient, but it’s getting tougher to resist the siren call of spending.

Flexo at Consumerism Commentary has a post about frugal lifestyles and whether we are missing out on some of the fun things in life. I completely agree with the analysis, and feel that it’s important to strike a balance between planning and saving for the future and enjoying your money now.

The followup article was also interesting, noting that actually having money provides a lot of freedom that “stuff” will never provide, particularly freedom and time. When you have enough assets to cover your living expenses, you no longer have to worry about a job and you are free to do whatever you want with your time.

How does this fit in with me wanting a new camera? Right now I still owe a lot of money on my credit card, and I feel that no matter what paying that off is priority #1. Although I would rather spend my money on fun stuff like gadgets and vacations, my debt is not going to go away on its own. My debt was incurred buying “fun stuff” when I couldn’t actually afford them, and now I am paying for it (with interest no less). But once that debt is paid off I shouldn’t feel so guilty about spending money, as long as the spending is kept within reason. On the bright side, I still have a lot of cool stuff sitting around to keep me occupied until then!

I just hope that I can keep up this mentality for another year while I continue to payoff debt and then build an emergency fund. Patience will be key.

Anyone care to comment on when they think it’s okay to spend money versus saving it for the future (especially if young ones are in the picture)? Cheapo, I know you’re out there somewhere! Let’s hear your thoughts!

Planning for retirement part 1 - the basics

Published on April 15, 2008 in Financial Basics and Retirement. 0 Comments

This post is part 1 of a series on retirement accounts, and a continuation of the financial basics series. The idea of becoming free from money is based on having enough passive income that you never have to worry about working for money again. For most people that is retirement. And one of the most powerful financial tools available for investors is the retirement account.

Why a retirement account?

In the past a company provided for their employees with a pension. You worked for the company for x number of years, and they would provide a fixed payment for you to live off of for the rest of your days. These are called defined benefit plans, since you will receive a predefined amount of money when you retire.

Then somewhere along the line employers made the switch to defined contribution plans. With this type of plan (typically a 401(k)) a company could shift the burden of funding a retirement to the employee. This is obviously a huge benefit to the company, but not so much for the employee, who now needs to plan to save enough, invest it wisely, and plan how long they will be living after they retirement (obviously not an easy thing to know!)

The big benefit of having an individually owned retirement account versus a company funded one is that you can take it with you between jobs. The old days of being chained to a job for a certain number of years so that you can collect your retirement are over if you are not receiving a pension. So now you can actively pursue jobs you want, and roll your accounts when you leave.

What types of accounts are available?

There are many different types of retirement accounts available, but the most common are the 401(k), the IRA, and the Roth IRA. There are a few other types of accounts available as well, but they generally all have a few things in common. First is that they are considered long-term accounts, and will impose steep penalties if you take money out of the account before you reach retirement age (typically 59 1/2 or older). Second is that they will allow your money to grow tax free every year. This is different from regular accounts that require you to pay annual taxes on interest, dividends, and capital gains.

The 401(k) is generally offered by a company to its employees, oftentimes with a match of some sort, either as a percentage of pay or a flat dollar amount. The money that goes in is pretax, but you will have to pay taxes upon withdraw of the money. As of 2008, the annual cap is $15,500, not including the match from your employer. So if your annual income is $50,000, you could contribute 31% of your income a year, regardless of what your company matches you.

The IRA is very similar to the 401(k) in function. The money you contribute goes in tax free, reducing your taxable income, and is taxed when you take the money out at retirement. The amount you can contribute is capped at $4,000 a year ($5,000 if you are 50 or older). IRAs can be opened with many different financial institutions depending on where you would like to invest. Stock market investors can open IRA accounts with brokerage firms and buy individual stocks and bonds. Mutual fund investors can choose a company like Vanguard or Fidelity. Even banks usually offer retirement accounts, although sometimes the selection of investment choices can be slim.

Similar to the IRA is the Roth IRA. The major difference between the two is that money that goes into a Roth IRA is after-tax, but the money you withdraw during your retirement years are tax free (since the money was already taxed before it went in). This annual limit is the same for each, and generally the same financial institutions offer both IRAs and Roth IRAs.

Which one should I pick?

If the company you work for offers any matching amount for contributing to a 401(k), then investing at least that amount should be a no brainer. Not putting money in is saying no to free money, and no matter how strapped for cash you might be there’s no reason to say no to free money, right? Add to that the tax savings and this is an easy place to start.

If your company doesn’t offer a match, or you’ve contributed enough to max out your company’s matching amount, an IRA (either a traditional or a Roth) might make more sense than investing in the 401(k). When a company sets up a 401(k) it generally has to choose a small number of funds for you to invest in. These may not always be the best funds, either due to poor management, lousy expense ratios, or they might just not be the types of funds you want to invest in. As I mentioned earlier, many financial institutions offer IRA or Roth IRA accounts. I personally invest with Vanguard and have been happy with them.

The decision to use a traditional IRA or Roth IRA is based on whether you think you will fall into a lower tax bracket when you retire or not. You could have both, but the $4,000 annual limit is cumulative between accounts - you cannot put $4k in an IRA and another $4k in a Roth IRA. If you are making a ton of money now, and could use a tax break, a regular IRA might be a good idea. Otherwise a Roth IRA may be a good idea.

Until next time . . .

So that wraps up part 1 of retirement basics. Hopefully this was helpful, and if you have any questions please leave a comment. Next week I will cover the basics of asset allocation and how to pick funds for your retirement accounts. See you then!

A quick thought on retirement savings accounts and expenses

Published on April 10, 2008 in Debt, Saving Money and Taxes. 0 Comments

Just a quick run through some numbers to get you thinking about another reason you should try to reduce your expenses and save for retirement.

Suppose you had $400 in monthly debt payments, and your tax rate was 20%. You would have to earn $500 a month before taxes to make a $400 debt payment. So once that debt is paid off, you can now contribute $500 a month to a pretax retirement account such as a 401k or IRA and still maintain the same budget you had when you were making the debt payments. So now not only are you not paying interest on your debt, but you can now save an extra $100 a month not paying the tax man. That works out to an additional $1200 a year that you can keep to yourself on top of the $4800 saved from not making debt payments.

Now of course if your tax rate is higher you will save even more money by paying off debt and investing in a tax advantaged account. If your effective tax rate is 30%, you will need to make about $572 to make $400 after tax. [$572 * 0.70 = $400.40]

Pay off that debt and you will have $6864 that you could contribute to a retirement account. With that retirement account growing at 9% a year tax free, you will have over $1 million in about 30 years. Start doing this at 30 and you can be a millionaire by the time you’re 60. And thanks to the miracle of compound interest, you will have $2 million in another 8 years at 9% interest. All because you reduced your expense $400 a month. Pretty cool, huh?

Stay tuned as I start a series on retirement accounts and investment decisions. And as always please fee free to leave a comment with any questions, or email me at rich@freefrommoney.net

Knowledge check: Are you smarter than a 12th grader?

Published on April 8, 2008 in Uncategorized. 0 Comments

U.S. News has a short 6 question sample quiz given to high school students by the Jump $tart Coalition for Personal Financial Literacy.

The quiz can be found here. Luckily I scored 6 out of 6 (I would be a little embarrassed to be writing this blog otherwise!) What did you score?

Quarterly Net Worth Update

Published on April 6, 2008 in Net Worth. 0 Comments

Well when I first posted our net worth back in January I intended to keep it up every month. But here we are in April with no updates, until now!

So the news is good: our net worth is now positive. Since January we’ve paid off over eight thousand dollars in debt, reducing the total by 23%. The majority of the paid off debt was the car loan, followed by the credit cards and the student loans. Our assets are up 12%, or $3.3k, since January. We’ve built up the emergency fund to cover about one month of expenses, and contributed a small amount to our 401(k)s. We did take a small hit in our accounts from declines in the stock market, but nothing too bad (yet).

Overall it’s very encouraging to see the changes in our finances. It’s still going to take awhile to payoff all of our debt, but it will be great to see our net worth calculation when there’s no debt dragging it down. Next month (or next quarter) we will have an updated net worth. Hopefully the news is just as good!