Category: Personal Finance

Deleveraging begins according to Fed data

Posted on by Evan in Debt, Personal Finance

Back on September 29th I wrote this post regarding the concept of “deleveraging”.  Over the past few decades American households and corporations were addicted to debt.  We used credit cards, home equity lines of credit, mortgage loans, auto loans, etc. to accelerate our consumption.

However, our unabated use of debt lead us to where we find ourselves today.  In the midst of one of the worst financial crisis’s in our nation’s history.  As a result, the credit spicket has been turned off and consumers are being forced to deleverage their personal balance sheets.

Data supporting this trend was released today when the Federal Reserve reported that consumer borrowing declined last month for the first time in nearly 20 years.  In the long-run this is good news.

Looking for ways to save money?

Posted on by Evan in Saving-Spending

With a recession looming many households across America are cutting back on spending.

I came across this article on Kiplinger.com which provides a variety of ideas for saving money in the areas of investing, food, transportation, travel, utlilities, phone/ internet/ cable, credit, and entertainment.

Among my favorite ideas:

* Investing: Buy beaten down ETF’s & index funds instead of mutual funds.

* Food: Take fewer trips to the grocery store.  This will cut down on the volumne of “impulse” buys.

* Travel: Use a house swap to save on lodging.

* Utilities: Use compact fluorescent bulbs in your lamps.  they can save up to $60 in electricity over their lifetime.

* Phone: For long distance calling use skype.com.

* Money: Track your spending by using the old fashion pencil and calculator or use websites like mint.com or wesabe.com.

* Entertainment: Use your local library to check out books, CD’s, and DVD’s.

Every home purchase is 100% financed

Posted on by Evan in Home Purchase, Mortgage Qualification, Personal Finance

Although many home-buyers do not realize it every home they buy has been bought with 100% financing.  How can that be you may ask?  The last home I bought I put 20% down.

It may be true that you took an 80% mortgage and used your own funds for a 20% down payment but what you may not realize is that the funds you used for a down payment was “borrowed” from your asset base that could otherwise have been used to earn a return on investment.  Economists call this “opportunity cost”.

If cash-flow were not an issue then every home-buyer would be left to decide the optimal level of down payment and mortgage based on the return on investment they think they could earn versus the cost of borrowing the funds.

To demonstrate this concept lets assume that a family is buying a home for $250,000 and is deciding whether to put $50,000 down (20%) or $100,000 (40%).

-If they put $50,000 down they will take out a mortgage for $200,000 at 7.00% with interest-only payments of $1,166.67 (net after tax payment of $793).  With the $50,000 that was not used for the down-payment they will invest the funds into an account that will earn 7.00% annually.

-If they decide to put $100,000 down they will take out a mortgage for $150,000 at 7.00% with interest-only payments of $875 (net after tax payment of $595).  We’ll assume that they will use the difference in their net after tax payment ($198) to invest into an account that would earn 7.00% annually.

Here is a look at how these choices would perform over 30 years:

Amount invested $ 198 $ 50,000
Return: 7.00% 7.00%
Term (years): 30 30
Growth: $ 241,554 $ 380,613

As you can see the decision to invest the money upfront would net this family almost $140,000 more after 30 years.

Borrowing out of necessity or opportunity

Posted on by Evan in Personal Finance

In his book “Borrow Smart Retire Rich” Todd Ballenger discusses the concept of borrowing money out of opportunity versus necessity and at the same time does a nice job of describing financial arbitrage:

Most of us have borrowed out of necessity for houses, cars, or other purchases.  Let’s say you borrow money from a local bank for your house at 7%, the same bank where you deposit your pay check each month.  When you make a deposit to your checking account, you loan the use and control of your money to the bank for a little interst, say 2%.  The bank as a professinoal creditor lends the use and control of their money back to you at 7%.  The bank earnes a 5% spread lending your money back to you.  You borrowed out of necessity, while the bank provided a loan based on opportunity.

Ballenger’s tic-tact-toe metaphor

Posted on by Evan in Personal Finance

From the book “Borrow Smart Retire Rich“-

The first time you played tic-tac-toe, did you win or lose?  How about the second time?  I’d guess that the first time someone showed you the game, you probably lost.  I’d also guess that the second or third time you played, you were less likely to lose.  Eventually, when both players understand the rules of tic-tac-toe, the winner is the one who can maintain their focus.

Like tic-tac-toe, the rules of managing wealth in the house are very much within your reach.  Once you realize that you’re playing a game, you’ll be more likely to want to understand the rules.  You can spend your entire life playing a game without realizing it.  Or, you can learn the rules and choose to play with a higher degree of awareness.

Prepaying mortgage versus saving

Posted on by Evan in General Mortgage Info., Personal Finance

Most people believe they should rid themselves of their mortgage before they save for other accumulation goals.  However, as Todd Ballenger pointed out in his book “Borrow Smart Retire Rich” this decision comes with hidden costs.

Here is an example, let’s assume a homeowner has $1,000 each month to either save or use to pay down their mortgage.  Let’s also assume that their mortgage carries an interest rate of 7.00% and that their savings/ investments will earn an after tax return of 7.00%.  Finally, we’ll assume that this homeowner has a 32% marginal tax bracket so their net after tax of borrowing is actually 4.76%.

Here is a breakdown of these two options over 30 years.
Amount invested: $1,000      $1,000
Return:                  4.76%        7.00%
Term (years):          30              30
Growth:             $796,282    $1,219,971

As you can see the decision to pay off the mortgage would cost this homeowner over $400,000 over the course of 30 years.

Net after tax cost of borrowing

Posted on by Evan in General Mortgage Info., Home Purchase, Personal Finance, Taxes

In Todd Ballenger’s book “Borrow Smart Retire Rich” he trademarks the term ‘EPR’ which stands for Effective Percentage Rate.

This concept it important in making decisions regarding how much a homeowner should borrow.  Here is a simple explanation:

1) First, it’s important to understand that most homeowner’s are able to deduct the interest that they pay on their mortgage from their taxable income to determine their tax liability.

2) Therefore, a homeowner’s interest rate does not truly represent the actual cost of borrowing.  For example, a person who has a mortgage with a 7.00% interest rate and finds themself in a 28% marginal tax bracket will have an EPR of 4.34% (7.00% * (1-.28%)=4.34%).

3) If cash-flow was not an issue this homeowner would be smart to borrow as much money as they could so long as the capital was used to earn a return in excess of 4.34%.

Principal payments make no impact on net worth

Posted on by Evan in Personal Finance

To build on this blog posting regarding the concept of the location of assets and liabilities on a household’s balance sheet.  Most people do not realize it but by making a principal payment towards a loan there is no impact to net worth at that specific point in time.  Why?

This is because by making a principal payment towards a loan a person is reducing the amount that they owe by the same amount that they are reducing the balance in their checking account.

A look at a household’s balance sheet

Posted on by Evan in Personal Finance

Most people understand that a household’s net worth is equal to: Assets – Liabilities.  However, many people do not realize that the location of their assets and liabilities within their balance sheet do not make a difference in terms of their overall net wroth.

I was reminded of this lesson recently while reading the book “Borrow Smart Retire Rich”.  Here is a look at a sample household’s balance sheet:

Sample balance sheet
Assets Value Liabilities Value
Checking $ 10,000 Mortgage $ 160,000
Savings $ 15,000 Auto Loans $ 35,000
Investments $ 175,000 Credit Cards $ 5,000
House $ 200,000
Total $ 400,000 Total $ 200,000
Net worth $ 200,000

In the next balance sheet the sample household takes $5,000 from their checking account and places it into their investment account.  Although the location of the assets change, the overall net worth does not change.

Balance sheet-$5,000 moved from checking into investments
Assets Value Liabilities Value
Checking $ 5,000 Mortgage $ 160,000
Savings $ 15,000 Auto Loans $ 35,000
Investments $ 180,000 Credit Cards $ 5,000
House $ 200,000
Total $ 400,000 Total $ 200,000
Net worth $ 200,000

In the next example the same household moves $5,000 from their checking account and pays-off their credit card debt.  Again, the location of the assets change but their overall net worth does not.

Balance sheet- $5,000 moved from checking to pay-off credit cards
Assets Value Liabilities Value
Checking $ 5,000 Mortgage $ 160,000
Savings $ 15,000 Auto Loans $ 35,000
Investments $ 175,000 Credit Cards $ –
House $ 200,000
Total $ 395,000 Total $ 195,000
Net worth $ 200,000

*

Cost of waiting to buy a home

Posted on by Evan in Home Purchase, Personal Finance

As I’ve told many people the stars are currently aligned for first-time home-buyers.  Grant it, there is a lot of uncertainty and anxiety amongst US workers right now and if the potential for job loss is high it would NOT be a good plan to buy a home.

However, for those who feel secure in their jobs and have been waiting for prices to fall it is a good idea to start getting serious.  After all, mortgage rates for loans requiring only 3% down remain very attractive and I believe homes in Portland have become much more affordable over the past few months.

But if that isn’t enough to convince you consider the cost of waiting.  I actually got this example from a book I recently read entitled “Borrow Smart Retire Rich”.

The table below illustrates the savings an individual will make over a 4 year period assuming they can save $4,000 per year   We’ll assume that their savings earns 8% annually:

Year Value Change
0 $ 4,000.00 n/a
1 $ 8,320.00 $ 320.00
2 $ 12,985.60 $ 985.00
3 $ 18,024.45 $ 2,024.00
4 $ 23,466.40 $ 3,466.00

Conversely, here is a table that illustrates the cost of waiting. Here’s how much a $200,000 home will appreciate over the next 4 years assuming a 4% appreciation rate:

Year Value Change
0 $ 200,000.00 n/a
1 $ 208,000.00 $ 8,000.00
2 $ 216,320.00 $ 16,320.00
3 $ 224,972.80 $ 24,972.00
4 $ 233,971.71 $ 33,971.00

As you can see over a 4 year period even though the individual was able to save $23,466 towards a down payment the home that they could have purchased 4 years ago has now appreciated in value by $33,971.  Therefore, this individual has actually lost $10,000 in waiting this long to buy a home.