Don’t Feed the Alligators

A Personal Finance Blog from a Small-Scale Landlord’s Perspective

Archive for April, 2008

Matt asks: “…is it actually the right time to be seeking leverage or playing it safe?”

Leverage (finance)

From Wikipedia, the free encyclopedia

In finance, leverage (or gearing) is using given resources in such a way that the potential positive or negative outcome is magnified. It generally refers to using borrowed funds, or debt, so as to attempt to increase the returns to equity.

I think that it’s always smart to be seeking leverage, but only using it in a way that’s safe. Easy enough answer, right?

History teaches us that investment risks are not so much about losing your asset as much as they are about the asset being devalued at the time that you need to access your equity.

Many soon-to-be-former homeowners are learning this lesson the hard way right now, having used too little leverage in a bubble market under unfavorable financing conditions. But there are many others, myself included (I would like to think…), who used leverage in the same market, but have done so with better risk mitigation.

Let’s look at 2 cases:

1. 0% - 5% down, 3/1 adjustable rate mortgage: Fast forward to today, and you’ll see that the home has lost 10% of it’s value in the last three years, there’s a balloon payment due or the interest rate on the mortgage is rising beyond their ability to make the monthly payments. These people are upside-down on their mortgages now, they owe more than the house is worth, and barring an act of Congress (which apparently isn’t all that far fetched…) will be in for a world of hurt very soon. Strike 1: Negative Equity, Strike 2: Can’t afford the resetting mortgage. Either of these problems could likely have been overcome on their own, but the combination of them is the real killer.

2. 10% - 20% down, 30 year fixed mortgage: Fast forward to today, and you’ll find that even with a 10% market decline, this homeowner can still sell his house and afford to pay back the mortgage. However he has no reason to sell the house, because he bought for the long term, and he knows that he can afford to keep making the payments because those payments won’t be changing.

The lessons to be learned here are: 1. Be sure that you can afford to keep feeding an alligator until you have positive equity and 2. Be sure that the timescale of the investment matches the calendar date for when you need the money.

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Partially inspired by Five Cent Nickel’s article on Reconsidering Our Asset Allocation, partly by my recent read of Burton G. Malkiel’s A Random Walk Down Wall Street, and partly by an urge to simplify, I have recently been consolidating a number of retirement accounts from a number of brokerages to one. I have chosen Vanguard as the host for the bulk of our assets, primarily because it offers the index fund options that I want with very low fees.

The process for consolidating is pretty easy. I logged into our existing Vanguard accounts and filled out 5 questionnaire pages that detailed what I wanted to move, from where, and into what fund(s). At the end of the process, I was prompted to download and print out a PDF to sign and return to Vanguard. This process had to be completed for each brokerage account not yet at Vanguard.

I called Fidelity to make sure that there would be no problem with Vanguard getting the money for the transfer. I was informed that in order for this to go smoothly, I would have to move all of our assets into cash positions. And by the way, I was told, I should do this today since the market is up… advice that smelled of market timing to me and was promptly ignored… Instead, I opted to wait until I knew Vanguard would have received our paperwork and started to execute the transaction.

Within a few days I saw that one of the Fidelity accounts was empty and the Vanguard had increased my almost the same value. Almost? you ask? Yes, Fidelity took a $50 “cash out” fee out of the money that was transferred. After researching this point for 30 minutes or so, I was unable to find this fee stated, explicitly, anywhere on Fidelity’s website. It does say that the law allows them to charge one, but they don’t say what the charge will be.

So I guess this is just Fidelity’s way of saying, “Don’t let the door hit you on the way out.” And this is yet another reason that I can’t, in good faith, recommend Fidelity to any potential investors who might seek my advice on the matter, even if it is the home town favorite in my neck of the woods.

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04.14.2008

I participated in my first blog carnival this week at the Carnival of Personal Finance. I submitted my article about the parallels between losing weight and growing wealth. You can see it and all the other great articles at this week’s host Gather Little By Little. This week I also joined the conversation on a number of topics at other blogs. Some of the blogs that mentioned me or in which I participated were:

  • Lynnae at BeingFrugal.net solicited the best financial advice that her readers had ever received. My words of wisdom were 1.Pay yourself first and 2. Anything you can measure can be improved.
  • Glblguy at GatherLittleByLittle.com wondered why he still has to carry cash. I don’t usually carry much cash, and it tends to sit in my wallet for a long time. In the comments I shared my strategy for using my rewards credit card for everything I can.
  • Frugal Dad at FrugalDad.com wondered whether it was cost effective to buy a new car for the explicit purpose of saving on gas mileage. I suggested that for people who continually carry loans, the cost of gas is minor compared to the other operational costs of a car.

Another article that caught my eye today comes from the Boston Globe’s Personal Finance Section which reported on a new study being conducted at my alma mater which will “explore how people make decisions about their money, and how technology can shape and assist in these choices.” This study is part of a new Center for Future Banking that seeks to understand how changes in technology will affect banking. This study will explore many of the questions that fascinate my about the social psychology of money decisions. It is a bit dubious, however, that Bank of America is providing the financing for the study… Lastly, I made some updates to my Blogroll at the right this week. Check out some of my fellow bloggers sites if you haven’t already. b

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“Anything that is measured and watched, improves.Bob Parsons

Over the last several years, I have embarked on two journeys that share a lot in common: dieting and wealth building. Both of these exercises require many of the same elements in order to be successful:

1. Planning - In most cases and for most people, you do not lose weight or grow wealth accidentally. Both require some kind of budget, one for calories and one for dollars. Good planning should include interim rewards, such as a new smoker and a pork butt to cook on it. (Might as well combine my vices!)

2. Organization - Both endeavors need some way to track progress. I use a spreadsheet for my diet and Quicken for my wealth.

3. Self Discipline - Ultimately, both of these projects require a large degree of self denial. You can’t eat everything you see. You can’t buy everything you want. You must stay the course even when the winds are blowing against you.

4. Inspiration - I’ve lost weight in the past, only to gain it all back and then some. However it was only after reading John Walker’s The Hacker’s Diet that I learned how to manage my weight once I reached my goal.

Weight

In wealth creation and growth, I am continually inspired by the lessons in some of my favorite books: David Bach’s The Automatic Millionaire, George S. Clason’s The Richest Man in Babylon, and a new favorite, Burton G. Malkiel’s A Random Walk Down Wall Street. I’m also inspired by a large number of insightful personal finance bloggers, many of whom are featured on my blogroll to the right.

5. Setbacks - I recognize the fact that I am only human and that I’m going to have moments of weakness, down markets, and other internal and external influences that are going to slow or reverse my progress. However, with a good plan (see Point 1 above) these short term reversals can be overcome quickly.

Net Worth6. Support - My wife has been my best partner in both of these undertakings. Her reports to me of how many calories were in meals she had prepared were essential to my calorie balances during my 1 pound per week loss phase. Her like mindedness and buy-in for our financial goals has been integral to the success of our net worth increase. Comments from people who haven’t seen me in a while are also a great motivator: “You’re smaller than you used to be,” said one particularly keen-eyed observer.

7. Investment in the Future - My pre-loss weight was not what would be considered morbid, but clearly was detrimental to my long term health. My pre-accumulation wealth (yes, it does tip the -40% level) clearly was detrimental to my long term well-being, both mentally and ultimately physically (eating dog food in retirement takes a toll…). I was never fat, and I was never poor, but by taking charge of both of these aspects of my life I have put myself on a long road to well-being, which with luck will allow me to enjoy many years with my wife and daughter and future children and grandchildren — not to mention parents, brothers, in-laws, nieces, nephews, etc. — all the things in my life that really matter.

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Editor’s note: After being alerted by Sharp Reader Steve, I went back and checked my numbers. I have included my corrections below.

In my earlier article on this topic, I wondered whether it made sense to pay down low interest debt, like car loans and low, fixed rate credit card balances. Last week, I finally sat down and ran the numbers. and contrary to my conclusions in the previous article, I found out that it actually makes sense to attack the debt as aggressively as possible and then put money away to save, almost regardless of what the interest rate on the savings is. My numbers confirmed my theory, but also additionally show that even if the interest rate on the investment is less than the interest rate on the debt, you may still make out better in the long run by investing rather than most aggressively paying down the debt.

To figure this out, I made a Google Spreadsheet with 2 sheets of 6 columns each. I paired the 6 columns on each sheet into 3 groups of 2 columns each. The first two columns represented my car loan. The next two represented my credit card balance, and the last two columns represented my savings. The first column of each pair represented the running total of the account and the second represented the monthly contribution to the liability or asset:

Car Loan Monthly Payment Car Loan Credit Card Monthly Payment Credit Card Savings Monthly Payment Savings

In the first cell under each of these I entered the initial condition. The running total was calculated by:

Rt = Tp*(1+i/12)-Mp

Where:

Rt = running total

Tp = previous total

i = annual interest rate (expressed in percent or decimal, 5% = .05)

Mp = monthly payment

In the case of the savings account, I added the monthly payment rather than subtracting it.

This is probably not exactly the right formula, especially depending on how frequently compounding occurs, but it’s close enough for our purposes.

Sheet 1 took the case where I put all of my extra money into savings and paid the minimums on the liabilities. The credit card account pays 2% of the balance each month, and as the monthly payment reduces, the difference from the initial payment gets applied to savings.

Sheet 2 took the case where I put all of my extra money into paying down the liabilities in the order of highest interest rate to lowest. When all debts were paid off, the total was applied to savings. In this case the savings doesn’t start for nearly one and a half years from now.

I set a savings goal of $80,000 (a down payment on a new house), and Sheet 2 Sheet 1 beats Sheet 1 Sheet 2 by about six four months in reaching this goal at any reasonable a 6% savings interest rates. It wasn’t until the savings interest rate exceeded 20% that Sheet 2reached the goal faster than Sheet1. Unfortunately, I don’t know if I can generate a 6% interest rate on such a short term cash goal. I originally used the 6% rate because it is higher than the debt interest rate and I was trying to see what happens with a rate higher than the debt rate.

In either scenario, the Sheet 2 won in the very long run by a few percent.  This is a bit surprising.

So there you have it: Pay down low interest debt (aggressively) and THEN roll the cash that you had been spending on debt payments into savings and investment.

Conclusion: If you are trying to save for something in the short term, then it can still be  real toss up between investing (saving) or paying down the debt.  You will get to your goal faster by saving rather than paying down the debt, but when you get there you may still have the debt.  However if you are saving for the long run, then even when the savings rate is less than the debt rate, you can still achieve overall savings by investing while you reduce your debt.

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