Don’t Feed the Alligators

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.

Matt also writes:

“Since you brought up long-term investments and real rates of return, an interesting and relevant topic for a future entry might be how to structure one’s investments in today’s challenging times of a depreciating dollar, rising inflation, falling real estate and seemingly low expected future real rates of return. How do we all invest for the short-term, medium-term and long-term?”

The short answer to this question is that one should not change his or her strategy based on the current market, no matter what the market is doing. To do anything else would constitute market timing, and I firmly believe that attempting to time markets is ultimately detrimental to achieving the highest returns.

My specific strategies for different terms are below:

Read the rest of this entry »

Matt says:

“I guess car loans are acceptable and almost the standard these days, but carrying credit card debt is viewed as irresponsible and a means for overextending and living beyond your means, even if that’s not always the case.”

It’s interesting that carrying car loans is the norm now — much like carrying credit card debit — without much stigma attached. But do we really have to borrow money to buy cars? Is this not just another case of being “overextended and living beyond your means”?

In an earlier post I define Consumer and Investment debts. Where does a car loan fall? On the one hand it is a not an investment debt because 99% or more of cars lose value over their lifetimes and it is impossible to tell which ones will gain value beforehand, so it’s not exactly an investment. On the other hand, cars are indispensable tools to most of us that enable us to get to jobs that put money in our pockets so that we can, among other things, invest it. I think that a car is a little bit of both, and can certainly lean towards Consumer debt when you factor in $2,000 Navi/Info/Entertainment Systems.

So if it’s at least partly consumer debt, why doesn’t it carry the same stigma as the debt we accrue to buy other consumer items? I can think of a number of arguments:

• Car loans have been around a long time — almost as long as cars have, according to this article.
• Cars represent debt at which you can point to a solid item and say, “That’s where my money goes every month.” The same is not necessarily true for credit card debts where all too often people have a big bill and can’t remember what it was for.
• Car loans typically have a lower interest rate than credit cards.  Right now, Bankrate.com reports the average new car loan interest rate to be about 7% while the average Gold level credit card has a rate of about 12.5%.
• Nobody could afford a car if not for car loans. I’m not sure that I agree with this one.

Are any of these arguments compelling?

Take the last point: What if there were no car loans? There would most certainly be fewer cars on the road, those cars would be older and less expensive on average, and far more people would use public transportation.  Everyone would know that there was no financing available for cars and would have to learn how to budget to save up for one.

Young drivers would not be able to own a car until they could save up to buy one or unless one was given as a gift.  Most likely (as is already the case for many young drivers) the car would cost in the low thousand dollar range.  Older drivers might trade in and out of cars more frequently as they moved from lower priced, lower optioned cars to more expensive cars with more features.  Everyone would pay far less for their vehicles — even if the only savings was on interest payments.

Those same cars that people would buy without cars loans are just as readily available now.  Open any newspaper to the Classified section and you will find dozens of cars available for relatively little money.  Not all of them will be as safe and reliable, and certainly not as indulgent as cars you can get for “no money down and $199/month”, but they will certainly be a lot cheaper.  Buy a cheap, but safe and reliable car up front (think mid-90s Honda or Toyota) and put the $199/month towards your next, much better car and you will save a serious amount of money.

I think that cars are similar enough to many of the other things we buy everyday that lose value (take J.D.’s encyclopedia, for example) that carrying debt on a car should be looked at no differently than carrying debt on any other consumer item.  The same stigma should apply to car loans as to credit card debt.  As such, my personal goal is to never have to take another car loan.

What do you think?

A reader asks:

What do you think of the recommendations near the end of this article, specifically about 1) not closing old accounts, and 2) what percentage of your credit limit to use?

http://www.cnn.com/2008/LIVING/personal/02/22/financial.security/index.html

My research on these points seems to concur with the advice given in the article. Bankrate.com has an article on what factors affect your credit score posted here. According to the article and some research I have done on the impacts of credit card arbitrage, it would seem that 35% of your score is based on how you pay your bills, which your oldest credit accounts play a large roll in demonstrating. 30% of you credit score is based on credit utilization. My read is that you generally do not want to exceed 50% of your available credit on any of your accounts. So if you have a lot of outstanding debt, it’s easier on your credit report to spread it around to a number of cards so that no single card is over 50% utilized.  Lastly, there is a 15% factor for length or credit history, which is another opportunity for your oldest cards to help you out quite a bit. You should be able to go ahead and close any shorter term credit lines that you have open and not suffer a credit hit.

One other point that I also made in the comments of Getting Out of Debt Part II is that banks will often let you consolidate lines of credit.  So if you have 2 Chase credit cards, one with a 90% utilization and one with 0%, call Chase and ask them to transfer most or all of the line from the 0% card to the 90% card.  This should, depending on how much credit you have, substantially reduce the utilization on the 90% card and improve your credit score.

General questions to readers: Do you check your credit reports annually? You can do so for free at AnnualCreditReport.com. When was the last time you checked your credit score? Are you looking for ways to improve you score? Are you about to take on a large debt like a mortgage or car loan?

A young reader writes:

“My husband and I got got into an argument after I paid a bill that he says he was going to pay. Since we keep our finances separate, what’s a good way to manage our combined bills?”

Firstly, let me tell you how my wife and I handle our finances, and then I’ll give you some ideas about what you can do in your present situation.

Mrs. MITBeta and I have combined accounts for all of our banking and credit accounts. Both of our paychecks get deposited into our Money Market account along with rent that we collect from our investment property. Our budget is set up such that all of our fixed bills are paid out of our Checking account. Periodically I make transfers from Money Market to Checking to be sure that all the bills are covered (remind me to automate this…). Our discretionary expenses — things that we don’t have to spend money on but choose to — all go onto our rewards credit card. This balance gets paid monthly out of Checking. Additionally, the following accounts are all held jointly:

• Mortgages
• Car Loan
• Some other credit cards
• ING Direct Savings Account

The only accounts that we own individually are my remaining student loan, our 401(k) accounts, and obviously our Individual Retirement Accounts (IRAs). Read the rest of this entry »