In February, Warren Buffett said he would buy hundreds of thousands of single family homes with 30 year mortgages if he had a way to manage them. Since then, mortgage rates have fallen further and are poised to drop more. Bottom line, consider buying a house. If you already have one, consider an investment property.
Viking @ September 20, 2012
Today Ben Bernanke announced the launch of QE3. The Federal Reserve will buy $40 billion of mortgage backed securities per month and continue operation twist, a program to extend the duration of the banks bond holdings. The Fed also promised to keep interest rates low at least through 2015.
What does it mean for you? Mortgage rates could drop even further over the next six months. Refinancing or buying a new house just became a more interesting prospect. Plus your stock portfolio just got a shot in the arm.
For a concise overview of monetary policy up to the Great Recession, read Inside the Fed: Monetary Policy and Its Management, Martin through Greenspan to Bernanke.
Viking @ September 14, 2012
Save Money on iPhone 4S
Today, Apple revealed the iPhone 5. The earliest adopters of new iPhones pay a hefty premium. For some people, it’s worth it, but most should consider buying an older model instead. The 16GB iPhone 4S is now only $99 with a two year contract. Compare that to $199 for a 16GB iPhone 5. The $100 you save could pay for your first month of service and new accessories.
Protect Your New Phone
No one wants to get a new iPhone and see it crushed the following day. Buy a cool case to make it last. It can be smart to own high-end products if you get a lot of use out of them, but having to buy the same gadget twice is utterly stupid. So protect your investment.
Sell the Old Phone
If you do decide to upgrade, sell your previous phone for extra bucks. Old smartphones can easily sell for over $100. Bartering with a friend or family member is another option.
Apple Marches On
More than 240 million iPhones have sold so far. That number is sure to shoot up when the iPhone 5 ships on September 21st. Apple stock has gained more than 60% on the year so far. The company seems unstoppable. Should Apple’s popularity dictate your buying decisions?
The Option Tim Cook Doesn’t Want You to Choose
Let’s get real. Do we need smartphones to survive? No. Billions of people had awesome lives before smartphones even existed. The most brilliant companies, Apple included, convince us we need products that didn’t even exist a decade ago. Give your wallet a break by skipping expensive monthly data plans. Use an “old fashioned” cell phone instead.
Pay Yourself Before Apple
An iPhone and service plan will easily run more than $500 per year. What else could you do with $500? Perhaps go on a weekend vacation or boost your savings. Apple has enough money. Keep some for yourself!
Viking @ September 12, 2012
Money advice columns, especially in the blogosphere, often make excessively optimistic assumptions. Of course all readers earn above the median income, have a million saved already for retirement, and max out their 401(k)s. NOT! The unemployment rate is 0ver 10% in the European Union and more than 8% in United States. Tens of millions of people are unemployed. So how should the unemployed manage money through these rough times?
Here are a few money rules for those out of work:
- Apply for unemployment benefits
- Use money in taxable accounts before withdrawing from tax-advantaged accounts
- Reduce expenses drastically to make your savings last
- Find cheap or free ways to have fun
- Consider downsizing if you own your home
- Consider renting out an extra room if you have one
- File taxes early. You’ll likely get a refund.
- Don’t neglect health insurance
What’s missing? Looking for a job! Tons of great job search books and websites are available, but they don’t often cover the issues in the list above.
Viking @ September 11, 2012
Frugaldad.com created a great infographic about the average guy. Look at how small the savings amount is. You’ll need more than that to fund your dreams and achieve financial independence. Make a goal to save a certain percentage of your income starting this month. Follow through and you’ll be above average in no time.
Viking @ September 10, 2012
A desire for more free time is perhaps the main reason people pursue financial independence. Retirees and self-employed workers have far more control over their time than corporate employees. Yet, most companies offer some vacation time, which varies widely by country. Can you guess which country is best for leisure-seeking folks and which offers the fewest public holidays? The answers, provided in this Economist video, might surprise you.
Viking @ September 9, 2012
Financial success requires careful management of the personal balance sheet. Optimizing debt as a percentage of assets is an essential task. Contrary to popular rules of thumb, borrowing money can be a boon to financial health. Debt should increase until the marginal benefits of the acquired assets, tax shield, and imposed fiscal discipline are equaled by the marginal costs of added risks to liquidity, solvency, and happiness.
To explain debt optimization, we will consider the trade-offs in balance sheet management and look at a few case studies. For starters, assume money borrowed is reinvested at the expected return on assets and that return is higher than the effective interest rate.
Trade-offs in Personal Balance Sheet Management
Someone with no debt incurs both benefits and costs from borrowing. The main benefits are:
- Decrease in taxes
- Budget discipline
Perhaps the most important benefit is a decrease in taxes. Interest on mortgages and business-related loans is tax deductible. Interest payments decrease taxable income and thus increase the present value of future earnings. This tax deduction reduces the effective interest rate paid on debt by the marginal tax rate.
Budget discipline is another benefit of borrowing. Interest payments crowd out unnecessary expenditures. This effect can be especially beneficial for people who don’t keep a tight grip on their budget. Servicing debt causes a serious evaluation of spending priorities.
The principle costs of borrowing are decreases in:
Liquidity is the availability of funds to meet short term obligations. As the amount borrowed increases, so do interest payments. Eventually, households may face challenges finding the regular cash flow to make payments. A decrease in liquidity increases the likelihood of bankruptcy, which is a clear drawback to borrowing money.
Solvency is a measure of a person’s ability to fulfill all debt obligations. Someone who owes far more than they have in assets is technically insolvent in terms of the balance sheet. Taking on more debt increases the risk of insolvency, because a drop in asset value is more likely to meaningfully harm a person’s financial position if they have a large amount of debt relative to total assets. Note that precise definitions of liquidity and solvency vary by context.
Happiness can be threatened by increasing debt through potential stress and anxiety regarding repayment. While the psychological aspect of debt may not be relevant in corporate finance, it certainly is worth considering in the context of household wealth management.
Optimal Debt Level
The optimal level of debt is reached when the net benefit of borrowing another dollar is zero. Eventually the costs of additional borrowing outweigh the gains. The chart above illustrates this idea. In this context, household value is the present value of all earnings less the present value of all obligations. We avoid the term net worth, because the definition often excludes the value of future cash flows. Note the optimal level of debt is not zero.
The graph makes several assumptions.
- Income is large enough to cover basic necessities and debt payments.
- A profitable use exists for additional funds, the return of which exceeds the effective interest rate on debt.
- Debt is tax deductible.
If a households financial situation does not meet these criteria, it is unlikely that increasing leverage is a wise decision.
This post does not encourage or defend borrowing to purchase consumer products that lose value and do not create future cash flows. In other words, clothes, shoes, and vacations should not be funded with debt. Auto loans are also not justified by this analysis. Though sometimes borrowing to buy a car might be necessary to get to work or school, such borrowing does not meet the assumptions outlined above.
It is possible that an individual’s optimal level of debt would be zero if that person is extraordinarily afraid of or psychologically opposed to incurring future obligations.
Debt is a value management tool, not an excuse for frivolous spending. It should be used carefully. It should be used to fund a profitable business, invest in securities expected to have a long term return higher than the interest rate, pay for valuable education, or buy real estate with a reasonable probability of appreciation.
Examples of Smart Debt Holders
1. Young Professional
A young professional has a long career of earnings ahead. Most of her value is in human capital. She needs to live somewhere. Buying a modest home in a desirable area at a low interest rate may very well be the ticket to greater future net worth. Even if the house appreciates only at the rate of inflation, leverage provided by the mortgage can create considerable return on equity after expenses.
The same person might also borrow to increase investment holdings. A debt-free lifetime financial strategy puts excess weight on asset returns late in life. Taking out loans early in life allows for an increased amount of investable assets early in life and partially corrects the excess weighting of late-life asset returns.
2. Middle-aged Retirement Saver
If a house is paid off and no consumer debt exists, a mid-career person might decide to borrow against his real estate and invest long term in a diversified portfolio of stocks, bonds, and alternative assets. Over a 20 year period he can reasonably expect a real return of 6% or more, which exceeds current interest rates. He gets the benefits listed above and a high probability of a larger pool of retirement savings.
3. New Retiree
It’s taboo to suggest that people carry debt into retirement, but sometimes it really can be a good idea. Inflation is a threat to retirees, especially those living on a fixed income. Payments on debt with fixed interest rates become less valuable as inflation increases, providing a boon to the retiree. All the while, the principle can be invested at a premium over inflation. Thus, debt provides a hedge against inflation. For older people, the extra safety valve of fixed payment debt can enhance retirement security in an inflationary environment.
Much more can be said on the uses and abuses of debt. Finance Viking is committed to providing thoughtful, detailed analysis of personal finance issues. Discussing the benefits of debt is unpopular and uncommon these days. However, people should maintain an open mind rather than quickly embracing a no-debt philosophy. Any corporate finance textbook will provide a more detailed analysis of debt’s role in the capital structure of a business. Don’t assume that academic finance has no application to household financial decisions. Conduct your own research and expect more helpful commentary from Finance Viking. May your financial journey be joyful and profitable!
Read In Defense of Debt for another look at this topic.
Comments? Criticism? Share your ideas below and become part of the discussion.
Viking @ September 8, 2012
Finance Viking loves frugality, but it must be smart frugality. The Wall Street Journal reports that coffee consumption is declining in Europe. Also, the average quality of European coffee is in decline. Coffee drinkers are subjecting themselves to robusta beans and instant coffee.
Austerity might be a good move for Europe, but quality coffee should be spared. Good vikings drink delicious coffee. No exceptions! This firm stand in favor of excellent coffee might seem to contradict the post about saving lunch and coffee money, but it doesn’t. Reducing unnecessary spending does not need to limit enjoyment. Make lattes at home with an espresso machine. Order reasonably priced premium coffee at the cafe. But never drink instant coffee unless you truly prefer it over a quality cup of Joe.
Here is the full Wall Street Journal article for those interested. Look for arabica coffee futures to recover from 2012 lows when Europeans realize it’s bad coffee that has left a bitter taste in their mouths, not the economy.
Viking @ September 7, 2012
It’s easy to frame happiness in terms of income or wealth. Reaching a financial milestone may seem like the next step to becoming happier. Unfortunately, we’re often disappointed when we discover that more money is not the secret to fulfillment.
Maximize Happiness Now
Rather than focusing on how awesome it will be to reach your next financial target, concentrate on maximizing happiness with your current level of resources. Many perceived impediments to happiness that involve money are cases of misallocated resources.
Think about your spending habits in categories like food, clothing, entertainment, housing, etc. Which category would give you the greatest happiness for each extra dollar spent? Where could you reduce spending without being noticeably inconvenienced? Shift money from categories with the least impact on your happiness to categories with the highest happiness return.
What activities do you enjoy most? Do all of them require money? Running outside, reading books and cooking at home are common hobbies that require little financial commitment. Dedicate your time and money to things that will have the most positive impact on your personal well-being.
You Might Not Need More Money
Personal finance bloggers don’t often say, “You don’t need more money,” but it might be true. If you can find ways to further enrich your life with what you have now, could it be that money isn’t the missing ingredient? Start thinking about money as a way to further your life goals instead of as its own goal.
Have you ever pinned hopes on a money target only to be disappointed with how little joy you received from reaching it?
Viking @ September 5, 2012
Many people don’t like their job, and it’s a shame. We spend such a large portion of our life at work. Why should it be less than fulfilling? Financial independence strategies usually focus on building a portfolio of assets that provides enough income to cover living expenses without losing principle. Once that goal is achieved, it’s ok to leave the corporate world. The safe rate to withdraw money from the investment portfolio is often considered to be around three to four percent. For example, someone who spends $30,000 per year would need a $750,000 investment portfolio to scrape by with a 4% withdrawal rate. That is a lot of money, especially for someone early in their career. Why wait to declare independence?
Take the Initiative: Grab the Rising Sun
What if we define financial independence as relying on only one’s own initiative to pay for life? Then, instead of waiting to be free from corporate boredom, young professionals can harness their creativity and start a new business. Why not save a couple years worth of living expenses as a security fund and take the plunge into entrepreneurship? Find the intersection of a common need and your greatest passion. Make that the cornerstone of your start-up. Grab the rising sun, be lifted by your aspirations, and don’t be afraid to fail. If the first six months are utterly unfulfilling, then find a new corporate job. Your bold business venture might even make you a more appealing candidate.
The Risk of Not Trying
Sure, quitting your job is a risky decision. You would lose the steady paycheck and a familiar routine. Friends and relatives might think you’re crazy. However, the risk of not trying might be even greater. If you sit in that career-track professional job for 30+ years, you’ll likely be able to live the upper middle class lifestyle, but it won’t be on your terms and there likely won’t be much upside. If you work for yourself, taking a chance on that business idea, you could make it big. On the journey your schedule, your projects, and your product would be in your control.
The most successful, innovative companies weren’t founded by meek and fearful people. Step outside of your comfort zone, think boldly, act intently, and you may find tremendous success. Read Zen and the Art of Making a Living for help exploring the possibilities.
The real cost of failure is quite low if you have a security fund and improve your skills during self-employment. Consider starting a business on the evenings and weekends to diminish risk and test your ideas before resigning. Obviously professionals married with children would have more obstacles than someone under 30 with no real responsibilities, but the path of entrepreneurship is open to everyone.
Admittedly, the idea of leaving a job when a job is exactly what millions of people are trying to find might seem silly. It’s not for everyone. If you love going to work or if you have no interest in being your own boss, financial independence without a huge portfolio isn’t for you.
For others, though, financial independence through self-employment is the way to go. Flexibility and freedom increase, corporate nonsense goes away, and personal growth becomes more of a possibility.
I recommend reading Financial Samurai’s post on financial independence for another perspective.
Have you ever considered leaving your job to start a business? Does it seem like a stupid idea?
Viking @ August 31, 2012