When you look around at people’s lives there seems to be 2 things that show up in most people’s financial worlds.  If they aren’t there directly it’s 2 things that the people are working towards.  Any guesses?  They are both marketed to widely by the largest financial companies in the US.  Give up?  The 2 things are your 401k and your house.

Chances are you read everywhere how you should be contributing as much as possible to your 401k.  Most of these messages are initiated by two groups, the financial companies and the government.  Then you add in that your whole life you are told that you need to own your own house.  It is instilled in us at such a young age that most people never even question it.  They work to get a mortgage, in order to get their own house.  I have to ask, is this a good thing?

As I was reading The Best Way to Avoid the Worst Financial Problems from @wisebread it reminded me of the 6 principles of the Evolution of Wealth.  Honestly, I have put aside the principles that I originally wrote up.  Why?  Well I really don’t have a reason, basically because life happens and I’ve tried to let this blog go where it goes.  It was the following paragraph in that post that jumped out at me:

I can give it to you in once sentence: Keep the cost structure of your household flexible. That is, arrange your life so that you can react to a fall in your income by reducing your expenses.

This screamed principle #1: the power of LUC.  Did I forget the k?  No.  LUC stands for liquidity, use and control.  These are the main features of flexibility.  Now let’s look at the 2 most popular financial tools that play a major role in everyone’s financial world.

How does a 401k provide flexibility?  Does it provide liquidity, use and control?

1. Liquidity – Fail!  When flexibility is most important, it is difficult to access the money that you put into a 401k.  There are penalties and fees associated with the access as well as probably having to jump through a few hoops.
2. Use – There’s only 1.  It’s saving for retirement.  The money is in your account doing 1 thing, or should I say hopefully doing 1 thing.  People loose track of the main purpose or maybe the only purpose of a 401k.  Saving for retirement.
3. Control – Do you even have any?  The government dictates when and how you can access the money.  The employer or plan administrator dictates the rules surrounding access and investments.  Might you just be a pawn?

How about your house?  Any flexibility there?

1. Liquidity - Is it easy to get money out of your house?  I guess you might be able to convince me if and only if you have a large equity line of credit established.  Oh, what did you say?  Banks are taking those away?  Guess this is a FAIL too.
2. Use - You could make an argument for some use here.  It provides shelter.  It provides some tax benefits.  It might provide some rate or return (emphasis on maybe).
3. Control - This should be a good one…who controls your house?  Let’s see, you need to ask permission and prove that you should be able to pay just to get a mortgage.  Then if something bad happens, just when you need there help the most, the bank says ‘NO’.  Doesn’t sound like much control to me.

Might the 2 most widely used financial tools also be the worst based on Principle #1 and wisebread.com‘s “Avoiding the Worst Financial Problems”?

Related posts:

1. Max Out Your 401k Math
2. 401k, God or Devil?
3. 6 Reasons Not to Max Your 401k

I wanted to share with you a lesson I learned from Douglas Andrew and his writings.  For anyone that has read his books before Douglas is a little over the top but as with most financial books there are at least some great pieces to take out of it.  For anyone who hasn’t read his books he talks about utilizing the equity in your house versus paying off your house in full.  If you are interested in learning more about his books a great one to start with is The Last Chance Millionaire.  I will warn you that it is definitely extreme and might be a little over the top for you.

To get back to the post…Probably the thing that sticks with me the most when reading Douglas Andrew’s book is his visual representation of separating the equity from your home.  Now I’m going to attempt to paraphrase his example in my own worlds and hope not to butcher it too much.

In one hand you have a pitcher with water in it.  This will represent you personal accounts and the water being your cash.  In the other hand, you have an empty glass.  The glass is your house.  Let’s say your house is worth $100,000 and you have $100,000 in water (cash) in the pitcher.  This means that your total assets are $200,000.

Then you pour all your water (cash) into your glass (home).  Now the pitcher is empty but the glass is full of water.  You’ve reduced your assets by $100,000 and eliminated your liability (mortgage).  So your net worth is still $100,000 and you have a full glass of water.

Now let’s assume your house appreciates by 5% next year.  It’s now worth $105,000.  If you water (cash) is still in your glass (home) that means that your assets are $105,000 and your net worth is $105,000.  Now let’s pour the water back into your pitcher (personal account).  You still have your house worth $105,000.  We brought back the $100,000 liability.  How did your cash do?  Did it earn 5% as well?  Then that asset is also worth $105,000.  This is what it looks like now:

The point being that when all your cash is in your house you only have one asset working for you versus two.  The rate of return on the equity in your home is always zero.  The equity isn’t an asset.  People want to talk about it and count on having it down the road and maybe even plan on using it.  All it is, is imaginary.  If you want to make it real at some point you most likely go to a bank and ask the bank’s permission and prove to the bank that you should be allowed to access your equity.  Is it really yours?

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Related posts:

1. Parents know best?
2. Bob or Jim?

In the first part of Bob or Jim? we looked at the similarities between the two neighbors.  Then we saw how their goals differed slightly.  Bob wanted to pay of his house as quickly as possible and Jim wanted to save money instead.  Finally, we looked at it from the bank’s perspective and said which would the bank prefer.

In Bob or Jim Part II we looked more closely at the numbers.  We wanted to see how far apart Bob and Jim would be today.  It turns out not very far apart.   They only differed by about $12,500 on a balance sheet.  The big difference was the ability to access their money and the control they had over it.

Now it’s time for the future.  To recap Bob and Jim both bought their houses at the age of 35 in 19997.  They then refinanced in 2003 to lower their interest rates.  We also learned that today, Bob would have about $80,000 left to pay on his mortgage.  Jim would still owe $193,000 on his mortgage, except that Jim would have about $100,500 in his side account so this would leave his balance sheet at -$92,500.  Not a huge difference but definitely a difference.

On his current pace, Bob is set to pay off his mortgage in full in 2013.  After that point he might feel a little bit behind with this savings.  However, he could begin to put aside the $1423 mortgage payment plus the extra $580 he was paying.  So he should be able to save a total of $2,003 per month.  That’s $24,036 per year.  That won’t really fit into an IRA or maybe even a 401k, of course hopefully the limits have gone up a lot by then though right?

Then there is Jim.  Jim who refinanced in 2003 isn’t set to pay his mortgage off until 2033.  However, we do need to look a the side account.  In 2013, when Bob is set to finish paying off his mortgage, Jim will have about $164,000 in his side account.  He will owe about $172,000 left on his mortgage.  Not quite in the positive yet, within the next year that crossover will happen.  So doing things Jim’s way will result in paying your mortgage off about 6 months later than Bob.  Not too bad huh?

We’re still left with the almighty question, where will they both be in 2033?  Jim will have just paid off his mortgage but we need to look at his side account.  His side account will have approximately $815,144.  So where will Bob be?  Using the same side account as Jim, Bob will have approximately $754,183.  So the second to last time I’ll ask, who would you rather be, Bob or Jim?

Don’t forget scenario B already.  Jim took out the extra $100,000 during his refi.  Let’s see where this would put him.  Jim will then have approximately $828,411.  So you see it leaves him in a little better situation.  Then we take into account more accessible cash, flexibility and what else?  Oh yeah, more interest payments.  Wait you don’t want to pay more interest?  Well the numbers say you are better off paying more interest and we haven’t even talked about any deductions on your taxes you might get from paying more interest.  So we haven’t even accounted for more money in your pocket.  Last time I’ll ask I swear.  Who would you rather be Bob or Jim?  We both know it’s not all about the math so I can’t wait to read your responses.

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Related posts:

1. Bob or Jim? Part II
2. Bob or Jim?
3. Your Mortgage: When 30 beats 15

It was 12 years ago that Bob met Jim, they were both 35 at the time.  See back in 1997 they just happened to be moving into their new houses on the same day.  It turns out they were moving in right next door to each other.  They had each just bought a brand new house in a fairly new neighborhood.  To tell you the truth it was one of those neighborhoods where all the houses kind of looked a like; same design, same amenities.

They both had recently been married and were raising their families in their new house.  As they got to know each other and their families became friends it turned out that they both paid $250,000 for their houses.  They both put 10% down and then started paying away.  The difference is that Bob wanted to pay his house off as soon as possible and Jim wanted to save money, inside and outside of retirement.

Well when they had moved in they were both sales people.  They were both making $65,000 a year which was good money at that time and things were good.  They were both contributing 6% to their 401ks respectively.  Another difference arose.  Since Jim wanted to build his savings he was saving $350 a month outside of his 401k.  Bob on the other hand, wanted to pay his house off.  So he paid an extra $350 per month on his mortgage.

In 2003, mortgage rates dropped.  Both Bob and Jim headed to the bank.  They were paying 8% interest on their original 30-year loans so this could save them a lot of money.  Jim, who had not been paying extra on his mortgage, still owed $212,000 but by cutting his interest rate to 5.5% he was able to cut his payment from $1,651 per month to $1,204 freeing up an extra $450 per month for him to save.  Bob had been paying extra to his mortgage and only owed $180,000.  He went with a 15 year mortgage at 5%.  This cut his payment from $1,651 to $1,425 and then put the $230 savings and put that towards the mortgage as well.

Now it’s 2008.  Both Bob and Jim advanced in their careers and are now sales managers making six figures per year.  Unfortunately, they both got laid off and they couldn’t make their mortgage payments.  At this point Bob only owes $80,000 on his mortgage while Jim owes $193,000.  The bank is knocking on their door.  Bob says ‘I have all this equity’ and goes to refinance.  The bank says you don’t have a job so the bank says no.

Let’s imagine they are the same exact financial situation.  No job, horrible economy, lending is tightening.  Things are going bad fast and getting worse.  Remember last year?  Which house will the bank foreclose on first?  Bob’s owing $80,000 on a $400,000 house or Jim’s owing $193,000 on a $400,000 house?  Banks are businesses remember out to make money.  Which can they make money off of the quickest?  What if we went one step further and said Jim took $100,000 out of the home when he did the refi in 2003.  Now he owes $290,000.  Does that change things? 

To Be Continued…

Continuing your reading with Bob or Jim? Part II

Or skip ahead to Bob or Jim? The Final Chapter

Related posts:

1. Bob or Jim? Part II
2. Bob or Jim? The Final Chapter
3. Saving $71,000 in mortgage interest continued…

I can’t believe I just said that.  Well if you asked me a month ago if I thought it would be 90, sunny and no rain  in Massachusetts for two days in a row I would have said no there as well.  It’s not that I don’t agree with some things she says it’s more about the way she makes blanket recommendations to people after them talking for two minutes.  I also don’t really like that her recommendations always support her advertisers but I understand that.  I just hope other people do as well.

The article I read was in the Sunday MetroWest Daily Newspaper.  Anyone out there still read the newspaper?  Suze Orman was on the cover of USA Weekend and her article was titled “Suze’s top 6 tips“.  Go read the article.

So from her article I am going to give you three things to do to find money.

1. Save a couple thousand dollars a year on property taxes  The rules vary from town to town.   So visit the assessor’s office and ask for your property record card.  Also ask for the process to get your house reassessed due to declining market value.  There is usually an application that is due by December 31st and decisions are made in January.  Now that you have the property card review it to make sure the information on your house is correct.  Then go on zillow.com and see how the assessed value compares.  If you feel the two are different, the next step would to be to hire a real estate broker to do a sales comparison or a licensed appraisor.  The simply follow the process of your town.

2. Save a few hundred dollars a year on your insurance  Dig out your homeowners and auto insurance policies.  Call up your insurance broker and make an appointment.  If you don’t like or trust your own agent, ask your friends and family for the name of a good broker and schedule an appointment with them.  Don’t waste your time by meeting with someone you don’t think will help.  Now you want to ask about how much you can save by having both policies with the same company.  Then look into raising your deductibles to $1,000.  (side note: if you get in a lot of accidents or dents and dings on your car this might not be good for you)  Have the broker review your policies and shop them around for you.

3. Stop giving the IRS an interest free loanDo you get a large tax refund?  If so, contact your human resources or payroll department at work and ask to increase your exemptions.  Instead of getting a lump sum back next April you will see an increase in your paychecks that will allow you to save this money and earn interest on it rather than letting the IRS do it.  This is also a great way to help pay down some outstading debt you might have.  Don’t spend this money though, save or pay down debt.

There are three easy ways for your to find money.  This could easily result in you having a $2-3000 extra each year to keep and enjoy.  I also want to commend Suze Orman for telling people to not max out their 401(k).  I think this is great advice and couldn’t agree more.  What do you think?

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I was talking with Matt Roberge ofSLC Bookkeeping about my blog post yesterday.  We had a great conversation and he made some great recommendations, so here’s my follow up post thanks to Matt:

Let’s first start by going over what Ramit Sethi’s concept is in “Have a mortgage? Save $71,000 in interest payments” and please correct me if I’m wrong.  Ramit talks about using a bi-weekly payment schedule.  The reasoning behind this is that most people are paid bi-weekly and it even works if you are paid weekly.  With a bi-weekly payment schedule you would pay half your mortgage every 2 weeks.  The dilemma with this, as the comments to Ramit’s blog bring attention to, is whether your bank will allow you to do this or charge a fee or whatever.  I’m not going to address this hear because the most important part is not necessarily paying every two weeks but it is instead the fact that this strategy uses 26 half payments a year.  This means that you make 13 monthly payments a year rather than the usual 12 and this is where the majority of interest savings is.  Ramit’s concept is paying that extra monthly payment to your bank or mortgage company allowing you to lower the principal and reduce interest.

As my last post referenced, this is what the banks/mortgage companies want you to do.  How do banks make money?  They make it off of your money.  They want as much of your money as possible as quickly as possible.  If we have learned anything from the current economic situation it should be that banks don’t keep money on reserves, they send it right back out the door in hopes of make more money.  This also give control to the banks.  If you have a mortgage and you want to do anything with your house, apart from selling it, you need to ask the bank.  The bank decides if and how much of the value (equity) in the house you can access.  If something changes with your financial situation (job losses anyone?) the bank can and will say ‘no’.  Not only can they say ‘no’ they can take your house regardless of what you’ve put into it.  If there were two of the exact same houses right next to each other and house A had $250,000 left on the mortgage and house B had $50,000 left on the mortgage which do you think the bank would foreclose on first?  Think about it from a business perspective.

So that being said, I think the bi-weekly payment schedule is great.  My concern is sending that extra monthly payment to the bank/mortgage company.  Why not take control of that money yourself?  Ramit seems to imply in the comments section that he feels most people aren’t able to be disciplined enough to do this.  Then follow Ramit’s own advice and automate it to another account.  The biggest question becomes where to put it.

Some people will argue for putting it into the stock market.  Their reasoning is that mortgage rates are near historic lows and over the 20+ years you have the mortgage the stock market should average some rate of return that is better than your mortgage rate.  Arbitrage.  The concept is sound.  My concern here is two fold, one, it can be difficult to control taxes with these investments and more importantly, two, you might not get a good rate of return.  Yes I said it.  The stock market can loose money.  Everyone realize that now?

So what do we need from a savings vehicle to make this work?  To make it a more viable options you would need safety, liquidity and a rate of return equal to or greater than your tax adjusted interest rate.  You also need to have a way to manage the tax implications of this savings vehicle.  You don’t want to have the compounding interest become a compounding burden (check back for this blog post soon).  So let’s start the discussion here…what do you know that has safety(rules out most market related investments), liquidity(rules out CDs, real estate, business ventures) and rate of return (rules out CDs again and money market accounts).  So what’s left?  Does it work?  I’ll be happy to do the math for you if anyone has a scenario.  The answers to these questions can really vary depending on your situation.  There is no right answer for all here, sorry.

Related posts:

1. The Way The Banks Want You To Pay Your Mortgage.
2. Your Mortgage: When 30 beats 15
3. Bob or Jim?

I received a question last week on the MET Group.  The question was titled “Was My Mother Wrong?”  Then today I was reading an article on the Wall Street Journal website titled “Is Your Home A Good Investment?”

They both seem to be about the same topic and come back to an age old truth: no one can predict the future.  Real estate just like other investments, are cyclic.  It will go through periods of great run as well as declines.  Unfortunately, now we are in a tough time to be owning and investing in real estate.  Will it get better?  Yes.  Will we have a run up similar to the past decade or so?  Yes.  When will this happen?  Who knows.

Real estate is an interesting investment because we are all taught that a huge step in life is buying your own home.  A lot of people believe the next step is paying it off to become debt free (if that’s what you believe debt free is).  So how do you judge this as an investment?  I’ll leave rates of return to the Wall Street article above.

The trouble is today all the bad information is in your face.  People have to deal with it.  It was easy when there wasn’t a record number of foreclosures because people could say ‘oh that won’t happen to me’.  Now just about anyone knows that they could lose their jobs, something could happen and they would be one of the people you are reading about.  How can you truly prevent becoming a statistic?

Planning.  Your house is a financial product.  It needs to be integrated into your velocity of money.  If the way in which you spend money on your house and invest in it is not coordinated with the rest of your financial affairs you could be setting yourself up for failure.  One of the best books I’ve read on managing the investment of real estate is “The Last Chance Millionaire” by Douglas Andrews.  This book is a little over the top and I should put the disclaimer of don’t try this at home on it.  However, it is a must read for so many reasons.

Now to take a step back.  A house, as with many investments nowadays, is not the perfect, best investment for everyone.  When managed properly though, it can give you great opporunity.  How are you going to figure out how to manage your investment properly?

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