How can a Bank Make Money on 0.9% Interest

As someone who works in the lending field, I often find it shocking that financial institutions can make any sort of money with interest rates as low as 0.9% (I’m thinking car loans here).  Intuitively, this doesn’t make any sense.  If your interest rate is lower than the inflation rate (usually between 2-3%), how can you make any money off your loan?  Well, banks are smarter than you think.

First, consider how a bank makes money; it takes your checking and savings deposits for essentially free (you get the guarantee that your money is safe), and it loans out your funds to people who need mortgages, car loans, etc.  This is a pretty nice little game of arbitrage here.

The second interesting thing to think about is how a fully amortized loan is structured.  If you have a fixed loan, you pay the same amount each month, however the way a bank structures the payment varies throughout the life of the loan.  Your monthly payment is almost entirely interest the first couple years and almost entirely principal the last couple.  Think about this example:  you take out a $20,000 car loan for 60 months at 0.9%.  In the first year, you will pay $432.86/month, but your total interest portion for the year will be $2,005.20.  If you divide this total interest by the average monthly balance, you have an average interest rate of 10.8% for the first year.  Now say, year two comes along, and you decide to pay off your loan: the bank gets its money back and loans it out again all the while making 10.8% interest the first year.  This is why banks eventually encourage you to prepay your loans.  Inflation will eventually catch up to the payment. 

So, what should you do as someone with a car loan?  Well, there is not much you really can do?  If after 12 months you decide to pay off your loan, you will have essentially paid $21,921.77 in today’s money (assuming a 3% annual discount rate) for the privilege to borrow $20,000.  If you went through the full term of the loan, you would have paid $24,089 in today’s dollars.  Borrowing money has a price to it, so the best advice would be not to get into debt in the first place.  The contrary point is that if you can’t get to your primary source of revenue, because you don’t have a car, then the cost of inaction is far more than the debt load.

Whatever you choose, it’s important to realize what you are getting yourself into and how the bank is going to make money off of you.  You will then be able to make smarter life decisions if you are armed with this knowledge.

Wonderful Moment of the Day: The smell of fresh cut grass makes me believe that summer is finally here.

What’s a Jumbo Mortgage?

Believe it or not, but the economy is actually getting better.  Property values are increasing and mortgages rates are starting to go up.  In fact, home prices in some areas of the country are increasing at such an alarming rate that it is reminiscent to the pre housing crash of 2008.  Nevermind that for now, because I want to focus on an interesting problem for those of you thinking about buying a new house in these newly expense housing districts.

An interesting thing happens to mortgages when they cross the magical threshold of $417,000, they gain the title of Jumbo.  What does this mean?  Well, here are some things to take into consideration if you decide to obtain a jumbo mortgage.

-          Jumbo mortgages have higher interest rates than non-jumbo mortgages.  If you think about, mortgage companies are taking a big risk by giving you a whole bunch of money with the hopes of you paying it back over time.  We won’t even discuss the concept of interest rate risk.  With that in mind, if a mortgage financer gives you even more money, you are now considered even more risky, so interest rate increases are inevitable. 

-          The next issue with jumbo mortgages is that they are harder to get.  A $416,999 mortgage is much easier to obtain than a $417,000 mortgage, and because of this arbitrary dollar cut-off, you’ll likely have a much harder time convincing a bank to loan you that high amount of money.  You will need a higher credit score, and most likely a much lower LTV on your home. 

Unfortunately, this classification can really harm people who just happen to live in higher cost of living areas.  Places like DC and NYC often have regular 2-3 bedroom homes well north of this dollar amount, and so those of us looking to own our home will have a rougher go.  With that in mind, do everything you can to get your mortgage below that $417,000 threshold.  The easiest way is to pay a larger down payment up front.

Wonderful Moment of the Day: While being new to this whole baby thing, I’ve found the resources online to be invaluable.  It’s actually made my research very enjoyable.

Cost of Living Comparison

Sometimes in life, you need to just pick up and start over in a new city.  Whether it's a new job, a new love, or just the need for a change of scenery, moving can often be a scary endeavor.  You could almost think about it as a leap of faith.  One of the most overlooked concepts when moving to a new city is it's cost of living.

Cost of living can be easily thought of as purchasing power for the basics of life.  If two cities have the same average $ value for a wage, and it costs $1.39 for a gallon of milk in one and $1.89 for a gallon of milk in the other, you could assume that it's cheap to live in the first city.  It might be far to say that the first city has a lower cost of living.  With that in mind, I found a nice site that lets you easily compare the cost of living in major cities around the world.  Site here.

A simple comparison between NY City and Washington DC will provide a varying array of results from consumer prices, rent, restaurants, groceries, and overall purchasing power.  In this particular example DC was lower than NY in all category except Consumer prices.  This type of tool is especially useful if you are going to compare a job opportunity in another city.  Say you are currently making $40,000 and you get a job offer for $45,000 in another city.  This would constitute a 12.5% increase in pay, however the city you are moving to has a 20% increase in the cost of living making your real wage go far less than when you were in your first city. 

Wages and costs are relative just like much of everything else in this world.  Don't accept absolute values, but instead, find ways to compare them and make an informed decision.

Wonderful Moment of the Day: Hitting the 70 degree F weather now!

The Sorry State of Financial Education Within our Schools

Financial education has always been sort of an ancillary topic within the US education system.  Usually covered in "Economics" class or one lesson within some other class, the net effect is to downplay something that is so very important to the survival of any potential graduate.  Think about it this way, you could have a child who is a genius at Math, Science, History, or English, but none of that will be very useful if they don't know how to manage their money.  Alternatively, if your child was rather average, and achieved a decent paying job, but knew how to manage their money, they will most likely have less stress in their life and live a better more fulfilled existence.

The truth of the matter is that our education system in the US is very inadequate when it comes to teaching children the fundamentals of personal finance.  In my own experience, personal financial education consisted of making an imaginary budget and watching movies on how people became millionaires...not very helpful.  

Instead, having every high school graduate go through a course that teaches them about budgeting, saving, investing, and other important financial concepts (such as buying a house, car, or opening a credit card), would pay for itself exponentially.  The net benefit to our economy by having a whole generation of financially literate children enter the workforce would be profound.  Who needs further regulation when all your customers can recognize that a no principal, adjustable rate mortgage sounds like trouble from the get-go.  

Changing the educational culture within the US is not an easy task, but collectively you can start making an impact.  Talk to your teachers, principals, and other educators.  Vote for the necessary funds at your next school budget vote, or even volunteer to teach a lecture at your local high school.  This change won't happen on its own.  

Finally, the most important asset in your child's financial education is the time you spend with them.  Don't rely on the public schools to teach them about personal finance.  Instead, take matters into your own hands and learn the subjects yourself.  

Wonderful Moment of the Day: Family celebration for my Wife's coming mission trip for 2 weeks to Egypt.

The Skyscraper Index

Here's an interesting pseudo-economic theory to start your Monday morning.  It's called the Skyscraper Index, and was originally theorized by researched Andrew Lawrence back in 1999.  You can read more about it here.  The general theory is just like it sounds; as higher skyscrapers are built, this would signify the peak of an economic cycle.  Soon after these skyscrapers are built, a global economic downturn occurs.

Lawrence examined a series of skyscraper builds throughout history such as the Empire State building, the World Trade Towers, and their seemingly predictable economic downturns immediately following.  The most recent example of this trend has occurred with the 2009 completion of the the Burj Khalifa in Dubai.  This was right around the collapse of the housing market.

These types of correlations are just fun to study and could play in the back of your mind when you are thinking about investing, but don't let it dictate your moves too much.  As the article suggested, there are studies that have found no correlation between skyscraper size and economic downturns.  In any case, this little tidbit of folk-economics still remains entertaining.

Wonderful Moment of the Day - Restaurant gift certificates, YUM!

Is the Stock Market Over-Valued?

As a general rule to my own investing habits, I tend to feel a little concerned when the S&P has had such a good run as it's done for the past couple years.  The reason why I get a little concerned is that throughout history, there has been times of boom and bust, and in more recent history, you had the stock market booms of the 2000-2001 dotcom and 2006-2007 home booms followed by pretty huge busts.  Booms have been around ever since there were ideas to invest in, and generally occur when new forms of technology make themselves apparent.  In the case of the dotcom boom, nobody new how to value internet stocks, and with home values, the new technology associated with specialty cuts in mortgage-backed securities presented a financial product as being more secure than it actually was.  In any event, it often pays to do some of your own financial research and so, one of the best ways to see if the market is over-bought is to check out the P/E (price to earnings value) of the S&P 500.

The P/E ratio in its most simple description is the price of the stock divided by the earnings per share.  Basically, it tells you how many times more valuable the stock is than how much money the company is actually making.  There's no set rule on what an appropriate P/E ratio is for any stock, and that's why you'll see such swings from very low to extremely high.  The important thing to note with P/E research is to see if anything has dramatically changed or if new technology/investing techniques warrant the change. 

I quick glance of the link I submitted above, you can see the historical P/E ratio of the S&P 500.  Everything looks pretty good until you get to 2001 (alright makes sense...dotcom boom), and then HOLY CRAP look t 2009!  What the heck happened here?  Well, obviously it's the fallout from the housing boom.  I think the incredible decrease in earnings relative to the stock prices of these companies played more into this high P/E ratio that people pushing up prices too much.  Either way you feel about it, the market was definitely over-bought. 

The chart tells you that the mean P/E ratio of the S&P over the life of the market is about 15.49, and it is currently pegged at just a little over 17.  This would probably start indicating over-bought territory, however I would argue that you should probably look at the past 20 years as they are more relevant historical information.  I also removed those two huge spikes as those are obviously outliers.  What you get is a new P/E ratio of about 20 which would suggest we still have some room to go in the market place. 

But what should you do even if the S&P is over 20 on a P/E basis.  If you're investing in the long term, and have a well diversified portfolio over multiple asset classes, then any sort of short term market fluctuation shouldn't bother you too much.  That said, if you start seeing the P/E shoot over 20, it might be a good time to contribute more towards bond funds or other kinds of investments.  Just my humble opinion.

Wonderful Moment of the Day: Warm sweaters.

Benefits of Dollar-Cost Averaging: Part II

Last month I introduced the concept of Dollar-Cost averaging with just a simple example. You can see that distributing your contributions to any sort of retirement fund will have the effect of averaging your purchasing power (and essentially your risk) over the course of time.  By making smaller monthly contributions as opposed to a once a year bigger contribution, you can take advantage of buying more share when the price is low, and less shares when the price is high.  Giving into this theory is also a humbling experience in that you are admitting that you cannot possibly know when the market will be ripe for the purchasing.

I took this example to the next step and applied a real world and "more true" example.  I did a thought experiment in which someone were to invest an inflation adjusted amount in the S&P on a monthly basis over the course of 26 years (this ended up being the data I found and was easily available).  What would their portfolio look like?  I first looked at the month end  values of the S&P going from December 2012 all the way back to 1986.  I then used the Consumer Price Index (CPI) to invest a monthly contribution of $230 in today's money.  You can do the math as to what portion of your gross income $230/month is.  It just seemed like a low enough amount to be plausible  and a high enough amount to make it worth while.  I should also note that these contributions are contingent on very low to zero commissions as found in a 401k or IRA.  The $230/month also worked out to be the value of the CPI in December 2012.  After doing the math, you can see my returns as the blue line in the graph below:

If the information looks a little small, I apologize, but the gist of it all is that an inflation adjusted contribution to an S&P pegged index fund (ignoring expense ratios) will net you a portfolio value of $109,660 over the course of 26 years.  Total dollar contributions ended up being $54,335.

The red line which correlates to the secondary axis is a calculation I did each month which determines the dollar cost average of the stock each month.  At the end of December 2012, the S&P was pegged at $1,426.19 whereas our portfolio dollar-cost averaged value was $1,037.42 which means we had capital gains of about 37% over the time span.  

The lesson learned here is that a simple index fund can really pay off over time.  Even during the dips and booms, buying an index fund as a proportion of your portfolio through a dollar-cost averaging process can really pay off.  You just need the discipline to pull this off, and you should find yourself ready for retirement.

Wonderful Moment of the Day: Coming home to a meal ready and prepared by my Wife...awesome!

Returns by Polictical Regime

I often find new ways of looking at information fun and exciting and I was delighted when a sample of the "Fidelity Independent Advisor" came through the mail last week.  Everyone with a Fidelity brokerage account should have received this newsletter which generally serves as a long-winded advertisement for their other financial products.  Needless to say, I usually through these type of magazines out (although Schwab's is often pretty good).  However, one particular article captured my eye.  It shows the annualized US Stock Market returns of the S&P by political regime.  I clipped a portion of the information below:

You can see that generally speaking, the best economic times occur during a split government.  When you think about it, it makes a whole bunch of sense.  Just like the market, voters like to hedge their bets by having a variety of political views in power.  Hopefully in these situations, more opinions will be heard, and better decisions are made. 

What was even more interesting to me is that our current situation of a Democratic President and a split Congress is almost unprecedented by occurring only 1.2% of the time.  That said, I'm a little wary to believe that there has been enough information to warrant a 9.2% annualized return.  We're talking like maybe 2 years worth of data here.  Also bear in mind that this chart does not necessarily correlate a particular political opinion with prosperity.  The chart is merely just showing what has happened in the past.  Some might argue that it was Republican framework which allowed for Democrat boom times such as with Reagan/Bush 1, and Clinton. 

Either way, this type of information fascinates me, and I hope it interests you as well.

Wonderful Moment of the Day: Lunch with friends.

Money Supply Update

From time to time, I like to check out the current state of the US Money supply and try to get a sense on whether inflation will be coming around the corner.  In my own personal opinion, inflation is the far worse of the economic problems.  Some may argue that unemployment is bad, but the way I see it is that unemployment sucks for a few, but inflation sucks for all as it can turn your salary and savings to nothing. 

Here’s the link to the Federal Reserve money supply release. 

The only difference between M1 and M2 money supply is that M2 includes savings and Time deposits.  M2 generally has a more complete view on the total amount of cash circulating in the economy.  Now before we look at this data too much, it’s important to realize that like any other commodity, money has a supply (obviously), but also a demand.  Anytime that supply is more than demand, you start seeing inflation.  The Federal Reserve does a good job at monitoring this, but they only have so many tools, so it’s often important to understand inflation on your own (or at least the threat of inflation).

A quick scan of the numbers shows that from January to December of 2012, the M2 money supply grew by over 7%, at least double the inflation rate.  When we look back from January 2011 to December 2012, M2 grew by 18%!  Now, these aren’t catastrophic numbers and the reason why we haven’t seen too much inflation is that the week global economy has increased the demand in stable US treasury bonds, so the demand is still high. 

That said, it’s always good to protect your portfolio and at least hedge against inflationary risk.  For that, I recommend TIPS (Treasury Inflation Protected Securities).  As the inflation rate increases, so does your return, so your after-inflation rate return is always constant.  It’s a nice way to round out a portfolio.

Fun Fact: I actually had the chance to visit the Federal Reserve and sit in Bernanke's seat.  I also got a bag of shredded $20 bills as a souvenir!  How cool is that!

Wonderful Moment of the Day: Weather starting to return from a deep freeze.

US Personal Savings Rate

I guess it's no surprise that I love finding new sources of data or interesting data related facts.  I great source of information is the Federal Reserve (particularly the St. Louis Fed).  Upon snooping around, I recently came across this data set which basically shows the U.S. personal savings rate since 1959.  The definition of the savings rate is all money put aside in savings (including retirement) divided by the after tax income. 

I found it a little concerning that the current personal savings rate was hovering just below 4%.  Taking into consideration an average inflation of 2-3%, and the average person only saves about 1-2% of their income each year for retirement.  Ultimately, this means that there are a whole slew of folks out there that are simply not ready for retirement.

Here are some tips for retirement savings:

1.) Save first then spend what you have

2.) Make a budget

3.) Track your performance

4.) Keep an emergency fund of at least 6 months were of spending

5.) Max out employer contributions in your 401(k)

6.) Start saving as early as possible

7.) Open an IRA or ROTH IRA if you are able.

Don't get yourself caught in the same situation as the rest of the US population...start saving for your future!

The other thing I found interesting with this data set is that until the mid 80's the average personal savings rate was about 8.5%.  Now, inflation was much higher then, but this was still a very robust number.  In the 1970's, people were saving aver 14%!

Wonderful Moment of the Day - January thaw!

Benefits of Dollar Cost Averaging

I know it sounds like a scary financial term, “Dollar Cost Averaging”, but it really is a good technique for everyone to practice if you have an IRA or some other form of a retirement account.  Chances are, if you are currently enrolled in an employer 401(k) and the like, you are probably already doing this.  Essentially, dollar cost averaging involves buying a few shares of your investment each period whether the asset is up or down.  Over the course of time, your average purchase price will hopefully be less then the current stock value.

Let’s put a concrete example together to help explain this scenario.  Say you’ve been investing for the last 4 months in an index fund that ranges in value from $25 to $50 and is currently priced at $50.  Let’s say also that you have been putting away $150 per month.  Here’s how it would look:

Month             Price             Shares         Total Investment

Month 1          $25                 6                     $150

Month 2          $30                 5                     $150

Month 3          $40                 3.75                $150

Month 4          $50                 3                     $150

At the end of the 4 month period, you now have 17.75 shares for a total value of $887.50 even though you only invested $600.  Your average buying price comes out to $33.80.  What happened here in this little bit of financial voodoo is you took much of the market timing risk out of the fund and reduced your overall volatility.  If you had invested all your money in month 4, you would have made nothing.  Consequently, if you had invested all your money in month 1, you would have made quite a bit more.  The whole point of this type of investing is that you will most likely get a better return with less volatility and risk.

I mentioned before that you are probably already doing this without even knowing if you contribute to a 401(k) or another form of retirement account.  Usually, your employer takes out a certain amount of money you’ve elected from your pay check each pay period and deposits it into your selected funds.  If you get paid bi-weekly, your dollar cost averaging is even more fine-tuned.

Ultimately, the only real downside to using dollar cost averaging is if you have high transaction or brokerage fees.  If it costs you $7 for a trade, then investing $100 a month probably doesn’t make sense.  To mitigate this issue, I tend to use funds in which transaction fees are waived by my brokerage.

I sleep more sound at night when I use dollar cost averaging, but ultimately, you have to invest in the mode that makes you happy.

Wonderful Moment of the Day:  Hot showers on cold days.

How Much "Home" Can I Afford?

“A house is not a home unless it contains food and fire for the mind as well as the body”

                                ~Benjamin Franklin

No doubt that whenever the topic of personal finances is to be approached, one cannot simple dismiss the potentially largest expense a person will ever had…their home.  Whether you’re paying rent for an apartment or a mortgage on a home, you’ve probably asked the question “How much home can I afford”?  This simple question has caused many people to live in financial straits and is usually “solved” through a trial and error process throughout your life.  Well, here’s my own two cents that may help you avoid some of the lessons at the school of hard knocks.

To cut to the chase, generally speaking your total rent/mortgage should not exceed 50% of your after tax net income.  This is a mantra I’ve always strived to live by (although with varying degrees of success throughout my life), and it will do your wallet some good to strive for this too.  Consider the salary of someone making $50,000/year.  This is a very good salary and you should commend yourself for making more than the average family of 4 in the United States.  Assuming taxes take up about 30% of your gross income, you are no left with $35,000/year.  If you divide that by twelve, you get $2,916/month, and half of that is $1,458.  This is your absolute highest expense you should pay for living in your dwelling, and most cities will easily accommodate a 1 bedroom apartment for this price.

When it comes to home ownership, make sure you take into consideration the hidden costs of upkeep into your monthly expense mix.  Say you have a $1,458 mortgage that includes your property taxes and home owner’s insurance, and now you have to replace your roof (a $15,000 job).  How are you going to fund this?  For home owner’s, that $1,458 should a monthly savings that you put away for home repairs and maintenance.  It might even be good for you to create a savings account specifically for home repairs that automatically links to your pay check through a direct deposit.  Thinking ahead like this will save you big time in the future.

You might be new to a city or starting out on your own.  Financial lessons such as “How much can I afford or should I spend on housing” are usually only learned the hard way.  I know, I’ve been there.  If you think about your income and do a little math, chances are you will be much better off than most people who first start out on their own. 

Wonderful Moment of the Day: Got my first A1C test back from being diagnosed a type 1 diabetic in October.  I got a 7.2% down from 11.5% two months prior (normal is below 7%).  On my way to living a healthy life!

Walking Off the "Cliff"

With all this talk about a "Fiscal Cliff", I'm sure many of you are wondering exactly what this might be all about.  Given the attention its garnered in the news recently, I thought it appropriate to discuss it and its potential impacts on the market.

So what is the fiscal cliff?  In short, it' a confluence of expiring tax reductions and government spending that when combined together could create enough of an impact to potentially send the US back into a recession.  In a little more detail, it is composed of the following:

1.) Income taxes will go up
2.) The capital gains tax rate will increase to 20%
3.) Dividend income will be taxed as normal income
4.) The estate tax will revert to a top tax rate of 55% with an exemption amount of $1 million
5.) The payroll tax cuts expire
6.) Automatic defense spending cuts kick in January 1st
7.) The US federal debt ceiling will need to be increased
8.) Other miscellaneous tax cuts will expire

So what does this mean to me?  Well, in the short run, expect your taxes to increase slightly (probably around 2%).  The sad thing about this is that the 2% increase coupled with about a 3% increase in the inflation rate means that if you don't get at least a 5% raise this year, then you will not be taking home as much money as you did the year before.  The other issues pretty much only involve you if your company has some connection with the federal government or if you trade a significant amount of money in stocks or other dividend related incomes. 

With that sad, not all is bad.  No politician wants this whole thing to erupt into a deep recession on their watch, so I suspect that many of them will put together some sort of comprise on the issues.  However, expect the markets to fluctuate significantly over the next month or two.  For long term investors like ourselves, this probably won't mean too much, but if you have some cash on the sidelines, it will definitely be a good time to buy some great stocks or mutual funds at bargain prices. 

Nobody is looking forward to another recession, but keep your eyes out for the diamonds in the rough.

Wonderful Moment of the Day: Turtle Truffle Pie!

We are Not in a Recession

Recession is a popular term in this day and age, and many people point to it as an accurate definition of what  the current state of the US economy is in.  I can't tell you how many times people have told me "recession this" and "recession that", as it is almost some sort of explanation for all their problems.  In fact, they even go out of their way to use some of the media bites they often hear and call the current market "the great recession".  These views are all incorrect.  In fact, we have been out of a recession since the 2nd quarter of 2009.

A recession by definition is two consecutive quarters of negative GDP growth.  As demonstrated by the chart to the right, the US has had positive GDP growth since 2009.  That said, it should also be noted that the US economy is not very robust and is only currently growing at about 2-4% per year.  

Alternatively, the economy has affected many individuals differently than others.  One of the most striking metrics for showing how the recent economy has affected others differently is the unemployment rate by education level.  Currently, those who have a 4 year college degree have an unemployment rate hovering anywhere between 4.5 and 6.8%.  Higher than the historical average, but pretty good overall.  The real situation comes with those who only have a high school degree.  For them, the unemployment rate is approximately 24%.  That seems almost absurd to think that 1 in 4 people without a college degree are unemployed.  Now if you take into consideration all the people who consider themselves underemployed (not working enough), and you have a far more significant problem.  

It's no wonder why many people consider the current economy to be in recession.  With unemployment high and affecting certain groups more adversely  people tend to find catchy words to classify the current state of things.  Instead of using recession, consider using the word "stagnation".  For example, "boy things are pretty bad in this stagnant economy".  Not only are your accurately describing the situation, but you might even wow some of your friends.

Wonderful Moment of the Day: Don't forget to vote tomorrow!

Student Loan Bubble Mimicking the Subprime Mortgage Bubble

If you went to college or some other form of higher education, there is no doubt that you have had or currently have student loan debt.  As I mentioned in a previous post, education costs are skyrocketing.  Prices are increasing so much so, that they are outpacing the healthcare industry.  No doubt that a major factor in this whole mess is the increased availability of student loans.  I came across this article while reading the news the other day, and it sheds some interesting light into how similar the student loan bubble is to the previous subprime mortgage bubble.

Our friends over at the Consumer Financial Protection Bureau (CFPB) have been receiving a number of complaints into predatory student loan practices, and have begun to investigate.  Their conclusion into the similarities with the subprime mortgage market are as follows:

1.) Misplaced Good Intentions - Society has put such a strong need for college and thus more people want to attend.  Since schools can only accept so many students, the easiest way to eliminate people from the applicant pool is to increase the price.

2.) Misleading Interest Rates - Borrowing when you're an adult is hard enough, but if you are a trusting and misinformed student, you could be really confused.  Someone might not know the difference between an adjustable rate, or fixed rate loan.  Even worse, it's often confusing on who you contact to understand how much debt at what interest rates you have.

3.) Lack of Scrutiny - Much like the subprime mortgage market of the early 2000's, there isn't many people looking over the legality and morality of student lending practices.

4.) Government Guarantees - With the implicit and more recently the explicit guarantees of the department of education, most lenders have become rather lax with their student lending practices.

5.) High Pressure Sales Tactics - Student loan originators make their money by having you sign up.  After they make the loan, it's not their problem anymore.  Therefore, any method or tactic to get you to sign up is a plus in their court.  This has lead to some pressure style lending.

And what are the differences to the subprime mortgage bubble:

1.) Size - Whereas the subprime mortgage bubble was approximately $600 billion, the student loan bubble is much smaller at about $20 billion.

2.) Can't Escape the Debt - Unlike a mortgage in which you could just walk away (and ruin your credit), student loans are not forgiven even in bankruptcy court.  Often times, these loans will literally follow you to the grave.

Do I think this bubble bursting will destroy the economy...no, but it will most likely have a significant effect in the near future.  If anything, hopefully some good lending practices come out of the whole foreseeable mess.

Wonderful Moment of the Day: Had an eye exam a couple days back, and there was basically no change in my prescription.

Your Own Personal Project Life Cycle

Have you ever thought about starting a project so much that you reached the point sheer excitement with every passing day?  No, well maybe you were just so excited that you couldn't wait to get started.  Finally, you reach the point where you dig in your heels and decide to dive right in.  Time goes on, and your excitement builds and builds.  The project continues along its merry way and everything seems good, until you reach your first hurdle.  Something bad or unforeseen happens and throws you off the rails.  You try your best but still have some setbacks.  After some hard work, you figure out a solution to your problem and your project continues, but you now have less enthusiasm than you previously had.  Time goes on, the project runs its course, and then you reach a point where you either abandon the project or phase it out.  Sound familiar?  This type of life cycle occurs in many different forms in life, and I submit the below model to help describe it:



A general Life Cycle Chart applied to business

 The chart listed is the general life cycle for most industries, however I believe it can apply to much more than just industries.  If you look at the subsequent stages (Embryonic, Growth, Shakeout, Mature, Decline), you can almost imagine a person's life cycle fitting into this category.  You are conceived, born and grow, experience a couple mistakes or setbacks in life, reach a state of maturity, and then gradually age and pass away. 

In the business world, each section can help describe where a particular industry is currently located.  This is often helpful when you are deciding whether an investment in a certain company is worth it.  CD makers are probably in the mature or declining end of the spectrum, whereas nanotech companies are most likely in the Embryonic stage as their just developing the technology for the industry. 

Many similarities from this chart can be drawn towards projects and experiences in your own life.  As the first scenario illustrated, projects tend to operate on the same life cycle whether it be work related or your own personal hobby or project.  Having the ability to understand where you reside on this curve will allow you to better understand the types of challenges ahead of you.  If you are designing some new invention and it's been smooth sailing thus far, chances are you are still in the Growth stage of your project and will soon meet the Shakeout phase.  Shakeouts in the business term generally indicate a series of industry bankruptcies and consolidations, but I'd like you to think of this in more broad terms as a challenge to your overall goal.  Everyone goes through these periods, and it's only through your drive and perseverance that you can overcome these.

The lesson in all of this is that it benefits you to think of project life cycles in the above format in order to understand what you should be focusing on.  Once you understand where you sit, you can begin to develop a strategy for the remainder of the plan.

Wonderful Moment of the Day: First day my wife is back from a conference after being away for 5 days!

Columbus and the Liquidity Trap

Happy Columbus Day my fellow readers! ...or is it Merry Columbus Day?  Either way, I'm sure you have your Columbus Day decorations all set for a wonderful holiday.  Unfortunately, only bankers and government workers get off today.  Let's not forget our Canadian friends as they celebrate their Thanksgiving, which is probably a more true to the real date of Thanksgiving since it is usually snowing in November.  As we look back towards the Western Civilization's discovery of the "New World", I want you to focus on your own sense of adventure and precisely in the spot that even the bravest of souls run for cover...that spot is your own wallet.  Let's talk about adding a little more risk to your life.

If you invest like me, more than likely you have some or most of your invested funds in the stock market.  With some economists calling the last decade the "lost decade" due to pretty much stagnate market growth, it's understandable why so many people are seeking out conservative and safe investments.  I can only imagine the folks who's retirement was was strong and in the market back in 2008 only to see half of their funds get completely demolished.  It's enough to run chills down your spine.

Due to this once in a lifetime market crash, people started fleeing the market and instead turned to safer investments such as CD's, money market funds, and savings accounts.  The Federal Reserve in their attempt to stimulate the economy is on its way to complete the third round of quantitative easing (a.k.a printing money).  This has essentially caused interest rates to fall through the floor, yet many people aren't investing in the market.  What the heck is going on?

Welcome the liquidity trap!!!

A representation of the liquidity trap

The above diagram essentially shows us the when we move from LM (liquidity of money) to LM', personal investment in savings increases and interest rates stay the same with little growth.  The problem is that we lost some of spending craze.

Wait a second here, I know what you're thinking.  I've been proclaiming the great word of saving to get your financial house in order, so what's wrong with this scenario.  The problem is that people are investing in the wrong kind of savings.  If you're not getting a return on your investment at least as large as the current inflation rate, then you are essentially loosing money. As of writing this post, annualized inflation is hovering around 1.69%, so if you're not making at least 1.69% after taxes and fees, you my friend are losing money.  

So what are we to do?  Well, what did Columbus do?  He ignored the critics and nay-sayers and sought out adventure.  Now, what he did was a little crazy and if it wasn't for the new world being in the way towards India, then Columbus and is men would have starved to depth, but I digress.

Instead of putting your money in a CD or Savings account, why not try an index fund.  I know there's risk, but life is risky and you won't get anywhere without taking chances.

Wonderful Moment of the Day: Bought 3 bags of cow manure for next year's garden!

The Savings Plateau

I figured it would be a great way to start the week with a nice math exercise.  Awhile back, I had to take part in a new home owner's workshop.  The reason for my attendance was because I was part of a first time home buying program through my bank and the state.  In order to fulfill my side of the agreement, I had to attend an all-day first time home-buyer workshop which focused on the financial and upkeep sides of owning a home.  Topics such as paying for your mortgage, knowing when to fix up a problem, and developing budgets were all discussed.  As you can imagine, this stuff was all pretty boring to me.

One aspect of the whole program bothered me though; the idea of savings accounts.  The instructor insisted that savings accounts were the best way to save up for large purchases.  Being a dutiful P-Money, I raised my hand and pointed out that most savings accounts are earning around 0.25% interest per year.  Assuming the inflation rate is about 3%, you actually lose approximately 2.75% of your money's per year by keeping it in a savings account.  The instructor promptly laughed at me, looked around at the other folks in attendance and said, "I don't know about you all, but to me, a dollar saved is a dollar earned".  As you can imagine, I was a little miffed, and was frustrated that this type of information was being taught.

Let's look at this concept another way with the scenario of someone who puts $100 a month away in a savings account.  They are probably sitting back and thinking that they are in fact doing a really good job, being responsible, and saving for a big purchase or two.  Even worse, what if the person in this case uses the savings account as their preferred medium for retirement savings.  Will they earn enough for their future.  Unfortunately, with returns below the inflation rate, this money will eventually reach a value plateau in conjunction with the amount the save each month.  The below chart illustrates how your money will reach an eventual plateau.

Savings Plateau

The blue line represents the $100/month savings deposit.  The red line represents the maximum value of the portfolio.  Each month, an additional $100 is added and the previous balance is multiplied by 97.25% (the inflation rate of 3% minus the savings account interest).  As you can see, the impact of that $100/month savings slowly deteriorates until it is only making up for the loss due to inflation.  The most this portfolio will ever me worth is $3,636.  An easier way to calculate this is to take your initial balance and divide it by (1-net inflation rate).  Needless to say, my point is that savings accounts are pretty terrible for any sort of long term savings plan (greater than 1 year).  Even CD's are pretty paltry at this point.  Even though there is more added risk, your best bet to at least keep up with inflation is to invest this money in something like TIPS which I mentioned before.

Investing can be really frustrating especially when you think you are doing such a good job.  Don't fret too much, reevaluate your situation and find a better alternative.

Good Luck!

Wonderful Moment of the Day: September weather, cool, and sunny.

How can a Factory Worker Earn More than a Doctor?

With all the talk about the college tuition bubble in the United States (link for further information), I started to   think whether it financially makes sense to compare 1 highly educated field of profession to that of something considered less skilled.  For this thought experiment, let us compare the first 10 years of post high school income potential for two very different people.  Raul just graduated from high school and is dutifully anxious to start his studies at Pre-Med U.  From there, he hopes to go on to medical school, attend a residency program, and start earning the big bucks.  John on the other hand has a different route in mind.  He has decided to work at his local ACME plant as a fork lift driver.  Let's compare their income over the course of 10 years and see who is better off.

First, we start with John since the math is a little easier.  John starts his job at ACME right after high school making $30,000/year.  This may be a little high, but we'll just assume he managed to acquire some overtime as well.  Now assuming a 3% cost of living adjustment each year for inflation (i.e. in year 2 John will be making 30,000 x 1.03 = 30,900, etc.), John will have cumulatively earned $343,916.  Seems pretty good.  This is also assuming John doesn't live below his means and invests for his future.  

Let's look at Raul now.  Right out of high school, Raul gets accepted into Pre-Med University where he pays a yearly tuition (we'll assume it's all inclusive at this point and nets out whatever summer job income Raul might acquire) of $20,000/year with a 3% COL adjustment.  Total debt over those 4 years equals $83,673. Now Raul gets accepted into medical school and starts with a tuition of $22,510 and over the course of 4 more years, acquires another $94,174 in debt.  Total debt before Raul even enters the workforce is now $177,847.  Economist have a little trick they like to add to this debt number which is the opportunity cost if he had instead became a factory worker and made $30,000/year.  Adding in the opportunity cost over that 8 year span to Raul's hefty debt load means that the true cost for all that education now equals $444,617.

So far, it doesn't look too good for Raul.  After 8 years of schooling, Raul now gets to earn some money via a residency program where he starts off making $45,500.  After 2 years of this work, we will have reached the 10 year mark since graduating high school.  Let's take stock of what we have thus far.  John has made $343,916, whereas Raul is in the negative by $352,252 meaning John made $696,168 more than Raul in the past decade.

In fact, becoming a doctor is so brutal, that Raul will not have earned more money than John until year 16 when Raul had been earning $170,000 per year for the last 5 years.  This is also assuming Raul doesn't pursue a specialty and has to spend more time as a fellow making low wages.  In the end, Raul will have made more money than John if they had both worked at least 16 years, however, here's the catch.  If John had been wise and religiously saved as much as possible all the while living very cheaply, he theoretically, could be retired at this point whereas Raul now has to work to pay off all that debt.  

This lifestyle for Raul also takes a dramatic toll on family life.  Potential children and marriage could be pushed off for years until Raul is done with school.  If you plan on having kids in your 20's, then becoming a doctor is probably not the best option for you.

The way life deals out our deck of cards can vary drastically from person to person.  Unfortunately, there's not much we can do about where we start, but we do have choices on how to live our life from that point on.  Being an honorable person, working hard, and practicing sound financial principles will put you on the right path towards a prosperous future.  Besides, who says Raul is living within his means?

Wonderful Moment of the Day - Planning my Great Aunt and Father's birthday parties at my house.

The Value of Index Funds: Part 2

Historical S&P 500 performance (thanks to Google Finance)

...and now for our dramatic conclusion of this series!

Previously, we left off on the cliffhanger on what should one invest in when it comes to their 401k or IRA?  Well, before I get into that, let me explain something else to you...I know, the suspense.  Whenever you look at different mutual funds, stock funds, or other types of investments in your 401k selection, I want you to draw your eye to a little section called "expense ratio".  This little expense is the management fee for your particular investment.  If it says something like 1%, then each year, the operators of this fund you have selected will take out 1% of your average assets for that year.  This can definitely lower your returns if you have a high expense ratio.  So what is the best investment you can select, while still keeping the expense ratio low?

INDEX FUNDS!!!


An index fund is a collection of stocks that tries to mimic a particular index like the S&P 500 or Dow Jones Industrial Average.  This investment you should select is essentially the market growth rate.  If you remember my post on beta, than you'll know that beating the market rate of return without taking on more risk is almost impossible in the long run.  Look in your company's investment choices and see if there is anything close to an index fund.  On top of the best returns you can expect, these type of funds are usually very hands off to run, and therefore are very cheap to you.  Whereas the typical mutual fund can have an expense ratio up to 2.5%, the expense ratio in an index fund is usually around 0.04%!  These cheaper fees go directly into your pocket.


Here are some other options for index funds that usually perform 1-2% better in the long run than a traditional index fund.  Company 401k programs usually don't include these, so you are more likely to use them in an IRA.  A simple search on any of these topics will bring up a series of funds to invest.


Equally Weighted Index Funds - Instead of being weighted by market cap (or size of the stock), these funds hold all companies in say the S&P equally as a portion of total fund's balance.  The benefit here is that it allows small cap companies to have much more influence over the fund


Fundamentally Weighted Index Funds - These take the same set of S&P stocks and weights them by economic size which includes factors such as 5 year averages of book value, cash flow, dividends, and sales.     The result is something similar to a market cap weighted index fund, but brings in a more true look at each company's economic strength.  This allows you to invest more in the better companies.


Value Weighted Index Funds - These funds weight the stocks by their relative value based on their stock price relative to their earnings.  The goal here is to own more of the stocks measured to be undervalued, thereby maximizing returns.


Any one of these investments will take care of you throughout your life, but just remember, these funds move with the craziness of the market.  In the short term (less than 5 years), you're bound to see dramatic ups and downs if your fund's value.  Just know that you are in it for the long haul and it will pay off.

Wonderful Moment of the Day: Eating a homemade chocolate covered marshmallow!