Myths On Money

This post is written in response to a question that a friend of mine asked. Here is his question:

Question:

When I think about rent VS buying I often think back to those dental students in [Ohio]. They bought condos, lived in them for a few years and then sold them. In most cases they sold them for a lot more than they paid because some of them made improvements to the property. Even the ones that didn’t were able to sell them for about 5-10k more than they paid. Rent would have to pretty low to make it better than buying from limited perspective.

Please show me where my thinking is wrong on that. I’m going to be in a position to make the choice between buying and renting quite soon. I always thought buying was the answer, but now I’m confused.

Before reading on, you may want to reread the post that illicited this comment. It may also be useful to consider all the cash flows.

Answer:

• Don’t Rush
• Consider All the Costs
• An Example
• The Nutshell

Don’t Rush

First off, do not think that I am trying to convince people not to buy a home. That’s not my point at all. Buying a home is a great way to build your wealth, and over the long term will almost certainly be better than renting. The point I am shooting for here is that people should not RUSH into buying a home just because REALTORs are advertising that renting is a waste of money. Rushing into any decision is a great way to make the wrong one. If you buy a home without considering every cost associated with buying a home, then you may find yourself overextended.

Homeownership is a great financial decision. But, it also happens to be the single biggest financial decision you will ever make. The reason that my posts seems in favor of renting is because there is no end to the people who are willing to promote homeownership, regardless of the cost to you. I think that buying a home is the best decision for most people. But it must be done under the right circumstances and at the right time, with a careful eye for the terms of the loan. More on the terms of the loan in a later post.

The problem with most people’s financial decision making process is that they limit their perspective. If you only look at the gain at the time of sale of the home, and ignore all other expenses and gains, then you will make a poor financial decision.

Consider all the costs

So what are the extra costs that people do not usually think about? First, closing costs. Closing costs typically will cost the buyer 3-7% of the amount of the loan. Next, selling costs. Selling costs vary a lot, and sometimes do not even exist, but if they do exist, then they will cut into your gains when you sell the home. Finally you have expenses that you incur while owning the home. These include property taxes, cost of maintenance and repairs, homeowner association fees, mortgage insurance, property and liability insurance, etc. Most experts agree that these costs usually amount to about 40% of mortgage payment.

An example

A hard, numbers-oriented example. Suppose a dental student buys a $150,000 condo, and lives in it for 5 years. He pays 9% interest on his mortgage. His condo appreciates at a rate of 6% per year. His monthly payment is $1,200, so his property taxes, condo fees, insurance premiums, and other expenses total $480 (40% * $1,200) each month. He has no selling costs. So, after 5 years, what did he gain? His condo’s appreciated value is $200,000, so he has gained $50,000 in only 5 years! If you ignore the costs, then you think, “Wow, he just got $50,000. I’m never renting again!” But what did he pay? He has paid $67,000 in interest, $29,000 in monthly expenses, and $4,500 in closing costs. So his total cost of owning the condo is $100,500 for those 5 years. So, did he make $50,000? Nope. He LOST $50,000.

But wait, we’re not done. You think, “$50,000 lost? I’m never buying a home!” But that’s not true. What would you have lost if you had rented? Suppose the student could have rented a comparable apartment for $1,200/month. So what did he gain? Nothing. No income. What did he spend? $72,000 ($1,200/month * 60 months). So the renter LOST $72,000.

So the student should buy, right? Well, if you limit your perspective to just that, then yeah, he would want to buy the condo. But there is a problem with this analysis. The problem is that the condo buyer has spent $1,680 a month (mortgage payment plus other expenses), while the renter has only spent $1,200 a month. Making a financial decision based upon different expenses like that is like comparing a motorcycle to a car on the basis of horsepower. A motorcycle will have less horsepower but be faster, right? The difference is in the weight of the vehicle.

Same thing here. So, what if the renter also spent $1,680? $1,200 in rent, and $480 to be saved. Even if his saved money earns no interest, he would have $29,000 in the bank. So, the renter would have lost $75,000 in rent, and gained $29,000 in savings, so his total loss would be $44,000. So, in this case, the renter would be better off than the condo owner.

But that only applies to THIS EXACT SITUATION. What if the appreciation of the condo were higher? Then buying is the better decision. What if the renter can earn a good interest rate on his savings? Then the renter wins. What if the monthly expenses of ownership are lower than 40% ? Then the buyer might be better off. This is why finance is a 4-year degree. This is why they offer masters and PHds in finance. Every situation is different. Every situation needs to be carefully analyzed. And it can get very complex, very quickly.

The Nutshell

You probably should buy if:

1. Real estate prices are appreciating at a high rate.
2. You can afford to pay more than the mortgage payment on the house (40% more).
3. You plan to be in the home at least 5 years.

You should probably rent if:

1. The mortgage payment is barely affordable.
2. You have the opportunity to save your money at a decent interest rate.
3. Local real estate prices have historically risen slowly.

If your situation falls somewhere in between these two categories, then a more thorough analysis is needed to give an accurate decision. If you can do this yourself, then great. If you can’t, you could find someone trained in finance to help, or you could just eyeball it. Just remember to include all of the relevant benefits and costs and you should come out fairly close. Remember that 5 years is a typical time frame for buying to be profitable. If you don’t know anyone who can run the numbers, just let me know and I would be glad to help.

Lastly, remember a financial loss is sometimes worth the satisfaction of home ownership!

A Shocking Discovery

I was recently watching a financial self-help video from a very popular finance guru, and I was shocked to hear this person say that buying a home was a great investment because it would yield a very high return in the first year that it was owned, and that it would continue to give high investment returns throughout the life of the home. This is surprising, because any one well grounded in finance would be able to tell you that a home is a very very bad investment for the first 3-5 years. It is not until after that time range that the home’s appreciation will begin to actually give a positive investment return.

How Could They Miss?

If the point of the high cost of a mortgage and the need for longevity in a mortgage are such a fundamental principles, then how could the guru have possibly missed it? The answer lies in the cash flows the guru used for the analysis. See, from a certain perspective, the guru was right. But it’s not the whole story. It’s kind of like in Star Wars, when Luke accuses Obi-wan of lying about his father’s death. Obi-wan tells Luke that what Obi-wan’s statement that Luke’s father had died was true, from a certain point of view. And it was. But did Luke realize that he was not hearing what he thought he was hearing? No. He thought that his father was physically dead, while Obi-wan meant that he was dead in a less literal sense. So, while what Obi-wan had said was true from a certain perspective, it certainly succeeded in deceiving Luke. Such is often the case in finance. What you hear may be true from a certain perspective, but it is still deceptive and does not tell the whole story of what is happening to your wealth.

So What Is Happening?

Before I can answer the question of what is really happening and what return you are getting from your investment in your home that first year, I first need to explain a financial tool called a cash-flow diagram. The diagram is fairly simple: it consists of a horizontal line with vertical hash marks all along it. Each hash mark corresponds to a specific time period (ie a month, a year, etc). The diagram must be consistent in that each hash mark must represent the exact same amount of time that each other hash mark represents. On each hash mark, the relative cash flows for that period of time are listed. A cash-flow diagram helps us visualize where the money is flowing, when it is flowing, and which way it is flowing (in to your pocketbook or out of your pocketbook).

With that brief introduction, let’s take a look at the two cash-flow diagrams below. Here’s the scenario: you make a $10,000 down payment on a $160,000 house, meaning that you must borrow the remaining $150,000. Closing costs (typically ranging from 3-5 percent of the balance of the loan) come out to $6,000, a conservative 3% of the loan amount. The home appreciates 4% the first year that it is owned. The top diagram shows the full, actual reality of what the calculation of mortgage returns would look like; the bottom one illustrates a diagram like the one the guru was using for their analysis.

The areas highlighted in yellow are cash-flows which the guru neglected to account for. Notice that in the top analysis, we have taken into consideration EVERY expense and EVERY income associated with the mortgage. In both cases, the final amount of equity in the home that you get when you sell the home is the same, but the amount of the expense is different. The difference in the “investment return” is 138%!

Okay, time to break out the ol’ thinking cap. A negative investment return means that you are losing money at that particular rate. In order to get an idea of the implications of this loan, think of the cash-flows above as a savings account. If you put $16,000 (the $10,000 down payment plus the closing costs) in a savings account today, and deposited $997.95 into that account every month and you only had $17,923.71 in that bank account at the end of the year, what would you think? You deposited almost $38,000 between the initial deposit and the monthly deposits. And at the end of a year, you have less than half of what you deposited in the first place. Wouldn’t that make you mad? I know I would be calling the bank and giving them an earful if my savings account exhibited such behavior!

This is why it is so very very important to consider all cash-flows associated with a purchase/investment. I am not trying to say that buying a home is a bad thing to do. I am only trying to show the importance of understanding and applying the effects of all relevant cash-flows when considering an investment. Suppose you had gone in to the bank and your mortgage officer had told you that you could earn a 79% return on your home in one year. Before you read this post, you would probably have believed him, wouldn’t you? But that fact remains that, while the equity growth from $10,000 to $18,000 is indeed 79%, it does not really tell the whole truth. What about the expense of closing costs? What about the interest expense? Shouldn’t that be considered? Isn’t that important? Doesn’t that strongly affect the investment returns your home is providing? Absolutely. So before you jump into a financial decision, stop and ask yourself the following questions: (1) What will it cost me, both now and in the future? and (2) What will I get (income) from it, both now and in the future? If you do that, you will find yourself making much better financial decisions. And if you can’t figure it out, or what a specific calculation in regards to your decision, then ask a (unbiased!) financial professional for help.

This post is a follow-up for MythTip: Recession Part 1. If you are nearing the time when you want to pull out your money from your investments, then bonds might be a good way to take advantage of a down market and lock in good interest rates for the future. This post will take a look at the interest rate gains that bonds can provide, and what to look for in a bond.

What is a Bond?

A bond is kind of like the opposite of a stock. When you buy a stock, you buy a piece of the ownership of the company. When you buy a bond, you are lending money to a company. When you buy a bond, you receive interest on the money that you lend to the company. These payments are typically made on either an annual or semi-annual basis, although other payment arrangements certainly exist. When the bond matures (read below), you get your full purchase price back.

Why Invest in Bonds

The return that bonds provide are dependant on a lot of factors, but many times they will be good investments when stocks are poor investments. Bonds can provide gains both from the interest paid to the bondholder and from potential increases in the price of the bond. This dual gains capacity is what really provides bonds with the ability to provide strong returns in a down market. Consider adding bonds to your portfolio when the stock market is performing poorly.

Bond Language

The words used in describing bonds and the returns they provide can seem like a totally foreign language. Here are the important terms you need to know about bonds. These will help smooth the future discussion.

• Price: This is the price you pay for the bond. Bonds can sell at face value, a discount, or a premium. More on bond pricing in the next mythtip in this series.
• Coupon Rate: This is the interest rate that the bond will pay. It is a percentage of the original price of the bond that is paid each year. i.e. a bond that originally sold for $1,000 with a 7% coupon rate will pay $70 per year.
• Yield to Maturity (YTM): This is the effective interest rate that the bond will pay if you buy it at it’s current price.
• Callable: A bond that is callable can be recalled by the company any time if interest rates for bonds drop. A callable bond is significantly less preferable than a non-callable bond because the call option makes it so that if you are getting a high return, the company can take that high return away from you an replace it with a lower return.
• Rating: This is very important. There are several companies that look at all the bonds that are issued and rate the riskiness of the bond based upon the relative strength of the company that issued the bond. Ratings are alphabetical: AAA is the best, then AA, A, BBB, BB, B, etc. Bonds with a rating below BBB are considered junk bonds, and are significantly riskier than bonds with ratings higher than BBB. Bonds with ratings higher than BBB are considered investment grade. It is not recommended for anyone except serious speculators to buy junk bonds.
• Maturity: This is the time period over which the bond will pay interest. At the end of the maturity period, the company will return the purchase price of the bond.

How They Work

Bonds are very complex. Many finance students struggle to understand the financial calculations and the logic involved with bonds. YTM calculations are among the more difficult calculations in all of finance because the logic behind the calculation can be quite confusing. Fortunately, you do not have to be able to make bond calculations in order to be able to make good bond-purchase decisions. Let’s take a look at an acutal bond today to help you get an understanding of what to look for in a bond.

ALLTEL corporation issued this bond in June of 2002. The original price was $1,000 per bond, the coupon rate is 7.875%, and the maturity date is July 2032. So this bond will pay whomever holds the bond $78.75 each year. Today, the price of the bond is $872.50. This bond is selling at a discount because current coupon rates for a comparable bond today are higher than the coupon rate of this bond (if that didn’t make sense, don’t worry, I’ll address bond pricing in the next post). The bond is rated “A”, so it is of moderate-to-low risk relative to other investment grade bonds. This bond is NOT callable.

Now let’s look at the YTM. The YTM for this bond is 9.816%. This is the important factor. The YTM determines how what interest rate you will actually earn if you buy the bond today. The reason the YTM is higher than the coupon rate is because the bond is selling at a discount. You will only have to invest $872.50 in order to get $72.50 per year. That is a 9.816% return. And this return is guaranteed for as long as the company is in business. In July 2032, you would get the original purchase price ($1,000) back. That is not a bad investment by any stretch of the imagination.

Bond Basics Summary

There are certainly times when bonds are more attractive investments than at other times. Consider bonds at times when the stock market is performing poorly. When stocks are doing poorly, people begin moving their money into bonds. This increases the demand for bonds and forces the interest rates on bonds up. But don’t forget that when stocks are low, it’s also a good time to buy stocks. Either way could be profitable, but bonds are certainly the less volatile way to attempt to cash in on a down market. When looking for a bond, look for a high YTM with a good rating. If you can find a bond that meets both criteria, then look for a non-callable bond. Also keep an eye on the maturity date. Longer maturity dates can be good to lock in your return for a longer period of time, but they also tend to have lower returns, so keep an eye on that as well.

What is a Recession?

A recession is technically defined as two or more consecutive quarters of declining GDP in an economy. GDP is a measure of all income for the economy. For most people, though, a recession can be defined more easily. It is any time when jobs are scarce, companies are failing, stocks are plummeting, and things are generally not-so-hot in the economy. When people hear the word recession, they tend to feel pangs of fear and uncertainty. Will their job be cut? Will their savings hit the tank? Will they lose their home? These are valid fears. And, while there is not much to be done about the potential for job losses and your home’s safety depends upon your past financial behavior there are ways that you can protect your investments when the market is down. There even ways to improve your portfolio over the long run. This post is the first of a short series about how to deal with a recession. This post will focus on what you can do to protect your funds that are held in stocks.

MythTip 1: Avoid the Problem

Just get out before the market crashes. This one seems obvious, but can be very difficult to implement because no one really know exactly when the market will take a dive. It is nevertheless the easiest way to deal with a down market. If you suspect the market could be going down for the count, then get out while your stock values are still high.

Here is a very useful tip for determining when to get out of the market and when to get in. The Federal Reserve, among other things, determines what the base interest rate for the economy is going to be. Theoretically, the members of the Federal Reserve Board should be among the best economists in the country, and have access to the most information pertaining to the economy. When the Fed reduces the base interest rate three times in a row, it is a signal that they expect troubled times ahead and you should get out of the market. Just look at what they did for interest rates recently. Since June of 2006, the Fed has lowered interest rates 10 consecutive times in efforts to curtail the emerging recession. If you had pulled your money out of the market and into a cash account after the third consecutive interest rate drop on October 31, 2007, you would have pulled out when the Dow had a value of 13,930 and avoided the plunge to 8,577 (the closing value of the Dow on October 15, 2008). You would have dodged a loss of value of 38%. When do you get back in? When the Fed raises interest rates 3 consecutive times. This strategy is not the most precise, but it is the easiest to understand and implement, and it works. For more information on the Fed and it’s functions, read this post.

MythTip 2: Pick Your Circumstance

I know what you’re thinking right now. “That was no help, my accounts are already down!” Right? For most people, this is the case. It is too late already in this particular recession to pull out. It just is. But that does not mean that you should not pull out. It also does not mean that you should stay in the market. All it means is that you have to now decide from the following options which best suits your circumstances.

1. Close your eyes and keep your faith. This strategy is primarily for people that have at least 15 years before they plan on cashing in their accounts. If you fit into this group, then here is what you do. You keep investing. Keep putting money into the market. If you have a well diversified portfolio, then your accounts will gain their value back and you will not want to miss out on investing when the market is in its current condition. What’s that you say? The market is still struggling? Why should you put money into it only to have a fair chance of it going down in value again? The answer is so very simple, you may be astonished. The cardinal rule of investing is this: Buy low, sell high. Simple, right? It is simple. But it can be very hard, and it requires courage and faith in the economy. Right now, stocks are CHEAP. VERY cheap. Many stocks are at 50% or less of the value they held only a year ago. Can you say, “Blue light special on aisle 4″? For the same amount of money, you can get almost twice as many stocks as you could have a year ago. What does that mean? It means that if you buy these half-off stocks, then when they rise again to more normal levels, you get to keep the increase in value.

   It will be hard to watch your accounts continue to dwindle. You may wonder why you are putting money into something that is losing value. In order to help you sleep at night, I suggest not looking at your balances each month/quarter, and instead focusing your attention on the future. You are investing for the long-term. Don’t let the bumps and dips of the present sway you from your ultimate goal. If you continue to invest even when the market is down, you WILL get the end result you want. Remember that a loss in the stock market is only a loss when it is realized. To realize a loss means that you sold something for less than you paid for it. If you hold the stocks that are low in value, your account value will look low on paper, but you will not have actually lost any money at all! Think of it this way: suppose you bought a Michael Jordan rookie card for $200. The next year, you want to sell your card, but find that it can only be sold for $100. You might be upset and think you have lost $100. However, you do not need to sell your card, so you decide to hold on to it for a while longer. In fact, you decide that since cards are so cheap right now, you also want to get a Magic Johnson rookie card for $100. Now you have two rookie cards that you paid $300 total for. The next year, you find that both of your cards have regained their value and are now worth $200 each. You sell them and gleefully pocket $100. Did you lose money when your MJ card was low in value? Nope. If you have sold the card for $100, then you would have lost money, but since you held the card until it rose in value again, you didn’t actually lose any money at all. And, since you bought the Magic Johnson card when it was cheap, you actually managed to profit from the slump in basketball card values! The same holds for stocks. If you sell them after a market crash, then you lose money. If you hold the stocks until they return to their original value, then you have lost nothing. And if you buy stocks when they are low and hold them until they are high, then you have made money. For more information on the benefits of continuing your investments, read my post on dollar-cost averaging.

   Please note: this strategy is effective ONLY for people who have many years of investing ahead of them. People who need their funds in 5 or 10 years may not be able to afford to wait for the market to rebound. Do not fear, the market will rebound. If you want/need your investment money that soon, they you probably should not use this strategy, because you may lose more money before you begin gaining. Those with longer investment horizons can afford those losses but you cannot. For you, a more conservative approach is in order.

2. Play it Safe. This strategy is for those who need to preserve the value of their accounts now because they need the money soon. It also is a good strategy for people who simply cannot bear to watch their account values drop any further. This strategy is a little simpler to understand. Just pull your money out of the market. That simple.

   The problem is, where do you put it? I suggest using a cash account. What is a cash account? It is any account with a guaranteed positive return. This includes: savings accounts, checking accounts, CD’s, some money market mutual funds, and a plethora of other accounts that are essentially the same but have dozens of unique names. Most brokerages actually have a high-yield money market account that they will put your money into whenever you pull it out of stocks. The yields on these are fairly competitive with any other high-yield savings account you might find at your local bank. While the returns are low (typically 2-5%), they are MUCH better than sustaining losses. By pulling out, you can maintain the value that you have without risk of losing any more.

   Want to take advantage of the low price of stocks? Don’t worry, if you follow this strategy, you still have a chance of getting the big returns. You can keep making your regular deposits into your investment account (those funds will simply be added to the cash account). When the stock market looks to be picking up, you simply get back into the market. But be careful. Sometimes the market seems to recover, only to drop again a week later. To be safe, do not get back into the market until the Fed raises interest rates at least twice in a row. Three times to be extra safe. While you probably will miss the very best days to be in the market that the people who stay in the market get to cash in on, you can still capture much of the gain in value that the market experiences as it surges out of recession.