Myths On Money

The Business Cycle

In economics, the business cycle refers to the tendency of the conomy to fluctuate up and down from growth to recession and back again. It is a pattern that is notable throughout all of recorded economics. The economy flips back and forth, from the roaring 20′s to the Great Depression, back up in World War 2, down again in the 70′s, up again in the 60′s down again in the early 80′s, up again in the late 90′s, down in the early 21st century, up again for just a couple years, and now down again. A downturn is almost always followed by an upturn, and upturns are invariably followed by downturns. On very rare occasions (only a few times in all of history), an economy can take a downturn and never recover, leading to the destruction of the nation supported by that economy (a classic example is the fall of the Roman Empire).

The Personal Money Cycle

In like manner, our individual financial situation has a tendency to flip from prosperity to disaster and (hopefully) back again. Like economies, it is possible for our personal finances to take such a devastating downturn as to render them unable to recover. This is what insurance is for. The most catastrophic events can have their severity reduced significantly simply by purchasing proper insurance. Death of the sole bread-winner, long-term disability, and devastating medical bills are examples of the types of tragedies that can ruin our entire financial future if not properly insured against.

But what about the smaller, more routine downturns, like unexpected unemployment or an unexpected increase in living expense (like rising gas prices)? How can you be prepared for such events? There usually is no insurance that you can buy to protect you from such downturns. So what can you do?

This is where the emergency fund can form a key role in your financial peace of mind. Examine the chart below. The red line represents the financial happiness a person without an emergency fund experiences through their money; the blue represents the financial happiness a person who saves up an emergency fund when times are good. For the unprepared individual, their financial happiness tends to cycle through ups and downs. When times are good, they happily spend all that they have and really get the most out of their prosperity. But, when a tragedy strikes and suddenly they lose the prosperity they once enjoyed, anxiety and fear enter the picture. How will they pay their bills, buy groceries, make the mortgage payment? Eventually, though, the problem corrects itself (ie a new job is found) and the problems they faced begin to be corrected. eventually, they get back to living the good life, enjoying their prosperity. Until life deals them the next unexpected card and they have to endure the whole ordeal again.

Now, let’s consider the situation of an individual who has established an emergency fund. When times are good, they save some of their money. This effectively lowers the pleasure they derive from their prosperity, relative to their friends who do not have emergency savings. Their friends mock their “frugality” and urge them to increase their spending so that they can be happy. But the saver has a plan; the saver is preparing to have a happy tomorrow, not just a happy today. Before the saver know it, tragedy strikes and he suddenly finds himself without income sufficient to meet his needs. But he doesn’t sweat it because he has some savings to fall back on. So, while his friends endure the anxiety, fear, and depression of trying to pay the bills, the saver experiences very little, if any, drop in his standard of living. There is no fear for the mortgage, no creditors banging on his door and calling on his phone. He can make all his payments to everyone he owes, and can still feed his family and provide for their needs. During these periods of downturn, the saver ceases to save, he instead begins to use his savings. Then, once the crisis has passed and the saver again finds himself able to sustain himself with his income, he returns to his savings habit and replenishes his emergency fund. For the next unexpected turn is somewhere down the road, of that, he is certain.

A Different Timescale

As I was preparing this post, my wife made a very astute observation. Don’t we see this cycle repeating itself EVERY SINGLE MONTH for some people? When people live “paycheck-to-paycheck”, they live within a rapidly repeating version of this cycle. Each month, they get their paycheck and quickly spend it all. Once the money is gone, they enter the anxiety and fear phase. They have no money left with which to buy anything (and their credit cards may be maxed out already!), and so they live in fear of having to make an unexpected expense. But then, the next paycheck comes in and they are happy again and they go out and celebrate by spending it all. Thus the cycle perpetuates itself.

I hope that you can see how an emergency fund can alleviate most of the stress that comes when life deals us an unexpected downturn. Notice in the chart that the saver winds up in the same place as the spender, he just does so without any of the problems that come from life’s little surprises. The stability it provides can make life so much more enjoyable.

The Word on the Street:

Everyone wants to have possessions as fine and expensive as their neighbors do. Most people try to spend in such a way as to ensure that they appear no different than “everyone else”.
 

The Truth:

While it is totally possible to keep up with the Jones’, do not do so without an understanding of where it will lead.

The Destination

 
If you keep up with the Jones’, that means that you must be on the same track. Where the Jones’ track leads, you will go. So what exactly do the Jones’ get in the end? John Cummuta, in his Transforming Debt into Wealth system, cited the following fact:

95% of American’s FAIL to achieve a true definition of finanical independance, where they are independent of having to work or get charity or help from the government or help from family members…What does that mean? It means that most people, the Jones’ for example, are doing it wrong…The Jones’ are chasing a barely achievable, unsustainable model of success.

If the 5% who achieve financial independance are spread equally among people of all income levels, that implies that only 2.5% of people with above average income (about $60,000 in the U.S. for a family in 2006) actually become financially independant. Why not? Because they spend all their money before they have a chance to earn it trying to buy a lifestyle that they cannot yet afford. So, you can keep up with the Jones’ if you want, but beware: they may be leading you into bankruptcy.

The Word on the Street:

Everyone seems to believe that the only way to get good credit to qualify for a necessary loan (usually a mortgage), they have to use credit cards, get auto loans, etc in order to get a good interest rate on future loans.

The Truth:

Your history of repaying debts is a relatively small portion of the considerations lenders make before offering to extend credit to a potential borrower. In short, a bad credit history can sink your hopes of getting a good loan, and a good credit history can certainly help, but a neutral (or non-existant) credit history will not preclude you from qualifying for a loan when it really matters because there are other, more important considerations.

Doubt me? Let’s take a look at the attributes and procedures used by lenders to determine a would-be borrower’s credit-worthiness.

The Three “C’s”

The only concern of the lender is your ability to repay the loan along with any related expenses. To assess this ability, lenders often look at the three C’s of credit:

Character

How you have handled yourself in previous financial dealings. This includes not only your credit history, but how reliably you have paid all of your financial obligations, including rent, utilities, alimony, etc. Your credit character helps the lender get an idea of whether or not you WILL repay the debt.

Capacity

Refers to your ability to repay debt out of your future income. Here, the lender looks not only at your income but also at future commitments that might restrict it. These commitments are almost always debts, although some commitments are non-debt related (such as alimony). Your credit capacity gives the lender an idea of whether or not you CAN repay the debt. This differs from the character portion of the analysis, where they simply want to see if you have been reliable in the past. In most cases, your credit capacity will be the most important factor that determines whether or not you qualify for a loan, for reasons that I hope will become obvious with an example.

Suppose you have the opportunity to loan money to one of two people. The first borrower, Jack, has a great credit history. He has carried lots of debt for a long time, and has never once failed to make his payments. The problem is, Jack spends most of his income on debt payments, and barely has enough extra income to make payments on your loan. The other borrower, Minnie, has only a small credit history. She has not debts whatsoever right now. A quick check show you that she has been very consistent in paying rent and utilities, indicating that she takes her financial obligations seriously despite having rarely incurred such obligations. She has plenty of money each month with which to repay you. Who would you give your money to? Personally, I would give it to Minnie because she actually has the ability to repay, and has not demonstrated a propensity for fiscal irresponsibility. Jack has managed his obligations well, but he has no wiggle room for your loan. The slightest mishap in his finances would cause him to lose the ability to repay you.

Capital

Refers to your financial strength, usually measured by net worth. Net worth is a financial term that simply means how much you own (assets) minus how much you owe (debts or liabilities). Essentially, this is a measure of how much money you would have left if you were to sell everything you own and repay all of your debts. This is an important consideration when looking at whether or not to lend money. If the borrower has extra funds or assets that he could potentially sell to repay the lender, then this reduces the risk that the lender will never get their money back in the event the borrower faces financial difficulty. Like the credit capacity rating, the credit capital rating measures whether or not you CAN repay the debt.

As you can see, only one of the three factors considered above pertain to your credit history and whether or not you WILL repay the loan. The lender is much more concerned about whether or not you CAN repay the loan, as measured by the capacity and capital components of credit-worthiness. Notice also that use of past debt is only a portion of the character component. In essence, it might be said that your use of credit in the past constitutes less than 33% of the considerations made when you apply for a loan.

This is not to downplay the importance of the character component. Certainly, if you took a test and missed 33% of the questions, you might be a bit disappointed in your score(well, I guess it depends a bit on which subject the test covered….66% might be a great score for some classes!). But it is important to realize that you do not have to go into debt in order to satisfy the charcter requirements. By simply showing that you have handled your finances responsibly, you can satisfy the character component.

How can you build your character score without going into debt? First is to take care of your obligations. Everyone has financial obligations, even if they have no debt. Pay your rent, make your utility payments, pay your taxes (and on time!). Next, take advantage of the fact that the three components are very interrelated. Your character score can be much improved by simply taking care of your capacity and capital scores. Think about it; if you see someone who has taken on a great deal of debt, and has maxed out credit cards, would it surprise you to learn that they had been evicted several times from various apartments? It wouldn’t surprise me. What if you saw someone who had a wad of cash in savings and whose income far outstripped their living expenses? Would you consider that person likely to take care of their financial obligations? I certainly would, and I would be much more inclined to lend that person money even if they had no past history of repaying debts. That person has improved their capacity and captial scores to the point where few would doubt their willingness to pay off their debts. And that’s what lender’s really want, isn’t it?

Risk and Return

The topic of investment risk and investment return could occupy an entire college semester (I have, in fact, attended just such a class). For the purpose of this post, I will just touch lightly on this topic to help you get an idea of how and why banks charge higher interest rates to some people, and not to others.

It is one of the most, if not the absolute most, fundamental principles of investing that higher returns cannot be gained without taking greater risk. In the stock market, higher risk is usually found in the volatility of a given stock; the chance it might go up by a large amount is offset by the fact that it might also go down by a huge amount. This principle becomes intuitive when we pull it out of the financial arena and bring it home in terms we see every day.

Suppose you were in Las Vegas with $100 in hand, and were considering which game upon which to place your bet. In one game, the dealer draws a card from the deck. If the suit of the card is a spade or club, then you win $200. If it is a heart or diamond, you win nothing. In the other game, a giant wheel with 100 slots in it is spun. If it lands on the number you picked, you win $200. Which game would you play? You would play the card game because it gives you the best chance (50% compared to 1%) of winning the same prize. Now let’s change the scenario a bit. Suppose instead of winning $200 on the wheel game, you had a chance of winning $1 million dollars. Now which game would you choose? It’s a harder choice, isn’t it? The card game is far less risky (because you have a 50/50 chance of winning), but the wheel game has a far greater reward. You would expect the games to be structured more like this because it doesn’t make sense for you to take more risk for the same reward, when you could take less risk and still get the same reward. This is the relationship between risk and reward(return), and it holds true in Vegas just as easily as it holds true in the stock market, the bond market, or even the mortgage market.

You are an Investment

You need to keep in mind that when you apply for a loan, the lender is not looking at YOU and deciding if YOU can have the money or not. They are looking at an investment, pure and simple. They want to invest their money in you. If you are a risky investment (i.e. with a low chance of repaying), then they will want a greater return in order to justify investing in you. They get that return by offering you a higher interest rate than they would to someone who was “less risky”. That is why it is important to make yourself appear as though you can repay them. If you look like you can repay them, then you most certainly can because lenders are very thorough and will find out if you cannot repay. So, when trying to qualify for a great interest rate on a loan, just think about what YOU would want to see in someone that you were considering loaning money to. Chances are, your lender will be looking for much the same thing.

The Word on the Street

There is a general opinion (fostered by aggressive advertising campaigns) that using credit will let the borrower have goods and services they could not otherwise afford, and thus improve their quality of life.

The Truth:

Credit, whether a mortgage, credit card, home equity loan, installment loan (ie making payments on a tv, washing machine, sofa, etc.) reduces your standard of living by taking money out of your pocket.

Doubt me? Let’s take a look at some very simple principles of credit and interest and see if I am right.

Credit Costs

Let’s stop for a moment and really think carefully about what credit is. Buying on credit means that someone else pays for your purchase, and then you pay them back for it. This is, of course, not a free service. The fee charged by credit companies is given a fancy name; they call it interest.

When you slap down a credit card, or get a new bed on installment payments, you are agreeing to pay more for the item than the sales price. Think about it: if you buy a $500 TV and pay cash, you will pay $500 for the TV, and no more. If you pay on credit, then you get the TV for $50/month for 12 months. $50/month x 12 months = $600. You just paid $600 for a TV that only cost $500 to begin with. You lost $100. So, while you may have the TV a few months before your friend (who paid cash), he will have not only a TV, but also a DVD player. So whose quality of life is higher? You, with your TV and $100 lost on interest, or your friend, with a TV and a $100 DVD player?

This is the great trick that marketers play on consumers. When was the last time you saw a car commercial where they told you the purchase price of the car? They are very rare. Why? Because the dealership doesn’t want you to pay for the car upfront; they want you to finance the car (or better yet, lease it!). They make much more money that way. Can you blame them? What if you were selling your car? Would you prefer $1000 up front, or payments of $200/month for 7 months? In some situations, you may need the cash immediatley, but if you can wait for the money and get an extra $400 for your patience, wouldn’t you do it? So the next time you are tempted to buy something on credit, just think: how much interest will I pay, and if I don’t pay interest, what could I do with that money instead?