Myths On Money

Question:

My bank is currently offering a 3 month CD that pays a 4% APR. Does that mean if I buy a $5,000 CD, it will pay me $200 after 3 months?

Answer:

• Short Answer
• APY Defined
• Other Rates
• Using Rates

Short Answer

The CD will not pay you $200. It will pay you $50.16.

APR Defined

APR is an abbreviation that stands for Annual Percentage Rate. The key point to emphasize is ANNUAL. This is the rate of return for a given investment spread over a year. Since this particular CD is only open for 3 months, we have to convert the annual rate. We will convert it to a monthly rate, and then add up the interest earned over 3 months. To convert an annual rate to a monthly rate, simply divide it by twelve. This means that 4% APR is the same as a 1/3% monthly rate. 1/3% of $5,000 is $16.66 each month, and for three months that gives us a total interest earned of $50.

Other Rates

Anyone notice something strange here? In the short answer, I said that the CD would pay $50.16, but in the previous section we figured it would pay only $50. What’s the difference? The difference comes from the power of compound interest.

The calculation of $50 in the APR section was a calculation of SIMPLE interest earned, but our CD pays COMPOUND interest. What’s the difference? See, in the first month, the CD will earn $16.66. This means that starting month 2, our CD has a value of $5,016.66. 1/3% of $5,016.66 is $16.72. The interest earned went up because the interest from the first period also earned interest. In the third month, our CD is worth $5,033.38. 1/3% of $5,033.38 is $16.78. So after our interest has earned interest, we are left with $5,050.16. Pretty cool, huh?

But what if there were an easier way to calculate the effect of compound interest? Sure, $.16 is not a large amount to be off, but what if you were calculating your mortgage, or your retirement? The effect of compound interest is much stronger over longer periods of time. Fortunately, there is usually a very easy way to determine the exact effect of compounding. This is done through the use of effective rates. An effective rate is a rate that factors in the effect of compounding to allow you an easy way to figure your exact return from an investment. There are many types of rates, from nominal to real to effective, from yields to rates, and it can be very confusing to determine which number you should be most concerned with. Well fear not. Below is a quick list of the most common terms you will find used in the financial world to describe interest rates:

APR

The annual percentage rate is the interest rate that is used to calculate the payment on a loan or an investment. This number is based on simple interest, and does not include the effects of compounding interest. Therefore, it can be used to give only an estimate of interest earned/paid.
APY

The annual percentage yield is the annual rate that factors in the effects of compounding on your interest earned/paid. It is used to calculate the precise amount interest on an investment or loan. If you want to know exactly what your investment will pay, use the APY as your interest rate. In the case of the above example, you could use the APY of the CD (which the bank probably provides) instead of the APR and calculate the interest the same as we did in the “APR Defined” section. This would providde you the precise interest earning of the CD. APY is more frequently used for interest that you

EAR

You will usually see this one on the same page as the APR for a loan, credit card, etc. You may have noticed that the EAR is always higher than the APR. This is because the EAR is the effective annual rate, and it takes into account the effect of compounding interest, fees, charges, and time. This is the rate you should use when comparing two loans. And remember that the EAR is the true cost of the loan, not the APR. The APR understates the true cost of the loan.

Is everyone thoroughly confused? Well, don’t stress about all these terms too much. You don’t have to memorize all these terms and what they mean and how to calculate them. What you need to be focused on is just one thing: Effective rates tell you the true cost of a debt, and APY tells you the true gains of an investment. When looking at a loan, look for the effective rate. It will probably be listed simply as the EAR. A CD or savings account may or may not tell you the APY, but you can at least use the APR to get a close estimate of your investment gains. If you are fortunate enough to be given the APY of the account, then use that instead of the APR to get a much more accurate picture of exactly how much interest you will earn.

Watch this first

(if you are having trouble viewing the clip, you can try going to the YouTube clip directly)

Personally, I think this video is fantastic. I wholeheartedly endorse the principles discussed here.
The principles that Dave Ramsey teaches in it are fantastic. How does this system work? Easy. No interest is paid. Instead of paying interest, you save that money and put it into your next car. Piece of cake. This is why debt is not your friend. Your monthly payment on the car isn’t really telling you what you are giving up.

What I would like to point out is how this illustration is effective only for the exact terms used. It assumes that you invest a full $464 a month at a constant 12% interest rate. And that’s great. There’s nothing wrong with that assumption. But if you want to run the same system yourself, and only save $200 each month at 4%, you may be surprised to find that you can’t upgrade the quality of your car quite so quickly.

This is why it is important for everyone to understand the basic principles of finance. Every situation is different and will yield different results from any other situation. So, what should you do? You should run this system for sure. You will save hundreds of thousands of dollars in car payments over the course of your working life. But, to minimize the number of surprises you encounter while operating this plan, you should run the numbers for yourself, for your situation. By doing so, you will be sure that your plan will run smoothly.

A Helping Hand

It just so happens that I have created a spreadsheet that you can use to create your own free-car plan. Ready? Then download it now to get started!

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.