By Steve Martin, CFP®, RLP®
Fort Collins, CO
http://www.mwm3.com/
Real estate as a wealth generator is hardly a new idea. People owned property long before the advent of stock exchanges and other capital markets. In more recent times, large corporations and institutions have held commercial real estate in their portfolios.
But individual investors have not traditionally had ready access to a professionally managed, diversified real estate portfolio. This has changed in the last few decades with the development and growth of real estate investment trusts, or REITs. Now individuals can add a real estate component to their portfolio to improve overall diversification.
What is a REIT?
A REIT is a company that owns, operates, and/or finances real estate property.1 Most of this discussion will address equity REITs, which manage different types of income-producing properties, such as hotels, office buildings, industrial facilities, apartments, and shopping centers. As commercial landlords, equity REITs typically generate dividend income from the rent paid by tenants. Many REITs in the US are traded on the public stock exchanges.
Publicly traded REITs offer investors several potential benefits:
•Real estate exposure. While publicly traded REITs account for only a small portion of the real estate investment universe and the equity market, academic evidence suggests that REITs have similar returns to the overall real estate market .2
•Low correlations with financial assets. Over longer periods of time, historical correlations of REITs and stocks have been generally low. (Correlation refers to the co-movement of asset returns. When two assets are positively correlated, their returns tend to move together; when negatively correlated, their returns are dissimilar.)
•Diversification. A REIT holds a portfolio of properties, which may specialize by property type and industry, or be broadly diversified according to industry and region. With the more recent advent of real estate securities overseas, investors can further diversify their exposure among foreign developed markets.
•Higher yield, regular income, capital appreciation. Since REITs have to pay out a large fraction of earnings as dividends, they tend to offer higher-dividend income than equities, and this may benefit certain income-oriented investors. Total return of the shares is tied to income and change in market value.
•Distinct asset class. While REITs are considered equity vehicles and can have significant exposure to the size and value risk factors, they are generally considered to be a separate asset class, due to their low long-term correlations with stocks.
•Liquidity and transparency. Publicly traded REITs can be bought or sold whenever the stock market is open for business. The availability of market-determined share prices can reveal information about the market’s assessment of the company’s prospects, including the ability of the firm’s management team.
•Tax treatment. REITs operate as “pass-through” corporations in which most income goes directly to shareholders. They typically pay little or no taxes on corporate income.3
Investing in REITS
A REIT mutual fund that manages a portfolio of REITs typically offers more diversification than owning a single REIT. Most REIT funds are either actively managed or indexed. An active fund manager seeks to pick securities that appear undervalued—an approach that often results in over-concentration in a single category, which may raise risks and potential costs, including transaction costs and management fees. On the other hand, an index fund tries to replicate a benchmark, such as the FTSE NAREIT Equity REIT Index or the Dow Jones US Select REIT Index. Although index funds may have lower fees, securities held in the portfolios may experience buying and selling pressure when indexes are reconstituted.
Our preferred approach is a structured strategy. Rather than trying to replicate an index, a manager may choose securities based on risk-return characteristics, diversification benefit, and favorable price negotiation. By keeping costs low and trading efficiently, a structured REIT strategy seeks to generate improved returns over time. Advantages of this approach include broader, more systematic exposure to the REIT universe at a lower cost.
Adding a real estate component to a portfolio may be a good diversification move. But strategy and implementation are crucial, and before investing, you should consider how a real estate strategy and the REIT you select may affect your portfolio. Some factors that may come into play:
• Asset coverage. Most actively managed stock funds and indexes include REITs in their equity holdings. This creates the potential for overlapping asset class exposure for investors who add a REIT component in their portfolio. Treating REITs as a separate and distinct strategy helps you achieve more precise risk exposure in the asset class weights. For example, investors with significant direct ownership in real estate may want to exclude REITs from the equity component in their portfolio to better control their overall exposure.
•REIT category. Equity REITs may operate property in a specific area of expertise, such as retail, office and industrial, hotels, or health care facilities. Residential REITs own and operate apartment buildings and multi-family commercial dwellings, rather than single-family homes. Mortgage REITs, which lend money directly to real estate owners or invest in existing mortgages or mortgage-backed securities, are generally excluded from the equity REIT universe because they perform more like fixed income instruments, with income based on interest payments. Hybrid REITs combine the strategies of equity and mortgage REITs.
•Diversification. As with financial assets, owning a broad mix of REITs can help reduce specific risk in a portfolio. This diversification eliminates exposure to a single REIT category, manager style, or geographic region. Also, adding international real estate can further enhance the potential diversification benefit.4 Correlations among international REITs are low across countries, regions, and equity markets, making them a useful complement to equities in developed and emerging markets.
Risk Considerations
REITs carry stock market risk, as well as risks specific to individual real estate properties, sectors, regional markets, and the operating firm. The securities are also subject to market pressures that may push share prices above or below the value of the underlying real estate. However, identifying a market premium or discount in a REIT is difficult since the underlying asset value reported by a REIT is based on an appraisal, which may be several months old. REIT returns also depend on the buying, selling, and operating decisions of management.
A manager may adopt risky strategies, such as heavy leveraging or lack of diversification. They may pay too much for properties, acquire poorly performing properties, change strategies regarding property mix, or make other business decisions that compromise performance. Investors holding foreign REITs or REIT funds are also exposed to risks specific to the country, such as legal structure, investment restrictions, ownership rules, tax treatment, and currency risk.
All of this underscores the importance of knowing your risk tolerance, carefully analyzing REIT fund managers, and diversifying to eliminate exposure to a single REIT manager or category.
Endnotes
1. Equity REITs make up about 91% of the REIT market. Mortgage REITs, which compose about 7% of the market, loan money to real estate owners or invest in existing mortgage-backed securities. Hybrid REITs combine the strategies of equity and mortgage REITs and make up about 1% of the market. Source: National Association of Real Estate Investment Trusts, Inc. (NAREIT).
2. Joseph Gyourko and Donald B. Keim, “Risk and Return in Real Estate: Evidence from a Real Estate Stock Index,” Financial Analysts Journal 49, no. 5 (September-October 1993): 39-46.
3. A US REIT must invest at least 75% of its assets in real estate and derive at least 75% of its income from real estate property or interest on real estate financing. It must also distribute at least 90% of its income to shareholders to maintain tax-advantaged status. This pass-through provision allows REIT investors to have access to the same cash flows as investors in private real estate equity. REIT shareholders, however, generally must pay taxes on income they receive from a REIT.
4. Over the 20-year period from 1990 to 2009, the annual return correlation between US REITs and the US stock market was 0.498 (1.0 denotes exact positive correlation in returns).
Disclosures
The information presented above was prepared by Dimensional Fund Advisors, a non-affiliated third party.
Diversification neither assures a profit nor guarantees against loss in a declining market.
May 31, 2010
May 28, 2010
Over One Third of Filers Paid Zero Taxes in 2008
By John Scherer, CFP®
Middleton, WI
http://www.trinfin.com/
A study of IRS data published by the Tax Foundation found that out of 142 million tax returns filed in 2008, 51 million paid no federal income taxes - meaning the filers got a refund of every dollar withheld from their paychecks, and often more than that due to 'refundable' credits such as the Earned Income Credit.
The number of returns with zero income taxes has grown from 32.6 million in 2000 to 51.6 million in 2008. That's a 59% increase in tax returns paying zero income taxes during a period where total returns filed increased only 10%.
A record for nonpayers has been set every year since 2002 (30.1 percent), primarily because tax cuts implemented by the Bush administration such as the refundable child tax credit pushed low- to middle-income people off the federal income tax rolls. So much for the Bush tax cuts benefiting the rich and punishing the poor, eh?
The study, Tax Foundation Fiscal Fact, No. 214, “Record Numbers of People Paying No Income Tax; Over 50 Million ‘Nonpayers’ Include Families Making over $50,000,” was authored by Tax Foundation president Scott Hodge. A couple of key quotes from Hodge (emphasis mine):
“Nonpaying status used to be a sure sign of poverty, but thanks to increased use of the Tax Code to deliver social benefits, incentivize behaviors and funnel money to targeted groups, middle-class families have now been pulled into the growing pool of nonpayers. We’re now in a situation where a record number of tax filers are completely disconnected from the cost of government.”
“Tax years 2009 and 2010 are likely to produce a number of nonpayers equal to or greater than in 2008 because of Obama's new tax credits targeted at lower- and middle-income taxpayers. As the number of refundable tax credits continues to grow, more and more tax filers are seeing the IRS as a source of income, not something to which taxes are paid."
"With no skin in the game, these nonpayers have little reason to care how much government grows.”
Middleton, WI
http://www.trinfin.com/
A study of IRS data published by the Tax Foundation found that out of 142 million tax returns filed in 2008, 51 million paid no federal income taxes - meaning the filers got a refund of every dollar withheld from their paychecks, and often more than that due to 'refundable' credits such as the Earned Income Credit.
The number of returns with zero income taxes has grown from 32.6 million in 2000 to 51.6 million in 2008. That's a 59% increase in tax returns paying zero income taxes during a period where total returns filed increased only 10%.
A record for nonpayers has been set every year since 2002 (30.1 percent), primarily because tax cuts implemented by the Bush administration such as the refundable child tax credit pushed low- to middle-income people off the federal income tax rolls. So much for the Bush tax cuts benefiting the rich and punishing the poor, eh?
The study, Tax Foundation Fiscal Fact, No. 214, “Record Numbers of People Paying No Income Tax; Over 50 Million ‘Nonpayers’ Include Families Making over $50,000,” was authored by Tax Foundation president Scott Hodge. A couple of key quotes from Hodge (emphasis mine):
“Nonpaying status used to be a sure sign of poverty, but thanks to increased use of the Tax Code to deliver social benefits, incentivize behaviors and funnel money to targeted groups, middle-class families have now been pulled into the growing pool of nonpayers. We’re now in a situation where a record number of tax filers are completely disconnected from the cost of government.”
“Tax years 2009 and 2010 are likely to produce a number of nonpayers equal to or greater than in 2008 because of Obama's new tax credits targeted at lower- and middle-income taxpayers. As the number of refundable tax credits continues to grow, more and more tax filers are seeing the IRS as a source of income, not something to which taxes are paid."
"With no skin in the game, these nonpayers have little reason to care how much government grows.”
May 25, 2010
What's Next: Inflation or More Deflation?
By Bert Whitehead, MBA, JD
Franklin, MI
http://www.bertwhitehead.com/
Excessive government spending fueled by ‘printing more money’ or selling Treasury Bonds always raises the specter of runaway inflation. Inflation causes prices to rise rapidly, and is measured by the Consumer Price Index (CPI). Since the current downturn in 2008, the CPI has barely risen, and some measures of CPI actually indicate deflation (which is why retired folks didn’t get a CPI increase in their Social Security benefits this year).
Financial journalists, who write articles and commentary, as well as advertisements selling gold as an investment, often predict future inflation and point to reckless federal spending that erodes the future value of the dollar. Some suspect that government believes it can solve our economic issues by adding programs that will eventually pay for themselves (even though they never have in the past). These commentators may well be right. Inflation is created by too many dollars chasing too few goods. As the money supply increases on a vast scale many armchair economists are convinced that run-away inflation is inevitable.
The economic environment of the 1970’s is often offered as an example of government bungling that poisoned the financial markets. The 70’s remind us of wage and price controls, gas rationing, and oil prices increasing at the whim of the oil cartel. Yet these aren’t pertinent to today’s issues (so far). There are some parallels to the ‘guns and butter’ deficits (i.e. Vietnam and expansion of social services), distrust of government leaders, and the federal government artificially holding down interest rates. So while rampant inflation is a potential outcome, today’s economy doesn’t compare exactly with the 70’s. Inflation is not the only possibility.
Another possibility is the opposite of inflation, or deflation, which is characterized by too few dollars being available to purchase the goods and services being produced. If there is not sufficient ‘velocity’ in an economy to maintain ongoing economic growth, then prices, wages and employment can all decrease. I am more concerned about deflation than inflation in the future because deflation hits suddenly, whereas inflation typically increases gradually.
The Great Depression is the most common example of the deflation vortex. It was very difficult to obtain bank loans, so businesses had to scale back production and inventories. Lower sales created more layoffs, leaving even fewer people to buy goods and services. Deflation, once ignited, can become a voracious beast that sucks the life out of an economy.
Some economists believe the programs initiated by FDR pulled us out of the Great Depression. Others believe that the federal intervention created ‘make-work’ programs that made the situation worse. They note that we didn’t recover until we went into World War II. World wars are a horrible way to create full employment.
But what about today? As in the past the government is intent on increasing the money supply to help the economy move forward. Is deflation a possibility? I think so. There are at least three current phenomena, which can deflect the impact of increasing the money supply, and result in deflation rather than inflation.
The first is productivity, which measures G.D.P. This is the output of goods and services produced per worker. If productivity increases while the money supply is increasing, the impact of inflation can be nullified. Generally, recessions are initially accompanied by increased productivity as firms lay off the least efficient workers. This, of course, creates higher unemployment and puts downward pressure on prices. During the current ‘recession,’ productivity has steadily increased.
When the government creates ‘make-work’ jobs, which do not increase G.D.P., economic activity may be propped up temporarily. But this approach is not sustainable and could ignite inflation. If it were to continue, the economy would reach the point where virtually everyone worked for the government, as in Russia during the Cold War. But these daily lives without private incentive ultimately create economic collapse, sometimes expressed by the Russian saying: “We pretend to work and they pretend to pay us!”
The second factor is personal savings. If the personal savings rate increases in step with increases in the money supply, then less money is being spent. As monetary velocity drops, there are fewer buyers, and eventually fewer workers. Japan experienced this during the ‘Lost Decade’ of the 1990’s when they did not address the core problems with their banking system. As the Japanese government tried to “paper it over” by printing more money, people who increased their savings thwarted its efforts. It should be noted that the personal savings rate in the U.S. has increased from 0.5% at the beginning of this recession to 6.0% currently.
The third factor that comes into play is the global economy. Alan Greenspan, the former Chairman of the Federal Reserve, commented as he stepped down from office that he had been baffled by the low inflation in the 90’s despite large increases in the money supply. But by the end of his term he had identified that the expanding global economy enabled production to move to the least costly sites, which offset inflationary pressures.
Consider a ‘Perfect Storm’ of higher government spending and expansion of the money supply, offset by 1) higher productivity with high unemployment, 2) increased personal savings rates generated by widespread fear, and 3) protectionism exacerbated by a cycle of retaliatory tariffs strangling the global economy. This could create a much more destructive deflationary spiral than creeping inflation.
I am not forecasting this outcome for our economy. But it is a significant possibility that concerns me. That’s why we continue to structure our clients’ net worth using the guidelines of Functional Asset Allocation. This approach is designed to hedge against both inflationary and deflationary environments, as well as provide for long-term portfolio growth whenever we are fortunate enough to return to a period of prosperity.
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
Franklin, MI
http://www.bertwhitehead.com/
Excessive government spending fueled by ‘printing more money’ or selling Treasury Bonds always raises the specter of runaway inflation. Inflation causes prices to rise rapidly, and is measured by the Consumer Price Index (CPI). Since the current downturn in 2008, the CPI has barely risen, and some measures of CPI actually indicate deflation (which is why retired folks didn’t get a CPI increase in their Social Security benefits this year).
Financial journalists, who write articles and commentary, as well as advertisements selling gold as an investment, often predict future inflation and point to reckless federal spending that erodes the future value of the dollar. Some suspect that government believes it can solve our economic issues by adding programs that will eventually pay for themselves (even though they never have in the past). These commentators may well be right. Inflation is created by too many dollars chasing too few goods. As the money supply increases on a vast scale many armchair economists are convinced that run-away inflation is inevitable.
The economic environment of the 1970’s is often offered as an example of government bungling that poisoned the financial markets. The 70’s remind us of wage and price controls, gas rationing, and oil prices increasing at the whim of the oil cartel. Yet these aren’t pertinent to today’s issues (so far). There are some parallels to the ‘guns and butter’ deficits (i.e. Vietnam and expansion of social services), distrust of government leaders, and the federal government artificially holding down interest rates. So while rampant inflation is a potential outcome, today’s economy doesn’t compare exactly with the 70’s. Inflation is not the only possibility.
Another possibility is the opposite of inflation, or deflation, which is characterized by too few dollars being available to purchase the goods and services being produced. If there is not sufficient ‘velocity’ in an economy to maintain ongoing economic growth, then prices, wages and employment can all decrease. I am more concerned about deflation than inflation in the future because deflation hits suddenly, whereas inflation typically increases gradually.
The Great Depression is the most common example of the deflation vortex. It was very difficult to obtain bank loans, so businesses had to scale back production and inventories. Lower sales created more layoffs, leaving even fewer people to buy goods and services. Deflation, once ignited, can become a voracious beast that sucks the life out of an economy.
Some economists believe the programs initiated by FDR pulled us out of the Great Depression. Others believe that the federal intervention created ‘make-work’ programs that made the situation worse. They note that we didn’t recover until we went into World War II. World wars are a horrible way to create full employment.
But what about today? As in the past the government is intent on increasing the money supply to help the economy move forward. Is deflation a possibility? I think so. There are at least three current phenomena, which can deflect the impact of increasing the money supply, and result in deflation rather than inflation.
The first is productivity, which measures G.D.P. This is the output of goods and services produced per worker. If productivity increases while the money supply is increasing, the impact of inflation can be nullified. Generally, recessions are initially accompanied by increased productivity as firms lay off the least efficient workers. This, of course, creates higher unemployment and puts downward pressure on prices. During the current ‘recession,’ productivity has steadily increased.
When the government creates ‘make-work’ jobs, which do not increase G.D.P., economic activity may be propped up temporarily. But this approach is not sustainable and could ignite inflation. If it were to continue, the economy would reach the point where virtually everyone worked for the government, as in Russia during the Cold War. But these daily lives without private incentive ultimately create economic collapse, sometimes expressed by the Russian saying: “We pretend to work and they pretend to pay us!”
The second factor is personal savings. If the personal savings rate increases in step with increases in the money supply, then less money is being spent. As monetary velocity drops, there are fewer buyers, and eventually fewer workers. Japan experienced this during the ‘Lost Decade’ of the 1990’s when they did not address the core problems with their banking system. As the Japanese government tried to “paper it over” by printing more money, people who increased their savings thwarted its efforts. It should be noted that the personal savings rate in the U.S. has increased from 0.5% at the beginning of this recession to 6.0% currently.
The third factor that comes into play is the global economy. Alan Greenspan, the former Chairman of the Federal Reserve, commented as he stepped down from office that he had been baffled by the low inflation in the 90’s despite large increases in the money supply. But by the end of his term he had identified that the expanding global economy enabled production to move to the least costly sites, which offset inflationary pressures.
Consider a ‘Perfect Storm’ of higher government spending and expansion of the money supply, offset by 1) higher productivity with high unemployment, 2) increased personal savings rates generated by widespread fear, and 3) protectionism exacerbated by a cycle of retaliatory tariffs strangling the global economy. This could create a much more destructive deflationary spiral than creeping inflation.
I am not forecasting this outcome for our economy. But it is a significant possibility that concerns me. That’s why we continue to structure our clients’ net worth using the guidelines of Functional Asset Allocation. This approach is designed to hedge against both inflationary and deflationary environments, as well as provide for long-term portfolio growth whenever we are fortunate enough to return to a period of prosperity.
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
May 22, 2010
Credit Card Rules Are Changing, Part 2
By Deb Hoskins, JD, CFP
Colorado Springs, CO
http://www.pikespeakfinancialplanning.com/
The Credit CARD Act of 2009 was made the law of the land on February 22. It gives consumers greater protection from the abusive practices of credit card companies, as well as better education on responsible credit use. I know that the word responsible implies a values-laden judgment on credit usage. My goal, however, is not to chastise or shame, but to nudge you toward better financial planning practices. I define better as that which saves you money.
One of the truly inspired provisions of the new law is the fuller disclosure of how much you are actually paying when you make only the minimum payment due. Every monthly bill will state how long it will take you to pay off the balance and what the total amount—principal and interest—is that you will pay to reduce the balance to zero.
Every bill will also tell you how much you need to pay per month to pay off the entire balance in three years. Again, you’ll see the total principal and interest payments to achieve that goal. Any net savings compared to the minimum payment due method will be highlighted. Having the real numbers stated so clearly every month should motivate consumers to pay off balances at a quicker pace, saving real money in the long run.
As of this writing, the national average of interest rates on credit card balances was 14.15%. Late payments or increased credit risk can increase that rate to 25% to 29%. My values-laden judgment is that these rates are obscene and should be avoided at all costs. Pay down your balances as quickly as possible!
Colorado Springs, CO
http://www.pikespeakfinancialplanning.com/
The Credit CARD Act of 2009 was made the law of the land on February 22. It gives consumers greater protection from the abusive practices of credit card companies, as well as better education on responsible credit use. I know that the word responsible implies a values-laden judgment on credit usage. My goal, however, is not to chastise or shame, but to nudge you toward better financial planning practices. I define better as that which saves you money.
One of the truly inspired provisions of the new law is the fuller disclosure of how much you are actually paying when you make only the minimum payment due. Every monthly bill will state how long it will take you to pay off the balance and what the total amount—principal and interest—is that you will pay to reduce the balance to zero.
Every bill will also tell you how much you need to pay per month to pay off the entire balance in three years. Again, you’ll see the total principal and interest payments to achieve that goal. Any net savings compared to the minimum payment due method will be highlighted. Having the real numbers stated so clearly every month should motivate consumers to pay off balances at a quicker pace, saving real money in the long run.
As of this writing, the national average of interest rates on credit card balances was 14.15%. Late payments or increased credit risk can increase that rate to 25% to 29%. My values-laden judgment is that these rates are obscene and should be avoided at all costs. Pay down your balances as quickly as possible!
May 19, 2010
Credit Card Rules Are Changing, Part 1
By Deb Hoskins, JD, CFP
Colorado Springs, CO
http://www.pikespeakfinancialplanning.com/
Have you noticed a flurry of mailings from your credit card account providers lately? Since the first of the year, I’ve received many letters that all start the same way: “Important Notice of Changes to Your Credit Card Account Ending in xxxx.” Almost all of them are notifying me of higher rates on any balances I might carry. Since I never carry balances, I just briefly scan the brochure and duly file it away without a second thought.
This month, however, I will do more than just scan. The law on credit card accounts is about to change, and for consumers, that’s good news. The Credit Card Accountability, Responsibility and Disclosure (CARD) Act of 2009, signed into law last spring, will take effect on February 22. The new law is lengthy (what act of Congress isn’t?), but a few features are worth noting.
First, credit card companies must give a 45-day advance notice before increasing your interest rate or other fees. This does not apply if you have a variable interest rate tied to an index or an introductory or “teaser” rate scheduled to expire. In addition, interest rates on newly opened accounts cannot increase for the first 12 months (again, unless you have a variable interest rate or an advertised teaser rate).
Another new feature is that the minimum payment due may increase, but it cannot increase by more than 100% at any given time. Also, account statements must be mailed 21 days before the bill is due, rather than the current 14 days, effectively lengthening the grace period for consumers.
But my favorite highlights of this new law are the provisions intended to change the borrowing behavior of consumers, nudging them toward more prudent use of credit. More on that next week.
Colorado Springs, CO
http://www.pikespeakfinancialplanning.com/
Have you noticed a flurry of mailings from your credit card account providers lately? Since the first of the year, I’ve received many letters that all start the same way: “Important Notice of Changes to Your Credit Card Account Ending in xxxx.” Almost all of them are notifying me of higher rates on any balances I might carry. Since I never carry balances, I just briefly scan the brochure and duly file it away without a second thought.
This month, however, I will do more than just scan. The law on credit card accounts is about to change, and for consumers, that’s good news. The Credit Card Accountability, Responsibility and Disclosure (CARD) Act of 2009, signed into law last spring, will take effect on February 22. The new law is lengthy (what act of Congress isn’t?), but a few features are worth noting.
First, credit card companies must give a 45-day advance notice before increasing your interest rate or other fees. This does not apply if you have a variable interest rate tied to an index or an introductory or “teaser” rate scheduled to expire. In addition, interest rates on newly opened accounts cannot increase for the first 12 months (again, unless you have a variable interest rate or an advertised teaser rate).
Another new feature is that the minimum payment due may increase, but it cannot increase by more than 100% at any given time. Also, account statements must be mailed 21 days before the bill is due, rather than the current 14 days, effectively lengthening the grace period for consumers.
But my favorite highlights of this new law are the provisions intended to change the borrowing behavior of consumers, nudging them toward more prudent use of credit. More on that next week.
May 17, 2010
Save Early, Save Often
By Joe Alfonso, CFP®, ChFC
Santa Clara, CA
http://www.aegisadvisory.com/
Investors fret about the performance of their portfolios. They worry whether they will be able to realize a rate of return sufficient to help them meet their goals and if they are taking on enough (or too much) risk to achieve this. While these are valid concerns, they are ultimately beyond anyone's control. Other than diversifying broadly to lower volatility and keeping investment and tax costs low to increase net gain, there is nothing we can do to determine the actual rate of return on our investments; the markets will ultimately decide this fate for us.
There is, however, something outside of investing that we can all do that is completely within our control and that can have a great impact on whether we achieve our life goals. Indeed, by forming certain habits early, we can help reduce the rate of return that we need to realize on our investments and even how much we need to invest in the first place. I am referring to the habit of saving.
Perhaps the greatest risk we all face is not saving enough to meet our long term needs. Saving as much as we can and beginning this practice early allows our money to grow exponentially with time given the magic of compounding. Just how significant an advantage one can reap from an early commitment to saving can be illustrated in the following example.
Ben and Jerry are twin brothers. Ben decides to begin saving at age 30 at a rate of $10,000 per year. He continues this practice until the age of 40, at which time he stops saving altogether. Jerry waits until he turns 45 to begin saving. He puts away $15,000 per year until retiring at the age of 65. If we assume both brothers earned the same 7% average annual rate of return, how much did each accumulate by the age of 65?
First, let's compare how much each brother socked away. Ben saved $100,000 in total over 10 years compared to Jerry who saved a whopping $300,000 over 20 years. In spite of having saved more over a longer period of time, however, it turns out that Jerry winds up with the smaller nest egg of the two. At age 65, Jerry's savings will have grown to about $615,000, certainly a significant sum. In comparison, however, Ben's savings will have grown to approximately $750,000, $135,000 more than Jerry in spite of Ben having only saved a third of what Jerry saved for half as long. This is the magic of compounding at work and a great example of why saving early is so beneficial.
The moral of the story is that we are more in control of our financial destinies than we think. By deciding to save early and often, we can minimize the need to risk our money in the stock market since even modest rates of return over long periods of time yield impressive sums. The secret to getting rich is to do so slowly, saving as much as we can for as long as possible. So take matters in your own hands and get started, now!
Santa Clara, CA
http://www.aegisadvisory.com/
Investors fret about the performance of their portfolios. They worry whether they will be able to realize a rate of return sufficient to help them meet their goals and if they are taking on enough (or too much) risk to achieve this. While these are valid concerns, they are ultimately beyond anyone's control. Other than diversifying broadly to lower volatility and keeping investment and tax costs low to increase net gain, there is nothing we can do to determine the actual rate of return on our investments; the markets will ultimately decide this fate for us.
There is, however, something outside of investing that we can all do that is completely within our control and that can have a great impact on whether we achieve our life goals. Indeed, by forming certain habits early, we can help reduce the rate of return that we need to realize on our investments and even how much we need to invest in the first place. I am referring to the habit of saving.
Perhaps the greatest risk we all face is not saving enough to meet our long term needs. Saving as much as we can and beginning this practice early allows our money to grow exponentially with time given the magic of compounding. Just how significant an advantage one can reap from an early commitment to saving can be illustrated in the following example.
Ben and Jerry are twin brothers. Ben decides to begin saving at age 30 at a rate of $10,000 per year. He continues this practice until the age of 40, at which time he stops saving altogether. Jerry waits until he turns 45 to begin saving. He puts away $15,000 per year until retiring at the age of 65. If we assume both brothers earned the same 7% average annual rate of return, how much did each accumulate by the age of 65?
First, let's compare how much each brother socked away. Ben saved $100,000 in total over 10 years compared to Jerry who saved a whopping $300,000 over 20 years. In spite of having saved more over a longer period of time, however, it turns out that Jerry winds up with the smaller nest egg of the two. At age 65, Jerry's savings will have grown to about $615,000, certainly a significant sum. In comparison, however, Ben's savings will have grown to approximately $750,000, $135,000 more than Jerry in spite of Ben having only saved a third of what Jerry saved for half as long. This is the magic of compounding at work and a great example of why saving early is so beneficial.
The moral of the story is that we are more in control of our financial destinies than we think. By deciding to save early and often, we can minimize the need to risk our money in the stock market since even modest rates of return over long periods of time yield impressive sums. The secret to getting rich is to do so slowly, saving as much as we can for as long as possible. So take matters in your own hands and get started, now!
May 14, 2010
What Our Tax Return Can Teach Us
By Troy Von Haefen, CFP®
Nashville, TN
http://www.vhfinancialmanagement.com/
Tax season is behind us, and it’s time to move ahead with 2010. But we need to take a minute or two more with our 2009 return before we send it off into the black hole of all things stored. We can learn a great deal about the current year by reviewing last year’s return. This is one reason why I strive for all my clients to file timely (by April 15th).
First, look is at the bottom of your return. Did you have a balance due, or did you receive a refund? This will illustrate how well you planned. If you overshot the runway in either direction, a change may be needed. The easiest way to make this change, for most people, is by changing your W-4. This document tells your employer how much to withhold from your paycheck every pay period. If you are not an employee, but own your own business or work as contract labor, the change needs to come through quarterly estimated tax payments. Remember a large refund is not a high-five-your spouse experience. You just gave the government an interest free loan! Underfunding your tax liability and generating an underpayment penalty is not the answer either. I generally like to see clients get less than $1000 back at tax time. Anymore than that is just too much….but there are always exceptions.
If you had an event in 2009 that will not occur in 2010, but you received a taxable benefit in 2009, you should make appropriate adjustments. Did you buy a car in 2009 and utilize the sales tax deduction? That may have saved you several hundred dollars or more in taxes. Unless you buy another car in 2010, that deduction will disappear. Did you have a college age child graduate or finish college. If so, you probably received some tax deduction. That tax savings will not be there in 2010 if you don’t have a child in college. Be sure to understand where your refund or balance due came from.
Some of this may sound a bit confusing, or maybe you don’t care to understand the tax code. I’m not suggesting you become a tax expert, but I am simply stating that it is important to understand, at least from the big picture view, your tax return. Your preparer needs to understand the details, but it’s your job to understand how the details affect you. If you don’t, you could be dinged. If it’s confusing, ask your preparer for a little explanation.
The next question to ask yourself is did you fund your retirement? Remember that most retirement contributions will reduce your taxable income, which means it saves you tax dollars. Taxes are the single largest recurring expense for most people, so we should do our best to manage that expense. If we contribute to our retirement and reduce our taxable income, an amazing thing happens….we create leverage. For example, a couple in the 25% tax bracket making a $10k 401k contribution will save a minimum of $2500 in taxes. That’s a 25% return on investment before the money is ever invested in the market. Let’s take it a step further. If that couple then plans accordingly and puts the $2500 tax savings into their 401k, another $625 tax savings is generated. It creates a positive snowball effect!
Take some time and learn where your tax savings are generated. Look for the areas that create a tax liability. Speak with your preparer to seek methods to maximize your tax savings and minimize liabilities. Taking a proactive approach to managing your taxes can set the stage for financial freedom. Reviewing your 2009 return and learning from your tax successes and failures can help plan accordingly for a successful 2010.
Nashville, TN
http://www.vhfinancialmanagement.com/
Tax season is behind us, and it’s time to move ahead with 2010. But we need to take a minute or two more with our 2009 return before we send it off into the black hole of all things stored. We can learn a great deal about the current year by reviewing last year’s return. This is one reason why I strive for all my clients to file timely (by April 15th).
First, look is at the bottom of your return. Did you have a balance due, or did you receive a refund? This will illustrate how well you planned. If you overshot the runway in either direction, a change may be needed. The easiest way to make this change, for most people, is by changing your W-4. This document tells your employer how much to withhold from your paycheck every pay period. If you are not an employee, but own your own business or work as contract labor, the change needs to come through quarterly estimated tax payments. Remember a large refund is not a high-five-your spouse experience. You just gave the government an interest free loan! Underfunding your tax liability and generating an underpayment penalty is not the answer either. I generally like to see clients get less than $1000 back at tax time. Anymore than that is just too much….but there are always exceptions.
If you had an event in 2009 that will not occur in 2010, but you received a taxable benefit in 2009, you should make appropriate adjustments. Did you buy a car in 2009 and utilize the sales tax deduction? That may have saved you several hundred dollars or more in taxes. Unless you buy another car in 2010, that deduction will disappear. Did you have a college age child graduate or finish college. If so, you probably received some tax deduction. That tax savings will not be there in 2010 if you don’t have a child in college. Be sure to understand where your refund or balance due came from.
Some of this may sound a bit confusing, or maybe you don’t care to understand the tax code. I’m not suggesting you become a tax expert, but I am simply stating that it is important to understand, at least from the big picture view, your tax return. Your preparer needs to understand the details, but it’s your job to understand how the details affect you. If you don’t, you could be dinged. If it’s confusing, ask your preparer for a little explanation.
The next question to ask yourself is did you fund your retirement? Remember that most retirement contributions will reduce your taxable income, which means it saves you tax dollars. Taxes are the single largest recurring expense for most people, so we should do our best to manage that expense. If we contribute to our retirement and reduce our taxable income, an amazing thing happens….we create leverage. For example, a couple in the 25% tax bracket making a $10k 401k contribution will save a minimum of $2500 in taxes. That’s a 25% return on investment before the money is ever invested in the market. Let’s take it a step further. If that couple then plans accordingly and puts the $2500 tax savings into their 401k, another $625 tax savings is generated. It creates a positive snowball effect!
Take some time and learn where your tax savings are generated. Look for the areas that create a tax liability. Speak with your preparer to seek methods to maximize your tax savings and minimize liabilities. Taking a proactive approach to managing your taxes can set the stage for financial freedom. Reviewing your 2009 return and learning from your tax successes and failures can help plan accordingly for a successful 2010.
May 11, 2010
Give a Man a Fish, You Feed Him for Today; Give a Man a 401(k)…
By Robert Schmansky, CFP®
Franklin, MI
http://www.nfa1040.com/
Originally published April 5, 2010 at the Financial Planning Association's All Things Financial Planning Blog
It seems to me a lot of the conversations these days about ‘reform’ are really more of a way to get people to act a certain way, invest a certain way, or own a certain product, rather than promoting ideas that solve the underlying problems. Regulating behavior, rather than teaching how to fend for oneself.
Pundits and politicians are proposing ways to ‘fix’ the 401(k). Two ideas working their way through Congress and the administration include attaching annuities to 401(k) plans and regulating investment advice for participants.
But do these ideas fix the problem? Are they even necessary?
Many advisors think the above regulations offer little benefit, and may have the potential for significant confusion for savers.
Sure, the 401(k) plan isn’t perfect, but what I wonder is how the above changes answer the following questions participants have:
• How much should I save and where? Do I save more for retirement, or an emergency fund, or perhaps a home down payment fund? Do I save more or payoff debt?
• More than simply knowing how much risk I think I may want to take, how do I invest based on my goals, personal risks and emotional tolerance? What is the tradeoff I may face in investing for higher returns and my goals? Do I need to take on market risk, and if not, how do I make sure my savings keep up with inflation?
• Is my 401(k) working in concert with my overall financial plan? My estate goals? My other investment accounts?
The 401(k) itself is not a problem. It is just an account, and since it has been introduced savers have become wealthier than past generations by being allowed to take control of their savings. But, with that opportunity comes personal responsibility.
Below are my two cents in the conversation to improve retirement plans:
Focus on planning, not products
Mandate that participants can access their qualified plan money at any age to pay for financial planning services and advice. This advice includes, but is not limited to, investment management. Proposed legislation focuses on investment management and investment products, which, from a planning perspective, stem from the financial plan. The above questions savers need to address are not investment management questions as much as they are personal financial planning questions.
Thousands of advisors would offer advice if they were allowed to be compensated. The financial plan dictates the investment plan, and therefore investment funds should not be held hostage, only to be used for services that place the cart before the horse.
In addition, offer tax breaks for companies who pay for financial education that is independent from the investment custodian. Upstart financial companies offer education-only services to employees; these companies are not seeking to invest your money for you, but to teach you on how to do it yourself, or refer you to someone to work with (in other words, they “teach a man to fish”). A financially savvy workforce is also a more productive and loyal workforce.
Promote competition
The 401(k) model as currently structured traps participants into the investment options one provider allows.
On the other hand, we work with 403(b) plan participants whose plan options and services are a significant improvement over any current 401(k) plan. The reason? Competition for plan participant dollars.
These 403(b) plans offer: the choice of multiple plan providers, lower cost investment options, and the ability to pay for investment management to an independent advisor. The result is a participant has the ability to pick the provider that is appropriate, at a lower cost, and can work with an advisor on their comprehensive investment plan.
Until the day the 401(k) is required to offer more consumer-friendly benefits, what you can do as a saver is keep an active dialogue with your employer or human resources department about your plan. Make sure they are aware of your concerns about costs, limitations, and investment options their provider offers. Your retirement savings plan is, after all, an employee benefit.
Franklin, MI
http://www.nfa1040.com/
Originally published April 5, 2010 at the Financial Planning Association's All Things Financial Planning Blog
It seems to me a lot of the conversations these days about ‘reform’ are really more of a way to get people to act a certain way, invest a certain way, or own a certain product, rather than promoting ideas that solve the underlying problems. Regulating behavior, rather than teaching how to fend for oneself.
Pundits and politicians are proposing ways to ‘fix’ the 401(k). Two ideas working their way through Congress and the administration include attaching annuities to 401(k) plans and regulating investment advice for participants.
But do these ideas fix the problem? Are they even necessary?
Many advisors think the above regulations offer little benefit, and may have the potential for significant confusion for savers.
Sure, the 401(k) plan isn’t perfect, but what I wonder is how the above changes answer the following questions participants have:
• How much should I save and where? Do I save more for retirement, or an emergency fund, or perhaps a home down payment fund? Do I save more or payoff debt?
• More than simply knowing how much risk I think I may want to take, how do I invest based on my goals, personal risks and emotional tolerance? What is the tradeoff I may face in investing for higher returns and my goals? Do I need to take on market risk, and if not, how do I make sure my savings keep up with inflation?
• Is my 401(k) working in concert with my overall financial plan? My estate goals? My other investment accounts?
The 401(k) itself is not a problem. It is just an account, and since it has been introduced savers have become wealthier than past generations by being allowed to take control of their savings. But, with that opportunity comes personal responsibility.
Below are my two cents in the conversation to improve retirement plans:
Focus on planning, not products
Mandate that participants can access their qualified plan money at any age to pay for financial planning services and advice. This advice includes, but is not limited to, investment management. Proposed legislation focuses on investment management and investment products, which, from a planning perspective, stem from the financial plan. The above questions savers need to address are not investment management questions as much as they are personal financial planning questions.
Thousands of advisors would offer advice if they were allowed to be compensated. The financial plan dictates the investment plan, and therefore investment funds should not be held hostage, only to be used for services that place the cart before the horse.
In addition, offer tax breaks for companies who pay for financial education that is independent from the investment custodian. Upstart financial companies offer education-only services to employees; these companies are not seeking to invest your money for you, but to teach you on how to do it yourself, or refer you to someone to work with (in other words, they “teach a man to fish”). A financially savvy workforce is also a more productive and loyal workforce.
Promote competition
The 401(k) model as currently structured traps participants into the investment options one provider allows.
On the other hand, we work with 403(b) plan participants whose plan options and services are a significant improvement over any current 401(k) plan. The reason? Competition for plan participant dollars.
These 403(b) plans offer: the choice of multiple plan providers, lower cost investment options, and the ability to pay for investment management to an independent advisor. The result is a participant has the ability to pick the provider that is appropriate, at a lower cost, and can work with an advisor on their comprehensive investment plan.
Until the day the 401(k) is required to offer more consumer-friendly benefits, what you can do as a saver is keep an active dialogue with your employer or human resources department about your plan. Make sure they are aware of your concerns about costs, limitations, and investment options their provider offers. Your retirement savings plan is, after all, an employee benefit.
May 8, 2010
What to Do When Your House Is Underwater
By Bert Whitehead, MBA, JD
Franklin, MI
http://www.bertwhitehead.com/
Almost one of every four homeowners are faced with the sad reality that they owe more money on their home than they could sell it for. In the real estate world, that’s called ‘being underwater.’ This blog is a realistic review of your options, and discusses the biggest mistake people make when they are in this tight spot.
1. If you can still afford to live in your home and enjoy living where you do, stay there. If you are still working (or retired with the same income as when you bought the house and qualified for the mortgage) and living within your means – don’t worry about how much your home is worth because you don’t have to sell it. Your home is an inflation hedge, especially if you have a long-term fixed rate mortgage. In most areas of the country home values will eventually rise again. Keep in mind that one of the primary purposes of owning a home is the joy of living there.
2. If, however, you need to move, then you have to review your options. It may be that you have become unemployed, or your job requires relocation, or you want to downsize to cut expenses. Many people have adjustable rate mortgages that have been reset to a higher interest rate, so they cannot afford to live in their home. The obvious answer is that you can sell the house for what you can get, then sell other assets (perhaps some investments) and bring a check to the closing to cover the amount of the mortgage not covered by your sales proceeds. As we will discuss later, this is often the best option.
Regardless of what you may have heard, the following options (#3-#8) are successful only for homeowners who stop making payments. Banks are not likely to negotiate with you if they are still getting paid…and why would they?
3. There are 12 states* in the U.S. which provide that homeowners have no personal recourse for a mortgage taken out to purchase a principal residence. That means you can just walk away from the loan. The bank will foreclose and sell the home at auction, but they will not be able to sue you for any deficiency should the net sales proceeds not equal what you owe. Your credit score will drop by about 200 points, but this is a viable option. From a moral perspective, keep in mind that you paid a premium (built into your closing costs) when you bought the home to have this option. So it is not unlike collecting on an insurance policy.
In the past forgiven debt was taxable as income but currently this does not apply to cancellation of the unpaid portion of a mortgage used to buy the house. If there is a second mortgage, any unpaid amount may be taxable income.
4. In the 38 other states, if you walk away from your home the bank will foreclose and sell the home at auction. If the house doesn’t sell for enough to pay off the mortgage, they can sue you for the deficiency. With a judgment they can then put liens on other assets (like bank accounts or other real estate) and garnish your wages. So not only are you on the hook for the deficiency (plus the bank’s collection costs and attorney fees), but your credit score will likely crash about 300-400 points and you could have to pay income taxes on the unpaid portion of the mortgage.
5. A better option than foreclosure is to deal with the bank and work out an arrangement called a “deed in lieu of foreclosure.” When banks stop receiving payments, they will be open to talking about this approach. In these situations the bank agrees to have you just sign over the deed so they don’t have the expenses of foreclosure. With the bank’s agreement, you can qualify for non-taxable debt forgiveness. It will cut your credit score by 300-400 points initially, but you end up free of the debt. Again, the bank is not likely to agree to this if you are working or have other assets they can levy
6. In recent years there has been an effort by the government to pressure banks to provide “Loan Modifications” to homeowners who are unable to make their payments and who meet strict criteria. For most people, this is not a viable option. Loan modifications may include lowering the interest rate or extending the term to reduce monthly payments. However banks are not willing to reduce the principle owed. This is a time consuming process, and thousands of applicants have overwhelmed banks. It takes an inordinate amount of time to check applicants and banks don’t make any money beyond the $1,500 offered from the federal government (more red tape) if a loan is modified. Of the 4 million homes in foreclosure last year only 2% were approved for modification and 2 of every 3 modifications were in default again within 6 months.
7. Most homes selling now are ‘short sales.’ This requires the owner to find a buyer at a reduced price. If a bank accepts the low offer, the owner signs the house over to the bank and the buyer/investor buys the home from the bank and the bank releases the owner. Thus, there is no deficiency and the forgiveness of debt does not trigger a taxable event. It will knock about 250 points off your credit score. There are now some real estate agents who specialize in these transactions, although most avoid getting involved because of the paperwork, the time commitment, and very small commissions.
8. The final solution for most people who need to move from their home is to continue cutting the price until it sells, even though it means taking a check to the closing to pay off the mortgage. There are very few buyers in the market now, mortgages are difficult to get, and appraisals are very conservative. So even if you get a willing buyer at a reasonable price, often the appraisal will not be high enough to get a mortgage. As prices drop, this process reinforces itself.
You can sell your house if it is priced right but the ‘right price’ has nothing to do with what you paid for it, what you invested in it, what it was worth 3 years ago, or how much you owe on it. The ‘right price” is what someone in this market will pay for it.
To arrive at the ‘right price,’ recognize that pricing is a process, not an event. Start by listing your house somewhat below other comparable houses in your neighborhood. Keep in mind that current listings are overpriced – otherwise someone would have already bought them. Then ruthlessly cut the price on your house every 6-8 weeks by 5-10%, and keep cutting until you get an offer. Cutting the price will put you on the top of the pile and keeps your house from becoming a ‘stale listing.’
This makes good financial sense when you realize the tremendous carrying costs of a vacant house. Ignoring carrying costs is the biggest mistake people make when they face this scenario. Carrying costs generally run about 10% per year of the home’s value and include the house payment, taxes, insurance, repairs and upkeep, as well as opportunity costs for the equity (if you still have equity.) So if your home is worth $400,000, the carrying costs are about $40,000/yr. If you are determined to get your price, you might easily wait 2 years until the market bottoms out. Then you will have paid out $80,000 in carrying costs. Now it will have to appreciate 30%-40% per year for the next two years for you to pay 2 more years of carrying costs plus ‘catch-up’ appreciation for you to break even. To expect this spectacular market turnaround is naïve. You’re better off selling the home for $350,000 now, and in two years you will have avoided $80,000 in carrying costs.
Living in a home you can’t afford, or trying to rent it out, doesn’t change the math much either because the carrying costs don’t take into account the continuing drop in home values in most areas. In many areas there are huge inventories of unsold homes in foreclosure, and we are facing another tsunami of homes likely to go into default in the next year or two as all the of 5-year adjustable mortgages from 3-4 years ago are reset.
Keep in mind if you use any of the techniques in this article, under a new federal law you will not be able to obtain a new mortgage for 4-7 years. If you lost your job, or had a catastrophic illness, this disqualification period is shortened to 2 years.
Of course, each situation is different. It is advisable to get professional advice from someone whose compensation is not dependent on the outcome of your decision. The upside is that, if you are buying a home, you will very likely find a great bargain once this housing bust ends!
*AK, AZ, CA, CT, FL, ID, MN, NC, ND, TX, UT, WA – laws vary by state.
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY., as well as the fact-checking of Terry Fraser (Mackinac Bank), and Trevor Smith (Incline Village Real Estate), and blog editing by Susan Stanley.
Franklin, MI
http://www.bertwhitehead.com/
Almost one of every four homeowners are faced with the sad reality that they owe more money on their home than they could sell it for. In the real estate world, that’s called ‘being underwater.’ This blog is a realistic review of your options, and discusses the biggest mistake people make when they are in this tight spot.
1. If you can still afford to live in your home and enjoy living where you do, stay there. If you are still working (or retired with the same income as when you bought the house and qualified for the mortgage) and living within your means – don’t worry about how much your home is worth because you don’t have to sell it. Your home is an inflation hedge, especially if you have a long-term fixed rate mortgage. In most areas of the country home values will eventually rise again. Keep in mind that one of the primary purposes of owning a home is the joy of living there.
2. If, however, you need to move, then you have to review your options. It may be that you have become unemployed, or your job requires relocation, or you want to downsize to cut expenses. Many people have adjustable rate mortgages that have been reset to a higher interest rate, so they cannot afford to live in their home. The obvious answer is that you can sell the house for what you can get, then sell other assets (perhaps some investments) and bring a check to the closing to cover the amount of the mortgage not covered by your sales proceeds. As we will discuss later, this is often the best option.
Regardless of what you may have heard, the following options (#3-#8) are successful only for homeowners who stop making payments. Banks are not likely to negotiate with you if they are still getting paid…and why would they?
3. There are 12 states* in the U.S. which provide that homeowners have no personal recourse for a mortgage taken out to purchase a principal residence. That means you can just walk away from the loan. The bank will foreclose and sell the home at auction, but they will not be able to sue you for any deficiency should the net sales proceeds not equal what you owe. Your credit score will drop by about 200 points, but this is a viable option. From a moral perspective, keep in mind that you paid a premium (built into your closing costs) when you bought the home to have this option. So it is not unlike collecting on an insurance policy.
In the past forgiven debt was taxable as income but currently this does not apply to cancellation of the unpaid portion of a mortgage used to buy the house. If there is a second mortgage, any unpaid amount may be taxable income.
4. In the 38 other states, if you walk away from your home the bank will foreclose and sell the home at auction. If the house doesn’t sell for enough to pay off the mortgage, they can sue you for the deficiency. With a judgment they can then put liens on other assets (like bank accounts or other real estate) and garnish your wages. So not only are you on the hook for the deficiency (plus the bank’s collection costs and attorney fees), but your credit score will likely crash about 300-400 points and you could have to pay income taxes on the unpaid portion of the mortgage.
5. A better option than foreclosure is to deal with the bank and work out an arrangement called a “deed in lieu of foreclosure.” When banks stop receiving payments, they will be open to talking about this approach. In these situations the bank agrees to have you just sign over the deed so they don’t have the expenses of foreclosure. With the bank’s agreement, you can qualify for non-taxable debt forgiveness. It will cut your credit score by 300-400 points initially, but you end up free of the debt. Again, the bank is not likely to agree to this if you are working or have other assets they can levy
6. In recent years there has been an effort by the government to pressure banks to provide “Loan Modifications” to homeowners who are unable to make their payments and who meet strict criteria. For most people, this is not a viable option. Loan modifications may include lowering the interest rate or extending the term to reduce monthly payments. However banks are not willing to reduce the principle owed. This is a time consuming process, and thousands of applicants have overwhelmed banks. It takes an inordinate amount of time to check applicants and banks don’t make any money beyond the $1,500 offered from the federal government (more red tape) if a loan is modified. Of the 4 million homes in foreclosure last year only 2% were approved for modification and 2 of every 3 modifications were in default again within 6 months.
7. Most homes selling now are ‘short sales.’ This requires the owner to find a buyer at a reduced price. If a bank accepts the low offer, the owner signs the house over to the bank and the buyer/investor buys the home from the bank and the bank releases the owner. Thus, there is no deficiency and the forgiveness of debt does not trigger a taxable event. It will knock about 250 points off your credit score. There are now some real estate agents who specialize in these transactions, although most avoid getting involved because of the paperwork, the time commitment, and very small commissions.
8. The final solution for most people who need to move from their home is to continue cutting the price until it sells, even though it means taking a check to the closing to pay off the mortgage. There are very few buyers in the market now, mortgages are difficult to get, and appraisals are very conservative. So even if you get a willing buyer at a reasonable price, often the appraisal will not be high enough to get a mortgage. As prices drop, this process reinforces itself.
You can sell your house if it is priced right but the ‘right price’ has nothing to do with what you paid for it, what you invested in it, what it was worth 3 years ago, or how much you owe on it. The ‘right price” is what someone in this market will pay for it.
To arrive at the ‘right price,’ recognize that pricing is a process, not an event. Start by listing your house somewhat below other comparable houses in your neighborhood. Keep in mind that current listings are overpriced – otherwise someone would have already bought them. Then ruthlessly cut the price on your house every 6-8 weeks by 5-10%, and keep cutting until you get an offer. Cutting the price will put you on the top of the pile and keeps your house from becoming a ‘stale listing.’
This makes good financial sense when you realize the tremendous carrying costs of a vacant house. Ignoring carrying costs is the biggest mistake people make when they face this scenario. Carrying costs generally run about 10% per year of the home’s value and include the house payment, taxes, insurance, repairs and upkeep, as well as opportunity costs for the equity (if you still have equity.) So if your home is worth $400,000, the carrying costs are about $40,000/yr. If you are determined to get your price, you might easily wait 2 years until the market bottoms out. Then you will have paid out $80,000 in carrying costs. Now it will have to appreciate 30%-40% per year for the next two years for you to pay 2 more years of carrying costs plus ‘catch-up’ appreciation for you to break even. To expect this spectacular market turnaround is naïve. You’re better off selling the home for $350,000 now, and in two years you will have avoided $80,000 in carrying costs.
Living in a home you can’t afford, or trying to rent it out, doesn’t change the math much either because the carrying costs don’t take into account the continuing drop in home values in most areas. In many areas there are huge inventories of unsold homes in foreclosure, and we are facing another tsunami of homes likely to go into default in the next year or two as all the of 5-year adjustable mortgages from 3-4 years ago are reset.
Keep in mind if you use any of the techniques in this article, under a new federal law you will not be able to obtain a new mortgage for 4-7 years. If you lost your job, or had a catastrophic illness, this disqualification period is shortened to 2 years.
Of course, each situation is different. It is advisable to get professional advice from someone whose compensation is not dependent on the outcome of your decision. The upside is that, if you are buying a home, you will very likely find a great bargain once this housing bust ends!
*AK, AZ, CA, CT, FL, ID, MN, NC, ND, TX, UT, WA – laws vary by state.
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY., as well as the fact-checking of Terry Fraser (Mackinac Bank), and Trevor Smith (Incline Village Real Estate), and blog editing by Susan Stanley.
May 5, 2010
How to Dig Out of Debt, Part 2
By Deb Hoskins, CFP®, JD
Colorado Springs, CO
http://www.pikespeakfinancialplanning.com/
Have you lived without your credit cards for the last week? Has it seemed rather mid-20th century, or even un-American, to go “cash only” for all of your purchases?
If it feels odd, just remember that your ancestors lived this way for all of history; consumer debt is a recent luxury. You may also feel like a little kid again, carrying your weekly allowance around in your pocket for purchases. Trying anything new is bound to feel strange until it becomes a new habit.
If you are the type who is tempted to overspend, I hope that going “cash only” will be your new habit for 2010. Cash-only living forces you to recognize three things.
First, you will understand that you are dealing with real money. Intellectually, we all know that credit card balances represent real money, just like we know that Las Vegas casino chips represent real money. But somehow it just doesn’t feel that way. That’s why casinos use chips. If it doesn’t feel like real money, you’ll spend more of it.
The same is true with dining out. Next time you take your spouse to a restaurant, pay cash. That $60 food and bar tab will feel more expensive if you use three $20 bills than if you whip out your Visa card. Yes, the transactions are equal, but it will feel different.
Second, using cash pushes your spending habits into consciousness. Using a credit card can sometimes be an almost mindless activity, since you’ve pushed the day of reckoning into the future. You’ll pay your credit card bill next month and worry about it then. Watching cash leave your hands forces you to worry about it now.
Finally, using cash will remind you that you are dealing with a finite resource. If the $50 you intended as your walking-around money for the week is gone, it’s gone. With no credit card in your wallet to fall back on, you will feel broke—never a comfortable feeling. And you will feel it now, not just someday in the future. That immediate discomfort will change your behavior, and you will spend less and save more.
Just remember that your ultimate goal is to reduce your credit card balance to zero. These first steps to achieve your goal should bring some comfort and satisfaction
Colorado Springs, CO
http://www.pikespeakfinancialplanning.com/
Have you lived without your credit cards for the last week? Has it seemed rather mid-20th century, or even un-American, to go “cash only” for all of your purchases?
If it feels odd, just remember that your ancestors lived this way for all of history; consumer debt is a recent luxury. You may also feel like a little kid again, carrying your weekly allowance around in your pocket for purchases. Trying anything new is bound to feel strange until it becomes a new habit.
If you are the type who is tempted to overspend, I hope that going “cash only” will be your new habit for 2010. Cash-only living forces you to recognize three things.
First, you will understand that you are dealing with real money. Intellectually, we all know that credit card balances represent real money, just like we know that Las Vegas casino chips represent real money. But somehow it just doesn’t feel that way. That’s why casinos use chips. If it doesn’t feel like real money, you’ll spend more of it.
The same is true with dining out. Next time you take your spouse to a restaurant, pay cash. That $60 food and bar tab will feel more expensive if you use three $20 bills than if you whip out your Visa card. Yes, the transactions are equal, but it will feel different.
Second, using cash pushes your spending habits into consciousness. Using a credit card can sometimes be an almost mindless activity, since you’ve pushed the day of reckoning into the future. You’ll pay your credit card bill next month and worry about it then. Watching cash leave your hands forces you to worry about it now.
Finally, using cash will remind you that you are dealing with a finite resource. If the $50 you intended as your walking-around money for the week is gone, it’s gone. With no credit card in your wallet to fall back on, you will feel broke—never a comfortable feeling. And you will feel it now, not just someday in the future. That immediate discomfort will change your behavior, and you will spend less and save more.
Just remember that your ultimate goal is to reduce your credit card balance to zero. These first steps to achieve your goal should bring some comfort and satisfaction
May 2, 2010
How to Dig Out of Debt, Part 1
By Deb Hoskins, CFP®, JD
Colorado Springs, CO
http://www.pikespeakfinancialplanning.com/
At the end of 2008, the total credit card debt of Americans exceeded $972 billion. For those households that had a credit card, the average outstanding credit card debt was $10,679. Uninsured medical expenses, lost jobs, and other emergencies no doubt contribute to many Americans falling behind. However, overspending—otherwise known as deliberately living beyond your means—is a significant cause as well.
If overspending describes your behavior, the next few blogs are for you. Later postings will address approaches used for debt relief, no matter what the cause.
First, overspending and income levels are not necessarily correlated. Plenty of high-income earners are plagued with the overspending habit, while many low-income folks diligently save 10% of every paycheck, the most surefire way to avoid consumer debt.
Second, overspending can range from mild or occasional overindulgences to chronic or habitual behavior that rivals other addictions in its power to destroy lives. If the latter condition describes you, psychological counseling is needed. Trying to follow standard financial planning and debt management techniques on your own will ultimately prove futile and only waste time. Getting to the root causes of addiction and obtaining effective treatment of this behavior must be your first concern.
If your overspending habit is merely mild, I challenge you to do one simple step—lock away your credit cards for three months. I’m not suggesting anything extreme or permanent. This is just a temporary experiment. Try it now. In the next post, I’ll discuss why this is simple but not easy.
Colorado Springs, CO
http://www.pikespeakfinancialplanning.com/
At the end of 2008, the total credit card debt of Americans exceeded $972 billion. For those households that had a credit card, the average outstanding credit card debt was $10,679. Uninsured medical expenses, lost jobs, and other emergencies no doubt contribute to many Americans falling behind. However, overspending—otherwise known as deliberately living beyond your means—is a significant cause as well.
If overspending describes your behavior, the next few blogs are for you. Later postings will address approaches used for debt relief, no matter what the cause.
First, overspending and income levels are not necessarily correlated. Plenty of high-income earners are plagued with the overspending habit, while many low-income folks diligently save 10% of every paycheck, the most surefire way to avoid consumer debt.
Second, overspending can range from mild or occasional overindulgences to chronic or habitual behavior that rivals other addictions in its power to destroy lives. If the latter condition describes you, psychological counseling is needed. Trying to follow standard financial planning and debt management techniques on your own will ultimately prove futile and only waste time. Getting to the root causes of addiction and obtaining effective treatment of this behavior must be your first concern.
If your overspending habit is merely mild, I challenge you to do one simple step—lock away your credit cards for three months. I’m not suggesting anything extreme or permanent. This is just a temporary experiment. Try it now. In the next post, I’ll discuss why this is simple but not easy.
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