Why Are Credit Scores So Important?

No doubt you’ve heard of the acronym FICO. After a quick Google search, you come to find out that it’s not the name of Warren Buffet’s pet dog, but actually an extremely complicated algorithm that summarizes the likelihood you’ll repay your loans in one easy number. The number will range from 300 (unlikely to repay) to 850 (very likely to repay). A good score is generally anything over 650. As you can imagine the more likely you are to repay a loan, the better rate you can receive on your loans. This basic principle drives millions of people to strive for the best FICO score possible. But have you ever stopped and asked ‘why’? What’s the point? 

I did.

I put that question to Google--Google’s response? “Tips to earn a higher score” “Manage your FICO score” and “Raise your score” where a sample of the results. In fact, nearly every hit was a strategy on how to keep a good score. It seems that not too many people are asking, “What’s the point?”

Now that you’re asking the right question... The point of a good credit score is to lose less money after you’ve already decided to lose it. Seriously. Credit scores are derived primarily on debt, whether or not you’ve repaid the money that you’ve borrowed in the past. Look over your last credit card statement. How many of those purchases increased in value? You’ve lost money on those purchases so that you’re FICO score would go up, thereby increasing your capacity to lose even more money in the future. FICO enthusiasts will tell you that a good score allows you to get a better rate on both a car loan and a home loan. As we’ve noted, both of these are poor investments and loose money in the long run. Thanks FICO for making it possible for me to lose more money faster. 

In this regard, FICO is no different than any other discretionary, fun(!) purchase. You shouldn’t decide not to buy your dream home simply because its a poor investment just like you shouldn’t decide not to buy a TV or a haircut because they are bad investments. If you have already committed to driving a brand new car that you will lose a huge amount on, a solid FICO score will help you lose a little less.

"Buy the best house you can afford" (Follow up to 'My House is an Investment' post)

Those were the words a realtor used to persuade one couple to purchase a slightly larger home than they needed. The thought was that homes always perform well as an investment so you can't lose. Well, its now obvious that was faulty logic. A recent post on this blog suggested that houses are exceedingly poor investments, returning an average of -1.4% after inflation.

While this remains true, it should be noted that rented over the same 30 years is possibly an even poorer decision. Let's revisit that couple who purchased their 155,000 home on a 30 year fixed rate of 4.875%. Remember they paid, a total of $400,000 on a house that would be worth $275,000 when they finish paying it off. Obviously, with such a terrible rate of return, the above realtor's financial advice is equally terrible (I try to make money on my investments).

However, (this is the caveat many of you have been waiting for) purchasing the least expensive home that you will be happy with for 10+ years isn't a bad financial decision. Even if you lost $125,000 on the above home, it's still better than the loss you'd take on renting an $800 home over the same time period. $800/mo x 30 years = a $288,000 loss.

The lesson in all this remains to be that homes are poor investments. If you know you'll be staying in the area, buy an inexpensive and small one to minimize your losses. If you don't want to live in an inexpensive and small home, look at it the same way you look at buying clothes or a computer and call it a discretionary, fun(!) purchase not an investment.

How to (lose less money the next time you) buy a car

As a friend takes off his cap and gown and puts on a tie to head toward his new job, he’s ready for whatever life throws at him. Sure, he has student loans, but he saved so much money from not buying a house right away (thanks to the previous posting) that he deserves a little spoiling. Time to enter the next right-of-passage into adulthood, buying a car. He decides that the best bet is something with room to grow, that’s fuel efficient, and fast (we’re still young after all). He settles on a Ford Fusion (starting at around $20,000, but since the base model doesn’t come with air conditioning or seats, everyone buys the $25,000 model. He trades-in his $5000 college car and it’s time to “sign and drive.” The fine print said something about a 5% rate on $20,000 for 6 years. He ends up paying $322.10/mo. Not bad.

Meanwhile, a different friend decides to keep driving her $5000 college car just to see what happens. She is a little more conservative with money and tends to shy away from loans whenever possible.

Let’s drop in on these pals six years later to see how they’ve done. According to BankRate.com cars tend to depreciate 15% to 20% each year. Let’s err on caution and figure only 15%.

The first friend ended up paying all 72 monthly payments of $322.10 for a total of $23,191. Finally, the car is his. But it’s now six years and worth $7,542. Yes, he lost money. Lots of it. However, cars depreciate and it’s just a fact-of-life. But wait, there’s more. He also had to maintain full coverage insurance on the vehicle because he had a loan on it. This cost him an extra $50/mo. for all 72 months. Adding up all his losses, and remembering that he still has a sellable car, we find that he lost a total of $19,249 or $267.34/month. Just the cost of owning a car, right?

The other friend kept her $5,000 car. Nobody wants to drive an junky car so she drove it for three years before she decided to sell it for $3,070 and buy another $5000 car, which she drove another three years and could sell for another $3,070. She didn’t take out a loan so she could “self-insure,” that is, if she was in an accident and her car was totaled, she was only out the value of the car and had enough in the bank to replace it. She spent a total of $3,860 or $53.61/month over six years.

Wow. That’s a difference of $15,389 or 213.74/month! That’s quite a savings. But what if your friends kept this behavior up for their entire working life. They both started at 26 and would like to retire at the earliest possible date to receive Social Security, 62 years old. They will both be saving for 36 years. If your used car friend took the difference and invested it in a Roth IRA that invested in Growth Stock Mutual Funds that returned 10% per year for 36 years...that’s $1,020,536.95! She’s paying herself a million dollars simply to drive used cars. If she has a matching 401(k) or pension at work, her whole early retirement will covered!

(Caveat: Some readers may question whether this strategy will be suitable for them due to extra car maintenance needed for older used cars. First, don’t fall prey to the fallacy that new cars have no problems. Every year, J.D. Power and Associates ranks cars in initial quality (problems in the first 90 days). On average over all major models in 2011 they found 122 problems per 100 cars. Proving that even brand new cars aren’t free from repair costs. Secondly, this is a bit anecdotal, but I follow the “used car” plan and have kept track of my repairs. Besides routine maintenance like oil changes and tires, I’ve found my costs are around $40/month in repairs per vehicle. Even with such repairs considered you still have $829,558.32 after 36 years.)

Itemized Deductions: are you actually deducting anything?

By guest blogger and friend: Timothy Buys, CPA – Crowe Horwath LLP

After reading Dirk’s blog post below about the poor investment decision of buying a home, you may be thinking to yourself, “Dirk! You didn’t mention anything about the HUGE tax breaks for homeowners! You left out one of the most financially responsible aspects of buying a home. I save all my receipts, turn them into my tax accountant and Uncle Sam gives me thousands of dollars in return!”

Wrong.

The truth is you are likely not saving anything. It may be quite the opposite. You are spending thousands and thousands of dollars on a poor investment!

As a CPA and former tax accountant, I hear about these ‘huge’ tax savings all the time. I hear it from the media, clients, friends, co-workers, the news and believe it or not, real estate salesmen. I find that most people are completely oblivious to their own tax returns, the tax code and especially, itemized deductions.

Let’s start off with some simple facts. When filing your taxes, you have the option between a standard deduction and itemizing your deductions. A standard deduction allows you to take a simple deduction of a predetermined amount from your adjusted gross income (AGI). On the other hand, itemizing your deductions allows you to deduct several amounts from purchases you actually made during the year – these purchases typically consist of mortgage interest, mortgage taxes, fees paid to tax preparers, medical expenses, etc.

You have the choice of one or the other.

For a 20-something, married couple in 2010, the standard deduction was $11,400. This means that to even BEGIN to benefit from the itemized deductions you would have to spend more than $11,400.

With that in mind, let’s run some numbers.

In 2010, let’s pretend Joe (plumber) and Mary (teacher) bought a house for $150,000 and have $70,000 adjusted gross income (AGI). They spent $2,000 in real estate taxes, $5,000 in mortgage interest, $300 to the CPA for preparing last year’s return, $5,000 on a car, $2,000 in medical expenses (they are some sick 20-somethings!), $2,000 in mileage to work and gave $2,000 to Encounter Church! Now let’s add up those HUGE tax deductions:
$2,000 real estate taxes
+ $5,000 mortgage interest
+ $300 CPA
+ $2,000 Encounter Church
+ $0 Car is not eligible
+ $0 Mileage to work is not a deduction
+ $0 Medical expenses are not eligible because they do not exceed 7.5% of AGI (limitation)
= $9,300 TOTAL ITEMIZED DEDUCTIONS

Remember taking the standard deduction without spending a dime during the year = $11,400.

You have the choice of one or the other.

So, Joe and Mary’s “savings” by itemizing their deductions = $0!!!! (Written out that says ‘zero dollars’)

“Wait!! But we spent thousands and thousands on this house!”.................................yep.

Even if Joe and Mary’s itemized deductions actually exceeded the standard deduction by $500, they would still only “save” $100-200 assuming they are in the 25% Federal tax bracket. For every dollar they spend above and beyond the standard deduction, they receive roughly 25 cents.

While this example may be simplified and may not take other factors into consideration, the key points are simple: 1. don’t assume you are deducting anything on your tax return – crunch the numbers for yourself, ask your tax accountant for an explanation. 2. The tax code is complex and stacked against you (in others words, Uncle Sam is #WINNING) – research www.IRS.gov to ensure you are in compliance with the law and understanding all the limitations and exceptions. 3. buying a house is wise if you call it a home not an investment. And 4. You could take those ‘thousands and thousands of dollars’ and invest them in a 401k, 403b, Roth IRA, rental property (good blog topic), etc.

A house is an investment...right?

You have just graduated from college (or more likely grad school) and you’ve been renting since you’ve lived with mom and dad. All your friends are are buying houses and you’re starting to feel like you’re falling behind. If that’s you, then you’re probably starting to fall prey to the “a house is an investment” fallacy (yes, I just made that up). The perception is that when you rent, you’re spending money that you’ll never see again. Compare this with a mortgage payment where you’re actually buying something that you can keep. Mortgages seem like the money-wise decision while renting seems like flushing money right down the toilet. Well, let’s just crunch a few numbers to see if we’re right. 

Let’s say you’re interested in buying a house that costs $155,000. Like most Americans, you don’t want to tie up too much of your monthly income so you opt for the 30 year fixed rate loan at a rate of 4.875%. You also put the minimum of 3.5% down. So your mortgage is about $152,000. You decide to use this account to also pay for property taxes and home owners insurance, these payments are called “Escrow.” Every month the bill comes in the mail and every month you are happy to write your check for $1,200. It’s a lot more than your previous rent of $800/mo. but you remind yourself than these payments are for something and you aren’t just flushing good money down the toilet. Sleep easy. 

You wake up at night realizing that 30 years of payments add up to just under $400,000. A steep price to pay for a $155,000 house, but you remember that this house will be appreciate and be worth a lot more. Sleep easy. 

Once more you wake up when it hits you that $400,000 is a ton of money and you’re worried than your house isn’t going to appreciate that fast. A quick Google search might lead you to an article in the Real Estate section on MSN.com by an economist who believes that based on historical returns, home prices are expected to increase after inflation 1-2% per year through at least 2020. Giving yourself the benefit of the doubt, you assume a 2% return add quick add it up. Your stomach drops when you realize that this economist expects your home to be worth $275,000 in 30 years (a difference of -$125,000). Does he know you paid $400,000 for it? So what happened?!

The perception is that a mortgage payment is bankable cash. This is an illusion.   That $1200 check you write each month goes toward a lot more than simply the principle and interest on your mortgage. Modest property taxes and even reasonable home owners insurance, along with private mortgage insurance (for not coming up with 20% down), all eat into that “bankable cash”. Within your payment in those first years: $600 goes toward interest, $415 goes toward owner’s insurance, taxes, PMI, leaving a measly $185 goes toward your actual principle. Add it up and you’re flushing over $1000 a month down various toilets. Suddenly that $800 rent payment doesn’t sound so bad anymore. 

Unfortunately, it gets worse. Your neighbors are finishing their basements, tiling their floors, updating paint colors, and replacing the carpet. There’s no way way your house is going to appreciate at 2% unless you sink some serious cash into it. You previously considered these projects an investment because they increased the value of the home, but you depend on these improvements simply to get your home to be worth the $275,000. If you didn’t spend your Saturdays weeding, mowing, and fertilizing the outside while painting the inside, you’d lose even more money than the $175,000 already mentioned!

Today we’ve learned that an average house, for an average family, in an average neighborhood, is essentially a -1.4% return on investment after inflation. If you still consider a house an investment, I’d like to sell you some more “investments”. Perhaps you’d be wise to continue renting that $800 apartment and saving the extra $400 in your sock drawer. You’d come out ahead.

One one final note, it’s worth mentioning that in many cities the most desirable neighborhoods are often not for rent. You’ll also find that the $1200/mo. home is much nicer than the $800 apartment. Furthermore, there may be something to be said, for intangibles like being able to get to know your neighbors and customizing your own house. And who knows, maybe you’ll sell during the next bubble and come out ahead! The bottom line is that buying a house is wise if you call it a home not an investment.

Reader Q: Index vs. Active Funds

Reader: One question I wanted to ask is about investment costs or "fees" that most mutual funds charge. Do you prefer market tracking or index funds with low costs or more actively traded funds that try to beat the market returns which typically have higher costs?
Answer: It’s clear that this reader has some investing experience. Although most of our readers don’t share this investors level of experience, it is a terrific question for those of you working on the “next step” of retirement planning.

Answer: The “index funds” that the reader is referencing are mutual funds specifically designed to mirror the stock market updates that you see on the news and hear on the radio. For example, you might hear that the S&P 500 is up 1% today (it isn’t). The S&P 500 is a market index that samples 500 large cap American stocks (big companies like Coca-Cola, Google, and Ford). An index fund is a mutual fund that is a balanced reflection of that index, so that if the S&P 500 is up 1%, so are you. The quick advantages of these funds are that they offer low “margins” (fees) and a stable return on investment. Vanguard is a major company who built an empire based primarily on allowing average Joe’s like you and me to invest in index funds at razor-thin expenses. The disadvantage is that they are limited in their scope. Let’s say the auto industry is on the verge of a comeback, sales are up and they’re hiring like crazy. Wouldn’t you want to disproportionally weight your portfolio to take advantage of the success of America’s oldest companies?

Actively managed mutual funds often have much broader parameters as to where your investment goes: growth vs. value, small cap vs. large cap, etc... These funds are free to trade stocks and bonds around those broad categories. The advantage of these funds is that they can generally go anywhere to make money. If the gold bubble, tech bubble, or housing bubble is about to burst, they can get out. However, actively managed funds require significantly more research and “know-how” on the part of the fund manager, so they usually require higher fees, sometimes called “loads” or “expense ratios.”

Now for the answer to the reader’s question: it should be noted that as long as you’re looking at a fund’s historical returns (at least 10% per year for 5-10 years) and making sure that the fees are low, you really can’t go wrong here. Speaking in generalities, actively managed funds out-perform index funds while the markets are up and under-perform while the markets are down. This is a higher-risk, higher return strategy that makes many investors uncomfortable. If you’d like an interesting article on this, ABC News reports on Morningstar’s research on this topic. The author, who’s admittedly biased toward index funds, concludes that actively traded funds are simply not worth the risk. Such a position is reasonable considering the overall value of index funds. However, the author also appears to be in his mid-to-late 40s and shouldn’t be reading a blog meant for 20-somethings. If you’re under 30 and have money in the markets, you’re way ahead of your peers and most financial blogs and reports aren’t considering the fact that you have so many years of investing ahead of you. The bottom line: you should be in higher-risk, higher-return funds, but this should change as you age.

Life Insurance

"I’m married and have recently started a family. Everyone tells me that I should buy Life Insurance but there are so many policies out there, I just don’t know what to do. Help!"

“Everyone” is right. You do need life insurance, especially since you have a family who need to be taken care of if something should happen. If you’ve got a small(ish) family and an entry-level salary, you probably need at minimum a $250,000 Term-based policy for both you and your spouse; however, it might be worth looking into a $500,000 policy too. Also, don’t waste your money on purchasing a policy for your kids. Life insurance is meant to replace lost wages and unless you’ve got Jr. is working the salt mines, he doesn’t have any wages that need replacing. 

But don’t just take my word for it, let’s run through a few of your options:

Term Life: Term-based life insurance is simple, easy, and just like insuring your flatscreen at Bestbuy. You pay a set amount, say $300/year and in exchange you receive a guarantee that if you die within the term, say 30 years, your beneficiary (spouse) will receive the policy amount, say $500,000. Both the total payout and that term are negotiable but if you’re a twenty-something you shouldn’t plan on anything longer than a 30 year term because by your late 50s you should be self-insured (covered below).

Whole Life: Whole Life Insurance is essentially an annuity (think: personal pension plan) that you buy gradually over time, often coupled with a large payout similar to a term-based plan. Whole life is popular because you’re guaranteed to receive some of your money back if you don’t die. Don’t buy whole life for three reasons. 

1. You won’t always need life insurance. by the end of your term, you should be self-insured (covered below).
2. Unused life insurance is no different than unused car insurance, its guaranteed lost money that you need to have “just in case...”. If I came up with a car insurance policy that would slowly pay for the cost of the vehicle over the life of the loan (all the while you still have to be making car payments), you wouldn’t buy it. Life insurance and retirement investing is the same way. You’ll have to invest anyway, so really invest!
3. If you’re investment strategy calls for an annuity (at your age it doesn’t), then buy an annuity. If your plan calls for a higher-risk, higher-return investments (at your age it does), then buy a growth stock mutual fund. Whole life is the opposite of what you should be doing. Its an over-priced, under-performing strategy that you should just avoid.

Gerber Policies: Why would you buy a financial policy from a baby food company?! Do you also get medical advice from the snack aisle? 

Self-insuring. As mentioned above, the aim of life insurance is to cover the lost wages between now and when you are financially independent (retirement). You’re financial aim is to save enough money that even after you retire and, therefore, cease to earn additional money, you will still have enough to live on. When you reach that point, you no longer need life insurance because you are “self-insured”. Congratulations.

What term-based policy do you need? You can purchase policies of $100k, $250k, $300k, $500, $1M, etc... actually you can buy a policy in almost any amount, so why did I recommend at minimum $250k or possibly $500k if you have a higher earning? The same reason why I buy diapers at Sam’s Club, for the bulk discount. The $250k and $500k policies are by far the most popular financial product, so they are often less expensive. When I was insurance shopping, $500k was actually less expensive than a $400k policy! 

A quick and easy way to determine what policy you need is to take your annual income and multiply it by 20. This is called the “Rule of 20”. It assumes that after inflation you can expect your investments to return 5% each year. Not-so-coincidentally, this is actually the amount that you should be saving toward in retirement (less Soc. Sec. and pensions).