The Pros And Cons of Credit Cards

The Pros And Cons of Credit Cards

“Once you get into debt, it’s hell to get out. Don’t let credit card debt carry over. You can’t get ahead paying eighteen percent.”

Charlie Munger, Vice-Chairman, Berkshire Hathaway

 

For me, credit cards have always been a double-edged sword, a fight between good and evil, or in Biblical terms, a blessing and a curse. Growing up, my parents predominantly used cash, using their retail business’s checking account to pay bills. I was the first in my family to go to college and the first to have a credit card. My parents celebrated the former and not so much the latter. They only accepted cash from their customers, refusing to believe in the benefits of the credit card. That’s where I probably get my reluctance to use credit cards instead of cash at times.

They may have been onto something though it may have been something else altogether. My mom, I still believe, may have been irked by the fact that women, on their own, could not get their cards until the passage of the Equal Credit Opportunity Act of 1974. Before that, women needed to have a man (husband or father) cosign for a credit card. How was it fair that my Dad, not my Mom, the brains behind all our finances, could get a credit card? Just saying why I think my Mom, until the day she died in 2000, never had any interest in a credit card (pardon the pun!).

The Credit Card Landscape

Credit cards are a financial tool. But like buying a new buzz saw, you need to use it with care. Some people collected credit cards like baseball cards when I was growing up. That seems like a formula for disaster to me. Clearly, we are not yet a cashless society with nearly 1 in 4 people unable to get approval for a credit card due to lack of credit history or discipline. Roughly 33 million people in the US are unbanked or underbanked, meaning they largely use financial products outside the banking system.

When COVID hit our shores in March 2020, new card applications dropped 40%. Inquiries for all kinds of loans–auto and mortgages–dropped substantially as our priorities changed during the pandemic.  The irony is that the use of credit cards increased out of necessity due to fear of touching cash on the risk of getting a coronavirus-related infection. That behavior is just another example of the strange happenings in 2020. Growth in new card applications should resume in 2021. 

Credit Card Statistics:

  • About 176 million or  67% of Americans have a credit card with about 3.1 cards per person.
  • The average card balance is $5,897 per person end of 2020.
  • Roughly 58% of cardholders carry some kind of balance.
  • The average FICO score for credit cardholders was 735.
  • The current credit card interest rate averages were 14.58%, but for those with fair credit scores, the rates rise to 23.13%For new credit cards.
  • The average rate was 17.87%.

 

Advantages of Credit Cards

 

1. Convenience

Compared to cash, credit cards are a suitable financial product. Before COVID, retail businesses were increasingly not accepting cash from customers. Credit cards provide fast payments, transfers between accounts, and withdrawals.

There are far more shopping options with a card. It is easier to make, change, and cancel travel, hotel, and car rental arrangements.  When traveling overseas, credit cards allow you to realize currency conversions automatically.  Let’s face it, carrying a lot of cash is hard –bills and change– around in your pockets, jingling around. That said, I do like window shopping without my wallet, so I don’t feel tempted to spend money unnecessarily.

2. Build Up Your Credit

For those who lack credit history, like young people, becoming an authorized user on your parents’ credit card is a rite of passage. This is an excellent way to build up a credit history so long as your parents’ credit scores are strong. Otherwise, it won’t help your credit situation at all.  Most states do not have minimum ages for your child to become an authorized user. I’d suggest you teach your kids about the responsibility of using a card safely and responsibly first.

Getting a new card may be a second chance to improve your credit score. You have missed payments, hurting your credit score in the past. If you are ready to be responsible, you should consider getting a secured card, putting some cash on account. You don’t need a massive number of cards to strengthen your payment history and length of credit history. Understand common credit mistakes and how to avoid them.

Related Post: 6 Ways To Raise Your Credit Score

3. Easy To Track Spending

You should regularly review your credit card bills helps you track your spending. It is easy to do (except when you know you spent a lot of money) and an excellent way to improve your financial discipline. Although spending cash is the best way to feel pain immediately, regular examination of the amounts you are consuming is a realistic way to correct yourself. The credit bills provide a purchase record when making returns.

One particular month, I recall seeing a very high bill with several items that seemed uncharacteristic of me. It was a posh store with a great salesperson.  Looking around,  I realized that the dress  “I had to have” was still in the bag with the tags on along with new shoes. Who did I buy that for? Not me, apparently so I returned those things and stayed clear of that salesperson.

4. Automate Your Payments

Paying your bills, especially credit cards, are so much easier when you use the automation feature. Most cards have this feature that you can set on or before the due date so you are not late on your bill payments. Also, consider paying more than once a month if the lower amounts feel better to digest. As payment history accounts for 35% of your credit scores, automating payments is one way to help you not miss the due date.

5. So Many Perks

Having a credit card may entitle you to perks. Typically, the card use may provide perks such as cashbacks, rewards, airline points, merchant discounts, hotels, travel insurance, welcome bonuses, access to tough-to-get tickets, and free museum passes. Before signing up a specific perk, make sure it aligns with your needs. One time I ordered four tickets for Hamilton on Broadway for my family, only to realize they were preview tickets for the opening in LA, 3000 miles away. The issuer reimbursed us and waived the fees.

6. Protections For Consumers, Not Necessarily For Businesses

Credit cards offer several features for consumers. When you lose cash, it is gone forever. The good news is that money is typically not attached to your personal information, like the loss or theft of your credit cards. Some cards provide zero-liability fraud protection. In a fraud situation, just notify your issuer to cancel your card. Alternatively, the issuer can get you a new account number at no charge. Safety is important.

Typically, when you lose your credit card, your losses are capped at $50 so long as you let the issuer know promptly. There may be a higher fee and responsibility for any charges that aren’t yours if you delay reporting them. I once thought I lost my card, I called the card company quickly to find that my card fell out of my wallet into a nook in my bag. Paying the fee was a fine for a lesson learned to at least look for your card first.

Cards often have spending limits. Occasionally, you may want to lift the limit if you know you may be spending more for an overseas trip, for example, where you plan to shop for jewelry. A cardholder can let their issuer know that they want to “opt-in” to allow for transactions that may put you over your credit limit. You can let them know the specific dates you’ll be traveling. Spending limits are a good feature, especially if you’re prone to overspending.

The Credit CARD Act of 2009 enhanced more protections for consumers that do no apply to businesses. With this law, issuers need to notify consumers of significant interest rate hikes at least 45 days beforehand. Also, fees, previously hidden, must be better disclosed clearly. There are some other practices that improved with the CARD Act discussed here. Still, it is always important to read the tiny fine print, especially when it comes to credit cards.

Disadvantages of Credit Cards

 

 

1. Overspending Leads To Higher Debt

Spending beyond your means can be the root of all evil related to your finances. Credit cards enable people to shop impulsively.  Having a card rather than a finite amount of cash gives you the ability to borrow more than you should. Overuse of your card leads to carrying high-cost debt on your balances. Paying double-digit interest rates on these balances can be overwhelming.

The convenience of using credit cards as compared to cash may encourage higher spending, according to studies. In the now-classic MIT study by Drazen Prelec and Duncan Simester, MBA students held an auction for tickets to sporting events. One event was a desirable basketball playoff game, and the other was a regularly scheduled baseball game. Those participants were encouraged to buy tickets using credit cards spent up to 100% more than those paid in cash. They called this the credit card premium.

Other studies seem to validate the MIT findings that we tend to spend more with a credit card than cash. For me, spending cash for purchases gives me an immediate pain instead of a nearly month delay of having to pay my credit card balance.  to me, mental accounting bias and overspending

2. Irresponsible Use of Your Credit Card

When you pay your card bill in full every month, you don’t pay any interest. Your credit card provides a lot of benefits without the pain of paying high interest costs. Unfortunately, many people just pay the minimum amount due at the end of the month, carrying a balance forward. The issuers prefer cardholders to carry balances as it is a lucrative income stream for the companies. 

At an average balance of $3,000 with an average interest rate of 16%, it can take 16 years to pay off that balance at the monthly minimum rate, roughly 3%-4% using a credit card interest calculator. That assumes that you haven’t used a credit card during those years. It is a vicious cycle. The magical powers of compounding that work so well when investing or saving for retirement works against you when you are paying interest charges on interest accumulated. If you cannot use your card responsibly, you should work hard to reduce your spending. Some people have too many credit cards, maxing out their limits, losing control of their spending.

Watch out for the particularly punitive penalty interest charge when you are late on your credit card payment. The penalty interest rate could be as high as 29.99%, above your regular interest rate, and may stay in place for some time.

3. Lower Your Credit Score

Just as you may raise your credit score, misuse of your credit cards can destroy your score. Missing payments, applying for credit too many times, and using more than the 30% limit of your available credit all can hurt your scores. Even closing a credit card account, you don’t use will result in a decline in your score. Your credit score reflects your creditworthiness to lenders, landlords, and other professionals and could negatively impact you.

4. Read The Fine Print

Just like any contract you sign, make sure to read the terms and conditions of the credit cards you are considering. Despite legislation to protect consumers, issuers are well known for hiding information about their perks, fees, charges, and other liabilities from consumers. In recent years, consumers have been able to compare credit cards more quickly. Among my favorite sites are WalletHub, NerdWallet, and CreditCards.com, which have a ton of good information on credit card features.

Be aware that you are usually subject to mandatory arbitration if you have a dispute with your card issuer. This has been relaxed in recent years but is still in the terms and conditions. It is one of my pet peeves and a project I assign my law students to look at the fine print. The average consumer can’t fight the legions of arbitration attorneys that support card issuers.

Exercise Financial Discipline By Using These Rules:

  1. Shop wisely for a credit card, finding the perks that most suit you.
  2. Read the terms and conditions carefully even after you made your selection.
  3. Pay your credit card bill in full, so you don’t carry a  balance.
  4. Have an ample emergency fund, so you don’t put high unforeseen costs on your card.
  5. Spend below your means always and make savings and investing a priority.
  6. Don’t close any credit card. Instead, cut your card in a million pieces or simply put it in a drawer.
  7. If you have multiple cards, decide how to use them for different categories and don’t max out their limits.
  8. Avoid cards with annual fees unless they have essential features you will use.
  9. Don’t get addicted to credit cards. Limit the number of cards you have.
  10. When it comes to paying your card bills, automate and don’t procrastinate. The penalty rate is punitive for a reason.
  11. If your child is an authorized user of your credit card, teach them how to use the card wisely and safely.
  12. Be aware of behavioral biases of spending more when using your credit card instead of cash.
  13. Review your credit card bills for errors, poor judgment on your part, or correct impulsive spending.
  14.   Use cash for some of your discretionary spending.

 

Final Thoughts

Credit cards serve an essential purpose as a financial tool in an increasingly cashless society. Used wisely, the advantages of credit cards will outweigh their disadvantages. Practice financial discipline in all aspects of money management. We have had our druthers about using credit cards, learned a hard lesson or two.

Thank you for reading! If you found some value in this article, please share it with friends, family, and colleagues. Consider subscribing to our growing community at The Cents of Money!

 

 

 

 

Getting Stimulus Money? Spend This Money Wisely

Getting Stimulus Money? Spend This Money Wisely

The third and possibly final stimulus check from the federal government is on its way. Most people will get their stimulus money via direct deposit to tens of millions of bank accounts. If you and your family qualify for the most extensive distribution, you likely have some immediate or future needs. Whatever you decide to do, strategize to spend this money wisely.

Stimulus Checks And Extended Unemployment Benefits

Did you get your stimulus check yet? The maximum tax-free amount is $1,400 per individual ($2,800 per married couple if jointly filing), and $1,400 per dependent, including those ages 17 and up. The federal government extended unemployment benefits with a $300 additional supplement to state benefits through September 6, 2021.

Typically, unemployment benefits are fully taxable. However, the IRS gave a tax break by allowing taxpayers to exclude up to $10,200 ($20,400 for married couples filing jointly) benefits on their 2020 taxes for those who made less than $150,000 in adjusted gross income (AGI). As stimulus checks were going out to households, the IRS announced tax returns are now due on May 17 this year instead of April 15.

How To Use Your Money Depends On Your Needs

Every household varies as to their need for this money. For instance, lower-income families are more likely to devote much of their spending to living necessities.

In a June 2020  US Census study,  adults in households with income between $75,000 and $99,999 were more likely to use their stimulus money to pay off debt or add to savings compared to households overall. In contrast, 87.6% of adults earning $25,000 or below planned to use their stimulus payments to meet their expenses.

The stimulus money is part of more considerable fiscal support targeted to boost consumer and business spending. As the economy grows, more people will work.

The Fed has accommodated our weak economy with low-interest rates and continued liquidity. These efforts will stimulate our economy and help our financial markets, but they may cause higher inflation. Fears of higher inflation have added volatility in the stock market.

Some believe higher economic growth and inflation may be transient, causing some stock market opportunities ahead. Chair Powell seems to be staying on course of a stimulative monetary policy and will tolerate higher inflation over the 2% target. 

Is This A Financial Windfall?

Merriam Webster  defines windfall as “an unexpected, unearned, or sudden gain or advantage.” A windfall can range from being a sum of $1,000 to something far more significant. This money may result from an inheritance, legal settlement win, salary bonus, or a winning lottery ticket.

A small windfall, newfound money, or stimulus money can serve a similar function by bringing you a step closer to your financial goals. That is a win for you whether you direct the money to help you with your day-to-day expenses or cushion your retirement nest egg.

Strategize What You Need Now And For Your Future

Strategize before spending your additional money by paying what is most urgently needed now.  The funds should improve your financial situation. Most people receiving checks have had a difficult time making ends meet. They may have lost their jobs, had their hours cut, or their job remains in jeopardy.

You may need to shore up your finances now. Are there holes in your budget that need mending that you can take care of first?   Pay your bills, reduce your debt to manageable levels, eliminating high-interest credit card debt. Should you have money left over, save for emergencies.

On the other hand, if you have little to no debt, devote your extra money to where you can catch up on retirement savings and investing.  Allocate where you can boost your financial future–replenish your emergency fund, retirement, investing– by adding to where the money can potentially grow.

Our Recommendations For Spending The Money Wisely  

 

1. Prioritize Your Everyday Bills

If you have outstanding household bills for your rent, mortgage, or utilities that need attention, consider negotiating with your providers. Ask if lower rates are possible or stretch out due dates. You want to avoid being late paying bills and affecting your credit score. It never hurts to try to do that at a time when people are most understanding.

Staying current on your bills can relieve the angst. And you don’t want to pile on late charges and add to your debt load.

2. Paying Off Your High-Cost Debt First

When you carry a lot of debt–credit cards, car, mortgage, student loans, or personal loans–can be overwhelming. Your stimulus money may not stretch that far. Interest rates are low for mortgages, car, and student loans, so your best bet is to reduce your credit card balances. Card issuers typically charge 15%-16% interest rates, and the compounding effect makes that balance grow faster.

It may be tempting to spread the cash proceeds around to all of your loans but target the most detrimental cost first.

3. Neglecting Any Car Repairs?

During COVID, you may be using your car less. If you are not following through with tune-ups, you can damage your vehicle in the long run. Do you have any car repairs you postponed but now can bring into the shop? Your repair guy will likely welcome you back.

4. Replenish Your Emergency Funds Or Start One

Many people have withdrawn money during the past year. They may have had to close businesses, leave jobs to take care of their family, or lost their jobs. It is time to reassess your emergency savings. Refill this fund so you can cover six months of your basic living needs should something unforeseen happen. A job loss, pet surgery, an unexpected illness, or car accident can mean higher costs beyond your budget.

Replenishing these savings can give you peace of mind. Those unexpected events do happen, as many of us learned the hard way last year.

Make sure to keep this money in liquid assets such as a higher-yielding savings account that is readily accessible. These days there is very little income to earn from low yields. But, economists are expecting higher interest rates as the economy strengthens. Therefore, use short-term securities like CDs so you can roll this money into higher yields when they are available.  

5. Add To Your Retirement Savings

Whenever you have extra money from a bonus, overtime, or raise, consider adding some of this money to your retirement savings. Notably, a 401K employer-sponsored plan or an IRA and Roth IRA makes sense. If you don’t have a retirement account, this is a good time to do so. 

Technically, your tax-free stimulus payment is unearned income. As such, it may be tricky to deposit money into your Roth IRA directly. Therefore, you may want to substitute earned money from other accounts, replacing those dollars with your stimulus money.

It is worth the effort to do so. Putting some money into a Roth IRA makes it a triple tax-free win. You aren’t paying taxes upfront. The contributed amount grows tax-free, and when you withdraw money after your turn 59.5 years.

Be Aware of Contribution Limits

You can have both a 401K and an IRA, but there are IRS contribution and income limits you need to be aware of so you can get the full deduction. Be mindful of those income limits for traditional IRA and Roth IRA for 2020 and 2021. They vary according to whether you are the single or head of the household, married, filing jointly, a retirement plan at work covers one or both spouses.

Contribute generously up to the maximum amount allowed:

The 2020 and 2021 limits are $19,500 for 401K and most 400 plans, and with a catch-up limit, $26,000 for employees aged 50 or over.

Total contributions for 2020 and 2021 are limited for all traditional IRAs and Roth IRAs to $6,000 or $7,000 if you’re age 50 or older.

6. 529 Savings For College

These accounts have federal tax benefits, like retirement accounts. Open a 529 savings account to set aside some money for your children’s college fund. Earnings on investments grow on a tax-deferred basis and tax-free when you withdraw money for educational costs. Generally, there are no contribution limits except for the $15,000 cap to qualify for the annual gift tax exclusion.

Each state has its own plan, and you don’t need to reside in the state to use their program. You may think that they are young and it is too early to think about their future, let alone college, if they are still at the crawling stage. The truth is that time goes by quickly, and before you know it, they are in high school. Don’t let this valuable time slip away without putting money into this fund. It will help your children to avoid borrowing heavily for college tuition.

7. Allocate Your  Savings To Investing

In a perfect world, all of your extra money should go toward investing. If you have a strong financial foundation with manageable debt, you should invest the money. Add to your investments or opening up an investment account for you or your kids.

Any savings you have from stimulus checks to a significant financial windfall should go to your investment accounts. That is if you have taken care of other needs. Invest early and have a plan in mind which considers your risk tolerance, timeframe, and diversification. 

When you are beginning to invest, you may not know where to start. Buying individual stocks can be very rewarding but can be risky. Consider low-cost index mutual funds or exchange-traded funds (ETFs) if you are uneasy purchasing individual stocks. Buying a pool of stocks is a popular way to own securities with diversification, avoiding concentration risk.

Professional portfolio managers actively manage mutual funds. They are constantly evaluating and choosing securities for the fund’s specific investment approach. Mutual funds are available for stocks, bonds, precious metals, other securities, varying risks,  and varying geographic markets. 

Active managers earn annual fees or expense ratios of your investment and are responsible for the fund’s performance. If you invest $1,000 in a mutual fund with a 1% expense ratio, you pay $10 per year towards the fund’s expenses.

Active Versus Passive Investing

Investors who buy actively managed funds pay higher expense ratios than passively managed index mutual funds that track a market-weighted portfolio. The latter index fund replicates the S&P 500 index via computers for a fraction of the fees, averaging 0.20%-0.50% expense ratios, below the typical 1%-2.5% costs of active managers.

You can buy a low-cost index mutual fund or an ETF consisting of a basket of securities, such as money markets, stocks, or bonds depending on your risk appetite. ETFs are similar to mutual funds but tend to be cheaper and more liquid. If both are available, I usually buy the ETF version. There are many funds with terrific choices, such as Vanguard, who pioneered indexed funds.

8. Give To Others

It is always a good time to give charitable donations to others. We always target giving 10% of our income to charitable contributions, but we have done more to offset the time we couldn’t do so. Everyone has their reasons for giving what they can and may stem from religious or ethical sources.

The minimum of one-tenth of one’s income belongs to God per measure handed down from the Patriarchs. As Jacob himself said to God, “Of all that You give, I will set aside a tenth to You” (Genesis 28:22). Giving 10% of your net income every year is a desirable goal—those who can do that.

Giving, like expressing gratitude, is among the most worthwhile healthy emotions to feel. Being grateful can even help us with our finances.

As part of 2021 $1.9 trillion American Rescue Plan, Biden extended the favorable tax deduction treatment in 2021 that was available last year. Taxpayers who take the standard deduction rather than itemize their tax deductions may set aside $300 (or $600 if you are married and filing jointly). The IRS suspended the typical limit of 60% of adjusted gross income for the amount of the charitable deduction made in a year.

The IRS has temporarily suspended limits on charitable contributions for those who itemize deductions on Schedule A. Check with your accountant whenever it relates to your taxes. 

 

Final Thoughts

Use your stimulus payment or windfall by spending the money wisely to improve your financial situation. It’s a personal decision based on your needs now or in your financial future. Strategize before spending this additional money so you can get the most of it. Hopefully, you are turning the corner to better times.

 

 

 

 

 

 

 

 

 

Why Liquid Net Worth Matters

Why Liquid Net Worth Matters

“Liquidity is a good proxy for relative net worth. You can’t lie about cash, stocks, and bond values.

Mark Cuban

Understanding your net worth and how to calculate it is hugely important for measuring your financial health at a particular point in time. It is simply the difference between assets and liabilities. However, it doesn’t consider the liquid nature of your assets.

For example, stocks and bonds tend to be more liquid than other assets as they can be quickly and easily converted into cash. Other assets like your house or car take time and negotiation to sell if you need money. Net worth remains a helpful benchmark but depending on the type of assets you have it may be a less accurate picture.

Liquid Net Worth Is A Realistic Snapshot Of Your Financial Condition

Liquid net worth is what really matters. It is a far more realistic reflection of your financial condition should you face an immediate need for money such as a medical crisis or a business opportunity. While liabilities remain the same for both calculations, your liquid assets have more significance when unforeseen events occur.

Those assets for readily available as cash with little or no loss of value to be counted in liquid net worth. Having liquid money provides a sense of financial security for disasters and opportunities alike.

Asset Rich Cash Poor Can Be Uncomfortable

To a great degree, when you need to take money out to pay for an unforeseen event, would it be easier to take $15,000 out of your savings account or sell your land? Depends if you have $15,000 in the bank. The expression “asset rich cash poor” comes to mind. Often, people have economic assets like land or other economic interests but are not able to easily liquidate them for money.

Land and antiques are assets we have owned and enjoyed. However, you can’t count on those assets to pay for a costly emergency in your life. When I think about mistakes I have made, those purchases stand as major regrets. You sleep easier with access to liquid assets.

What Is Net Worth?

Your net worth is your personal balance sheet that provides a snapshot of your financial position at that time. Net worth is all that you own less than all that you owe. For an expanded explanation, see 10 Reasons Why You Need To Know Net Worth.

The  Formula: Net Worth =  Total Assets less Total Liabilities

Using an excel spreadsheet with different assets/liabilities is an excellent tool for you to put all of your categories in one place that can be periodically updated. You should do it on at least a quarterly basis. However, if you are true to your monthly budgeting, reviewing your monthly net worth is better.

Try putting it on a spreadsheet first. You can use Personal Capital’s net worth app for tracking your investments. Frankly, any way you can keep on top of your net worth with an eye towards building the amount will work.

Knowing Your Net Worth:

  • is a crucial benchmark and report card at a particular time.
  • will allow you to set near-term and long-term goals.
  • track its changes for better money management.
  • highlight your liquid asset balances.
  • helps you to get a loan for a house, car, college tuition, or new business.
  • pay down high-cost debt.
  • refinance your mortgage loans.
  • encourage you to save and invest more.
  • buy your own home, rather than pay high rent.
  • is a great road map to building your wealth.

 

What Is Liquid Net Worth?

Although net worth provides a view of your current financial condition, it doesn’t differentiate the assets that can provide you with liquidity quickly and easily. When facing a medical crisis or an opportunity to buy a business, getting access to your money matters. Sure, you can sell your car quickly but likely for less than the estimated value. Understanding what assets are more liquid means they can be readily converted into cash with little or no loss in value.

The Formula = Liquid Assets Less Total Liabilities

You can either remove non-liquid assets from your total assets or discount their values from their appraisals. Additionally, you need to recognize that tapping certain assets too early such as retirement accounts could result in paying penalties and taxes. More than that, you lose momentum when you withdraw assets that were benefiting from compounding growth.

 

Your Liquid Net Worth:

  1. Understand the differences between your net worth and liquid net worth. Liquid net worth is what you need to count on for immediate funds.
  2. Liquidity varies among our assets which have different growth rates. Money market accounts are liquid but typically have lower returns than stock investments long term.
  3. Consider costs involved in the transactions such as penalties, taxes, fees, and such

 

How To Calculate Your Liquid Net Worth?

Liquid Assets:

  • Cash
  • Cash-Equivalent Securities
  • Brokerage/Investment Accounts

The most liquid assets are cash, cash-equivalent (or money market) securities, and investment or brokerage accounts. These are either already in cash or are those financial or monetary assets that can easily turn into cash with little or no loss in value.

Cash is the best form of liquidity but of course, doesn’t grow unless it is invested.  This category broadly consists of cash on hand, prepaid cards, savings accounts, checking accounts, money market accounts, certificates of deposit (CD), savings bonds, and emergency funds. If your CDs are in a fixed term like 6 months or a year, you may need to pay a small prepayment penalty but this is fairly accessible money. Separately, you need to have an emergency fund earmarked for unforeseen expenses.

Brokerage/Investment Accounts

All types of financial securities can be bought or sold in your brokerage account. Typically, they are stocks, bonds, REITs, mutual funds, and ETFs that are in these taxable investment accounts. While these accounts are liquid in a matter of three business days, you do pay taxes on price appreciation based on the time you held the security. Holding the securities for over one year is taxed at a lower 15% capital gains rate. Otherwise, you pay taxes at the same rate as ordinary income.

Less Liquid Assets

The cash value of your life insurance policy is fairly liquid but you may have to absorb small fees. Depending on the company, it can take more time (eg. 10-20 days) than access to financial securities. On the other hand, access to pensions and investments in real estate such as multifamily homes are less liquid.

Retirement Accounts

When withdrawing money from your retirement accounts before you turn  59.5 years,  you will likely be hit with a 10% penalty and immediate payment of taxes, losing the deferred benefit on that amount. Generally, if you withdraw early from a 401K plan or IRA account you will pay taxes at your marginal tax rate. The marginal tax rate is the tax rate paid on the dollar of earnings (eg 22%-24%).  On the other hand, Roth IRAs are treated differently. For those accounts, so long as you have had this account five years or more, you may withdraw contributions you made to your Roth IRA anytime tax-free and without penalty.

While you may have access to your retirement savings, these are not considered to be liquid. You should not dip into your retirement accounts unless needed as a last resort. By withdrawing these funds, you lose the compound benefit on this money for your future when you are less likely to earn money at your job.

A Temporary Exception

The federal government had waived the 10% penalty if you made a withdrawal between January 1 and December 31, 2020, for those impacted by COVID. Qualified individuals that put back this withdrawn money within a three-year time frame will be excused from paying taxes on the money.

If you are including retirement accounts in your liquid net worth, you should discount your retirement balances by 25% to be conservative.

529 College Savings Accounts

Like retirement accounts, withdrawal of money saved in a 529 college savings plan may be subject to a 10% penalty and you will have to pay taxes. The exception to this rule for 529 savings is withdrawals made for qualified education expenses such as tuition, fees, books, computer, and related costs.

If you are including 529 accounts into the liquid net worth, I would use a similar discount of 25% off the account balance.

Other  Assets

The cash value of your life insurance policy is fairly liquid but you may have to absorb small fees. Depending on the company, it can take more time (eg. 10-20 days) than access to financial securities. On the other hand, access to pensions and investments in real estate such as multifamily homes is less liquid.

Tangible assets

These assets are real and personal property that reflects your lifestyle and is harder to liquidate for funds.

Your Primary Home

If you own the primary home you live in, this may be your largest asset. While the home is an investment, it is not a liquid asset like financial securities you invest in. You cannot count on liquidating real property for quick conversion to cash. You need to figure out how the real estate market is faring in your area using Zillow Zestimate and other sources.

Selling your home is a complex process that can take several months or more to accomplish. An appraisal value is not necessarily your sales price which is often lower. Also, to complete your sale, you are responsible for fees and costs including broker fees of 5%-6% on the sales price, closing costs of 1%-2%, and attorney costs.

Most likely you are carrying a mortgage that is picked up in total liabilities. Upon the sale of your home, you will pay off your mortgage in full from the proceeds of the sale of your home, reducing your liabilities.

Your primary home as an asset should be discounted about 25%-30% off its estimated value for purposes of liquid net worth.

Other Real Estate

Besides your primary home, you may own other types of real estate, including vacation or second home, timeshares, land, and rental property. Having just sold a plot of land, I can tell you that we took a 30%-35% hit from our cost basis in an ugly market after putting it on the market over a year ago.

Use current conservative market values for real estate. Appraised values may not reflect actual sales or liquidated values. You should not be inflating your liquid or net worth unrealistically.

You would need to approximate the value of your home, cooperative, condominium, cars, boats, and any other large items. To approximate real estate values, you can look at Zillow Zestimate, Redfin, Chase Home Estimator, or real estate websites for your zip code.

Your Business(es)

If you own businesses outside of your primary income, it is tricky to calculate a value let alone consider it to be a liquid asset. While you may want to include in your net worth statement a discounted multiple of annual revenues, it doesn’t make sense to include for purposes of liquid net worth unless you had the business appraised and a ready buyer.

Personal Property Is Tricky To Value

Unless you have a meaningful fleet of cars and boats, you should not add these to your assets for your net worth or liquid net worth.  These assets depreciate too fast and sell too slowly to add fairly to your liquid net worth. If you do have that fleet, for cars, you can look at Kelly Blue Book, Edmunds, or AutoTrader. Similarly, for boats, you can consult Boat Trader.

What Else Goes Into Total Assets?

Art, rare books, rugs, and antiques may be a large part of the net worth of wealthy households handed down to the next generation. Unless they are highly desirable or rare, these assets tend to be wildly low liquidated values to count on if you needed money in a pinch. Musical instruments have their value, but again, they are very difficult to peg and their sales are less predictable to raise capital.

This category has a lot of sentimentalities but its value may be very difficult to ascertain. In my opinion, these assets should not be counted on unless you work with an estate professional steeped in knowledge and who has a terrific network to help you sell the items.

My Own Personal Experience Provides A Valuable Lesson

When I worked on Wall Street, I was restricted from making investments in financial securities. If on that rare occasion I was able to buy certain securities, I was often not allowed to sell that security when I wanted to. So, on either side of the trade, I was burned and finally abandoned investing until I left my career as an equity analyst.

So what did I invest in?

A large part of our assets was in art, rugs, rare books, and antiques. What was I thinking?

These assets are on our walls (art), in our bookcases (rare books such as the first edition of the Federalist Papers), on the floors (ancient rugs), and antique furniture (signed in the mid-1760s by the cabinetmaker).

Ever try to sell an 18th-century Tiger Maplewood card table? We have! And we are still waiting for that sale.

Beautiful stuff, but they can’t pay the bills! So I don’t include these personal assets. The few pieces we have sold were at prices 70% below what we paid for them.

I digress but a worthwhile lesson for those who are collectors.

List all your Liabilities By Current Balances

 

Mortgages

  • Your mortgage loan balance is probably your largest liability.
  • The home equity loan balance.
  • Separate mortgage loan balances for the other real estate property (listed above in assets)

Other Loans

  • Student loans at the current balance.
  • Loans associated with the business(es) even though you aren’t including the value of the businesses.
  • Personal loans
  • Credit card account balances (you should break these out individually).

Related Post: Pros And Cons of Credit Cards

Total Liabilities

As mentioned earlier, the formula is fairly easy:

Total  Liquid Assets minus Total Liabilities = Your Liquid Net Worth

Depending on the composition of your assets, it is possible that your liquid net worth may be negative, especially when you are conservatively discounting large assets like your home but including the full mortgage balance. It is important for you to consider whether you need to adjust your investment strategies, spend less, save more, and make sure you have money for emergency purposes.

 

How Can You Build Up Your Liquid Net Worth: Make Good Trade-Offs

Track changes in your liquid net worth statement as early as possible to make sure you are making progress towards your goals.

Track your spending, review for areas you can reduce and produce savings

Have an ample emergency fund of 6-12 months for unexpected events like a lost job. Invest this fund in a liquid account like money markets.

Put more of your money into investment assets like stocks that can expand wealth rather than in personal possessions.

Add to your retirement accounts to the contribution limit. Avoid withdrawing money from these accounts which trigger penalties and taxes. The same goes for 529 plans.

Making more money at your job or a side gig to boost income.

Consider buying recently used cars than luxury fast-depreciating vehicles.

Choose to invest based on your appetite for risk and where you are in your life cycle.

Related Post: How To Make Better Trade-Offs

Where Should I Invest My Money To Maximize My Liquid Net Worth

Stocks are riskier but generate higher returns than keeping your savings in bank accounts at low returns.

According to Bankrate, the best annual percentage yield (APY) which is your effective annual return as of August 28, 2020 ranges from  0.60%- 0.91% for the top ten banks. Those paltry rates which do not provide much in the way of income. Typically, banks may require a minimum balance from $1 to $25,000 and have monthly fees up to $15.

The younger you are, the more able you are to ride out the greater risk found in stock investing, with the benefits of compounding effects.

Homeownership remains a worthwhile investment with currently low mortgage rates. But your home is less liquid than financial securities.

Decreasing your loans or debt liabilities will increase your liquid net worth.

Your Mortgage Loan Deserves Your Careful Attention

Look into refinancing your mortgage if you carrying a mortgage with more than 5% loan rates. You may realize savings.

Target carefully what you borrow, for how long, and at what rate. Look at taking out a 15-year mortgage loan versus a 30-year mortgage loan. While your monthly payments will be higher for the 15-year loan, total borrowing costs will be lower.

Taking on a mortgage loan is a big cost but home prices have generally kept pace with inflation until 2008-2009 when subprime mortgages played a huge factor in declining home values.

Lower Your Debt Where Possible

Pay off your credit card debt in full. It’s likely your highest cost debt so use extra savings, bonus, or tax refund to lower this amount. Otherwise, slow your spending.

Pay off your student debt as soon as you are able.

Final Thoughts

While net worth is a more common benchmark, refining your assets for liquidation purposes gives you a more realistic picture. Tracking liquid net worth helps you to understand your ability to deal with a crisis or an unexpected opportunity. When facing an immediate need for cash, you don’t want to withdraw funds that are earmarked for retirement.

Thank you for reading! If you found this of value, consider reading other articles on our blog, and join us by subscribing to The Cents of Money. Please let us know your thoughts!

Key Financial Concepts When Saving, Investing, and Borrowing

Key Financial Concepts When Saving, Investing, and Borrowing

“Many people take no care of their money till they come nearly to the end of it. And others do just the same with their time.”

Johann Wolfgang Von Goethe

Use Time Value Of Money To Achieve Your Financial Goals

Understanding financial concepts can help you make better decisions. Time and money relate to each other as in  “Time is money.” A dollar in your pocket today is worth more than a dollar received five years from now. The time value of money is the notion that money can grow in value over a given period.

You should save or invest today’s capital so that it is worth more in the future. Present value relates to what the sum is worth today. On the other hand, the future value is what an investment (or a series of investments) made today will be worth later on.

Earning Simple Interest Is Good

Invest your savings today to have more money tomorrow. This earnings capacity’s potential depends on how you invest the money and earn on its interest rate.  One way of calculating interest is using the simple interest formula. Here, the principal generates interest income dependent on the interest rate. So if you had $10,000 in your savings account at 8 percent for four years, you would earn $3,200. However, you can do better by compounding the interest.

Compound Interest Is Far Better In Building Your Wealth

A different and more beneficial way is to earn income through compound interest, closely related to time’s money value. Assuming you don’t withdraw any money, compounding allows you to earn interest on interest on your balance. That is, your principal continues to rise as you make interest—the frequency of the compounding matters.  More frequent compounding (daily rather than annually) adds incrementally to more money.

Compounding serves as the basis of the time value of money. By adopting good financial habits of saving money, compounding over time is what builds wealth. Instead of earning $3,200 over four years at an 8% interest rate, compounding gives $405 more or $3,605 on your initial $10,000 deposit. Over a more extended time of 40 years, that $10,000 would grow to $217,245. Most of that growth comes from interest earned on interest. Ka-ching!

A Positive Effect On Your Money

Compound interest is one of the most powerful forces of investing. It fuels the urgency to set aside money early for your retirement. This financial term simply means that you add interest to the sum of a loan or deposit or interest on interest. Your balance grows at an increasing rate so long as you don’t withdraw money from your funds.

The power of compounding is the basis of key financial decisions, from your personal savings plan, 529 Savings Plan, retirement, and investment accounts. The earlier you save and invest money in the stock market, the longer the compounding works for you.

To better illustrate the power of compound interest is the classic question, “what would you rather have, a penny that doubles every day for 30 days or $1,000,000?” And the answer is the doubling penny which yields $10,737,418.23. Quite a bit more than the one million dollars. Take a look at our excel spreadsheet here.

It is not reasonable to assume a 100% annual growth rate for any investment annually, let alone daily.

However, suppose you save $2,000 per year in an investment account when you are young at 8% return, and save an additional $500 per month over 35 years. In that case, you could accumulate $1.1 million. Try using a compound interest calculator.

Saving For Retirement Early Beneficial For Growth

The power of compounding interest, linked to the time value of money, will benefit you the most if you save and invest early. Let your earnings accumulate and grow rather than withdraw cash from your accounts. It makes a big difference if you start saving for your retirement ten years later than your friends or if you invest for ten years and then stop contributing to your 401K retirement account. It is difficult to catch up by doubling the amount if you start investing later on.

As a goal, try to contribute to your 401K plan to the maximum level, which is $19,500 in 2021.  Some years it may be hard to do, especially when you are experiencing a job loss. Resist withdrawing money from your retirement account as there is usually a 10% penalty tax to do so before you turn 59.5 years. Withdrawing this money will put a dent into your retirement fund that will be painful later on. Instead, your plan is for you to retire comfortably in the future.

Lottery Winners: Lump Sum Or Annual Payments

There is only a tiny probability of winning the lottery. However, it uses the time value of money calculations (present value and future value) to decide whether to win a lump sum or annual payments. Lottery winners, after the rush of adrenaline, have a choice to make regarding time and money. Most lotteries allow the winner to take a lower lump sum or an annuity. The annuity option is a series of annual payments.

If the jackpot is $100 million, the lottery could arrange for 20 annual payments of $5 million while investing a lump sum to fund those payments to the winner. Assuming a present value of a series of equal payments of $5 million at 6%, they would need only $57,349,500 to fund the stream.

What Should The Winner Do?

If the winner takes the lump sum payment immediately (setting taxes aside), they would receive cash of $57,349,500 before taxes. I used a present value of an annuity table, finding a multiple of 11.4699 (at 20 years and 6%), multiplying it by $5 million.

The savvy winner would have the opportunity to invest the money and take advantage of compound interest. They would have to pay federal taxes and possibly state and local taxes as well.  Most lottery winners do take the lower lump sum payment upfront.  They want to have full access immediately rather than over several years, which is fine if they stave off friends and family who often benefit from this sudden wealth.

Choosing the annuity may be better for tax implications than the lump sum. Receiving a large lump sum can lead to sudden wealth syndrome and the risk of overspending for many people.

Like Warren Buffett, Invest early in the stock market, consistently with a long-term perspective, so you can build lasting wealth. 

The Downside Of Compound Interest

When borrowing money, compound interest works against you. Your lenders are reaping the benefits of earning interest on interest on your loans. Consider this when going for a loan such as a mortgage, student loan, personal loan, and credit cards.

Using credit cards can be particularly detrimental when you carry balances rather than paying the entire monthly balance. By merely paying the minimum on your monthly card balance, your debt is ratcheting up quickly with high-cost debt. Most credit cards carry interest rates at the mid-high teens level. Your lenders are channeling the Rolling Stones, “Time is on my side, yes it is..”

Manage Debt Carefully

Let’s say your credit card balance is $5,000 with a 20% interest rate, and you pay only the monthly minimum. The average minimum is usually a small percentage, such as 3% of the balance or a flat amount of $25. We ignore this for illustrative purposes. The issuer will add your interest of $1,000 to your new total of $6,000. At the end of the second year, you will have a debt of $7200, adding interest of $1,200.

The debt mushrooms in a negative way, holding you back from paying your debt off. Spend less than you earn. Make savings your priority, so you outpace the growth in debt and reduce it to more manageable levels.

Related Post: How To Manage Debt For Better Financial Health

Financial Implications For 30 Year versus 15 Year Mortgage

Typically, when buying your home,  you put 20% down and borrow  80% of the value of a house or an apartment. You will pay less interest when opting for a shorter-term mortgage.

When comparing the different loan maturities on a $300,000 loan:

  • The annual percentage rate (APR) will be higher for the 30-year mortgage than a 15 year one, all else being the same.
  • The monthly mortgage payments will be significantly higher for the 15-year mortgage, given the shorter period. If you can afford to pay the higher monthly amount, you are better off with the 15-year mortgage because you pay less in total interest.
  •  Assuming you have a 720 credit score, the total home price, including total interest paid and down payment, will be lower with a 15-year mortgage loan.
  • The 30-year mortgage is much higher because you are paying interest on your loan longer, so the total home price or principal is $375,000 plus $189,622, equalling $564,620.
  • If you opt for a 15 year mortgage, your total home price or principal  is $375,000 ($300,000 loan + $75,000 down payment of 20%) + $76,012 in total interest equals $451,012 for principal and interest.

Rent As An Alternative To Buying Your Home

On the other hand, renting provides flexibility and freedom. Your rent is usually more affordable than home costs, not having to deal with the home’s repair and maintenance, freeing you to use savings to make investments, and not having to worry about potential declining home values. The downside of renting your home has restrictions to do what you want to make your place more livable. Your landlord could decide to sell the property and require you to move. There is always the risk of having a bad landlord whose actions force you to pick up and leave.

Related Post: A Guide To Buying Or Renting Your Home

 

Rule Of 72: How Long To Double The Principal

This handy formula always reminded me of a card trick. The Rule of 72 is a simplistic formula used to determine how long an investment will take to double given a fixed rate of return. Simply divide the interest rate that the money will earn into the number 72.

For example, suppose that you owe $1,000 on a loan and the interest rate you are charged is 20% per year, compounded annually. If you didn’t pay anything off at this interest rate, how many years would it take for the amount you owe to double? The formula for this rule is 72 divided by interest rate or 72/20 and equals 3.6 years.

As mentioned earlier, it is always key to use the magic of compounding in your favor and money growth, not debt. For other financial ratios like the Rule of 72, read this related post.

Opportunity Costs in Decision Making

The opportunity cost of any decision is the cost or the value of the following best alternative that must be foregone. We have many choices that may consider time, money, effort, health, and enjoyment in our lives.

When we invest in financial assets and building our net worth, we should consider risk, return, safety, and liquidity. We are making tradeoffs between these variables that we balance off of each other. Am I seeking higher returns in my portfolio and taking on some high yield bonds, or am I opposed to such high levels of risk?

When managing money, you may need to reduce high-cost debt before actively saving and investing. Consider your alternatives and research to find reasonable options. We have written on How To Make Better Money Tradeoffs here.

Final Thoughts

Time value of money and compound interest are among the most important financial concepts. Understanding these terms can improve your decision-making when managing your finances. Time is money though time is a priceless resource. Use it wisely and more productively.

Thank you for reading! Please visit us for more articles like these and consider subscribing to get our weekly newsletter.

 

How To Make Better Money Tradeoffs

How To Make Better Money Tradeoffs

“There are no solutions; there are only trade-offs.”

Thomas Sowell

There are tradeoffs in most aspects of our lives. We have a plethora of choices and cannot do everything we want to do. For every choice we make, opportunity costs requiring us to forego benefits for the option not selected. Opportunity costs are the loss of potential gains from other alternatives when making a choice.

Tradeoffs between time and money differ significantly based on age and lifestyle based on our unique set of values. With less time like Boomers as an older generation, you might place more importance on time while young people may favor money. That is not always the case.  Based on this global survey, those in the 20s and 30s tend to lean more time than money, valuing experiences over possessions than boomers, as seen in this infographic.

Each of us has to decide based on our characteristics and circumstances. Typical examples of trade-offs between time and money as we ponder our individual decisions, we:

  • Opt for a job requiring a long commute for a pay hike.
  • Have one income with mom or dad staying at home with the kids.
  • Go to a movie instead of working on an assignment due the next day.
  • Job security with the government or seeking a wealth opportunity with long hours and traveling.
  • Attend a community college initially, then transfer to a four-year college.
  • Work at home to spend more time with family.

Sure, we can try multitasking or combine activities when we face conflicting demands on us. However, there is often a price to pay when poor execution results.

Make Diligent Choices

Instead, we may inform ourselves by making diligent choices. How conscious are we when we make these decisions? For some decisions, make complex financial calculations as needed. On the other hand, there are times when we may not even be aware of having made a choice. Time, money, productivity, and health may act as alternative constraints, reflected in your priorities.

Time is a precious finite resource we often waste. Even if we have unlimited capital available, we just don’t have the time to spend it fruitfully. We want to enjoy our lives to the fullest, with health on our side. Without taking care of ourselves, time is short, and no amount of money may cure our illness. Since we have longer life expectancies, we need to support ourselves by fulfilling well thought out financial plans.

Typical Tradeoffs We Face:

 

Your Home: Buy or Rent

Owning versus renting your home is among the most common tradeoffs involving personal preferences, age factors, and your financial situation. Our family has rented and owned our home. After many years of ownership, we are renting a home in a lovely town, taking advantage of a great public school system.

If you seek to own a home, do you prefer stability, building equity, control over the home, and its responsibilities and tax benefits? Will you enjoy a sense of pride in ownership? These benefits come at a high cost based on a 20% down payment and mortgage loans for 80% of the home’s principal price, with interest rates strongly determined by your credit scores. The opportunity cost of owning your home may prevent you from saving for retirement and making other investments. Your home will not likely appreciate more than inflation.

The term of your loan can vary based on 15 years versus 30-year mortgages–another trade-off. The longer the loan, the lower your monthly payments. However, the 30-year mortgage raises your total costs compared to the 15-year loan.

Financial Implications For 30 Year versus 15 Year Mortgage

When comparing the different loan maturities on a $300,000 loan:

  • The APR will be higher for the 30-year mortgage than a 15 year one, all else being the same.
  • The monthly mortgage payments will be significantly higher for the 15-year mortgage, given the shorter period. If you can afford to pay the higher monthly amount, you are better off with the 15-year mortgage because you pay less in total interest.
  •  Assuming you have a 720 credit score, the total home price, including total interest paid and down payment, will be lower with a 15-year mortgage loan.
  • The 30-year mortgage is much higher because you are paying interest on your loan longer, so the total home price or principal is $375,000 plus $189,622, equalling $564,620.
  • If you opt for a 15 year mortgage, your total home price or principal  is $375,000 ($300,000 loan + $75,000 down payment of 20%) + $76,012 in total interest equals $451,012 for principal and interest.

On the other hand, renting provides flexibility and freedom. Your rent is usually more affordable than home costs, not having to deal with the home’s repair and maintenance, freeing you to use savings to make investments, and not have to worry about potential declining home values. The downside of renting your home has restrictions to do what you want to make your place more livable. Your landlord could decide to sell the property and require you to move. There is always the risk of having a bad landlord whose actions force you to pick up and leave.

My Take

The necessity of the tradeoffs of owning your home versus renting considers the tug between time and money differences.  When buying your home, you are making a long term commitment to the neighborhood, greater responsibilities in maintaining the property, insurance, and keeping up with monthly payments for some length of time. Alternatively, renting is usually a shorter-term commitment that may require future moves but with less responsibility and costs.

For families who want to control their home, buying is the way to go, especially if you can handle the shorter mortgage terms so you can pay off your debt sooner. Understand your long term goals for your family and financial priorities for your money. Don’t take on too big a house that you can’t afford. Renting is a great choice, especially if you don’t want the headaches of your own home. We compare advantages and disadvantages in our guide to owning and renting your home here.

A Car: Buy, Lease or Borrow

If owning your home is seen as the American dream, our culture has long embraced car ownership as a faithful supplement to our lifestyle. When seeking a car, you have a few alternatives. Do you want a new or used car, preferably certified pre-owned? Are you buying or leasing this car? If you are getting this car for personal rather than business use, the tradeoffs between buying the car with a loan or a lease are relatively straight forward. Assume you are getting a new car in a low-interest-rate environment and similar credit scores whether you are buying or leasing. About 30% of those getting a new car is leasing.

The Advantages And Disadvantages Of Leasing A Car:

There are lower upfront costs requiring a security deposit and usually the first month’s payment. Payments for registration and taxes are needed for leasing and buying the car. When leasing, you will make lower monthly payments for the lease term. Your credit score influences the amount, favoring those with very good to excellent scores.

The manufacturer’s warranty covers most if the leased car’s repairs.

Depending on your term, you are getting the latest technology available in safety, entertainment, and comfort. Those who lease can get a new car every 2-3 years.

There are mileage limits on the car though you may be able to negotiate a bit.

You don’t own the car at the end of your lease. Gap insurance is an optional add-on car insurance covering the difference between the amount owed on a vehicle and its actual cash value in the unforeseen event it is totaled or stolen. When returning the leased car, you may have to pay for excessive maintenance, wear and tear costs.

End of lease costs can be a bit shocking when returning the car. When we finished our lease recently, we were quite surprised at some of the hidden fees discussed when we initiated the lease. We incurred costs close to $1,000 to the lessor to reimburse them for taxes to the local municipality. These fees were relatively new to us, causing dismay. This lease was likely our final one.

Advantages and Disadvantages Of Buying A Car:

Higher upfront costs, including down payment and trade-in, if you have another car. Of course, the more the upfronts costs, the lower your monthly expenses.

Owning presents higher monthly costs than leasing, depending on term length. According to ValuePenguin, the national average of US auto loans is 4.37% in 60 months, though in recent years, buyers have increasingly extended their loan terms to 72 months, with 84 months gaining popularity. The longer the loan, the higher the total interest you are adding to the car’s cost. Experian has reported that new car buyers with the highest credit scores have average loans of 63 months versus those with the lowest scores taking out loans of 72 months.

As you own the car, there are no restrictions on mileage or what tires you want. While you can resell your vehicle, keep in mind that it is a depreciable asset that loses value in the early years and is impacted by mileage long term.

My Take:

The tradeoff on buying or leasing a car is similar to owning or renting your home. A third option to buying or leasing a new car is buying a certified used car. Depending on its age and mileage, it may have remaining time left on the manufacturer’s warranty. After purchasing and leasing cars for years, we recently chose this third option. We paid cash for a 4-year-old certified Subaru as a second car, given its strong reputation for longevity. We are tremendously happy with it.

Spending vs. Saving

This tradeoff’s concern is that it ignores the need to temper spending in favor of saving money. If you spend more than you earn, you either will be withdrawing from your savings and investment accounts or, worse, borrowing to pay for your purchases. On the other hand, if you spend less than you earn, you can better afford your living costs and enjoy life. Having money left over to build an emergency fund, save for retirement, and make investments provides you with more options over the long term.

Adopt an attitude that allows you to enjoy life but not be so costly that you can’t afford your bills. Avoid lifestyle inflation, which comes about when your earnings rise, and you increase your spending. The more you can delay spending and reduce impulse buying, the better your financial health. Many experiences are free, healthy, and worthwhile pursuits. Make room in your budget for a solid emergency fund, pay off your debts to manageable levels, and save for retirement.

Emergency Fund Vs. Debt Payoffs

You should be put savings aside for an emergency fund to cover at least six months of essential living costs. This habit will eliminate the stress of the unknown and reduce your need to abuse your credit card. Many people lack $1,000 in savings to pay for unforeseen costs like a job loss, an emergency surgery for a favored pet, or a damaged car. Having to pay for these costs often leads to higher debt, especially credit card debt with higher interest costs. Set small savings amounts aside earmarked specifically for an ample emergency fund and invest this money in a readily accessible liquid account.

Paralleling these savings, you need to pay your monthly student loans and your credit card bills. If you can’t pay your credit card balances in full, reduce your spending. It is easier said than done. However, committing to keeping debt at a manageable level is critical.

Saving For College Or Retirement: A Tough Choice

When faced with helping your children with their college funding or tapping your retirement money, it becomes a tough choice you don’t have to make. If you are in your 50s or more, you should not touch your retirement account. True, you want to avoid burdening your kids with student loans early in their lives. The average student loan is $31,172, a significant amount of debt to carry. However, they have the benefit of a longer-term horizon than you.

As a young couple, your earnings are rising through your 20s, 30s, and beyond. To avoid having to make a difficult choice, later on, save, and invest now. These are the years you should make your money work for your future. It may mean spending less now, so you have more money to address critical areas of your lives later consciously. These involve essential trade-offs.

Don’t ignore what you can do now to provide plenty of benefits to you and your family long term. Handling money allocation into key baskets for college funding, retirement, and investments early will improve your financial outlook.

Save For College Early Using A 529 Savings Plan

When you expect a child, put aside some money into a 529 Savings Plan or other plans you can read about here. You get tax benefits using pretax money invested in several options based on your preferences. The more money you can put into these funds, the greater likelihood of lower borrowing in your children’s college years. Most states have their plans and have a lot of investment choices. Prioritize saving early in your child’s life so that you don’t have to borrow from your retirement funds.

Retirement Savings In Your 20s

You should begin to save for retirement as soon as you enter the workforce, if not before. Most employers offer 401K retirement plans that make it easy to fund your account through your paychecks. Automating these payments is simple though it may require an opt-in process. Setting this up at work is among the first things you should do when you start your first job.

Many employers will contribute to your retirement account based on a pre-determined match formula. For example, if you save a targeted percentage of 6% of your paycheck to your company-sponsored retirement plan, they may add 50% of that amount or an additional 3% of the money to your account. Separately, you should also set up an IRA or a Roth IRA and focus on contributing up to the maximum amount allowed.

Saving for retirement in your 20s allows you to have a sizable nest egg with compounding returns when you are ready to move to the next stage of life. On the other hand, catching up to saving for retirement in your 50s, while possible, is very difficult. It may mean working longer or tapering down your lifestyle in your later years. The risk you have of waiting too long to accumulate retirement money is that of losing your job in your 50s or if, for health reasons, you no longer can work.

Facing these tradeoffs head-on and early in life create a lot of flexibility and freedom in your later years. Make your money and time work for you as productively as possible. It is easier to sacrifice some choices for the more significant wallet needed later on. Long term comfort in retirement is a worthwhile aim.

Final Thoughts

Making tradeoffs that consider time and money may be intuitive or involve financial calculations balanced with your financial priorities. Addressing many major decisions early in life may provide you with financial flexibility and the freedom to choose an array of lifestyle options. The more you delay thinking about your choices, the harder the trade-offs you have to make. Your 20s and 30s are golden times to tackle savings as your earnings rise. Avoid finding more things to spend on that don’t positively add to your comforts.

Thank you for reading! Please visit us at The Cents of Money to see other such posts and subscribe to our weekly newsletter.

What kind of tradeoffs have you been facing? Did your choices involve your lifestyle or career? We would love to hear from you!

 

 

 

 

 

 

7 Steps To Buying A Home Thru Closing Day

7 Steps To Buying A Home Thru Closing Day

You and your family have decided to buy a house. Now what?

Buying a home takes about six months from your search to the closing day at a minimum. There is a lot to consider when likely making the biggest purchase of your life. So you will need to make some effort to get things in order.

Pay special attention to the steps we outlined below. You will be working with key professionals—real estate agent, banker, title insurer, attorney, inspector—that will be part of this process. Mortgage rates happen to be at record lows.

However, Don’t Hurry!  Ok, ready?

Step 1: Get your finances in order.

You will likely need a loan unless you have loads of cash to pay for your house. Hopefully, you have been budgeting and saving for a house purchase.

Review Your Credit Report

Review your credit file to make sure it is in good shape. You will need to check with the credit bureaus, Equifax, Experian, and TransUnion credit reports. Make sure your credit report is accurate. If not, make corrections to clean up your credit file. At the same time, look up your credit scores and see if there are ways you can raise your score.

You need a working estimate of what your ongoing monthly costs for your new home will be. The budget for your home will include the mortgage principal and interest cost, real estate property taxes, homeowner’s insurance, and mortgage insurance.

These costs could be at least 50% higher than what your current home costs are. You should look at current mortgage interest rate levels at www.bankrate.com. There are calculator apps to help you estimate your monthly payments. Look for a conventional fixed loan and consider a shorter term of 15 years versus 30 years. Your interest costs, and therefore your total home costs, will be lower. See our post on Making Better Money Tradeoffs, such as shorter-term loans.

Also, you are likely moving to a larger space. If so, you will need to calculate incremental utility costs (heating,  A/C, electric, and water).  These costs are different than the one-time costs associated with buying a house, which I will discuss below.

 Step 2: Prequalify For A Mortgage – Takes About One Month.

Before you actively go house-hunting, it is a good idea to get preapproved for a mortgage. It will help to narrow your search. By doing so, it will save you some angst from the disappointment of finding a dream home out of your price range. The pre-approval letter may expire between 90 days and 120 days, giving you an idea about how long you should time your house search.

Many online mortgage providers, such as LendingTree, Lending Club, or Rocket Mortgage by Quicken Loans, streamline the process. Find three lenders in addition to your banker in your local area to speak to at this point.

Pre-Approved Letters Reflect Motivation

Keep in mind, getting prequalified does not guarantee a loan. However, it does help to have a preapproved letter for a mortgage. Lenders want to see motivated buyers who have made an offer with a pre-approval letter from a lender or mortgage broker in hand. The sellers expect this and even demand it, so this step is a must.

Go to a lender, either in person or online, complete a form, provide your financial information to the most minute detail. They are looking for a good income and good credit history to pre-qualify you. When you decide that you are ready to purchase a house, what do you do? Location.

You’ve narrowed down the locale, the state, and the city or town. Now what?

Step 3: Search for your home online and in-person*. This process can take two months or longer.

Early in this process, you may what to explore desirable areas. Driving around can be a fun part of the process or emotional as you move to the next stage of your life. You will need to consider your budget. Brace yourself from making an impulsive buy of a too big or too perfect home that will be difficult to afford.

Check on Zillow.com  to get an idea of what you get for your budget in terms of floor plans, features, square footage. You may want to go to a couple of Open Houses.

*During the pandemic, it is likely you will see homes virtually.

Should I Get A Real Estate Agent?

You may have started thinking that you will do your search without a real estate agent and deal directly with the listing real estate agent. As you probably know, the seller usually pays the real estate agent. Still, engaging a real estate agent is very important.

The search can be overwhelming. Ultimately, you may decide to grab an excellent real estate agent after all.  There are many pluses to this as a real estate agent likely knows the neighborhoods you are exploring. I recommend you interview a few real estate agents, so there is good chemistry. There is a lot at stake here for the buyers and agents.

Respect Your Agent

Once you have a real estate agent, make sure to understand the ground rules for working with your agent. You want your relationship to go smoothly. We hear some stories where the buyers are late to appointments or call the listing agent without their agent. Being late is a no-no. Respect your agent.

Unlike a rental arrangement, the seller pays both buyer’s and seller’s real estate agents. The agents split the commission per a written agreement. You should sign a representation letter so that you can be sure that the broker is representing your interests as the buyer, not his or her pocketbook.

Now you are ready to search for that new dream home. After seeing a “zillion” houses, you finally found the one for you and your family. The search can take two months or longer depending on the buyers, frankly.

Step 4: Always Negotiate  With The Seller

This step is complicated with some parallel tracks.

Now The Negotiations Begin

You can negotiate the price, the timing of the closing, the outdoor furniture, and other details.

Everything Is Up For  Negotiation,

Sometimes there are contingency clauses designed to protect the buyer in individual events. These clauses could be a down payment, usually between 3% and 10% of the house price. The down payment may be returned to the buyer if:

  • the buyer cannot get satisfactory financing;
  • the appraisal value done by the buyer’s lender comes in below the agreed-upon price, or
  • the home fails inspection.

Make a written offer for the purchase of the home.

Before accepting an offer, there usually is a counteroffer. The agent will submit a written offer once you are comfortable with a price. That offer should be subject to a formal contract review and approval by your attorney (more to come on that).  Your bid is also subject to home inspections by a qualified professional.

Home Inspection Is Needed

Once your offer is accepted, you will want to have a home inspection before signing a contract. 

Your broker should have a list of competent licensed home inspectors. They are usually civil engineers, retired building inspectors or experienced contractors. 

You should expect a DETAILED report of the inspector’s inspection of the house, from the roof to the basement. The information should highlight the defects and deficiencies that the inspector discovers throughout the house. Ask the inspector for repair estimates and how they would rank the repairs based on their urgency. This report should be written and delivered to you in a few days.

The home inspection could be a means to negotiate the price downward

The findings can help you negotiate preclosing repairs the seller will pay for or get a price reduction. It also gives you an idea of the work that you will need to address in the future. The inspector should also conduct a termite inspection and provide you with a wood-boring insect certificate. Your lender will require this certificate.

Depending on where you live, you will want a radon gas test. Radon is a dangerous, odorless gas that tends to get trapped in basements and crawl spaces. It quickly breaks up, but you first have to discover it. An older house, pre-1978, may have lead paint residue. After 1978 lead paint was no longer in use in the US.

Ask your inspector to check for lead paint. Buyers can move forward with a satisfactory inspection and an agreed price for the house. The next stage is the transaction deal memorandum or “The Deal Sheet”.

While this is all happening, the agents are generating a transaction deal memorandum for the parties.

Step 5: Hire An Attorney And Formally Apply For A Mortgage Loan

Once you make an offer for the house, you will want to hire an attorney. Their role is to write a contract of sale through the home’s closing. 

Typically the seller’s attorney will draft and present a printed form of a contract of sale, a seller’s rider, and a lead paint disclosure. Your attorney will then provide a purchaser’s rider in response. Riders are common additions for most purchase agreements containing provisions such as a buyer’s obligations and special conditions relevant to the deal.

The purchaser provides the down payment, which is a show of earnest money or good faith deposit. Attorneys review many of the documents in an exchange between the buyers and sellers.

Among those key documents that will need to be reviewed by your attorney are:

  • mortgage loan estimate
  • title documents
  • closing disclosure
  • title or uniform settlement statement
  • closing costs.

After you sign the purchase contract, you will formally apply for a mortgage loan.

Mortgage Loan

Getting a mortgage loan can take time, even though you have preapproval from a lender. That preapproval letter speeds up the process for getting a formal loan but could expire before you found your desired home.  It is a good idea to consider more than one lender. You will likely want a lock-in agreement for your mortgage, especially if the interest rate is changing. These agreements are usually for 30-60 days.    

Step 6: Prepare For The Closing

Once you have made an offer, you will need to engage an attorney to represent you in the title’s negotiations and the closing. With that in mind, we will explore the contract process through the eyes of a  New York residential deal.  In many states, attorneys are minimally involved, if at all. A contract is a fill-in-the-blank form prepared by the brokers and a title company. This step takes place within one month of the closing.  

Step 7: The Closing

Who attends?

There is some nervous excitement when you reach this step. Several key people attend the closing. They are the buyers and sellers, their respective attorneys, the buyer’s and seller’s real estate agent, the lender’s representative (either a paralegal or an attorney), and the title company’s representative, usually called a closer.

At the closing, the buyer signs the mortgage documents, the seller signs the deed, transferring the title to the buyer. The buyer writes big checks in exchange for the keys to the buyers’ new home.

You did it! Time to celebrate!

Final Thoughts 

 

Thank you for reading! If you found this of value, consider subscribing to The Cents of Money and receive some freebies and our weekly newsletter.

If you own your own home, how was your home buying experience? Please share your thoughts with us. We want to hear from you!

 

Pin It on Pinterest