What should you invest in first?

My wife just got back (well, just before our Noosa trip) from a trip overseas to attend her nephew’s wedding; and, the young happily married couple decided to spend part of their honeymoon in Australia … so, they are staying with us right now!

This was an opportunity for me to interfere in their financial lives … naturally, I couldn’t resist

It’s also an opportunity for me to share my financial plan for our younger readers, whether single or married.

The plan is simple:

Step 1: Start working!

Step 2: Use your pre-work spending and living standards as a guide to ensure that you save at least 10% of your gross salary; preferably more.

Step 3: No matter what your Step 2 Income and Expenditure, save at least 50% of any future salary increase

Step 4: That includes any ‘found money’ such as: change found on the street; tax refund checks; small handouts/inheritences from friends/family (naturally, you will ‘up this’ to saving 95% of any LARGE handout/inheritence); etc.

It won’t take too long to actually have some money (perhaps for the first time in your life) to think about actually INVESTING.

So, what to invest in? Stocks; car parks; italian art; … ?

It’s simple: your own home!

It will probably be a small house or condo to start with … possibly with some ‘fixer upper’ potential …

But, what about the 20% Equity Rule and the 25% Income Rule, which will ensure that you can only afford to buy a shoe-box (literally) at this early stage of your financial life?

You forget them for your first home …

… and, replace them with these guidelines:

- Put as much equity into your house (by way of making a deposit) as you have savings (you’ll want to keep a little buffer against immediate expenses)

- Borrow as much as the mortgage payment that you can afford, which will be the amount per month that you are currently saving (of course, you’ll want to keep a little buffer against extra expenses).

When you (eventually) get tempted to ‘trade up’ to a bigger house, that’s when you apply the 20% Rule and the 25% Income Rule!

But, shouldn’t you invest in something else first? Perhaps you’re not even married yet and can happily rent for a while?

This is true: but, buy the condo anyway … then you can evaluate if your rent is so cheap that you should rent out the condo for a while before moving into it. Same applies if you move to another location: rent out the house/condo and rent for yourself elsewhere until you are ready to trade up (or across).

Why?

Let’s decide whether, over the course of your life, real-estate will go up in price or down in price? The answer for all of history has been UP (over a sufficiently long period).

Decide whether you will ever want to own your own residence? Again, the answer is YES for the overwhelming portion of humanity (and, even if you think not, I guarantee that your eventual spouse will have a very hard go at convincing you otherwise).

So, unless you have an overwhelming reason to believe that RE won’t go up in price for the next X month/years, then you are compounding your money at RE’s typical growth rate (6% … depending upon who you believe and where you live) TIMES the leverage that the bank is giving you LESS (your mortgage payment/costs – rent you would have otherwise paid).

Run the numbers; it’s a VERY good/safe rate of return

Be the bank!

My son asked why I don’t just plonk by money into a safety deposit box to tap into those wonderful gross margins that banks earn buy ‘buying’ your money at 3% and ’selling’ it back to you (or to other people/businesses) at 7%.

That lead to a great discussion on P2P lending, which partially addressed the problem of risk for me: P2P offers filters to allow you to sort loans; ratings to allow you to evaluate loans; and FICO-based ’risk rated’ interest rates (circa 10%) to go along with all of this.

But, that doesn’t satisfy me …

And, it’s not because the banks have MUCH better systems to evaluate and manage loans and it’s their core business, it’s because I can do much better with my limited capital than P2P levels of interest.

Here’s two things to think about:

- Does P2P provide the annual compound growth rate that YOU need to reach your Number?

- Do you have the bank’s virtually UNLIMITED access to capital or is the amount that you can apply to P2P as a % of your Net Worth limited?

These points are critical: you have a limited amount of investment resource available to you and (probably!) a very large Number / soon Date to achieve using what you currently have as a springboard.

Now, let’s flip to the other side:

Banks dig into their ability to borrow (which IS the basis for their entire business, investment banking / asset management services aside) and lend to us for what?

Either to SPEND (on consumer items, if we are dumb) or to INVEST (in our homes, businesses, etc.) if we are smart.

So, let’s put those things together to create our own ‘bank’:

1. We have limited cash to ‘lend’ at our disposal, so we need to find a way to tap into vast amounts of borrowing power just like the banks.

2. Well, we don’t have the Regulations, Reputations, and Resources (e.g. access to the capital markets) that allow the banks to borrow (then lend) so much, but we do have something that allows us to achieve effectively the same huge jump in personal borrowing capacity: the spare equity in our houses.

[AJC: You knew there was a catch! If you don't have a house, have GFC'ed your equity out the window, or otherwise don't have enough equity built up yet, bookmark this post and take the rest of the day off ...]

3. If you DO have spare equity in your house, and can refi. to a fixed rate loan that locks in your borrowings circa 4% or so then you are probably now sitting on a relatively large sum of cash to lend, just like a bank (relatively speaking!).

4. So, you can either:

- Do, what the banks do and lend to somebody who needs the cash at a higher rate; e.g. P2P where you may get 10% for each 4% ‘unit’ that you supply … a VERY healthy 150% gross margin (plus, you have NO staff or overheads), OR

- Do, what I would recommend: cut out the middle-man and lend the money to yourself!

What would you do with that money that you have borrowed?

What any sensible investor would do with money that they borrow from the bank – depending upon their Number and their appetite for risk:

- Buy some investment real-estate,

- Buy stock [AJC: a friendly 'bank manager', no margin calls .... sweet],

- Start a business … it could even be a P2P lending business

That last one isn’t such a joke; I would be more tempted to invest IN a P2P business than I would be to lend VIA a P2P. Why?

It’s simple … the former gives me ho hum 10% returns (with some credit risk attached), whilst the latter gives me access to potentially, unlimited returns!

Are you worried about the risk of business failure?

Well, if the P2P site goes under, isn’t my risk of capital loss the same as if my cash was sitting in their investment accounts [AJC: which is one of the reasons why the SEC is VERY interested in regulating P2P, all of a sudden ... but, until they do ... ;) ]?

Peer to Peer Lending. A 7m7y tool?

In my last post, I suggested that banks are profitable businesses because they have such a large mark-up. If they’re so great, my son asked, why don’t I simply plonk my cash into a safety deposit box and dole it out to willing borrowers like some kid with a lemonade stand?!

Why not, indeed?

The simple and obvious answer is risk, which the bank handles, I said to my son, with a combination of volume (to spread risk), people (to manage risk), and systems (to assess and ‘price’ risk).

However, Rick Francis offers perhaps a better-lemonade-stand-solution (?) … Peer-to-Peer Lending:

There is a fairly easy way to become the bank- peer to peer lending. It doesn’t remove the risk of default but does allow for diversification and there is a framework to asses the risk. They break loans into many small pieces that different individuals fund, so you don’t risk too much on any one loan.

Yep, P2P Lending certainly helps to address one of the banks’ three mechanisms for handling risk: you can spread your loans (the bank lend $400k many/many times over … you lend $40 many/many times over).

But, what about the experienced PEOPLE? It can take some time/trouble to sift through all of those loan apps listed on the leading P2P sites, as Jake points out:

P2P lending requires you to pick through hundreds of loan apps, and filter it to the set that you believe has the best risk / return ratio.

Then you have to diversify – invest in many loans so that a single default will not wipe you out. I think that you should invest no more than 1% of your portfolio into a given loan – so lets say you need to invest in at least 100 loans. Unfortunately, that requires you to pick through probably 1,000 applications hand-by-hand (you already discard the vast majority based on search criteria).

That’s frankly just too much work to be worth it, no?

it’s worth it for the bank, but probably not worth it for you and me (even though you can filter/sort the loan applications by various criteria) ‘just’ to get that 10% return that Rick has experienced …

And, we still haven’t addressed the risk management SYSTEMS that the bank applies, what does P2P offer there? Many sites, as Rick pointed out, offer some sort of FICO-based ranking, but banks rely on a lot more than that (for example, where’s that little thing called ‘collateral’?!) …

The only compensation for these last two (PEOPLE and SYSTEMS), that I can see, is that P2P borrowers may not want to default for a combination of:

- Getting locked out of the P2P sites … perhaps a similar mechanism to eBay’s Rating system is available?

- Perhaps it’s enough that P2P borrowers appreciate the opportunity that they have been given and don’t wish to abuse it by defaulting?

It is perhaps these two reasons that help to explain why micro-lending in 3rd world countries has such a low default rate?

But, it’s the simple logistics that Jake pointed out that put the kibosh on P2P for me …

Have you had any experience with P2P and would you use it again?

A (post)Vacation Question – Part III

Now that we’re back from vacation I can retain my blogger’s right to semi-anonymity, yet risk little by answering Mike’s [and, some of our other readers'] question:  ”Which beach in Australia is this?”

Noosa in Queensland.

After discussing the real-estate ‘deals’ of Bill the shaved ice man, and Massimo the ice-cream man [AJC: did I mention him?], while buying – naturally – shaved ice and icecream, as one does when in Noosa on vacation, now that we were finally home and ready for a change of scenery …

… we discussed bank-financing of real-estate on our way back from buying ice-cream at the 7-Eleven store not far from our own home

The conversation went something like this:

Son: “Why has the bank invited you to their private corporate box at [a certain upcoming international sporting event]?”

Father: “Well I have a lot of money on deposit with them”

Son: “But, they have to pay you money [interest], aren’t their important customers the ones that they lend money to and who have to pay the bank money?”

Father: “Good point!”

So, I explained to my son that I am now both a borrower and a lender to my bank:

- As a lender, they pay me roughly 3% on the money that I have sitting in their bank,

- As a (recent) borrower, they charge me roughly 7% (interest + bank fees and charges) on the money that they lend me.

Son: “So, they only make 4% interest … is that enough for the bank to make money on?”

Father: “Don’t feel too sorry for the banks!”

As I explained to my son, the bank is like any other business buying a product for $3 (or, in the bank’s case, borrowing money for 3%) and selling that same product for $7 (or, in the bank’s case, lending money for 7%):

They are operating on (at least in this example) a 133% Gross Margin.

Most people DREAM of having a business that operates on 133% Gross Margin …

… of course, the banks have costs:

- They have to carry stock (i.e. pay interest on funds deposited) even if they don’t sell it (i.e. lend it) … unlike a ‘normal business’ the bank has these great treasury departments who simply put this ’spare money’ into the short-term money market and earn interest,

- They have the usual staff, office lease, and overhead expenses of any other business,

- They have the risk of fraud / credit default on the money that they lend out.

All of this is factored in to produce a Net Profit that is amongst the best of any type of business (GFC aside). This got my son thinking:

Son: ” So, why don’t you put your money in a safety deposit box and lend it out to other people instead of letting the bank make all the profit on your money?”

Well, as I explained, I actually do: I have a finance company of my own, and we look at our finances this way; the interest that we charge our clients is treated as ‘fees’ … we divide that Fee Income (very roughly) into three parts:

- 1/3 goes to pay the bank’s interest and fees on the money that we borrow from them to lend to our clients,

- 1/3 goes to pay our staff, rent, and overheads, leaving

- 1/3 which goes to our [AJC: my] profit.

This is strikingly similar to the ’standard’ restaurant formula:

- 1/3 goes to pay for the raw material [AJC: pun intended :P ],

- 1/3 goes to pay their staff, rent, and overheads, leaving

- 1/3 which goes to their profit … of course, that’s the theory but the reality for restaurants and many other businesses is vastly different (but, that’s a subject for another post).

So, why don’t I do what my son suggests for the bulk of my money?

Simple: I don’t have the ability to handle the credit / fraud risk!

But, the bank can because they have the people, the systems, and the sheer bulk of money out there which effectively spreads their risk (IF they have followed sound credit lending policies ….enter housing crash and GFC).

Later on this week, though, I will tell you how YOU can become the bank … without the risk.

Stay tuned!

Call me … make it happen!

OK, so he wants you to buy five houses this year … and, he gives you the quick ‘hard sell’ at the end … but, the basic philosophy – to me – is sound:

- Houses are depressed in the USA, but so are interest rates,

- Unless the USA ‘double dips’ prices will begin to go up (when?)

- You can fix an incredibly low interest rate on your primary residence (can the bank rewrite the mortgage if you move?)

- You MAY be able to receive enough rent to cover most/all of the mortgage

- Who says you need to buy five houses (except for this Realtor!?) … just think about one for now

Do the numbers for your area/s of interest (price of house, monthly cost of mortgage, likely rental income, other expenses such as 6% – 9% property management etc.) … if you can even come close to breaking even, could you find a better return on your deposit plus the cumulative cost of any monthly shortfall (or gain of any monthly excess)?

Now, run the numbers again assuming that the US market stays flat for another 5 years before some sort of rebound … maybe it still makes sense?

Have you run the numbers? If so, what do you think?

A Vacation Question – Part II

But, what about the other financial question that my son asked while we were on vacation?

Well, we were walking along the beach and Bill, the shaved ice vendor, drove past with his little all terrain vehicle pulling his ’shop’ behind only to stop a few yards up the beach to tempt my son – and, the many other children running along the sand and swimming in the warm surf.

Naturally, I  quickly became $3.50 poorer and my son had his paper cone filled with shaved ice with various color sweeteners poured over it (he chose ‘rainbow’ flavoring), which got us talking:

You see, it’s popular folk-lore that Bill, who has been selling his flavored shaved ice along the beach for 20 to 40 years, owns many of the apartments in the vacation rental buildings all around [AJC: check out the aerial shot in yesterday's post] … if true, then Bill is the poster-child for the Wealth Alchemist i.e. turning temporary cashflow into long-term assets.

It’s not hard to see that Bill turns over thousands of dollars a day, most of it costing him nothing (little staff, few overheads, little-to-no-cost-of-goods-sold), after all, how much can ice cost to make?!

Instead of spending all of that money, it’s not a great leap to assume that Bill saves up enough for a deposit to buy a property every now and then; we figure $1 million worth of property each year (with 20% initial equity).

Here is my son’s question:

“Would he pay cash for the properties, or would he just save up enough for a deposit and borrow the rest?”

Now, this is a seemingly simple – yet terribly interesting – question; one that we could labor over for many posts … instead, we’ll look at this another way, by asking:

“Does Bill need the property for income now or for its future value (hence, future income)?”

The answer is clear: Bill has plenty of income now, but what does he do if his income stops?

Presuming that he can’t rely on being able to sell his business (for example, the council could decide that they no longer want people peddling ice on their beaches), then Bill will probably want his properties to generate a replacement income “one day”.

So, which would do that better? When Bill moves into MM301, it’s likely that owning the properties outright and living off the rental treams that they throw off will be best …

… until then, Bill has to (in my opinion) work on the strategy that will produce the most properties by the time he wants to retire.

So, I had to explain the concept of leverage to my son:

SCENARIO A: If you purchase a property for $100k CASH and it doubles in 10 years, then you have $200k of property. Well done!

SCENARIO B: But, if you purchase TWO $100k properties, putting $50k deposit into each and borrowing $50k for each from the bank, then in 10 years (assuming they both double), you now have $400k of properties, of which you owe the bank $100k (assuming that you haven’t paid down any of the loan in the meantime), leaving you with $300k of property … a $100k improvement over Scenario A.

At least, that’s what the property spruikers would have you believe …

… because, they have conveniently forgotten that in Scenario A, you also have some rental income (after, say 25% costs) coming in, whereas in Scenario B that income would be largely offset by interest owed to the bank.

The question is, is that differential in income ‘worth’ $100k over 10 years?

Let’s assume that we can get a 5% return from our Scenario A property (after costs), giving us $5k a year initially (when the property is worth $100k), increasing over time to $10k a year (when the property increases to $200k in value). It doesn’t take a genius to figure that this comes to less than the extra $100k that Scenario B gives us (if you assume an average $7,500 per year rent for the 10 years, we are comparing $75k in rent for Scenario A to $100k in additional capital gain for Scenario B).

Now, add the benefits of:

- 80% gearing (i.e. only making a $20k down payment in our example), which should buy you 5 properties instead of Scenario B’s 2 properties (cost = $500k; worth in 10 years $1 mill., less $80k loan on each = $600k v $300k for Scenario B and $200k for Scenario A. Get it?),

- Increasing rents offsetting fixed interest rates (possibly producing some positive cashflow from each of our 5 properties as time passes),

- Tax deductibility of any excess of interest over income in the early years (a.k.a. negative gearing),

- And, any additional tax and depreciation benefits of 5 properties v only 2

… and, it’s just possibly a ‘no brainer’, even if that does make some of those scummy spruikers right

But, how does Bill pay his bills?

Well, that depends on how much excess of income the properties produce by the time Bill is ready (or has) to retire …

… if  insufficient to pay Bill’s bills, he can sell enough properties to pay off the bulk (or all) of the bank loans, thus forcing a positive cashflow situation (assuming the properties aren’t total dogs, which is highly unlikely in this well sought after tourist area, which boasts near 100% year-round occupancy) and that (after a reserve to cover costs of vacancy, property management, and repairs and maintenance) is his infltation-protected income for the rest of his life.

Then Bill can spend the rest of his days lazing on the beach … buying shaved ice from the next shmuck who chucked in his chance at earning a college degree for the life of a beach bum :)

Make the move ….

Guys, as the economy improves (if it improves) interest rates will surely rise, as they already are in other countries.

If you haven’t already done so, seriously think about buying some fire-sale real-estate and locking in the the interest rate for 30 years; one strategy – especially if the banks won’t let you take out a 30 year fixed rate mortgage on an investment – is to buy your NEXT home now (it need not be any bigger/better than your current), taking the 30 year fixed on that one, and keeping your current as a rental.

I’m not sure if that’s exactly what Lee was thinking when he asked:

Although the market in our area has held up fairly well through this housing crisis, it’s definitely a buyers market.  I don’t think I’d get top value for my home.  So, I’ve seriously been considering renting it out after we move.  If I did rent it, then I could go a couple different routes:

1. Refinance current home to 30 year (to help cash flow) and take enough cash out to put 20% down on our new home.

2. Refinance current home to a 30 year but take no cash out to get the payment down to a very low amount to have a very good positive cash flow.  Then put 20% down out of pocket on the new home.

3. Take out a home equity loan on the current home just to cover the 20% down payment on the new home loan (30 year).

4. Just go ahead and sell our current home so I can take advantage of the tax free capital gains … I could then use part of it to put 20% down on our next home … and use the remaining as a down payment on one or two rental properties.

5. I have to throw in one scenario just because of that little guy I call Mr. Conservative that sits on one of my shoulders, lol!  I could just pay my current home off within the next 2 years or so, then rent it out with a large cash flow, and use that cash flow to pay the mortgage of the new home we buy.

6. Maybe something I’m not even thinking of?

I think I see a case of paralysis by analysis coming on, so we had better head this off at the pass …

… while I can’t give direct personal advice (as I told Lee), I can point out that in cases like this it’s always good to ask yourself a couple of key questions before Mr. Conservative starts to get very vocal (in your subconscious) and you end up taking no action at all, so I suggested that Lee run some numbers:

a) What would be the situation on your current home, if you just took out a new (or refi) FIXED rate 30 yr mortgage, and put tenants in … what would be your new monthly mortgage payment and what monthly rent could you conservatively [it's good to have Mr Conservative on your shoulders] expect?

b) After pocketing the excess of 75% of rents over mortgage from a) above – or, making up the deficit on the excess of mortgage over 75% of the rent – how much per month do you think you could save from your other sources of income assuming for the moment that you have FREE accommodation for yourself somewhere?

[AJC: the 75% of rents is to allow a buffer for vacancies and other costs of renting ... just a very rough approx. for now]

Once you answer these two questions, my feeling is that the best scenario for you will become obvious … I hope

In Lee’s case, here are his current numbers:

3 bed / 2 bath 1450 sq ft. home in a great location.
Cost Basis: $158,000
Current value: $210,000
$96,000 (9 years 6 months) remaining on a 15 yr mortgage @ 4.625%
Current P&I repayment: $1,042 per month

And, if he refinanced the $96k remaining balance his bank has given him two options for a 30-year fixed loan:

$508/month @ 4.875% Closing costs: $2,000
$493/month @ 4.625% Closing costs: $2,700

For rent, Lee thinks “being ultra conservative” $900/month to $1100/month, which means:

Using 75% of excess over mortgage ($300) and assume living in FREE accommodations, I could easily save $3,000/month because that’s what I save currently even with my $1042 mortgage.  Throw in not paying our current mortgage and having $300 in additional cash flow and $4,000+/month would not be unreasonable.

For now those are the numbers, although I have to say the 75% of excess over mortgage number is probably high considering taxes and insurance on this place are about $200/month.  But as you said, these are rough numbers for now.

So, Lee is getting closer to being able to make a meaningful decision; here are the steps that I suggested:

STEP 1: OK, it seems to me that if you decided to keep your current home as a rental, you would lose money if you stuck to your your current $1k pm mortgage, and produce a positive cashflow of $100 to $200 p.m. if you refinanced.

STEP 2: It seems to me that your $3k pm savings rate will be enough to cover the expected $200k mortgage on your new home. Right? BTW: You WILL fix for 30 years, too (because this will become an ideal 2nd rental, eventually)?

STEP 3: Next, all you need to think about is how to raise the deposit; well, if you don’t have it now, go back to Step 1 and revisit these numbers, assuming that you refi, say, $150k instead of $96k. I’m guessing that you’ll be close to B/E – or, a slight monthly loss – on the rental?

STEP 4: You keep 25% of the rent (plus another $200, say) to cover taxes, ins, and contingencies PLUS you have plenty of excess monthly savings to cover you, until this ‘provisioning fund’ builds up.

Now, what do YOU think Lee should do?! Here’s what he thinks:

I think the smartest thing would be to refi without taking any equity out so that I have a nice cushion of cash flow.  I would then need to come out of pocket with the down payment for the new home which I should be able to do, and even if I need a little help, I could always get a small home equity loan on the rental temporarily.  But I feel pretty confident I could raise enough cash to cover the down payment without having to do that.

My next step…develop my plan of action.

Take Lee’s advice: model these questions to develop a plan of action that works for you … and, take it!

Speculating on your own home?

Ryan, who is upside down on his own mortgage asks:

I agree that plenty of investments, if not most, will give you a better APR than your house, but what about leverage?

$500,000 House( $400,000 Bank’s money, $100,000 Your Down Payment) * .05(expected year 1 appreciation = $25,000

$100,000(Your would be down payment) * .15 (from a successful investment or business venture) = $15,000

This is POSSIBLY true IF you gain market appreciation; that’s called speculation.

On the other hand, if you put the same money into a cashflow positive rental, then you make money on the rents and any future appreciation is a bonus; that’s called business.

A case can possibly be made for using your own home as a ‘business’ investment IF you presume to (nominally) charge yourself market rent for the same type of accommodation …

… but, would you pay that same rent rent to somebody else?

The answer must be ‘yes’ for this to work.

If so, then compare how the property then stacks up as an investment if you were the owner and renter i.e. is the pseudo-rent greater than the mortgage?

But, there is still a catch: you also lose most of the great tax benefits of a true investment (e.g. depreciation), even though as home owners in the US you gain some (capped) tax-benefits – particularly in relation to your mortgage interest.

But, there is a solution: buy a house to rent out, and rent the identical one from somebody else!

Rent out the one that you own and rent the other one from the owner: this way, you ‘force’ yourself to treat the one that you own as a real cashflow investment and the other as a place that you live in.

What do you give up?

Probably that sense of ‘ownership’ (but, hey … you do own the identical one, right?) and security of tenure.

But, you must weigh this up against the benefits:

1. True investment ’status’ … buy, sell, hold, refi as the numbers dictate

2. Gain depreciation benefits for anything that you add (works great if this is a new’ish house!)

3. Full, uncapped tax-deduction on mortgage interest, etc.

4. ???? [you tell me?]

In fact, if you have a friend, why don’t you each buy a house and rent it to the other? Now, that is a strategy worthy of a millionaire … in training!

The upside down car?

Trees Full of Money shows us how to deal with a situation where we’re ‘upside down’ on our car loan:

If you can no longer afford your “upside down” vehicle, here is a a better way to get out of your loan:

Step 1
The most important step in unloading a vehicle with negative equity is to accept the situation for what it is. Saying “if I sell my vehicle now I’ll lose money” is not a plan. The quicker you sell your “upside down” vehicle, the less money you loose due to further depreciation.

Step 2
The second step in selling an “upside down vehicle” is deciding on a fair market value. Lately, the value of used vehicles has been just as volatile as the stock market or the price of oil. The fair market value of your vehicle may be significantly more or less than used vehicle pricing guides such as NADA and Kelly Blue Book suggest.

Step 3

Once you’ve established a competitive price, you need to secure funding for the difference between what you owe and what the vehicle will bring.

Step 4
Once you have met the obligations of your loan, it’s time to do a little marketing and salesmanship. I little effort in the marketing of your vehicle can pay huge dividends.

Step 5
When you have identified a prospective buyer for your vehicle, be sure to ask your bank how to proceed with the transaction. Each state has different laws so be sure to contact your state’s motor vehicle division as well.

[AJC: If you do want to sell your financed vehicle, I recommend that you read the full post here, as I have only extracted TFoM's highlights]

But, where is Step 6??!!

It should be the one that says: how do I buy a replacement vehicle?

You see, unlike many things that you may choose to own, a car is probably a necessity … now, that doesn’t mean that you need the best car, but you do need a car that can achieve [Insert objective of choice: get to/from work; haul stuff around the farm; schlepp the kids; etc; etc].

So, what do you do?

Well, you first try as hard as you can NOT to get yourself into a financed vehicle in the first place …

… you see, almost anybody who has a financed vehicle is in a negative equity situation:

- As soon as you walk a new car off the lot it has depreciated 10% to 30%, yet you still owe 100% – deposit + payout costs on the loan,

- If your loan is longer than a year or two, the car is probably depreciating at a faster rate than you can pay down the loan.

If you’re not convinced that you are already ‘upside down’ on your loan, ask for a ‘payout figure’ from your finance company – this is the amount that they would expect in a check today to hand over the title to the vehicle to you ‘free and clear’ – and, get ready to choke! Go on, try it …

So, don’t get yourself into this predicament!

But, if that is the only way that you can get into your first set of wheels (is it really, truly the only way? Or, are you just kidding yourself?!), or you are already into a financed vehicle, don’t sweat it.

Just take a look at your current monthly payments and the payout cost … if you can payout the vehicle and buy a cheaper one with cash, go for it. But, the chances are you will need to hang onto your current vehicle, as long as you can afford the payments.

Now, if you can’t afford the payments and you ARE upside down on the loan (as you surely will be), you will need some help to negotiate your way into handing back the vehicle, walking away from the loan and finding a way to start again. Now, that’s a whole can of worms that you just don’t want to open …

… so, next time you’re thinking of upgrading your car with a nice little “low-interest dealer loan” … don’t

No such thing as a free lunch …

This concept has come up three times recently, so it deserves a post of its own!

First Time

My son asked me why he can’t buy a car (when he’s old enough) on finance, and I explained it to him…

… he then asked me the million dollar question:

What about if there is a 0% finance deal on the car? Can I finance it then?

And, my answer was:

There’s no such thing as a free lunch.

Second Time

Ryan was posting about his car and Josh commented:

I would suggest buying used until you have cash to buy a new…BMW, you have no maintenance bill for 4 years, 50,000 miles.

And, my answer was:

There’s no such thing as a free lunch.

Third Time

I wrote a post about a hypothetical real-estate deal, with the key feature of a rental return guarantee. Rick said:

The description sounds like a good deal to me for a low risk- a guaranteed 7.5% return + possibility of great appreciation. It really sounds too good to be true.

And, it is (too good to be true); you see:

There’s no such thing as a free lunch.

… really, there isn’t. Somewhere along the line you are paying.

Let’s take the last case first: guarantees are usually not worth the paper they’re written on. Especially when they are “thrown in” to make a “great deal” sound even better. In the real-estate deal the ‘guarantee’ could actually cost you money, if the developers/promoters have to borrow money against the future value of the project to make a current payment to you.

In most  new projects where, say, a 2 year rental guarantee is offered, the value of the guarantee is built into the price that the property is offered to you at … might explain some of the very dramatic rises and falls in RE values in Florida, for example.

Similarly with the second example of the ‘free servicing’, which is – of course – built into the price of the car. Naturally, if you simply MUST have a brand-new BMW then you will get the ‘free’ servicing with it. On the other hand, if you can buy a used BMW just after the ‘free servicing warranty period’ has expired, you will be buying at the best possible price point, because (in a normal market) you should expect a sudden drop in the value of the car … this sudden drop represents the real, current value of the ‘free servicing’.

If you understand this concept, then so-called 0% down deals should become obvious … YOU are actually paying for all of the interest, at commercial rates, up front!

I did some consulting work for a finance company that underwrote so-called “2 year interest free” loans on furniture sales for large retailers; they made their money because the store paid a fixed amount up front when you signed up to the deal, then the finance company HOPED that you would not be able to make all your payments on time, because the ‘fine print’ on the deal then let them charge you interest at credit card rates (19% p.a. to 29% p.a.) on the entire financed amount for the entire time that you had the “0% loan”.

Here’s the test; always ask:

… and, if I don’t take the [insert: free lunch du jour] how much do I have to pay then??

Then you can decide if the free lunch is something that you can afford!