A primer on compounding interest …

If you want to understand the difference between ‘simple’ interest and ‘compounding’ interest – and, if you want to understand why it makes a difference as to how often you compound that interest – then watch this video (until the presenter starts writing with a blue pen … from that point on, only watch if you are a mathematician) …

The Cash Cascade ™

I wrote a series of posts about Dave Ramsey’s Debt Snowball, and have found this great summary / illustration on Blueprint for Financial Prosperity’s blog (does he just sign his checks BFFP to save ink?):

One of Dave Ramsey’s most popular ideas is that of a debt snowball. The idea is that you pay off your smallest debts first, then roll that debt’s monthly payment into the next smallest. When the next smallest is paid off, you roll the two former payments into the next smallest debt.The snowball grows and grow with each debt that’s repaid.

Here’s a real life example; here are your three debts and minimum payments:

  • $10,000 @ 20% APY, $500 minimum monthly payment
  • $4,000 @ 10%, $200 minimum monthly payment
  • $1,500 @ 12.5%, $75 minimum monthly payment + EXTRA PAYMENT

The debt snowball method states that you should put all extra debt payments towards the $1,500 balance. When you finally pay off that debt, your new payment schedule should look like this:

  • $10,000 @ 20% APY, $500 minimum monthly payment
  • $4,000 @ 10%, $200 minimum monthly payment + $75 + EXTRA PAYMENT
  • $1,500 @ 12.5%, $75 minimum monthly payment

I have only added the words “EXTRA PAYMENT” to both examples, because I want to clarify – then expand upon – BFFP’s example.

First, though, what Dave Ramsey is saying – and, what BFFP is trying to illustrate – is the concept that you take one of your debts (the highest interest rate in the traditional ‘Debt Avalanche’ or the smallest balance owing in Dave Ramsey’s more psychologically-friendly ‘Debt Snowball’ method) and pay that down completely … merely making the required minimum payments on any other loans (but no more!) to stop them from going into default.

The credit card companies will love you for this!

Then when that loan is paid off in full you apply the payment that you USED to make on the first loan that you tackled to the next remaining debt, and so on …

… it ‘snowballs’ because you are applying more and more to each remaining debt, while never having to commit more (or less) to debt servicing than when you first started budgeting.

So, in both examples we are paying $775 (i.e. $500 + $200 + $75) towards debt repayment until all debts are paid off … THEN – conventional financial wisdom will tell you – you get to start INVESTING that $775 a month and you are FINALLY debt free and on your way to … what?

Well, let’s go back and make the small correction: if you only make the minimum payments, you will never pay off any of the debts (or, way too slowly), so you need to find some extra money and make some extra payments to the first loan that you decide to tackle; let’s use an example of $225 a month as an extra payment …

… and, from now on you commit to that monthly $1,000 i.e. $500 + $200 + $75 + $225 EXTRA PAYMENT + C.P.I. + 50% of any ‘found money’ (second jobs, part-time business income, loose change, IRS refund checks, etc., etc.) for your entire working life!

So, we are on the road to success! Or, are we?

The problem is that we have to decide where we’re heading: if our aim is to become a Ramseyesque Debt-Free=Happy clone, then well and good. Your financial plan is set.

[sign off now]

But, if we intend to get rich(er) quick(er)™ we have two huge limitations, neither of which the Debt Snowball or Debt Avalanche address:

1. Time to invest, and

2. Money to invest.


We all know the time value of investing early and investing often:

If we lose just 10 years to our investing plan by delaying investing while we pay down ALL of our debt and/or pay down our mortgage we can halve our potential return.

Do you think that might be significant?

So, we don’t want our debt-repayment strategy to unnecessarily delay our investment strategy.


Where are we going to get the money to invest?

Sure we can accumulate $1,000 a month (after paying off debt) – and, grow that amount through C.P.I. and ‘found money’ strategies -but, will that really set us off on the path to financial riches?

The same graph shows that for every $1,000 A YEAR we invest, we can expect $100,000 after 20 years … so, our $1,000 A MONTH strategy should yield $1.2 Million over the same time period … unfortunately, that won’t be enough for a DEPOSIT on the Number that you really need …

… and, inflation will take at least a 50% chunk of that (not to mention taxes)!

So, the solution for most people – who don’t want to lower their expectations to match this depressing, but debt-free (!) scenario – is to move INTO debt … to invest!

This is so-called ‘good debt’ and I’m not sure what Dave Ramsey and Suze Orman’s take on this is, but most financial pundits call it ‘good debt’ for a reason. Assuming that you agree, read on [AJC: if not, I’m guessing that you hit <delete> about 4 or 5 paragraphs ago]

So, here’s what we need …. a different mind-set:

Since we already know that we will more than likely need to incur SOME ‘good debt’ as part of our investment strategy (i.e. some safe level of leverage for investment purposes e.g. a loan on a rental property) …

why pay off OLD debt now in order to accumulate NEW debt later?

It doesn’t make sense, does it?

We merely waste time and money … instead, we should resolve the following:

1. To treat all Consumer Debt as ‘bad’ and incur no further such debt, unless it’s not really Consumer Debt at all (e.g. we need to buy a car to run our catering business, and public transport or a bike really won’t cut it)

2. To apply the minimum required payments + extra payment(s) + c.p.i. + ‘found money’ not merely to the lesser goal of paying down debt, but to the greater goal of helping us get to our Number (i.e. the financial representation of our Life’s Purpose [AJC: if you don’t buy into that philosophy, then simply insert the words “helping us become financially free”])

3. To, from this day forth, look at all debt as an INVESTMENT in your financial future: and, simply ‘invest’ where you get the greatest returns: is that in paying off an old debt? Or, is it in acquiring a new debt?

Example 1

In the example above, we have three debts of 20%, 12.5% and 10% (are they tax deductible? If so, look at the after tax cost which will be 25% to 35% lower than the nominal interest rates circa 14%, 8.5%, and 7% respectively) …

Compare these interest rates to the cost of money for the types of investments that you want to make …

… in this example, all three are higher than current mortgage rates so you will probably want to keep paying them off (although a good argument can be made for paying off the 20% loan first, then buying an investment property BEFORE paying off the others).

Example 2

Let’s make two changes to our example:

Let’s assume that one of the loans is a 2.5% Student Loan, and swap the amounts owing (so that the Student loan is now the ‘biggie’) and, let’s assume that we have at least 5 more years before it HAS to be paid back (so we have time to make an investment work for us); here’s our starting position:

  • $1,500 @ 20% APY, $500 minimum monthly payment + $225 EXTRA PAYMENT
  • $4,000 @ 10%, $200 minimum monthly payment
  • $10,000 @ 2.5%, $75 minimum monthly payment

In this case, we tackle first the 20% loan; I can’t imagine an ‘investment’ that will provide such a quick & safe 20% post-tax return! Then, we tackle the 10% loan.

Again, an argument could be made for leaving it in situ; however, it is only $4k – and, we’ll pay it off in just 4 months – so let’s go ahead do just that:

  • $10,000 @ 20% APY, $500 minimum monthly payment
  • $4,000 @ 10%, $200 minimum monthly payment
  • $10,000 @ 2.5%, $75 minimum monthly payment
  • $10,000 Reserve #1 @ (1%)  + $200 + $500 + $225 EXTRA PAYMENT

See what we are doing?

Once we have paid off our two HIGH INTEREST loans, instead of paying down the low interest student loan, we continue to make its minimum monthly payment, and instead apply all of the previous / extra loan payments (from our OLD loans) to building up a ‘reserve’ in a bank account (it pays us a – low – rate of interest!) …

… at this rate, we will have a deposit on a small rental (or our own first studio apartment) in less than a year, then our financial picture will look something like this:

  • $10,000 @ 20% APY, $500 minimum monthly payment
  • $4,000 @ 10%, $200 minimum monthly payment + $200 + $500 + $225 EXTRA PAYMENT
  • $10,000 @ 2.5%, $75 minimum monthly payment
  • $10,000 Reserve # 1 @ (1%)
  • $40,000 @ 6% FIXED, $240 required monthly payment
  • $10,000 Reserve # 2 @ (1%) + $185 + $500 + $0 EXTRA PAYMENT + $185 Rent

Keep in mind that if you used Reserve # 1 to build up a deposit on a small apartment to live in, then you will have no rent to pay, so you can apply part to home ownership expenses (rates/utilities/taxes) and part towards your next Reserve!

And, if you bought a rental, then you may be in an excess rent situation and have more to apply to building your next Reserve, as well … if not, then you will need to decrease the amount going towards your next reserve to cover any rental shortfalls (e.g. mortgage payment deficits, vacancies, repairs & maintenance fund, etc.).

Now, you know why this is not a Debt Snowball, a Debt Avalanche, or even a Debt Meltdown:

It’s the Cash Cascade …

… the new way to look at paying down debt!

In the two years that it would have taken you to pay off your Student Loan and buy your first property, you now own two properties and are well on your way to financial freedom!

What do you think? Will it work for you?

Will you ever put a penny in your 401k again?

I stuck my neck out, and made a candid admission; as expected, I copped a little flak – after all, I admitted to the world that I don’t even know how much is in my own Retirement Accounts 😉 Whoo boy!

What surprised me is that I didn’t lose readers … I even gained some; Josh pointed to the reason why in his comment to that post:

Controversial? This article was absolutely controversial and that’s why I come here. If you want extraordinary results you need to make controversial moves, a.k.a “taking risk”.

Thanks, Josh. Here’s how I see it:

I’m not a risk-taker, far from it … to me, the so-called controversial move is usually not “a.k.a. taking risk” …

… blindly following Conventional Wisdom can be the riskiest move of all because you may unwittingly be risking a good proportion of your financial future!

To prove my point, and (hopefully) change the way that you look at investing in your 401k forever, let’s take this example from another comment to that same post, by Alex:

This strikes me, in a good way. I am about to be eligible for the 401k at my company. Normal people who cannot think of anything else better (and safer) than sticking their money in the funds.

Correct me if I’m wrong, what you are really saying is: instead of saving diligently and sticking $30,000 into a fund, maybe that same $30,000 can be used as a down payment for a rental property that will both appreciate and generate cash flow.

Now, I cannot advise Alex – or anybody else – on what to do with their money … that’s the job of financial advisers.

But, isn’t it Rule # 1 of Personal Finance to FIRST PUT YOUR MONEY IN THE 401K TO GET THE COMPANY MATCH?

After all, isn’t that FREE MONEY?

If the employer matches your entire contribution, aren’t you getting a 100+% return on your investment … impossible to match anywhere else?

Absolutely, which is why almost every personal finance writer (be it books, magazines, or blogs) recommends to at least invest to the limit of your employer’s matching contribution …

…. except for one problem, this thinking doesn’t hold up to scrutiny!

You see, your money is in the 401K for the long-run (isn’t it?) … your contribution – and your employer’s match is only a Year One issue; over the long run, your Contribution (with the employer’s match) will tend to a much, much lower return.

Alex’s question is: will that $30,000 be better off in the 401k or in a rental property?

The only way to find out is to run some numbers over the expected life of your ‘plan’ to see what happens … fortunately, just like a cooking show, I have prepared the numbers for you and here are some very interesting results:

SCENARIO # 1 – Assumptions

A. Let’s simply take Alex’s question ‘as is’ i.e. make a one-off $30,000 contribution to the employer’s 401k:

We will assume that the employer is VERY GENEROUS and match 100% of the entire $30,000; and we will assume that the markets are equally generous and compound an 8% return for us – tax free – for 30 years.

B. Alternatively, we can put that entire $30,000 as a 20% deposit against a $150,000 house; and we will assume that it’s value increases by a more conservative 6% (also compound) each year. We will also assume that Capital Gains Tax (15%) is payable.

SCENARIO # 1 – Results

1. We know that in Year 1, the employer’s 100% match provides a 100% return on the 401k; but, in year two that return drops to 58% (the employer’s $30,000 ‘match’ effectively becomes a $15,000 ‘return’ over each of the two years … then add the 8% Net Managed Fund Return).

This rate drops each year – because we are looking for the equivalent compound return, it drops fast – so that it only takes 9 years for the overall compound return to drop below 20% and by Year 18 through to Year 30, it averages a compound return of ‘just’ 11% – 12%; still almost twice real-estate, though!

2. The total amount available to cash out of the 401k at the end of the 30 years is $559,000

3. However, if the entire $30,000 was used as a deposit on real-estate, even with a 15% Capital Gains tax on any increase, the total 30 year Capital Return will be $713,000.

That’s a 28% advantage by putting the $30,000 into real-estate instead of the 401K …

… a greater overall $ return even though the % growth was half that of the 401k!

How can this be so?

The power of leverage (we borrowed 80% on the real-estate and nothing on the 401K except for the employer’s Year 1 ‘match’).

But, wait, there’s more!

The property is an investment property (if you choose to live in it, simply figure that you pay yourself a ‘market rent’ and these conclusions still hold true) … so, we can assume:

That we fix the mortgage at 5.25% (that’s $8,000 a month), and average a 5% rental return based on current market value (means that our ending-rent grows to nearly $36,000 a year!), and assume that 25% of rents will go towards expenses (other than the mortgage) and vacancies (a useful Rule of Thumb).

4. The net income (with any ‘surplus’ over mortgage and expenses being held on CD at a 30 year average of just 5%) is an additional $217,000 for the real-estate option.

Taken together, here’s how it looks:

 Total Return:       
 401k   $    559,036  CGT+Income   CGT Only  
 Real-Estate   $    930,476 66% 28%

So Alex, by (a) forgoing the exceedingly generous employer match in your 401k and (b) putting that $30,000 into a pretty tame residential real-estate investment instead, your overall 30 year return increases by 66%

Now, this is not how the ‘real-world’ usually works:

We don’t usually invest in one lump sum … we usually make annual contributions to our 401k of 10% – 20% of our salary. So, how does The Alex Plan work under this ‘real world’ scenario?

Let’s see …

 SCENARIO # 2 – Assumptions

A. Let’s adjust Alex’s question to instead make an annual contribution of 10% of an assumed annual salary of $50,000 (4% inflation-adjusted, so that the contributions also increase by 4% each year)  to the employer’s 401k:

We will assume that the employer will remain generous and 100% match the employee’s contribution each year; and we will assume that the markets are very generous and compund an 8% return for us – tax free – for 30 years.

B. Alternatively, we can simply put each year’s contribution in a bank account (earning a paltry average of 5% over the entire 30 year period):

When we save around $30,000 [Year 6] , we take that money out of the bank as use it as a 20% deposit against a $150,000 house; and we will assume that it’s value increases by 6% (also compound) each year. We will also assume that Capital Gains Tax is payable.

Once be buy the house, out bank account is depleted, but we are still saving 10% of the employee’s salary, so we start to build the bank account up again … of course, similar properties get more expensive, so we wait until we have saved around $38,000 [Year 11] as 20% deposit and buy our SECOND property … then we repeat: saving around $46,000 [Year 16] for property THREE, and around $56,000 [Year 21] for property FOUR and final.

Why final? Well, we are within 10 years of retirement, so the BEST PLACE for our final 9 year’s worth of annual contributions is probably the 401k … 9 years is simply not long enough to chance the property market (for this reason, we could even be really conservative and also forgo the purchase of the 4th property).

SCENARIO # 2 – Results

1. The numbers are too complicated to measure the effect of the employer’s match on the hypothetical return … but, the overall numbers are far more important.

2. The total amount available to cash out of the 401k at the end of the 30 years is now $1.8 Million (now, you know why you want to make annual contributions to your investment plan!).

3. With the purchase/s of the 4 properties (the last of which we hold for just 10 years), even with a 15% Capital Gains tax on any increase, the total 30 year Capital Return on the FOUR properties (plus the final 9 years of 401k savings) PLUS the net income for each of the FOUR properties, will be $2.4 Million.

That’s a 32% advantage by putting 10% of your salary into real-estate instead of the 401K …

 Total Return:   
 401k   $  1,833,746  CGT+Income 
 Real-Estate   $  2,412,898 32%

Before you say, well 32% is just too much work to worry about … you’re not thinking like a millionaire. Over the 20 years, you will have built up enough equity in properties #1, #2, and probably #3 to also purchase properties #5, # 6 and possibly #7. And, so it goes until rich …

So, Alex, will you invest in your 401k? If you have a lump sum … I’d guess definitely not?

But, for your long-term savings plan: the 401k is certainly more convenient … but, is that convenience ‘worth’ $600,000 (or – a lot – more!) to you?

That’s only a choice that you – and, aspiring followers of The Alex Plan – can make 🙂

Is this the future of money management for children?

I know that there have been a number of posts on other blogs about a new savings product called SmartyPig.

I initially dismissed their site [AJC: particularly because they USED to have a $25 fee – now gone … site is now totally FREE – and they didn’t offer a ‘cash out’ option – now also gone … you can get your money back as a wire transfer to your bank or as a Debit Card] … but, reviewed their FAQ’s, I really believe that they have something interesting here.

 What triggered my second look was an e-mail that I received today from Jon Gaskell, one of the co-founders of SmartyPig:

I had a very interesting conversation last week. It was with a young lady saving for a down payment on her first home with her fiancée. They want every penny they can scrape together funding that goal – especially the presents she is anticipating receiving when she finishes up graduate school later this spring. 

They thought they had found the perfect way to reach this goal faster when they stumbled upon SmartyPig, she told me. They were really excited about the public contribution piece and the social nature of SmartyPig. They thought the widget would draw attention and letting friends and family members know about their goal would keep them focused.

The next day, when my business partner, Mike Ferrari, and I spoke to a mother who is using SmartyPig to not only teach her 10- and 12-year-old sons how to save “in a cool way,” but is using SmartyPig to help them save up for their cars when they turn 16. 
When our site update is complete, the customer will have a third option when he or she has reached their goal: an ACH transaction back to their checking or saving account.

There you have it, a quick’n’easy way to set up a specific account to save up for a specific goal – whether large (e.g. a car) or small (e.g. an iPod) … in fact, that is the advantage that SmartyPig has over typical bank accounts [AJC: SmartyPig is supported by a bank, hence all deposits are FDIC Insured]:

It is easy to separate money into ‘pockets’ for specific savings goals.

I’m not sure what their future plans are, but I see a big future for them  – in addition to the Adult-saving-for-‘stuff’ market – I see a particularly big opportunity in the kids market.

Most kids’ allowance sits in cash … for example, we divide our kids allowance into two: Savings and Spendings, which means that we would need to open at least two Smarty Pigs accounts for each child, with one having a Goal of ‘Retirement’. Actually, our kids are smart enough to roll their retirement savings into my Scottrade account, so they are fully invested in my stock portfolio … but, for most people, simply having an account where kids earn interest on their money is a big step ahead of sitting in cash in the top drawer of their bed-side table! 

From a marketing perspective [AJC: I simply can’t help myself!], the founders of SmartyPig COULD gain tremendously by writing two books:  

1. SmartyPig – Sensibly Spending Your Way to Wealth – this would be a Making Money 101 book squarely aimed at breaking down the debt and credit-card mentality. Any personal finance blogger worth her salt could ‘ghost write’ or, even better, co-write this with them. 

2. SmartyPig for Kids – which would lay out a simple – naturally, SmartyPig-supported – process for dividing money earned by doing chores etc. into Savings and (possibly, more than one) Spending/s accounts. It would lay out a basic money-management philosophy for children to follow that will help lay the foundation for a consumer-debt-free, savings/investment-driven adult life.

The children’s angle, I believe will be where the growth is for SmartyPig, as their product (with some, minor modification) solves a real need …

… but, the account balances involved will be small and the demographic (i.e. children) will not be as lucrative, so some some additional ‘smart marketing’ will be required to drag the parents along for the ride.

Now, I haven’t tried SmartyPig myself, yet, so please don’t consider this an endorsement until I (well, more likely my children, as I don’t really need to save for ‘stuff’ any more) have tried it …

On the other hand, if you have tried it already, please let me know what you think!