Tag Archives: money

The true cost of debt …

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deal-case-yes

Have you cast your vote yet?

Deal or No Deal … YOU DECIDE

Click here to vote!

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In my post about debt, I said that it is not always correct to simply pay down old debt … in this post, you will see that it’s rarely ever correct.

First, let’s look at Jeff’s comments, which summarize the traditional view that it’s all about interest rate comparisons:

My opinion is to still compare your debt interest to prevailing debt rates (is it cheap money compared to what else is available?), how does inflation affect the rate (cheaper future dollars point again) and can I out perform the debt rates with the investment opportunity that is competing for this money.

Without the tax advantage, I’m more inclined to pay off the debt, i.e. lower tolerance for high debt interest.

I haven’t done any math on it…yet, but my gut feel is that 6% or higher on the debt and I’d be giving serious thought to paying off the loans.

This may be true, Jeff, if all else is equal …

… but in the ‘real world’ of investing, you will find that all else is rarely equal!

You see, I don’t look at interest rate and cost anywhere near as much as I look at utility – a concept that I introduced in this post: if I am serious about investing, I am struggling to find a scenario where putting my money INTO reducing leverage (by paying down existing loans) returns more than taking on new ‘good’ debt …

…. or, leaving old ‘bad’ debt in place, as long as it is cheap’ish and, much more importantly, available!

I’m sure that our resident real-estate experts (e.g. Shafer Financial) could point you to 1,000 examples where it is still viable to maintain debt of 8% – 15%+ as long as you could find cash-flow positive real-estate that appreciates at not much more than inflation.

It doesn’t even need to be real-estate, but it does depend on what you are prepared to invest into; e.g. assuming Michael Masterson’s numbers:

  • CD’s return 4%, so I would pay down the 6%+ debt
  • Index Funds return 8%, therefore, I would be inclined to keep the debt if it were very close to 6%; anything above and we would have a more difficult decision
  • Individual Stocks return 15%; I would buy the stocks (and, probably margin borrow into them as well), but that’s just me … Warren Buffett would say ‘never borrow to buy stocks’, so you have a ‘philosophical’ decision to make
  • Real-estate (together with stocks) returns 30%; @ 6% I would keep the loan (for as long as possible!) and buy the real-estate
  • Businesses return 50%+, so I would keep the loan in place (again) and use the ‘repayment money’ to help start up

Besides the obvious tax implications (e.g. CD’s and Index Funds – depending upon whether they are inside or outside a 401k – could become ‘line ball’ with paying off the 6%+ debt (IF it were pretty close to the 6% mark) …

BUT, you have highlighted a more important flaw in my argument: this table only looks at the use of the money; what if I could get a cheaper source of funds by paying down the old debt then acquiring new?

Great argument, in theory, but let’s see how it stacks up in the ‘real world’ … the simple question is: can we refinance or otherwise acquire cheap, new debt (thus allowing us to pay down the expensive, old debt) as Jeff suggests?

Let’s see:

CD’s: I don’t see any easy way to finance except with personal loans, credit cards, a refi or HELOC over our home, so I would say let the debt ride. But, the list above suggests that this would a recipe for losing money, anyway, because of the low returns.

Index Funds: possible to borrow on margin (i.e. finance) through a brokerage account (but, not in your 401k) but only to a max. of approx. 50% so you would still need to come up with the other 50% elsewhere.

Individual Stocks: same as with Index Funds (e.g. I am 100% financed in the US market through a combination of HELOC and margin loans).

Real-Estate: usually able to refinance, so I would agree with you to “compare your debt interest to prevailing debt rates”; other than right now, 6% is extraordinarily low historically … 8% – 10% would be closer to my refinance decision-point.

Small Businesses: very hard to finance except with personal loans and credit cards, so I would say let the debt ride if you were highly enthused and confident of success.

In other words, finance is simply not readily available on most investment choices available to us.

So, the questions that you need to answer – probably in this order, Jeff – are these:

1. Do I want to get rich(er) quick(er)?

2. If so, am I prepared to increase – or, at least maintain – leverage by borrowing for investments?

3. If so, am I prepared to make the mental leap of moving to the concept of ‘pools of debt’ and ‘pools of equity’ by not actually having the debt entirely on the asset that I am acquiring?

And, more importantly:

4. Is new debt available to make the investment/purchase (if so, is it cheaper than my current debt)?

5. Does the investment/asset that I am considering acquiring return more than my current (or new) debt?

If you don’t get past Question 1. then paying down debt is the only Making Money 101 strategy that you need to be concerned with … otherwise, I don’t really see this going half-way 😉

Deal or No Deal – Part 3 – Reader Poll

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Late last year, I asked you (a number of times … just like Howie Mandel) …

…. Deal or No Deal?!

What would you have done [AJC: if you haven’t yet ‘cast your vote’, please go back to this post and drop a comment]?

We know that Ms Tomorrow Rodriguez (sounds like a character out of a James Bond movie)  said “No Deal!” to the miserly Banker’s’ offer that only paid out 1-in-3 for a 50/50 chance …

… Vote 1 for the ‘math kings’!

But, look at the situation that she’s faced with right now (in the photo above):

4 suitcases left: 3 of them contain ONE MILLION DOLLARS and 1 contains only $300!!

Ms Rodriguez – with the odds clearly stacked in her favor – has two choices:

1. Take the Banker’s Offer of $677,000

OR

2. Say “No Deal” and select just one more suitcase (then she will be presented with another offer)

Deal or No Deal?

Let’s examine the options:

1. Take the $677k and run!

OK, the banker has offered $677,000 but there are 4 suitcases left of which three contain $1 Million and one is a (virtual) blank.

That smells like a 75% chance of $1 Million to me … ‘worth’ $750,000 (any maths whizzes out there to counter this?) … seems to me that the Banker is short-changing Tomorrow Rodriguez by $73,000 buckaroos!

2. Select just one more suitcase and see what happens next (after all, she can’t lose on the next turn)

Well, here is the problem … unlike any of the lead-up turns, this time there is only ONE non-million case left; so, there are actually two possible outcomes here:

i) Tomorrow selects the one suitcase containing the blank (i.e. $300) which means that she automatically wins (there are only 3 suitcases left … since each would then have to contain $1 Mill. she can’t lose)

OR

ii) Three times more likely, Tomorrow selects one of the three suitcases that contain $1 Million and the chance of winning on the next round drops from 75% to 67% (3 suitcases left: 2 contain $1 Million and 1 contains $300 only)

The significance?

From this round on, the Banker Deals can only get worse, because the next round after this one would leave just 2 suitcases (assuming that she hadn’t won by then) … or, a 50/50 chance (and, we’ve already seen how much the Banker will rip her off on that)

In fact, Tomorrow is effectively paying for each ‘roll of the dice’ from here on in … whether she realizes it or not …

So, if she turns down $677,000, Tomorrow is really saying: “$1 Million or Bust … I’m going all the way, Baby!” … because she will surely turn down the later, much lower offers (been there, done that!) as well.

So, Ms Rodriguez really has just two practical alternatives:

1. A guaranteed $677,000 if she walks away right now

OR

2. A 75% chance of winning $1 Million AND a 25% chance of walking away virtually empty-handed

Deal or No Deal?

Just like last time, make a vote & drop your vote into the comment section below (I’d love to hear your reasons) … next week, we’ll check out what our readers had to say … it should be interesting!

In the meantime, do you want to know what Ms Rodriguez chose? Do you agree?

A little perspective …

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For a bit of fun, I typed in an annual income of $220,000 into this handy little online calculator, and it shows that I’m the 107,565th richest person in the world … whoohoo!

Now, if I typed in my real annual income, I think that I could jump myself higher up that list … and, if I factored in that I get that money mainly passively, well ….

Reminds me of an interview that I saw with Guy Laliberté, founder of Cirque Du Soleil, who went from street performer (read homeless hustler) to sharing the same level of wealth as Oprah.

Now, that’s not the bit that blew me away; what did was that they were sharing something like 160th place on Forbes’ list of the richest people in the world: Oprah … Cirque Du Soleil Man … and, they ONLY get to be joint 160th (approx.) on the list??!!

Who are these other dudes between them and Bill Gates?!

So, it’s really good to be able to put things in perspective and realize that if you are earning almost ANY regular salary, you are in the Top 10% of the richest people on the planet:

The Global Rich List calculations are based on figures from the World Bank Development Research Group. To calculate the most accurate position for each individual we assume that the world’s total population is 6 billion¹ and the average worldwide annual income is $5,000².

Below is the yearly income in percentage for different income groups according to the World Bank’s figures³.

Percentage of world population Percentage of world income Yearly individual income Daily individual income
Bottom 10 percent 0.8 $400 $1,10
Bottom 20 percent 2.0 $500 $1,37
Bottom 50 percent 8.5 $850 $2,33
Bottom 75 percent 22.3 $1,487 $4,07
Bottom 85 percent 37.1 $2,182 $5,98
Top 10 percent 50.8 $25,400 $69,59
Top 5 percent 33.7 $33,700 $92,33
Top 1 percent 9.5 $47,500 $130,14


The world’s distribution of money can also be displayed as the chart below.

¹ 2003 world population Data Sheet of the Population Reference Bureau.
² Steven Mosher, president of the population research institute, CNN, October 13, 1999.
³ Milanovic, Branco. “True World Income Distribution, 1988 and 1993: First calculations based on household surveys alone”, World Bank Development Research Group, November 2000, page 30.

So, realize that UNLESS YOU ARE PLANNING TO DEVOTE SERIOUS SLABS OF YOUR TIME AND MONEY TO WORTHY CAUSES this blog and everything we are doing here is about as useful as a blog on whittling … and, probably a darn site less so, because there’s nothing inherently of artistic merit in even the best-crafted bank account.

How much does it take to feel wealthy?

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The answer is “about double” 🙂

But, that’s not really a tongue in cheek question / answer, it’s actually scientifically researched and verified fact …

… let me explain.

Most people want to become rich (when we strip away the houses, cars, vacations, sex, drugs, rock and roll [AJC: Boy, I must lead a great life!]) simply to feel secure … to stop having to worry about money.

So, the definition of ‘rich’ for most people is related to how much more money that they feel that they would need in order to stop feeling financially insecure. And, that always seems to be about twice what you currently have; take a look at this report by MSN Money (if anybody can find the base source, please send me the link … I hate to quote quotes).

  • Those who earned less than $30,000 thought that a household income of $74,000 would qualify as rich.
  • Those who made $30,000 to $50,000 said an income of $100,000 would be rich.
  • And people in the top half [$50k – $100k+] of earners were more likely to say that an income of $200,000 earns you the right to the R[ich] word.

So, it seems that no matter what income level you are on, you need two (to perhaps three) times that in order to feel ‘rich’.

Perhaps, you feel that it would be different if we weren’t talking penny-ante incomes here, and jumped straight to millionaires and multi-millionaires? Surely, things would be different for them?

Well, not so … according to Robert frank, Author of Richistan, most of America’s Ultra-Wealthy still consider themselves as ‘middle class’ and would need “about twice what they already have in order to feel wealthy”.

So, this is just another reason why picking a random income or net worth $$$$ target and calling that ‘rich’ doesn’t cut the mustard … you’ll never be relaxed with your level of wealth, no matter how much you have.

No, what you need to do is:

1. Understand WHY you need the money: we call this Understanding Your Life’s Purpose

2. Understand HOW MUCH you would need so that you would be free to LIVE your Life’s Purpose: we call this Calculating Your Number

… and, when you finally reach your Number, not worrying about chasing more, because that’s about as sensible as a dog chasing it’s tail!

The definition of insanity …

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“Insanity: doing the same thing over and over again and expecting different results.”  Albert Einstein

Thankfully, this blog isn’t for everybody … only those who want to get rich(er) quick(er) … I’ve proved that it can be done successfully, and I am conducting a ‘grand experiment’ at one of my other sites to prove that it’s not just luck and that others can do it, too.

But, the vast majority are still in the ‘work for 40 years and hope to have saved enough’ mindset … and they have worries of their own, as this recent Gallup Poll showed:

Of course, recent economic woes are probably ‘skewing’ this a little … but, think about it – most aren’t retiring tomorrow, or even in the next 10 years, so markets will have plenty of time to boom and bust again for them.

No, the problem is more endemic: most people simply don’t think that they will be able to retire happy or comfortably – and certainly not wealthy – despite the ‘formidable’ array of ‘retirement weapons’ at their disposal:

So, if the majority of people are using these tools and the majority of people believe that they won’t work for them …

Whatup?!

Surely, at some level, these people know that these tools – as I have been hammering home in this blog for some months now – simply won’t do the job?!

Let’s take a look:

1. 401k’s – High fees; low returns; lousy investment products on offer:

STRIKE 1 – I have never had a 401k and I have no idea what is even in any of my tax-advantaged / retirement accounts.

2. Social Security – An unfunded program; USA in the highest level of debt in history’ what’s the chances of Social Security being around in the same form when YOU retire?:

STRIKE 2 – When my social security statement arrives I chuck it in the trash without reading it, it’s irrelevant, it won’t be around when I retire, and I had this same line of thinking BEFORE I became rich.

3. Home Equity – Please! Where do you intend to live when you retire? By the time you buy and pay changeover costs etc. if you see any spare cash, it may be just about enough to pay off your remaining credit card debt:

STRIKE 3 – I live in my home equity, don’t you?

4. Pension Plan – Do you work for Ford/GM/Chrylser? Any airline? Just about any bank?:

STRIKE 4 [AJC: 4 strikes???!!! I’m an Aussie, what do I know from baseball?] Ditto to the above, in fact, I have never subscribed to an employer-sponsored pension plan, even where I have had the choice.

… need I go on?

The point is, if you know these tools aren’t going to work for you – as the majority of Americans surveyed by Gallup seem to – yet you keep using them – as the majority of Americans do – isn’t that the very definition of ‘insanity’?

Now, that’s a question that I would love to see the Gallup Survey for!?

Merry Chrismas?!

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Why am I posting a really nice Christmas video on January 25th?!!

Well, it’s simply to make a point …

… it doesn’t matter how late you start, but how well you execute that counts.

Just ask Ray Kroc (McDonalds), ‘Colonel’ Sanders (KFC), my father (who started a business at the age of 60), and (hopefully, soon) our very own Lee Martin …. old is the new young 🙂

Advice for a small investor …

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Glossary asks:

With limited funds at ones disposal, say in the 10K to 40K range, what are the arguments for and against buying outright low price stocks to accumulate more shares than would be possible with higher priced stocks. Or, alternately, of using call or put options to purchase stocks of any share price?

To which the ‘common wisdom’ response was:

Whether you are a “big investor” or a “small investor” doesn’t matter as much as you think, IMHO. Nobody likes to lose their money. Everybody needs the same general principles when it comes to investing.

Figure out your risk tolerance. The market is volatile. If your investment drops 10% will you be up nights puking your guts out into the porcelin throne?

Never put all your eggs in one basket. This means only 2%-4% in any one investment AND make your individual investments in different types of investments such as large cap value and medium cap growth.

But, you know my take on this by now: if you diversify your investments, then expect to get ‘market returns’ or less …

LESS to the extent of fees and the losses that you can expect from mis-timing the market … which the Dalbar Study shows will be often and the cost of these mistakes will be very, very, expensive:

Fees: Of these, the fees are the reason why even the most disciplined investors (even 75% of Mutual Funds) perform worse than the market.

Market Timing: But, it is the second – the market timing risks – that mostly affect smaller/individual investors: it’s the reason why the Dalbar Study found that during a long period where the S&P 500 grew at an average rate of 11.9% ‘smaller investors’ only managed a paltry 3.9% return … they would have been better off in CD’s!

So, here is my suggestion:

A. If you want ‘passive investments’ and are satisfied with market returns (circa 9% AFTER inflation … current market aside) then plonk your money in a low-cost S&P 500 Index Fund and let it sit until you retire … add to this investment as much and as often as you can.

OR

B. If you want (need?) ‘above average’ market returns – and, are prepared to ‘gamble while you learn’ (the price of an investment education) – then pick an investment that you can study up on and DO NOT diversify into that asset class; instead, put all of your eggs into no more than 4 or 5 baskets (i.e. stocks and/or real-estate holdings) … but, recognize that you ARE gambling-while-learning, so that you can get the higher returns that you crave.

OR

C. If B. is not for you – or it simply doesn’t work out for you when you are still only ‘gambling’ with small amounts, then it’s not for you at all! Quit while you are not too far behind and then refer to A.

That’s it! 🙂

Money Makes the World Go Around …

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It’s sad, but true … it seems that money does make the world go around.

It’s what seems to drive people to make – lose then make – lose … and, so on … their money. It becomes an end rather than merely a means.

But, I have a slightly different view:

1. FIRST decide WHY you need the money … I call this Understanding Your Life’s Purpose

2. THEN decide HOW MUCH money you need in order to do whatever it is that you need the money for (and, by WHEN) … I call this Calculating Your Number

3. FINALLY, when you DO get to your Number, STOP and LIVE YOUR LIFE.

… the fallacy of dividend paying stocks!

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When I’m not writing posts here, I’m hanging around the Share Your Number Community Site, talking to the other members.We launched this site in 2008, and in 2009 we are planning a major expansion so please join now … it’s FREE and easy!

Remember, helping others get to their Number is the best way to get to yours …

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I have been itching to write this post for some time now, and yesterday’s post about investing in income-producing real-estate v speculating in (hopefully) appreciating RE should have provided the necessary comments/questions …

… but, it didn’t 🙁

However, Steve chose this particular day to finally complete his comment on a post that goes back 6 months … a comment that is right ‘on topic’ for me … and, is a question that all of us should be asking … so, thanks Steve!

Here’s what Steve had to say:

I don’t purport that he is write [sic] in his article but would really love to hear your views on [this] story…

http://seekingalpha.com/article/84850-investing-in-dividend-paying-companies?source=d_email

what i liked about it is the dividend paying stock situation. certainly i wouldn’t consider as an only avenue to wealth, but do you feel dividend paying stocks are a better choice than non dividend paying stocks?

The article promotes a method of investing that the author claims returns “a little over 8.68% annually … while not earth shattering by any means, compare[s] very favorably with the market’s performance over the same period. From July 1988 to now, the S&P 500 has advanced … around 7.86% annually.”

The ‘now’ is actually July 2008, so only reflects some of the recent stock market losses, but the principle is clear, at least according to the author: invest in dividend-paying stocks …

… and, this is certainly ONE (of many) Making Money 301 tactics that I recommend when you have made your Number and are trying to preserve your wealth. However, it is just that – a tactic – and, certainly not the best one there is.

Given this, and my strong recommendation that you invest in RE for income, you might be a little surprised to hear me say:

As a Making Money 101 or 201 strategy, seeking out dividend-paying stocks is almost irrelevent!

Why?

Well, let’s take a look:

Stocks return in TWO main ways, just like real-estate:

1. Capital Appreciation

2. Dividends

Capital Appreciation

Just like real-estate, the price of a stock tends to go up according to the profits of the company. When I say “just like real-estate”, I mean just like commercial real-estate … residential real-estate has other, less tangible drivers of future value. So commercial real-estate tends to rise in value as rents rise, and stocks tend to rise in value as the company’s profits rise.

Naturally, inflation is a key driver (forcing rents/profits up, hence the price of the real-estate/stock) but there are plenty of other ‘micro’ and ‘macro’ factors as well e.g. for real-estate it could be job growth, for companies it could be competitive pressures, etc.

This is what I would call the Investment Factor that tends to drive up the value of such investments, and you can generally be confident that prices will increase according to this factor – over the long-haul.

An equally important factor is ‘market demand’ for that type of investment, which is reflected in ‘capitalization rates’ for real-estate and ‘Price-Earning (PE) Ratios’ for stocks … this is essentially a measure of how long somebody who buys that investment is willing to wait to get their money back via future rents/profits.

This is what I would call the Speculation Factor that tends to drive up or down the value of such investments, and you can never be sure which way this will drive prices – over the short-haul.

Unfortunately, as recent market events in both real-estate and then stocks have very clearly shown – the Speculation Factor has a much greater effect on pricing than the Investment Factor … unless your time horizon is very long, indeed.

This is why it is much better to look for the underlying investment returns, unfortunately often mistakenly confused with …

Dividends

Because Real-estate produces rents – and, hopefully positive cashflow after mortgage and holding costs are taken into account (which, should be your main criteria for investing ), people often confuse dividends paid on stocks with returns on real-estate investments.

This is not the case:

Whereas real-estate returns are simply the rents that you receive less the costs (e.g. mortgage, repairs and maintenance, etc.), stock dividends do NOT directly reflect the profits of the underlying business.

Commercial real-estate usually provides an investment return set by a ‘free market’ (for things like competitive rents, competitive interest rates, etc.) …

… but, the dividends on most stocks are simply set by a board of directors according to whatever criteria makes sense to them at the time.

People who invest in dividend-paying stocks are confusing dividends with company profits … but they are NOT directly aligned: a company may make super profits and not pay a dividend at all (for example, Warren Buffett’s own Berkshire Hathaway has NEVER paid a dividend).

A company that makes NO profit may still choose to pay a dividend (perhaps from cash or even borrowings) … just to keep their shareholders happy (for example, in 2004 Regal Cinemas paid a $5 per share dividend; “to make the $718 million payout, Regal first had to borrow from its banks”).

Is it a sound financial strategy TO invest in Regal Cinemas because they DO pay a dividend, or NOT TO invest in Berkshire Hathaway because they DON’T?

I’d love to hear your views …

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You can also find us at the latest Money Hacks Carnival, hosted this week by Money Beagle …

Investing is a business …

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There was a craze that hit Australia in the 90’s and America in the 2000’s … we know the result, but what was the cause?

It was the ‘negative gearing’ craze …

… people were promoting real-estate purchases on the basis that you take a loss now and make a (hopefully, huge) capital gain in the future.

The benefits that used to be promoted by the real-estate gurus are stated very nicely in this comment on Andee Sellman’s blog:

You have forgotten tax benefits which can be substantial. Also, the actual equity needed to purchase his investment could have been minimal compared to the purchase price. Most importantly, over time the tenant and the tax man pay for the majority of his investment.

Now, I would understand this comment if it were from 2005 or even 2006, but it is from only a couple of months ago …

… if we don’t learn from our mistakes, we are doomed to repeat them!

When real-estate is going up in price, it is easy to get caught in the trap of buying on the basis of future capital appreciation, and use tax deductions on the mortgage and depreciation benefits on the building and improvements to help ‘soften the blow’ as running costs were typically higher than the income (in some places, severely so … yet we still bought!).

Given the current market we all KNOW the problems this causes, but real-estate – and sentiments – cycle every 7 to 10 years, so WHEN you forget what happened in 2007 and 2008 during the next boom, pull up this blog and remember:

Treat your real-estate investment as a BUSINESS.

A real business is bought (or started) because it does (or soon will) produce profits and free cash-flow year in and year out, and then MAY be sold at a future date for a speculative gain. At least, that’s what happened to me …

… I can’t understand why we shouldn’t look at any other investment, including property, exactly the same way?

Can you?!