First Time Home Buyer Credit

Some friends of mine, Corey and Sally, are considering buying a home. They've been thinking about buying a home for a couple months. They're now thinking about rushing through the process in order to take advantage of the Federal First Time Home Buyer Credit, which gives a refundable tax credit up to $8,000.

Corey and Sally are feeling pressure to make a decision because the credit expires at the end of April. I talked with them about their house plans the other day then had a follow-up conversation with a mutual friend of ours, Garth.

They're looking to buy a home for around $140,000, so on the surface the $8,000 looks like a compelling reason to buy now. The $8,000 credit is significant for Corey and Sally, so guaranteeing themselves a 6-percent savings isn't a bad way to start off. There is no guarantee they could get the seller (this is a pre-approved short sale on a bank owned property) to come down another 6-percent.

Garth wanted to make sure they'd considered all of their options and knew what they wanted in a home.

I agree with Garth's assessment around knowing what you want and considering options. Buying a home is far more than a financial decision. The place you will raise your kids, spend 1/2 of your time, and build your life is one of the most impactful decisions a couple will ever make.

Garth recommended our friends build a spreadsheet with all of the features and requirements they have in a home. The sheet should include everything from budget impact and square footage to location and school information.

Building a detailed spreadsheet with all of the features and home requirements will take a while and might slow down Corey and Sally's ability to get the home buyer credit.

Should they rush their decision?

I ran a quick analysis to see how much they would really save by purchasing now versus taking their time. I considered purchase price, a 5-percent down payment, that they'd add the credit to their down payment if they got it, and a 30 year mortgage at their pre-approved rate.

By buying now and getting the credit they would save $16,127 over the life of a 30 year purchase, $538 per year, $45 per month, and $1.47 per day.

I don't think the savings are as much as my analysis shows. Some portion of the home buyer credit is currently built into starter home prices. By that I mean, once the credit expires home sellers are likely to lower their price (if not the advertised price, the contract price). The market as a whole has factored in the home buyer credit today and will have to factor it out after April 30. If the market shifts Corey and Sally will save less by getting the credit.

The Decision

As I mentioned, a home buying decision is far bigger than finances. Your home impacts your time, the quality of your kids' friends and education, and several hundred other things.

In most cases, I'll make an argument that small savings add up to significant amounts over a lifetime. When we're talking about cutting a coke a day to save an extra $25,000 over the next 30 years, I'll argue for cutting the coke.

In this case, I'm taking the opposite approach. I'm recommending cutting the coke each day for the next 30 years instead of taking the federal tax credit. Corey and Sally won't get $8,000 today, but in the long run they'll most likely be happier with a well planned and analyzed house buying decision that costs them an extra $16,000 over the next 30 years.

Personal Savings Epidemic

Malcom Gladwell’s book Tipping Point argues that a minor event can create a dramatic change. Gladwell tells of a child coming to school with the measles. Within a few days every other student has caught the virus and is sick. Within a week they are all better and will never have the virus again. One child with measles can possibly affect hundreds of lives.

One of the things we can do with Everyone Can Build Wealth is help create a savings epidemic. Hopefully, one that lasts generations.

Each generation of Americans has typically had more than the previous. Generation Y immediately wants everything our parents have after 30 years. We’ve spent the first decade of our adult life accumulating things at a pace never before seen in the United States.
For most of the last decade the personal savings rate in the United States bordered on zero. From 2004-2007 it was a rounding error away from zero. Most of us were putting money into our 401k or other savings vehicle. However, most of us were treating our homes like an ATM. We’d refinance and withdraw cash at a rate faster, or as fast, as we saved.

Beginning in 2007, Americans started saving again. We could no longer withdraw cash from our homes and started to understand the difference between needs and wants. We stopped shopping on Fifth Avenue and started shopping at WalMart. WalMart actually experienced revenue growth during the fourth quarter of 2008 and through 2009, while most retailers reported reduced sales and profit.

A return to big box retailers over the specialty stores is just one area we started saving. Here are some of my favorite savings examples from the last 18 months.

1. We’ve got several friends who have gone back to using their wood burning stoves for heat.
2. Game nights and potluck are replacing eating out with friends.
3. Cable TV is getting shut off or at least scaled back.
4. Gas guzzling SUVs are being replaced by minivans and other more economical vehicles.
5. Home phones are being turned off since we’ve all got cell phones. I haven’t won this debate with Kerri yet, but I’m working on it.
6. The library is replacing the book store.
7. Vacations are getting smaller and being paid for in cash.

Reduced consumer spending will keep the economy from quickly breaking out of the slump. Slow recovery is probably best for our long-term financial health. We have become extremely dependant on imports, debt, and consumption in the last 20 years. A slow recovery is far more likely to permanently change behavior toward saving and build a stronger economic engine. Even in 2009 we only saved about 5-percent, so we still have a long way to go to save like other countries. Chinese citizens save nearly 30-percent of their income.

The “Great Recession”, as many pundits have dubbed it, is hardly one of Gladwell’s minor events. In the grand scheme of things, it will be smaller than we see it today. This recession has caused a tipping point in American saving. The change toward saving in our society hasn’t reached epidemic proportions yet, but it can. Let’s spread the virus!

Investing or Gambling

Ten years ago this month, I learned the most painful personal finance lesson of my life. In November, 1999 I had $3,000 to invest in the stock market. Everyone told me it was a great time to be in the market. I bought shares in several tech companies. Everyone was building wealth in tech, right?

By February, 2000 I had day (or week) traded my little fund to $6,000. At the pace I was on, I'd retire by 30. I upgraded my stock account to allow for trading on margin. Trading on margin means I borrowed money from my broker to fund more stock. I paid 8-percent interest, but my stock trading was earning more than 700-percent.

The day I got my $6,000 loan a friend of mine told me to buy stock in his employer. He gave me some detail about the technology that sold me on it being a solid idea. Basically, they were a typical year 2000 dot-com company; fast SPENDING tech company with no revenue and a great idea. I bought $6,000 of his company with his great tip in mind. Two weeks later the market turned sour. Because I'd bought on margin, every dollar the stock dropped caused me to lose $2 of my account value. Buying on margin essentially doubles your growth or your loss.

I received my first margin call around March 15. A margin call is a broker demand to deposit enough to bring your account value to the minimum requirement. Basically, the stock in my account might not cover what I'd borrowed from the broker without a cash infusion. The first margin call was around $1,000. I sent the check and kept day trading. Three weeks later I got my next margin call for around $3,000. I drained our savings account and had to sell a certificate of deposit (CD) we had bought for our son. I sold all of the remaining stock and closed my account the same day.

I learned a lot of lessons through my day trading expedition. The five biggest all deserve a post of their own. Here are some of the big ones. They all probably deserve a post on their own. I'll tackle that in the future.

1. Trading on margin is NEVER a good idea.
2. Trading stock and investing in a business are dramatically different things.
3. A broad-market index fund is lower risk and more likely to help you achieve your goals than picking individual stocks.
4. Diversify, diversify, diversify is to investing as location, location, location is to real estate.
5. A "hot tip" from someone with no financial expertise is best ignored.

What was your first personal finance lesson? How did it change your strategy?

Cash Flow: Keeping Cable TV Optional

The other day a salesman knocked on our door. He was selling satellite systems. He talked about why his product was the best on the market for ten minutes. He showed me how the monthly costs were better than cable for the first 12 months. Finally, he told me they'd install the system for free. Everything pointed to this being a better deal than my current cable.


The biggest question in my mind was, will I have a contract? I can turn my current cable solution on or off whenever I want with no cost. The salesman bounced around on features and savings, but didn't answer my question. Finally, after I asked again, he told me I had to sign a 24 month contract and the early termination fee was $180 for the first 12 months then it went to $60.

I did some quick mental math and came up with the result below.


After 12 months the satellite bill would increase to about the same as my current cable TV. By then I would have saved enough to make an early termination fee a non-issue and my monthly cost would be a wash.

From a long-term financial standpoint, switching was probably the best solution. One of my rules for finance is avoid obligating myself to future payments when possible.

I asked myself the following questions:

1. Are we likely to have cable TV for the next 7.2 months? Most likely.
2. Could I get my cable company to match the satellite offer? Worth a shot.

I took the satellite guy's information and told him I'd call if I decided to switch. Then I called my cable company. Within 10 minutes they reduced my monthly cost by $20. My new breakeven was beyond around 24 months, so I stayed with cable. More importantly, I avoided adding a fixed expense in case I ever need to minimize my monthly cash outflow.

What examples do you have of keeping fixed costs variable and optional?

More Hangers isn't the Answer

The other day I was helping my son hang his shirts. He didn't have enough hangers in his closet, so we went through his sisters' closets. We ended up a few hangers short of enough for all of his shirts.

I mentioned this to Kerri and she said she'd get more hangers. I've been pondering our predicament for a few days. I've been asking myself, how many clothes are enough? How many pairs of shoes does one person really NEED? What ways does too much "stuff" impact our lives positively or negatively?

We use a lot of hand-me-downs in our family. We've got an older son and an older daughter who pass things to their younger siblings and Kerri has two generous sisters who pass things on to our kids. The result is our kids closets are full. The other day I counted the shoes in our daughter's closet. She had 10 pairs of shoes. Kerri showed me that we'd paid for four of those pairs. I'm still hung up on 10 pairs of shoes, a closet full of shirts, and the message to our kids about how much stuff they "need".

We haven't decided if we should do anything about this situation right now. We don't seem to be overspending on clothing for the kids. But, are we creating a false illusion about the amount of stuff they should have?

What are the areas of your life where you have too much stuff? How have you managed the stuff battle in the past?

How much do we really have?

Have you ever bought something on credit only to realize you owed more on it than it was worth the next day? The first car Kerri and I bought was like that. We borrowed nearly the entire purchase price and as cars do, it started depreciating faster than we paid for it.

Calculating net worth is the exercise of figuring out everything you own, everything you owe and subtracting your owes from your owns. Net worth is second behind cash flow in determining your ability to build wealth. It's actually your primary metric for whether you're building wealth.

What you own:
Figuring out what you own is usually pretty easy. Figuring out how much it's worth is a little harder. Start by making a list of all of your major assets.

The things I recommend including are savings accounts, retirement accounts, home, vehicles, and possibly some of your toys worth more than $1000 like ATVs or RVs. Some advisors would suggest you not count vehicles and toys. I prefer to count them because you can sell them. I suggest using a very conservative valuation for both.

The things I would not include are furniture, animals (they die), anything consumable, and toys worth less than $1000.

Assigning a value to all of your assets can be really difficult. We'll talk through each of them.

1. Savings or retirement accounts: These are easy. Just grab your latest statement.
2. Home: You can assign value of your home based on a variety of things. Before the real estate boom crashed, I used the purchase price of our home. Since then I have started using online tools like zillow.com. They keep track of sales in your area to determine rough values.
3. Vehicles: I use kbb.com or nada.com to value my vehicles then I use 80-percent of the worst value they list (usually trade-in). I use this conservative approach because I'm confident I could sell them for that low amount if I ever needed or wanted to.
4. Toys: I don't have a lot of experience with toys, but my approach has been to watch local sites (in Utah KSL.com is best) to see how much sellers are listing their toys for. KSL.com allows sellers to mark items sold, so you can see what a sold item was listed for. I suggest being extermely conservative with toys and valuing them at 60-percent of what you see them selling for.

Assigning value to what you owe is easy. Get all of your statements out and write down the amount owed.

When you are finished with the exercise, you should have a table that looks like the one below.

What if you have a negative net worth? A negative net worth occurs when what you own is worth less than what you owe. Regardless of whether you have a negative or positive net worth, the goal is usually the same. You want to improve it.

Net worth can be improved either through cash flow or asset appreciation. We've covered cash flow at length. Asset appreciation occurs when the value of an asset increases. One of the reasons to invest in a stock based mutual fund is long-term growth or appreciation.

Over the last couple weeks we've looked at setting goals, measuring cash flow, and calculating net worth. These three tools are a significant part of a personal finance foundation.

What are the other things you consider foundational finance principles? I'd enjoy learning and / or writing about them.

Everyone Can Build Wealth -- An Example

One of the things I plan to do is share examples of people who live within their means, save, and have built wealth the really old fashion way--$1 at a time. I hope having examples will inspire us all to save for the future.

Growing up in the depression surely had a dramatic affect on many people. Some it caused to have a deep desire to possess things. Others learned the value of saving, saving, and saving for a rainy day.

Grace Groner may or may not have understood time value of money, but she certainly understood saving and frugality were a road to security. The Chicago Tribune tells the story of a woman who never earned very much, bought 3 shares of Abbott Labs in 1935, lived in a small home her entire life, was extremely charitable, and never showed her wealth to anyone. Even the donation she made at her death was not known in size until after her passing. Those three shares of Abbott Labs, her added savings, and the discipline to reinvest all dividends for 70 years ended in nearly a $7 million nest egg.

I'm inspired by this woman's resolve, discipline and generosity. Her journey to wealth resembles that of many "Millionaires Next Door".

Enjoy the article.

Josh

The Real Cost of Hobbies: Total Cost of Ownership

I've been in China for the last five days and didn't realize my blog site would be blocked there. It works in Japan, so I'm back. Sorry for the brief hiatus so early on.

Have you ever bought something only to find the total cost of ownership (TCO) is much greater than you initially thought? Many times a purchaser underestimates the real cost of a purchase by only considering the initial price.

Total cost of ownership is the upfront price plus any ongoing maintenance or spending required. A car’s TCO includes purchase price, insurance, gasoline, and maintenance. A hobby’s TCO is, also, likely to have ongoing expenses. For example, golfing might require the purchase of clubs upfront and ongoing costs for green fees and replacing balls or tees.

My family’s primary hobby is riding horses. My Dad put me on a horse as soon as I could stand and I always wanted to provide that same opportunity for my kids. As my kids have gotten older, I have spent a lot of time thinking about whether horses should be one of our hobbies. Total cost of ownership is the primary reason I often reconsider our investment in horses.

The best way to determine the TCO of a particular hobby is to annualize the upfront costs then sum the annual ongoing costs. Here is my analysis for a horse hobby.

I haven’t included the cost of a vehicle to tow the trailer because we need a vehicle one way or the other. Even when we didn’t have horses (we took a break from horses for ten years) we had a vehicle with the ability to tow a trailer. If we only had our truck for horses, then I would include it in this analysis.

Not all upfront costs can be recouped if you choose to get out of a hobby. Some of these costs become sunk (spent and non-recoverable) as soon as you make the purchase. With horses, much of the upfront expense can be recouped. For example, I could get most of my investment in a horse back if I chose to sell him after a year. I may even be able to make a profit, but would never plan on that as part of a hobby analysis.

Seeing the bigger picture of a purchase, like a five year horse hobby, helps clarify and understand if it is right for you. Most other costs associated with horses are optional, so this gives us a good feel for what we are committing to over a longer period. An exercise like this sure raises big questions when you see five years of horses might pay for one or two years of college. Total cost of ownership analysis makes us far wiser consumers.

Knowing this information before we decided to start our horse hobby helped us decide if it was right for our family. We have three horses, so the annual cost is a big investment. I wouldn’t have wanted to be surprised by the maintenance costs. Our entire family enjoys horses and it brings us together. We could have gotten that from a lot of hobbies, but the ancillary benefits swayed us to having horses. Our oldest son wants to be a veterinarian and animal experience is one of the biggest factors in vet school acceptance. Also, our kids have learned to care for something other than themselves, work for something they enjoy, and have patience and love for an animal. Horses are a good choice for us right now, but the costs are certainly something that keep us asking whether we're getting enough from our investment.

Most of my life I only considered the upfront costs associated with a purchase. TCO analysis has helped us make more informed decisions. It can be used for nearly any purchase or investment including homes, cars, or hobbies. If you are choosing between multiple items you can do the TCO for each then compare the outcomes. Many people use TCO to decide between purchasing or renting a home.

What other tools have you used to decide if a purchase or hobby was right for you and your family?

Cash Flow Continued

The other day we talked about how to determine your cash flow. What happens if you get to the end of the exercise and your expenses are greater than your income? Or, maybe they're just closer than you need to achieve your goals.

As we discussed, some expenses are necessary or fixed while others are optional or variable.

Analyze your optional expenses first. The first time I did this exercise we were eating out a lot, had two car payments, and were paying for cable TV. We were really struggling to make ends meet at the time. Many months we'd end with $20 to $50 left in our checking account. Our savings account was minimal. I didn't realize how much optional spending we did.

We chose to focus on a couple areas of spending.

Kerri and I both worked at the time and were eating out every day for lunch. We immediately switched to eating out once per week each. We saw savings of nearly $200 just by making this one switch. (NOTE TO SELF: You've fallen off this bandwagon over the last few years and could cut spending and calories.)

Vehicles certainly weren't optional for us. We both commuted 10-25 miles to work. Our vehicles weren't fancy and were roughly in line with our needs. We still felt there was some element of optional in our vehicles. We considered several options.

1. Sell vehicles and buy something for cash or lower payments.
2. Use $200 saved from not eating out to accelerate payoff.
3. Use wind falls to accelerate payoff.
4. Continue with the same payment schedule.

We ultimately chose to go with a combination of 1-3. We sold our car and bought a slightly older car. As a way to reduce expense further we were able to get a lifetime warranty on parts because we bought it from a salvage yard that rebuilt cars. We greatly improved our cash flow and saved ourselves significantly in terms of vehicle depreciation. Finally, a small kicker to our cash flow was the "new" car had a lower insurance premium.

After we swapped the first vehicle we decided to keep our truck and accelerate payoff. We added the payment from the old car plus started applying any bonus or overtime income to pay it off. Two short years later we had improved our cash flow and were applying both payments to Kerri's student loans.

Cutting all optional expenses wasn't our preference and isn't what I'm advocating. We decided to keep cable, although we went to a cheaper package. We also could have saved money by selling the truck. Eventually, we got serious enough about getting out of debt to sell the truck in exchange for a very utilitarian truck.

Not everyone will have such obvious optional expenses. Some of you might even have necessary expenses that match or exceed your income. Here are some questions you could ask yourself to identify opportunities to reduce fixed expenses.

1. Am I spending money on something I could get for free? I have a penchant for buying books. The library has been a great replacement.
2. Are our necessary expenses really necessary? An example is your home. A home is necessary. A 3000 sq ft five bedroom house might not be.
3. Could we sell something to payoff a loan? eBay, Craig's list, and other local sites have made selling things much easier. Paying off a monthly loan to minimize future cash outflows is a great way to help in the long-term.

What are your big optional expenses? How far have you gone to reduce expenses? In the near future we'll talk about the other side of cash flow--income.

Have a great weekend.

Josh

Cash Flow

I've heard people wonder how a seemingly unsuccessful company survives while a highly successful company suddenly fails. Often, success or failure is caught up in cash flow. Whether you're a multi-billion dollar corporation or an 18-year old college student, cash flow is a cornerstone to financial success.

My first lesson in cash flow came early in college. My tuition was paid by a scholarship, but I had to buy books then get reimbursed. I was employed and had a system for managing cash flow. Each pay period I deposited my paycheck then spent until my next paycheck came.

I'd been doing fine with this approach until I went to buy books for Spring semester. I had a reimbursement coming that hadn't arrived. I thought my checking account had enough money to cover books. A swipe of my debit card revealed it didn't. I stood there with books on the counter and no way to pay. A quick phone call to Mom and I was back in business, but I'd burned myself. What could I do?

Cash flow is one of the easiest and hardest things to tackle. This is the first in a series of cash flow posts that'll take us from figuring out where our money goes to deciding where our money should be going. Today we'll tackle figuring out where money is going.

For the first five years on our own, Kerri and I had no idea where our money went. For the most part, it wasn't hard to figure out. We were poor college students, so there wasn't that much to spend. Even then, when we finally figured out where we spent money, we were keeping Taco Bell in business.

Figuring out where your money is going is easy with a little discipline. I like to use the following process.

1. Receipt Bucket: Put a jar or container of some sort on your kitchen counter and keep every receipt for 90 days. Every receipt includes your utility bills and your afternoon diet coke. If you buy something with cash and don't get a receipt, write it down on a slip of paper. The goal is to keep track of every expense regardless of amount.
2. Categorize Your Receipts: Categorize all of your receipts at the end of each month. Choose categories that make the most sense for you. Your categories will probably become clear as you start looking through receipts. Mine were something like household (utilities and rent), automobile (maintenance, car payment, gas), and Taco Bell. I like to use a tool for this part. A spreadsheet is as effective as any.
3. Categorize Categories: Once you know your categories, you can determine which of them are necessities versus optional. Eating is necessary, Taco Bell is optional.
4. Total Necessary and Optional
5. Compare Your Spending to Income: How does it look? It didn't look good for us. We earned more than we spent over the 90 days, but not every month and had several relatively large optional expenses.

Once you've gone through this exercise, you'll have an output for expenses that looks something like the following table.

If you've come this far, you're on your way. Tomorrow we'll talk about how to improve your cash flow by managing expenses.

Josh