Advanced Personal Finance

The following was a guest post I did that was featured on Money Smart Life.

When it comes to their money, some people do inexplicable things. I came across an appalling figure the other day. The average length of a car loan today is 70 months - nearly six years! Now couple that stat with the fact that, on average, people only keep their cars three to five years. If you do that, it doesn’t take a calculator to figure out you’re digging yourself into a hole.

Upside Down

Being ‘upside down’ is the term used to describe when you owe more on something than it’s actually worth. When you’re talking about cars, it can happen surprising easily.

As a rule, new cars immediately lose value as soon as they’re driven off the lot. It takes several months or even a year of payments to owe less than the resale value of the car. For that period of time, you’re upside down. The longer your loan term, the longer it takes to get to the break-even point.

So it seems that what more and more new car buyers are doing is not entirely paying for a car before they turn around and sell it. Then they buy another car and roll the old loan balance into the new loan. After a few cycles of this, you’re driving a Chevy with a Mercedes-size loan.

The Numbers

To put numbers to the point, let’s say you want to buy this nice new Toyota Camry with a loan of $20,000. If you finance for five years at 6.24% (what my bank offers), you’ll be paying $3,333 in interest over the life of the loan. If your loan term is three years, total interest is $1,770. Financing for the longer term nearly doubles the interest you pay.

If you decide to trade in that car after four years, you still owe over $4,000 on the loan. No problem - just roll that into the loan for your new car.

Do this a couple of times and you’ll quickly be driving a car worth half what you owe on it.

Lease Instead

Since evidently a great many people are doing just that, it seems they should be leasing instead of buying. At least at the end of a lease you don’t owe any money (assuming you fulfill the terms of the lease). Not only that but you’ll be able to afford more car than you would by buying outright.

Like I said, people do unbelievable things when it comes to money.

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I’m still in search of the best way to combat the effect of inflation. My search has hit another dead end.

Over at Generation X Finance, Jeremy hosted a question-and-answer session with a couple of authors of a personal finance book. I asked a question and it was answered on this post. Here’s my question and the answer:

Q: In your opinion, what is the absolute best hedge against inflation?
A: Broadly speaking your investment options fall into three main categories: stocks, bonds, and real estate. Historically speaking, over the long-run, stocks have done the best job of fighting inflation amongst these three asset classes. When you think about this, it makes sense as stocks are pieces of ownership in underlying businesses – and businesses can raise their prices to keep up with inflation in order to maintain earnings growth. There certainly are more complex strategies to hedge against inflation (using options, derivatives, swaps, etc.). But if history is any guide, investing a portion of your long-term money in stocks is a keep-it-simple way to combat the corrosive effects of inflation.

I don’t mean to snipe at this answer, but it wasn’t exactly what I was looking for.

Here’s why. After adjusting for inflation, stocks basically don’t return squat. In return, you bear all their market risk. That’s not a solution.

For an explanation of what I mean, see the below graph (from Chartoftheday.com). When adjusted for inflation, the Dow Jones is now 3 times where it was in 1929. That’s a whole 1.6% return per year over the very long term. Now you get to pay taxes on that. And what about management fees (assuming you use the most common method of investing - mutual funds)? Even cheap funds like Fidelity and Vanguard charge at least a few tenths.

Sum it all up, and here’s what I get. Invest in stocks and keep your money there for a very long time. Try not to look when your investment whips up and down. Pay fees and the man. At the end of it all get exactly what you put in, in terms of real purchasing power. Great.

And what about extended periods of time like the seventies when investing in stocks got you killed in terms of real purchasing power. If this was 1982, I doubt very seriously the authors would be saying investing in stocks combats inflation. And, yes, I consider 1962 to 1982 a sufficient period of time to define it as ‘long-term.’ It’s long enough that someone could easily have spent their entire retirement in the time period.

…the search for the best inflation hedge continues…

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Proper insurance is a cornerstone of good personal finance practice. The proper type and amount of insurance can literally mean the difference between wealth and poverty. But insurance isn’t something people like to think about (other than insurance salesmen, I suppose). Knowledge of the basics is pretty common:

• Auto insurance (I did a three-part series on it - Part I, Part II, Part III)

• Life insurance (Get term - here’s why)

• Homeowners insurance (Mandatory if you have a mortgage but also essential if you rent)

• Disability insurance (You do have this, right?)

• Health insurance (Or use a Health Savings Account)

There’s one more kind of insurance that can be important. It’s called an umbrella policy. It’s called that because it’s a general-purpose kind of insurance. It provides coverage against claims over and above your other insurance and fills in gaps between them.

Who needs it?

You only need an umbrella policy if your assets are significant. What’s significant. Usually you’re talking over $500,000. If your assets are below that, your primary coverage (through auto and home) is probably adequate. It’s my understanding that you can’t be sued for more money than you have assets.

How much does it cost?

Not much. A typical $1,000,000 policy costs about $200 a year with a $1,000 deductible.

How do I get it?

A good insurance company won’t sell you insurance you don’t need. Umbrella policies are typically sold in increments of $1M. So they’re going to ask you right off the bat whether you have enough assets to make an umbrella policy worthwhile. You’ll likely also have to have maximum coverage through other insurance. Finally, you’ll probably only be able to buy an umbrella policy from the company that sells you your other policies.

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A few months ago, I went through the steps to convert my paper savings bonds to electronic format through TreasuryDirect.

Today I got an automated email:

We’ll soon make some changes to how we process certain transactions.  The changes will cause these transactions to take longer to process.  Check the Investor InBox in your TreasuryDirect account for important information about these upcoming changes.

Super.  You made changes that will slow order processing.  Go, federal government!

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Businessweek.com had a really interesting angle on the sub-prime mortgage situation. In this article, author Peter Coy explains that many sub-prime borrowers are choosing to pay the credit card bill first and the mortgage if there’s anything left over.

It seems the percentage of sub-prime borrowers 30 or more days late on their mortgage rose from 32% to 36% from 2003 to 2006. At the same time, those with credit cards 30 or more days late dropped from 32% to 24% over the same time period.

I find this fascinating. I always assumed in an extreme emergency people would pay their bills in roughly this order: shelter, food, utilities, everything else. It seems that’s not the formula for a large group of people (according to Freddie Mac, 5% of all home loans are to sub-prime borrowers) .

I tend to agree with the author’s analysis that the reason for this peculiar finding is that many sub-prime borrowers have little to lose in foreclosure. They’re already sub-prime credit risks. A foreclosure’s not going to lower their already-low credit score much. And many of them put little or no money down on these houses. Combine that with the fact that foreclosure takes a remarkably long time and I can see why you’d get people more interested in making their credit card than mortgage payments. With a current credit card you can buy groceries and gas. Not so much with a current mortgage.

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