Advanced Personal Finance

Surely by now you’ve heard about the foreclosure moratorium instituted voluntarily by six major banks.  Loan holders of these banks who are facing imminent foreclosure have a 30 day breather to try to find a fix.

• Bank of America
• Countrywide
• JPMorgan Chase
• Citigroup
• Wells Fargo
• Washington Mutual

At the risk of adding to the already substantial din of commentary about the current credit situation in the US, I had a couple of quick thoughts on this particular development.

First, this is hardly a magnanimous move on the part of these banks.  It was only a matter of time until Congress decided this was a great opportunity to grandstand and moved to do something similar.  Big company executives aren’t dumb and they’d rather call the shots and write their own regulations than be dictated to. 

Beyond that, 30 days is not going to help a great many people in danger of foreclosure.  Nothing says the banks have to work with the homeowners during that time, just that they’re giving the time to them.  From what I know of pre-foreclosure proceedings, if you’re behind on your payments, you have to come up with the whole arrears, not just start making payments again.  Big difference.  How likely is it for someone who can’t make one month’s payment to come up with several all at once?

Second, when I heard about the plan, my initial instinct was to get frustrated.  I play by the rules, pay my bills, get car insurance, pay my taxes.  We took out a prudent loan on a modest house.  It’s galling to me when people who don’t follow good, basic personal finance practices get a pass.  That’s what this feels like to me to some degree.

Though I’m loath to admit it, I have to agree with the banks on one thing about this.  Bail-outs and assistance subvert the market process.  It makes borrowing more expensive for everyone.  Where I diverge from the banks is that they’re all for bail-outs if they are the ones who benefit.  Cutting the discount rate feels like bank assistance to me.

Anyone have thoughts pro or con about this moratorium?

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Now is not a great time to be a saver.  In fact, it’s a down-right lousy time.  Rates on everything from high-yield savings accounts to CDs are way down.  In the meantime inflation is up (though still moderate by historical standards), by even the federal government’s dubious accounting.  Mix that together and what you get is negative real interest rates.  I’m going to explain exactly what that means to you and your finances.

My use of the term ‘negative real interest rates’ refers to the phenomenon when the return from completely safe investments is lower than the Consumer Price Index (CPI) - commonly known as ‘inflation.’ 

So you know exactly where I’m coming from, let me specify a couple of the elements.  I consider ‘completely safe’ to be FDIC insured or US government backed.  For our simplified purposes, let’s take that to mean a high-yield savings account.

While the term ‘inflation’ isn’t technically correct in this context, it’s close enough.  Inflation for our purposes is the increase in year-over-year consumer prices.

Here’s where the numbers are for these elements right now:

• CPI 2007: 4.1%
• Typical high-yield savings account represented by ING Direct: 3.4% APY

If you keep your money in this savings account, after inflation, your real return is a negative 0.7%.

Strategies

A couple of thoughts on how to deal with the situation:

1. Consider saving using TIPS.  Treasury Inflation Protected Securities are essentially savings bonds that guarantee a real rate of return after inflation.  There are all kinds of things to consider when thinking about TIPS (like the tax implications), but for some situations they work.
2. Pay down debt.  I know this may seem counterintuitive but consider paying off high interest debt (think credit cards) at an accelerated rate instead of saving more money.  Sure you need an emergency fund, but if it just gets smaller in real terms, you’re losing.
3. Shift savings/investments into retirement accounts.  If you save and invest outside a retirement account, now might be a good time to bump up the amount you put into that tax-advantaged retirement account if possible.  Your investments inside those accounts will likely be slanted toward a more aggressive allocation.
4. Don’t try to ‘make up the difference’ by seeking out unnecessary risk.  So your super-safe savings are returning a negative real rate.  Don’t lose sight of what those funds are for and why they’re in a safe place to begin with.

That’s just what I could come up with.  Anybody want to chime in with other suggestions?  I’m interested to know how other people deal with negative real interest rates in practice.

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If you or a loved one is in the military and is or is about to be deployed to a hazardous duty zone, there’s a great federal program that gives you a guaranteed 10% interest on savings up to $10,000.  It’s a great program I learned about recently offered by the military called the Savings Deposit Program (SDP).

Savings Deposit Program

Not to be confused with the Thrift Savings Program (TSP), the Savings Deposit Program is an awesome way for deployed military members to earn a great, guaranteed return on their savings.  By participating in the SDP, you are guaranteed to earn 10%, compounded quarterly, for as long as you’re deployed in a combat zone.  10% Guaranteed!  That’s phenomenal.  It would be a very respectable return in any environment, but with interest rates as low as their are right now and the volatility in the stock market, this is practically unbeatable.

The SDP has several key eligibility requirements:

• You must be an officer or enlisted member of any U.S. military service
• You must be deployed to a ‘hazardous duty zone’ for the period of time you participate in the program
• You must be in that combat zone for at least 30 consecutive days or one day in each of three consecutive months

Key things to know about SDP

Besides the stringent eligibility requirements (it sucks to be in a combat zone), there are a few key points about the program to be aware of.

• To participate in the SDP, you submit your deposit through your pay office either in cash or check, or you can set up an allotment out of your LES.  Obviously it’s to your advantage to deposit as much money as you can right at the start of eligibility since it gives you the most opportunity to earn the 10% interest.
• You’re limited to a $10,000 deposit in the program.  You can actually deposit more, but since anything over $10,000 doesn’t accrue interest, why would you?  This might be important to note if you participate by allotment.  Once you reach $10,000, you should stop the allotment.
• You can’t withdraw your deposit until after you redeploy except in extreme circumstances.  Don’t put in any money you might need before you get back.  On the other hand, your spouse can’t get at the money either, so that might be an advantage to some people.
• You can actually leave your deposit in the plan for 90 days after you return and it keeps earning interest.  After that, it stops earning anything, so you should close out the account.  Again, you could leave your money there, by why would you?
• Though your pay in a combat zone is free from federal tax, the interest earned in this program is not.

The Savings Deposit Program is simply a great benefit to the generally cruddy situation of being deployed to a combat zone.  I highly recommend looking in to it if you or a loved one is about to be deployed.

Links of interest:
DFAS homepage
SDP information pamphlet

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Homeowners insurance policies specifically exclude flood.  All of them.  Yours, too.  That’s something a lot of people don’t know and find out the hard way.  You don’t have to live on the coast to be the victim of a flood, either.  My wife has a pretty tragic story from her childhood about flooding.  It’s served as something of a lesson for us as we buy the new house.

When my wife was little, her family lived somewhat near (within a mile) a river.  Thing is, to look at the river, you’d never even consider the possibility of it overflowing its banks.  The water is way down a drop-off - probably 15-20 feet below the level of the town.  Her parents actually inquired about flood insurance, but were told that the area was in a hundred year flood plain and they couldn’t buy flood insurance.

I guess it was the hundredth year because the unthinkable happened and after a particularly heavy rain storm, the river rose and didn’t stop until half the town was underwater.  My wife’s childhood home was ruined.  When the water receeded, the first floor was buried in mud.

Her parents’ homeowners insurance, of course, did not cover the damage.  Homeowners insurance policies - all of them - specifically exclude flood.  Yours, too.

Her family got through the ordeal through a combination of very hard work, luck, and generosity, but it was a lesson my wife never forgot. 

Flash-forward to our recent home-buying. 

Our new house is within several hundred feet of an intermittent stream.  Right now the area’s in a drought, so there’s nothing there.  But it doesn’t take a lot of imagination to picture that ‘little stream’ growing into a rapidly-expanding lake.  In fact, the area is peppered with lakes of various sizes.  Not only that, but being on the eastern part of the country, we’re within reach of hurricanes.

Flood insurance basics

Here’s what I learned when I inquired about getting flood insurance for the new house.

• Flood insurance is federally regulated.  That means the government sets the rates - everybody charges the same thing for the same level of coverage.  Here’s the FEMA website for flood insurance.
• Your home has a 26% chance of being damaged in a flood over the course of a 30 year mortgage compared with a 9% chance of damage by fire.
• One third of claims paid last year were in ‘low risk’ areas.
• There are three categories of risk -  low to moderate, high, and high-coastal.
• There is no place that can’t be insured against flood.
• The maximum insurance you can buy through FEMA is $250,000 dwelling and $100,000 possessions.  If you want more, you go to independent insurers for what’s called “excess coverage.”
• There’s a 30 day waiting period for coverage to begin.  It can be waived if you haven’t closed on your house yet.
• Homeowners and renters both can buy coverage.

We got the maximum coverage and it was pretty reasonably priced - $352/year - since we’re in a low/moderate risk area.  The same coverage for a coastal dwelling is a whopping $5,358.  There’s a great reason to reconsider that beachfront property, huh?

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