Financial Literacy

Since 1980, mortgage rates have been in a long-term downward trend. If you have high interest-rate debt, or a mortgage rate over 5%, it is likely that it would be beneficial to look into refinancing your home.

Rates are so low for 30-year mortgages (around 3.5%), that many people can change their mortgage to an affordable 20-year or 15-year fixed mortgage, with even lower rates. Fixed rates for a 15-year mortgage can be as low as 2.75%; a 10-year rate is about the same as the 15-year rate.

Anytime you refinance a mortgage, there are two important considerations:

1. How long do you expect to remain in this home? First, never take a mortgage with a variable rate for a term less than you expect to be living in your home. If rates increase, you could be financially forced to sell your home if rates increase. Second, if you expect to move within 3 years, then it may not be enough time to cover the expense of refinancing. The average closing cost to refinance is $1,350. Divide your estimated closing costs into your monthly savings (old mortgage payment – new mortgage payment). The result tells you how many months it will take to recover your closing costs. You need to expect to remain in the home as least as long as it takes to recover those closing costs.
2. When someone refinances their mortgage, it is normal to extend the term of their mortgage. For example, if their old mortgage had 19 years left and they refinance it back out to 30 years, then they’ve added 11 more years of debt payments. Instead, any monthly payment savings MUST be used to pay down the principal balance so that the new 30-year mortgage will be also paid off in 19 years, or less. But you need to map it out to make certain that you are NOT extended the term of your mortgage when you refinance.

Since mortgage rates are so low, many people are refinancing but they are not evaluating these two important criteria. I predict that they will mistakenly take the payment savings to increase their lifestyle spending, making them financially worse off. Please do not join them and evaluate shortening your mortgage term instead of lengthening it when you refinance.

Since 2014, one by one, several central banks around the world are pushing interest rates negative to try to re-inflate their economies to unsustainable levels of growth – countries such as: Denmark, Sweden, Netherlands, Japan, Austria, Belgium, Finland, France, Ireland, Italy, Spain, and Germany. In addition to central banks forcing negative interest rates through banks, there are negative corporate bonds, such as giant chocolatier, Nestle’.

Today, there are $10 billion in bonds with a negative interest rate. According to legendary bond-fund manager Bill Gross, “This is a supernova that will explode someday.” Meaning, if interest rates ever rise, then this $10 billion in bonds will be worth $5 billion, or less, in an instant.

Let’s examine what some people and companies are doing, on the front lines of negative interest rates:

1. Home safes are selling out in Japan because individuals are taking their money out of the bank and keeping their savings in cash at their home. Being charged to put money in a bank is something they want to avoid. They also need room in their safes for gold. Japanese individuals have been buying gold ingots since 2014, when it became less likely that Prime Minister Shinzo Abe’s financial policies would jump start the Japanese economy. Instead, Abe has been devaluing the Japanese Yen so people are buying gold to maintain their purchasing power.
2. In Switzerland, demand for the 1,000 Franc note is surging (their largest currency denomination) because people are taking their money out of banks to avoid negative interest rates.
3. The second largest re-insurance company in the world, Munich Re, just took $8.1 billion out of their bank to purchase gold bullion. They did this to avoid Europe’s negative interest rates.
4. One of the largest banks in the world, Germany’s Commerzbank, is looking into storing billions in cash vaults instead of paying interest by loaning their excess reserves to the European Central Bank.

There are some negative-interest rate bonds in the U.S., but it is not yet a formal policy of the U.S. Federal Reserve. However, interest rates may continue to fall in the U.S., and if they do turn negative, it would be prudent for you to have a plan on what to do if that occurred. One suggestion is to buy a home safe to store cash and gold. The purpose of the cash is to avoid bank fees from negative interest rates; along with having money if there are problems with the banking system. The purpose of the gold is to own something that will retain its value in the event that the U.S. dollar falls in value from excessive money printing or continued economic deflation.

When someone leaves home and starts off on their own, one of the first financial obstacles is a lack of credit history at the three credit agencies.

This is a big problem because:

• Many jobs require you to have favorable credit
• Many landlords require credit to become a renter
• Many insurance companies review your credit to determine how much to charge
• Many utility companies require credit to open an account
• Many lenders will charge the highest rates for no/low credit scores

The three large credit rating agencies evaluate your credit history to create a single number to provide potential lenders a simple overall score. This overall score indicates how reliable you’ve been in paying your lenders back and on time. The credit rating scale ranges from 850 (perfect) down to 300 (horrific), and your target is to maintain an excellent credit score of 760 or above. If your credit score falls below 760, then you are likely to have to pay higher interest rates, higher insurance rates, because your score indicates you are more likely to default. If your credit score falls below 650, this is so low that it is unlikely any company will grant you credit.

A credit score is based upon 5 main categories:

1. Do you make credit payments on time?
2. How much debt do you have compared to your credit limits? The lower this ratio is, the better your score.
3. How long you have had a credit account open?
4. The variety of credit history, the more the better: store credit card, car loan, installment loan, credit cards, lease, home mortgage, etc.
5. Recent, high-frequency of loan applications – indicates that are you desperate for money right now and possibly in a financial crisis.

The easiest way to build credit history is to get a credit card, use it for routine purchases, and always pay the full balance each month. By paying the full balance on time, you will never be charged interest or penalties. Since you’ll want to keep this account open forever, do some homework to determine which kind of credit card benefits appeal to you the most: airline miles, hotel points, restaurant points, cash back (my favorite), etc.

When someone pays off a car loan, they feel great relief. They believe that they now have more spending money available for other lifestyle spending. While it is true that their loan obligation is now gone, what they may be missing is the invisible car payment that they are incurring but not recognizing.

To explain this invisible car payment with an example, let’s say that you just paid cash for a $20,000 car. The financial balance of your personal assets stayed the same during this transaction: cash went down by $20,000 but your transportation assets increased by $20,000. Then, over the next year, let’s say that the market-value of your car declined by $2,000, so it is only worth $18,000 if you were to sell it. Where, exactly, did that $2,000 go? It was consumed by you. The vehicle depreciated by both time and usage while you owned it. Your financial balance of transportation assets declined by $2,000 over the year, and that is a real reduction to your net worth. In order to get your transportation asset values back up to $20,000, you must deposit $2,000 into a car-savings reserve. This is the money that you will need to make your next vehicle purchase. This payment of $2,000 (or $167 per month) is the invisible car payment. It is a real expenditure, the natural fall in value, that anyone is incurring while they own a vehicle, but very few are aware that it exists.

Anytime that your current car is due for a replacement, and you’ve been making invisible car payments to your car-savings reserve, then you will always have the money to purchase a replacement vehicle. By making invisible car payments, you’ll always have $20,000 of value – either in the form of cash (the car-savings reserve) or in the current blue-book value of the car that you can turn into cash by selling it. By making car-reserve payments, you maintain the value of your transportation assets to balance out the depreciating value of your current car.

What would happen if you do not make any invisible car payments? Sooner or later you will need to replace your car, and when you do, you will not have the money to make a purchase with cash. In this situation, many people commonly borrow money or lease a car, both of which require interest payments that make anyone who incurs them financially worse off. The only way to avoid the interest and fees from car loans and leases is to build a car-savings reserve for your next car while you are driving your current car.

Below are a few common financial struggles that people admit to:

“I need new brakes but bought concert tickets instead.”

“I want to buy a car but my extra money goes to clothes and make-up.”

“I just got my $110 tax refund for textbooks but bought a ring.”

Sure, each of these people displayed short-term thinking superseding long-term desires; and probably a lack of any budget. But in my opinion, one of the easiest ways to turn things around is to begin with tiny financial habits.

There is a general pathway of building sustainable financial habits, the first one of which is a routine of saving money. As kids, we may have put change in a jar, advanced to setting aside some allowance dollars, and then at some point get a small savings account at a bank. This is where there are two paths, one group has the self-discipline to continue saving money into their teens and twenties, while the other group, who don’t have as much self-restraint, blow through every penny they get their hands on.

In my experience, the best way to get back on a track of saving money is to set a percentage of all income into a location where you do not spend the money. It can be an envelope, in a safe, or a savings account; any place where you normally do not access for spending money. The percentage of money that you save is important. I have found that people who start saving less than 3% get too discouraged and quit after a few months when they realize that their savings isn’t amounting to much. People who have never saved before and begin by trying to save at a rate of 10% or more normally find that percentage too restricting and painful. So they abandon saving money as well within a few months. In my opinion, it is best to start at a ratio between 3% and 10% when starting from scratch. The money that is saved must be viewed as going into a one-way vault: money can go in but it can rarely come out. The only person who can stop your savings from being blown on short-term desires is you.

Once you have begun the habit and have found a comfortable percentage, you need to slowly ratchet up your savings rate to something meaningful. For example, save 5% of your income as a reserve for an emergency fund and then larger expenses. Plus, save an additional 15% of your income into savings for retirement, hopefully into a qualified tax-deferred account like a Roth-IRA.

The tiny financial habit of saving only 3% of your income, and then slowly ratcheting up that rate over time is the mechanism to build financial stability for yourself. This savings habit is one that you will want to maintain over your lifetime. This habit builds your net worth and will provide you many financial options in your future, but they are only available to those who remain vigilant with their savings plans.

There is an important aspect to any decision-making, the consideration of time. Do you spend more time thinking about what you are going to do today or 2-5 years from now? Do you spend anytime thinking about 25-50 years from now? Nearly every aspect of your life can be improved by moving your evaluations and decision-making more distant in time. For an obvious example, if you want to be healthy and active in your sixties and beyond, that depends a lot on how well you treat your body during your twenties through your fifties. Other categories of your life that improve with long-term thinking include: relationships, career, and money.

I recently heard that an acquaintance is getting evicted from his apartment. None of the usual reasons for this difficulty apply to him: job loss, illness, or too much debt. He earns enough money to pay his reasonable rent, but his short-term thinking and chronic need for instant gratification prevents him from having financial stability. I happen to know that he buys a huge amount of scratch-off lottery tickets and spends many evenings at bars racking up expensive bar tabs. These two discretionary pleasures are not affordable for his level of income. I have the impression that being evicted is still not jarring enough for him to begin evaluating and changing his behavior.

In contrast, the long-term thinkers that I know are generally far more financially successful. I do not think it is a coincidence that the person I know who evaluates the furthest into the future also has 3 fabulous homes. For him, short-term thinking is 10 years out and long-term thinking is 3 generations. For all of his travel, it is planned 1-2 years in advance. From his career, to child rearing, to investing, he considers everything that may occur over the next 10, 20, +30 years and more.

Sure there needs to be some balance and immediate rewards, but most people that I know are far too short-term in their decision-making. This is crippling when it comes to finances because time is your greatest asset. And if you spend all of your money on short-term gratification, then there won’t be any money for important long-term gratification. It is my advice that you consider moving your time-frame for decision-making much further into the future for all areas of your life; particularly your finances.

Before credit cards and loans were easy to get, the act of budgeting consisted of spending your weekly income, in cash, until it was gone. Those who were more diligent put their cash into envelopes labelled for different categories of spending, such as rent, groceries, entertainment, savings, retirement, transportation, and medical. Once an envelope was emptied, then any further spending in that category was prohibited.

Today, most people charge everything to their credit card with the best points plan and they hope to pay most of if off when they get their paycheck. Playing with debt is always a dangerous strategy, particularly if you do not have financial literacy basics, such as budgeting. The good news is that there have never been more tools available to track your spending and create a budget.

While you can still manually track your spending with envelopes or paper and pencil, there are many free software solutions to choose among. The first decision is whether you want a smartphone app, online website, or desktop software. Many vendors offer several versions of their tracking service: a basic one that is free, and then, depending upon your needs, different deluxe versions that have a monthly or annual fee. In addition, many banks and credit cards offer summaries of your transactions that you can download into a spreadsheet and sort. You can find many options by searching for “free budgeting” or “free money management.”

If you do not track your spending it is similar to driving a car around blindfolded – sooner or later you will have an avoidable accident. Whichever methods you choose to track your spending, it is something that must be done. This is the very first step in managing your money: knowing how much is coming in and knowing where it is going out. This is necessary for day-to-day cash flow planning and a longer-term overview of your financial life.

There are three different ways in which borrowing money from your 401(k) is a very big financial mistake. There is no reason to borrow from this account that is worth the three types of financial downsides that are listed below.

I The actual results for people who borrow:

1. People who borrow from their 401(k) usually stop making contributions to their 401(k), or sharply reduce them. So not only have you reduced your 401(k) balance, you’ve stopped the contributions, the most important driver to reach your retirement goals.
2. Any loan from a 401(k) is due within 60 days if you leave or lose the job for any reason. Few people can repay in this time period and so the IRS declares the loan an early-retirement distribution. This means you are charged a tax penalty of 10% on the money you withdrew. Again, many people do not set this money aside from the loaned amount and so they owe interest and penalties on the withdrawal that they cannot pay.

II The financial mechanics to your income and net worth:

1. In order to make interest and principal payments, you earn money and are taxed on it once. What remains is after-tax income. This after-tax income is then used to repay the loan, which moves the money into a pre-tax account, an account that has not been taxed yet. So, once you are in retirement and withdrawing money from your 401(k), you are taxed on all of the money at high ordinary-income tax rates. This means you are paying income tax twice on any loan repayment to your 401(k).
2. When you borrow money out of your 401(k), you are missing out on any potential investment growth during the loan period. This is defeating the only reason that you have money in a 401(k), for investment growth over time.

III You are mixing categories of money:

Money that is designated for your retirement money is actually for your retirement; not for a home repair, not a car, not college, and not for spending on anything else. When money is taken from savings or investments for a different purpose, it financially imperils the goals from where the money was taken. Unlike most other spending categories, there are no grants or subsidies for retirement; it is solely up to you and your contributions. If you fail to make contributions, or borrow money from retirement accounts, you are risking your capability to ever retire (at a time when most people are least able to work).

So what do you do instead of borrowing from your 401(k) when you really need the money? A few recommendations:

1. Immediately eliminate any extraneous expenses.
2. Act like you’re in high school and hustle for cash: cut grass, clean gutters, walk dogs, clean windows, run errands, tutoring – any service that you can perform this week with minimal marketing and supplies.
3. Dramatically reduce your housing costs, move to a cheaper living situation because housing is normally one of our largest expenses.
4. Implement a plan to earn more money: job search, getting certifications and other resume’ builders, network to expand your job search to other geographies/industries.
5. If you must borrow, try to get an unsecured loan with a low-interest rate. Just make certain that the interest and principal payments to pay back the loan are easily affordable to you. Otherwise, you are putting your finances into an even worse condition.
6. If you are interested in borrowing money from your 401(k), you are likely facing a serious financial challenge. How did this come about? How is it that you hadn’t saved or insured for this possibility? Is it really your responsibility? Whatever the reasons, you must learn from them to prevent them from occurring again. But more important, you must act immediately to address your situation using the previous suggestions.

In helping others with their finances, I find the people who are least able to afford anything routinely pay the most in unnecessary fees. When going over their finances to help them improve their financial stability, I am saddened by how much money they needlessly spend in extra fees. This is money that could have been applied to pay down debts and build up necessary savings.

Some of the voluntary fees they could reduce include:

• ATM fees – plan ahead and use your own bank network
• Late fees on bills – schedule all of your payments and use autopay
• Exceeding phone data plan because of games and music downloads – instead of changing your plan
• Check cashing services – find a cheaper way or get a free bank account
• Having credit cards that charge an annual fee – most cards do not charge a fee
• Doubling up on insurance – you may already have insurance on a rental car through your own car insurance or from the credit card that you used to pay for it, so don’t pay it again to the rental company
• Cellphone roaming charges when traveling abroad – instead use Wifi or a pre-paid SIM card
• Not tracking all of your accounts and then losing that money to the state as “abandoned property”
• Directory Assistance from phone companies – I’ve seen charges from $2.99 to $6.99 for each call
• Routinely paying for parking at a job when there are free options nearby or free/discount-validating by employer or stores

Recurring charges for services that you may not be using:

• Subscriptions – newsletters, websites, magazines, clubs, etc.
• Mortgage insurance when it is no longer needed
• Safe-deposit box for items that are inappropriate to store there
• The classic charge is an unused gym membership
• Access to apps, music, or movie catalogs, etc. that you thought were a one-time charge that are actually recurring charges for membership
• I also find people paying monthly fees for financial services that they are not using:
  • Financial planners not doing anything
  • Bank trust departments not doing anything
  • Transaction tracking software they do not use
  • Financial consolidation services they could easily do on their own
  • Very expensive tax preparers completing a simple tax return

There was one acquaintance I was helping and he was paying around $50 a month in ATM fees and another $11 to have a bank account. He paid cash for most things but he’d only withdraw $20 at a time at ATMs; each time a charge of $2-$4 in fees. His banking routines costing him $61/month adds up to $730 per year. This is more money than he had ever saved in his life! Instead of volunteering to pay the ATM machine owner he could build his savings account instead. This is just 1 unnecessary fee that he was volunteering to pay; there were several that I discovered for him. When you’re not paying attention to small financial details, these tiny fees can invade, build up, and consume far too much your income. At least once a year, go through all of your statements and expenses to locate any voluntary fees that you can stop paying to others. Instead, accumulate them in your savings account.