Education – Page 10

You have no freaking idea, do you?

August 19, 2011

She's an otter. What's your excuse?

Where’s your money invested? TELL ME. NOW. No checking resource materials.

Here’s another difference between those with the propensity for wealth and those without. A rich person can give a semi-detailed answer to the above question immediately. A person who’s treading water can’t.

If you have a regular job, and you don’t have a 401(k), insist on opening one the next time you’re in the office. Also, ask if your employer matches your contributions. [This post isn’t about the vagaries of the 401(k); we’ll write about that soon enough. But just know for now that you can contribute 15% of your income to retirement savings, which will immediately reduce your taxable income by 15% and possibly put you in a lower bracket. Plenty of employers also “match” employee contributions up to a certain limit, which makes it free money if you want it. You like money, right?]

The “legacy” rich people have real estate and collectible art. For most of the rest of us, building through a 401(k) will have to suffice. So assuming you have a 401(k), where do the actual monthly contributions go?

Probably in a mutual fund. But which one, and are you happy with the results? Do you even know what the results are? Do you even bother opening the monthly statement to see which components rose and which fell? While it’s crazily obsessive to check stock prices every day, it’s even crazier to check them once every 40 years.

There’s a fair chance that your 401(k) is a part of the Capital Income Builder Fund from American Funds. We picked the Capital Income Builder Fund pseudorandomly; it’s one of America’s 10 biggest mutual funds. Let’s assume your 401(k) is indeed in this particular fund. You might want to know that this fund consists of:

25% The PMI Group (a mortgage insurer)
25% Horizon Lines (shipping containers)
25% AbitibiBowater (pulp and paper)
25% Allied Irish Banks (one of Ireland’s 4 biggest commercial banks.)

Isn’t that nice and diversified? Those industries are all over the map, right?

Alright, that was a lie. We just selected the 4 companies that have lost the most value on the New York Stock Exchange over the past half year (87, 83, 75 and 75%, respectively.)* But if you asked the average 401(k)holder if she holds any of those companies in her mutual fund, she probably couldn’t answer definitively.

Here are the actual components of the Capital Income Builder Fund. But before we get started, how big do you think its biggest component is? Stop here, just take a guess. We won’t screw with you again, honest. Just make an educated estimate as to what percentage of the fund is made up by its biggest component.

(That’s 2 tobacco manufacturers in the top 4. Death paradoxically remains a growth industry.)

GDF stands for “French Gas”, in French. It’s the world’s largest utility, selling mostly natural gas and electricity, although you’d never figure that out from a visit to their website loaded with buzzwords. “Southern” in “Scottish & Southern” refers to southern England: the company was created by a merger.

This is nothing unusual: mutual funds like the one your 401(k) is invested in really are that diverse. But we’re ten components in, and 91.1-92.1% of the fund’s value is still unaccounted for. So what companies is the lion’s share of the Capital Income Builder Fund invested in?

Beats us.

American Funds’ own site doesn’t give us any specifics, only vague generalizations about market sectors and types of component.

If you’re one of the millions who are invested in this fund, you should be outraged that your fund manager keeps your investment such a secret. It’s not quite a secret – you can doubtless contact the investor relations department for a full breakdown – but you shouldn’t have to. Furthermore, what incentive does American Funds have to attract new investors when they won’t let potential buyers see the merchandise? (Or even know what it is?)

Things to take away from today’s post:

Your 401(k) is in more pies than you think.
You probably don’t know what those pies are.
Even with a little research, you’ll still only be able to identify a handful of the pies.

401(k)s themselves are a good idea for those eligible for them. The tax savings alone make them worthwhile, to say nothing of the employer matching. But if you’re relying on your employer’s mutual fund company representative to make financial decisions for you that could end up impacting you for decades, you need to take ownership.

*This isn’t necessarily bad news. The chances of picking the 4 worst-performing stocks on the NYSE are infinitesimally low – several quadrillion to one. But even if you did, with a balanced portfolio you’d only lose about 80% of your money. That’s not easy to do. We invite you to check those companies’ financials (easy to do, with the help of our e-book) and see if they aren’t among the best bargains on the board.

**This article is featured in the Yakezie Carnival: The Wonderful Wizard of Oz Edition**

Filed Under: Bad Examples, Education, Estate Planning, Finance Tagged With: 401(k), investment, mutual fund, retirement account

The money’s sitting there. JUST TAKE IT!   

July 22, 2011

Speaking of UC-Santa Barbara, here’s some loser who couldn’t get into a better school. Carol Greider. America’s latest Nobel laureate in physiology/medicine.

A few weeks ago we got chided (chiding is a regular occurrence in our world) by the guy in change of a far more prominent personal finance blog that we occasionally contribute to.

A high school senior had a choice to make – a free ride at a demanding but obscure college, or full price ($40,000) at a heralded school in the Ivy minor League. Let’s call the first school Commuter University, and the latter Pretension College. She posted her dilemma on the site and asked commenters to weigh in.

Can you guess what people recommended? Here, we’ll do it in multiple-choice form:

__ Do whatever you think is best.
__ Either one is a good choice, there are pros and cons to both.
__ This is the time to live, not to think about financial considerations.
__ Have you thought about student loans?
 __ Are you insane? Go to the school that’s offering the full scholarship.

The answers were evenly split among the first 4, with one vote for #5. You can probably guess whom.

#1 and #2 don’t even count as advice, but that doesn’t stop people from sharing their non-opinions. #3 and #4 are essentially the same (rotten) advice, which is to incur debt now and worry about the ramifications later.

The worst part is that she was going to study a hard science, too. Look, if you major in chemistry, it doesn’t really matter whether you do it at Duke or at the University of North Texas. It’s not going to impact your ability to get a job in your chosen field. Only those who employ non-scientists (sociologists, social workers, basically anything that starts with “soc-”, with the possible exception of soccer coaches) care that you went to a “prominent” school. A Harvard English degree might be more profitable than one from Cal-Santa Barbara, only because of that ridiculous concept called cachet. It’s not as if the professors at the former can inspire you to parse the meaning of Pilgrim’s Progress any better than those at the latter.

This girl was obviously bright enough to get the attention of multiple schools, but her financial acumen was the equivalent of a kindergartner’s. And along with the failure to make the obvious decision were a litany of excuses, most of them citing “life experiences” and other non-monetary considerations. Not that non-monetary considerations aren’t important in this life, but paying for college isn’t one of them. Knowing that you’re going to be incurring 4 years’ worth of student loans is like knowing that you’re going to have a gigantic credit card balance in 2015. Or knowing that you’re going to lose every game of chance you play. Or knowing that your house is going to lose $40,000 in value. The last three examples are somewhat subject to explanation, but the first one was a fixed cost that this woman gleefully embraced. The two birds in the bush are the primary motivating factors for many a young person who can’t see the giant California condor resting in her palm.

We finished our diatribe by asking an equivalent question with a slight twist, which no one (including the story’s protagonist) bothered to answer:

This time, it’s Pretension College that offers you the full scholarship. Meanwhile, Commuter University starts off your freshman orientation week by handing you a $40,000 check. Now which school do you prefer?

**This article is featured in the Carnival of Personal Finance #320-Plutus Awards Edition**

Filed Under: Bad Examples, Consumer Debt, Education Tagged With: Carol Grieder, college, Nobel Prize, Santa Barbara, yakezie

The Easiest Money You’ll Ever Make

July 18, 2011

Here’s what you need:

1. 20% of the price of a house, condo or townhome.
2. A few months’ worth of patience.

Welcome to the lucrative world of lease options. They’re a way to increase your wealth with almost zero downside.

Lease-option holder. Still, you probably want one who uses a bottle opener

A lease option involves you buying a second home, renting it out, and giving the tenant the choice (or “option”, if you will) of buying the home once the lease expires. What makes the lease option so wonderful for the average landlord – correspondingly less so for the average tenant – is that you can charge above-market rates throughout the lease. After all, you’re doing the tenant the favor of letting her own the house after a year (or whichever term) expires. It’s like a layaway plan for what the hackneyed expression calls “the biggest investment you’ll ever make.” You let your tenant lock in a price for the house, essentially saying “You can buy the house for $x a year from now, regardless of what the market does. What’s a better deal than that?”

Meh…I don’t know. I’d have to charge an awful lot more than market rents to make it worth my while, if I’m going to have to surrender the asset within a year.

First, kudos for understanding that the house in question is an asset, and can help you grow your wealth regardless of what market conditions are doing.

My pleasure. You do realize that I’m not an actual person, and merely a device of your own creation that you use to clarify your thoughts, right? You’re talking to yourself.

Anyhow, you can typically charge at least 10% above market rent on a lease option. But that’s not really important. What’s important is this:

Most tenants never pick up the option. When the time comes for them to exercise it, it turns out they didn’t spend the previous year saving the requisite cash for a down payment. That’s one reason why they’re renting instead of owning in the first place. Renters, by and large, aren’t as bright as landlords. (Hopefully the smart-but-sensitive renters reading this can comprehend the phrase “by and large”.)

A lease option is similar to stock options, or commodity futures – you’re assuming market risk for the tenant. Real estate prices might rise 50% in the next year, but you’re offering the tenant a chance to lock in a price today. If your $100,000 house ends up being worth $150,000 a year from now, you, the landlord, will have forgone $50,000.

Of course prices could fall, too. Should they, even by just 1%, you’re protected. Obviously your tenant isn’t going to exercise an option to buy a $99,000 house for $100,000. Which means free money for you: you just received a year’s worth of premium rent payments that went well beyond covering your mortgage payments. That’s the ultimate hedge against a declining real estate market.

And if the market rises, rather than declines, you as the landlord still won’t necessarily get screwed. Again, the typical tenant doesn’t plan far ahead enough to take advantage of the lease-option. If the house does indeed rise in value 50%, and theoretically turns into an immediate $50,000 bonus for your tenant, she still needs to exercise the option. That isn’t easy. For an FHA loan, she’d need to put down 3 1/2% to buy the house from you. If she can’t put the necessary down payment on the house together once the lease expires, her opportunity will disappear and she’ll be back where she started, with no equity in a home and a rent payment due at the end of the month. (Actually, the tenant will be several steps behind where she started; now with 12 months of rent payments gone forever.)

Let’s see how this works in practice.

Say you buy a $100,000 house with 20% down. We’re assuming 20%, so you won’t have to pay mortgage insurance. At current 30-year fixed mortgage rates of 4 1/2%, that means you’d be making monthly payments of $405.35. You find a tenant who wants to own a home one day, and offer her a lease-option. Once you do, there are two ways you can do this.

Get the lease-option money up front, or
Spread it over the course of the lease.

Let’s assume a 1-year lease, and that fair-market rent is $450 a month. That’s what you’d charge an ordinary tenant who has no intention of buying the place. That ordinary tenant would pay $900 up front (1st month’s rent + security deposit).

With a lease option, you could ask for an extra $450 payment up front, and let the security deposit apply to the down payment if the tenant exercises the option (which she probably won’t.) Now you get a total of $1350 up front, $450 of which the tenant will never see again, after a year expires and she’s nowhere near amassing the down payment that would guarantee her the house.

Or instead of getting an additional $450 up front, you could just raise the monthly rent. Using our rule of thumb from above, of charging a 10% premium, that means you’d collect monthly rent payments of $495. Now you’re getting an extra $89.65 a month (the difference between the rent you collect and your mortgage payment) simply for getting the tenant to sign one additional piece of paper. Even better, your lease-option tenant is going to be a little more motivated than the average tenant to keep the place looking nice and in good repair. After all, the lease-option tenant hopes to own the place, and relatively shortly.

By the way, that $45 premium applies to the option only. Technically, it’s not even part of the rent even though you’re collecting it every month. If the tenant doesn’t exercise the option, you keep the premium payments.

Imagine test-driving a car for a year, and paying for the privilege.

Again, like in any deal, you’ve got to look at the potential downside: the tenant might be one of the responsible few who actually exercises the option. In this unlikely case, at the end of the lease you’d refund the tenant $990 (or $900, if we’re using our initial scenario of getting the lease-option money up front.) Now the tenant only has to scrounge up $2,510 (or $2,600) to take title of the house under an FHA loan. And she’d still have to make prohibitive mortgage insurance payments. Or she could put 20% down and avoid mortgage insurance, which means she’d need to have saved $19,010 (or $19,100.) As if.

And even if that does happen, you’ve still got a year’s worth of above-market profits to show for it. Plus, you won’t be obligated to your mortgage lender for the next 29 years. Theoretically you could buy another house and do the same thing again. Remember, the tenant is only going to exercise the option if she has a) sufficient fiscal discipline to sock away money for a year, but b) so little fiscal discipline that she’s renting instead of owning in the first place. That’s a tiny, tiny area of overlap.

Wednesday, Part II of how to ~~steal~~ make money with a lease-option.

**This article is featured in the Carnival of Wealth #48**

**This article is featured in the Totally Money Blog Carnival-It’s So Hot Edition**

Filed Under: Education, Entrepreneurship, Estate Planning, Finance, Real Estate Tagged With: lease option