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April 15, 2011

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The reason I like this blog is that it proves better reasoning than the conventional stupidity out there.

I agree with your reasoning more than anything out there.

I agree with Matt (and you). #3 and 5 are particularly terrible advice. An emergency fund is absolutely imperative to protect against disasters and even little expenses that can pop up. Paying off a mortgage early can take years off of it and save thousands and thousands on interest, and gives you peace of mind. The other 3 listed are nowhere near the "worst" mistakes you can make. What a sensationalist article.

I am with FMF - I am also not with the points recommended. Example, paying off mortgage early? couple years back when 3.75%s were being given away like bread, who would pay those off early? just recently i moved some money overseas in a 9.5% CD rate!!! yes, fully insured by the fed government (India - so relatively stable). make arbitrage work for you!

What a weird article. These are both horrible and good advice, depending upon the degree to which you take them. For instance, I borrowed money to go to law school and have paid the loans off while working in a lower paying public sector job. However, that was several years ago. One year at my law school now costs the same as my three years. No way in hell would I take on that debt to be an attorney--without some serious promise that I'd be making six figures the day I graduated. But borrowing's not all bad.

Another one--home as an investment. If you're thinking of flipping it in three years and doubling your money, just go to Vegas. But, we bought our home, have put money (cash, not a refi) into it for renovations, upgrades, etc. I get to enjoy these and should be able to pull 100% (maybe over 100% of those "investments" out if and when we sell this home. As good an investment as the market or something? Probably not, but I look at my "gain/interest" as actually getting to enjoy the stuff we did to the house and then getting that money back in the future. So an investment of sorts, but not a typical one.

Liz Weston's article advises us to embrace debt and live with it because we can not comprehend basic arithmetic. Then she loads her article with numbers with the assumption that we can't comprehend it, just accepting her viewpoints as fact. I hope her books aren't as nonsensical as this article.

I think that for each one, you could give a positive about why that advice would be good, it all depends on the circumstances and the economy.

I used to think of a house as an investment when I was young and didn't live through the housing bubble yet. I didn't think of it as something to use toward retirement, but it was an asset that I thought would definitely appreciate over the years. Not anymore!

Regarding paying off the mortgage early, not everything in life is about huge capital gains. Some people really need to have that house paid off psychologically. If it makes someone feel more secure and happy, then who cares about making a little less on investments each year.

As I said, each scenario is very individual.

A home is absolutely an investment! Now, like all investments, might it go bad on you? Again, absolutely, but when it does the reason is a reflection of our lack of financial planning and understanding of how mortgages can work for or against you.

First of all, a mortgage payment and rent are not the same thing in your budget although both accomplish the goal of paying for housing. But a mortgage payment is actually the cost of acquiring the underlying asset (the house); a rent payment will never accomplish that.

AND -- a part of every mortgage payment stays in your pocket because it is simply converted to equity so some of every payment you make stays on your net worth statement. Rent? 100% consumed.

And, really, buying a house is simply buying a lifetime annuity that you can pass onto your heirs. A house once it is paid off starts paying you back in the form of eliminating the previous cost of principal and interest from your budget -- forever! It is one key aspect of making retirement actually affordable.

Most of those who advise you NOT invest in your mortgage are stock market touts. They claim that your money will earn more in the stock market and base that claim on some mythical long-term return -- the usual number is 8%. That is total BS!

The real return in the market, based on how the majority of middle-class investors actually "play" the market is 1.4%. And, there have been three twenty-year periods in the last 100 years during which the average return was less than one percent!

All her other advise I can take or leave because buying a house simply overwhelms them in terms of how important your decisions in that regard will effect your lifetime financial outcomes.

Buying the home that you want to live in MAY or MAY NOT turn out to be a good investment in the short term but if you live in it long enough, and pay it off by the time you retire I think it is the smart thing to do.

You have to live somewhere after you retire.
Where would you rather be? We live in the home that we bought in 1977. We love it, we love the neighborhood and most of all we love our fantastic garden. The best part is that we don't have any monthly payments to make other than utilities and renters also pay utilities. We do have property taxes but they amount to $2,172/year for a custom 2,500sq ft, 4br, 3ba home on a 1/3 acre lot at the very end of a very quiet court, close to all the amenities that we need.

There are good reasons to rent at a certain time in life but when the time is right there's nothing like living in a home that you dearly love and enjoy. We cannot be foreclosed upon, we cannot be evicted, and that provides great peace of mind.

I'm with FMF here, especially with the college education. I know too many friends who have a degree in social work and finished school with 80k in debt. It's a much needed career, but when workers are only paid $30,000 out of college, it makes 80k of debt a huge burden.

Question regarding #5: My husband and I have an emergency fund of somewhere in the neighborhood of 5-8 months of expenses, depending on how we budget in any given month. But we also have student loan debt. Would we better served by diverting a large portion of our emergency fund to one of our student loans (most likely mine, because it's larger and has a higher interest rate) and just keeping $1-2k for emergencies?

That would bring down the balance of my student loan considerably, but it would also leave me feeling really uncomfortable in regards to what we'd do if disaster struck.

What say you?

Alotta --

How big are the loans and at what interest rates?

Mine is about $45k at 6% interest and my husband's is about $15k at 2.9% interest. I currently pay 50% more than I'm required to each month (based on my re-payment plan) and my husband makes only the required payment, since his interest rate is so much lower.

While I hate that I still have so much student loan debt, I haven't reached a point of desperation or 100% commitment to getting rid of them as fast as humanly possible, which is why I don't overpay even more than I already do, and haven't wiped out our savings to bring down the balance.

Alotta --

Assuming you're already contributing enough to your 401k(s) to get the entire match(es), I personally would work on the 6% loan to get it paid off asap. It's a 6% guaranteed return -- where else can you get that these days?

As for using your emergency fund to pay some of it down, that's a tough call. Basically, IMO, you need to decide what you as a couple feel comfortable with regarding an emergency fund. Then once you hit that amount, start diverting your excess cash elsewhere. If you're already past that point, then you could consider using some to pay off part of the loan.

The funny thing is that number 5 on that list used to be a great form of investment now it seems like a joke to purchase house as an investment.

I generally agree with FMF's take.

I think there can be exceptions to some of these things but those aren't the norm.

Its sad that 5-6 years ago when home prices inflated people thought they were great investments but now that homes are dirt cheap people are saying they're bad investments. Buy high, sell low?

@J: Funny thing is ... the best time to buy anything is when everyone else thinks it is a joke as an investment.

Thanks for the advice, FMF. That's what I've been leaning toward lately. Technically, we could pay even more toward my loan and just let our savings stay exactly where it is, which is an amount we're both comfortable with at the moment.

We each contribute 10% of our salaries to our 401(k) plans, but neither of us has a company match. Boo!

I think these are actually 5 of the best pieces of advice.

#1 - Return on money is all that matters. Label on the money means nothing. Asset or liability, retirement or blow money, whatever. Doesn't matter. Liability have returns, assets have returns. IT jsut depends on who the return is going to that changes.

#2 - exactly. Don't borrow for anything if you don't have to.
#3 - exactly. Try to not borrow for a house. If you have to, pay it off ASAP.
#4 - Anything purchase is an investment. Not all investments go up consistently. Stocks that lose value are still investments. So is real-estate. The mortgage isn't, but the real estate is certainly an investment, and generally a positive retun investment. plus an inflation hedge, tax shelter, and a host of other great things. Rent is for suckers.
#5 - exactly again. Emergency fund should be number one. and make it big. Make it huge. Then pay off debts in chunks. Donl;t pay them down, pay them off.

Sometime when there is more time and space we can discuss why paying OFF a house is vastly different than paying it DOWN. Fools pay it down. Financially savy people pay it off. Risk transfer and all that gets discussed.

I have to disagree with #5 being a bad piece of advice. My wife and I have followed the Dave Ramsey baby step philosophy fairly strictly and that 3-6 month buffer is definitely a priority *at the time*. It gives you peace of mind when you know you have a second firewall behind the mini emergency fund. We made that our intense focus for about 7 months, and, now that it is in place, we can focus on other priorities. Having said that, I do agree that all non-mortgage debt should be eliminated before saving the big emergency fund.

If you sell your home what do you do with the money? Do you pocket it and move on? Do you give it away to charity? Do you pay for your child's college? No you dont. Why? Because one requirement of life is shelter. If you sold the home you lived in, you have to buy another home or find shelter of some kind. The home you live in is not an investment- its a requirement to basic life. If you home doubled in price chance are the new home will cost as much if not more.

Everything purchased is an investment? I just bought a pack of gum. Please explain how its an investment.

One of the amusing things is that financial professionals like to use the Sharpe ratio to evaluate investments, yet never apply that when you start talking about paying off your house. The return is not nearly as high as the stock market certainly, but the volatility is ridiculously low. Per unit of risk, the return on paying off your mortgage is excellent. Thirty year treasury bonds are yielding 4.47% today, even in this market you can get a better return for less risk by paying off your mortgage, why wouldn't you want to do that?

Here are my 5 worst pieces of advice:

1. Spend more than you earn - you can always turn it around later
2. Embrace as much debt as you can safely pay back with minimum payments
3. Live without reserves - it makes life exciting!
4. Aim at nothing in regard to goals - you'll hit it every time.
5. Live selfishly and with no regard to the financial needs of others - someone else will probably take care of them

Derrik Hubbard, CFP

The title of that article should have been "Why I hate Dave Ramsey". Thanks to FMF and fellow readers for offering up some common sense wisdom.

2 is usually stated this way but I think that is mixing up 2 issues. you should not spend too much for an education thats not worth it. If I had nothing, I'd borrow $40K to go from a high school diploma to a State U engineering degree (if I wanted to be in that field). BUt I certainly would not spend $40k on a 2 year basketweaving degree from Phoenix U even if the $40k was sitting in my checking account.

Sure you should never go too far into debt, which many do given the cost of school today, but thats a separate issue.

Troy:
You hit the nail on the head - Return on money is all that matters.

My portfolio has grown steadily since I started managing it in 1992 when I retired. I have not had a losing year since then. I examine the chart of each of my investments daily and look at the current APR for periods of either the last 2, 3, 6, or 9 months or since the start of the current year. As soon as one of my investments starts disappointing me because the APR has started dropping relative to the others I start looking for a replacement. I have the tools and data to examine the 4,721 mutual funds available to me through Fidelity's Funds Network. I don't like or ever use ETF funds since their volatility is always higher than comparable mutual funds. I then rank them by volatility. I like "Maximum Drawdown" as a measure of volatility and rank by it first with the issue with the lowest drawdown at the top, I then scan down the list looking for the securities with the highest APR values. I jot down the best few candidates. The next step is to look them on Fidelity's website and examine their "Fees" and their "Composition". Obviously I never buy a fund that has a load fee and avoid funds with short term redemption fees. I also check the minimum investment required. When I have found the one fund that best suits my requirements I sell the fund that is performing poorly and the next day I buy the new fund. This way my portfolio is ALWAYS trending upwards. In the very rare case where I cannot find anything I like I would park that money in a very low duration bond fund until the market improves. This technique will automatically move me in and out of the market as conditions dictate.

Since making the decision to move into the slow lane at the end of 2007 and invest in very dull laddered CDs and Municipal Bonds which are being held until maturity I only have 1/3 of my portfolio in mutual funds so my overall volatility is very low. I make on the average $1,500/day. That may not sound like a lot of money but figure it out over 250 trading days in a year and it more than satisfies a 76 year old retired engineer like me.

This method is NOT "Market Timing" it IS "Fund Selection" and it keeps your portfolio running on ALL cylinders and not being dragged down by a poor performer. In the worst case scenario in a really miserable market it doesn't take very long before everything you own is in very safe investments and your money is protected. You cannot effectively use this method unless you have your own database of all the funds available to you and the tools available to analyze the data. The database also has to be updated every market day and adjusted for all distributions, particularly in the case of income funds. Last time I checked there were about 6,000 investors and financial advisors subscribing to the same database and tools that I use - they are the fortunate ones.

I can tell you that keeping your money liquid like this is far less trouble and heartache than investing it in rental properties like several people I know, and dealing with all of the ensuing problems they bring. Owning a bunch of rentals is a quick way to drive yourself nuts unless you pay a property manager to take care of everything for you.

Any article with a banner proclaiming "Sponsored by Bank of America" should, by default, be taken with a healthy dose of skepticism.

" I make on the average $1,500/day. That may not sound like a lot of money but ..."

To whom does $1,500 a day not sound like a lot of money? Thats a ton of money.

Jim:
It wasn't always like that for me but if you follow the two most important investment rules of all it can happen.

Rule #1 - Don't Lose Money, i.e. Never, ever, have a losing year!
Rule #2 - Understand the power of compounding.

If you thoroughly understand how Rule #2 works over many years then it will be obvious why Rule #1 is so important.
This is why "Active Fund Selection" works far, far better than "Buy and Hope".
Many people don't realize that taking a 50% loss requires that you must double your money just to get back to where you were. Doubling your money is very hard, losing 50% can be very easy.
The longer you have been investing and the larger your portfolio the more catastrophic a big loss is to recoup.

I have a big wall chart of seven of the major averages going back to 1970. The only way "Buy and Hope" works is if you get lucky and hit a very lengthy good period. You can't afford to depend upon Luck for your retirement planning, you must have a strategy that will always make money in in any kind of market. Obviously some years will be much better than others, but every year needs to be positive.

Old Limey,

Trying get get maxiumum APR with the lowest volitility seems a reasonable strategy.

However, there are two things I don't understand about your system:

> scan down the list looking for the securities with the highest APR >values.

The APR is only based past performance, so why doesn't this system direct you to investments that are part of a bubble about to burst?

If you look at composition last wouldn't you potentially end up with all of your investments concentrated in a particular sector, which would increase your risk if that sector tanks?

Also, do the charts you have include dividends? If you don't include the reinvesting the dividends as part of the returns it isn't a fair comparison.

-Rick Francis

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