Tara Unverzagt April 4, 2016 No Comments

Use Debt to Your Advantage

Debt has fueled much of the growth in the world over the last four decades. Debt has made many business owners, investors, and individuals wealthy. But debt has also been the ruin of many businesses, investors, and individuals.

The “final exam” of my MBA involved a business simulation. Each study group was tasked to run a business manufacturing hairdryers. My study group was mostly made up of bankers. When our door shut at the start, the bankers immediately said, “We need to get a line of credit.” I said, “We’re starting with a lot of available cash.” They explained that bankers only loan you money when you have money. At some point down the road, we may need money, but we should secure it in the beginning. That 10 minutes was more valuable to me than the two years that led up to it. Indeed, “down the road” the hairdryer market was booming, but we didn’t have enough cash to build a new plant. That line of credit provided the opportunity to grow our business. Our study group ended with millions of dollars more than any other study group. We had that line of credit right when we needed it while the others were just starting to negotiate with the banks.

This was a lesson in how debt can make you wealthy. The other side of that coin occurred as the housing boom went bust in 2008. There were a lot of people who borrowed money to buy a house, but didn’t have the funds to pay the debt. They lost their house and their wealth.

Debt helps magnify your return. If you want to buy a house, most people can purchase a bigger house with a loan than if they only used savings to purchase the house. If the value of that house goes up, there is a larger gain on the larger investment. But if the value of that house goes down, there is a larger loss.

So how do you use debt to your advantage? As the bankers in my MBA study group pointed out, you will only get debt when you have money. The more money you have, the more debt you will be allowed to carry. If you think like a banker, and only incur debt that you can pay off, you can use it to your advantage.

You can’t predict what’s going to happen to the housing market in the next 2-5 years, but the longer you are in the housing market, the more likely you are to see the value grow above what you invested. If you plan to stay in the housing market for the long haul, it’s fine to incur debt to purchase your home. But make sure you have enough funds to pay the mortgage for 6-12 months, even if you lose your job. This should be part of your Emergency Fund. If you don’t have enough savings to make future mortgage payments, you may find yourself in the position that so many people did in 2008 and risk losing your home.

When you buy a car, you do not typically expect it to increase in value. As a matter of fact, as soon as you drive a new car off the lot, it loses value. Buying a car with debt increases the cost of the car and therefore increases your loss. If you have a 10%, five year loan on your $20,000 car, you are really paying $25,500 for the car. In addition to the decrease in the value of the car, you are losing an extra $5,500 from interest payments. Many people lease a car instead of buying. Keep in mind this is just building the loan costs into the price of the car. Typically it’s easy to hide higher loan costs in the “low” monthly payments of a lease agreement. The more expensive the car, the more you lose in value and interest paid.

In order to sell more cars, dealers often offer 0% loan deals. This can be a way of using debt to your advantage. If you can get a 0% loan for $20,000 and then invest that money in a bond giving you 4%, you win. Make sure you have the $20,000 to pay off the loan. If the 0% interest is only for a limited time, pay the balance as soon as the interest rate goes up. Typically, if you miss a payment, you will pay high fees and/or the interest charges. So make those payments.

Bottom line, you can use debt to make money, but you can also lose money with debt. Follow some basic guidelines to use debt to your advantage.

  • Make sure you have the cash to pay the debt on time. For long term debt, have enough in cash to make payments for 6-12 months.
  • Use debt to increase your income, like paying for college tuition, but not for consumables like going out to eat or a nicer apartment.
  • Use debt when you can invest those funds at a higher return or in a business that can make more income than the cost of the debt.
  • If the item you purchase is not an investment that can increase in value, pay cash.

Debt always increases risk, but the risk can be managed if debt is used wisely.

 

All information provided is general in nature and not meant to be advice for you in particular. If you’d like to know more about how this topic relates to your situation, contact me at tara@southbayfinancialpartners.com

Tara Unverzagt March 22, 2016 No Comments

Why Are Interest Rates So Low?

Bond prices go up when interest goes down. If you read the Wall Street Journal, they mention this fact a lot, especially these days, but what does it mean? It takes just a moment to understand this, but longer to have it become ingrained.

Let’s start with an example:

If a bond has 3% interest (that is, you receive $3 for every $100 you invest in that bond every year), the bond starts out costing $1 for every $1 of bond. Therefore, a $10,000 bond would cost $10,000 and you receive $300 every year for holding the bond.

If interest rates went up to 3.5%, who would pay $10,000 for a 3% bond when you could invest $10,000 in a 3.5% bond now? You might be willing to buy that 3% bond for less. How much less? It would have to be enough less so that you get 3.5% for your investment.

The math requires algebra. Remember that class that you probably hated and wondered “when will I EVER use this?!” Well, here’s your opportunity. The math comes down to: if you can pay $1 for a bond with a 3.5% coupon, you would need to pay 3%/3.5% or .85 (i.e. 85 cents) to have a bond with a 3% coupon to be equivalent to a 3.5% payout.

What happened in the US from 2008 until recently? Interest rates came down so prices went up.

What’s happening now? The Federal Reserve has been trying to raise rates, but the demand for US bonds has also gone up. And the old rule “when demand goes up, prices go up” trumps the interest rule “when interest rates go up, price comes down.” The demand forces the price up which actually causes the interest rate to go down, despite the Fed’s desires.

We are living in interesting times.

 

Check out other articles on bonds and interest rates

 

Tara Unverzagt March 11, 2016 No Comments

Sold Your Home? Now What?

A client recently contacted me about selling their home to retire in a sunny, warm place. They wanted to know what information they would need to collect about the sale of their home for their taxes. There are many tax benefits to purchasing a home which are well known, like deducting interest payments on a mortgage. And tax reporting occurs when you sell your home. I wish I could say gathering the data to report the sale is simple, but it’s not. The following outlines what you need to track when you buy a home.

When selling your house, you will need to know the dates you purchased and sold your home, the selling price and expenses, and the adjusted cost basis of the home. The first three are easy to determine. The adjusted cost basis is not.

The cost basis of real property (land and anything built on or attached to it) is usually its cost. Your adjusted cost basis is your cost basis plus any increases or decreases as described below. I’ll refer to adjusted cost basis as “basis” from now on.

It is easiest to calculate the basis of your house as you go along. If you wait until you sell your home, you are likely to miss many expenses that could increase the adjusted basis. You might consider keeping a ledger (on paper or in a spreadsheet) that keeps track of your basis, much like you do for your checking account balance.

Some costs/expenses you incur during the buying, selling, and maintaining of your home are added to your basis while other expenses you can deduct during the year the expense is incurred. You can’t do both.

Some credits reduce your taxes this year, but also reduce your basis, so you DO pay tax on those expenses, just not now.

If you add the cost of a capital improvement to your basis and you later remove the capital improvement, you must also reduce your basis. For example, if you add a fence to your property, you would increase your basis. If you later replaced that fence, the cost of the original fence would be subtracted from your basis and the cost of the new fence would be added.

Keep in mind that expenses which add to your basis will result in the sale of your home having a smaller gain (the sell price minus the basis) and thus potentially less taxes owed. Credits that cause you to reduce your basis will result in a bigger gain on the sale of your home and therefore potentially increasing taxes.

If you’d like a summary of what expenses increase and decrease your basis, please contact me.

The information given here is found in the IRS’s Publication 17.

Tara Unverzagt February 19, 2016 No Comments

What’s up with 529 plans?

Let’s explore college planning for your children or grandchildren. There are so many great questions about the “best way” to get ready financially for college, but the answers are very complicated. There’s no way to cover this vast topic in one shot, so let’s look at one college saving method: the 529 plan.

If you haven’t heard of 529 plans, they are college saving accounts that are run by states. You can invest in the state where you are a resident or most any other state’s plan. Most people only look at their state, but if you are considering a 529 plan, it’s a good idea to look at what plan fits your needs best. That may be your state’s plan or another state’s plan.

I’ll use Illinois and California as examples of the differences between states. California has one 529 plan which is a savings plan. Illinois has four different plans which include saving plans and pre-paid tuition plans. I’ll just be addressing the Illinois Bright Start program here which is a savings plan similar to the California 529 plan.

What are the advantages of saving for college in a 529 plan?

  • On the state level, there are often tax advantages on contributions.
  1. California does not have a tax advantage for California residents.
  2. Illinois has a deduction of up to $20,000 of Illinois income for a married couple. Illinois businesses can also get a tax break for matching contributions. And there’s a tax break for rolling over another state’s program into Illinois.
  • On the federal level, 529 accounts are somewhat like a Roth IRAs. Contributions are after-tax dollars while the account’s earnings and growth are tax free.
  • The accounts are professionally managed. If you don’t have an investment advisor or you aren’t comfortable managing your own investments, 529 plans can help you with investment decisions.

Are there disadvantages to investing in a 529 account verses other investment accounts?

  • At the state level, some of the advantages mentioned above can come back to haunt you.
  1.  If you rollover your Illinois account to another state, it will be included in your Illinois income.
  2. Since California doesn’t allow deduction on contributions, there is no recapture if you move the funds to another state.
  • Most 529 plans have low fees, but each plan is unique. Illinois has the same plan via advisors and direct with the state. The Advisor version can have almost 1% higher fees than the direct plan. If your account has $100,000, that’s almost $1,000 per year going to fees!
  • Most plans are with a particular investment company (for example, TIAA-CREF or Fidelity) and you will be limited to the investment options they allow. This doesn’t always represent the best choices for you.
  • On the federal and state level, if you don’t take the funds out to pay for qualified expenses, you may pay taxes on the earning and a penalty. I’ll discuss this further later.

What if my child doesn’t go to college or goes to a cheaper college than we expected?

  • Non-qualified distributions (distributions not used for tuition or fees) will be taxable and have a 10% penalty on the earnings if withdrawn.
  • You can use the funds if your child wants to go to graduate school or take vocational/advance skills classes.
  • You can change the beneficiary and use it for someone else’s educational expenses. Haven’t you always wanted to go to culinary school?
  • You can save it for the next generation’s education.
  • There are exceptions that can eliminate the penalty (but you will still pay taxes on the earnings), including: the beneficiary dies or becomes disabled, goes to a US Military Academy, or receives a scholarship.

How does a 529 account affect federal financial aid?

  • A 529 account is counted as an asset of the parent. Federal financial aid considers 5.64% of parents’ assets and 30% of their income “available” to pay for college and 20% of a student’s assets and all their income over $6,260.
  • A grandparent can also start their own 529 account for a grandchild. That account is not included in financial aid reporting.
  • The catch with a grandparent’s account is that the distribution is included in the child’s income the following year.
  • If a grandparent plans to have a 529 account with one year of tuition and fees, your grandchild could save it for their senior year. The funds would never be counted as assets or income for financial aid.

What are the advantages of using a retirement account to pay for college instead of a 529 account?

  • A Roth IRA or Roth 401(k) makes a good college saving tool. You don’t pay taxes or penalty on Roth distributions for principal that has been in the plan at least 5 years.
  • Retirement accounts aren’t counted toward assets for financial aid.
  • If you distributed the taxable earnings from a Roth IRA or Roth 401(k) or from a traditional IRA or 401(k), the funds distributed won’t be penalized (they will be taxed though)

What are the disadvantages of using a retirement account to pay for college instead of a 529 account?

  • The limit for a Roth IRA or Roth 401(k) contribution is $5,500 ($6,500 if you’re over 50) in 2016 and phased out for higher incomes.
  • Each 529 plan has its own limits, but many will let you contribute $300,000 or more at one time.
  • Grandparents should remember you will have to pay gift tax for contributions over $14,000 ($28,000 for married couples) to each beneficiary or up to $70,000 each using a special 5 year exemption, but requires a Form 709, Estate & Gift Tax form, to be filed for each grandparent.
  • Distributions will count as income towards financial aid the next year.

Whether you should use a 529, a Roth IRA/401(k) or other saving plan depends on your needs and expectations. You also need to think about everyone’s tax situation, likelihood of wanting financial aid or need based scholarships, and flexibility. There’s not one right answer for everyone.

admin January 26, 2016 No Comments

Financial Planning Girl Scout Style

People don’t normally think about Girl Scouts and financial planning together. Common thoughts are more along the lines of cute little girls in green, camping, and of course cookies. But a lot goes on to make those camping trips happen. And cookie sales are really an owner-run small business. Like any family or business, a troop has chores to do, conflicts to overcome, projects to plan (that might require buying insurance in case anything goes wrong,) and a budget to balance.

As a Girl Scout leader for twelve years, I most enjoyed watching the girls learn financial planning, Girl Scout Style. I knew they’d apply these financial skills in their personal lives in the future. Here are the key lessons learned by Girl Scouts.

  1. The girls learned that it’s ok to dream about fun adventures. We started each year determining what the troop wanted to do.
    1. Financial planning starts with a desire to buy or experience something.
    2. Write down your goals and dreams, short term and long term.
  • What are your daily/weekly/monthly expenses? Girl Scouts pay for snacks, meeting supplies, field trips, badges. Families have food, shelter, clothes, medical expenses, and transportation. These are actually just short term goals.
  • What are your required long term expenses? In Girl Scouts, there are handbooks & badge books to buy at each level, replacing/repairing tents for camping, and ceremonies. In a family you have cars and appliances to replace, a roof to replace/repair, college education, retirement. These areas need to fit in the budget too.
  • Most people, whether Girl Scouts or not, want to help their community or a charity by donating money, time, or talent.
  • After making sure the basics are covered, it’s nice to have a reward to look forward to. Both Girl Scouts and families dream about going trips, making big purchases, and having money for extras/luxuries. It easier to get through the day to day expenses if there’s a fun dream to look forward to.
  1. Look at what your income sources are. Are you able to make more money? Do you want to?
    1. Girl Scouts income sources include dues, fall product sales (nuts, magazines, and/or calendars), cookies sales, money earning projects (babysitting nights, carwashes, etc). Family income sources include jobs, investments, pensions, and inheritance.
    2. The girls and their chaperones can work harder at the Girl Scout fundraisers or do more money earning projects to increase their income. Families can choose to work longer hours to get more income, invest in more education to get a better job, or save money to buy investmentsthat provide more money in the future.
  2. The fun part of money is obviously spending it. Really, the main reason we work, Girl Scouts or family members, is to make money to spend.
    1. When choosing how to spend money, have a plan based on your goals. All stakeholders need to be involved, including Girl Scouts, Leaders, and parents in a . Involve all members in the family, including kids, in family financial decisions.
    2. It’s easier to make choices and sacrifices if everyone is involved. You may have to cut back on eating out to buy the clothes you want. You may want to cut back on the short term goals to get to your long term goals faster.
    3. Set realistic goals based on realistic income – you can’t spend more than you make in the long run.
    4. Don’t waste money because you don’t have goals. It’s easy to mindlessly buy things. With a goal, you can ask “do I want this or do I want more money in the Dream fund?”
    5. Understand the value of money when you make purchases. With your goals in mind, you can determine if a purchase is appropriate. Is the item you want to buy worth more than progress towards your Dream?
  3. Monitor, Celebrate, Reflect, and Plan your next Dream
    1. Monitor your progress and adjust income and/or expenses to stay on track.
    2. Periodically revisit the dream goal to ensure it’s still what you really want. Is it worth the sacrifices you may have to make?
    3. After you realize your dream goal, celebrate successfully reaching your goal.
    4. Reflect on what went right, wrong, how you could do better next time.
    5. Once a goal has been completed (short or long term goal), it’s time tolook forward to what’s next.

Remember: to safely navigate your life without emergencies, plan instead of react. As Benjamin Franklin said, “If you fail to plan, you plan to fail.” Guarantee success with a plan in place and track your progress.

Whether you’re a Girl Scout troop, a family, or an individual, setting goals, making a plan, and monitoring progress will help you get what you want out of life. Goals sometimes change and plans shift, but you’re still further ahead than wandering around in the dark. The more focused you are on your goals, the easier it will be to reach them.

admin January 11, 2016 No Comments

Have you been paying attention?

Interest rates have gotten REALLY Interesting

Interest rates continue to be a mystery. The Federal Reserve Board (The Fed) is trying hard to raise interest rates on government securities. They are meeting headwinds for two reasons.

First, the economic mandates that The Fed is tasked to use as guidance, inflation and unemployment, aren’t helping them raise rates. The Fed is struggling to get to the targeted 2% inflation rate. A large part of the problem is that oil prices are at historic lows. But there are other areas where prices are also not hitting the 2% mark (consumer goods, food). Unfortunately, there’s a good chance inflation will be like a clog in a pipe, water will resist getting through until suddenly the clog works it way out with a gush.

Unemployment, while in its target range doesn’t feel like it. This is partly due to many people who would like to be in the market have given up and aren’t counted. And people who would like full time work are struggling with part time jobs. There has been improvements but the progress is very slow.

The other reason for headwinds against interest rates increases is the world continues to pour money into US bonds. The US seems to be one of the few stable countries in the world and the world’s perennial favorite “safe haven” is the 10 year US Treasury Bond. Even if the Fed raises rates, with demand for US bonds going up, the price goes up pushing the rate down since bond rates go down when prices go up.

While The Fed raised rates in December and have said they plan to continue raising rates, they will struggle to actually make that a reality.

I explored interest rates and the effect on the bond market in two previous posts:Interesting Thoughts about Interest Rates and The Bond Case .

 

All information provided is general in nature and not meant to be advice for you in particular. If you’d like to know more about how this topic relates to your situation, contact me at tara@southbayfinancialpartners.com.

admin December 18, 2015 No Comments

Saving Your Bubble Gum Money

“It’s just not worth $60 to go to [a famous amusement park].” It’s a proud moment when a Financial Planner Mom hears this from her child.

I started teaching my kids financial skills where most financial planners will tell you to start, with an allowance. I started when they were about three. They received three-quarters that would be split between three jars. One was for spending (we called that “bubble gum money”), one for long term savings (in a two-year old’s world that means a week or longer), and one for charity. I let them split their quarters among the three jars however they like.

In the beginning the quarters were basically randomly deposited. I knew over time they would start to understand how different decisions would impact future options. I didn’t guide them because really, how big are mistakes a three year old can make verses how big the life lessons to be learned are?

Bubble gum money could be spent whenever and wherever. In the beginning, my youngest did spend most of her money on bubble gum.

The “long term savings” could only be “saved up” for bigger purchases. My requirement was that nothing was spent the same week the item was discovered. If they wanted that Lego™ set and had the money to buy it, they had to wait until the next week. They learned that impulse purchases were sometimes not the best financial decisions. Many angry moments led to a change of heart. In the moment, it was the only thing that would make them truly happy, but upon reflection they realized the happiness would be fleeting. On the other hand, there were times when the following week they still wanted to use their money for that Lego™ set and we’d go buy it.

Eventually, they started saving their bubble gum money. They realized bubble gum now was not nearly as rewarding as something big later. Shortly after, I started adding to their allowance. I gave them the birthday party budget. They could have a party or could use it to take a friend to Disneyland. Or they could save it to use for something else if celebrating their birthday was a low priority.

If the choice is a birthday party or no birthday party, who wouldn’t take the birthday party. But if the choice is a birthday party or saving for an iphone or xbox gaming system, there’s some serious thinking to be done. I also gave them the clothes, movie, and dance budget to use as they like. Empower your kids to make those financial decisions. They learn best through experience.

Kids who are older can still learn how to make financial decisions. With older kids still at home, sit down and negotiate an allowance. While it might take time and effort to figure out how much and what it covers, make sure you stick to giving them only the allowance. They may be sad or mad they can’t afford something, but help them realize they can save up by reducing their spending in areas that are less important to them. They can also look into getting a job to have more money available to them. If something is really important, they will figure out a way to save for it.

Adult children may need help learning to live within their salary. You are doing them a disservice by buying them a house they can’t afford or loaning them money for a nice, new car. Making loan payments is no easier than saving a little each month for their next car. Help them open a money market account to keep that money until they need their next car. It is hard to say “no” to your children, but know that they will be happier in the long run if they are financially secure.

The foundation of making financial decisions is understanding that you have a finite amount of money. If you choose to spend money today, you won’t have it available for tomorrow. As adults, our “long term” spending isn’t a week, but years or decades. Is that new car more important than your child’s education? Can you afford to do both? How about retirement? Are you going to put your children through college and then expect them to put you through retirement because you don’t have enough money left over?