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Archive for August, 2005

Can You Save Your Way to a $1,000,000 Dollars?

I recently had a discussion with a friend of mine on whether or not it’s possible to save your way to a million dollars or if it’s only possible to earn it. We talked about it from many angles, and yes it’s possible, but it’s very unlikely. You’ll have to live very cheaply for a long time, at least more much more cheaply than I care to.

So how did we come up with this finding? Like most of the other articles on this blog, I worked out the numbers. Today’s article is all about the numbers we worked out during that discussion. We’ll start from one angle and then work the what-if’s, how-to’s, and what-about’s after.

Ok, let’s start with a basic premise, let’s start with a salary. Where do we start here? To make things simple, let’s take the median Californian’s household salary of about $54k. Let’s assume a 25% tax rate straight off the top (which is probably lower than the actual rate, therefore working in our favor), leaving us with $40.5k in net income. Now, according to “The Wealthy Barber”, we should invest 10% of our income. Again to pad it in our favor, let’s make that 10% of gross (pre-tax income) rather than the net income. This means we will put away $5.400 a year into an investment instead of $4,050. As for the interest rate, let’s take an easy to measure interest rate, the current 30-year fixed US Treasuries rate of 5.375%/year. After 30 years, you would have $391,792.50 in your account. You’d be short about 61% of your goal of a million dollars!

Alright, now that we have a baseline, let’s start looking at these numbers in more detail, let’s change them, and let’s work with different assumptions. Ok, first, what if instead of 10% we saved 20%? What difference would that make? $783,585.05. Much closer but still over 21% short of our one million dollar goal. To make our goal of one million dollars we would need to put away $13,782.81 each year! Assuming a median income of $54k, that represents over 25% of gross income, or over 34% of net income! In other words, for ever dollar you take home after taxes, you need to put 34 cents into your investments, you need to live off of just under $27k a year. In California, assuming the rent is at least $1k a month (which is low), that means you need to live on $15k a year for everything (car, food, health, kids, entertainment, travel, etc.) for 30 years! That’s not very much, not much at all.

Ok, let’s look at it from another angle. What if we increased the interest rate to a more aggressive interest rate? Let’s take the average compound rate of return on stocks from 1802 through 1991, 7.7% per year. Assuming this rate of return with our original 10% of gross, would we make our one million dollars in 30 years? Unfortunately no, we would have made only $609,226.29, still shy over 39% of our targeted one million dollars. At that rate of return, we would need to invest $8,863.71/year, over 16% of our gross or almost 22% of our net. Although possible, I personally think that consistently investing 20% or more of the net income of the median family is probably asking for too much for the ordinary person. Investing 20% of 100k net in revenue is possible, but not for the median income family, it’s just too much.

Ok, so let’s look at it this way, assuming we want to save only 10% of our net income, the smaller of the two numbers, at the higher rate of 7.7%, then how much income would we need to produce? $88,637.11 in net income. Assuming a tax bracket of 25% again (it’s probably higher as taxes get progressively higher with additional income), then we would need to make $118,182.81 in gross yearly revenue!

The next question that comes to my mind is what interest rate would you need to earn on the median salary to have 1 million dollars after 30 years, assuming you’re putting away 10% of the net income of the median household income of $54k? You would need to earn consistently over 30 years 10.139% compounded interest a year. This is very doable, however it tells me that I most likely need to be a smart equity investor, a smart real estate investor, or start my own business. Chances are that I won’t attain my 1 million dollar mark (in today’s dollars) otherwise.

Now I can already see some of you saying that with inflation, one million dollars isn’t going to be anything in 30 years. Very true, but remember these calculations are in today’s dollars. That is, what you have in the bank (or in investments) then will buy the same amount of stuff then as it does today if you had a million dollars today. In actually, if you add inflation into the calculations, these numbers look even worse because you now have to reduce your real interest rate by 3.5% (today’s inflation rate). So if you make 7.7%, you’re actually only making 4.2%!

I can also suspect some of you will comment about increasing your income, and hence contributions, over time. Yes, that’s all true and all, and I completely agree. The thinking is that although you might not make over $100k today, you will tomorow so you should be able to play catch up by putting away bigger and bigger amounts. Yes, this is true, sort of except that there’s a catch! This is where the power of compound interest becomes very very interesting! Again, nothing speaks as well as working out the numbers, so let’s do just that.

Say I invest 10k in year 1 and do nothing for 10 years at 7.7%. I will end up with $100,003.52 after 30 years. Now, what if I invest $1k every year for 30 years (i.e. I invest for a total of $30k)? I will end up with only $112,819.69, a difference of about 10%! Wow! I invested 3 times as much money only to make 10% more! Catching up really didn’t help much.

Compound Interest Graph

Of course, in the example above we spread it out over 30 years. What if we do the same numbers, but over 10 years now? Get ready for a shock! For the initial $10k investment in the first year and nothing after I end up with $21,544.60. If I do the second scenario, investing $1.5k a year for 10 years, I end up with $21,706.79. I actually have to invest 50% more money to get the same final balance.

Let’s look at the effects of compound with one last example. Let’s say I have no money initially, so I invest nothing for 10 years. Then for the next 10 years I invest $2k a year, then for next 10 years after that I invest $3k a year, what will I end up with? $105,768.77! Wow! I end up with almost the exact same as if I invested $10k the first year. I have to invest a total of $50k to catch up to my initial $10k investment. 5 times as much money to end up with about the same final amount! That’s the power of compound interest!

You can play with the numbers, but you’ll find that as interest rates climb, the differences become even more staggering. Basically the idea is that you should let time be your friend. The longer you can compound a number the higher the return. Remember, compound interest is an exponential formula, so use its power to your advantage. Put as much as you can early on, it’ll make a world of difference tomorrow because its very costly to catch up later. Therefore using the argument that you’ll be making more money later and hence bigger investments is probably not a good one.

All in all, it’s possible to save a million dollars but the odds need to be in your favor. The math above assumes historical averages with median salaries. The math here does not deal with factors such as unemployment losses (you’ll probably have some bad months in your life, etc. The numbers also doesn’t deal with inflation which could substantially affect the results. Also, since these calculations don’t consider inflation, they assume that you’re gaining the full stock return which is completely untrue! For example, if you’re stocks went up say 10% this year, then you only really made 6.5% after adjustments for inflation. That’s right, you need to remove 3.5% for inflation. So for example if you had $100 invested and you made $10 for a total of $110, then you’re $110 can only buy $107 of equivalent goods as compared to your $100. As a more concrete example, if you could buy gold at $1/lbs, then in year one you could buy 100 lbs of gold. In year two gold would have gone up to $1.035/lbs because of inflation (assuming a 3.5% inflation rate), allowing you to buy only 107 lbs and not 110 lbs. This means that in reality our calculations are better than reality because we didn’t take this inflation into consideration.

Also, these calculations assume you never pay taxes on your investments. If you do pay capital appreciation taxes then the numbers change drastically. Therefore, a quick tip for this type of investing, try to pick investment vehicles that you can stay with for a longer term to avoid taxes because they can have drastic differences in these calculations as seen in my previous article on the affect of taxes on the real estate investment returns.

Now that you know most of the math what do you think? I personally don’t think it’s feasible to assume most people will be able to save and invest $1,000,000 dollars in 30 years. Not that it’s impossible, people have done it, but I don’t know that I want to live that type of financially squeezed lifestyle. Rather I think you’ll have to look at other avenues to increase your revenues (or rate of return) rather than just try to save your way to $1,000,000. You should probably look into investing wisely in equities, real estate, or building your own business. Basically, you need to look at something other than just putting money away in your mattress, because the honest truth is that in 30 years you’ll likely not have the $1,000,000 you worked so hard to save for, you’ll only have a fraction of that. I’m not saying don’t invest, I would never say that, actually I’m a very strong proponent of investing. All I’m saying is that you probably need more than just plain saving in your financial plan to get your $1,000,000.

Home Prices Show Strongest Increase on Record

A recent quarterly survey by N.A.R. found (National Association of Realtors) that U.S. home prices rose at an annual rate of 13.6 percent. When you adjust the rise with inflation, according CNN Money, this is the strongest increase ever recorded! The biggest gainer being Phoenix, AZ.

When you compare this with the last article I published, it looks like the market is ripe for a bad downturn. Based on this last article which showed that the majority of Californian’s were over $70k short of income to support the median home, it’s hard to find where these gains are coming from. Earlier in the boom, interest rates really helped to explain the growth. Of course there are other factors like population growth, increased economic health, etc., however interest rates were probably the biggest driver to increased housing prices. Almost every 1% drop in interest rate increased the housing affordability by approximately 10% (based on the same monthly mortgage payments).

Today however the real estate market is completely different. Interest rates are now climbing thereby decreasing the mortgage amounts people can afford. The problem is that the lowering of interest rates created a bubble, where the prices were no longer determined by logic. If you ask the vast majority of people on the street just how much interest rates can affect real estate prices, they can’t tell you. Actually, if you ask these same people why housing prices have increased, they can’t give you a logical answer other than houses are a great investment and they’ll always increase (which isn’t true by the way). What’s happened is that emotions are now ruling the market, setting us up for a large real estate crash! The good news is that there are many things you can do to protect yourself.

10 things to do to protect yourself from the upcoming housing crash:

1. Generally avoid the real estate markets with the strongest gains. Although not perfectly accurate, it’s a good metric to start with. It’s the same principle as the dot com boom. The tech companies that has the largest and unexplainable gains where the most likely the ones that fell the hardest. Not always, but generally. The same is probably true for real estate markets.

2. If you’re going to buy a property, get a fixed rate mortgage of at least 10 years, preferably more. Based on the last 40 years of data, no real estate bust has lasted more than 7 years, so with a 10 year fixed rate, you should be protected from any interest rate increases that cause the market to crash. As well, this gives you a much more accurate idea of what your fixed costs will be. Therefore if you can’t get positive cash flow today, you should be able to keep that positive cash flow for at least 10 years.

3. Avoid interest only mortgages. Plain and simple, avoid them! These are very risky for most people because very few people are adept at handling the associated risk. If you can only afford your home this way then you’re buying too much home. You’re putting yourself at a high financial risk. Fortunately for real estate investors, and unfortunately for uneducated home owners, 31% of all new single family mortgages in 2004 were interest-only mortgages which will create great deals in the next few years.

4. Start hoarding your cash now for when the market does drop. This will be a great time to get properties much lower than today. Based on the housing affordability index of California, we could see drops as high as 56.7%. Who wouldn’t appreciate the possibility of purchasing properties as much as 50% lower than today!

5. If you’re going to pull out equity from your house, verify that you’re not over-financing yourself, that you have the same protections mentioned above as someone buying today.

6. Assumable and transferable mortgages provide you with more protection than not because if interest rates increase as expected, you can sell your mortgage with your property at today’s low rates. So for example, if interest rates climb to a historical average of 8-10% lowering the prices of homes, you can still sell your properties higher than the neighbors because you can also sell the mortgage with the property. That is you don’t have to decrease the price of your property by 30-50% to keep the same monthly mortgage payments, your transferable mortgage does it for you!

7. Whatever equity you pull out today, don’t use it to acquire consumer goods or pay off consumer debt. Use it wisely because you will need it tomorrow.

8. Assuming you went with a low down and a short term mortgage (either variable or 5 year fixed), start preparing yourself by saving as much cash as you can because if you have to refinance (say in 5 years), and you owe $200k on your property, but the price has dropped to bring it below that, say to $180k, then you will have to come up with some additional cash to cover your refinancing. In a bust real estate market, banks will probably not lend out 100+% mortgages. You’ll have to come up with at least that additional $20k, probably more.

9. Verify that all your properties are cash flow positive. Not that they shouldn’t be, but if they aren’t, it’s going to get a whole lot more difficult for you if you have a short term mortgage (5 years) or a variable mortgage as interest rates increase.

10. CASH IS KING! Start saving your cash now. This is where fortunes are made and lost, and fortunately for those with cash, this is where they are made! If you look at history, the common person buys at the peak of market booms and sells at a loss in market busts. Whereas strong investors, those that have lasted through many busts and booms, generally do the opposite. The near future will be one of those times, be prepared for it!

Until This Week Californian's Were $70,480 Short of Income to Purchase a Home, It's Now Increased!

The California Association of Realtors, recently released a survey indicating that Californian’s where $70,480 short of income to afford a median home priced at $530,430, even worse for San Francisco Bay Area where the shortage in income is $102,230. These numbers assume a 20% down payment, with monthly payments for principal, interest, taxes, and insurances that are no more than 30% of the household’s total income. Based on the Fed’s interest rate hike this week, how much can this hike increase the income necessary to afford a home?

This week the Federal Reserve raised the interest rates by another 1/4 percent, with another raise expected on September 20 of this year. Assuming housing prices don’t change and an initial interest rate of 5%, that means that on September 20 (assuming another expected 1/4 percent interest rate hike), Californians will have to come up with an additional $133.29 a month, or gross income before taxes of another $205.27/mth. That’s $2,463.20 a year. In other words, the median affordable income will then be raised to $72,943.20 a year, an increase of salary of at least 3.4%.

If interest rates keep climbing, the real estate market is in for a lot of problems. Although $2,463.20 in additional income a year might not seem like that great an increase considering the scale of things, note that that’s just two minor rate hikes with more expected in the near future! And not only that, but according to BusinessWeek.com, 31% of all new single-family mortgages in 2004 were interest only! This means that many people are already financially stretched to their very maximum. And do remember, the numbers above are with a 20% down payment which is not nearly as common with interest only mortgages. Assuming the worse case, a 0% down payment and an interest only loan with the same 5% rate, the monthly amount is $2,210.12. Now add the two rate hikes to that rate and you get a monthly payment of $2,431.13, an increase of $221.01/mth, or $4,048.26 a year, almost double! And don’t forget that interest only loans generally have higher interest rates.

As you can see from these numbers, if interest rates continue to climb, we’re definitely going to see real estate housing prices drop. The good news is that you can plan ahead and protect yourself today. You can, for example, refinance your property and lock in today’s low interest rates for longer terms, the longer the better. And if you do purchase a new property, you should avoid purchasing at the upper limits or your budget and especially avoid interest only mortgages.

Now that we know the income required to own a home in California, let’s look at the numbers from another perspective. How far do real estate prices need to decrease to make housing affordable to Californians today?

Given the same 20% down payment, the mortgage amount comes to about $430,430 (20% is actually $424,344, but we’ve rounded it up a little to add some acquisition costs). Assuming the same 5.5% interest rate, we have a monthly mortgage payment of $2,443.93, making our yearly payment $29,327.16. At this point we have two options, we can determine how the survey calculated their numbers or we can make a rough approximation. For the scope of this article, we’ll use the rough approximation approach. Since we know that as we lower the housing prices some of our other numbers will also be relatively affected we can safely assume that the decrease will likely be less. As an example of such an affect, lowering the price of a property should also lower the insurance costs as it requires less coverage. Using our rough approximation, we can take the percentage difference of the required income of $124,320 and the shortage of $70,480 to give us an income shortage percentage of 56.7%.

What this means is that we need to drop the price of our mortgage by as much as 56.7% to make housing affordable today for Californians. Or in other words, the real estate housing price needs to drop from $$530,430 by approximately 56.7% to $300,753.81! That’s a large difference.

Odds are that real estate prices won’t decline this drastically because, as mentioned just above, if you add other factors such as inflation, insurance, taxes, etc., the drop will be a slightly less. How much less exactly, I’m not sure. But if you assume a drop 56.7% then you should be safe. And based on the past history of the real estate market, such drops have existed before. The good news is that no bust has yet lasted for more than 10 years. So again, if you’re going to buy in today’s market, buy with a long term fixed interest rate with the expectations that there will likely be a significant price drop before for some time.

Recent Survey Shows Some Markets Heading for a Price Decline

As is evident by the articles on this blog, it’s no mystery that I’ve been a large proponent that real estate prices are exaggerate, that they have to fall. Well a new survey from PMI Mortgage Insurance Corporation shows that some of the US’s housing markets are increasing their chances for a price decline based on factors such as home prices, employment conditions, affordability, etc.

The study shows that more than one city has a higher than 50% chance of a price decline, cities such as Boston MA, Nassau NY, San Diego CA, San Jose CA, Santa Ana CA, Oakland CA. Actually, the national average is 21.3%!

The good news is that based on the article, the cities less likely to be affected by the bubble burst include cities such as Pittsburgh PA, Philadelphia PA, Indianapolis IN, Cincinnati OH, Columbus OH, Memphis TN, Nashville TN, San Antonio TX, and Seattle WA.

I was not able to find the details of how exactly they came up with these numbers, but they are interesting nonetheless.

The Great Real Estate Dilemma

As you probably know from my previous real estate posts, I believe that we’re past due for a real estate bust. This week I came accross another very interesting article related to the topic by Dr. Steve Sjuggerud. I’m not sure I’m in full agreement with the article, but it does provide some very interesting arguments that are definetely worth reading.

Home Prices Adjusted For Inflation

For example, the graph above shows the prices of new houses adjusted for inflation. There are a few interesting points to notice about this graph. First, the general trend over time has been upwards. That is, as populations increase and space within cities become more condensed, prices have to go up, that’s the law of supply and demand. What’s also very interesting is that the prices have not always gone up steadily, there have been some drastic dips!

The delimma faced by today’s real estate investors is whether or not to buy, or to hold out until the bust when you can buy properties for much cheaper. Based on the fact that interest rates have nowhere to go but up, and the effect interest rates have on property prices, I know a lot of you out there are thinking of waiting it out. The reality is that a great investor can invest successfully in any market! The key is what you select and how you finance it. That’s the topic of this article.

If you look closely again at the graph above you’ll quickly notice that over the last 40 years that no dip has lasted 10 years. Although this graph is for new houses, let’s take the assumption that it applies for all housing (since conceptually it’s very similar). Therefore, assuming that you buy a property at the very height of a boom, if you can hold it for at least 10 years, than by all accounts you should be able to sell it at least the price you paid! At quick glance, that might not look so good, but take a second to think about it…

This means that no matter what the market, if you have at least a 10 year fixed mortgage at today’s interest and you can hold it for at least 10 years, you’ll make money (assuming you picked a good income property). At the very least you’ll have paid down the equity with your rental income. However, chances are that you will be able to sell it at a price higher than what you paid for at at least one point over those 10 years.

All said and done, it’s important for today’s investor to lock in their interest rates for at least 10 years and select positive cash flow properties. Actually, You should never purchase a negative cash flow property!!! Why would you? How can you call it an income property when you continually dump money into it? What’s the benefit of it? I’ve heard people say that they will make their profit when they sell. Why would you want to do this? You might need to make payments for who knows how many years before you can sell at a profit, maybe as much as ten years. How much profit will you really make? If I have a negative cash flow of say $200/mth for 10 years (which some people accept today), that’s $24,000 that you will need to put into your property over those 10 years.

Scenario 1 – $200/mth Negative Cash Flow

Total cash flow payments over 10 years


Total Annuity earned on $24,000.00


Total equity paid down





What about the equity you paid down? Sure, you’ll have paid some down, but very little. At the beginning of a mortgage, most of your payments go to pay the interest. Actually, you’re $200/mth from the above example probably pays half your principle. Anyways, getting 5% interest on your money will not make you rich quick, so let’s look at some real numbers. Let’s say you paid $200,000 for the property at 5% interest. After 10 years, you’d have paid the equity down to $162,288.34, or $37,711.66 of equity. Based on our previous example, after you calculate the money you put in, you only made $13,711.66 profit. Now let’s make it more accurate and take that $200/mth and put it into an annuity for the 10 years. After 10 years, we’d have $31,056.46, or $7,056.46 in interest. That means that we made a total profit of $6,655.11, which is pretty poor interest on $24,000 over 10 years! Especially considering the leverage and risk. Going back to our example, to break even after 10 years, we need to sell the house at no more than $6,655.11 less than what we initially paid for it. That’s not counting any commissions, lawyer fees, home inspections, etc. which would probably bring us to a loss. This makes it very difficult for us to make a profit, even if we hold out for the next boom.

Scenario 2 – Break Even Cash Flow

Total cash flow payments over 10 years


Total Annuity earned on $24,000.00


Total equity paid down





Do the scenario with a break even cash flow, or +200/mth positive cash flow, and you can see the numbers change drastically! A small difference of $400/mth cash flow, the difference between -$200/mth to +$200/mth is over $60,000 over 10 years at today’s low interest rates! By the way, although I haven’t yet done the calculations, I assume these changes get much more drastic as the interest rates climb.

Scenario 3 – $200/mth Positive Cash Flow

Total cash flow payments over 10 years


Total Annuity earned on $24,000.00


Total equity paid down




All in all, if you plan on investing in real estate today, and you want to absolutely guarantee a profit in today’s market, invest with at least a 10 year forecast because you might just be investing at the height of a boom market. With a 10 year forecast, at a profitable cash flow today with a locked in interest rate for at least that term, you should on all accounts come out ahead. Make sure you do the numbers and you should come out ahead in all markets!
So for today’s investors the dilemma should be simple, if you’re going to invest make sure you can hold at a fixed cost for at least 10 years and that you are at least making some positive cash flow for that duration. There are 10+ year fixed rate mortgages out there for low interest rates, you just need to find them. I personally found one recently for 5.4% fixed for 25 years that is both assumable and transferable. This means that should the market dip as I expect, I should be safe because I can outlast the dip, even if it’s the longest dip in recorded history! Like I said at the beginning, smart investors should be able to invest and profit in every market condition, it’s just that the it’s much much tougher to find good deals in boom markets than it is in bust markets.



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