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7 Simple Tips And 5 Secrets to Increase Your Credit Score

In last weeks article I suggested that your credit score can greatly affect your real estate investment property’s cash flow. Today as a follow-up, we’ll go over 7 simple tips and 5 secrets to help increase your credit score.

Credit Score Graph

7 Simple Tricks:

1. Always, always, pay your bills on time. Late payments and collections can have serious consequences on your credit score. Your payment history is a major factor as it represents 35% of your credit score.

2. Do not apply for credit too frequently. This will decrease your credit score because this is a characteristic of high credit risk groups.

3. Keep your credit-card balances low. If you’re “maxed” out on your credit cards, this will affect your credit score negatively. A good rule of thumb I’ve heard several times is to keep your credit card balances at or below 25% of your credit limits.

4. Fix any mistakes you have with the major credit bureaus right away because it can take time and have significant impacts. This entails getting in touch with the lender to verify that the information is accurate. If the lender can’t confirm or doesn’t respond, then the information is removed from your credit report. Also, if you have paperwork proving that the information on your account is false, send it to the credit bureaus and keep copies of everything.

5. Hang on to your old card because the credit bureaus reward loyalty. 15% of your credit score is based on the length of your credit history, and that includes the age of your oldest account as well as the average age of all your accounts. In other words, lenders want customers who will stay around and not move their accounts to whoever has the lowest current introductory offer.

6.Don’t bother to close accounts that have had missed payments or have had collections. Open or closed, they will be part of your past credit history for some time.

7. Being self employed is not good for your credit rating, fortunately you can plan ahead (as described in the 5 Secrets section). Many lending institutions, especially banks, won’t even look at you if you’re self-employed. If you plan on being self-employed consider a corporation because you can be “employed” by the corporation, however please note that even with a corporation it generally takes at least 2-3 years of consistent income before most lending institutions are ready to talk to you again.

5 Secrets:

1. For credit cards that are “maxed” out or have balances above the 25% rule of thumb, and you have no way of reducing the balance, fortunately there are other means to bring their ratios to more preferred levels. Remember that although the rule of thumb is to have no more than 25% of the maximum balance on credit, it doesn’t state just how much that 25% amount is in real dollars. Therefore another option is to increase your maximum balance. So for example, if you have a $1000 credit card and you owe $500 on it (a 50% ratio), then if you increase the balance to $2000, your ratio is now a preferred 25%! Just remember not to use the card anymore otherwise you will lose that preferred ratio.

2. Every time you do request a loan and the lender pulls your credit report, it generally reduces your score by a few points. It is part of the credit score formula to handle people trying to apply for credit and loans to live beyond their means. As another general rule, keep your loan processes within two-week periods so that all of the credit report lookups are bundled together to appear as one single request (such as trying to achieve the best rate for a mortgage).

3. Avoid using credit card introductory offers if you can. They might help you in the short run financially, or get you out of difficult debt, but as a long term solution they will most likely hurt you. Lenders want to acquire customers that are loyal because there is a cost associated for each loan. They would rather lend money to someone who is very likely to stay than someone who has a very unlikely to stay and move their money over at the next good looking introductory offer.

4. If you have little or no credit score, a quick way to bring up your credit score is to acquire debt. If you don’t pay off any debt, then how can you show that you’re a good borrower? Acquire some debt and pay it off. I’ve seen too many people looking to get their first mortgage denied simply because they’ve never acquired any previous debt before. They’ve paid everything in cash and they’re very proud, which they should be! However, you still need to establish a track record before someone will loan you bigger amounts, such as a mortgage. You need to prove your trustworthiness. Buy a car with a loan, get a credit card, get a personal loan, and basically establish some track record. At a bare minimum, borrow at least a few times before you go looking for larger loans.

5. For those of you looking to be self-employed, it’s crucial that you get all the loans you’ll need for at least 3 years now, probably even longer. Once you become self-employed it will be extremely difficult if not impossible for several years, therefore be prepared. Now I’m not saying use it, all I’m saying is that you get it. Increase the maximum on your credit card, get that line of credit, etc. Prepare for inflation, for future needs, etc. To use the cliché, an ounce of preparation is worth a pound of cure.

Related Article: A Lesser Known Secret Tip to Increase Your Credit Score

How Your Fico Score Can Greatly Affect Your Cash flow

I recently read an interesting magazine article, again this time from Business Week, about how your Fico score can affect your housing affordably. Taking that one step further, it can also greatly affect a real estate investor’s cash flow. The very same property can be cash flow positive for one real estate investor while being cash flow negative for another. How? With the aid of MyFico.com, let’s take a look at the difference in cash flow (assuming no other costs than the mortgage to greatly simplify this article).

Using data directly from MyFico.com, below is the interest rate and mortgage amount for a $150,000.00 rental property with a 30 year fixed mortgage.

Fico Score Interest Payment
760-850 5.94% $1,287
700-759 6.16% $1,318
680-699 6.34% $1,342
660-679 6.55% $1,373
640-659 7.53% $1,435
620-639 8.96% $1,515

As you can quickly see from the table above, there is a large difference, up to about 1.5% difference in interest rates based on the FICO score alone. The amount difference is $228/mth to the cash flow bottom line! That’s a huge difference!

In other words, a real estate investor with the highest FICO score can buy a residential rental property up to 18% more expensive than one with the lowest FICO score! That or they can make 18% more cash flow which is even better!

Therefore, another way to increase your cash flow from your real estate rental properties is to increase your own personal FICO Score.

Location, Location, Location

Everyone has heard the cliche that the three most important factors in buying a property are “location, location, and location“. Just how important is location in determining the price of property? It’s very important. I came accross a study this week done by Coldwell Banker which compared the prices of properties. The study surveyed prices of similar homes in 324 real-estate markets for a similar 2,200 square foot, four-bedroom, two-and-a-half bath, two-car garage house. The difference between the most expensive and the cheapest was very large! The biggest gap was between La Jolla, California, and Killeen, Texas. You could either own 1 of these properties in La Jolla, California, or 14 identical ones in Killeen, Texas! And with even with the 14 properties in Killeen, Texas, you’d still have $36k left over!

Why such a big difference? Because of the desirability of the locations. La Jolla is a beautiful city California perched on the Pacific Ocean with lots of coastal properties, it has year round beautiful weather, lots of amenities, and so on. In contrast, Killeen is a city built around an army base in the middle of the prairies with much harsher weather. Should the discrepency be so large? That’s a debatle subject, however the reality is that it is.

Most Expensive Markets
Market Price
La Jolla, CA $1,875,000
Santa Monica, CA $1,766,666
Beverly Hills, CA $1,656,500
Santa Barbara, CA $1,603,750
Palo Alto, CA $1,550,000
Newport Beach, CA $1,499,000
San Mateo, CA $1,334,425
San Francisco, CA $1,300,000
San Jose, CA $1,272,625
Greenwich, CT $1,267,500
Least Expensive Markets
Market Price
Killeen, TX $131,328
Minot, ND $133,266
Beckley, WV $137,875
Arlington, TX $139,510
Billings, MT $142,500
Tulsa, OK $142,600
Parkersburg, WV $146,000
Fort Worth, TX $148,610
Yankton, SD $149,521
Grayling/Roscommon, MH $149,600

Some Markets Are Already Starting to Fall. Good Times Ahead for Real Estate Investors

Today I came across an article online from the Boston.com entitled “Suddenly, area’s housing market favors the buyers“. This article was very interesting for several reasons. Firstly it seems to indicate that several real estate markets are starting to collapse, as I’ve been predicting for a while now. Also, although the article states many reasons for the decline in real estate property prices, I personally believe that the main contributor is the increase in interest rates. This is good because it makes it much easier to calculate approximately how much the real estate market should fall.

In any case, the good news for real estate investors is that there will be profitable cash flow rental properties available in the market once again. So start preparing your finances to be able to capitalize on it.

Some interests highlights and exerts from the article:

  • In Jamaica Plain, a $70,000 price cut (15% of the total purchase price) for a house on the market for about a month generated only four people for an open house (two of which were the neighbors).
  • “‘My seller is willing to consider a lower price’, said the broker, Anne Connolly, ‘but there’s no buyers to deal with.'”
  • One Remax broker said that she is still selling houses, but at prices 5-to-10 percent lower than what comparable homes sold for in spring.
  • “the number of condominiums listed for sale is up 50 percent from a year ago, while the number of price cuts has more than doubled
  • Recently, after viewing a home in Norwell, listed at $645,000, Brown was told as he walked out, ‘We’ll take $535,000.’

These are all very telling snippets of information from this article! All six reveal just how the market is truly doing. Again, as I mentioned before, this should be great news for real estate investors. Money is made in low markets, not high markets, so prepare yourself because the market is about to get very interesting in the near future!

Why do Real Estate Investors Not Invest in Stocks the Same Way They do in Real Estate?

Although it’s a discussion I’ve had a number of times before in the past, this weekend it re-occurred again. Although not directly in the context of investing in real estate, the concepts are the same. Basically, I’ve seen this happen over and over again, people who invest wisely in other assets (business, real estate, etc.), don’t always use the same principles when investing in stocks. I don’t know how the last people I had this last discussion with invest (we didn’t discuss those details), but the discussion did come up which prompted today’s article.

Often I see many wise real estate investors, wise business owners, and so on, look at the whole of their related investment, do their due diligent, and then only invest in income generating ventures. However these same people will then often completely ignore the same investing principles when dealing with other assets such as stocks! How? Why? I don’t know. If you look at a buying an investment real estate property, you will look at its total cost, at its cash flow, etc. When looking at a stock, you should do the exact same thing. Same concepts, same principles, same research. However the reality is that most people don’t.

In this article we’ll go over how and why you should look at stocks the same way as buying other assets such as investment real estate, businesses, etc.

Let’s start by looking at a basic deal. When you purchase an investment real estate property, you’ll want to look at the total price of ownership to decide if the property is expensive. That is, you want to know what the property is selling at. If you buy a business, say a Subway franchise down the street, you also want to know how much it’s going to cost you to invest in it.

When people buy stocks, more often than not, they want to know the stock price. Then based on this stock price they’ll determine if the stock is expensive or cheap. That doesn’t work! Think about it this way, stocks are only partial ownership of the company you buy stocks in. If you buy a share of Microsoft at $10/share or $40/share, you don’t own the price of the whole company, so how do you know if that’s expensive? If I sold you part of a real estate property for $10 or $40, how do you know which is worth more? You DON’T! You can’t with just that information. Why? Because how do you how big a piece of the pie that share is worth? What if for the $10 a share of the real estate property I sold you there are 1,000,000 shares? That makes the property cost $10,000,000. Now what if I told you the $40 a share real estate property only had 10,000 shares, making that property cost a total of 400,000! That’s a drastic difference! That’s the reality of stocks. That’s why many people fail at investing in stocks. If someone doesn’t even know the total cost of ownership, then how can they be investing? That’s gambling. If I bought an investment real estate property without knowing how much it truly costs, then how could I be expected to make a profit? I couldn’t! Whether or not I did would just be luck.

It’s very easy to get the total price of any publicly listed company, that’s what called the market cap. The formula is as simple as I stated above, the total number of shares multiplied by the cost of each share. This number of course changes daily, because stock prices change, but in any given instance you can quickly determine the total price of a company. Because it changes, don’t expect to be 100% accurate, just use it as a ballpark figure. Like in our example above, we can quickly have an idea of what’s what without needing to know it’s precisely $40,192 versus $40,000 compared to precisely $10,234,725 versus $10,000,000.

Now that we know how to calculate the total cost of ownership, then the next thing that should come to your mind is what is its true value? One theory, the efficient market theory, states that the market always accurately reflects the true value in the stock price. That is to say, the stock is worth what its selling for because everyone has all the information now and can correctly evaluate it. The reality is that it’s not efficient! Stocks are bought by many people, many who know what they’re doing, and many who don’t. Stocks are bought on gambles, stocks are bought on information, stocks are bought on name recognition, stocks are bought on tips, stocks are bought on emotions, stocks are bought for almost every reason.

What this means is that the actual value of a stock is not necessarily what it’s selling for, just like real estate, just like businesses. However the good news with stocks is that the discrepancies can be much larger than they will ever be for real estate properties. For example, if you look at the dot com boom and bust, the discrepancies were incredible! At other times, in a down market, prices can also be much below their true value. It’s possible to buy stocks for much less than they are worth, just as it’s possible to buy real estate much below its true value. The difference is that with stocks, because they are so easy to buy and sell as well as having a low barrier to entry, these fluctuations can be much bigger and faster.

Now that we know that the real value of a publicly traded company and its stocks are not always the same, how do we determine its true value? This is where it gets a little more complicated. There is a lot of debate here. You can talk about trends, you can talk about potential, deals coming up, patents, etc. That’s all fine, but for the scope of this article, we’ll only focus on hard nosed financial facts and figures. How much equity does the company really have? The first place to look is the balance sheet (which is available through SEC fillings and many online sites such as Yahoo Finance).

For our example, we’ll use a really well established company like Microsoft through the Yahoo Finance website. Generally balance sheets are divided into two sections, assets and liabilities. This is just like any investment real estate property or business. In assets section you want to know the hard values of the items you’re purchasing. For a publicly traded company, the easiest hard asset is cash. What’s the cash balance? For Microsoft in June 2005 it is $37.75 billion. That is, if the company went bankrupt tomorrow, assuming no debt, they could give out $37.75 billion to all the shareholders ($3.52/share).

What other hard assets can a company have? Many. It can own factories, inventory, etc. The only issue I have with this is that if the company went bankrupt tomorrow, you might not be able to sell these assets at full value. Therefore you should recalculate the balance sheet to reduce the assets at a discounted value. How much? That depends on the industry and how much security you wish to pad your price with. I like to be conservative myself, so I really low ball these assets.

One word of warning when calculating other assets, there are two rows you need to be extremely careful of, they are intangibles and goodwill. Without going into too many details, these are items that have no real hard assets behind them, that is if the company disappeared tomorrow, that value wouldn’t be paid out in cash to you. Examples can include the value of a brand name. How much is the name brand “Coke” worth? “Microsoft”? That is how much people buy their products because they know the name. The answer is that it depends. It’s worth something, but how much can’t really be determined.

Another item that’s often added here is the premium paid when a company acquires another. For example, if a company acquires another that was going for $1,000,000 but they paid $1,250,000, then you would add $250,000 as goodwill. This is the premium paid to acquire a company (which is very common). Therefore to be safe I completely discount these two rows because to me they have no really definable value that I can easily equate. This is just like how much is it worth to have beach front property? It’s definitely worth something but how much exactly I don’t know, there are just too many variables to be anywhere near accurate. Therefore to be safe I don’t assign any values to it and therefore I’m excited when I find a beach front property that has a balance sheet exactly as one that isn’t beach front!

The second section is debt. Debt can be your friend, but in business it’s a liability. These are payments you need to make every month. You need to verify that the company you are buying is not overloaded with debt. This is the same as verifying that you yourself are not overloaded with debt when purchasing a real estate investment property or a small business. You need to verify that the company can service its debt otherwise it will go bankrupt. What’s too much, well that depends again. Each industry is different and each business is different. I personally like to play it safe and avoid companies that have more than 25% of their cash reserves in debt. I understand this is stringent, but I don’t like to lose! No debt is even better when it comes to acquiring a business. Imagine if you could buy two real estate investment properties for the same amount of money, but one would require you to be in debt while another wouldn’t. Which is better?

Another thing to avoid is companies that grow through solely through debt. You can grow through debt, but eventually a company will cap out. Think of it this way, if the only way you could grow your real estate portfolio is 100% through financing (not from re-investing profits from your current properties), then eventually you will get crushed by a downturn in the market or by a lack of acquire future funding. You want some margin for safety. If I went out and bought every rental property I could with 100% financing, at some point I would get crushed. I might last a while, but if interest rates climb by even a small rate, or if one of my properties has some problems for even a short time, I’m at risk of collapsing my entire portfolio. The same is true for companies.

Now that we quickly looked at the balance sheet, what about the cash flow statement? When you buy an investment real estate rental property, you should definitely look at cash flow. Is the company consistently generating positive cash flow? Would you buy a real estate rental property that’s generating negative cash flow (assuming you couldn’t do anything to fix it yourself because you can’t personally manage a publicly traded company either)? I wouldn’t. So why is this important aspect so often ignored? I wish I knew… However, the reality is that it is often completely overlooked.

Looking at a publicly traded company’s cash flow statement is almost the same as looking at real estate property’s cash flow statement. For example, if we look at Microsoft’s, we can quickly see their yearly cash flow is positive with the exception of this year (2005), which was highly negative in comparison. In this particular case, rather than completely dismiss the company without looking further, we can quickly see on the cash flow statement that the reason it had such a negative amount is that it paid a one time dividend of $36 billion dollars! There’s no way the cash flow cannot be affected by such a large dividend. However, on a normal basis, what we’re looking for is a consistent positive cash flow, just like a real estate rental property. Sometimes you’ll get the odd inconsistency, however overall you want positive consistency.

There are many other aspects of publicly traded companies that are almost identical to real estate rental properties (and commercial properties). However for the scope of this article we’ll stop here today. The idea is that if you take the same amount of time and pay the same amount of attention to your real estate rental properties as you do to purchasing stocks, you’ll probably come out ahead. If you don’t, then you probably should look at buy index funds because they basically mimic the market average. You will never beat it, but you will also never lose to it. For the astute investor who has the time and is willing to put in the effort, the rewards can be very positive, I can assure you from personal experience.

Before I end this article, just a couple of other quick tips for you when purchasing stocks. Firstly, pay careful attention to ROE (Return On Equity), it’s one of the metrics I use myself very religiously. This metric is basically supposed to measure the return on the value of the equity. So if you have an ROE of 15%, then the true business value (the value of the assets of the company) as suppose to increase by 15% for the year. Please note that you should calculate this value yourself, after you’ve made the adjustments we talked about above. For example, a company can say that its brand value is increasing by 50% a year while its real hard assets are actually decreasing by 35% in value each year, giving it an ROE of 15%. This could give you a nice looking positive ROE where in reality it’s very negative. I’ve seen this very legal trick played much too often.

The other tip is to avoid company’s that inconsistently take huge financial hits in down markets. Without naming names here, there are several companies over the last 2-3 years that have taken large losses, larger than they acquired in any one year. You can do this for many reasons, for adjustments, right-offs, etc. However some companies use this to absorb all their losses during a down market, when their stock price is already depressed. This way they can absorb losses for many years at one time while the stock is already low, after all it can only go so low. Then when the market picks back up, their profits are back, because the losses they should have claimed for that year are all used in that one bad year. This way they can have one extremely bad year and maybe 5 or so good years. However, if you average the company over say 7 years, then the rosy picture of the 5 good years no longer look so good. This is the same as someone who inflates their real estate rental income just before they sell. For example, they can pay all the regular expenses a year or two beforehand by buying all their supplies and stock piling them in anticipation, making the property look cheaper. The can also keep their entire inventory loss (renovations, etc.) and write it all off as one massive loss in one single year. There are many tricks that can be used to inflate the real price that can be used for any investment asset, including real estate and business. Real investors can generally see these, or at least have lots of red flags firing off left and right when they encounter them. I personally don’t believe in these tactics, but I do need to be aware of them to properly and correctly valuation all of my investment assets.

Lastly, if you are interested in buying stocks, then there are definitely some books I think you should at least read. If you’re only going to read one book, then I would suggest the The Intelligent Investor: The Definitive Book On Value Investing, Revised Edition by Benjamin Graham. It’s not a complete book on stock investing, there are more enhanced ways of valuating companies, but it’s a great start at understanding the fundamentals. After all, he’s the one who thought Warren Buffett how to invest in stocks. In any case, please find below a quick list I compiled of some of the books I found very informative (in no particular order):

Mortgage Fraud is Expected to More Than Double this Year

Just like at the height of the dot com boom, being at the height of this real estate boom is causing real estate related fraud to become more and more prevalent. The number of FBI mortgage fraud cases has already climbed from 534 for all of 2004 to 642 cases for just the first half of this year alone (2005)! The FBI report also specified that 26 states have more serious mortgage fraud problems than others.

The biggest scam today is people artificially inflating the prices of houses. A recent article in Business Week (the September 05, 2005 issue) has an article entitled “The Accidental Mortgage Detective” which gives a fairly good explanation of how they do this. The general idea is to buy and sell the property many times over within a certain time period to people within the same group. Each sale is priced slightly higher, to give the impression that the property is quickly increasing in value. And this can be done with multiple properties in the same area, even within the same street to give the appearance of an even bigger local real estate market boom. Eventually the prices gets inflated enough that it is sold to the general public for a sizeable profit. As soon as the properties are sold, they quickly lose value because the value really wasn’t there in the first place.

There are many other fraudulent methods, such as using fake identities, fraudulent documents, etc., but I believe this one is the most important and least likely to be noticed, especially in a high market. Just another thing to pay attention to when purchasing your properties, especially considering that 80 percent of the cases involve industry insiders (people who know what they’re doing).

Alan Greenspan Implies Some Housing Market Have Risen to Unsustainable Levels.

Alan Greenspan (the Fed Chief) suggested this week that “signs of froth have clearly emerged in some local markets where home prices seem to have risen to unsustainable levels”. Based on the fact that Greenspan always weighs his words very precisely because of the effects it has on the economy, this is not a statement to take lightly. Remember that back in the dot com craze, he also used similar carefully worded sentences to describe the stock market bubble just before it burst.

He’s also suggested that “the vast majority of homeowners have a sizable equity cushion with which to absorb a potential decline in house prices”. Again based on the carefulness of his wording, Greenspan is clearly implying that price adjustments are coming in the housing market, that prices will very likely drop! Also, in this same statement, he believes that most homeowners have sizable equity cushions to absorb the fall in prices which I don’t believe is correct. If you read further in this article from CNN Money, he also has some other statements that might suggest otherwise, which we’ll go over in this article.

Going back to Greenspan’s first comment suggesting that housing prices are in a bubble stage, this is very scary! First and most importantly because he acknowledges it. For Greenspan to suggest this is very significant, because he’s the one that sets the interest rates, because his very words can alter the economy. This man is very influencial because of his position and his knowledge and therefore careful attention must be paid to everything he says. Although he may be wrong at times, the effects of his decisions are felt worldwide.

He also states “The dramatic increase in the prevalence of interest-only loans, as well as the introduction of other, more-exotic forms of adjustable-rate mortgages, are developments that bear close scrutiny“. Reading between the lines as one must when listening to his statements, he’s basically saying that there are too many lending vehicles that have exceptionally high risk, as well as their increased prevalence. This is not new news to the people who come to this website, we’ve already talked about the large increase in interest only loans and their potential problems.

Christopher Low, the chief economist at FTN Financial also agrees with this interpretation with his statement: “It’s nice to know that the Fed is taking (exotic home loans) seriously. It looks like (Greenspan’s) trying … to squeeze out the speculative element in housing; they don’t want a repeat of the stock bubble”.

The only statement this week that I don’t agree with is that homeowners have a sizeable cushions to absorb the price downfalls. Firstly, we already know that a substantial amount of new homeowners are using interest only mortgages to purchase houses, which means that they have little to no equity down. We also know that many houses today are bought with 5% down. And we also know that “4/5 of the rise in mortgage debt resulted from people extracting their home equity“. What do they do with this equity? We can’t know for sure, but unless they invested it, it often used for consumer spending. For example paying off credit cards is considered consumer spending if the debt acquired on the credit card was through consumer spending in the first place. Therefore, we have just shown that a large percentage of the population has minimal cushionning.

One last thing to notice about Greenspan latest statement, he is quoted as saying “shocks should be largely absorbed by changes in prices, interest rates and exchange rates, rather than by wrenching declines in output and employment.” Again, based on his careful wording, if he is using the word “shocks” as a potential outcome, then I would seriously take head of that statement…

Another 2-3% Drop in Housing Prices Coming

The Fed’s have again increased interest rates by another quarter point today, bringing interest rates to their highest in more than four years. What does this mean for the upcoming real estate bust? Based on my previous article about the effects of interest rates on real estate prices, for monthly mortgage payments to stay the same housing prices will need to drop by another 2-3%. So for example, that $300k property is now going to sell for $291k – $294k. Not that a huge difference, but it can quickly add up! At the level interest rates are today, each full percentage increase means about a 10% drop in housing prices to keep the same monthly payments!

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!



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