Money Management and the Economy

Thursday, May 24, 2018

The Myth of Taking Equity from Your House

You aren't smarter than the market. It really is that simple.

The idea that you can "take money" out of your home is a common myth that gets a lot of people in trouble in a hot real estate market. It is a myth that is based on several misunderstandings that are often repeated.

Myth 1: When an investment you own goes up in value you have "made money."

In fact, you only make money from an asset's appreciation when you sell the asset. Until then, the current valuation is just an estimate of how much money you will make when you actually sell it. As long as you still own the asset, the value you will get is still in play. It isn't money. This is particularly important with a home. If you want to take your profit out of your house you have to sell it and that usually means replacing it with another home.

Myth 2:  Refinancing  "takes your equity" out of your house.

This myth is particularly pernicious. In fact, the description of people "using their home like an ATM" feeds the notion that you are simply using money you already have.  But a more apt comparison for getting cash by refinancing your home or taking out a home equity loan is that it is like using your credit card for a cash advance. Like a cash advance on your credit card, you are simply taking out a loan on which you will have to make payments, including interest.

Of course the advantage of a home equity loan, or a refinance, is that the interest you pay is lower and the term of the loan is often longer. This means lower payments and lower total costs than a similar cash advance on your credit card.  Those advantages result from your putting up your home as collateral. If you don't make the payments, the lender takes your house and sells it to get repaid.

Myth 3: You will at least get a tax deduction for interest on a home loan

Even before the recent tax law eliminated the tax deduction for home equity loans that weren't used for home improvements, the value of this tax deduction was misunderstood. Almost 80% of taxpayers do not itemize, instead they take the standard deduction, currently $24,000 for a married couple. So they have no ability to take a deduction on their mortgage interest.

But even many people who do itemize are only recovering a small part of their loan interest. This is because they don't have $24,000 in other deductions. The result is that a substantial part of the interest deduction is just replacing a portion of the standard deduction they would have received anyway.  Consider that 5% interest on a $500000 loan is $25,000 and if you have no other deductions, that is only $1000 added deduction. The tax savings in the 24% tax bracket are less than 1% of the interest paid or .05% of the loan value.

Refinancing your home, home equity loans and home equity lines of credit all have their purposes. They are often a low cost way to borrow money. But you are borrowing money, not harvesting the proceeds of your investment. As many people have discovered when a hot housing market turned cold and they were stuck with a house they couldn't afford to sell. Or worse, lost their home when they couldn't make the payment on all that "equity" they "harvested".


Thursday, August 3, 2017

The Stock Market hasn't gone up, the Value of the Dollar has Just Gone Down.

You aren't smarter than the market. It really is that simple.

The New York Times had an article about the stock market's recent gains. The story noted that while the market had gone up 11% since the election, the dollar had dropped 10% against a basket of foreign currencies during that same period. They described this as "almost a mirror image."

Unfortunately it is exactly a mirror image for people who hold those foreign currencies. Lets say they paid a $100 for a share of stock the day of the election and they exchanged 100 units of their own currency for that $100. Now if they sell that stock they will get $111 dollars, but when they exchange that $111 dollars, they will get back 100 units of their own currency. They have earned nothing, in their own local currency's terms the price hasn't changed.

In a world investment market, the price of stock is set by what people around the world are willing to pay for it. Most people are still paying the same price for stock as always when measured in their own currencies. Its only Americans who are paying more for stock. But if the value of the dollar remains where it is, we are eventually going to be paying more for everything else as well. The money we made from those higher stock prices is going to disappear in inflation.

If you read the story, there are all sorts of explanations for the stock market increase, but the reality is that in world currencies the market has been flat since the election. Its not a "bubble" or Trump's pro-business promises or "animal spirits" or "retail investors" or "growing earnings" or any of the other media cliches. Its that the dollar has fallen in the world marketplace. The real question is why that has happened and is it going to be a permanent.

Saturday, October 27, 2012

How Safe is Gold?

As often happens when the markets are bouncing up and down, some people are turning to the "safe haven" of gold. But how safe is gold?

Gold has several attributes that make it attractive:

1) Gold is durable. In fact, some of the gold you buy today was probably mined by the Inca's thousands of years ago.

2) Gold is universal. With very few exceptions, gold always has value. This is true historically. And no matter where you go today you can likely trade gold for other goods either directly or by converting it into the local currency.

3) Gold is portable. While heavy, gold packs a lot of value in a small package.

4) Gold is beautiful. You can store it as jewelry or other decorative art.

So if you are looking for an investment that will last a 1000's of years and still hold value, gold is a great commodity. Or if you are looking for something that will be likely to survive a complete societal breakdown like a war. However, when you start to look at likely financial conditions in your lifetime, gold's risks start to come into focus.

Because while gold is durable, universal, portable, beautiful, it will not always have the same value. In fact, the price of gold in dollars (or any other currency) is quite volatile. And its value doesn't just change relative to cash, what you can buy with an ounce of gold varies a lot. You might pay $1700 for an ounce of gold today. Perhaps that would make a down payment on a new car. But if the price falls back to where it was 10 years ago, the $280 you get for your ounce of gold won't be much of a down payment. And if you bought an ounce of gold in 1980, you still wouldn't be able to buy as much as it cost you then relative to inflation despite today's high gold prices.

Of course, if you bought GM stock ten years ago you would have done worse, since it would be worthless today.  So the fact that gold goes up and down in value is not fatal.

The difference is that GM lost its value because it stopped being able to produce cars at a profit, couldn't pay its debts and went bankrupt. Gold loses or gains value based solely on changes in how much the people who want to buy it have to pay to find a willing seller.  The gold itself never changes. The gold remains the same durable, beautiful lump.

This is the difference between investment and speculation. Investments are like planting a tree or purchasing fertilizer to make it grow. You expect a return because the investment leads to more production that has value.  Of course the plant might die and you get nothing in return.

Speculation relies on buying low and selling high.  For you to buy low, someone else has to sell low. And to sell high, someone else has to buy high. In the case of stock, the value might have changed based on economic conditions or growth in the company. You are still speculating, but your money is working to make the company more valuable. Its like a mature tree. The company stock is more valuable because the company is more productive. Meanwhile, the gold still remains the same durable, beautiful lump.

So why is gold approaching a record high? Why are people willing to pay more for it now than they were ten years ago? It seems many gold investors believe we have inflation in our future and others are afraid of other investments after having been burned in the stock market and real estate.

In theory, gold can be a hedge against inflation. As the price of other things raise, gold will raise along with them. Unfortunately that theory doesn't really appear to be how gold prices respond. It probably explains part of the price, but it doesn't explain gold's extreme price fluctuations. We have had a run up in the price of gold over the past decade despite low inflation. And gold prices crashed even when inflation was higher than today.

Today's gold price is six times what it was a decade ago. Total inflation over that period has been about 20%, one 30th of that. Assume that the long-term price of gold relative to other goods and services should be the same as it was a decade ago. The cost in dollars of everything else would have to go up to 6 times just to sustain the current price of gold.

Far from being a safe investment. Gold is always a highly volatile, speculative investment. You are hearing the same reassurances from its promoters you heard during the bubble and the housing bubble. Gold prices don't go up endlessly any more than housing prices do. Right now it looks like the next bubble. And folks who buy high now will end up holding the bag when the bubble pops.

You aren't smarter than the market. It really is that simple.

Friday, April 20, 2012

Self-Directed Real Estate IRA's the New Scam?

You aren't smarter than the market. It really is that simple.

You know the marketing folks have been out talking when the New York Times does a fluff story on some new way to make more money with your investments. So watch out for the new scam promoted by the same media advisers who told you a few years ago to buy the most expensive house a lender would finance.

Paul Sullivan story is about people'e successful investment of their retirement money in real estate using a self-directed IRA. He provides us with several "success stories".  Of course they are all recent converters to this idea and, not surprising, all but one of the people whose story Sullivan tells are also in real estate sales.

The problem isn't really Paul Sullivan. Its that there is no one who makes money by digging out the horror stories from people who invested their retirement funds in real estate at the height of the housing bubble. There aren't any public relations firms devoted to debunking exotic investments so long as they remain exotic.

There are, in fact, several problems with self-directed IRA's.

The first problem is fees. They are typically far higher than for standard actively managed investment funds. So if you are following the standard advice to look for a low fee mutual fund, this is the opposite. These are an ongoing cost that cuts into any return you receive.

The second problem is lack of diversification of your risk.  During the housing bubble the claim in the media was that there had been a sea-change in valuations of real estate that explained the almost nationwide appreciation in prices. It turned out its was just a bubble. Its likely any future increases in prices are going to be driven by local conditions. So you are betting you bought the right house at the right price. Your investment is tied in up in one property. If prices go up in your area, that's great. But if they don't, you are stuck.

The third problem is liquidity. You can't sell part of the house a little at a time. You will need to sell it all at once. In the meantime you need enough cash in your self-directed IRA to cover any unexpected expenses on the house. If it should need a new roof or other major repair, you can't pay for it out of your own income. While you can borrow on the house, but you can't personally guarantee the loan so you are likely going to pay a substantial premium in interest. When you are 72 and are forced to make minimum distributions, you will need to include the value of the real estate in calculating that amount you take out. Again, this means you have to have enough cash in the account to meet the minimum distribution.

The fourth problem is that real estate does not provide the same investment advantage in an IRA that other investments do. Any appreciation in real estate is normally taxed at the favorable capital gains rate. This means that the tax advantage from holding real estate in your IRA is usually much smaller than for other investments. Its also important to remember you will likely have to pay your real estate agent 6% of the value when you sell.

What this comes down too is that these are VERY high risk investments. You may get a great return, you may suffer a big loss. There are a lot of costs that will cut into any return you do get. Ignore the PR campaigns in the financial media. If you want to gamble, this isn't really the best way to do it. Buy a high risk mutual fund with low fees instead. Keep it simple s...

Sunday, May 1, 2011

Traditional IRA and Roth IRA Contributions are Not Equivalent

The Minneapolis Star-Tribune financial advice columnist, Chris Farrell has an article in the Sunday May 1, 2011 edition that epitomizes the results of over-simplified financial analysis. For some reason, most of the media's financial advisers seem intent on ignoring the complexity of comparing Roth and IRA contributions and the result is often poor advice. Let's take a look at the media's conventional wisdom and how it compares to reality.

Most media financial columnists will say that an IRA and a Roth contribution are equivalent assuming that your tax rate is the same on both ends. If you expect your taxes to be lower in retirement, then the IRA will give you a better return. If not, then the Roth is probably a better investment. On one level this is accurate.

If you put $100 into a Roth IRA and are in the 25% tax bracket, you will have spent $125 including the taxes. Lets assume your investments break even over the next ten years and then you withdraw the balance of the account. You will have $100.

If you put that $100 into a Traditional IRA. You will save $25 in taxes, but you will have to pay $25 in taxes when you take the $100 out if you are still in the 25% tax bracket.

Assuming you saved the $25 you would have paid in taxes, this is a wash and you end up in exactly the same spot with $100 to spend. (Whether your investments do better or worse than break even doesn't effect the comparison, they will have the same effect on either choice.)

Unfortunately the assumption that you will save the tax savings never seems to get dealt with. And if you don't save the money you would have paid in taxes, that investment in a traditional IRA is going to be worth 75% of the same investment in the Roth IRA.

Now what happens if, as in the article above, you decide to maximize your contributions to each? For the example in the article that amount is $6000 per year. If you save this amount in a Roth IRA you will have $6000 when you withdraw it. If you save it in a traditional IRA you will have $4500. Again, that assumes the 25% tax bracket. To have an equivalent amount in retirement, you need to put the $1500 you saved in taxes into a traditional savings account to be saved for your retirement along with your IRA contribution.

Essentially for someone in the 25% tax bracket, a quarter of their traditional IRA (or 401(K) and other tax-deferred accounts) belongs to Uncle Sam. When they withdraw their money, they are going to have give Uncle Sam his share by paying the taxes on both the principal and earnings for that 25%. With the Roth IRA, it is just like any other savings account, the money is all theirs and there are no taxes when money is withdrawn.

I suspect one reason this rarely gets discussed is that it makes explicit the fact that you aren't really "saving" anything on your immediate taxes by putting money into an IRA or 401(k). To get the same results as a $6000 contribution into a Roth IRA, you will need to save $1500 in addition to the $6000 contributed to traditional IRA. These tax deferred accounts are simply kicking the tax bill down the road. Its "tax-deferred", not "tax-free", and there are no "tax-savings".

There are still benefits to retirement accounts. There are real tax savings from earnings on the deferred taxes. But a $6000 contribution to a traditional IRA is not equivalent to the same contribution to a Roth IRA, no matter how often the media gurus tell you otherwise.

Sunday, April 17, 2011

Taming the Risk of Markets

You aren't smarter than the market. It really is that simple.

A few years ago, in October 2008 right after the market "crash", I did a post on confusing volatility and risk. Yesterday an article on CNN Money in their "Ask the Expert" column made it clear that confusion about the risk of volatility extends to the media who provide advice on personal finances.

You can read the column for details. But the short version is that someone approaching retirement asked for advice on changing the balance between different assets in their retirement accounts to reduce its overall risk. Specifically they wanted to know "Should we rebalance all at once or slowly over time?"

The columnist response was all at once. His argument was "by transitioning to the new asset mix over time, you're really postponing (or perhaps more accurately, undermining) your decision to re-set the risk-reward balance in your portfolio."

This is just plain bad advice. The market can go up or down several percentage points in a day. The risk from that volatility exists only when you make a transaction. The risk is that you happen to sell when prices are temporarily at the bottom of a cycle or buy when they are temporarily at the top. The more money you move at once, the bigger the impact of luck (good or bad).

If you want to REDUCE your risk the dumbest thing you can do is to move a lot of money all at once. Whether you like it or not, you are timing the market. The only difference is that you are doing it with one random roll of the dice instead of some anticipation of the market direction. Averaging those moves over the course of the year won't eliminate the risk the market will be down or up over a longer cycle. But it will reduce the risk from day to day, week to week and month to month fluctuations. And given current market volataility, those risks are substantial.

Some people will argue that if the market goes back up again, you will have restored whatever losses you had. But that also misunderstands how volatility plays out. If you buy stock at a higher price, you get fewer shares. Regardless of what price you sell them at, you will get less for them in direct proportion to the higher price you paid.

I keep our personal finances in Quicken. I can follow the balance in our retirment accounts as the fluctuate from day-to-day. And occasionally I will joke to my wife that we made (or lost) some big sum of money. Since we have no intention of buying or selling, the reality is that those fluctuations are meaningless. And for accounts that we will not touch for another ten years, monthly and even annual changes don't mean much.

But once you go to buy or sell, those fluctuations can have a dramatic impact. Buy when the price is 5% higher than its average over the next twelve months and you have effectively lost 5% of the value. And that loss is permanent.

Put in different terms. If you gamble a large sum of money on the flip of a coin, there is a 50% chance you will lose it all. If you flip the coin twice, the chances of losing everything drop to 25%, if you flip three times they are 1 in 8 or 12.5% and flip once more and they are down to 6.25%. Of course your chances of winning every time also drop. But if your goal is to reduce risk, then the more times you flip, the less risk. Investments work the same way, the more times you gamble on market volatility the less likely you are to get badly burned.

I would note, I have not considered the cost of transactions here. If you are paying a fee every time you move money then you need to consider how much extra the over time strategy will cost.

Monday, October 18, 2010

The T-Party Movement and Running Government Like a Business

There is a media narrative out there about the T-party that it is made up of people who are angry because they lost their jobs or fear losing their jobs. The actual demographics of T-party supporters don't really reflect this at all. Instead, the typical T-party adherent is male, moderately well to do and in his 40's. Of course, not all fit that demographic. But far from being "trailer trash" as some people imagine, the T-party folks have been relatively successful.

So why are they angry? Because they fear life is getting worse, rather than better. And they, as individuals, react psychologically to their fears by getting angry, as opposed to other extreme of going to bed and pulling the covers over their head. But to focus on the causes of their anger, which are mostly personal psychology, is to ignore the causes of their fear.

Of course, we can't expect politicians or the media to address those causes. Success in politics requires validating that fear and anger regardless of its source. And playing on people's emotions is what holds an audience for advertisers. Neither one has any real interest in deconstructing people's emotions and addressing their fears rationally.

But confronting the sources of fear is probably the only way to pull out of a death spiral of fear feeding the anger and the anger just adding to the level of fear. The causes of people's fear are both rational and irrational. And they are not universal. So lets take a look at several of them.

One of the complaints you will here from the T-party folks is that they are paying taxes and "most Americans" aren't. This is based on the current talk show meme that most income tax is paid by the highest earners, while a large number of American families get off "scot-free", paying little or no taxes. It isn't really true, but that is a different issue. The T-party folks believe it because it fits their own experience.

Under our tax system, we pay income tax at different rates during different periods in our lives. Obviously most children pay no income tax. When we are teenagers, we may pay very little even if we have a job. Once we enter the workforce, we will start to pay a significant portion of our income in taxes, but our overall earnings are generally low. But the tax system is set up that once we start a family, there are numerous tax breaks that are income tested. People whose income is in the mid-range of household incomes, may find that with deductions they get for their children, there tax bill is again small or non-existent. Much like when they were teenagers.

Unfortunately(?), children leave home. When they do family expenses decline, but the tax man comes to take away a lot of that extra income. I think that may be why you see the T-party demographic being well-to-do 40-something male Republicans. These are folks who have moved from the "tax-privileged" category, that people who have families with children are in, into the tax-paying part of their lives. They had looked forward to the time when the kids were out of college and they would have a lot more money to spend on themselves. They found instead that Uncle Sam was going to take a much bigger share. So, while taxes in general haven't gone up, theirs have.

As we age, our income increases and the expense of maintaining a family disappears, our tax bill continues to increase. But once we retire, its likely the bill will fall again. Most people do not pay additional taxes on their Social Security benefits. So people totally dependent on social security and their savings for their expenses, may pay no taxes. Of course, that will be less true in the future when people have large amounts of tax-deferred savings that are taxable when used.

Of course, this process is nothing new. What feeds the fear now for those in the middle of that proccess, is that many of them have lost confidence in the future. They don't necessarily expect to be earning more in the future. They are under water on their mortgage, even if they can make the payments. The savings they thought guaranteed a comfortable retirement looks a lot less certain. In short, when it looks like hard times ahead, we all tend to hoard our resources. So as taxes take a bigger share of their income, it is coming at time when they are feeling very insecure about the future. They NEED that money.

You can see this fear of the future play out in the political debate. Concern about the federal deficit, the cost of paying for our retirement system, opposition to public investments and the demands to cut back assistance to the less fortunate all reflect a lack of belief in a prosperous, productive future. It is that fear of the future and feeling the need to hoard our resources for the coming lean times that is emotionally driving the current political/media discussions.

The problem is that acting on those fears makes that future all the more likely. Which brings us to "running government like a business".

I always wonder that when people use this cliche they seem to mean "run government like a small, unsuccessful business". They don't seem to include the most successful, large businesses that are perpetually in debt. Those businesses borrow money and invest it in production, confident that they will produce enough income to repay the debt and return an even larger profit than if they hadn't borrowed. They are always trying to reduce costs, but not at the expense of productivity.

Even small businesses faced with falling revenue or low profits have two choices. One is to cut costs even if it reduces productivity, the other is to invest to bring in new customers or increase productivity to serve current customers at lower costs. Its really the unsuccessful business, the one that is dying, that cuts its necessary expenses in order to maintain a profit. Successful businesses, large and small, go by the adage "you have to spend money to make money".

Of course, many small businesses are not successful or even run like a business. Instead, they are just a way for someone to make a living. As one local business owner said of a store that was for sale, "Its not really a going business, but someone might be able to buy it to create a job for themselves." For people who own and operate those businesses, cutting the advertising budget to pay for their kids college makes perfect sense. The success of the business is a secondary consideration. Its really just a way to have a job.

Those same choices exist with government. There are certainly good arguments that some of the money government spends is wasted. Government, like a business, should always be trying to identify and cut that waste. And other public costs, like retirement and other social service benefits are not going to bring a return in the future. Instead those are debts being paid to those who helped to build the vibrant country we inherited. But many of the folks who say they want to "run government like a business" also want to cut costs that are really investments for future success - education, infrastructure and effective business regulation. And that's because they have lost confidence in the country's future. They don't really believe those investments will bring a return that will repay them. They want to run the country like a failing small business that cuts advertising because it "can't afford it" only to have even fewer customers. They have given up on the American dream.

Rather than looking to the future, the T-party and its allies are fearful. Instead of building for the future, they are just trying to hang onto what they have until their lives run out. Of course that is not how America became the greatest country on earth, but it is how other country's have lost that status in the past.

I still believe in American exceptionalism. As a democratic country we can decide we are not going to go into decline and die. We can leave a better and stronger country for the next generation to build their prosperity on , just as our parents provided the basis for our own prosperity. I'm an optimist, the meme of the day is fear and anger, but this too shall pass.

"Courage... is mastery of fear – not absence of fear" - Mark Twain