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September 2008 - Posts - The Dollar Stretcher
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The Dollar Stretcher

The Dollar Stretcher blog will explore people and money.

September 2008 - Posts

  • Lessons from an Economic Crisis - part 1

    Lately the economy is big news. As someone who discusses personal finance I'd have to say that the discussion is good. But, if you add up all the news reports (print, radio, television, internet) you wonder whether Jane and Joe Consumer are really learning anything. So much of what is being reported has no practical value for folks like you and I. So let's see if we can learn something from the turmoil all around us. 

    Lesson #1. "Zero Down" mortgages can be dangerous. "No money down" - sounds like every would-be homeowner's dream offer. No need to struggle saving a down payment. No need to wait until you do. Just sign on the dotted line. Only one problem. You're upside-down in your home as soon as you close on it. Yep, you owe more than it's worth. Unless you managed to keep all the closing costs, origination fees, attorney's fees, etc out of the mortgage. And, that doesn't typically happen (because your goal was to show up at closing with nothing but your ball point pen). 

    So maybe being upside-down in your home isn't so bad. Guess again! You can't sell your home (unless you can afford to bring a check to the closing). Yep, you're stuck. And, you'll stay stuck until the house appreciates to the point where it's worth more than the balance of your mortgage. 

    Lesson #2. "Interest Only" mortgages can be dangerous. Interest only mortgages were sold to help keep your payments "affordable" (oh, how I hate that phrase - it means we've done something to your loan that'll hurt more later so that it doesn't hurt now). Yes, it's true, you won't have a pay a portion of the principal you owe each month. So your payment will be lower. But, because you're not paying any principal the amount you owe doesn't go down each month. That means that the only way that you'll actually own more of your house is if the value of your home increases. If home don't appreciate? You could end up owing more than the home is worth (see "zero down" mortgage comments).

    Lesson #3. The 30 and 15 year fixed mortgages have advantages. Both the lender and homeowner benefit. Because the interest rate is fixed, both know how much the payment will be. For the entire life of the loan. No worry that increases in the interest rate will outpace the borrower's income. 

    Plus, with every payment a portion of the mortgage is paid off. In small amounts at first, but increasing as time goes on. That means that every payment check is just a little more efficient than the one before. And, the homeowner's equity increases each month. Even if house prices fall, a portion of the monthly payment will help increase the amount that the borrower owns. 

    Lesson #4 Not everyone can afford the home that they want. We'd all like it if everyone could afford a nice, spacious home in a good neighborhood. After all, that's the American dream. But, the truth is we're not there yet. When you want to own a home badly enough you'll be tempted to believe anyone who will lend you the money to buy your dream palace. Don't be fooled. You won't find them anywhere nearby when you struggle to make the payments. They won't even recognize you on the street. They sold your mortgage to Freddie Mac or Fannie Mae and you are so yesterday. They're busy working today's deal. Don't place all the blame at their feet. If you buy a house and take on a mortgage without thinking about how different future situations (like a falling housing market) will play out, you have no one to blame but yourself. (and ignorance is no excuse. You don't have to be too smart to ask for help from someone who knows more)

    Lesson #5.Just because the government says it's ok doesn't mean that it really is ok. Back in 2004 Congress held some hearings. Problems were identified at that time. You can read what the NY Times reported here Shortly thereafter the head of Fannie took early retirement as reported in USA Today  At the time some in Congress said that there was nothing seriously wrong and let business go on as usual.

    If you took out one of these mortgages since the fall of 2004 you might want to do a little research and see what your representative was saying about Fannie and Freddie back then. They could have prevented you from falling into this trap. It's sad, but you trusted people for good financial advice and didn't get it.The rest of us should also check the voting record. Instead of solving a $9 billion problem, now we're going to have to pay to clean up a $700 billion problem. 

    Lesson #6. Assuming that house prices will go up is dangerous. Back in 2004 housing prices had been increasing for 25 years. No one knew for sure what the future would bring. History said that prices were going up. But, there was no guarantee that it had to continue without a break. In fact, from about 2002 on many people were predicting that housing prices had to retreat.

    Homeowners who bet the house on a rising market are doing just that. Betting their house. Shame on the people who promised them that prices couldn't drop. And shame on the borrowers' who believed them.

    Lesson #7. Accumulating a down payment before buying a home is a good thing. Sure it's nice to be able to buy your dream home today even if the only thing you have in your pockets are your hands and some credit cards. But, it's not a good idea. Here's why. When you save for a down payment you're forced to live below your income. So you get used to sacrificing. You also limit your standard of living. Then later when you've saved the down payment and buy your home you've created the habit of controlling your finances. Not so if you buy with no money down.

    Lesson #8. Americans had too much of their wealth tied up in their homes. For the last 25 years housing prices went up. So we didn't need to do anything to become wealthier. Just stay in our house. That would be ok, but during the same time we've been spending just about every dollar we earned. In fact, it was very tempting to use the newly created home equity loans to tap into that new wealth to buy cars, vacations, pay off credit card debt or anything else that came into our little noggins. It also caused us to think that we were wealthier than we really were.

    Lesson #9. Just because someone will lend you the money doesn't mean that you should borrow it. You'd think that if a bank or mortgage company were going to lend you $250,000 that they want to be fairly sure that you'd be able to repay it. Only seems logical. But, in this particular case you'd be wrong. The reason is that the bank/mortgage company was only going to own your mortgage for a short period of time. They sold the loans to Fannie and Freddie. So beyond the first few months they didn't care whether you could afford the mortgage payments.

    In our next installment we'll look at some lessons that can help people without problem mortgages from being sucked into the crisis.

    In the meantime, keep on Stretching those Dollars!

    Gary 

  • Readers' Digest.com

    It's always nice when The Dollar Stretcher is included in an article on how to save money. It's even better when the article is good. And better still when the article is published in a widely recognized source like Readers' Digest. Just found out that we're mentioned in the section on buying a new car. Lots of good links in the article. I'm sure that you'll find it helpful. You can find it here Get a Great Deal on Anything.

    Keep on Stretching those Dollars!

    Gary 

  • Stocks, Options and Futures Contracts

    Gary,

    I was wondering if you might be able to help sort out how futures and stocks and options etc work.  I'd like to get into investing but I'd prefer to have a little bit of an understanding before I sit down with an investment consultant--I'd prefer that the person teaching me not have a financial interest in which avenue I choose.

    Thanks!

    Don

    If Don wants to begin investing he will need to know the difference between stocks, options and futures. And, he'll need to know how they work. But chances are pretty high that he won't ever get involved in either options or futures.

    We'll begin by defining what each type of investment is and how they work. Starting with stocks. A stock is a share of ownership of a company. Let's create a simple example. Suppose you own a lemonaid stand 50/50 with your brother. You each own half of the lemonaid stand company. If there were 2 shares of stock, you'd each own 1 share. That share of stock would entitle you to participate in any cash distributions that the company made and also in any of the profits.

    A share of stock in any publicly traded company is the same thing. The only difference is that you have thousands of partners (not just your brother). Suppose you own shares of stock in the local electric company.  If they make a cash distribution (also known as a dividend) you'll receive your proportionate share of the distribution. If the electric company has profits that they don't distribute as dividends, then that money will increase the 'book value' of the company. That increased 'book value' should translate into higher prices for shares in the company that are bought/sold. The reason is simple. People are willing to pay more for a company that's doing well and making money. So you can benefit two ways from owning stock: dividend checks and an increase in share price.

    You can own stocks by purchasing shares in the company (typically from another investor using a broker & exchange, but occasionally from the company itself) or through a mutual fund (where a manager invests your money).

    So much for stocks. Next let's look at options and futures. Most investors never buy or sell an option or a futures contract. And, with rare exceptions, most investors never have the need to buy or sell an option or futures contract.The reason is that they're both designed for a specific purpose and most investors never get near that situation.

    An option is just what it's called: an option to buy or sell a specific number of shares of a specific company at a preset price until a specific date (a lot of specifics, huh?). For instance, it could be the right to buy 100 shares of Ford at $4 per share until October 17, 2008. The right to buy shares is termed a 'call' because you can 'call' for your shares. The right to sell shares is termed a 'put' because you can 'put' your shares into someone else's hands. Just because you own the option does not mean that you have to 'exercise' it. In other words, you could have the right to buy Ford shares at $4 per, but decide that you'd rather not. Typically that happens when they're selling on the exchange for less than $4. No sense exercising your call when you could buy them cheaper on the exchange if you wanted to.

    There are some situations where owning a put or call makes financial sense. But most investors will live a lifetime and never get into any of those situations. Some, however, will use options as a way to try to leverage their investment. Let's make up an example. Take our Ford call. Suppose that you thought that they were about to announce a major breakthrough in gas mileage. Something that could double their stock in short order. You don't need to buy the stock to bet on that announcement. All you have to do is to buy calls on the stock. Much cheaper than buying the shares. If the stock pops you exercise your calls and make a bundle. On the other hand, if the announcement doesn't happen or happens and doesn't move the stock, all you're out is what you paid for the calls. Not nearly as expensive as buying the stock and watching it decline when the expected move doesn't happen! Another way to make money on puts & calls is to buy and sell them before they expire. Because they have a limited life they tend to be much  more volatile that the stock that they represent.

    Now, some would argue that that's a legitimate reason to buy an option - to gamble on a short-term move without risking a bunch of money. And, to that extent, they're right. But, Don described himself as an 'investor' not a 'speculator'. There is a difference. A speculator is looking for the quick buck. Bascially gambling. If you're into gambling there's nothing wrong with that. But, an investor is looking for good companies that he/she would like to own a part of. Not the same thing.

    Futures contracts are somewhat similar to options. They're a contract that commits you to buying/selling a certain amount of a commodity at a set price on a specific future date. I believe that originally they were created for farmers that wanted to know for sure what price they'd get for their crop at harvest time. And, they work well in that situation. They can also allow large consumers (think cereal producers who use tons of product) to know what they'll pay for a commodity regardless of how big this year's crop is. In fact, one airline managed to lock in it's price for jet fuel for most of the past year because they had futures contracts at prices that were set up before the latest round of oil price jumps. Great use of futures. 

    But, for the individual investor there's not much reason to put a futures contract into your college fund or retirement portfolio. Unless you're like the farmer or the airline, the only reason that an individual would be involved is because they can leverage their money to make very large bets on price swings. Not that people don't make big gains (and losses) in the futures market. I recall back when I was a broker with Smith Barney in the 80's we had a commodities broker who claimed that he could teach anyone to make money buying and selling commodities. But, he told them up front that they'd probably lose about $40,000 in the learning process. In today's dollars that's probably 4 times as much.

    So for Don, it's really a matter of learning more about stocks. Unless he has some special needs or is looking to make a quick buck, there's no need to consider options or futures for his portfolio.

    Keep on Stretching those Dollars!

    Gary 

     

  • FADD?

    If you Google "attention deficit disorder" you'll get 3,150,000 returns. Leading the pack is the Attention Deficit Disorder Association. As near as I can tell, it was about 1980 when doctors first started talking about people who had "attention deficit disorder". Move forward a few decades to today and you'll hear the phrase frequently. Not only in relation to children, but also to adults. there are a variety of similar disorders and ways to describe it:  ADHD (A.D.D., ADD/ADHD, ADD-ADHD, A.D.D.) according to the add-adhd.org

    I think that it's time for a new designation: FADD. It will stand for Financial Attention Deficit Disorder. Hard to say how many people suffer from FADD, but based on my email and the headlines in the local paper it's a lot.  

    There are a variety of symptoms. An inability to see the financial consequences of a decision. The need for immediate gratification regardless of cost. The overwhelming desire for an immediate solution to a financial problem. These are the most common of symptoms. Let's look at them one at a time.

    Many people are inable to see the financial consequences of their decisions. In fact, that's why credit cards were invented. You can see FADD at work at malls and other places where people shop. Many who suffer with FADD begin with smaller items. It's not uncommon for them to spend an entire day at the mall shopping. Those suffering from advanced FADD will be carrying multiple shopping bags from various stores in the mall. Acute sufferers sometimes take purchases out to their car in the parking lot and return for more shopping. When challenged as to how they'll pay for their shopping sprees they can become dangerous. Be cautious approaching someone displaying this type of FADD behavior. They've been known to ridicule the financial status of people who don't share their urge to shop. 

    Another similar FADD behavior is the person who compelled to make a purchase now without thinking of the costs. Any time that you hear someone convincing themselves that they can afford the payments you're probably dealing with a case of Immediate FADD (or IFADD). It's unfortunate, but salespeople are prone to encourage FADD behavior. Initially people exhibiting this type of FADD limit themselves to small items and they make an attempt to delay purchases. Some IFADD victims are able to limit themselves to buying knives and costume jewelry on the shopping channel or internet. But most find their IFADD is progressive and they soon move to larger items. Most commonly they'll progress to electronics/appliances, then automobiles/boats/recreational vehicles and finally to overly large homes (sometimes known as "McMansions").

    The third most common symptom of FADD is the inability to pursue a long-range financial plan (sometimes known as LR-FADD). This sufferer requires an instant solution. The symptoms vary from case to case. In one variation victims are unable to save for the future. They're unwilling to put money away today for a need later. IRAs and 401k plans are especially vulnerable to the FADD sufferer although the symptoms differ. Someone with LR-FADD will be unwilling to fund an IRA ("I'll never live long enough so see the money"). If they have funded a 401k account (typically with an employer's encouragement), they'll borrow the money out to buy a car or to pay off other debts ("I'm only borrowing from myself"). 

    There are other very similar LR-FADD symptoms that can be hard to identify. In one strain the victim who is in debt because of his FADD behavior expects that any solution will be immediate and painless. Any solution to their debt problem that takes months or years will be rejected as taking too long and being 'impossible' to complete. Unfortunately in these cases, bankruptcy has been the only solution that's proven effective (and then only under supervision to prevent the victim from returning to previous FADD behaviors). 

    It's unusual for a FADD victim to recognize that they have a problem.  Usually it's up to a friend, loved one or financial advisor to identify the symptoms and suggest treatment. If you see someone you love exhibiting FADD approach them cautiously. While not prone to violence, they have been known to terminate long-standing relationships when confronted with their FADD symptoms by a friend, relative or co-worker. 

    Drug and alcohold therapy does not appear to work. Typically self-administered in moderate doses, only a very temporary reduction of symptoms is produced. And, in some cases, the patient can become agitated while self-medicating. Therefore drug and alcohol therapy is to be avoided.

    Counseling appears to provide the best opportunity for the FADD sufferer to recognize their condition and embark on a course to reduce or eliminate FADD symptoms. Many patients report that by studying their habits and seeking out alternative behaviors they can lead a normal, productive life. In a majority of those cases patients demonstrate no propensity to return to FADD behavior patterns. 

    Friends and relatives are encouraged to addess the topic of FADD with those who demonstrate the symptoms described. A non-confrontational approach emphasizing alternative behaviors is generally perceived to be the best method (sometimes called "informational therapy"). Suggesting written resources (like The Dollar Stretcher ) is often used as a first step. As with all interventions, care for the victim is paramount. Fortunately the new information therapies appear to be making a difference for many FADD sufferers and may offer great hope for the future.

    Keep on Stretching those Dollars!

    Gary 

     

     

     

     

     

     

     

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Gary is a former financial planner and purchasing manager who edits The Dollar Stretcher website <www.stretcher.com> and newsletters. You can follow Gary on Twitter.com/gary_foreman
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