Get Financially Fit!

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I was talking with a friend the other day and he asked me if it was better to pay off the mortgage first or focus on retirement savings.  My personal preference is to save 15% toward retirement savings and then use incremental money to pay off your house.  My post titled, Create a financial plan, outlines my 10 recommended steps to retirement security.

If you have incremental money to put toward your mortgage here is a strategy to pay off your mortgage in half the remaining time of your loan.  In brief you create an amortization table and double up on principal payments.  The accelerated payment method that I’m describing worked for fixed loan mortgages. 

Step one of the process is to create an amortization schedule for your mortgage.  An amortization schedule details your principal and interest payment for each month.  I found a good amortization calculator at Bankrate.  Simply enter the loan amount, number of payment periods (in years or months, the interest rate, and the starting date of the loan.  The calculator will calculate both your monthly payment and the principal and interest payment for each month.  The Bankrate calculator also has the option of adding an incremental payment each month, adding an incremental payment each year, or adding a one time payment. 

To cut your mortgage payment time in half, simply send an incremental payment each month that matches the principal payment corresponding to the month that you are in.  Here’s an example:

Loan amount:  $200,000
Loan term:   30 years
Interest rate:  6%

The calculator determines that your monthly payment is $1199.10

In the first month, $199.10 goes to principal and $1000 goes toward interest.  In month 1 then send in an incremental $199.10 and your loan duration will shrink by an incremental 1 month. 

In the second month $200.10 goes to principal and $999.0 goes toward interest.  In month 2 send in an incremental $200.10 and your loan during will shrink by an incremental month (your loan will now end two months earlier). 

In an alternative scenario if you are 10 years into this same loan and want to begin this process, the incremental payment would be $341.20.  Simply print out the amortization schedule and begin paying the principal payment amount. 

The great thing about this recommended process is that you can send in incremental money and quickly determine the decrease in the loan term.  One way to apply this process is to print out the amortization schedule for your mortgage.  Whenever you send in an incremental principal payment for the current month then you cross off the last month on the schedule.  This has the benefit that you can visually see the the progress that you are making toward eliminating your mortgage.

One of my  motivations for writing this post is to warn you off of expensive software packages ($1000 to $5000) that supposedly help you pay off your mortgage faster.  You are much better off putting that money toward your mortgage payment. 

Follow your dreams, Achieve your goals! 

Help others!  Spread the challenge to Get Financially Fit!   

 Little things done well over and over are far more important
than spectacular achievement done every once in a while.
-Richard Quick

What are the best and worst financial decisions that you’ve made?  I’m sharing my best and worst financial decisions to encourage you to focus on your next improvement step. 

The best personal finance decision that I have made was contributing to my 401k from a young age.  The worst personal finance decision was not putting down 20% on a real estate purchase.    

In my last year of college, I took an engineering economics course.  In this class I learned about the importance of investing early for retirement.  For example, if you invest the same amount of money over time into the stock market, half of your final portfolio will come from the contributions that you made during the first 7 years.  This is because after 7 years your portfolio will earn returns equal to your contributions. 

When I started working I worked with an engineer who was 10 years older than me.  He educated and coached me on the importance on starting 401k investment.  He regretted  that he didn’t start his 401k contributions immediately.  I pass along the challenge to everyone to both start retirement savings as early as possible and contribute as much as you can.  At this point in my life I can see the benefits of starting retirement savings from a young age.   

The worst decision that I ever made was purchasing real estate without putting down a 20% down payment.  I wanted to own real estate so bad that I purchased a condo with only 5% down.   A key lesson that I learned is to be patient and save sufficiently.  I wish I could have learned my lesson from reading about it versus paying expensive tuition.   

Whatever your best and worst personal financial decisions,  I believe we can all make significant improvement by by focusing on continuous improvement.  I encourage you to focus on the following question:  What next action can I take to day to improve my personal finances?   To help you get started in improving your personal finances, I am sharing worksheets and templates from my book, Get Financially Fit! 

Goal Setting Templates  Goal-Setting-Template.pdf
   Related article:  Write down your goals
 
Financial Steps Financial-steps.pdf
   Related article:  Create a financial plan

Financial Fitness Survey  financial-fitness-survey.pdf
    Related article: Take the financial fitness test

Debt Elimination Debt-Elimination-Worksheet.pdf
   Related article: Eliminate Debt

Follow your dreams, Achieve your goals!

A Roth IRA is a great retirement savings vehicle. Money is invested with after tax dollars and grows tax-free. When you withdraw your money in retirement you do not pay taxes. Let’s review income limits, contribution limits, and the easiest way to get started.

Individuals are allowed to invest $5000 in 2008 (if you are over 50, you can add an additional $1000) as long as their adjusted gross income is less than $101,000. The adjusted gross income is shown on line 4 on a 1040EZ tax form, it’s on the bottom of page 1 for a regular 1040 form. If you make between $101,000 and $116,000 the allowed contribution is gradually phased out. Above an adjusted gross income of $116,000 a Roth IRA contribution is not allowed. A married couple can invest $5000 each as long as the combined adjusted gross income is less than $159,000. Above an adjusted gross income of $169,000 the allowed contribution is phased out. If you exceed these income limits then you can invest in a traditional IRA.Starting a Roth IRA is easy.

The easiest investment option for starting your Roth IRA is to use a lifecycle retirement fund.  All that you need to do is identify the year that you want to retire.   For example if you want to retire in 2035, you would invest in a 2035 lifecycle retirement fund.  Lifecycle retirement funds automatically transitions from a high percentage of stock market investments  (typically 80% stocks for young investors) and transition to a balance of 50% stocks and 50% bonds.  Your main job is to add money, the fund automatically takes care of the asset allocation (the mix of stocks and bonds).  Recently most lifecycle funds have added a small percentage of international investments.   

To get started simply contact a low expense no-load mutual fund company (such as Vanguard or Fidelity) by visiting their web site or by telephone.  I like Vanguard and Fidelity because they use low cost index funds in their lifecycle retirement funds.  Vangaurd calls their lifecycle retirement funds Target Retirement Funds and Fidelity call their the Freedom Funds.  

I really like and recommend lifecycle funds for retirement because I think it’s most important for people to get started with retirement savings.  The next most important tasks are increasing the savings rate and then evaluating if you want to take a more proactive role in choosing index and no-load mutual funds.

Follow your dreams, Achieve your goals!

A small house can hold as much happiness as a big one.
         –Chinese Proverb

Purchasing and owning a home is a cornerstone of the American Dream.  This dream is poignantly captured by a recent quote that I heard from a woman,  “My dream is to own a small yellow house with a blue door; every other Sunday I will have my family and friends over for dinner.”  The fulfillment and benefits of owning a home can be significant. For example, when you own a home, you experience an increase quality of life from both having housing stability and having your own safe retreat from the stresses of life.  Buying and owning a home does have its risks and pitfalls though. For example, it’s important that you don’t overstretch yourself with too much house.

I recommend that you implement the following strategies to maximize your success with buying and owning a home:
1. Be patient and selective in your home choice.
2. Make a significant down payment.
3. Finance with a fixed mortgage.
4. Purchase a home appropriate for your income.
5. Build increasing equity in your house.

Let’s review these points one at a time.

Be patient and selective in your home choice.
Most people desire to minimize the frequency of buying and selling houses to minimize both transactions costs (real estate and mortgage fees) and the significant amount of work required to move. I recommend that you treat buying a house as a significant project. When making any significant purchase it’s best to clearly list out your requirements and preferences and take adequate time to make a wise purchase.

Clearly defining your purchasing musts and wants will prevent you from buying a house that doesn’t meet your needs. List out important factors such as the number of bedrooms, number of bathrooms, single or double story, proximity to your work place, size of garage, and of course price. Then define each factor as a must or a want. If you are married, I recommend that requirements and preferences are listed individually and collectively.

When you are in the process of buying a house, you will likely experience pressure from both real estate agents and mortgage brokers to proceed quickly. You may hear comments such as, “This house won’t last long at this price” or “You should move to lock in these interest rates.” This occurs when these people prioritize their interest of making money ahead of your interest of making the right purchase. I recommend that you ignore these pressures and take the time to be confident in your purchasing decision. When my wife and I purchased our house we took nine months to buy. By the time we purchased we knew exactly what we wanted and the fair market value of homes for sale.

Make a significant down payment
We are currently going through a national housing price correction that reminds us that putting no-money-down is a bad strategy. No-money-down mortgages are appealing because the enables people to get into a house, but can be painful when real estate values decline and people need to sell their house. I recommend that you make a 20% down payment on your house. At 20% you do not have to pay mortgage insurance (mortgage insurance is insurance paid by the borrower but provides protection for the lender). Of course, another advantage of paying 20% down is that your mortgage payment is lower. This is important because, many people underestimate increased expenses associated with owning a house. For example, you may need to pay for landscaping your yard, you may purchase furniture, and you may make home improvements.

Finance with a fixed mortgage
Traditionally most mortgages were sold with a fixed interest rate. This means that the interest rate charged (and thus the payment) was the same over the loan period. There has been a dramatic increase in the sale of adjustable rate mortgages. There are a wide variety of adjustable rate mortgage, but the most common ones have a period of time where the interest rate is fixed (five years for example), and then the interest rate changes annually based on the prime interest rate. If you are confident that you will be in a home for only five years, an adjustable rate mortgage may be appropriate. People are attracted to adjustable rate mortgages because the initial low interest rates enable them to purchase more house. The dilemma with adjustable rate mortgages is that if interest rates increase then your payments increase accordingly. Given that the majority of people don’t get a pay raise when interest rates increase, it’s more prudent to buy with a fixed interest rate. I recommend purchasing a house with a 15 or 30 year fixed mortgage. Be sure to compare the costs and rates of a mortgage from three different lenders.

Purchase a home appropriate for your income
Owning a home should bring fulfillment into your life; not increased stress. Banks and mortgage companies evaluate two ratios to determine your maximum mortgage. If you have no debt then the mortgage payment can be 28% of your gross income. The limit of your mortgage payment plus other consumer debts is 36%. For example, for a monthly income of $3000 the maximum mortgage would be $840 per month. If your income is $3000, you have an auto loan for $250, and a student loan for $200; then the maximum mortgage would be $630.

It’s important that you don’t take on too large of a mortgage. You will want to have incremental money for retirement savings, building up your rainy day fund, and sustaining a desirable quality of life. Before you purchase a home, mimic making a mortgage payment by saving the difference between your rent and the anticipated mortgage payment.

Build increasing equity in your house
In time, you will likely build equity in your house from the value of your house increasing, from improvements that you make, and from your mortgage principal decreasing in time. I recommend that you resist the temptation to take out home equity loans. I think that it’s a good idea to continuously improve your home over time. If you are energetic and skillful you may choose to make many improvements, if you hire professionals then you may initiate an occasional improvement. Home improvements provide an immediate increase in your quality of life. The long-term benefit of making improvements is that you should be able to sell your house easier if necessary. Home improvements typically don’t have full immediate payback, thus it’s best to limit the amount that is financed by a home equity loan.

Life Application
The next time that you purchase a home: slow down, enjoy the process, and make a great decision for your household. I recommend that you put down 20%, use a fixed interest rate mortgage, and limit your mortgage payment to 20% of your take home income. Once you own a home, continuously build equity by both avoiding equity loans and continuously improving and updating your home.

Follow your dreams, Achieve your goals!

When investing, the majority of people don’t evaluate the significant impact of investment expenses over time. There are three classes of mutual funds relative to expenses; index funds, no-load managed mutual funds, and loaded mutual funds.

Index funds are designed to mirror major market indices such as the Wilshire 5000 (the largest 5000 US Corporations) or the S&P 500 (the largest 500 US corporations). The most common index that you hear quoted daily is the Dow Jones Industrial (which tracks 30 large Corporations).

One key feature of an index funds is that the ownership of different shares is proportion to the market value of each corporation. This is to say that the Wilshire 5000 index invests a lot more in large corporations such as Exxon and Microsoft, and a lot less in a small growing company such as Starbucks. Index funds are self-correcting in that they will increase investments in winning companies like Microsoft and Starbucks and divest from tanking companies such as and Enron and WorldCom. Given that these adjustments occur daily, an index fund investor can sleep soundly knowing that they don’t have to worry about the performance of individual stocks.

The most significant advantage of index fund investing is the low expense ratio fee. The average managed mutual fund has an annual expense ratio of 1.35%, while index fund expense ratios from low cost mutual fund companies such as Vanguard and Fidelity are 0.2%. This represents a 6X reduction in cost from the typical mutual fund- this is like buying a $30,000 car for just $5,000.

Managed mutual funds differ from index funds in that the fund manager attempts to beat the index by picking a portfolio of stocks. In the long-term, less than 20% of managed funds outperform index funds; therefore the risk with managed funds is that 80% of the time you will end up with lower performance plus higher expenses. Average expense on a no-load managed fund is 1.35%, but can range from 0.4 to 2% depending on the specific fund. I recommend that you only purchase managed funds that have outperformed their comparative index for last 3, 5, and 10 years.

Loaded mutual funds charge an upfront sales fee of 3% to 6% and have annual expenses that range from 1 to 2%. The upfront sales fee is charged to provide a commission to the salesperson. For example, a 5% load fee means that only $95 out of every $100 is invested. I recommend that you NEVER invest in loaded mutual funds since a portion of your money is confiscated.

The following graph shows the impact of expenses when investing $100 per month over 30 years. In this calculation different levels of fees are applied to average annual historic stock market returns. In reality the returns for different mutual funds vary and 80% of managed funds do not achieve average market performance. The black dashed line represents a portfolio without fees.

The impact of expected returns based on the expense ratios and upfront fees is quite dramatic. Examine the difference in the expected return at 30 years of each portfolio versus the benchmark index. The expenses of an index fund only absorb 4% of the portfolio potential, while the expenses of a loaded fund confiscates 35% of your portfolio potential. A mutual fund with a 1% expense ratio eats into 17% of your portfolio. Many investors do not notice the impact of fees until their portfolios are large. I recommend that you think with the end portfolio in mind. Employ low fee mutual funds all of the time to maximize your nest egg.

Follow your dreams, Achieve your goals!