Kamis, 27 Desember 2007

Is it better to save, or invest in your business?

A reader recently sent me this e-mail:

"My daughter-in-law wants to save, but cannot convince my son. He thinks that every dollar she tries to save would be better off going straight into his business.

She and I have talked about the importance of saving. I would love to show her the plan to save $1 million by the time she is a certain age. She is 34 now. How much per month will she need to save to reach $1 million by age 50 or 60?"

Figuring out how much to save per month to reach $1 million can be a good motivational tool, especially if someone is young. (In fact, I recently used it with my daughter.) But to get the reader's son onboard with a plan to put away some money for the future, it may work better to focus less on the potential reward of saving and investing, and focus on the potential risk of small businesses instead.

Not much motivation
The sacrifice required to reach $1 million by age 50 won't sway the son (or encourage his wife) to start saving. To reach that goal, the couple would have to sock away nearly $2,300 per month for the next 15-1/2 years (assuming a 10% average annual return, which you can get with a well-mixed portfolio of stock and bond mutual funds).

Waiting a decade or so makes the amount more palatable, but still tough to swallow: $725/month to reach a million by age 60, and $427/month to get there by age 65 (such is the magic of compounding). Doable, but still unlikely to convince Sonny Boy that the money is better off invested in stocks and bonds than in his own business-building skills.

Offsetting a huge risk
Which is where risk comes in. Investing solely in one's own business is a lot like investing in the stock of an individual company--except, if you're just starting out, even riskier. Many small businesses fail within the first five years (depending on the source, between 50% and 80%). The son may invent the next Google, but he may not. Saving money for the future to offset this huge risk isn't a comment on his business idea or abilities; it's good financial sense.

Come together on a plan
That said, my e-mail friend should encourage her son and his wife to sit down together and establish a concrete plan. It should have room for both saving for tomorrow and investing in the business, with well-defined and mutually agreed upon goals and definitions of success.

Since they are relatively young, the couple could put more money toward the business initially, with the caveat that they evaluate the return on their investment in a year or so. If the business is showing signs of progress, they may even be able to increase the amount they're putting toward both goals. If not, they could evaluate whether it's time to shut the operation down. Either way, the decision should be theirs--not his or hers.

Potential reward is the aspect many people consider first about investing, but don't forget about risk. Understanding your own comfort with it--as well as that of your spouse--can go a long way toward making you a wise investor.

Kamis, 13 Desember 2007

Federal Student Loan Consolidation

The end of the semester is always a useful time to remind people about options for consolidating federal student loans. A few starting points (general do’s and don’ts):

- You CANNOT consolidate until you graduate.
- If you consolidated in the past to take advantage of lower rates (good for you!), you CAN [and want to] reconsolidate assuming you have borrowed something since then.
- You CAN consolidate wherever you want – you are not required to use your lender even if they are your only lending source.
- NEVER consolidate federal loans with private loans (for those with private loans, I have a link in the resource section to provide information about refinancing them).
- ALWAYS shop around for the program that will best meet your needs.

The most commonly asked question is always where to do it. Keep in mind that as long as you are doing a federal consolidation loan (which is the only thing you should do), the only difference between the products are (1) who you are paying each month; and (2) the financial benefits the companies offer [or don’t offer]. Everything else about the loans (eligibility for deferment, etc.) are identical, the lender chosen won’t offer anything better than another. Those two items listed are the only real differences with one ‘new’ (as of October 1, 2007) exception which I’ll outline later.

For the vast majority of people, item one (who you pay) is obviously not a real big deal – whether I make my payment to Sallie Mae, MOHELA, Dept of Ed, Citibank, or anyone else doesn’t matter. The second item (financial difference in benefits offered) is really the primary criteria that should be used in evaluating loan consolidation offers. How you look at the products is based upon how you intend to repay your loans.

If you plan to repay your debts quickly (2 years or less).
Find the program that offers the largest “up front” (principal balance) credit. Key Bank used to offer a 5% principal balance credit; I’ve been told this is still available, but it is not listed on their website, so you’ll want to do some homework. I’ve never seen a principal balance credit larger than this.

If you plan to repay your debts over time (graduated/extended).
If paying over time, an upfront benefit will be much less meaningful than a reduction in your interest rate. There are two states that currently offer the most substantial interest rate incentives. New Hampshire (which is open to anyone) offers a .5% reduction for auto payment, an additional 1% reduction when repayment begins, and a $250 principal balance reduction after 12 consecutive on-time payments (so the total rate benefit is 1.5%, given on day one). North Carolina offers a slightly larger benefit (2.25%), but the benefit is provided in a tiered fashion over time (.25% reduction for paying automatically; .5% additional interest rate reduction after 24 on-time payments, .5% additional after 12 more months (36 total), and 1% more after 12 more months (48 total) – 2.25% total rate reduction after 4 years). Obviously if I’m planning on repaying my debt in ~5 years, a program like New Hampshire where that benefit is immediate would serve me better than a principal balance credit and will also serve me better than a program like North Carolina where I have to wait 4 years to fully realize the benefit. North Carolina is going to best serve those intending to utilize an extended repayment (12+ years) option. North Carolina does require people to have a “state connection” in order to utilize their program. The easiest way to create that connection is to open up a 529 college savings plan for a child, sibling, niece/nephew – you can do so online in about 5 minutes with as little as $25. Once that is opened, you then have your connection and are eligible for their State Consolidation program.

I mentioned above that there is one exception where I would not consolidate with a company offering the best financial incentives – that case would exist if I am being hired [and plan to continue working] as a “public service” professional. The best working definition I’ve seen is at http://projectonstudentdebt.org/2669_forgiveness.vp.html (is still being crafted). If I fit this definition, then I am the “potential” exception. An example of who this new program would serve is a student that just completed a graduate program in a field like social work; has a high level of student loan debt working in a field where their salary will never likely dramatically increase over time. This is the prime person for this program. How it works: Consolidate with the Department of Education (ONLY scenario where consolidating with the Dept of Ed will make financial sense) and select the income sensitive repayment. After 10 years of payment, the remaining balance will then be forgiven [you’ll be responsible for taxes on the forgiven amount, but the remaining loan amount will be wiped away]. This scenario is ONLY available if you use the income sensitive repayment option and ONLY if you consolidate through the Dept of Education. Even if I am a public service employee, if my debt level will not require me to repay my debt over more than a 10 year period, I will be better served by one of the other programs previously outlined!

Additional Resources.
Accessing your Federal Loan Info
OFS Consolidation Resources (Weighted interest rate calculator, repayment plan information, payment calculator, and other resources)
Private Loan Consolidation (READ PRIOR TO DOING – often not smart)

Kamis, 06 Desember 2007

Mortgage bailout is the object of my ire

Ok, I know it's been a while--more than three months since my last post. In that time, I've welcomed a new daughter into the world, passed another test on my way to a Chartered Financial Consultant designation, and scrambled to find and buy a replacement car for my Sentra, which unexpectedly died on the Pa. Turnpike. So I've been busy.

What prompted me to write today? Outrage. The culprit? The Bush mortgage bailout plan. It's even made me do something that I've never done before: write to my congressman and senators. (That would be Jim Saxton, Frank Lautenberg, and Bob Menendez--and you didn't even think I knew who they were, did you, Dad?)

Wish I had the government in step in to freeze the rate on the ARM I took out on my first house back in 1999, when I didn't know any better. Would have been nice to pay the low initial rate I got for an extra five years.

Better yet, wish M and I had used an ARM to buy that oh-so-nice $464,000 house we looked at a few years ago. We knew we could never afford it with a fixed-rate mortgage on our five-figure income. What were we thinking? We could still be living there, sitting pretty with an affordable rate until 2012. And who knows, by then I could have turned this blog into a money-making machine, become CEO of my company, or hit the lottery, so we could afford the payments when the rate resets then.

One anonymous poster on Real Time Economics sums up my feelings about the Bush plan pretty well, plus gave me a chuckle:

"I would like the government to help me out with my gambling debt in Vegas. The casino didn’t explain the rules very well. And I didn’t realize that the house had the advantage. I would like my life savings back. If you could just give me a little more time, I think I could win it all back. Please help me!"

Shhhh, anonymous...Don't give Washington any more bright ideas.

Credit Cards ('Risk-Based Re-Pricing')

Congress has been talking about revising current regulations surrounding credit cards for several months now. Some members of Congress are being very vocal about current practices in the credit card industry (practices described by one critic as “abusive and confusing”). You’re likely aware of one common practice referred to as ‘universal default clause’ – a provision in a card agreement that enables the cardholder to raise your rate if you miss a payment to anyone [doesn’t need to be that particular card]. Universal Default is a concept I’ve outlined in prior tips on card management.

Earlier this week I read about a Senate subcommittee scrutinizing a newer practice that was being called “risk-based re-pricing.” Ultimately, this takes universal default one step further. The idea behind universal default was to raise the interest rate because of the increased risk placed on the card company; with risk-based re-pricing, rather than raising rates due to missed payments, rates can be raised in any circumstance where your credit score is lower than it was when they initially gave you the card. Keep in mind that 30% is commonly the rate charged when one’s rate is raised! Obviously the high rates were of concern to the subcommittee, but they were also concerned about consumers having little notice of the increased rate [often automatically triggered by unexplained declines in ones credit score]. In some cases, merely opening another account (i.e., dept store card) triggered the downgrade in credit score … One of the curious cases cited was a consumer that had four credit cards from the same company (the argument is that she should have similar rates based upon this type of model); her current interest rates: 8%, 14%, 19%, and 27%.

My opinion – legislative change often never occurs; I wonder how much of this “conversation” is in hopes that the credit card companies will change questionable practices on their own prior to changes in law. Not a bad start. Citigroup and Chase recently have said they will discontinue the practice (Citigroup has already stopped) and Chase will take effect in March. We’ll see if others follow suit.

What are legislators seeking? Ultimately, everything I’ve read really boils down to two requests:
(1) Clarity for Consumers. The Truth in Lending Act [specifically Regulation Z] is designed to promote consumer awareness of loan terms. The argument on the part of consumer advocates is that credit card billing and interest rate practices are much too complex for an “average” person to understand. The proposed rule change would require card issuers to ultimately redesign card applications and solicitations [enhancing disclosures] providing clearer [more easily understandable] information on fees.

(2) Mandatory Notification. The second item currently being requested would require card companies to give its customers at least 45 days notice before ‘penalty pricing’ (raising rates).

Additional Resources.
- AP Article: Credit Card Execs Defend Rate Policies
- Truth in Lending Act