Author: Susie Q

Diversification: Don’t Get Misled by these Charts

Diversification: Don’t Get Misled by these Charts

Diversification is an important component of any investing plan.  It assists you in limiting your risk either to a single asset class or a single security within an asset class.  However, I have seen a couple of graphs from which you could form the wrong 

Why I Don’t Hold the All Seasons Portfolio

Why I Don’t Hold the All Seasons Portfolio

The All Seasons Portfolio reports amazing statistics about its returns.  I’d never heard of the All Seasons Portfolio, so had to check it out.  As I’ll discuss in more detail, it is an asset allocation strategy with more than 50% of the portfolio allocated to 

Selecting Stocks with a Score

Selecting Stocks with a Score

A friend of mine really likes selecting stocks with a score, the Piotroski score in particular.  Briefly, Professor Piotroski created a set of nine financial ratios that contribute to the score. If a company meets a certain criterion and has favorable results on 8 or 9 of the ratios, his analysis indicates that the company’s stock is likely to do well. My friend is primarily a value investor. The appeal of the Piotroski score to him is that it focuses on value stocks and, while it relies heavily on statistical analysis, it isn’t a black box.

In this post, I’ll identify the group of stocks to which the Piotroski score applies. I’ll then briefly explain the financial ratios that determine the score. I’ll close with a specific example of a stock I bought solely using the Piotroski score and provide some general guidance on applying the results of the score.

Book-to-Market Ratio

What is It?

The book-to-market (BM) ratio is a financial ratio. The numerator is the book value of the company. This value is shown on the balance sheet in the company’s financial statements and is usually reported as “Shareholders’ Equity.”

The denominator of the ratio is the total market value of the company on the evaluation date as the financial statements. The total market value is the stock price multiplied by the number of shares outstanding and is also called the market capitalization.

In mathematical terms,

BM Ratio = Book Value divided by Market Capitalization

Piotroski waits for the financial statements to be published for a particular year end to get the book value. He then looks up the market capitalization on the evaluation date of the financial statements for use in the ratio.

Piotroski’s Criterion

In his paper, Piotroski identifies value stocks as companies that have BM Ratios in the highest quintile (highest 20%) of traded stocks. These stocks have high book values relative to their market capitalization. Looked at from the other perspective, these stocks have low market capitalizations (and therefore low stock prices) relative to their book value.

Recall that the book value is the company’s assets minus its liabilities. In theory, if the company were liquidated on the evaluation date of the financials, shareholders would get their portion of the Shareholders’ Equity, based on the proportion of shares owned. Therefore, a BM ratio of 1.00 means that the market capitalization of the stock is equal to the Shareholders’ Equity.

By comparison, the cut-off for the highest quintile of BM ratios[1] across all stocks reported in the ValueLine Analyzer Plus on May 29, 2020 is 1.47. The book values per share of these companies are almost 50% higher than their stock prices!   You can see why Piotroski might consider these stocks to be potentially good values at their current prices.

Why Might It Be High?

There are at least two reasons that the BM ratio might be high.

First, the market may perceive that either assets are overvalued or liabilities are undervalued. Both of these situations would cause the reported book value to be higher than its true amount.

For example, some companies have not fully funded their pension plans. That means that the estimated present value of the future pension benefits is more than the liability on the balance sheet. Companies disclose these differences in the Notes to Financial Statements. If the liability for pension benefits is understated, it will cause the company’s book value to be overstated.

Second, financial theory tells us that the market value of a company’s stock is equal to its book value plus the present value of future profits. If the market perceives that the company is unlikely to make money in the future, the market capitalization will be less than the book value.

The Piotroski score focuses on companies in the second category. That is, it attempts to identify companies that will be profitable in the future from among all of the companies that the market thinks will have negative future profits.

Piotroski Score

The Piotroski score is calculated as the sum of a set of 9 values of 1 or 0. There are 9 criteria in the calculation, in addition to the BM ratio being in the highest quintile. The process assigns a 1 if a company’s financial statement values meet each criterion and a 0 if it does not. As such, companies that meet 8 or 9 of the criteria are considered more likely to have above market average performance.

The 9 criteria are listed below:

  1. Return on assets (ROA) = Net income / Total assets at beginning of year > 0
  2. ROA this year > ROA last year
  3. Cash flow from operations > 0
  4. Cash flow from operations > net income
  5. Long-term debt / Total assets this year < Long-term debt / Total assets last year
  6. Current ratio this year > current ratio last year
  7. Shares outstanding this year <= shares outstanding last year
  8. Gross margin this year > gross margin last year
  9. Total sales / Total assets this year > Total sales / Total assets last year

Piotroski performed his analysis using data from companies’ financial statements from 1976 to 1996. The average of the one-year returns for the companies with scores of 8 or 9 was 7.5 percentage points higher than the average for all companies with high BM ratios and 13.5 percentage points higher than the average for the market as a whole.

How to Calculate It

If you are familiar with reading financial statements, you can calculate the Piotroski score yourself using the formulas above. Or, you could extract the key ratios from a source, such as ValueLine, Tiingo or Bloomberg, all three of which require subscriptions. I use the latter approach as I have a subscription to ValueLine that I use for a variety of purposes.

An easier option is to use a Piotroski calculator or screener.   I’ve never used any of these tools, but I used Google to find a couple free options you might try.

  • Old School Value – This Excel spreadsheet will calculate and show you how a company does on each of the 9 tests and the total score.
  • ChartMill – This screener lets you identify stocks based on their Piotroski score. As such, it helps you find stocks with scores of 8 or 9, but does not show you the details of the underlying calculation.

I suggest being careful to check the documentation of any of these tools to make sure that the descriptions of the 9 tests are the same as I’ve included above (which I took directly from Piotroski’s paper). In poking around on-line, I found more than one site that did not correctly specify the nine tests.

My Experience Selecting Stocks with a Score

Although I’ve looked at stocks using the Piotroski score several times, I’ve made only one purchase using it as my primary buying criterion. I purchased FUJIFILMS (FUJIY) in March 2012. At the time, FUJIY had a BM Ratio of about 1.40, as compared to a market average BM ratio of about 0.5. It had a Piotroski score of 8, having failed the test for an increase in gross margin.

For many, many years, FUJIY’s biggest product was film for cameras. With the advent of the digital camera, its market shrank rapidly. In the year before I purchased the stock, its price decreased by 32%. As I was looking at the company, it was transitioning its business from camera film to other types of related products, including medical imaging and, more recently, office products with its purchase of Xerox. With a good story and a high Piotroski score, I decided to buy the stock.

It turns out I was a little early in buying the stock. In the 12 months after I bought the stock, it decreased by 19% while the S&P 500 increased by 13%. However, if I had bought it a year later, my total return would have been much better over both the short and long term, as shown in the table below.

Total Return starting in March 2013
1 Year2 YearsUntil June 2020
FUJIFILMS+51%+84%+171%
S&P 500+22%+36%+110%

 

So, even though my returns were lower than the market average because I bought the stock too early in the company’s turnaround, I correctly decided to keep it after its first year of poor performance. That is, if I had sold the stock one year after I purchased it and bought an S&P 500 index fund, I would have been worse off.

Caution

As with any investing strategy, it is important that you understand the assumptions underlying the Piotroski score. I also recommend that you understand the story behind the company you are considering for investment, as described in my post on buying stocks based on their financial fundamentals. There are companies that may have a Piotroski score of 8 or 9 that don’t have a good turn-around story, such as the one I described for FUJIY. In those cases, you may not want to rely solely on the Piotroski score.

 

[1] Calculated in this case as Book Value Per Share at most recent fiscal year end divided by Price on May 29, 2020, so not exactly equal to the ratio as calculated by Piotroski.

Picking Stocks Using Pictures

Picking Stocks Using Pictures

Technical analysts select companies for their portfolio based on patterns in stock prices.  That is, it allows them to enhance their process of picking stocks by using pictures. This approach is very different from some of the others I’ve discussed, as buy and sell decisions 

How to Buy Life Insurance

How to Buy Life Insurance

Choosing the right type of life insurance policy and its death benefit can be confusing. Not too long ago, I published a guest post from Baruch Silverman of The Smart Investor on the different types of life insurance. In this post, you’ll learn how to 

Do I Need a Financial Planner?

Do I Need a Financial Planner?

Creating your own financial plan can be a daunting task. If you aren’t sure where to get started or have a plan but want to improve it, a financial planner might be able to help. I’ve never used a financial planner, so I interviewed two friends who use a planner and Graeme Hughes[1], The Money Geek, to get their insights and perspectives.

In this post, I’ll first distinguish financial planners from other types of financial advisors. The rest of the post provides responses to questions asked by a few of my readers to help you with the following:

  • Figure out whether and how a financial planner can help you.
  • Prepare for your first meeting with a financial planner.
  • Understand the process for developing a financial plan and the deliverables.
  • Select a financial planner who meets your needs.

Financial Planners vs Other Financial Advisors

There are many types of advisors who can help you with your finances. In this post, I’ll focus on professionals who provide financial planning services. These professionals can be independent advisors, work for firms that perform solely financial planning services or can be employed by mutual fund companies, stock brokerage firms (e.g., Schwab or Morgan Stanley), other financial institutions (e.g., Ameriprise) or other types of firms (e.g., accounting firms). Most of these financial planners provide a brand range of services intended to assist you in creating a sound financial plan and attaining your financial goals.

Types of Other Financial Advisors

There are many other types of financial advisors, some of whom may be called financial planners, who specialize in segments of your financial plan. Examples of these advisors include:

  • Insurance agents who can assist you in finding the best insurance policies to meet your needs. Some insurance agents specialize in just property & casualty lines (such as residences, cars or umbrella policies) or health or life insurance or annuities, while others can assist with several or all types of personal insurance.
  • Stock brokers who provide advice about specific companies or financial instruments in which you might want to invest.
  • Money managers who make decisions about what to buy and sell in your portfolio and execute the transactions.
  • Debt consultants or consolidators who can help you find the best strategy for paying off your debts.
  • Tax accountants and tax lawyers who can provide advice about your tax situation and how it might impact your financial decisions. Tax accountants can also prepare your tax returns.

What’s Best for You

You’ll want to choose an advisor who has the right expertise to address your questions. If you want help with your overall financial plan, a financial planner is best. If you go to an advisor with a narrower focus in that situation, you might not get the best information for your overall financial health. For example, an insurance agent who specializes in life insurance and annuities would be less likely to focus on non-insurance savings mechanisms, such as 401k’s or exchange-traded funds, than a financial planner with a broader area of expertise.

To be clear, all of these types of advisors can be very valuable in refining your financial plan, but you’ll want to make sure you have the right expectations about their expertise. In fact, your financial planner may refer you to one or more of these consultants on a specific aspect of your financial plan.

What Services do Financial Planners Provide?

The primary service provided by a financial planner is the development of a sound financial plan. This process can include assistance with setting financial goals, budgeting, estate planning, retirement planning, selection of insurance coverages and investment strategies.

The specific services provided will be tailored to your needs. If you are just getting started, the financial planner may focus on identifying goals and creating a budget. If you already have a financial plan and want increased comfort that you will meet your goals, these services could be as sophisticated as statistical (Monte Carlo) modeling of your future financial situations under a wide range of assumptions regarding future investment returns.

As part of or before your first meeting, a good financial planner will ask about the current status of your finances and what your goals are for deliverables to make sure the planner helps you in a way that makes sense for you.

Do I Need a Financial Planner?

Using a financial planner is a matter of personal preference. I’ve never used one, but my background as an actuary and working with the finance and risk management departments of insurance companies has given me the confidence to go it alone. However, most people can benefit from good advice. As Graeme says, though, “You only need to be careful not to pay for more than you need.” His thoughts about the services you might want to use by age are:

  • A young person starting out might get counseling on budgeting, savings strategies, how much to save, and which tax-advantaged accounts to use.
  • Middle-aged individuals with more substantial savings ($100K+) might want to get an assessment of where they stand for retirement and how much to save to meet their retirement income goals, considering all of the resources at their disposal.
  • Pre-retirees (5-10 years out) will want to have a comprehensive plan to ensure they have adequately covered all likely scenarios, so they can be confident in their retirement plans before pulling the plug on work.

If you have enough assets for it to matter and aren’t highly confident you are on track to meet your goals or you suspect there are gaps in your knowledge, a professional financial planner can help.

For a different perspective on using a financial planner, check out this article from Schwab that I happened to read as I was writing this post.

What Will I Get?

Primary Deliverable

The most important deliverable from a financial planner is a financial plan. Depending on where you are in the process of managing your finances, it will include some or all of the following items:

  • Your financial goals
  • A statement of your current financial position (assets and debt)
  • A budget
  • Your savings strategies and actions, including
    • Short-term savings
    • Designated savings
    • Retirement savings, sometimes including investment advice
  • A plan for re-paying your current debt
  • Guidance about the types and amounts of insurance to buy, along with descriptions of your current policies
  • A brief description of your income tax situation
  • Guidance on what needs to be done to ensure that the legal documents are in place in case you become incapacitated or die

Other Deliverables

In addition, financial planners can provide longer term projections that show estimates of the growth in your income, assets (from investment returns and additions to savings) and expenses. These types of projections can provide insights about your ability to retire when and in the style you want.

Another benefit of working with a financial planner is that you can get referrals to other advisors and can become aware of other financial resources to help with different aspects of your financial life. For example, most financial planners do not draft legal documents, such as wills, trust agreements or powers of attorney. Many financial planners, though, have worked with lawyers who have this expertise and can provide you with a referral.

How Should I Prepare?

All financial planners have their own unique processes. As such, you’ll want to ask your planner the format of the information he or she would like to see. Many planners will provide you with a questionnaire and/or an information request to guide you through the process of compiling your information. Nonetheless, there are a number of fundamental pieces of information that every financial planner will request. They are your:

  • Assets, including retirement accounts
  • Liabilities
  • Income
  • Monthly expenses
  • Current or future defined benefit pension benefits
  • Financial goals
  • Values

Graeme was quite clear that the numerical values above should be firm, accurate numbers, not guesses. It will take some time to compile all of this information, but will ensure that you get the best service from your financial planner. He also added that you should “run away” from any planner who makes recommendations before obtaining this information.

What is the Process?

You are likely to meet with your financial planner once or twice to create or refine your financial plan initially. Some planners prefer to learn about your finances by reviewing documents and answers you provide to their questionnaires. Other planners prefer to have an introductory meeting to learn about you and your finances. In either case, the financial planner wants to learn your objectives and concerns, along with your family structure.

The financial planner will then assess your situation and goals, identify gaps and challenges, and determine the most appropriate strategy for ensuring your goals will be met. The planner will prepare a financial plan and an investment plan, including an asset allocation assessment for investments, and provide them to you in writing.

Your financial planner will then meet with you in person to present the plan and make recommendations. You and your planner will then identify the action items that come out of the plan and assign them to either you or the planner, depending on their nature and your planner’s areas of expertise.

How Often Should I Check Back In?

Financial planning is not a “one and done” exercise. You’ll want to track your progress against your plan and adjust it as necessary. Adjustments might be needed as there are changes in the economy and investing markets or changes in your personal life, such as marriage, a death in the family, children, or a change in your goals.

If both your life and the economy are fairly stable, once a year may be often enough to meet with your financial planner. More typically, you’ll want to check in with your financial planner twice a year. Of course, if you have any life changes, it will also be a good time to check in with your financial planner to see if any tweaks or more significant changes to your financial plan are indicated.

How are Financial Planners Paid?

There are a number of different ways in which financial planners are paid. Here are some of the more common options.

No Charge

If you use a financial planner at a brokerage firm or mutual fund company, you can often get some financial planning services at no charge. The more money you hold at the brokerage firm, the more services you can get at no charge.

Fixed Fees Per Service

Many independent financial planners will provide services on a fixed-fee basis. That is, they will charge you a fixed cost for each of the different aspects of your financial plan with which they provide assistance. Financial planners at brokerage firms also can charge fixed fees for services that are beyond those that are provided at no cost.

Commissions

Financial planners who also sell products, such as insurance or mutual funds, are often paid based on the products you purchase through them. For example, sellers of insurance are often paid 5% to 15% of the premium on the policies you purchase.

Percentage of Assets

Although it is more common with people who manage your money than with advisors who help you with your financial plan, some financial planners are paid as a percentage of the market value of your assets that they manage. This type of compensation is also common for financial planners who work for mutual fund companies.

What’s Best for You

When you get advice from a financial planner, you’ll want to understand the possible biases introduced by the form of their compensation. The vast majority of financial planners are ethical and are focused on your best interests. Nonetheless, you’ll want to be aware of the possibility that the solution proposed by a financial planner is potentially influenced by their compensation. As such, I suggest seeking financial planning advice from people who provide their services either at no charge to you or for a fixed fee.

How Do I Find the Financial Planner that is Best for Me?

One of the best ways to identify possible financial planners is to get recommendations from other financial professionals with whom you already have a relationship, such as an accountant or attorney. If you have friends who are particularly financially savvy, you might ask them for a recommendation. However, you are probably at least as skilled at selecting a financial planner as any friends who are in the same boat as you. And, you are a better judge of a good fit for you than anyone else. Also, I strongly recommend against using a family member as a financial planner. There are almost always too many emotions tied up in family relationships for a family member to be able to advise you on a subject that often requires difficult conversations, such as your finances.

Check their Qualifications

Once you have identified one or more possible financial planners, you’ll want to check their qualifications and whether they have been disciplined. In the US, the most common designation attained by professional financial planners is a Certified Financial Planner, though there are many other designations that indicate expertise, such as a Certified Financial Analyst or a Certified Public Accountant (CPA).

Once you’ve identified the candidates’ professional designations, you’ll want to check to see if there has been any disciplinary action against them. Disciplinary actions are all available on-line. Graeme’s words of wisdom are, “I don’t care how minor the infraction. I wouldn’t go near anyone who has been disciplined. It’s not hard to be an honest advisor, and I wouldn’t trust anyone who has failed at that.”

Interview a Few Financial Planners

You then want to interview the remaining candidates. Again, I’ll provide Graeme’s advice, as I think it is right on target.

  • Are they generous with their time?
  • Do they listen to you?
  • Do they listen to your spouse?
  • Are they genuinely curious about your situation and your plans and goals?
  • Do they ask questions?
  • Or, are they too quick to sell you something?

Your Final Selection

Look for a combination of training and experience. A financial planning designation should be a minimum, along with several years in the industry. They should also be able to refer you to current clients who can recommend their services.”

I suggest that you also think about whether you feel you can develop a good, long-term relationship with the potential advisor.  Also, consider whether they garnered your respect during the interview. Starting the process of financial planning on a shaky foundation will be unproductive at best.

[1] Graeme Hughes is an accredited Financial Planner with 23 years of experience in the financial services industry. During the course of his career he completed hundreds of financial plans and recommended and sold hundreds of millions of dollars of investment products.

A Man is Not a (Sound Financial) Plan

A Man is Not a (Sound Financial) Plan

“A Man is Not a Plan!” It sounds like a very dated statement, but a guide on a recent trip I took told me about a conversation he had with one of his nieces about her finances.  They were talking about how she could improve 

At What Price Should I Buy a Stock?

At What Price Should I Buy a Stock?

Deciding at what price to buy a stock or other security is almost as hard as deciding whether to buy the security at all.  There are many different approaches for deciding at what price to buy a stock.  One of the ones I’ve seen discussed 

Your Bills: Pay Them or Defer Them?

Your Bills: Pay Them or Defer Them?

Many of you are facing difficult financial decisions as your hours are reduced, you have to take an unpaid leave of absence or you are laid off. At the same time, some creditors are offering to help you by waiving or deferring payments. In this post, I’ll provide my thoughts on how you might decide whether to pay or defer your bills.

Key Takeaways: Pay or Defer Your Bills

Here are the key takeaways about whether to pay or defer your bills.

  • If a creditor is willing to waive some or all of your debt, accept the offer.
  • When creditors are willing to defer payments without any extra charges, accepting that offer, rather than paying from your emergency savings, is likely to make sense for most people. The same holds true when the extra interest or late fees are small.
  • The only situations in which dipping into your emergency savings is preferable for most people are those in which the fees or extra interest are expensive.
  • If you are unable to make your payments on time, whether they are from your income or emergency savings, it is very important to contact your creditors. If you do, you are less likely to incur fees and it is less likely that there will be an adverse impact on your credit score.

What are Debtholders Offering?

Before deciding whether to pay or defer your bills, you’ll want to make sure you understand what is being offered. There are generally three types of offers made by creditors:

  • Eliminate some or all of your debt.
  • Defer payments without extra interest or fees.
  • Defer payments with extra interest or fees.

I explain and provide examples of each of these three options.

Waive Some Payments or Forgive Debt

Under this option, the creditor forgives some or all of your debt. Debt can be forgiven by waiving (eliminating) some of your payments or reducing each of your payments. If all of your debt is forgiven, you will not need to make any more payments.

Clearly, you will want to accept offers from any creditors that are willing to forgive some or all of your debt. If only a portion of the debt is forgiven, you’ll want to make sure that you understand how that portion will be reflected in your payments.

  • Will you have to continue making payments as in the past, but with fewer payments?
  • Are you able to stop making payments for a certain period of time?
  • Will you have to continue making payments as in the past, but with a smaller amount?

As an example, I have seen several proposals from US Senate Democrats ranging from wiping out all education debt to cancelling between $10,000 and $50,000 per borrower of Federal student loans (but not private student loans). One description of the latter indicates that the $10,000 of forgiveness would be accomplished by having the Department of Education make monthly payments on behalf of borrowers during the course of the “emergency.” Under this proposal, you would be able to stop making payment for a certain period of time and then would continue making payments in the future as if you had been making your payments instead of the Department of Education.

Defer Payments without Interest or Fees

Under this option, you take a break from making payments. At the same time, the creditor does not charge you any fees and no interest accrues on your outstanding balance. Once the break is over, you will make the same number and amounts of payments as you would have without the break, but they will extend further into the future. That is, your payment scheduled will be shifted by the length of the break.

On March 20, 2020, US President Trump announced that this approach would apply to Federal student loan payments. Federal student loan debtors will not have to make any payments for 60 days and no interest will accrue. If you have a US Federal student loan, you should research the details of this mandate, as debtors whose student loan payments are not currently in arrears will need to apply to get their payments suspended.

Income taxes for 2019 are another example of payments that can be deferred without interest or fees as the result of the coronavirus upheaval. In the US, the Federal government and many states have extended the deadlines for filing and paying 2019 income taxes until July 15, 2020.

Defer Payments with Interest or Fees

Under this approach, the creditor allows you to take a break from making payments, but will charge you one or both of interest during the break and additional fees. Once the break is over, you will not only make the number and amounts of payments you would have without the break, but you will have to pay the additional interest and/or fees.

If you select this option, you’ll need to understand when these additional amounts will be due.

  • Will they be due immediately at the end of the break?
  • Are the extra amounts added to each payment ?
  • Will you have to make more payments?

Utility Example

An example of this option is the Enmax Relief Program. Enmax is the power utility company in Alberta. It has indicated that it will allow customers to set up payment arrangements for overdue bills, but only if current monthly charges continue to be paid. It appears (though isn’t 100% clear) that customers who miss any payments, even customers with payment plans, will need to pay late charges.

Mortgages

According to an article in Forbes, many mortgage companies are also offering flexibility. Some Federal and state mortgage programs are halting foreclosures, but aren’t necessarily waiving or deferring payments. More importantly, some private mortgage companies are allowing payments to be deferred. Not all of these companies have been clear about how interest or late fees will be treated during this period. As such, if you need to defer some mortgage payments, it is important that you get the details specific to your lender and loan.

The Forbes article contains a bit more detail from Ally. It will allow mortgage payments to be deferred for 120 days with no late fees, but interest will accrue. As such, the total amount you will pay for your mortgage will increase by an amount slightly more than your annual interest rate divided by 12 times the number of months you defer your payments times your outstanding principal at the time you started deferring your payments. The “slightly more” in the previous sentence refers to the fact that the interest will compound over the deferral period, so you’ll have to pay interest not only on the outstanding principal but also on the interest that has accumulated since you made your most recent payment.

Deciding What to Do

Once you’ve understood the options available from your creditors, you’ll want to make informed decisions about whether to pay or defer your bills. In this section, I will illustrate the analysis you can do to help support your decision.

In this illustration, you have $20,000 of emergency savings. You have a debt with $50,000 of outstanding principal, 10 years remaining on the term and a 5% interest rate.   This combination of characteristics leads to a monthly payment of $530. Although the illustration looks at payment of a debt, it is equivalent to a monthly bill of the same amount. You are able to resume your regular payments at the end of three months.

When looking at the option to take the payment out of your emergency savings, I assume that you plan to replace that money within a year. I also assume that your emergency savings is in a checking, savings or money market account that is currently paying such a low interest rate that it can be ignored.

Waive Some Payments or Forgive Debt

No analysis is needed for the option under which a creditor offers to waive some of your payments or forgive your debt completely (without any additional costs on your part). You will always be better off if you accept the offer.

Deferring Payments without Interest

For this illustration, you defer three months of payments without interest. You re-stock your emergency savings within a year.

Take Out of Emergency Savings

The table below shows the cash flows and balances if you pay the three months of payments from your emergency savings.

Take Out of Emergency Savings/No InterestTodayIn 3 MonthsIn 12 MonthsWhen Debt is Paid in 5 Years
Amount Paid to Creditor from Savings$0$1,590$0$0
Amount Paid to Creditor from Income004,77057,240
Contributions to Savings from Income001,5900
Emergency Savings20,00018,41020,00020,000
Principal50,00049,03046,0460

In the first row, you see the three months of payments, totaling $1,590, that you pay the creditor from your emergency savings. The second row shows the payments you make from your income after the initial three-month period. The amounts you put in your emergency savings to bring it to the pre-crisis level are shown in the third row.

The last two rows show the ending balances for your emergency savings and the outstanding principal on your debt. At 3 months, you can see that your emergency savings has been reduced by $1,590. It returns to its original level after 12 months. Your principal declines to $0 in five years as anticipated under the original schedule, as you have made all payments as planned.

Defer Payments

The table below shows the cash flows and balances if you defer three months of payments.

Defer Payments/No InterestTodayIn 3 MonthsIn 12 MonthsWhen Debt is Paid in 5 Years, 3 Months
Amount Paid to Creditor from Savings$0$0$0$0
Amount Paid to Creditor from Income004,77058,830
Contributions to Savings from Income0000
Emergency Savings20,00020,00020,00020,000
Principal50,00050,00047,0530

In the first and third rows, you see that there are no payments to or from your emergency savings. The second row shows the payments you make from your income after the three-month deferral period. The total of these payments is the same as the total payments from your emergency savings and income (first and second rows) under the Take Out of Emergency Savings Strategy. The difference is that the $1,590 paid from your savings in the Take Out of Emergency Savings Strategy in the first three months is added to the amount paid from your income in the last column of the Defer Payments Strategy. In addition, the header on the last column shows that your payments are extended for three months to 5 years, 3 months instead of 5 years.

The last two rows show the ending balances for your emergency savings and principal. Your emergency savings stays constant at $20,000. Your principal doesn’t decrease in the first three months when you defer your payments. After that, your principal declines to $0 in five years and three months. It is higher at 12 months than under the Take Out of Emergency Savings Strategy because you deferred three months of payments.

How I’d Make the Decision to Pay or Defer Bills

When the creditor won’t charge you extra interest or fees, the choice between whether to pay or defer your bills is one of personal preference. It depends not only on your current and anticipated future financial situations, but also any increase in your level of comfort by having more money in your emergency savings. The creditor isn’t increasing the amount you owe. As such, the financial inputs to the decision relate to the timing with which you make the payments to the creditor.

I would probably defer the payments unless I were expecting difficulty in making the extra three months of payments at the end of the loan term (because I was planning to retire in exactly five years and don’t want to change that goal, for example). I’d rather have the extra money in my emergency savings in case something else happens.

Defer Payments with Interest

For this illustration, you defer three months of payments at the loan’s interest rate with no late fees. If you tap your emergency savings, you re-stock them within a year.

Take Out of Emergency Savings

The transactions are the same under the “Take Out of Emergency Savings” Strategy regardless of whether the creditor charges interest on the deferred payments. I’ve shown the table again so it will be easier to compare it to the “Defer Payments” Strategy under this scenario.

Take Out of Emergency Savings/With InterestTodayIn 3 MonthsIn 12 MonthsWhen Debt is Paid in 5 Years
Amount Paid to Creditor from Savings$0$1,590$0$0
Amount Paid to Creditor from Income004,77057,240
Contributions to Savings from Income001,5900
Emergency Savings20,00018,41020,00020,000
Principal50,00049,03046,0460

 

Defer Payments

The table below shows the cash flows and balances if you defer the three months of payments during your time of reduced or no income.

Defer Payments/With InterestTodayIn 3 MonthsIn 12 MonthsWhen Debt is Paid in 5 Years, 3 Months
Amount Paid to Creditor from Savings$0$0$0$0
Amount Paid to Creditor from Income004,83359,607
Contributions to Savings from Income0000
Emergency Savings20,00020,00020,00020,000
Principal50,00050,62847,6440

In the first and third rows, you see no payments to or from your emergency savings. The second row shows the payments you make from your income after the three-month deferral period. For this illustration, the extra interest is added to each payment, increasing it from $530 to $537 a month and your payments extend for an extra three months (see header in last column). As a result, the total of the amounts paid the to creditor are $840 higher than if no interest had been charged.

The last two rows show the ending balances for your emergency savings and principal. Your emergency savings stays constant at $20,000. Your principal increases in the first three months as the additional interest is added during the deferral period. After that, your principal declines to $0 in five years and three months. It is higher at 12 months than under the Take Out of Emergency Savings Strategy because (a) you deferred three months of payments and (b) additional interest accrued.

How I’d Decide

From a financial perspective, you will be better off in this scenario if you make your payments out of your emergency savings because you will avoid paying interest or late fees. You also will have paid off your debt sooner – in five years instead of five years and three months.

Low Interest Rates

If the interest rate on your loan isn’t very high, say less than 6% a year, the additional payments may be relatively small. For example, at a 6% interest rate, the extra accumulated interest on a $200,000 loan with 10 years of payments left (such as our mortgage) is about $3,000. That may sound like a large number, but it adds only $34 to each payment.

Credit Cards

Some people are suggesting that you should make only the minimum payments on your credit cards as a way to keep as much cash in your emergency savings as possible. To date, I haven’t seen any credit card companies that are deferring interest or fees if you don’t pay your credit card in full. Credit card interest rates are generally quite high, often in excess of 10% per year, and many credit card companies charge fees if you don’t pay your balance in full. While many debts have interest rates that are low enough to justify deferring payments, most credit cards do not fall in that category. As such, I would pay off as much of my high-interest credit card balances as I could afford, even it if meant dipping into my emergency savings.

Personal Decision

Here is where the decision to pay or defer your bills becomes more personal. There is an emotional benefit to leaving the money in your emergency savings in case something else happens or your reduction in income lasts longer than you expect. You’ll need to weight that increased comfort level with the additional cost of deferring the payments under this scenario. For many people, the $34 a month increase in their mortgage payment in my illustration is a small cost to pay for the additional comfort. For other people, particularly those whose budgets are already very tight or who have a fixed amount of time until they retire, the increased payments and lengthening of the term of the loan are too expensive. As such, you’ll need to decide for yourself whether to pay or defer your bills, but now you’ll be able to make an informed decision.

Impact on Credit Rating

Another consideration in deciding whether to pay or defer your bills is your credit score. If you miss payments, there could be an adverse impact on your credit score, as timely payment is one of the important factors that drive your score. To be clear, if you make your payments from your emergency savings, there will be no adverse impact on your credit score. If you are not able to make your payments, even from your emergency savings, it is important that you communicate with your creditors and agree to a plan.

What Experian Says

I contacted Experian by e-mail and received the following quote from Rob Griffin, senior director of consumer education and awareness.

If you think you may have trouble making any of your monthly payments, contact your lender or creditor as soon as possible – try not to wait until you’ve missed your payment due date. Lenders may have several options for helping you cope with a variety of COVID-19-related financial hardships including placing your accounts in forbearance or deferment for a period of time. This means effectively suspending your payments until the crisis has passed and can help minimize the impact to the credit score if the account is in good standing and hasn’t had previous delinquencies reported.

While reported in forbearance or deferment, your accounts will have no negative affect on the most common credit scores from FICO and VantageScore. Keep in mind, lenders do not want you to fall behind on your payments any more than you do. Contacting your lenders early can help you protect your financial health in the long run.[1]

Other Credit Bureaus

I found similar statements on the web sites of the other two major credit bureaus, Equifax and Transunion.

How it Impacts You

These statements indicate that you may be able to avoid a deterioration in your credit score if you are proactive with your lenders about skipping or deferring payments.

 

[1] E-mail from Amanda Garofalo, PR Specialist, Experian, March 19, 2020.

Don’t Panic!  Just Plan It.

Don’t Panic! Just Plan It.

Financial markets have been more turbulent in the past few weeks than has been seen in many years, probably more volatile than has happened since many of you started being financially aware. You may be wondering what actions you should take. With the sense of