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 Interest Today In 3 Months In 12 Months When Debt is Paid in 5 Years
Amount Paid to Creditor from Savings $0 $1,590 $0 $0
Amount Paid to Creditor from Income 0 0 4,770 57,240
Contributions to Savings from Income 0 0 1,590 0
Emergency Savings 20,000 18,410 20,000 20,000
Principal 50,000 49,030 46,046 0

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 Interest Today In 3 Months In 12 Months When Debt is Paid in 5 Years, 3 Months
Amount Paid to Creditor from Savings $0 $0 $0 $0
Amount Paid to Creditor from Income 0 0 4,770 58,830
Contributions to Savings from Income 0 0 0 0
Emergency Savings 20,000 20,000 20,000 20,000
Principal 50,000 50,000 47,053 0

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/Wit Interest Today In 3 Months In 12 Months When Debt is Paid in 5 Years
Amount Paid to Creditor from Savings $0 $1,590 $0 $0
Amount Paid to Creditor from Income 0 0 4,770 57,240
Contributions to Savings from Income 0 0 1,590 0
Emergency Savings 20,000 18,410 20,000 20,000
Principal 50,000 49,030 46,046 0

 

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 Interest Today In 3 Months In 12 Months When Debt is Paid in 5 Years, 3 Months
Amount Paid to Creditor from Savings $0 $0 $0 $0
Amount Paid to Creditor from Income 0 0 4,833 59,607
Contributions to Savings from Income 0 0 0 0
Emergency Savings 20,000 20,000 20,000 20,000
Principal 50,000 50,628 47,644 0

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 panic and urgency surrounding recent news, it often feels as if drastic action is necessary. If you have created a financial plan with key elements similar to those in many of my posts, inaction may be the best strategy for you!

As indicated elsewhere on this blog, I do not have any professional designations that qualify me to provide professional advice. In addition, my comments are provided as generalities and may not apply to your specific situation. Please read the rest of this post with these thoughts in mind.

Biggest Financial Risk from Recent News

I suspect that losing your job or losing business if you are self-employed is the biggest financial risk many of you face. Understanding your position within your company and how your company will be impacted by coronavirus, oil prices and other events will inform you as to the extent to which you face the risk of a lay-off or reduction in hours/salary.

If you think you might have a risk of a decrease in earned income, you’ll want to look into what options for income replacement are available to you, including state or federal unemployment programs, severance from your employers, among others. Another important step is to review your expenses so you know how you can reduce them to match your lowered income.  In addition, you’ll want to evaluate how long you can live before exhausting your emergency savings, with or without drastic reductions in your expenses. You may even want to start cutting expenses before your income is lowered and put the extra amount in your emergency savings.

Your Financial Plan & Recent News

In the rest of this post, I’ll look at the various components of a financial plan and provide my thoughts on how they might be impacted by the recent news and resulting volatility in financial markets.

Paid Time-Off Benefits/Disability Insurance

If you are unfortunate enough to get COVID-19 or are required to self-quarantine and can’t work from home, you may face a reduction in compensation. Your first line of defense is any sick time or paid time-off (PTO) provided by your employer. In most cases, your employer will cover 100% of your wages for up to the number of days, assuming you haven’t used them yet.

Once you have used all of your sick time/PTO, you may have coverage under short- or long-term disability insurance if provided by your employer or if you purchase it through your employer or on your own. Disability insurance generally pays between 2/3 and 100% of your wages while you are unable to work for certain causes, almost always including illness. It might be a good time to review your available sick time/PTO and disability insurance to understand what coverage you have.

Emergency Savings

Emergency savings is one of the most important components of a financial plan.  There are two aspects to your emergency savings that you’ll want to consider. The first is whether you have enough in your emergency savings.  The second is the risk that the value of the savings will go down due to financial market issues.

Do I Have Enough?

If you are laid off, have reduced hours or use up all, exhaust your sick time/PTO or get less than 100% of your wages replaced by disability insurance, you may have to tap into your emergency savings. The need to spend your emergency savings increases if you tend to spend most of your paycheck rather than divert a portion of it to savings.

I generally suggest one to six months of expenses as a target for the amount of emergency savings. In light of recent events and the increased risks lay-off and illness, I would focus on the higher end of that range or even longer. As you evaluate the likelihood you’ll be laid off, the chances you’ll be exposed to coronavirus and your propensity to get it, you’ll also want to consider whether you have enough in emergency savings to cover your expenses while your income is reduced or eliminated.

In certain situations, such as in response to the coronavirus, creditors will allow you to defer your payments.  You will then have the option as to whether to defer them or make those payments from your emergency savings./a>

Will it Lose Its Value?

I’ve suggested that you keep at least one month of expenses in emergency savings in a checking or savings account at a bank or similar financial institution. The monetary value of your emergency savings is pretty much risk-free, at least in the US. The only way you would lose any of these savings is if the financial institution were to go bankrupt. In the US, deposits in financial institutions are insured, generally up to $250,000 per person per financial institution, by the Federal Deposit Insurance Corporation (FDIC). For more specifics, see the FDIC web site. Similar protections may be available in other countries.

I’ve also suggested that you keep another two to five months of expenses in emergency savings in something only slightly less accessible, such as a money market account. There is slightly more risk that the value of a money market account will go down than a checking or savings account, but it is generally considered to be very small. Money market accounts are also insured by the FDIC. For more specifics, see this article on Investopedia.

As such, the recent volatility in financial markets are unlikely to require you to take action related to your existing emergency savings and could act as an opportunity to re-evaluate whether you have enough set aside for emergencies.

Short-Term Savings

Another component of a financial plan is short-term savings.  Short-term savings is money you set aside for a specific purpose. One purpose for short-term savings is expenses that don’t get paid every month, such as property taxes, homeowners insurance or car maintenance and repairs.   Another purpose for short-term savings is to cover the cost of larger purchases for which you might need to save for several years, such as a car or a down payment on a house.

Short-term savings are commonly held in money-market accounts, certificates of deposits (CDs) or very high quality, shorter term bonds, such as those issued by the US government. CDs and US government bonds held to maturity are generally considered to have very little risk. Their market values are unlikely to change much and the likelihood that the issuers will not re-pay the principal when due is small.

Thus, the recent volatility in financial markets is also unlikely to require you to take action related to your short-term savings.

Long-Term Savings

Savings for retirement and other long-term goals are key components of a financial plan.  If they are invested at all in any equity markets, your long-term savings have likely taken quite a beating. Rather than try to provide generic guidance on how to deal with the losses in your long-term savings, I’ll tell you how I’m thinking and what I’m doing about mine. By providing a concrete example, albeit one very different from most of your situations, my goal is to provide you with some valuable insights about the thought process.

Think about the Time Frame for My Long-Term Savings

As you may know, I’m retired and have just a little income from consulting. As such, my financial plan anticipates that I will live primarily off my investments and their returns. I have enough cash and bonds to cover my expenses for several years. As such, I’m not in a position that I absolutely have to liquidate any of my equity positions in less than three-to-four years.

For many of you, your most significant goal for long-term savings is likely retirement. As such, your time horizon for your long-term savings is longer than mine and you can withstand even more volatility. That is, you have a longer time for stock prices to recover to the recent highs and even higher.     In the final section of this post, I’ll talk about how long it has taken equity markets to recover from past “crashes” to help you get more perspective on this issue.

Know Your Investments

My view is that, if I wait long enough, the overall stock market will recover. It always has in the past. If it doesn’t, I suspect something cataclysmic will have happened and I will be focused on more important issues such as food, water and heat, than my long-term savings. For now, though, my view is that my investments in broad-based index funds are going to recover from the recent price drops though it may take a while and be a tough period until then. As such, I am not taking any action with respect to those securities. Once the stock market seems to settle down a bit (and possibly not until it starts going up for a while), I might invest a bit more of my cash to take advantage of the lower prices.

I have a handful of investments in stocks and bonds of individual companies. These positions have required a bit more thought on my part.   I already know the primary products and services of these companies and the key factors that drive profitability, as I identified these features before I purchased the stocks or bonds as part of my financial plan. I can now look at the forces driving the economic changes to evaluate how each of the companies might be impacted.

Example 1

I own some bonds that mature in two to three years in a large company that provides cellular phone service. As discussed in my post on bonds, as long as you hold bonds to maturity, the only risk you face is that the issuer will default (not make interest payments or re-pay the principal). With the reduction in travel and group meetings, I see an increased demand for technological communication solutions, such as cell phones. While the stock price of this company has gone down, I don’t see that its chance of going bankrupt has been affected adversely, so don’t plan to sell the bonds.

Example 2

One company whose stock I’ve owned for a very long time focuses on products used to test food safety. While the company’s stock price has dropped along with the broader market, I anticipate that people will have heightened awareness of all forms of ways of transmitting illness, including through food-borne bacteria and other pathogens. As such, I am not planning to sell this stock as the result of recent events.

Example 3

I own stock in an airline that operates primarily within North America. This one is a bit trickier. It looks like travel of all types is going to be down for a while. I’m sure that US domestic airline travel will be significantly impacted, but suspect it will not be affected as much as international or cruise ship travel. The reduction in revenue might be slightly offset by the lower cost of fuel, but that is probably not a huge benefit in the long term.

I’ve owned this company for so long that I still have a large capital gain and would have to pay tax on it if I sold the stock. At this point, I don’t think there is a high probability that this airline will go bankrupt (though I’m not an expert and could be wrong). I expect the price to drop more than the overall market average in the coming months, but also expect that it will recover. As such, I don’t plan to sell this stock solely because of recent events.   However, if this company had most of its revenue from operating cruise ships, was smaller, or had more foreign exposure, I would study its financials and business model in more detail to see if I thought it would be able to withstand the possibility of much lower demand for an extended period of time.

Summary

I have gone through similar thought processes for each of the companies in my portfolio to create my action plan. I will re-evaluate them as time passes and more information becomes available.

What We Can Learn from Past Crashes

Although every market cycle is different, I thought it might be insightful to provide information about previous market crashes. For this discussion, I am defining a market crash as a decrease in the price of the S&P 500 by more than 20% from its then most recent peak. I have identified 11 crashes using this definition, including the current one, over the time period from 1927 to March 14, 2020.

As you’ll see in the graphs below, the market crash starting at the peak in August 1929 is much different from most of the others. It took until 1956 before the S&P 500 reached its pre-crash level! Over the almost three years until the S&P 500 reached its low and then again during the recovery period (from the low until it reached its previous high), there were several crashes. I have counted this long cycle as a single crash, though it could be separated into several.

Magnitude of Previous Crashes

The table below shows the dates of the highest price of the S&P 500 before each of the 11 crashes since 1927.  It also shows the percentage decrease from the high to the low and the number of years from the high to the low.

Date of Market Peak

Price Change Years from High to Low

9/17/29

-86% 2.7

8/3/56

-21%

1.2

12/13/61 -28%

0.5

2/10/66 -22%

0.7

12/2/68

-36%

1.5

1/12/73

-48% 1.7

12/1/80

-27% 1.7

8/26/87

-34%

0.3

3/27/00 -49%

2.5

10/10/07 -57%

1.4

2/20/20 -27%

0.1

While they don’t happen all that often, this table confirms that the S&P 500 has suffered significant decreases in the past. What seems a bit different about the current crash is the speed at which prices have dropped from the market high reached just a few weeks ago. In the past, the average time from the market peak to the market bottom has been 1.4 years, but the range has been from 0.3 years to 2.7 years. While the 27% decrease in the S&P 500 from its peak on February 20, 2020 until March 14, 2020 is large and troubling, the average price change of 10 preceding crashes is -41% (-36% if the 1929 crash is excluded). As such, it isn’t unprecedented.

What Happened Next?

This table shows how long it took after each of the first 10 crashes for the S&P 500 to return to its previous peak. It also shows the average annualized return from the lowest price until it returned to its previous peak.

Date of Market Peak

Years from Low Back to Peak Annualized Average Return During Recovery

9/17/29

22.2 9.3%

8/3/56

0.9 29.8%
12/13/61 1.2

31.7%

2/10/66 0.6

55.3%

12/2/68 1.8

28.3%

1/12/73

5.8 12.0%

12/1/80

0.2 293.4%

8/26/87

1.6

28.1%

3/27/00 4.6

15.7%

10/10/07 4.1

22.9%

For example, it took 1.6 years after the market low price on December 4, 1987 (the low point of the cycle starting on August 26, 1987) for the S&P 500 to reach the same price it had on August 26, 1987. Over that 1.6-year period, the average annual return on an investment in the S&P 500 would have been 28%!

Because the values from the 1929 and 1980 cycles can distort the averages, I’ll look at the median values of these metrics. At the median, it took 1.7 years for the S&P 500 to reach its previous high with a median annualized average return of 28%.   There are obviously wide ranges about these metrics, but, excluding the 1929 crash, the S&P 500 never took more than 6 years to recover from its low. This time frame is important as you are thinking about the length of time until you might need to use your long-term savings.

After hitting bottom, the S&P 500 always had an average annual return of 12% or more over the recovery period, a fair amount higher than the overall annual average return on the S&P 500. Anyone who sold a position in the S&P 500 at any of the low points missed the opportunity to earn these higher-than-average returns – a reminder to not panic.

From Crash to Recovery

The graph below shows the ratios of the price of the S&P 500 to the price at the peak (day 0) over the 30 years after each of the first 10 market peaks in the tables above.

The light blue line that stays at the bottom is the 1929 crash. As you can see, by 30 years later, the S&P 500 was only twice as high as it was at its pre-crash peak. For all of the other crashes, the S&P 500 was at least four times higher than at each pre-crash peak, even though in many cases there were subsequent crashes in the 30-year period.

To get a sense for how the current crash compares, the graph below shows the same information for only the first 100 days after each peak. The current crash is represented by the heavy red line.

As indicated above, one of the unique characteristics about the current crash is that it occurred so quickly after the peak. The graph shows that the bright red line is much lower than any of the other lines on day 17. However, if you look at the light blue line (after the peak on September 17, 1929) and the brown line (after the peak on August 26, 1987), you can see that there were similarly rapid price decreases as occurred in the current crash, but they started a bit longer after their respective peaks.

Current Crash

We can’t know the path that the stock market will take going forward in the current cycle. It could halt its downward trend in a few days to a week and return to set new highs later this year. On the other hand, if other events occur in the future (such as the weather conditions that led to the dust bowl in the 1930s and World War II in the 1940s that exacerbated the banking issues that triggered the 1929 crash), it is possible stock prices could decline for many years and take a long time to recovery. Based on the patterns observed, this trend is less likely, but it is still a possibility.

As such, it is important as you consider your situation that you look at your investment horizon, your ability to live with further decreases in stock prices and your willingness to forego the opportunity to earn higher-than-average returns when the stock market returns to its pre-crash levels if you sell now, among other things.

Closing Thoughts

My goal in writing this post was to provide you with insights on how to view the disruptions in the economy and financial markets in recent weeks and plan your responses to them. My primary messages are:

  1. Don’t panic. While significant action may be the best course for your situation, do your best to make well-reasoned and not emotional decisions. Although you might want to sell your investments right away to avoid additional decreases in value, it isn’t the best strategy for everyone.
  2. Stick with (or make) a financial plan. Having a financial plan provides you with the ability to look at the impact of the uncertainties in financial markets and the overall economy on each aspect of your financial future separately, making the decision-making process a little easier.

 

Good Debt vs Bad Debt: Key Characteristics

Not all debt is bad! The specific definitions of good debt vs bad debt will vary from person to person. For people who plan to retire very early and live on a limited income or for people who know that they have a hard time paying their bills either for lack of money or organization skills, most debt is likely to be problematic.  For other people, taking on debt is less of an issue.

One of my followers was thinking of expanding his business and was concerned that taking on debt would be harmful. As part of helping him with his thinking, I identified general characteristics that distinguish good debt vs bad debt. He ended up selling his business instead of expanding it, but I am sharing my insights in this post. These characteristics may not apply to your particular situation, so be sure to think about them in the context of your own situation and temperament.

Characteristics of Bad Debt

Here are five characteristics of debts that I would consider bad.

You Don’t Understand the Terms

Loans and other sources of borrowing, such as credit cards, all have different terms. It is important that you understand the terms of your debt. For example, some loans, mortgages in particular, have adjustable rates. That is, the interest rate that you pay on your loan will change as a benchmark interest rate changes. If the benchmark interest rate increases, your loan payments will also increase.

Credit cards also can have interest rates that change. A teaser rate is an interest rate that applies to credit card debt for the first several months to a year. After that initial period, the interest rate charged on credit card debt can be very high.

Another example of a loan provision that can be problematic is a balloon payment. Some loans, including some mortgages in the US and many mortgages in Canada, have balloon payment provisions. For the initial period of time (often five years for Canadian mortgages), you make payments on your loan as if you were re-paying the loan over 30 years. However, at the end of the fifth year, the entire balance of the loan is due. The Canadian mortgage I reviewed requires the lender to re-finance the loan at the end of the fifth year, but at an interest rate that reflects the then-current interest rate environment and your then-current credit rating. In effect, that loan has an adjustable interest rate that depends not only on a benchmark interest rate but also changes in your credit score.

I consider any debt for which you don’t fully understand the terms, best avoided by reading the entirety of the loan document, as bad debt.

You Can’t Afford the Payments

When you enter into a loan agreement, you will be provided with the amount and timing of loan payments. With credit cards, the payments are usually due monthly and are a function of how much you charge and the card’s interest rate. Any debt that has payments that don’t fit in your budget is bad debt.   I would even take it one step further and say that any debt that has payments so high that you aren’t able to save for emergencies, large purchases and retirement is bad debt.

High Interest Rate

Some types of debt, such as credit cards and payday loans, have very high interest rates. The definition of a high interest rate depends on the economic conditions. Currently (around 2020), I would say any interest rate of more than 8% to 10% is high. By comparison, when I was young in the early 1980s, the interest rate on a 10-year US Government bond was more than 15% and mortgage rates were even higher.

If you have debt with high interest rates, you will be better off re-paying them as quickly as possible as you can’t earn a high enough investment return on any excess savings to cover the interest cost. That is, the investment return you can earn on the money, especially after tax, is going to be less than the interest rate you pay on the debt. In that case, it doesn’t make financial sense to invest any excess cash but rather you will be better off by using any excess cash to pay off the debt.

Depreciating Collateral

In many cases, debt is used to purchase something large, such as a boat, a home or a car. When you make a large purchase, the item you bought is considered collateral and the lender can take the collateral if you don’t make your loan payments.

The value of some items goes down (depreciates) faster than the principal of the loan. If you default on your payments when that happens, the lender is allowed to make you pay the difference. Determining whether your purchase is something that will retain its value or will depreciate quickly is a good test of whether it is financially responsible to use debt to make the purchase. If not, I would consider the purchase a poor use of debt.

No Long-Term Benefit

Many other purchases for which debt, such as credit cards and payday loans, is used have no long-term benefit. For example, if you buy a knick-knack for your home with a credit card and don’t pay the balance when the credit card is due, you will be paying interest for something that has no long-term benefit to you. I consider using debt for items or experiences with no long-term benefit to be bad.

There is a gray area. If you use debt to buy clothes that are required for your job, the clothes themselves don’t have a long-term benefit, but they could be considered as creating the ability to go to work and earn money.   As such, while I would normally consider clothes as a poor use of debt, I can see how work clothes that allow you to increase your income might need to be financed for a month or two on a credit card.

Characteristics of Good Debt (vs Bad Debt)

The first requirement of good debt is that it doesn’t have any of the characteristics of bad debt. That is, good debt:

  • Has terms you fully understand.
  • Fits in your budget, especially if your budget also includes saving for retirement, large purchases and an emergency fund.
  • Is one that has a reasonable interest rate.
  • Isn’t backed by depreciating collateral.
  • Is used for something with long-term benefit.

There are many ways in which a debt can create a long-term benefit. I’ve mentioned buying clothes required for a job that allows you to earn money, in particular a lot more money than the cost of paying off the debt.

Your Primary Residence

Most people borrow, using a mortgage, to purchase a home.   The market values of homes generally increase over long periods of time, though there are periods of times when the market values of homes decrease. In addition, there are a lot of carrying costs of owning a home, such as insurance, property taxes, maintenance and repairs. However, by owning a home, you don’t have to pay rent which, in theory, covers all of the costs of home ownership.

I think that buying a house is a good use of debt as long as the mortgage meets all of the criteria identified above. Although not specifically related to the use of debt, you might want to think carefully about buying a home (with or without debt) if you plan to live in it for only a short period of time. The transactions costs of buying and selling a home are high and you increase the likelihood that the value of the house will decrease if you own it for only a few years.

Your Car

Using debt to buy a car is also quite common. If you are using the debt to cover the cost of your only mode of transportation and you need it to get to work, it can be a good use of debt. Again, you’ll want to check that it has the other characteristics of good debt identified above.   Using debt to buy a car that is more expensive than you need or leads to loan payments that are higher than you can afford is not as good a use of debt.

Your Education

Many people use student loans to pay for college. From an economic perspective, student loans can be either good or bad. The criteria for evaluating the student loans are:

  • Will the increase in your wages will cover your loan payments?
  • Will you earn enough after graduation to allow the loan payments to fit in your budget?

For example, let’s say you can earn $30,000 a year if you don’t go to college and $40,000 if you get a degree. If you borrowed $50,000 a year for four years at 5% with a 10-year term, your payments would be more than $25,000 per year.

First Criterion

Over the term of the loan, your increase in wages ($10,000 per year) is less than your loan payments. Over your working life time, the return on your investment in your student loans is about 3.5%. The return on investment is positive, so the use of debt could be justified using the first criterion.

Second Criterion

It might be very difficult to cover the $25,000 of annual student loan payments on annual wages of $40,000 a year. If you are willing and able to live on $15,000 a year until your student loans are re-paid, they could be considered a good investment economically.

A smaller amount of debt or a larger increase in salary will improve the economic benefit of student loans. If you are considering student loans to finance your education, you’ll want to look at their economic costs and benefits carefully.

Your Business

When you start your own business, you often need to invest in one or more of equipment, inventory or a place to run your business.  Many people borrow money to make these initial investments. Starting a profitable business can be a very good use of debt, as it provides you the opportunity to increase your net worth. However, 30% of businesses fail in the first year and 50% fail in five years, according to the Small Business Administration, as reported by Investopedia. If you borrow money to start a small business and it fails, you will often still be liable for re-paying the debt, depending on whether you had to personally guarantee the loan or if the business was able to procure the loan.

Investing

There are at least a couple of ways you can use “debt” to invest.

Don’t Pre-Pay Your Debt

The most common way to use debt to invest is to invest extra money rather than using the money to pre-pay your mortgage or other debt. Whether it is good or bad to use this “debt” to increase your investing depends on several factors and your financial situation:

  • The longer the term on your debt, the better the choice is to invest instead of pre-paying your debt. If your loan payments only extend over a year or two, it is more likely that your investments will lose money making you worse off than if you pre-paid your loan. Over long periods of time, your investment returns are more likely to be positive.
  • The lower the interest rate on your debt, the better the choice it is to invest instead of pre-pay your debt. If the interest rate on your debt is higher than you can expect to earn on the investments you would buy (after considering income taxes), you will almost always be better off pre-paying your loan. If your interest rate is low, e.g., less than 3% or 4%, you are more likely to earn more in investment returns than the interest cost on your debt.
  • You have another source of income to make your loan payments if your investments decrease in value. For example, if you were planning to retire in the next few years, pre-paying your debt is more likely to be a better decision than investing. On the other hand, if you plan to have other sources of income besides your investments for the next 10 or more years, you might be better off investing rather than pre-paying your debt.

Investing on Margin

Another way you can use debt to invest is to buy your investments on margin. Under this approach, you borrow money from the brokerage (or similar) firm to buy your investments using your existing invested assets as collateral. In many cases, you can borrow up to 50% of the value of your existing assets. So, if you have $100,000 of stocks, you could borrow $50,000 to make additional investments.

The drawback of buying investments on margin is that the lender can make you re-pay the loan or a portion of it as soon as the value of the assets you own (the $100,000 of stocks in my example) decreases to less than twice the amount you’ve borrowed. Unfortunately, the amount you borrowed may have decreased in value at the same time while the amount you borrowed as stayed constant. As such, buying investments on margin is considered very risky and should be done only by people who fully understand all of its ramifications.

Final Thoughts on Good Debt vs. Bad Debt

Debt, when used carefully, can greatly improve your life and your ability to earn money. However, if you take on too much bad debt, it can lead to significant financial problems. This post has provided a framework to help you decide whether any debts you have or are considering are likely to be good debt vs bad debt.

The Best Ways to Pay Off Your Debt

The Best Ways to Pay Off Your Debt

The best way to pay off your short-term and revolving debt depends on your priorities and what motivates you.  Two of the common approaches for determining the order in which to re-pay your loans discussed in financial literacy circles are the Debt Snowball and Debt Avalanche approaches.

Both of these methods apply when you have more than one debt that needs to be re-paid.  If you have only one debt to re-pay, the best strategy is to pay it down as quickly as possible, making the minimum payments as often as you can to avoid finance charges which will be added to your principal in addition to the interest charges on any portion of your balance you don’t pay.

In this post, I’ll describe how the two debt-repayment methods work using some illustrations.  I will then help you understand which approach might be better for you.  For more information about the fundamentals of debt, check out my posts on loans and credit cards.

What’s Included and What’s Not

The debts covered by this post include credit cards (one kind of revolving debt), personal loans, car loans and other bills that are overdue. While longer-term loans, such as mortgages, are referenced in the budgeting process, I haven’t included them in the debt re-payment examples. If you have unpaid short-term debt, you’ll want to keep up with the payments on these longer-term loans first, but don’t need to pre-pay them. For this discussion, I will assume that you intend to re-pay all of your debts to your current debtholders. That is, you haven’t dug a hole so deep you need to declare bankruptcy and you don’t feel you’ll benefit from transferring some or all of your high-interest rate loan balances to one with a lower interest (i.e., debt consolidation).

Debt Snowball

Dave Ramsay, a well-known author on financial literacy topics, proposed the Debt Snowball method for paying off your debts.  Under this method, you do the following:

  1. Identify all of your debts, including the amounts of the minimum payments.
  2. Make a budget. (See this post for more on budgeting generally or this one for the first of a step-by-step series on budgeting including a helpful spreadsheet.) Your budget should include all of your expenses excluding your short-term and revolving debts but including the payments you plan to make on your longer-term debts (e.g., car loans and mortgages).
  3. Determine the total amount left in your budget available to re-pay your debts, remembering that you need to be able to pay for the total cost of all of your current purchases before you start paying off the balances on your existing debt. If the amount available to re-pay debts is less than the total of your minimum payments, you may need to look into your options to consolidate or re-structure your debts, get them forgiven or declare bankruptcy.
  4. Otherwise, make the minimum payment on all of your debts except the smallest one.
  5. Take everything left over in your budget from step (3) and reduce it by the sum of the minimum payments in step (4). Use that balance to pay off your smallest debt. After you fully re-pay the smallest debt, you’ll apply the remainder to the next smallest debt and so on.

Debt Avalanche

The Debt Avalanche method is very similar to the Debt Snowball method, except you re-pay your debts in a different order.

The first three steps under the Debt Avalanche method are the same as the first three steps under the Debt Snowball method.  It differs from the Debt Snowball method in that you pay the minimum payment on all of your debts except the one with the highest interest rate at any given time instead of the one with the smallest balance.

Examples

I’ve created the two examples to compare the two methods.  In both examples, I have assumed that you use a different credit card or pay cash for all new purchases until your current credit card balances are re-paid.  That is, to make progress on getting out of debt, you need to not only make extra payments on your existing debts, but also not create additional debt by borrowing to pay for new purchases.  It’s tough!

Example 1

In this example, you have two debts with the balances due, interest rates and minimum payments shown in the table below.

Example 1 Balance Due Interest Rate Minimum Payment
Debt 1 $1,500 20% $30
Debt 2 500 10% 10

You have determined you have  $100 available to pay off these two debts.  The minimum payments total $40 in this example, so you have $60 available to pay off more of the principal on your debts.

Example 1: Debt Snowball

Under the Debt Snowball method, you will use the additional $60 a month you have to pay off Debt 2 first, as it has the smaller balance.  That is, you will pay the minimum payment of $30 a month on Debt 1 and $70 a month on Debt 2 for 8 months, at which point Debt 2 will be fully re-paid.  You will then apply the full $100 a month to Debt 1 for the next 17 months until it is fully re-paid

Under this approach, you will have fully re-paid both debts in 25 months and will pay $428 in interest charges.

Example 1:  Debt Avalanche

In Example 1, you will use the additional $60 a month you have to pay off Debt 1 first under the Debt Avalanche method, as it has the higher interest rate, whereas you used the additional amount to pay off Debt 2 first under the Debt Snowball method.  That is, you will pay the minimum balance of $10 a month on Debt 2 and $90 a month on Debt 1 for 20 months, at which point Debt 1 will be fully re-paid.  You will then apply the full $100 a month to Debt 2 for the next 4 months until it is fully re-paid

Under this approach, you will have fully re-paid both debts in 24 months and will pay $352 in interest charges.

Example 2

In this example, you have five debts with the balances due, interest rates and minimum payments shown in the table below.

Example 2 Balance Due Interest Rate Minimum Payment
Debt 1 $1,000 10% $40
Debt 2 500 0% 25
Debt 3 10,000 20% 100
Debt 4 3,000 15% 75
Debt 5 750 5% 30

You have $500 available to pay off these debts.  In this example, the minimum payments total $270, so you have $230 available to pay off the principal on your debts in addition to the principal included in the minimum payments.

Example 2: Debt Snowball

Example 2 is a bit more complicated because there are more debts.  As a reminder, under this approach, you apply all of your extra payments ($230 in this example) to the smallest debt at each point in time.  In this example, you will make the additional payments on your debts in the following order:

Debt 2

Debt 5

Debt 1

Debt 4

Debt 3

It takes only two months to pay off Debt 2 and another four months to pay off Debt 4.  As such, you will have fully re-paid two of your debts in six months.  In total, it will take 43 months to re-pay all of your loans and you will pay $5,800 in interest.

Example 2:  Debt Avalanche

In this example, you will make the additional payments on your debts in the following order:

Debt 3

Debt 4

Debt 1

Debt 5

Debt 2

It turns out that Debt 2 is fully re-paid in 20 months even just making the minimum payments.  Debt 5 is paid off 7 months later again with only minimum payments, followed by Debt 1 2 months later.  As each of these debts is re-paid, the amounts of their minimum payments are added to the payment on Debt 3 until it is fully re-paid after 39 months.  At that point, the full $500 a month is applied towards Debt 4 which then takes only 2 additional months to fully re-pay.  In total, it will take 41 months to re-pay all of your loans and you will pay $5,094 in interest.

Comparison

Dollars and Sense – Two Examples

Looking at the two examples, we can get a sense for how much more interest you will pay if you use the Debt Snowball method instead of the Debt Avalanche method.  The table below compares the two methods under both examples.

Example 1 Example 2
Interest Paid Months of Payments Interest Paid Months of Payments
Snowball $428 25 $5,800 43
Avalanche 352 24 5,094 41
Difference 74 1 706 2

In these two examples, you pay more than 10% more interest if you use the Debt Snowball method than the Debt Avalanche method, leading to one or two additional months before your debts are fully re-paid.

Dollars and Sense – In General

The difference in the amount of additional interest depends on whether your debts are similar in size and the differences in the interest rates.  I’ll take that statement apart to help you understand it.

  • If the debt with the lower interest rate is very small, you will pay it off quickly.  As a result, there is only a very short period of time during which you are paying the higher interest on the larger loan under the Debt Snowball method.  As such, there will be very little difference in the total amount of interest paid between the two methods in that case.
  • If the debts all have about the same interest rate, it doesn’t really matter which one you re-pay first, as the interest charges on that first loan will be very similar to the interest charges on your other loans.

Dollars and Sense – Illustration

The graph below illustrates the impact of the differences in interest rates and sizes of two loans on the difference in the total interest paid.  To create this graph, I took different variations of Example 1.  That is, you have two loans with outstanding balances totaling $2,000 and the interest rate on the larger debt is 20%.

 

How to Read the Axes

The interest rate on the smaller loan was calculated as 20% minus the increment shown on the axis labeled on the right.  That is, the interest rate on the smaller loan for scenarios near the “front” of the graph was 18% or 2 percentage points lower than the 20% interest rate on the larger loan.  Near the “back” of the graph, the interest rate on the smaller loan is 0% or 20 percentage points lower than the interest rate on the larger loan.

The loan balance on the smaller loan divided by the total debt amount of $2,000 is shown on the axis that goes from left to right.  The small loan is $40 (2% of $2,000) at the far left of the graph and increases as you move to the right to $960 (48% of $2,000) on the far right.  Note that, if the small loan exceeded $1,000, it would have become the bigger loan!

The Green Curve

The green curve corresponds to the total interest paid using the Debt Snowball method minus the total interest paid using the Debt Avalanche method.  For example, at the front left, corresponding to the small loan being $40 with an 18% (=20% – 2%) interest rate, there is a $2 difference in the amount of interest paid.  At the other extreme, in the back right of the graph (0% interest rate on a small loan with a balance of $960), you will pay $167 more in interest ($308 versus $140 or more than twice as much) if you use the Debt Snowball method rather than the Debt Avalanche method.

What It Means

Interestingly, moving along only one axis – that is, only decreasing the interest rate on the small loan or only increasing the size of the smaller loan – doesn’t make very much difference.  In the back left and front right, the interest rate differences are only $15 and $22, respectively.  The savings from the Debt Avalanche method becomes most important when there is a large difference in the interest rates on the loans and the outstanding balances on the loans are similar in size.

Sense of Accomplishment

For many people, debt is an emotional or “mental-state” issue rather than a financial problem.  In those situations, it is more important to gain a sense of accomplishment than it is to save money on interest.  If you are one of those people  and have one or more small debts that you can fully re-pay fairly quickly (such as Debts 2 and 5 in Example 2 both of which were paid off in six months under the Debt Snowball method), using the Debt Snowball method is likely to be much more successful.

Key Points

Here are the key points from this post:

  • A budget will help you figure out how much you can afford to apply to your debts each month.
  • If you can’t cover your minimum payments, you’ll need to consider some form of consolidation, re-financing or even bankruptcy, none of which are covered in this post.
  • If you have only one debt to re-pay, the best strategy is to pay it down as quickly as possible, but making the minimum payments as often as you can to avoid finance charges.
  • You will always pay at least as much, and often more, interest when you use the Debt Snowball method as compared to the Debt Avalanche method.
  • Unless you have two or more debts that are all about the same size and have widely varying interest rates, the total interest you will pay is essentially the same regardless of the order in which you re-pay them.  As such, if the sense of accomplishment you get from paying off a few debts will help keep you motivated, using the Debt Snowball method may be the right choice for you.
  • If you have two or more debts that are all about the same size and have disparate interest rates, you will want to use the Debt Avalanche Approach.  Because the balances are all about the same, it will take about the same amount of time to re-pay the first loan regardless of which loan you choose to re-pay first!  As such, it is better to focus on the interest you will save by using the Debt Avalanche approach.

 

Credit Cards: What You Need to Know

Credit-Cards

Credit cards are a terrific convenience but also can be very costly.  Effective use of a credit card can make life easier and improve your credit score.  On the other hand, credit cards are an example of bad debt. It is easy to buy more than you can afford using a credit card, leading to high interest charges and a lower credit score.  The latter process can lead to a downward spiral as the purchases you couldn’t afford lead to ever increasing finance and interest charges on your credit card.  At the same time, your credit score goes down which increases the interest rate on other loans, if you can get them at all as discussed in this post. For a real-world example of how credit cards and lead to a financial disaster, check out this post about a friend of mine.

In this post, I’ll explain how credit cards work, including how finance and interest charges normally apply.  Every credit card is different, so you’ll want to look closely at the terms of any credit cards you currently carry or for which you plan to apply.

How They Work

When a financial institution issues you a credit card, it is offering you a loan in an amount that you can choose based on the amount of your purchases up to your credit limit.

Credit Cards from Your Perspective

From your perspective, you:

  • Pay the annual fee, if there is one.
  • Make purchases or get a cash advance. When you get a cash advance, you are borrowing cash from your credit card company instead of borrowing money to buy something.  You can get a cash advance at an ATM, among other places.
  • Pay your bill – hopefully the full amount every month, but at least the minimum payment if at all possible. If you don’t pay your bill in full, issuers will add interest charges to your next bill, as discussed below.  If you don’t pay as much as your minimum payment, they will also add finance charges.
  • Get rewards. Many credit cards provide rewards in the form of cash back or “points” that can be used for travel or other purchases.

In addition, you have the option to transfer your balance from one credit card to another.  Many people make this type of transfer when they have at least one credit card with a very high interest rate and one with a low interest rate.  By transferring the balance from the high-rate card to the low-rate card, you can reduce the amount of interest you will pay.  Most issuers charge a fee of roughly 3% of the amount transferred when you make a transfer.  If your interest rate decreases by more than 3 percentage points and you are paying off your credit card debt fairly slowly, though, your interest savings will be more in one year or a little longer than the transfer fee. As discussed below, though, the transfer could impact the interest charged on other purchases, so you’ll want to look at the whole picture before making a transfer.

Credit Cards from the Issuer’s Perspective

Income

The credit card issuer generates revenue from several sources:

  • Your annual fees.
  • Interest and financial charges you pay.
  • Fees it receives from vendors who accept their credit cards. Most issuers require vendors to pay them 2% to 4% of the amount of your purchases.  Recently, some vendors have started passing these fees on to customers.  That is, they charge customers who use credit cards more than customers who use a check or pay cash.  I ran into that when paying for many of the costs of our daughter’s wedding.  To keep the cost down, I made sure I paid any vendors who charged these fees using an electronic transfer.
  • Finance charges. If you don’t make a payment toward your credit card bill at all or the amount you pay is less than the minimum payment, issuers charge you a fee in addition to the interest charges.
  • Cash advance fees.  Many issuers charge $10 to $25 or 5% of the amount every time you get a cash advance.  I never use my credit card for a cash advance as 5% of the cash is a steep charge to access cash.  There are emergencies, though, when having cash at any price is imperative.
  • Foreign transaction fees. Many issuers charge fees when you buy something outside your home country.  I carry two Visa cards one of which charges me 3% on my purchases every time I leave the US.  For years, I carried only one credit card but I was leaving the US for a month to travel and decided I wanted a back-up card.  I went to the bank where I keep my checking account and clearly didn’t read the fine print! In hindsight, it was silly to get a back-up credit card for travel with such a high foreign transaction fee.

Issuers’ Expenses

Credit card issuers have four primary expenses – their overhead costs (salaries, rent, etc.), the cost of the rewards they give customers, the cost of borrowing the money that they “loan” you between the time you make a charge and pay your bill, and the amount of money they have to write off because customers don’t pay their bills.

When Do You Pay Interest

If you pay your credit card bill in full every month, you don’t transfer a balance from another card and you don’t get a cash advance from your credit card, you won’t pay any interest.   When you do any of those things, you’ll get interest charges.

Interest on Unpaid Balances

You pay interest on unpaid balances from the day they are due until the day the issuer receives your payment for those charges.  Once you haven’t paid your previous bill in full by its due date, though, the issuer starts charging interest on the day you make each future purchase rather than starting on the day the bill is due until all charges have been paid in full.  I’ll provide an example of this difference below.

Interest on Cash Advances

You pay interest on cash advances from the day you withdraw the money until the day the credit card company receives your payment.  I looked at one of my credit cards and it has a higher interest rate on cash advances in addition to having interest charges from the date of the withdrawal.  The same is true with other credit cards I’ve seen on line or discussed with my friends.

Interest on Balance Transfers

Some issuers allow you to transfer the balance from one credit card to another. You might want to do this type of transfer if the interest rate on one card with a balance is significantly higher than another card you hold.  When you make this type of transfer, the issuer starts charging you interest on the day of the transfer and continues to do so until you pay the balance in full.

In addition, even if you had previously paid off the balance on the card to which you transferred your balance, you will pay interest on all new purchases starting on the date of purchase.  That is, until you have fully paid off your credit card balance including the amount transferred, you do not get a grace period between the date of purchase and the due date of your bill.  The additional interest could offset some or all of the savings you attain by reducing your interest rate when you transfer a balance.  This article from creditcards.com provides more details about some of the risks and benefits of transferring a balance.

How Is Interest Calculated

Still confused about how and when interest is calculated?  Hopefully these examples will help.  Before going into the examples, I need to explain what the interest rate or APR (annual percentage rate) really means.

A 24% APR, for example, doesn’t mean you pay 24% interest if you carry your balance for a full year.  The 24% is divided by 365 (number of days in a year) to get a daily rate.  The daily rate is multiplied by your balance on each day and added to the balance for the next day.  As such, if you didn’t pay or charge anything on your balance for a year, the interest rate on the beginning balance would not be 24%, but rather 27.1%!  I calculated 27.1% as (1+.24/365)365 – 1.  By raising the term inside the parentheses to the 365 power, I’m compounding the daily interest charge for a full year (365 days).

Example 1 – Paid Bill in Full Last Month

In the first example, I’ll show how interest is calculated if you paid your bill in full at the end of the previous billing cycle.  Here are the assumptions for this example:

  • Interest rate on charges = 18%
  • Cash advance interest rate = 24%
  • The cash advance fee is the greater of $10 or 5% of the amount of the cash advance
  • You make a $500 purchase on Day 5
  • You take a $100 cash advance on Day 8
  • Your issuers receives your payment on Day 10 of the next billing cycle (i.e., 33 days after you took the cash advance)

In this example, you don’t pay any interest on the $500 purchase during this billing cycle.

The cash advance is different.  First, you are charged the cash advance fee.  5% of your cash advance is $5 which is less than the $10 minimum, so you will be charged $10 as a cash advance fee.  In addition, you will pay interest at a 24% APR.  The interest charge is $2.19 which is calculated as:

As such, you will re-pay the issuer $112.19 for the $100 cash advance you received. This example illustrates why it is often better to tap sources of cash other than your credit card, if at all possible.

Example 2 – Didn’t Pay Bill in Full Last Month

In this example, I’ll show how interest is calculated if you didn’t pay your bill in full at the end of the previous billing cycle.  Here are the assumptions for this example:

  • Interest rate on charges = 18%
  • Unpaid balance from last month = $750
  • You make a $500 purchase on Day 5
  • Your issuer receives your payment in full on Day 10 of the next billing cycle

I haven’t included a cash advance in this example because it will cost you the same amount regardless of whether you paid your bill in full in the previous month.

In this example, you will pay interest on your unpaid balance for the 30 days in the month plus the 10 days into the next billing cycle, for a total of 40 days. The interest on this balance totals $14.93 and is calculated as:

In addition, you pay interest on the $500 purchase for 25 days in this billing cycle plus the 10 days in the next billing cycle, for a total of 35 days.  The interest charge on this purchase is $8.70 for a total interest charge of $23.63. If you have gotten behind on your credit card balances, check on this post for strategies that will help you get caught up.

The Best Credit Card for You

As with every financial decision, picking the best credit card for you requires balancing the costs and benefits.  In large part, the best credit card for you depends on how you will use it.  The bottom line is that you want the credit card that will have the greatest net benefit or lowest net cost for you.  Here’s how you can calculate that benefit/cost.

Plusses

The plus in the equation that determines your net benefit is the value of any rewards you earn.  Some credit cards provide no rewards, so the total plusses equal 0.  Other credit cards provide rewards, such as  1% of all purchases or 5% of gas purchases plus 3% of food purchases plus 1% of everything else.

To calculate the value of the benefits, you’ll need to estimate how much you expect to charge on your credit for each category of expense.  You can then multiply those benefits by the corresponding reward percentage.  As an illustration, I’ll use the 5% for gas, 3% for food and 1% of everything else example I mentioned above.  The table below shows three different combinations of monthly expenses in those categories and the rewards you would earn.

Category Scenario 1 Scenario 2 Scenario 3
Gas 100 200 500
Food 300 500 300
Other 600 300 200
Monthly Rewards 17 23 33
Annual Rewards 204 276 396

By comparison, you would receive $10 a month or $120 a year with a credit card that provides 1% back on every purchase under all 3 scenarios.  I note that most credit cards do not give rewards for cash advances, so I have not included them in the table above.

Some rewards are harder than others to access or might be in a form that isn’t useful for you.  If that is the case with one of the credit cards you are considering, you might reduce the annual benefit by some amount, such as 50%, for the chance that you don’t use it.

Minuses

Offsetting the rewards are all of the fees and charges I mentioned above – the annual fee, cash advance fees, finance fees, foreign exchange fees and interest charges.

The table below shows the fees I’ve used for illustration for the two cards above.

Rewards 5%/3%/1% 1%
Annual fee $75 $0
Cash advance fee $10 $10
Cash advance APR 24% 18%
Purchase APR 18% 12%

To keep the examples simpler, I’ve assumed you make at least the minimum payment every month so there are no finance charges and you have no foreign transactions.

Example 1

In the first example, you have $1,000 a month in charges plus a $200 cash advance 30 days before your issuer receives your payment.  You pay your bill in full every month.

In this example, your annual costs are $243 using the higher reward card and $150 using the lower reward card.  The table below shows the net cost of using your credit card under each of the 3 scenarios above for both cards, remembering that the lower-reward card has the same rewards under all three scenarios.  A negative net cost means that you pay more in fees than you get in rewards, whereas a positive net cost means you get more in rewards than you pay in fees.

Card 5%/3%/1% 5%/3%/1% 5%/3%/1% 1%
Scenario 1 2 3 All
Rewards +240 +276 +396 +120
Costs -243 -243 -243 -150
Net Cost -3 +93 +189 -30

 

In this example, you don’t incur many fees, so the lower fees in the lower-reward credit card don’t help you.  As such, you are better off with the higher-reward credit card under all three spending scenarios.

Example 2

In the second example, you have $1,000 a month in charges plus a $200 cash advance 30 days before your issuer receives your payment.  Unfortunately, you got behind on your credit card payments so you average 60 days between the time you make each purchase and take out your cash advance and pay your bill.

Your annual costs are $652 using the higher reward card and $379 using the lower reward card.  The table below shows the net cost of using your credit card under each of the 3 scenarios above for both cards.

Card 5%/3%/1% 5%/3%/1% 5%/3%/1% 1%
Scenario 1 2 3 All
Rewards +240 +276 +396 +120
Costs -652 -652 -652 -379
Net Cost -412 -316 -220 -259

 

In this example, the lower-rewards credit card has a lower net cost than the higher-rewards card, unless you buy a lot of gas in which case you are somewhat better off using the higher-rewards card.

Summary

This comparison illustrates that high-rewards credit cards are not always the best.  To select the best credit card, you’ll want to balance the fees you are likely to pay based on your spending and payment patterns with the available rewards and their usefulness to you.

 

6 Ways to Slay Your Student Debt This Year

Slay-Student-Debt

From Susie Q: I’m not as familiar with student debt as I am with the other topics on which I write, so was pleased to accept this guest post from Kate Underwood.  Kate is a freelance writer and staff writer for Club Thrifty, a website dedicated to helping people dream big, spend less, and travel more.  With Kate’s permission and approval, I’ve interspersed some comments and numerical examples in italics to expand on a few of her points.

Unless you’ve been living under a rock, you’re probably aware that we’ve got a bit of a student loan crisis on our hands. The amount currently owed by borrowers isn’t in the billions…nope, it’s actually past the $1 trillion mark!

Chances are, you don’t want to be saddled with your own student debt forever. Debt can hold you back from buying a home, starting a family, traveling the world, and other exciting parts of life. Don’t let student loans ruin your dreams – it’s time to start slaying your student debt this year.

Think it’s impossible? Check out the following ways to attack your student loans with a vengeance.

Follow A Budget

A budget is an essential financial tool that gives a job to every dollar you earn. Get yourself on track by making and following a smart budget. Be sure to account for all necessary expenses, including your student loan payments.

Balance out how much you’re earning with how much you’re spending (and don’t spend money you don’t have). When you’re stuck with student loan debt, it’s key to eliminate luxury spending. Put every spare dollar, after necessities, into paying off your loans.

While it’s tempting to overspend when you get your first “real” job, it’s a bad move. Don’t make the mistake of financing new cars or spending too much on stuff you don’t need. Living within – or below – your means could make a big dent in your student debt. Just live like a college kid for a little longer.

Susie Q adds: For a more detailed discussion of how budgets can be helpful, check out this post or start here for my week-by-week guidance on creating a budget using a spreadsheet template I’ve provided.

Trust me, it’ll be worth it! The faster you pay off your loans, the sooner you can get started building wealth and planning for your next big goal!

Start Repayment Right Away

That little grace period from your lender is appealing, but don’t hang out there too long. The sooner you can begin repayment, the better.

Even during the grace period, interest accrues for many types of loans. So, while you’re allowed to postpone repayment for a time (usually 6 months), it’s prudent to begin repayment as soon as possible.

Susie Q adds: As an example, if you have a $30,000 balance on a 5% loan with 15 years left in the term and don’t defer your payments during the grace period, your payments will be $237 a month. You’ll pay a total of $12,703 in interest over the life of the loan. If you make the same payments and defer your loan, you’ll pay an extra $1,628 in interest payments and extend your loan by 13 months (6 months of grace period and 7 months of extra payments to cover the extra interest).

Pay Extra Each Month

Once you know what your minimum payment amount is every month, don’t get too comfy with it. If you push yourself to increase that amount by even $25 or $50 more each month, you could destroy those loans much faster! At the very least, round up to the nearest $10 or $50 mark. So, a minimum payment of $62 could be rounded up to $70 or $100.

Just be sure that, if you’re making extra payments, they’re applied to the principal, not the interest. If you’re in doubt, talk directly to your lender or loan provider to find out how you can go about doing this.

Susie Q adds: Using the same example as above, if you don’t defer your loan for the grace period and round up to $250 a month, you’ll save over $1,000 as you’ll pay only $11,676 in interest and will pay off your loan a full year earlier.   You can include your student debt in your debt repayment strategy to figure out how much you can pre-pay each month, as discussed in this post.

Another tip: make biweekly payments rather than monthly. After one year, this simple step will add up to having slashed an extra month’s payment off your total. However you choose to set it up, paying more than the minimum will lead to student loan freedom sooner!

Refinance Your Loans

One strategy for paying off your loans faster is to refinance your student loans. The general idea is that if you refinance to a lower interest rate, you’ll end up paying less over the life of the loan. Plus, you can pay them off faster, since you won’t owe as much in interest! Win-win!

A couple of factors to beware of: you usually don’t want to refinance if your credit score has taken a recent hit. That will likely only get you a higher interest rate – you definitely don’t want that! Also, if you plan on utilizing student loan forgiveness programs, you typically need to stay away from refinancing. Most of the forgiveness programs will disqualify you if you’ve refinanced.

If you’re unsure about how to go forward with refinancing, Credible is an online loan marketplace that can make that decision easier. Compare interest rates for which you may qualify with different lenders in order to make the best choice.

Susie Q adds: Using the same example as above, if you are able to re-finance your loan at 3.5% and continue to make the same $237-a-month payment, you’ll save over $5,000 as you’ll pay only $7,485 in interest and will pay off your loan almost two years earlier. This savings will be offset by any fees you need to pay when you re-finance your loan.

Now, if you’re such a rock star that you plan to pay off the full balance within a really short time, like 2 or 3 years, refinancing might not be worth the trouble. Just pay those babies off and be done with them!

Start A Side Hustle

One of the best ways to pay off any debt fast is to increase your income. I’m a big proponent of side hustles. You can make extra cash to pay down debt and side hustles are often super flexible with your other responsibilities.

If you’re looking to begin your own side hustle, you can check out these work-from-home jobs and see which might be a good fit. The possibilities are nearly limitless, so be creative and think about your skills and things you enjoy doing anyway.

You could start doing freelance writing or blogging from home (our favorites!). Or start selling your to-die-for cakes for special occasions. Try your hand at bookkeeping, photography, or proofreading or any number of other ways people are raising their income.

Susie Q adds: For more ideas about ways to increase income or reduce expenses to help free up money to reduce your student loan debt, check out this post. Also, if you decide to pursue a side hustle, you’ll want to make sure you don’t spend more money than you earn!

Just imagine how much extra money you could throw at your student debt by starting a side hustle!

Use Employer Benefits

Some companies are looking to build positive relationships with employees by offering student loan repayment assistance. So, before you decide to take a job, it might be beneficial to ask if it offers this option. If you’ve already signed on to work somewhere, talk to your HR department to see if it’s available.

You should also explore various government student loan forgiveness programs. Though it’s extremely important to follow all of their rules to be eligible, if you’re working in a career field that allows you loan forgiveness, you might as well go for it!

A piece of advice: save enough during your repayment period that you could pay the entire loan balance off just in case the forgiveness doesn’t come through! Most applications for forgiveness so far have been rejected, so those borrowers are still on the hook for the full balance.

Say Goodbye to Student Loans Fast

Debt sucks. You know you don’t want to keep your student loans around forever, so use any and all of these tips to slay your student debt as fast as you can!

 

 

 

New vs Used Cars

Is buying a used car really all that important to your financial health?  I’ve seen lots of articles and posts that say that financially responsible people buy only used cars.  Being the data geek that I am, I was curious so looked into the question.  In this post, I’ll provide you with my insights on the importance of buying a new vs used cars.

Summary of Findings

Here are the important things I learned from studying this question.

  • The cost of your car is more important than whether it is new or used. For example, you will have more savings if you buy a new car for $15,000 than a used car for $20,000, assuming you own them for the same length of time.
  • How long you own your car can be more important than whether you buy a particular model when it is new or when it is three years old.
  • The accumulation of savings from buying less expensive cars and owning them longer, especially after the compounding benefit of investment returns, can be significant though not as large as the amounts I’ve seen reported by some other authors on this topic.

The chart at the very end of this post illustrates these points (so keep reading).

Cost of Buying A Car

How much you pay for a car depends on several factors – its make and model, how old it is, how many miles it has on it, whether it has been in an accident, among other things.  It also depends on how you pay for it – cash, lease or borrowing – as discussed in my post on that topic.  If one of your goals is to save as much as possible, you’ll want to buy the least expensive car that meets your needs, regardless of whether it is new or used.

The biggest argument against buying new vs used cars is that the value of the car decreases more per year when it is brand new than when it is older. This decrease in value is called depreciation.

Depreciation

The chart below illustrates estimates of the patterns of depreciation for five different makes and models – a Subaru Impreza, a Ford Fusion, a Toyota RAV4, a Ford F150 and a BMW M4.

These estimates are based on a combination of data from Edmunds and the National Automotive Dealers Association (NADA). These two data sources didn’t have always values that were consistent, so I applied some judgment in deriving these curves.

The graph shows that all five models depreciate between 18% (Impreza) and 29% (F150) in the first year.  In the next 10 years, depreciation is generally between 13% and 17% per year and is even lower when the cars are older than that.

Depreciation in Dollars

To look at these values from a different perspective, I created the next graph that shows the dollar amount of estimated depreciation each year.

This chart shows that, even though the Fusion has the second highest percentage depreciation in the first year, it has the smallest dollar depreciation.  When considering how much a car will cost you, it is the dollar depreciation that is important.

These graphs make it fairly clear that, if you plan to reduce the cost of a car purchase by buying used, you save the most money by buying a car when it is one year old. The amount you will save gets smaller with each additional year the car ages.

Costs of Owning a Car

In addition to depreciation and, if applicable, finance or lease costs, there are five other major costs of owning a car – fuel, insurance, taxes and fees, maintenance, and repairs.

Fuel

The cost of fuel (e.g, regular, premium or ethanol-free gas, diesel or electricity) will generally stay constant for each mile you drive, other than inflationary changes in fuel prices.  For modeling the total cost of ownership, I assumed you will drive the same number of miles every year so the real cost of fuel will be constant.  I used the first-year fuel cost from Edmunds True Cost to Own as the real cost of fuel in every year.

Insurance

The portion of insurance that covers liability will likely be constant for a particular car in real dollars.  The cost of liability insurance will be higher for makes and models of cars that are in more accidents (e.g., sporty ones) and larger cars (e.g., pick-ups that will cause more damage to another vehicle or more severe injuries).  For my analysis below, I have used the first-year insurance cost from Edmunds True Cost to Own.  I assumed that 40% of that amount was for liability insurance and would stay constant in real dollars.  That leaves the remaining 60% for physical damage coverage which I assumed would decrease, in real dollars, in proportion to the value of the car.

Taxes and Fees

Taxes and fees can be constant over time or decrease with the value of the car, depending on the state in which it is registered.  For my analysis below, I used the first-year amount for taxes and fees from the Edmunds True Cost to Own.  For subsequent years, I have assumed that taxes and fees, in real dollars, would decrease with the value of the car.

Maintenance

This component of the cost of owning a car includes regularly scheduled maintenance and parts replacement, such as oil and other fluid changes, tire rotation, balancing, alignments and replacement, brakes, transmissions, tune-ups and anything else included in the maintenance schedule provided by the dealer when new. It excludes repairs for damage to the car and repair or replacement of parts not on the schedule.

I have assumed that the real cost for maintenance is fairly constant per mile over the life of the car.  Because I am assuming that your annual mileage is fairly stable, I can assume that the real cost of maintenance is constant from year to year.

Warranties Reduce Maintenance Costs

The significant exception is that many manufacturers include the cost of up to five years of maintenance in the purchase price of a new car.  In my analysis below, I have relied on the information in the Edmunds True Cost to Own for the length of time that maintenance is covered by the manufacturer.  After that, I used the average maintenance cost for the remaining years included in the Edmunds data and assumed it was constant in real dollars for the rest of the life of the car.  I also assumed that the maintenance provided by the manufacturer is transferrable to a new owner.

If you are comparing the cost of a new car with that of a used car, you will want to make sure you understand which maintenance costs are covered by the warranty for each vehicle.  For most of the cars in this comparison, the average annual cost of scheduled maintenance was estimated by Edmunds to be between $750 and $1,150 a year.  The exception is the BMW for which the average annual cost after the warranty ends was closer to $3,000 a year.  The maintenance covered by the dealer could offset some of the higher depreciation you experience in the first few years of owning a new car.

Repairs

Repair costs include repair of damage to your car, such as cracked windshields, and repairs or replacement of parts that break.  For my analysis below, I used the repair costs provided by Edmunds for each of the first five years after the car is new.  I then looked at the results of a Consumers Report study to estimate how much repair costs would increase as the car got older.  Based on that study, I estimated that repair costs increased about 4% per year in real dollars.

Total

The graphs below show the components of the cost of ownership (excluding purchase price, financing cost and depreciation) for the five illustrative cars in each of the first and fifth years of ownership.

 

A comparison of these charts shows the much lower cost of owning a new car than a five-year old car if the costs related to its purchase are excluded.  While the insurance goes down from the first year to the fifth year, the cost of maintenance increases significantly as the manufacturer is no longer paying for it.  In addition, Edmunds shows no repair costs in the first year after it is first sold, but they can be significant, especially for the BMW M4, by the fifth year.

The chart below shows the total of these costs for each car by the number of years since it was new.

For most of these cars, the ownership cost is fairly constant starting in the second year. The Impreza, Rav 4 and Fusion all have annual ownership costs of about $3,500.  The F150 has a similar pattern, but its annual ownership cost is closer to $4,500.  The BMW M4 ownership cost is similar to that of the F150 for the first three years, but increases dramatically when BMW stops covering the costs of maintenance and repairs.

Total Cost of Ownership

To provide insights on the long-term costs of different car-buying decisions, I calculated the total cost (in real dollars, i.e., without adjustment for inflation) of owning a car assuming the same choice was made for 60 years.  I used 60 years as I thought it fairly closely represented the length of time people own cars – from the time they are about 20 until they are about 80.

In these comparisons, I included the initial purchase price of each car (using the new car costs from Edmunds and used car costs using my approximation of depreciation) and the other costs of ownership as discussed in the previous section. Also, whenever a replacement car was purchased, I assumed that the preceding car could be sold at the depreciated price.

New vs. Used

The two graphs below show the total cost over 60 years of owning each of the five cars. The three bars for each car correspond to buying a new car, a one-year old car and a three-year old car.  The first graph compares the total cost if you buy a replacement car every five years; the second, every 15 years.

If you replace your car every five years, it is clearly less expensive to buy a three-year-old car than a one-year-old car or a new one, though it becomes less important if you are buying inexpensive cars such as the Fusion.  The difference between buying a new car and a one-year-old car is quite large for the F150 and the BMW, both of which have high depreciation in the first year.

If you own each car for 15 years, the benefits of buying a used car are much smaller. In fact, the increased maintenance and repair costs of buying a one-year-old car essentially offset the high first-year depreciation for the Subaru, Toyota and Fusion.  Buying a three-year-old car is still clearly less expensive for all models.

More Expensive vs. Less Expensive

The Subaru and Fusion are fairly similar cars – both are basic 4-door sedans, though the Subaru has all-wheel drive.  If you don’t need all-wheel drive, you might be indifferent between the two cars.  By comparing the total costs of the Subaru and Fusion in the above charts, you can see that the long-term cost of ownership of the Fusion is less than that of the Subaru.  In particular, the cost of buying new Fusions is less expensive than buying three-year-old Subarus.

This comparison emphasizes the point I made in the Summary that the initial purchase price of your vehicle is a more important factor than whether you buy new vs used cars.

Length of Time Owned

The graph below compares the total cost of ownership if you buy new cars and own them for different lengths of time.

The longer you own your cars, the fewer times you need to replace them. Replacing cars fewer times is less expensive over the long run, even though you get less for them when you sell them.  One consideration when you own your cars for a long time is that you’ll need to save up more for the replacement car because you will get less when you sell the old car.

For the Subaru, Toyota and Fusion, there is a small difference in total cost between replacing your car every three years and replacing it every five years.  For the BMW and F150, which have higher depreciation, the benefit of keeping your car for five years is larger.

For all five cars, you will save a significant amount over your lifetime if you replace your cars every 15 years as compared to replacing them every three or five years.

The graph below emphasizes the importance of how long you own your car.  The blue bars represent the total cost of ownership if you buy new cars and own them for 15 years.  The orange bars correspond to buying a three-year old car and replacing it every five years.

For all fives makes and models, replacing a new car every 15 years is about the same total cost or slightly less expensive than replacing three-year old cars every five years.

Compounded Value of Savings

Many of my readers look at how much more money they will have when they retire if they make certain financial decisions.  I think this perspective is terrific, as it focuses on long-term financial objectives.  It also encourages financial responsibility in that these analyses assume that you will save the money in a tax-advantaged retirement account, such as an IRA or 401(k), rather than spend your savings on something else.  My post at this link provides more information about tax-advantaged retirement accounts.

Common Assumptions

I’ve read a few other posts that look at how much money will accumulate if you buy used cars instead of new cars and invest the difference in stocks.  These posts tend to make the following assumptions:

  • You have enough money to pay cash for a new car every certain number of years (such as 10), but buy a used one instead. One example I saw assumed that a three-year old car would cost 50% of a new car.
  • You replace your car when it is a certain number of years old, such as 10, regardless of whether you buy it new or used (three years old, for example).
  • You are able to invest the difference between (a) the stream of cash needed to buy the new car every 10 years and (b) the stream of cash needed to buy the used car every seven years in the stock market at 8% to 10%.

Better Assumptions

There are a few aspects of this process that most posts I’ve seen overlooked.

  • They exclude the cash you get when you sell your car.
  • They overstate the cost savings from buying a three-year old car. My analysis indicates that cars depreciate between 35% and 45% in that time frame, not 50%.
  • They ignore the other costs of ownership, especially the much lower repair costs and the maintenance costs covered by manufacturers’ warranties in the first few years of ownership.
  • They ignore the riskiness of investing in the stock market. That is, if you invest the savings from buying a used car in the first year, there is as much as a 15% to 20% chance that you will not have enough money in the seventh year to replace your used car.

In the discussions below, I will use essentially the same paradigm, but will refine some of the assumptions.  In particular, I will revise the investment assumptions so they:

  • better reflect the cash flow needs,
  • use the higher purchase costs for the used car,
  • include all costs of ownership, and
  • eliminate the risk that you might not have enough money to buy your second car.

This analysis is simpler than it could be.  In the entire analysis, I stated all of the cash flows in current or real dollars. That is, your actual savings will likely be higher than is estimated in this analysis because, with inflation, the cost of the more expensive strategy will be even more expensive than if we had assumed that all costs were subject to the same inflation rate.

Reasonable Investment Assumptions

To avoid the risk that you won’t have enough money to pay for the second used car, I will assume that you can earn 3% in an essentially risk-free investment for the first 10 years (until you replace your new car for the first time). In the current interest rate environment, you can earn close to 3% on CDs, corporate bonds or high-yield savings accounts.  After that, you have enough savings built up from buying two used cars instead of two new cars that you can afford to take on the risk of investing in the stock market.

I have used the annual returns on the S&P 500 from 1950 through 2018 to model the amounts you will have accumulated by selecting the less expensive strategies.

New vs Used Cars

For the first comparison, I will look at the example discussed above – buy a new car every 10 years or a used car every 7 years.  In this comparison, I calculated how much you would have at the end of 40 years if you invested the difference between the new car costs and the used car costs.  For the first 10 years, I assumed you would earn 3%.  For the remaining 30 years, I used the time series of 30 years of S&P 500 returns starting in each of 1950 through 1968 (for a total of 39 time series).  To reiterate, this comparison assumes that you invest the difference in a tax-advantaged account and don’t spend it on something else.

If you buy used F150s instead of new ones, the historical stock market returns indicate that you will have an average of $390,000 more in retirement savings at the end of 40 years with a range of $200,000 to $800,000.   For the Subaru, the average is $160,000 in a range of $75,000 to $350,000.

This analysis indicates that, if you prefer to drive fairly expensive cars that depreciate quickly when they are new, you can accumulate a substantial amount of money if you buy used cars for 40 years.  For less expensive cars that don’t depreciate as quickly, the additional savings amount isn’t as large but is still significant.

More Expensive vs. Less Expensive

You can get almost as much additional retirement savings if you buy a less expensive new car and own it for 10 years as you can if you buy the used F150 instead of a new one and more than if you buy a used Subaru instead of a new one. For example, if you buy the Fusion (currently about $15,300 new) instead of the Subaru Impreza (currently about $26,000 new according to Edmunds) every 10 years, you would have an average of about $300,000 more in retirement savings.  That additional money comes from:

  • the $11,000 of up front savings from the first car purchase,
  • the $8,000 of savings for purchase of the three replacement cars after trade-in,
  • the $250 to $350 a year less it costs to own the Fusion, and
  • the investment returns on those savings.

This analysis shows that you can save more by buying a less expensive new sedan (the Fusion) every 10 years than by buying a three-year old Subaru every seven years. That is, if instead of buying new Subarus you buy new Fusions, you will have an average of $300,000 in additional retirement savings, but only $160,000 if you buy used Subarus.

Length of Time Owned

You can also accumulate savings by buying cars less often.  For this comparison, I looked at comparison of buying new Subarus and F150s every five years and every 15 years.  If you replace the Subaru every 15 years, you will accumulate an average of $300,000 of additional retirement savings in 40 years as compared to replacing it every five years.  With the faster depreciation and higher cost of the F150, the average additional savings in 40 years is about $600,000.

Comparison of Options

The box and whisker plot below (discussed in more detail in my post on risk) compares the amount of additional retirement savings you will have under the options above.  Briefly, the boxes represent the range between the 25th and 75th percentiles, while the whiskers (lines sticking out of the boxes) represent the range between the 5th and 95th percentiles.  Recall that the only source of variation in these results is the different time periods used for stock returns – the 39 30-year periods starting in each of 1950 through 1988.

The first three boxes relate to the purchase of fairly modest sedans – the Subaru and Fusion.  The graph shows how much more retirement savings you will have if you either buy new Fusions instead of new Subarus (second box) or replace your new Subaru every 15 years instead of every 5 years (third box) than if you buy three-year-old Subarus instead of new ones (first box).

The last two boxes relate to the purchase of the more expensive F150.  Again, you will accumulate much more in your retirement savings if you replace your F150 every 15 years instead of every 5 years (last box) than if you buy three-year-old trucks instead of new ones (second to last box).

Final Words

Ultimately, you’ll need to buy a car that best fits in your budget and meets your needs. As you make your choice, though, you might want to remember that there are clearly ways you can save money even if you prefer to buy new cars.

My Next Car: Pay Cash, Borrow or Lease?

The finances of buying a car can be tricky.  In addition, there are so many other things to consider. What kind of car do I like?  How often do I want to replace my car?  How many people (and pets) do I need to be able to transport comfortably?  Through what weather conditions do I need to drive? Do I want a new or used car (as discussed here)? In this post, I’ll focus on the finances of purchasing a car once you’ve decided generally what car(s) fit your other needs.  Specifically, I’ll describe the financial considerations of three options for buying your next car: pay cash, borrow or lease. I will also provide a spreadsheet to allow you to compare the finances of specific deals.

The Basics of Leases and Loans

I have a post that provides all the basics you need to understand about loans.

There are plenty of resources available to provide you with information about leases, so I won’t repeat that information here.  Here are a few resources:

  • This article focuses on teenagers, but it covers a lot of important aspects of leasing. Consumer Reports is considered an independent source for information about purchases.
  • Edmunds is a company that values and researches cars, as well as having a platform for selling used cars. Its guide on leasing can be found here.
  • The first several sections of this post by Debt & Cupcakes (@debtandcupcakes) provide details about leasing, along with the pros and cons.
  • Real Car Tips also has a guide for leasing. Here is the link for the leasing guide.

Your credit score is an important driver of the terms you will be offered whether you lease or borrow.  When I looked for examples on line, all of the offers were contingent on your credit score being above 800.  A credit score of 800 is excellent.  I have a post on how you can check and improve your credit score.

The Finances of Owning a Car

Cars are expensive to own.  This post will focus on the cost of buying a car under three different options – cash, borrowing and leasing.  As you evaluate which of the options works for you, you’ll also want to make sure you are able to afford the other costs of ownership of a car.  In addition to the purchase costs discussed below, there are four other categories of expenses:

Fuel

Your car needs gas, diesel or electricity.  As you are selecting a car, you’ll want to consider the type of fuel your car needs, the miles per gallon the car gets and how many miles you are going to drive.

Registration

You will need to register your car every year.  In the states in which I’ve owned cars, registration is a function of the value of the car – the higher the value, the higher the registration fees. I recall that a car worth $20,000 cost about $300 to $400 a year to register, whereas the minimum charge (for older cars) was about $50 a year in Minnesota, but the amounts vary widely across states.  In other states, registration fees are a flat amount regardless of the age or value of your car.

Insurance

In all states you are required to buy car insurance. This post provides information on insurance you are required to purchase and coverages you might want to purchase.  Liability insurance usually doesn’t depend on the value of the car, though can be higher for sportier and faster cars.  The premiums for physical damage coverages (comprehensive and collision which protect you against damage to your car) increase with the value of your car.

Maintenance & Repairs

Cars need regular maintenance – oil changes, replacement brakes and tires, among other things.  Some dealers provide regular maintenance at their location for one or more years if you buy a new car, but that is not always the case.  In addition to regular maintenance, cars break down and need to be repaired.  Repair expenses tend to be higher on older cars.  Even on new cars, repairs can be expensive and unexpected.

You’ll want to keep some money in your designated savings for car repairs, as discussed in this post.  Another option is to buy an extended warranty to cover repairs to your car.  Extended warranties can be quite expensive, but cover the cost of some major repairs if they are needed.  I’ll write about extended warranties in another post in the future. If you choose to purchase an extended warranty, you’ll need to include that cost as part of your expenses related to owning the car, along with a provision for repairs not covered by the warranty.

How to Think About the Finances of Buying a Car

Determine Your Needs

I always find it helpful to define what I want and can afford before I go shopping for anything expensive, cars in particular.  My husband does all of the negotiating on price for our cars because that is a skill I never acquired and I don’t like the process so don’t want to acquire it.  I figure out what I need, what’s available in our price range that meets those needs and make a very detailed list so he can go to different dealers to negotiate the terms.

As part of your needs, you’ll want to think about the length of time you’d like to own your car.  Some people like to drive a new or at least a different car every few years.  I was that way when I was young – I bought a different car every 3 years for a bit.  I’ve always regretted selling the first one – a 1969 Mustang convertible. Live and learn!

Other people drive cars until they die or become unreliable.  Now that I understand the finances of cars better, I have moved to the second category.  The most recent two cars I’ve sold (both Honda Preludes) had 250,000 and 150,000 miles on them respectively.  The only reason I sold the second one is because I moved to a place with hills and snow, as opposed to flat and snow, and a Honda Prelude just wasn’t going to get me home reliably in the winter.

Figure Out What You Can Afford

The second step in the process – figuring out what’s in your price range – can involve several perspectives.

  1. How much cash do you have available to either pay for the entire car or put as an initial payment towards a loan or lease? As you consider that amount, you’ll want to take the total cash you have available and reduce it for the other costs of ownership I’ve listed above.
  2. If you aren’t going to pay cash for the car, how much you can afford to pay every month? Again, don’t forget that you’ll need to pay for registration, insurance, fuel, maintenance and repairs, too.
  3. If you can’t find new cars that fit in your budget, you might need to look at used cars. I have another post planned that will address the finances of buying new versus used.

Gap Insurance

Gap insurance is another expense you may have to pay if you don’t pay cash for your car. In some cases, you’ll want to buy it for your peace of mind.  In other cases, the lender or lessor may require it.

Gap insurance protects you against the difference between the value of the car and your outstanding balance at any point in time during the loan or lease.  Although it may not be clearly stated in your lease agreement, lessors think of your lease payments as including compensation to them for the reduction in the value of the car as you use it (depreciation) and interest on the value of the car (similar to loan interest).  As such, both loans and leases have outstanding balances at all times during their terms.

The chart below compares the outstanding balance on a loan with an estimate of the value of a $23,000 car over the term of an 84-month loan.  For this illustration, I’ve assumed that the borrower paid $1,000 towards the value of the car as a down payment and the loan has a 3% interest rate. I estimated the value of the car by looking at the clean trade-in value of a Ford Fusion from prior model years on the National Automobile Dealers Association (NADA) web site, a common source for lenders to get car values.

For the Ford Fusion, the loan balance is more than the value of the car between 4 and 36 months.  If the car is totaled, your car insurer will reimburse you for the value of the car minus your deductible.  During that time period, you will owe the lender not only your deductible but the difference between the blue line and the orange line.  To protect yourself from having to pay the additional amount, you can buy gap insurance.

You’ll want to investigate the cost and need for gap insurance for the particular make and model you are buying.  Cars depreciate at different rates.  For example, when I looked at the NADA web site for a Subaru Impreza, the value never went below this illustrative loan balance.

The Finances of Cash, Leases and Borrowing

Now that I’ve covered the preliminaries, we can get to the main topic of this post – the details of paying cash, borrowing and leasing.

Cash

When you pay cash for a car, there is only one number on which you need to focus. It is the out-the-door cost of buying the car.  This amount will include some or all of the following:

  • The cost of the car,
  • The additional cost of options you choose,
  • Sales tax (called excise tax in some jurisdications),
  • Processing and documentation fees,
  • Delivery charges, and
  • Title and registration fees.

Not all of these charges are included in every state or by every dealer.  I recently bought a new car in Montana. There is no sales tax in Montana, there wasn’t a delivery charge and you pay the state for title and registration fees directly, so the only things on my invoice were the cost of the car, the cost of the two options I added and a $100 documentation fee.  If you are comparing prices from different sources, you’ll want to make sure that they consistently treat all of these possible costs. For example, you should make sure they either all include or all exclude title and registration fees.   If not, you’ll need to add them to your analysis of the total amount you can pay for the car.

Leasing

The finances of leasing involve many important numbers, even more than borrowing.  All of these numbers should be available to you in the contract and from the dealer or leasing company. 

Up-front Payment

You’ll want to make sure you know the total amount of the up-front payment, including sales taxes, title and registration fees and the base charges from the dealer and finance company. The up-front payment often includes the first month’s lease payment, but not always, so you’ll want to be sure to know whether it is included for each offer you consider.

Monthly Payment

The amount that you’ll pay every month.

Sales Tax Rate

You pay sales tax on your monthly lease payments.You’ll need to know if the sales tax is included in the monthly payment you’ve been quoted and, if not, what sales tax rate applies.

Term

The term is the number of months you are committed to the lease. It is important to note that my spreadsheet assumes the lease term is 36 months and you will honor your commitment to the lease for its entire term.  There can be significant penalties if you choose to return the car before the lease ends.

Allowed Annual Mileage

Every lease contains a maximum number of “free” miles you can drive on average each year.

Estimated Actual Annual Mileage

You can use your actual annual mileage to estimate how much you will have to pay in excess mileage charges to understand the full cost of a least.

Cost Per Extra Mile

If you exceed the total allowed mileage (the allowed annual mileage times the term), you will pay an extra fee when you return the car. To calculate the extra amount, you first take your actual mileage and subtract the total allowed mileage.  You then multiply the excess miles by the cost per extra mile.  As I’ve looked on line at leases, I’ve seen several that charge 15 cents per extra mile.  If, for example, you drive 50,000 in three years on a car with 12,000 miles allowed and a 15 cent per mile charge, you will pay an extra $1,800 when the lease ends.

You may also need to pay a fee if your car experiences more than the normal amount of wear and tear. For example, if you live on a gravel road or a busy street, your car may have many more nicks and dings than someone who lives on a quiet paved cul-de-sac.

Residual Value

If you think you might want to buy the car at the end of the lease, you’ll need to know the residual value.This amount is what you will pay to keep the car.

Monthly Cost of Gap Insurance

If you want or need to buy gap insurance, you’ll want to know by how much it costs each month. You can buy gap insurance from your car insurer and, sometimes, the dealer, though I’ve read that buying it through the dealer tends to be more expensive.

Borrowing

The finances of taking out a loan for a car are a bit less complex than leasing. Here are the important numbers you need to know.

  • Up-front payment – You’ll want to make sure you know the total amount of the up-front payment, including sales taxes, title and registration fees and the base charges from the dealer and finance company. The up-front payment often includes the first month’s lease payment, but not always, so you’ll want to be sure to know whether it is included for each offer you consider.
  • Amount financed – This amount is equal to the total value of the car minus the portion of your up-front payment that goes towards paying for your car.
  • Monthly payment – The amount that you’ll pay every month. There is no sales tax on loan payments.  The sales tax was considered in the total amount of the car used to determine your up-front and monthly payments.
  • Interest rate – The interest rate, along with the amount financed and monthly payment, are used to determine the remaining principal on your loan at point in the future. If you want to sell your car before you have paid off your loan, you’ll want to be sure to know the amount financed and the interest rate so the spreadsheet can calculate the remaining principal.
  • Loan term – The term determines how many monthly payments you will make.
  • Monthly cost of gap insurance – If you need or want to buy gap insurance, you’ll want to know by how much it costs each month.

Illustrative Comparison

Because I just purchased a Subaru Impreza for around $23,000, I use it and two other cars advertised as having similar costs as illustrations.

The Offers

The table below summarizes the values I found on line and/or created for a Subaru Impreza, a Toyota Camry and a Ford Fusion

Although the cash prices are similar, the Lease and Borrow options have fairly different terms. The amount due at signing and monthly payment are much lower for the Toyota Camry lease than for the other two cars. The interest rates on the loans are very different, even though the monthly payments are all essentially identical. The Subaru has a lower interest rate and shorter term than the other two cars.  Because the payments are the same and the interest rate is higher, the amount due at signing must cover more of the cost of the Toyota than for the other two cars.

Not all of these values were clearly identified in the terms I found on-line.  The actual offers could be somewhat to significantly different from the values I’ve shown above.  Nonetheless, the differences in the terms help differentiate the total financial cost of these offers.

Look at Just the Subaru

We will first look at a comparison of the three options for the Subaru Impreza. Before we can do that, you need to determine for how long you want to own the car.  For illustration, I’ve looked at two options – own it for the term of the lease (assumed to be 36 months) or own it until it dies (or at least until you’ve made all of your loan payments).

Sell in Three Years

The first row of the table below shows the total of all of the payments you will make under each of the three options over the course of the first three years.  For the Cash option, it is your out-the-door cost. For the Borrow and Lease options, it is the sum of the amount due at signing, your monthly payments and the monthly cost of gap insurance.  For the Lease option, I added sales tax to the monthly lease payments.

Three Years Cash Borrow Lease
Upfront Cost + Monthly Payments $23,691 $14,133 $15,971
Amount on Sale 12,000 761 -1,350
Net Cost 11,691 13,372 17,321

The second row shows how much you would get or pay at the end of 36 months.  For all three cars, I have assumed you can sell them for $12,000 after three years. For the Cash option, the second row shows the total sales price of the car.  For the Borrow option, it is the difference between the $12,000 sales price and the loan balance.  For the Lease option, the value is negative meaning it is an amount you have to pay instead of receive.  It is the charge for the extra miles put on the car.  If you look at the inputs table, you’ll see that there is a 15 cent per mile charge for every mile over 12,000 a year and I have assumed you will drive 15,000 miles a year.

The third row shows the total net cost, calculated as the first row minus the second row.  For the offers for the Subaru Impreza, the Cash option is cheapest if you plan to sell after 3 years.  If you can’t afford to pay cash up front, the Borrow option is preferred to the Lease option.

Drive Forever

Under the Drive Forever option, the sales price of the car is assumed to be essentially zero, so we can look at just the cash outflows.  The table below summarizes the total cost of the three options.

Drive Forever Total Cost
Cash $23,691
Borrow 25,581
Lease 31,321

The total cost of the Cash option is the same as in the Three Years table.  There are no purchasing costs other than the amount paid at signing under this option.  For the Borrow option, the total cost has increased from the Three Years option because it now includes the monthly payments after three years until the loan is fully re-paid.  For the Lease option, the cost has increased by the residual value of the car, $14,000 in this case.  That is, in addition to the up-front and monthly lease payments, you’ll need to pay the $1,350 for the extra miles and $14,000 to buy the car from the lessor.

Using the longer time frame, the Lease option is even more expensive than the Borrow option.  Because the interest rate is fairly low, the additional interest paid after three years isn’t a lot so the difference between the Borrow and Cash options doesn’t increase by a large amount from what was observed for the Three Years option.

Look at All Three Cars – Three Years

The relative order of the three options varies depending on the terms of the offer. The graph below compares the net costs of ownership of the three cars if you anticipate selling the car in three year.

The values for the Subaru Impreza are the same as the ones in the third row of the Three Years option table above.  As can be seen, leasing isn’t always the worst option as was the case for the Subaru. The Lease option is less expensive than the Borrow option for the Camry and is only slightly more expensive than the Borrow option for the Ford, using the three-year time frame.

If you are indifferent among the three cars, you could also compare the costs among the cars.  For example, let’s say you don’t have enough cash to pay for the car up front, so you are looking at the Lease and Borrow options. The net cost of the Lease option for the Camry is about the same as the Borrow option for the Impreza.  The risk of the Lease option is that you will drive even more miles than you’ve estimated adding to the net cost of the Camry Lease option.  You would want to offset that risk with the risk that you might not get $12,000 for the Impreza when you sell along with the hassle of having to sell the Impreza.

This comparison highlights the importance of getting all of the detailed terms of every option.

Look at All Three Cars – Drive Forever

The graph below shows the same comparison for the “Drive Forever” option.

Other than the total costs of ownership being higher (because you are owning the car until it dies instead of having to replace it or selling it in three years), the relationships among the three options for each car are essentially the same. That is, the order and relative costs of the Cash, Borrow and Lease options are the same for each vehicle.

Of the Lease and Borrow options, the Impreza Borrow option is the least expensive in this example.  The Camry Borrow and Lease options and Ford Borrow option are all $3,000 to $4,000 higher, so you might choose from one of those if you didn’t like the Impreza.  If you have cash to buy the car outright, the Ford Cash option is the least expensive, though the Camry is only a few hundred dollars more.

In addition to comparing different makes and models, you can make similar comparisons among offers you obtain from different dealerships for the same car.

Can I Invest my Cash and Use it to Pay Off my Lease or Loan?

For those of you who read my post about Chris’s mortgage, you know that I suggested he consider paying the minimum payments on his mortgage and investing the rest of his money.  You may be wondering why I haven’t talked about the benefits of investing money under the Lease and Borrow options.

There are a few reasons.

  • Most people who buy a car using a lease or borrowing don’t have the cash available to pay for the car up front. If you don’t have cash to invest, there is no possibility of investment returns.
  • The term of a lease or loan is much shorter than the length of a fairly new mortgage. In Chris’s case, he had 26 years of payments left on his mortgage.  As I discussed in my post on investments and diversification, the likelihood you will earn the average return increases the longer you invest. With the short time span of a car loan or lease, investing in stocks with the expectation of having money to pay off your lease or loan would be very risky.  There is a fairly high probability your investments wouldn’t return enough to make those payments.
  • To avoid the chance that your investments wouldn’t cover your car payments, you could invest in something with very low risk, such as a money market account, certificates of deposit (of which you would need a lot to match the timing of your loan or lease payments) or high yield savings account. Low risk investments currently have very low returns – generally less than 2.5% pre-tax and even less than that after tax.  There are very few loans or leases that have interest rates (implicit in the case of a lease) that are less than 2.5%, so there isn’t much benefit in investing cash in risk-free assets until your loan or lease payments are due.

How To Use the Spreadsheet

To help you create your own comparisons similar to the ones above, I’ve provided you my spreadsheet at the link below.

Overview

The flowchart below will help guide you through the financial aspects of the car-buying process.  It assumes that you have identified one or more cars that will meet your needs and possibly fit in your budget.

The hexagonal boxes in a flow chart correspond to decision points. The rectangular boxes contain action items.

The first step is to determine whether you can afford to pay cash.  If not, you won’t have to negotiate a price for the Cash option for any of the cars you are considering.

Next, take a look at estimates of the up-front and down payments for the Lease and Borrow options.  If you can’t afford either of them in addition to the other costs of car ownership, you will need to find a less expensive option – either new or used – and go back to the top of the flowchart.

The next decision point is how long you want to own the car – the term of the lease (which I have assumed will be three years) or a much longer time (at least as long as the term of the loan in the Borrow option).  When you are done entering the values, you’ll look at the summary at the top of the Lease Term tab if you plan to own the car for the lease term and the Drive Forever tab if you want to own it longer.

If you want to own the car beyond the end of the lease, you’ll need to be able to afford to pay the residual value at the end of the lease.  If not, you’ll want to exclude the Lease option from consideration and focus on the Borrow option.

Collect Terms

Once you’ve narrowed down your choices to a few cars and figured out which of the Cash, Lease and Borrow options work for you, you will be ready to talk to dealers and other car sellers.  The Inputs tab of the spreadsheet lists all of the information you need for each type of purchase.  I defined each of the inputs earlier in this post.  For every deal you are offered, be sure to get all of these values.  I found that there are some of these values that are consistently unavailable if you look on line.  You may need to ask for some of these items specifically.  If you aren’t sure you are getting straight answers, you can always ask for the actual contract.  It is required to have all of the terms.

Enter Values in Spreadsheet

Next, enter all of the values into the Inputs tab.  Then, go to the tab that corresponds to the time period you plan to own your car – Lease Term or Drive Forever.  You can see the total cost of the options for which you entered the data.

If you have deals for more than one car, I suggest making one copy of the spreadsheet for each car.  You can then compare not only between the Cash, Lease and/or Borrow options for a single car, but can compare whichever options are available to you across cars.

Your final choice of car and deal could be the least expensive or a different one. It will all depend on your personal financial situation, your qualitative considerations and their relative importance.  Buying a car is an important decision, so cost may not be the only factor to influence your decision.

Download Car Comparison Spreadsheet

The Basics of Loans: What You Need to Know

Loans are the financial instruments people use to borrow money.  Whether they are getting a mortgage to buy a house, borrowing money to buy a car (as opposed to leasing or paying cash as discussed in this post),  or other large purchase, not paying off their credit card in full or borrowing money from a friend, they are taking out a loan.  In this post, I will cover the basics of loans, including:

  • an introduction to the key terms
  • a description of how loans work
  • the factors that determine your monthly payment
  • some common borrowing mistakes

In other posts, I talked about the pros and cons of pre-paying your student loans; more quickly.

The Basics of Loans: Key Terms

There are four basic terms common to almost all loans.  They are:

  • Down payment – The amount you have to pay in cash up front for your purchase.  For large purchases, such as homes, condos and vehicles, the lender requires that you pay for part of the purchase immediately.  This amount is the down payment. The lender wants you to have a financial interest in maintaining your purchase so it doesn’t lose value (as in the case of a residence) or lose value more quickly than expected (as in the case of a car).  For some other types of loans, no down payment is needed. Examples of such loans are student loans, credit card balances and personal lines of credit.
  • Principal – The amount you borrow.
  • Interest rate – The percentage that is multiplied by the portion of the principal you haven’t repaid yet to determine the amount of interest you owe.  Interest rates are usually stated as annual percentages. They are divided by 12 to determine the interest that is due each month.
  • Term – The time period over which you re-pay the loan.

The Basics of Loans:  How They Work

How the Money Moves

When you borrow money, the lender usually pays a third party on your behalf.  For example, when you buy a home or use a credit card, the lender gives the money directly to the seller or its escrow agent.  For some loans, the lender gives the money to you, such as with a line of credit. The amount of money the lender gives you or pays on your behalf is the principal.

You then re-pay the loan by paying the lender periodically (usually monthly or bi-weekly).  For most loans, you start making payments immediately. For some loans, though, such as student loans and some car loans, you don’t have to make payments right away.  Most student loans don’t require any re-payments until after graduation. When entering into a loan that doesn’t require immediate payments, it is critical to understand whether interest will be adding up between the time you enter into the loan and the time you start making payments.  Several years of interest, even at a low rate, can increase the amount you need to re-pay substantially.

Payments Include Principal and Interest

Part of each payment is the interest the lender charges you for letting you use its money.  The rest covers repayment of the principal. For example, if you borrowed $20,000 (the principal) at 5% (the interest rate) and started making monthly payment right away, the lender would calculate the interest portion of your first payment as 5% divided by 12 (months) times $20,000 or $83.33.  Your monthly payment also includes some principal. If you have a 10-year term on this loan, your monthly payment will be $212.13. In this case, you will re-pay $128.80 ($212.13 – $83.33) of principal in the first month.

In the second month, you’ll pay interest on $19,871.20 which is the original $20,000 you borrowed minus the $128.80 of principal you paid in the first month.  Your interest payment will be $82.80 and your principal payment will be $129.33. Every month, you will pay more principal and less interest. The chart below shows the mix of interest and principal in each of the 120 payments of your 10-year loan.

Loan Interest and Principal by Month

Factors that Determine Your Monthly Payment

The monthly payment on a loan is a function of three numbers:

  • Interest rate – the higher the rate, the higher your monthly payment.
  • Principal – the more you borrow, the higher your monthly payment.
  • Term – the longer the term, the less your monthly payment.

Sensitivity to Interest Rate and Term

The table below shows the monthly payment on a $20,000 loan for a variety of combinations of interest rates and terms.

Term (in years) Interest Rate
3% 5% 7% 9%
5 359 377 396 415
10 193 212 232 253
20 111 132 155 180
30 84 107 133 161

The amount of principal for all of the loans in the table above is $20,000.  Therefore, when the total amount of your payments increases, it is because you are paying more interest.  The table below shows the total amount of interest you would pay for each of the same combinations of interest rates and terms.

Term (in years) Interest Rate
3% 5% 7% 9%
5 1,562 2,645 3,781 4,910
10 3,175 5,456 7,866 10,402
20 6,621 11,678 16,214 23,187
30 10,355 18,651 27,902 37,933

Even with the loans with interest rates as high as 9% have much higher payments and total interest than loans with lower interest rates. The interest rates charged on credit cards are often even higher than 9%. This table shows the importance of avoiding the use of credit card debt and refinancing your credit card debt through another lender if it is very large, if at all possible.

What Determines the Interest Rate?

There are several factors that determine your interest rate.

The Economy

The first is the economic environment. If interest rates, such as those on government bonds, are high, the interest rate you will be charged will be also be high.  The US government is considered to have almost no risk of not re-paying it loans, whereas individuals have varying levels of risk. The higher the risk that a loan won’t be re-paid, the higher the interest rate.  Therefore, most loans to individuals have an interest rate that is higher than the interest rate on a US government note, bill or bond with the same maturity.

Credit Score

Along the same line, your credit score is also an important factor in determining your interest rate.  When you have a higher your credit score, lenders believe the risk you won’t re-pay the loan is lower so they charge you a lower interest rate.  My post on credit scores provides lots of details on how to improve your score.

Collateral

A third factor in determining the interest rate is whether or not you pledge collateral and how much it is worth relative to the amount of the loan.  If you pledge collateral, the lender can take it from you if you fail to make your payments. Examples of loans that automatically have collateral are vehicle loans and mortgages.  On those loans, the lower the ratio of the principal to the value of the collateral, the lower the interest rate. That is, if you make a larger down payment on a particular house, your interest rate is likely to be lower than if you make a smaller down payment.  Examples of loans that don’t have collateral are credit cards and student loans. When there is no collateral, interest rates tend to be higher than when you pledge collateral.

Co-Signers

Another approach for reducing your interest rate is to have someone with a better credit score co-sign your loan.  The co-signer is responsible for making your payments if you don’t. For young people, parents are the most common co-signers.

The Math behind Your Monthly Payment

In this section, I’ll briefly explain the math that determines your monthly payment and will provide a bit of information about the Excel formulas you can use.  Feel free to skip to the next section on common borrowing mistakes if you aren’t interested in this aspect of loans!

Present Values

The fundamental concept underlying the determination of the monthly payment on a loan is that the sum of the present values at the loan interest rate of the monthly payments on the day the loan is issued is equal to the principal.  A present value tells the values today of a stated amount of money you receive in the future. It is calculated by dividing the stated amount of money by 1 + the interest rate adjusted for the length of time between the date the calculation is done and the date the payment will be received.  Specifically, the present value at an interest rate of I of $X received in t years is:

Present Value of Single Payment

The denominator of (1+i) is raised to the power of t to adjust for the time element.

The present value of all of your loan payments is then:

Present Value of Monthly Payments

where t is the number of months until each payment and i is the annual interest rate.

Solving for Your Monthly Payment

This amount is set equal to the principal.  The monthly payment can be calculated using a financial calculator, such as in Excel, or mathematically.  The Excel formula is pmt(i/12, t, X). It will give you the negative of your monthly payment. ipmt and ppmt return the portion of each payment that is interest and principal, respectively.  In month y, the interest is ipmt(i/12, y, t, X).

For those of you who really like math, you can also calculate the monthly payment directly.  If payments were made forever (an infinite series), the sum above would equal X/i. We need to eliminate the infinite series of payments after the end of the loan to determine the present value of the loan payments.  Those payments have a present value of X/i divided by (1+i)term.  If we subtract the present value of the payments after the loan term ends from the present value of the infinite series, we get

Principal Formula

That is a bit of a messy formula, but, having gotten rid of the big sum, it can be solved using a fairly basic calculator.

Common Borrowing Mistakes

Some people end up in difficult financial situations, in bankruptcy or even homeless due to poor borrowing decisions.  A few of the more common mistakes are identified below.

Not Understanding the Terms

Many mistakes result from not reading or not understanding the loan agreement.  For example, some loans (mortgages in particular) have teaser rates or adjustable interest rates.  If the interest rate goes up on your existing loan at some point in the future, your payments will also go up.  If you have an adjustable interest rate on a loan, you want to make sure you’ll be able to afford higher payments if interest rates increase.

Another example of a loan provision that can be problematic is a balloon payment.  Under some loans, the monthly payment is calculated as if the loan has a long term, such as 15 or 30 years.  However, after a shorter period of time, say 5 or 10 years, the remainder of the principal must be re-paid and the loan terminates.  If you haven’t built up enough cash to re-pay the principal or can’t get another loan at a rate you can afford, you might default on your loan.

High Cost of Ownership

Many things that people buy with a loan come with other costs that they haven’t considered and might not be able to afford.  For example, when you buy a car, you not only have to make your car payments, but also will need to pay for insurance (including physical damage coverage at a fairly low deductible if required by the lender), gas and maintenance.  Similarly, while you may be able to fit your mortgage payment in your budget, you also need to be able to afford the costs of utilities, homeowners insurance and maintenance. In some cases, these additional costs lead to financial difficulties.

Mistakes that Increase Monthly Payments

Some mistakes cause people to have higher payments than necessary.  For example, if you take out a personal loan from a bank, you often have the option to post collateral.  If you do so, your interest rate is likely to be lower, possibly by as much as 50%.

Another way people end up with monthly payments that are higher than they need to be is to take out a loan that is bigger than necessary.  For example, if you can afford to make a larger down payment than you actually make, the principal on your loan will be higher which increases your monthly payment.  Many loans have pre-payment penalties which make it cost-prohibitive to pre-pay your principal to bring it back in line with the amount you should have borrowed in the first place. Also, if the lower down payment increases the ratio of the principal to the value of your home by too much, it will also increase your interest rate which further increases your payment.

Overestimating the Value of Your Collateral

Another problem people encounter is an inability to borrow as much as they need because they overvalue their collateral.  Common issues that arise include:

  • Lenders get their own appraisals of houses.  The lender’s appraisal is often lower than the purchase price and sometimes even lower than the assessed value.  If the appraisal is less than the purchase price, the buyer must increase his or her down payment so the ratio of the loan to the appraised value is within the lender’s limits.  Even worse, some banks won’t issue the mortgage at all if the difference between the appraisal and the purchase price is too big, even if you increase your down payment. In those situations, you need to either find another lender or re-negotiate your purchase price.
  • Lenders use the National Auto Dealers Association (NADA) Guides to value used cars.  These values can be different from Kelley Blue Book. In particular, the NADA Guides adjust the value based on the specific location of the vehicle.  Also, the values in the NADA guides assume that the vehicle is in pristine condition for its age. If it has had any heavy use at all, the lender will reduce the value before determining the value of the collateral.
  • For used cars, washed titles are also a problem.  When a car has been severely damaged, its title is changed from the more typical “clean” title to a salvage title.  However, when a car’s title is transferred from state to state, its damage history can get sometimes get lost as some states do not require salvage titles.  However, other sources, such as CARFAX, maintain the information about the damage. Lenders will check these other sources before determining the value of the collateral.

While collateral helps reduce the interest rate on your loan, it is important to consider these points in determining the value of your collateral.

Poor Uses of Debt

There are many things for which loans can be used, some of which are valuable and some of which are less so.  This post provides a discussion of the characteristics that can help you identify which loans might be good for you.

Investment Diversification Reduces Risk

Diversification-2

Investment diversification is an important tool that many investors used to reduce risk. Last week, I explained diversification and how it is related to correlation.   In this post, I’ll illustrate different ways you can use investment diversification and provide illustrations of its benefits.

Investment Diversification: Key Take-Aways

Here are some key take-aways about investment diversification.

  • Diversification reduces risk, but does not change the average return of a portfolio. The average return will always be the weighted average of the returns on the financial instruments in the portfolio, where the weights are the relative amounts of each instrument owned.
  • The smaller the correlation among financial instruments (all the way down to -100%), the greater the benefit of diversification. Check out last week’s post for more about this point.
  • Diversification can be accomplished by investing in more than one asset class, more than one company within an asset class or for long periods of time. One of the easiest ways to become diversified across companies is to purchase a mutual fund or exchange traded fund.  Funds that focus on one industry will be less diversified than funds that includes companies from more than one industry.
  • Diversification reduces risk, but doesn’t prevent losses. If all of the financial instruments in a portfolio go down in value, the total portfolio value will decrease.  Also, if one financial instrument loses a lot of value, the loss may more than offset any gains in other instruments in the portfolio.
  • A diversification strategy can be very risky if you purchase something without the necessary expertise to select it or without understanding all of the costs of ownership.

I’ll explain these points in more detail in the rest of the post.

Diversification and Returns

The purpose of diversification is to reduce riskIt has no impact on return.  The total return of any combination of financial instruments will always be the weighted average of the returns on the individual financial instruments, where the weights are the amounts of each instrument you own.  For example, if you own $3,000 of a financial instrument with a return of 5% and $7,000 of a different financial instrument with a return of 15%, your total return will be 12% (={$3,000 x 5% + $7,000 x 15%}/{$3,000+$7,000} = {$150 + $1,050}/$10,000 = $1,200/$10,000).  Similarly, two instruments that both return 10% will have a combined return of 10% regardless of how correlated they are, even -100% correlation.

Investment Diversification among Asset Classes

When investing, many people diversify their portfolios by investing in different asset classes. The most common of these approaches is to allocate part of their portfolio to stocks or equity mutual funds and part to bonds or bond mutual funds.

Correlation between Stocks and Bonds

Two very common asset classes for personal investment are bonds and stocks. Click here to learn more about bonds, including a comparison between stocks and bonds.  Click here to learn more about stocks.

 

The Theory

The prices of stocks and bonds sometimes move in the same direction and sometimes move in opposite directions.  In good economies, companies make a lot of money and interest rates are often low.  When companies make money, their stock prices tend to increase.  When interest rates are low, bond prices are high.[1]  So, in good economies, we often see stock and bond prices move in the same direction.

However, from 1977 through 1981, bond prices went down while stocks went up.  At the time, the economy was coming out of a recession (which means stock prices started out low and then rose), but inflation increased. When inflation increases, interest rates tend to also increase and bond prices go down. [2]

Correlation of S&P 500 and Interest Rates

Over the past 40 years, interest rates have generally decreased (meaning bond prices went up) and stock markets increased in more years than not, as shown in the graph below.

The blue line shows the amount of money you would have each year if you invested $100 in the S&P 500 in 1980.  The green line shows the interest rate on the 10-year US treasury note, with the scale being on the right side of the graph.  Because bond prices go up when interest rates go down, we anticipate that there will be positive correlation between stock and bond prices over this period. If we looked at a longer time period, the correlation would still be positive, but not quite as high because, as mentioned above, there were periods when bond prices went down and stock prices increased.

Historical Correlation of Stocks and Bonds

I will use annual returns on the S&P 500 and the Fidelity Investment Grade Bond Fund to illustrate the correlation between stocks and bonds.  The graph below is a scatter plot of the annual returns on these two financial instruments from 1980 through 2018.  The returns on the bond fund are shown on the x axis; the returns on the S&P 500, the y axis.  Over this time period, the correlation between the returns on these two financial instruments is 43%.  This correlation is close to the +50% correlation illustrated in one of the scatter plots in last week’s post.  Not surprisingly, this graph looks somewhat similar to the +50% correlation graph in that post.

Stock and Bond Returns and Volatility

Recall that diversification is the reduction of risk, in this case, by owning both stocks and bonds.  The table below sets the baseline from which I will measure the diversification benefit.  It summarizes the average returns and standard deviations of the annual returns on the S&P 500 (a measure of stock returns) and a bond fund (an approximation of bond returns) from 1980 to 2018.  The bond fund has a lower return and less volatility, as shown by the lower average and standard deviation, than the S&P 500.

Bond Fund S&P 500
Average 0.6% 0.8%
Standard Deviation 1.6% 4.3%

 

Diversification Benefit from Stocks and Bonds

The graph below is a box & whisker plot showing the volatility of each of these financial instruments separately (the boxes on the far left and far right) and portfolios containing different combinations of them.  (See my post on risk for an explanation of how to read this chart.)

In this graph, the boxes represent the 25th to the 75th percentiles.  The whiskers correspond to the 5th to 95th percentiles.  As the portfolios have increasing amounts of stocks, the total return and volatility increase.

Diversification Benefit from Stocks and Bonds – A Different Perspective

These results can also be shown on a scatter plot, as shown in the graph below.  In this case, the x or horizontal axis shows the average return for each portfolio.  The y or vertical axis shows the percentage of the time that the return was negative. (See my post on making financial decisions for an explanation of optimal choices.)

There are three pairs of portfolios that have the same percentage of years with a negative return, but the one with more stocks in each pair has a higher return.  For example, about 24% of the time the portfolios with 30% and 50% invested in bonds had negative returns.  The 30% bond portfolio returned 8.9% on average, whereas the 50% bond portfolio returned 8.5% on average.   Therefore, the portfolio with 30% bonds is preferred over the one with 50% bonds using these metrics because it has the same probability of a negative return but a higher average return.

How to Pick your Mix Between Stocks and Bonds

The choice of mix between stocks and bonds depends on how much return you need to earn to meet your financial goals and how much volatility you are willing to tolerate.  A goal of maximizing return without regard to risk is consistent with one of the portfolios with no bonds or only a very small percentage of them.  At the other extreme, a portfolio with a high percentage (possibly as much as 100%) of bonds is consistent with a goal of minimizing the chance of losing money in any one year.  The options in the middle are consistent with objectives that combine attaining a higher return and reducing risk.

Other Asset Classes

There are many other asset classes that can be used for investment diversification.  Some people prefer tangible assets, such as gold, real estate, mineral rights (including oil and gas) or fine art, while others use a wider variety of financial instruments, such as options or futures.  When considering tangible assets, it is important to consider not only the possible appreciation in value but also the costs of owning them which can significantly reduce your total return.  Examples of costs of ownership include storage for gold and maintenance, insurance and property taxes for real estate.  All of the alternate investments I’ve mentioned, other than gold, also require expertise to increase the likelihood of getting appreciation from your investment.  Not everyone can identify the next Picasso!

Investment Diversification across Companies within an Asset Class

One of the most common applications of diversification is to invest in more than one company’s stock. It is even better if the companies are spread across different industries.  The greatest benefit from diversification is gained by investing in companies with low or negative correlation.  Common factors often drive the stock price changes for companies within a single industry, so they tend to show fairly high positive correlation.

Diversification across industries is so important that Jim Cramer has a segment on his show, Mad Money, called “Am I Diversified?”  In it, callers tell him the five companies in which they own the most stock and he tells them whether they are diversified based on the industries in which the companies fall.

To illustrate the benefits of diversification across companies, I have chosen five companies that are part of the Dow Jones Industrial Average (an index commonly used to measure stock market performance composed of 30 very large companies). These companies and their industries are:

American Express (AXP) Financial Services
Apple (AAPL) Technology
Boeing (BA) Industrial
Disney (DIS) Consumer Discretionary
Home Depot (HD) Consumer Staples

 

Correlation Between Companies

The graph below shows the correlations in the annual prices changes across these companies.

The highest correlations are between American Express and each of Boeing and Disney (both between 50% and 55%).  The lowest correlation is between Apple and Boeing (about 10%).

The graph below shows a box & whisker plot of the annual returns of these companies’ stocks.

All of the companies have about a 25% chance (the bottom of the box) of having a negative return in one year.  That is, if you owned any one of these stocks for one calendar year between 1983 and 2018, you had a 25% chance that you would have lost money on your investment.

Adding Companies Reduces Risk

The graph below shows a box & whisker chart showing how your volatility and risk would have been reduced if you had owned just Apple and then added equal amounts of the other stocks successively until, in the far-right box, you owned all five stocks.

The distance between the tops and bottoms of the whiskers get smaller as each stock is added to the mix. If you had owned equal amounts of all five stocks for any one calendar year in this time period, you would have lost money in 19% of the years instead of 25%.  The 25th percentile (bottom of the box) increases from between -5% and 0% for each stock individually to +14% if you owned all five stocks.  That is, 75% of the time, your return would have been greater than +14% if you had owned all 5 stocks.

As always, I remind you that past returns are not necessarily indicative of future returns. I used these five companies’ stocks for illustration and do not intend to imply that I recommend buying them (or not).

Investment Diversification Doesn’t Prevent Losses

The above illustration makes investing look great!  Wouldn’t it be nice if 75% of the time you could earn a return of at least 14% just by purchasing five stocks in different industries?  That result was lucky on my part.  I looked at the list of companies in the Dow Jones Industrial Average and picked the first five in alphabetical order that I thought were well known and in different industries.  It turns out that, over the time period from 1983 through 2018, all of those stocks did very well.  Their average annual returns ranged from 19% (Disney) to 40% (Apple).  The Dow Jones Industrial Average, by comparison, had an average return of 10%.  That means that most of the other stocks in the Average had a much lower return.

Being diversified won’t prevent losses, but it reduces them when one company experiences significant financial trouble or goes bankrupt.  Here’s a recent example.

Pacific Gas and Electric

Pacific Gas and Electric (PG&E) is a California utility that conservative investors have bought for many, many years.  I’ve added it to the box & whisker plot of the companies above in the graph below.

PG&E’s average return (10%) is lower than the other five stocks and about equal to the Dow Jones Industrial Average.  Its volatility is similar to Boeing and Disney as shown by the height of its box and spread of it whiskers being similar to those of the other two stocks.

However, on the day I am writing this post, PG&E declared bankruptcy.  PG&E has been accused of starting a number of large wildfires in California as the result of allegedly poor maintenance of its power lines and insufficient trimming of trees near them.  Here is a plot of its daily stock price over the past 12 months.

In the year ending January 26, 2019, PG&E’s stock price decreased by 72%.  From its high in early November 2018 to its low in January 2019, it dropped by 87%.

How to Reduce the Impact of Another PG&E

Although diversification can’t completely protect you from such large losses, it can reduce their impact especially if you are invested in companies in different industries.   If the only company in which you owned stock was PG&E, you would have lost 72% of your savings in one year.  If, on the other hand, you had owned an equal amount of a  second stock that performed the same as the Dow Jones Industrial Average over the same time period (-6%), you would have lost 39%.  The graph below shows how much you would have lost for different numbers of other companies in your portfolio.

This graph shows how quickly the adverse impact of one stock can be offset by including other companies in a portfolio.  In a portfolio of five stocks (PG&E and four others that performed the same as the Dow), the 72% loss is reduced to about a 20% loss.  With 20 stocks, the loss is reduced to 10% (not much worse than the -6% for the Dow Jones Industrial Average).

Investment Diversification Over Time

Another way to benefit from diversification is to own financial instruments for a long time. In all of the examples above, I illustrated the risk of holding financial instruments for one year at a time. Many financial instruments have ups and downs, but tend to generally follow an upward trend.  The volatility and risk of the average annual return of these instruments will decrease the longer they are held.

20-Year Illustration

For illustration of the diversification benefit of time, I have used returns on the S&P 500. The graph below shows the volatility of the average annual return on the S&P 500 for various time periods ranging from one to twenty years.

To create the “20 Years” box and whiskers in this graph, I started by identifying all 20-year periods starting from 1950 through the one starting in 1997.  I calculated the average annual return for each 20-year period.  I then determined the percentiles needed to create this graph.  The values for the shorter time periods were calculated in the same manner.

The average return over all years is about 8.8%.  Because we are using data from 1950 to 2018 for all of these calculations, the average doesn’t change.

The benefits of long-term investing are clear from this graph.  There were no 20-year periods that had a negative return, whereas the one-year return was negative 25% of the time.

More Complicated Example

My post about whether Chris should pay off his mortgage provides a bit more complicated application of the same concepts. In that case, Chris puts money into the account for five years and then withdraws it for either the next five years or the next 21 years. The longer he invests, the more likely he is to be better off investing instead of paying off his mortgage.

A Caution about Individual Stocks

As a reminder, it is important to remember that this concept applies well to financial measures such as mutual funds, exchange-traded funds and indexes.  It also applies to the financial instruments of many companies, but not all.  If a company starts a downward trend, especially if it is on the way to bankruptcy, it will show a negative return no matter how long you own it.  If you choose to own stocks of individual companies, you will want to monitor their underlying financial performance (a topic for a future post) and news about them to minimize the chance that you continue to own them through a permanent downward trend.


[1]The price of a bond is the present value of the future interest and principal payments using the interest rate on the date the calculation is performed.  That is, each payment is divided by (1+today’s interest rate)(time until payment is made). Because the denominator gets bigger as the interest rate goes up, the present value of each payment goes down.    I’ll talk more about this in a future post on bonds.

[2]An explanation of the link between inflation and interest rates is quite complicated.  I’ll write about it at some point in the future.  For now, I’ll just observe that they tend to increase at the same time.