A reverse mortgage can be a valuable financial management tool for seniors and their families. However, if misunderstood or misused, borrowers and their heirs can encounter any one of a number of different challenges. In this post, I’ll define “reverse mortgage” and provide illustrations of …
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Ever wonder how you’d handle a complete reversal of your finances? I have a friend who had a lifestyle most people would envy and lost everything, including her marriage. I didn’t meet her until after her recovery from her financial disaster. She is one of the most resilient, generous people I know and was kind enough to let me interview her about the changes in her life, the financial lessons she learned and her advice to you on how to avoid finding yourself in a similar situation.
The High Life
“My life was very plentiful with many material objects.
- 6,000+ square foot custom designed home – 6 bedrooms, 5 bathrooms and two full kitchens
- Photography and recording studios
- In ground swimming pool
- Custom designed furniture
- Six cars
- Private education for both kids
I never priced groceries, just grab and dash. We belonged to a private country club as well. We also had an investment property that we rented to a family member.”
Tell Me about Your Finances
“I did not think of my financial future. I was in my mid to late 40s and I thought the gravy train would never stop. We had many investments, 401(k) and IRA retirement accounts for us as well as the children. My husband was a very successful stock broker, financial planner and money management specialist. We had a dual income, and mine paid for the cream on the top.”
“The stock market along with the real estate market became very soft in 2007. When I began to notice that these change were imminent, I suggested that we liquidate assets into a strong cash position. My husband dismissed my thoughts on this topic because I had never been persistent in being a co-manager of our funds. The economy was showing its ugly powerful head and so was our 40-year marriage.
Things went from bad to worse. We lost our home. Instead of getting money from the buyer when we sold our house, we had to come to closing with a six-figure check to pay off the mortgage balance (because we owed more than we got for the house). Otherwise, we would have had to negotiate a short sale with the holders of the loan on the house to try to get them to accept only the amount for which we sold it, but chose to close in a traditional manner due to a prideful attitude that made no sense at all.
We divorced. The money, the investments and the lifestyle were gone. I was 59 years old. Our children were grown and gone. Thank God they had their educations!”
What Did You Do?
“I moved into a house with five other people to secure a reasonable rent of $600 a month. I rolled up my sleeves and decided to re-invent myself as a strong salesperson with a steady stream of income. As part of creating a fiscally responsible lifestyle, I consolidated my debt and made a conscious effort to understand my taxes and my expenses. These changes allowed me to pay off the tax liability for which I was half responsible after the divorce.”
What is Your Life like Now?
“My lifestyle now is very simple.
- I use one credit card.
- If I can’t afford something, I don’t buy it.
- I shop at thrift stores, make curtains, paint, have learned some electrical skills and can do just about anything.
Having made the financial changes, I now have the opportunity to travel. I have investments and simple monthly debt. My credit score is very high and I am able to contribute to my savings account and an IRA on a regular basis.”
What Advice Do You Have?
“I learned these financial lessons that might help your readers:
- Always know your cash position whether or not you are wealthy.
- Have a good grasp on your finances. Knowledge is power.
- Cash is king.
- Know your financial position at all times.
- Stay away from credit cards and their incredible interest rates.
- Save and keep adding to your retirement.”
Closing Thoughts from Susie Q
You’ll notice that my friend’s financial lessons learned are similar to themes you’ve seen in posts I’ve written, especially in the post on advice we gave our kids.
- Only invest in things you understand.
- Always have an emergency fund that is highly liquid (e.g., in cash).
- Maintain a budget.
- Only buy things you can afford.
- Be careful with credit cards and debt.
- Save for retirement.
Her story, though, provides real-life insights into why these actions are so important.
You’d never know if you met my friend now that she had to make such a long recovery from financial disaster. She is always upbeat, willing to lend a hand and a great motivator. In fact, she contributed to the initial costs of this blog because she was so thrilled that I am willing to share my knowledge with others to help them be financially literate. I hope I am as resilient as she is if I ever face an equally daunting challenge.
You may have thought you were done when you created and balanced your budget. However, there is one very important step left in the budgeting process – making sure you are living within the guidelines set by your budget, i.e., monitoring your budget. That is, …
You made it! This week your only task will be to create a first draft of your budget.
Budgeting can be challenging as you try to balance your long-term goals with your short-term needs and wants. As such, I suggest creating it in two steps. This week I’ll provide guidance on creating the first draft of your budget. Next week’s post will talk about how to refine it.
To create your budget, you will enter values in Column D of the Budget tab of your spreadsheet. As long as you don’t enter values in Column D of any of the “Total” rows, the formulas will automatically calculate those values.
While the spreadsheet was built to be fairly flexible, one of its weaknesses is that it is not easy to add or delete income or expense categories once you have started entering your budget amounts. So, before you get started, I suggest making a final review of the line items on the Budget tab. If you need to make changes, you can look back at last week’s post for the instructions.
If you find you need to add or delete a line after you have entered budget amounts, here’s what you’ll need to do:
- Make a note of the budgeted amounts of all of the line items you’ve entered.
- Add or delete the line item name according the instructions in the last week’s post.
- Copy the formula from cell D110 to all of the cells into which you previously typed values. You can copy a formula by:
a. Going to cell D110.
b. Holding down the Ctrl key and hitting C.
c. Moving your cursor to cell D11.
d. Holding down the shift key and then hitting the down arrow until all of the cells into which you entered values are highlighted.
e. Holding down the Ctrl key and hitting V.
f. Re-enter the budget amounts that you noted.
If you don’t take this approach, some or all of your category names in Column A will change rows, but your budgeted amounts in Column D will stay in the same rows. You’ll end up with a mismatch between category names and budget amounts.
For each line item in your budget, you’ll need to select a budget amount. These selections will require your informed judgment. Things to consider in making your selection include:
- How much you’ve recorded in each category over the past several weeks, as shown in Column B.
- Any changes in your income or expenses you anticipate in the next several months.
- Some of these changes might result from life changes – a new job, moving, getting a roommate, getting married, having children or the like.
- Other changes might result from intentional changes in your habits – fewer meals in restaurants, hiring a cleaning service, newly carpooling, among others.
- You’ll also have changes from prior expenses if you change your spending or income to better align with your financial goals.
- If you’ve used the tax approximation, the amounts in Column C for Federal and State/Provincial income taxes.
- The goals you set as described in my post on setting financial goals. You might want to increase one or more of your emergency savings, savings for a designated purchase (vacation, house, new car) or long-term or retirement savings.
Final Steps for This Week
Once you have completed your first draft, take a look at the value in Column D of the Grand Total row. If that value is positive, it means you have more income than expenses and additions to savings. If it is negative, your expenses and savings goals are higher than your income. In this href=”https://financialiqbysusieq.com/how-to-budget-step-8/”>post, I’ll talk about things you can do so the value is close to zero.
You’re almost there! Only one more week until I describe how to create your budget. Before you can do that, you’ll want to make sure that the income and expenses you’ve entered don’t have too many mistakes. In this post, I’ll talk hot to review the …
Your budget includes your income in addition to money you spend. In my previous posts on the budgeting process, I talked about setting your goals and tracking and recording your expenses. This week, I’ll focus on your paycheck and other sources of income. Before getting …
This week, I’ll conclude the case study about Mary and her savings. Her last question focused on whether to pay off her student loans. The considerations include:
- The interest rate on her loans.
- How many more payments she has.
- What she can earn if she doesn’t pay off her loans.
- Her risk tolerance and other cost-benefit trade-offs.
To help set the stage, I created a fictitious person, Mary, whose finances I use for illustration.
- Mary is single with no dependents.
- She lives alone in an apartment she rents.
- She makes $62,000 per year.
- Mary has $25,000 in a savings account at her bank and $10,000 in her Roth 401(k).
- Her annual budget shows:
- Basic living expenses of $40,000
- $5,000 for fun and discretionary items
- $10,000 for social security, Federal and state income taxes
- $4,000 for 401(k) contributions
- $3,000 for non-retirement savings
- Mary has $15,000 in student loans which have a 5% interest rate.
- She owns her seven-year-old car outright. She plans to replace her car with a used vehicle in three years and would like to have $10,000 in cash to pay for it.
- She has no plans to buy a house in the near future.
I’ll explain how she decides what to do and then will conclude with a summary of the benefits of all of her decisions. As a reminder, Mary has $10,000 of student loans outstanding at a 5% interest rate. She has 5 years of payments remaining, so her monthly payment is $189. She has $25,000 in total savings and has already decided to set aside $13,000 for emergency savings and $5,500 for her car. These decisions leave her with $6,500 for long-term savings and paying off her loan. There are several different approaches Mary could take to pre-pay her student loans. In her case, she could pre-pay up to $6,500 with her savings. Alternatively, she could pre-pay her students loans more slowly using one of the methods in this post.
Should I Pay Off the Principal on my Loans?
Instead of investing her long-term savings, Mary could use some of her savings to pre-pay her loans. When you pre-pay a loan, it is the equivalent to earning a return equal to the interest rate on the loan. I’m sure that analogy sounds weird. To help make more sense of that statement, consider the following thought process:
- You don’t pre-pay your student loan.
- You loan the money you have available to make pre-payments to someone else at the interest rate on your student loan. The loan to the other person also returns your principal at the same rate you are paying principal on your student loan. The return on the loan that you made to the other person is the same as the interest rate on your student loan because that is what you are charging the other person.
- When you combine your student loan payments and the payments you get from the loan you made to the other person they offset and you have no net cash flows.
- If you pre-pay your student loan, you also have no net cash flows.
As you can see, pre-paying your student loan puts in you the same situation as if you didn’t pre-pay your student loan and you loaned that money to someone else at the same interest rate. Therefore, the return on the money you use to pre-pay your student loans is equal to the interest rate on the loans. In Mary’s case, she has student loans on which she pays 5% per year on the outstanding balance. The simple approach to answering Mary’s question is that it makes sense for her to pre-pay her loans if the after-tax interest cost on the loans is higher than the after-tax return she could earn on the money if she invests the money in financial instruments with the same level of risk.
What is Risk?
Risk is the volatility in the returns on a particular financial instrument, as discussed in more detail in this post. If you buy a Treasury bondand hold it to maturity, you are pretty much guaranteed that you will earn the yield to maturityat the time you buy it. If you buy an S&P 500 index fund (a form of exchange traded fund or ETF), the long-term average return is around 9%, but the returns can vary widely from one year to the next. In fact, the S&P 500 return was outside the range of 0% to 18% in half of the years from 1951 to 2017.
Risk of Pre-paying a Loan
There is no volatility in the return Mary gets from paying off her loan. In all scenarios, it will be the interest rate on the loan. As such, the simple approach will tell Mary she should pre-pay her loan if her interest rate is higher than she can earn on a Treasury bond with the same time to maturity as her loan, after adjusting for the difference in the tax rates.
There are several benefits to Mary if she pays off the loan, including:
- The sense of relief that she no longer has to make the payments.
- Extra cash in the future she can either save or spend.
- Improvement in her credit score.
On the other hand, Mary is so eager to start investing in something other than risk-free instruments which she can do if she doesn’t use all of her available savings to pre-pay her loan. That is, Mary has the choice between taking the risk that she will lose money (if she doesn’t pre-pay her loans) and not having the opportunity to start investing (if she does pre-pay her loans). Her view on this choice is called her risk tolerance. Risk tolerance is an individual decision. To make this comparison, Mary needs to know or decide:
- At what return can she invest the money if she doesn’t pre-pay her loans?
- What is the tax rate applicable to the investment returns she would earn?
- Is the interest on her loans tax-deductible?
- If she can deduct the interest on her loans, what is her marginal tax rate?
After-tax Return by Paying Off Loan
In the US, you can deduct up to $2,500 of student loan interest as long as your income (measured using a value calculated on your tax return called modified adjusted gross income which, for Mary, is essentially her wages) is less than $65,000 for an individual. Mary’s state uses the same rules as the Internal Revenue Service. Her total interest is below $2,500 and her income is below $65,000, so the entire 5% interest is tax-deductible. Mary’s marginal tax rate (the percentage she will pay on the next dollar of income) is 25% including state income taxes. We can calculate the after-tax cost of the loan as the interest rate times the portion she keeps after she pays taxes (= 100% – the tax rate of 25%): 5% times (100% – 25%) = 3.75%
After-tax Return of Treasuries
Mary’s combined Federal and state tax rate on a Treasury bond is the same as her marginal Federal tax rate (20%) as Treasury bond interest is exempt from state tax. As I write this post, the yields on US Treasuries of between one and five years are all right around 2.7%. She can calculate the after-tax return on a Treasury bond as: 2.7% times (100% – 20%) = 2.2% Because the after-tax interest rate on her loans of 3.75% is higher than the after-tax return on a risk-free US Treasury bond (2.2%), the simple approach would tell use she should pay off her loan.
Expected After-tax Return of S&P 500 Index Fund
Mary will consider an S&P 500 index fund (a form of exchanged-traded fund that is intended to track S&P 500 returns fairly closely) as a risky asset in which to invest any money she doesn’t use to pre-pay her loan. Mary’s combined Federal and state tax rate on the S&P 500 index fund is 20%. She can calculate her expectedafter-tax return on the S&P 500 index fund as: 8.9% times (100% – 20%) = 7.1%
Cash Flow Comparison
Mary isn’t quite sure she knows what the differences in the returns mean to her. She therefore calculated the total amount of interest she will pay in the future if she pays off her loan immediately ($0) and if she pays it off as scheduled ($1,323). She then calculates the total expected return she would get if she invests in her savings account, Treasuries and the S&P 500 index fund between today and the time each loan payment is due. She also adjusts those returns for the tax payments she will make and the reduction in her taxes she will get if she makes the interest payments on her loan. She summarizes her findings in the table below. As a reminder, these values are the total amounts she would pay or earn between now and the time she has made all of her loan payments.
Future Interest Payments
Average Future Investment Returns
Average Future Taxes
Average Cash from $10,000 in 5 Years
No Pre-Payments, Leave in Savings
No Pre-Payments, Invest in Treasuries
No Pre-Payments, Invest in S&P 500
As you can see, on average, she will earn $2,383 if she invests in the S&P 500, leaving her with $914 at the end of five years once all her loan payments have been made and after consideration of interest payments on the loan and taxes. If she pays off her loan immediately, she has no future interest payments or investment returns, so she has no cash from investments in five years. If she puts the $10,000 in savings or Treasuries, she is worse off than pre-paying her loan because the average cash she will have in five years (the fourth column) is less under these two options than if she pre-pays the loan. These findings are consistent with the calculations presented earlier about the expected yields – she is better off if she doesn’t pre-pay her loans and earns the expected return on the S&P 500 and worse off using the returns on a savings account or Treasuries.
How to Think About Risk
Looking at the table above in isolation, Mary might conclude that she should not pre-pay her loan and, instead, invest in the S&P 500. However, as noted above, the S&P 500 returns are volatile or risky. That is, she will not earn the average return in every single year. To try to get a view on how much risk she will take if she takes this approach, Mary asked me for some help. Because modeling future stock returns is very difficult, I chose to use historical returns to provide Mary some insights. I downloaded the monthly prices of the S&P 500 from January 1951 to August 2018 from Yahoo finance. I then created all of the possible five-year time series of S&P 500 prices to use as returns over the time Mary will make loan payments. I explained to Mary that there are many flaws in this approach, but that it can help inform her decision nonetheless. The first risk metric I calculated is how much money would she lose if the stock market had the worst returns of any five-year period in the historical data. I calculated that she could lose $3,592. The second and third metrics I calculated were the percentages of the time would she be better off investing in the index fund than if she (a) didn’t pre-pay her loan and invested the $10,000 in Treasuries or (b) pre-paid her loan today. That is, out of all of the possible five-year periods, would the cash she had after she paid off her loan be greater than (a) $-451 or (b) 0? Using the historical returns on the S&P 500, she was better off investing in the S&P 500 than Treasuries 73% of the time and better of than pre-paying her loan 65% of the time.
Mary decided that $3,592 was too much to lose in the worst-case scenario. She then considered pre-paying only a portion of her loan and investing the rest in the S&P 500 index fund. To help her understand how much she might want to pre-pay, I repeated my analysis assuming she pre-paid of each of 25%, 50% and 75% of her balance. To put these results in perspective, I created a graph that showed the average amount of money that she would have (the x or horizonal axis) as compared to the least amount of money she would have, using the historical returns on the S&P 500 (the y or vertical axis). Here’s my graph.
There is a lot of information in this graph, as follows.
- First, let’s figure out the axes.
- The horizontal axis is the average cash Mary will have after she pays off her loan. Higher numbers are better so anything to the right is better than anything to the left.
- The vertical axis is the cash she will have after she pays off her loan in the worst-case scenario from the historical data.Again, higher numbers are better so, in this case, anything that is higher on the graph is better than anything lower on the graph.
- These concepts are illustrated by the arrow pointing to the upper right and the words next to it.
- Next, we’ll look at the dots. I plotted a dot for each of the options she is considering. The first part of the label for each dot tells in what she will invest with the money she doesn’t use to pre-pay her loan. The second part of each label shows what percentage of the loan she pre-pays.
- I added lines connecting the dots in which she invests in the S&P 500.
- All of the dots corresponding to investing in the S&P 500 have average cash after she pays off her loan that is positive (to the right of the y-axis). The less of her loan she pre-pays, the higher that average (further to the right on the graph).
- These same dots all have negative values for the worst scenario (the one with the least cash after she pays off her loan).The more of her loan she pre-pays, the less she loses in the worst-case scenario (further up on the graph).
- These lines form something called an efficient frontier. For each of the values of the average cash at the end of five years, the efficient frontier identifies the least bad result in the worst-case scenario. That is, there are no points to the right of or above the efficient frontier in this chart.
- When making a choice among the options, Mary will want to pick an option on the efficient frontier. If she picks one of the other options, the average cash will be higher for some other option with approximately the same worst-case scenario result. For example, let’s look at putting her money in a savings account. The average and worst-case results are both $-992. If she pre-pays 75% of her loan and invests the rest in the S&P 500, the average result is $58 (to the right on the graph – the good direction) and the worst-case result is $-1,083. So, she can have a slightly worse worst-case result and a somewhat higher average cash after she pre-pays 75% of her loan.
- The choice of option along the efficient frontier is one of personal preference as defined by your risk tolerance. Mary needs to decide how much risk (in this case measured by the worst-case result) she is willing to take in order to get the higher return (in this case measured by the average result).
The last consideration in Mary’s decision is how much cash she has available to pre-pay her loan. While she has decided she really likes the characteristics of the option in which she pre-pays of 75% of her loan, she has only $6,500 in savings available and would very much like to start investing. She decides to pre-pay 50% of her loan or $5,000. She will put the remaining $1,500 in a Roth IRA. The historical data indicate that 64% of the time, she will be have most cash in five years than if she was able to fully pre-pay her loan today and an 84% chance of having more cash in five years than if she doesn’t pre-pay the loan at all and invests in Treasuries. These two options are the risk-free options, the riskier option she has chosen has a high probability of putting her in a better position (based on historical S&P 500 returns) and she gets the benefit of starting to invest.
To recap, here are the answers Mary selected to her questions.
- Should I start investing the $25,000 in my savings account? ANSWER: Mary decided to move all of her money out of her savings account. Mary set aside $13,000 for emergency savings. She put half of her emergency savings in a high-yield checking account so she is sure to have instant access to it and half in a money market account. This decision gives her an average return of 1.275%, as compared to the 0.06%she was earning on her bank’s savings account.
- Should I have a separate account to save the $10,000 for the car? ANSWER: She allocated $1,500 a year from the money identified for savings in her budget over the next three years for her car. To meet her $10,000 goal, she had to designate $5,500 of her current savings for the car. Rather than create a separate account for the car savings, Mary bought a certificate of deposit earning 3.4% to distinguish those savings from her other savings.
- Should I pre-pay some or all of the principal on my student loans? ANSWER: Mary considered how much of her savings was available after allocating money for her emergency and designated savings and the risks and rewards of different options. She decided to pre-pay $5,000 of the principal on her student loans. This decision saved her 5% interest on the portion she pre-paid.
- What are good choices for my first investments for anything I don’t set aside for my car or use to pre-pay my loans? ANSWER: Mary chose to invest her long-term savings ($1,500) in an S&P 500 index fund. She sees the benefits of this choice as (a) easily attained diversification and (b) less time needed for research relative to owning individual stocks. Over the long-term, the average return on the S&P 500 is about 8.9%.
The pie chart below illustrates how Mary will use her savings.
In summary, Mary has increased the long-term average pre-tax return (excluding her 401(k) investments) from the 0.06% return on her savings account to a weighted average return of 2.9%.
The key takeaways from this portion of the case study are:
- Pre-paying your student loans is equivalent to earning a pre-tax return on your money equal to the interest rate on your student loans.
- If you live in the US, the full amount of your student loan interest reduces your taxable income unless you have a high income (more than $65,000 a year) or high interest payments (above $2,500 a year). The tax benefit will be the highest tax rate applicable to your income.
- Other risk-free alternatives to pre-paying your loan include leaving the money in a savings account or investing in risk-free instruments, such as government (Treasury) bonds with the same maturity as the term of your loan.
- If you are willing to take more risk, you could invest some of the money in a riskier instrument, such as an S&P 500 index fund. If you make that choice, your average or expected cash when you are finished paying off you loan will usually be higher, but there is a chance you could end up with less money.
Suggested Next Steps
This post talks about Mary’s situation. Here are some questions you can be asking yourself and things you can do to apply these concepts to your situation.
- Determine if you have any savings left after setting aside emergency and designated savings and, if so, how much.
- Compare the interest rate on your student loans with the values that Mary calculated. If your interest rate is similar to the 5% Mary paid, you can review her analysis. If it is higher, pre-paying the loan will be more attractive than it was for Mary. If it is lower, pre-paying the loan will be less attractive.
- Consider your own risk tolerance. You can think in terms of making bets. At the extremes, think about how much would you pay to have a 1% chance of winning $1,000. Then use numbers that are closer to the question you are evaluating. What is the most amount of money you are willing to use to have a 70% chance of being better off than the risk-free alternative? How much for a 90% chance of being in a better position?
As a reminder, a Treasury bond is issued by the US government. The term Treasury bond is used broadly to include bills (maturities less than one year), notes (maturities of one to ten year) and bonds (maturities of more than ten years). The term Treasury bond can be confusing because it can mean two different things. You’ll need to figure out which is being used based on the context. When you buy a bond, your brokerage firm will provide the yield to maturity. It is different from the coupon rate on the bond if the bond price is different from $100 when you buy it. More on yields to maturity and bond prices in a future post. All statistics about the S&P 500 were calculated based on data downloaded from https://finance.yahoo.com/quote/%5EGSPC/history?p=%5EGSPC. https://www.irs.gov/publications/p970#en_US_2017_publink1000178280, December 10, 2018. For the definition of modified adjusted gross income, see Worksheet 4-1 in https://www.irs.gov/publications/p970#en_US_2017_publink1000178298. Modified adjusted gross income includes your wages and any investment returns, reduced by contributions to your health savings account, some moving and education expenses, among other things, and adjusted for some items related to foreign income and income from Puerto Rico and American Samoa. https://home.treasury.gov/, December 10, 2018. This rate is lower than the marginal rate on her wages because dividends and capital gains are taxed at a lower rate than wages and interest by the Internal Revenue Service. Expected is a statistical term referring to the expected value or average over all possible results. To keep the math a little simpler, Mary does the calculations assuming she has $10,000 available to fully pre-pay her loan. She will take into consideration the fact that she has only $6,500 available to pre-pay her loan later when she is making her final decision. The fourth column is calculated as the second column minus the first and third columns. Negative numbers in the third column mean that the tax savings from the interest deduction from her loans is more than the taxes on her investment income. The positive number for the S&P 500 option indicates that the taxes on the dividends and capital gains is more than the tax savings from her interest deduction. I’ll provide details of how to do this type of analysis for yourself in a future post. For now, I suggest focusing on the logic of the analysis and not thinking about the nitty gritty details. See the fourth column in the table above. Because Mary chose to put her money in a Roth IRA, she won’t pay taxes on any investment returns and won’t get a tax benefit in years in which the S&P 500 index fund loses money. She’ll want to consider this additional volatility in her decision-making process. https://www.wellsfargo.com/savings-cds/rates, November 17, 2018.
Case Study To help set the stage, I created a fictitious person, Mary, whose finances I use for illustration. Mary is single with no dependents. She lives alone in an apartment she rents. She makes $62,000 per year. Mary has $25,000 in a savings account …