Chapter 24 – Home Building Industry Oversimplified

“Repeat after me:  Your house is not an asset.” ~Robert Kiyosaki

We’ve discussed home ownership and the home building industry in the last couple of chapters (see the Table of Contents).  In this chapter, I want to visually display how complex the home building industry is by oversimplifying it.  All the amounts are fictional and rounded.  All the percentage rates will also be fictional and easy to calculate.  We’ll ignore all the extra stuff like taxes, fees, and insurance.  Let’s dive into the home building industry oversimplified.

Like nearly everything in the Financial Genome, it starts with the federal government, specifically the Federal Reserve and Treasury Department determining interest rates and how much a bank must have in reserves (or actual cash).  Let’s say we have a bank with $10,000,000 dollars in cash.  The federal government says banks must have 10% reserves at all times before loaning money to people.  This bank has $10,000,000 which means it can loan out $90,000,000.    Just like that, $90,000,000 appeared in our economy.

Now, let’s say there’s a home building company.  It wants to buy land, build homes, and then sell the homes.  The company has $10,000,000 in cash and applies for what’s known as a jumbo corporate loan.  The bank requires a 10% down payment, so with the $10,000,000 in cash it has, the company takes out a $100,000,000 loan.  The home builder gives $10,000,000 to the bank in cash as a down payment and the bank gives the home builder a $100,000,000 loan (technically, the home builder only took out a $90,000,000 loan, but this is an oversimplification).  Wait, how did that happen?  Didn’t we just say that the bank only had $90,000,000 to give out because it has to keep $10,000,000 in reserves?  Yes, but with the home builder giving the bank $10,000,000 in cash as a deposit, the bank now has $20,000,000. It can now loan out $180,000,000 dollars.  And just like that, with only $20,000,000 in cash, there’s $180,000,000 extra dollars in the economy.

So, now the home builder company has a $100,000,000 loan.  The bank charges a 1.2% annual interest rate on the loan.  That’s .1% a month.  Remember, this is an oversimplification, which as I’m typing this, I realize I’m failing already.  So, .1% interest rate on a $100,000,000 loan is $100,000 a month.  Home builders usually take 1-2 years before selling their first home, so they ask for additional money from investors.  Let’s say investors give the home builder $1,200,000 in cash to pay the bank for the first year of home building.  In month 1, the home builder pays the bank $100,000 in cash.  With only being required to maintain 10% cash reserves, the bank can take that $100,000 and loan an additional $900,000.  $900,000 isn’t enough money to give to home building companies, but it is enough to loan individuals money to buy homes.

After year 1, the home builder paid $1,200,000 in cash, which allowed the bank to loan out $10,800,000 to individuals ($12,000,000 less the 10% cash reserves).  In one year, an additional $190,800,000 appeared in our economy from only $21,200,000 of cash.  The home builder completed its first home and is ready to sell it to you.  The bank only requires a 3.5% down payment (not exactly fictional).  Your new house costs $200,000, so you need $7,000 in cash.  You give the bank $7,000 in cash and the bank gives you $200,000.  The bank can now loan an additional $63,000 ($70,000 less $7,000 is $63,000).  You give the home builder $200,000 and the house in yours.  Congratulations!

The home builder’s monthly payment to the bank is only $100,000 a month and you just gave it $200,000.  That $100,000 difference is the home builder’s oversimplified profit.  In reality, the homebuilder determines profit by taking what it sold that individual house to you for less the cost of the individual house to build.  In my oversimplified explanation, I’m actually showing what’s known as the Statement of Cash Flows.

As you can see, as long as the home building industry is operating positively, the true money maker is the bank.  The more loans it gives out, the more cash it generates, which allows the banks to loan out more money.  This process can keep going until something changes.

The Federal Government has complete control of the home building industry, and ultimately, its citizen’s ability to buy a house.  If the reserve requirement goes up, less money can be loaned out.  If interest rates go up, loans become more expensive.  Additionally, if the Federal Government doesn’t properly address employment, less people will buy new homes or will default on their loans. This limits cash in the system and reduces the ability for banks to loan money.

I wanted you to have a solid, albeit oversimplified, understanding of this concept because the next chapter will be slightly controversial.  Readers of Robert Kiyosaki’s “Rich Dad, Poor Dad” were shocked to hear that their home was not an asset.  The American Dream of owning a home wasn’t what we thought it was.

Chapter 23 – Home Building

The ache for home lives in all of us, the safe place where we can go as we are and not be questioned.~Maya Angelou

In Chapter 22 – Land Ownership, we discussed the commoditization of land on our planet.  The land can be owned by an individual, a company, or a government.  Land is typically taken from native people by a conquering government. Sometimes this is done by force, and sometimes this is done simply by squatting.  These methods are how much of the middle and west U.S. was colonized.  It wasn’t until the Homestead Act of 1862 did the American government come up with real guidelines of what land ownership entailed.[1] In most developed countries, the government piece-and-parcels the land out to its citizens.  The most common usage of this commoditized land is to build homes.  In this chapter, we’re going to focus on the home building industry.

The majority of home building activity is done by large public companies and small, but highly resourced, private companies.  There are hundreds of small, privately financed companies and, in 2006, the ten biggest homebuilders represented 35% of new houses being built.[2]  Both types of companies get loans, buy huge amounts of land, and then build properties on the land.  Individual home owners go through a similar process of securing a loan to buy a home.  It’s fascinating to me that all this is done primarily through the transfer of debt with little actual cash trading hands.

Typically, changes in local employment availability will determine the local home building industry.  Wealth distribution typically determines the size and quality of the homes in each area.  I say typically, because a cliché, but true, saying when it comes to building a home is “location, location, location.”  This means that home buyers may place equal weight on a specific location as some buyers would put on tangible considerations like schools, crime rates, value, etc.  These ideal locations and places with superior tangible considerations means home buyers will sometimes suffer long commutes.  Los Angeles continues to rank #1 in the worst commutes in both distance and quality.[3]

Commutes can also be impacted by local population density.  For example, friends that live in the Texas, live in neighborhoods where homes come with one acre per home.  My previous home in Bossier City, Louisiana has more tightly packed neighborhoods with a small backyard and above average sized backyard.  In Washington D.C./Virginia, where I currently live, there are townhomes which are physically connected to each other.  There are almost no front yards and the back yards are as big as a large closet.  The city seems to have more people than available housing.

When cities start running out of available housing, the prices will start to rise quickly.  I’m paying three times as much for the same size house in Virginia than I was in Louisiana, despite the Virginia house being 60-years older.  This, of course, is supply and demand.  Housing prices are impacted by changes with supply and demand, sometimes independent of each other.  For example, in California, the demand can be high irrespective to the available supply which drives up the prices of similar houses.  Some cities are in unfavorable locations and have an adequate supply, but the demand is missing which lowers the price of housing.  For example, the mayor Akron, Ohio, says “We have a city of 200,000, with the capacity for 300,000.”[4]

Individuals build homes as well.  Instead of a conventional home loan, individuals receive construction loans. Once the house is built, these are converted to traditional loans.  There’s quite a bit of conflicting data available on whether it’s cheaper to build your own home versus buying it from a home builder.  Conventional advice suggests that the more customization or niche demands you have (i.e., off the grid requirements or ornate finishing) the more building your own home becomes cheaper.  If you’re fine with the homogenous design and features offered by a home builder, then you’ll more than likely save money buying the house.

In 2014, 50,000 individuals built their own homes. [5]  To me, it’s not important how many people built their own homes.  I do think it’s important to focus on how the home building industry is founded largely around debt.  If you’re a frequent reader of this website, you know that the entire Financial Genome is built on the belief that the whole system is real (and legitimate), and it’s enforced by a government.  If either of these two conditions cease to exist, or are weakened in any way, the entire system gets put at risk.  I’ll save apocalyptic planning and the lack of a government for another chapter, so we’ll keep the enforcement by our government intact.  In 2008, we got a glimpse of what happens when people get insight into how complicated and crazy our system truly is, and what happens when our beliefs are challenged.

For most people, the dream of owning a home is simple, and we assume the system that supports the dream is also simple.  A company buys land from the local, state, and federal government.  A company builds a house on that land and sells it to you.  You buy the house and have achieved the “American dream”.  This is how it would work in an all-cash system which we don’t have.  We have something less secure, and the USA saw it unfold in 2008.

We’ll stay out of the political and ideological arguments in this chapter, but I believe the start of the 2008 financial collapse actually started in 1995 when President Bill Clinton changed the Community Reinvestment Act which forced banks to lend to more low-income families.[6]  This started a slow departure from what banks were willing to risk when they issued loans, the risk people were willing to take in getting loans, and finally, what practices the government were willing to enforce.

To force banks to loan to low-income families, the government provided default protection to many banks.  This made banks more comfortable with taking risk and issuing loans.  With interest rates dropping, people felt they could take more risk with a mortgage, despite the rapidly rising housing prices.  People were focused more on the monthly mortgage payment and less on the purchase price of the home.  Banks saw this as an opportunity and provided alternate mortgage types to keep the focus on the monthly mortgage payments such as Adjustable Rate Mortgages and even Interest Only mortgages.  The euphoria was so great that banks starting loaning money to people with barely any income.

Banks realized that the government only provided insurance on a small percentage of the loans, so other banks provided more insurance to help banks loan more money.  The insurance premiums were low because the insurance policies invested in mortgages that were bundled and traded like stocks.  These insurance policies became so popular that the insurance companies started to need their own insurance policies.  Resultingly, banks started providing re-insurance policies that were cheap because they too were invested in these securitized mortgage bundles.  The government enforced it all and also invested in the securitized mortgage bundles.  In less than two years, the bubble popped in 2008.

The home building industry came to a screeching halt.  Home building companies and the banks that primarily dealt with home financing went bankrupt and either disappeared or were bought out by bigger banks.  That was an oversimplified version of what actually happened, but the basics are all there.  It changed the whole fabric of America…or did it?

In 2019, we’re facing similar issues.  There are slight variations that may protect us this time such as increased down payment requirements.  A 20% down payment used to be the standard for home buying.  This protected the buyer, the bank, and the home builder by providing more cash (and liquidity) into the system.  Banks are required to have greater cash reserves when they loan to home builders and home buyers now.  The government is slightly more awake this time.

The home building industry is interesting.  For the most part, it’s an industry built entirely on loans with barely an cash transferring in the system.  If you’re thinking about purchasing a home in the next five years, it’s important to evaluate the home building industry for trends.  One of my favorite sayings in personal finance class was, “A house is only worth what someone is willing to pay for it.”  This was important to me because many people fall into a trap of thinking a house has an intrinsic value to it and your mind anchors on that imaginary price.  Also, the saying should be changed to “…willing and able to pay for it.”  If the economy is in a recession, there may not be someone able to buy a house and get the loan for it.

Over the next couple of weeks, I will be working to create a feed of important reports that Wall Street and economists normally read.  I’ll update this chapter when that feature is available.

[1] https://www.archives.gov/education/lessons/homestead-act

[2] http://www.valueline.com/Stocks/Industries/Industry_Overview__Homebuilding.aspx

[3] https://losangeles.cbslocal.com/2017/11/06/survey-la-ranks-1-most-stressful-commute-in-us/

[4] https://www.washingtonpost.com/realestate/the-other-housing-crisis-cities-where-home-prices-are-low-because-people-have-left/2018/11/28/

[5] https://www.census.gov/construction/nrc/pdf/quarterly_starts_completions.pdf

[6] http://content.time.com/time/specials/packages/article/0,28804,1877351_1877350_1877322,00.html

Motivation

THE MOTIVATION

“A choice architect has the responsibility for organizing the context in which people make decisions.”  ~Richard Thaler

I’ve spent nearly two decades helping people with their finances.  The most common feedback I receive is, “I never knew about this.  I wish someone taught me this before.”  This is where the motivation came from to start my website.  There are hundreds, if not thousands, of personal finance blogs and websites.  There’s significantly less economic websites and blogs, but there are still many.  The motivation behind this website is to combine the information from economic websites and the recommendations from personal finance sites to help you navigate your way through the Financial Genome.

You can read more about the motivation for this site on my About page.  The inspiration came from my interest in visual graphics of economic data.  The chart below specifically caught my eye.  It’s a couple of years old now, but it shows the consolidation of the companies involved with the world’s mass-food production.  They key takeaway of the picture is that only about 10 companies control the world’s commercial food production.  That was fascinating to me, and I wanted to tell everyone.  So, I started a website.

Who owns all the food?

For now, this website is a simple blog.  I have a full-time job, I’m married, and have kids, so I’m limited to publishing one article a month.  I’d like for this site to develop into an interactive website where people can explore any aspect of the Financial Genome.  For example, if you were interested in food production, you could navigate through the picture above and all the stock symbols and other financial information of those companies.  This would show you other fascinating data such as ~11% or $18.4B of Coca-Cola’s stock is owned by Berkshire Hathaway—the company managed by the famous investor Warren Buffet.[1]

The motivation isn’t just to show you the financial aspect of the world around us.  I’d also like to explore how different people can exert influence on the financial genome around us.  For example, in the picture below, someone graphed out the conspiracy-theory fueled obsession with the Bilderberg Group.  This group is rumored to control the world using their massive wealth, power, influence, political affiliation, and positions.  It’s difficult to see, but you can do a Google image search for “high-res Bilderberg Group” and zoom in.

The Bilderberg Group

I mentioned that this Bilderberg Group is conspiracy-theory fueled because according to normal news stations, this group is just an advisory council that meets regularly in lavish settings.  It reminds me of an award show for the wealthiest people in the world.  Some of the people involved in our generation’s biggest conspiracies attend these meetings, such as the Rothschild family (believed to be the wealthiest family in the world ever by conspiracy theorists).  So, if you wanted to research these conspiracies you would have to sift mostly through mainstream media.  The picture below gives you a good indication of who actually owns the mainstream media.

Who own’s the media companies?

In this picture, the bigger circles own the smaller circles.  The internet and television are the primary sources people get their information, so basically Disney, NBC, and CBS own most of the world’s televised media.  You can find similar graphics showing who owns just the news websites.  Some of these companies are public companies with public shares being traded and owned and some are private companies.  Wealthy people can own controlling interests in these companies and control the information we use to research these same people.  It’s not just individual companies or people I’d like to track either.

Countries and governments control large amounts of commodities, companies, and political interests.  These are done primarily through Sovereign Wealth Funds (SWFs).  The graphic below is a quick snapshot of the growth of SWFs since 2000.  Some of these SWFs are bigger than countries, in terms of assets under management.

Sovereign Wealth Funds

My end goal is to have a website and/or app that combines the tracking services of personal finances sites such as Mint while overlaying your specific impact to the financial genome all the way up to a Sovereign Wealth Fund.  What could you do with this information?  The primary goal is to allow people to make better decisions.  Not all entities in the Financial Genome are nefarious, but many are self-serving.  I’d like to expose all your options so you know how the impact of your decisions.  Borrowing a term, I read in the book, “Nudge: Improving decisions about health, wealth, and happiness,” I’d like to improve the choice architecture in the Financial Genome.[2]

WHAT TO EXPECT IN 2019

I’ll unlikely be able to increase article production beyond one a month, so you can expect at least one a month.  I’d like to refine my stock tracker so it’s more interactive.  The motivation of the Financial Genome Project was not to be a solo affair.  I’d like to start creating a team of people creating content and developing interactivity of the website.  I hope you find the information interesting, and that you support the project by Liking the posts and Sharing it with your friends on all the social media platforms.  Thanks for all your support in 2018!

[1] https://www.businessinsider.com/warren-buffett-letter-2018-berkshire-hathaways-biggest-stock-holdings-2018-2

[2] https://www.behavioraleconomics.com/resources/mini-encyclopedia-of-be/choice-architecture/

Chapter 22 – Land Ownership

Land Ownership

“Private property was the original source of freedom. It still is its main bulwark.” ~Walter Lippman

We’ve spent many chapters talking about housing expenses, renting, home ownership, and then took a deep dive into the rental market.  Before going any further, it’s important to understand what real estate and housing really are.  The basis of real estate is the land on our planet and the subject of land ownership.

Our planet has land surface and as a global society, we’ve endowed other humans to commoditize and own that land.  These ruling class humans sell the land to other humans, usually for a profit, and/or amass greater quantities of land.  We’ve also given power to governments which can also own land.  Throughout history, civilizations and governments have taken over the land of other civilizations and governments.  The victors take over the land and establish a society and government, and then promote land ownership.

Governments then create borders around the land it believes it owns, and then as a global society, we accept this fact.  The land is named, and its people now belong to the continent, country, federal government, state, city, and community.  Owning land is perhaps ingrained in us through our animal instincts—with a strong connection to group territoriality.[1]  In many cultures, owning land is a source of power and a public display of one’s wealth.

Federal, state, and local governments then zone the land and decide which parts of the land should be used for residential, commercial, or industrial purposes.  Zoning is actually quite complicated and the government can decide specific requirements as to the type of buildings allowed, location of utility lines, restrictions on accessory buildings, building setbacks from the streets and other boundaries, size and height of buildings, and even the number of rooms.[2]

Like we mentioned in the previous chapter, this whole process is called commoditization.  Land is piece and parceled and then sold and owned.  The land owner gets the property zoned and then keeps it intact or builds on it.  If it’s residential property, typically a home or apartment building is built and then an owner can buy that specific lot of land where the house and building are located.

The government also owns land for its federal agencies and for national parks through the Department of Interior or a foreign government’s equivalent.  Except for federally-owned land, land owners pay property taxes to state governments.  The property taxes are normally used for road construction and maintenance, local government staff salaries, police, fire fighters, and local public works.[3]  For effectively-ran states, property taxes stay local, but some states centralize the funding at the state level.  This can sometimes lead to local communities not being maintained properly according to the property taxes paid.

Some people own a lot of land.  In the United States, John Malone owns the most land with a staggering 2.2 million acres.  You can see a list of the people who own the most land in the US here.  (https://www.msn.com/en-us/money/realestate/these-people-own-most-of-americas-lands/ss-AAzDXvk) Globally, the Catholic Church owns the most land, more than the size of France, 71.6 million hectares.[4]  A hectare is the size of two football fields (not the stadium) side by side.[5]

Why is land ownership important?  If you remember from Chapter 19, I said you are important to the Financial Genome.  We’ve established imaginary borders, with individual languages, cultures, and socioeconomic systems.  You can own a piece of this world, and our society and its laws, recognize and support your ownership.  Through ownership, you can exert influence on others.  We all believe in the system of land ownership and abide by it.  How does one person own 2.2 million acres of land?  We, as a society, accept it and enforce private property laws to support his ownership.

Civilization, society, and power are only thinly kept together.  We see small slivers of humanity quickly collapse regularly.  On a small scale, there are hundreds of videos of animal-like behavior during Black Friday shopping.  People getting injured and killed for some arbitrary product.

On a larger scale, Americans experienced the carnage of the Hurricane Katrina aftermath.  Days after the deadly hurricane, humans had to worry about other humans looting, raping, and killing each other.  The rule of law no longer applied even after the hurricane had passed.

What would happen to the belief of land ownership during an apocalyptic event?  Would we still accept the Catholic Church’s or Mr. Malone’s property ownership?  Would the borders of a country matter anymore?  If the show The Walking Dead came true, would zombies know about borders?  Are animals born in the United States “American” or does this apply to humans only?

Barring a Black Friday event on your property, a natural disaster, or an apocalyptic event, one of the key tenants of a solid personal financial plan is to own things.  In most developed countries, housing and land tend to appreciate over time.  These assets can be passed onto your children when you pass away, creating a financial legacy.  You can be a part of a Homeowner’s Association (HOA) and vote on the future of your neighborhood.

In reality, banks own most of the property in the world.  Property and real estate are mostly owned through financing in which the bank actually owns the property until the loan is paid off in full.  You may have equity in the property, but the banks still owns it.  That being said, you still have all the responsibility for maintaining the property and securing it.  In a more somber reality, the government actually owns all the land in its borders and can exercise eminent domain.  This is the authority for a government to seize private property for public use, with “compensation.”[6]  I put compensation in quotes, because historically, governments have not provided fair compensation, and sometimes the compensation is your life.  We’ll discuss this in greater detail in future chapters.

SUMMARY

I find the whole system surrounding the belief of land ownership fascinating, and an important break in our articles.  At any time, you are occupying a part of land owned by a person or entity.  I imagine for those that don’t own any property, this idea is overwhelming and enslaving.  I imagine the opposite is true for those that own property; the idea is freeing and empowering.  I own a house on a small parcel of land, and it is indeed freeing and empowering.

[1] https://www.context.org/iclib/ic08/gilman1/

[2] https://realestate.findlaw.com/land-use-laws/land-use-and-zoning-basics.html

[3] https://law.freeadvice.com/tax_law/property_tax_law/property_tax.htm

[4] https://www.lovemoney.com/gallerylist/70168/revealed-the-worlds-biggest-private-landowners

[5] https://www.quora.com/What-is-the-visual-size-of-one-hectare

[6] https://www.law.cornell.edu/wex/eminent_domain

Chapter 21 – Renting vs. Buying

“I figure if I have my health, can pay the rent and I have my friends, I call in ‘content’” ~Lauren Bacall (Actress)

In Chapter 8 – Renting, we introduced renting as part of your expenses.  Then in the previous chapter, we explored the rental market even further.  In this chapter, I want to go even deeper into the renting vs. buying decision.  I often hear the common, yet incorrect, saying of, “renting is throwing your money away.”  I disagree—the decision of renting vs. buying, like all financial decisions, is based off timing.

In Chapter 7 – Housing, we discussed that all housing expenses shouldn’t exceed 35% of your (post-tax) income.  So, before you decide on whether you want to rent or buy, you should first focus on making sure you don’t exceed 35% of your income.  Renting vs. buying comes with different expenses that may encompass that 35%.

Renting a property includes paying your rent, utilities, and renter’s insurance.  Rent is normally higher than a mortgage.  Unless the property owner pays for a utility, utilities are the same whether you’re buying or renting.  Renter’s insurance is normally lower than homeowner’s insurance because renter’s insurance pays for all your belongings inside the house and the damage you may or may not cause the home.  Homeowner’s insurance is for both your belongings and the property itself.

When you know how much 35% of your income will be, the next thing that you should research is home prices.  Dramatic decreases in home prices can instantly wipe away wealth and rapidly increase the financial risk of property owners.  In the 2008 housing collapse, many properties saw a 50% reduction of home values from their tops.  In my hometown of Rosamond, California, average prices went from $300,000 to a low of $165,000.

Renting vs. Buying
Price History of Rosamond, CA

If you had bought at the height, you would’ve lost $135,000 in less than 9 years.  Renting would’ve shielded you from that massive loss—especially if you renegotiated the rent as the housing prices fell.  Additionally, buying a house costs quite a bit of upfront money.  There are paperwork costs, down payments, realtor fees, and upfront taxes.

Suze Orman has 4 signs why you shouldn’t buy and one of them is those large upfront costs.  Another is if you have a lower credit score.[1]  It’s not just the upfront costs that can be worrisome either.  There are routine costs like Homeowner’s Association (HOA) fees and repairs.  When you take out a mortgage, the interest rate depends on how much you put down and your credit score.  When you rent, your credit score is a simple “to rent or not to rent,” and lower credit scores are more easily forgiven when renting.

With interest rates being so low these last several years, the U.S. Census Bureau shows U.S home ownership is at near highs with 64.3% of Americans “owning” their home.[2]  I put owning in quotes because many Americans don’t actually own their homes. The banks do. While mortgage debt-to-GDP rate is lower than the high in 2010, our real mortgage debt is higher than it’s ever been.[3]  As interest rates rise, we’ll probably see a rise in foreclosures and short sales, and then a drop in the home ownership rate.

This is a lot to consider for renting vs. buying, but luckily enough, many finance sites have rent-to-buy calculators.  My favorite is here at Nerdwallet.com.  The assumptions are listed at the bottom if you want to dive deeper into the calculations.  Michael Dinich, at Your Money Geek, as a great article using Smart Asset’s tool.  Like NerdWallet’s calculator is breaks down all the costs associated with buying a house and compares it to a renter paying rent and renter’s insurance.  Both of these sites give you an estimate and I recommend running through these calculators before making the decision of renting vs. buying.

A 20% down payment is a major part of the factor.  Typically, the deposit a renter pays is the first month’s rent and they receive the back when they move, assuming there’s no property damage.  You may have lost pennies on interest you could’ve earned, but it’s not a sunk cost into renting.  20% down payments help homeowners avoid the Premium Mortgage Insurance (PMI) and get the lower interest rates.

Down payments are great for lowering the loan cost, but can disappear instantly if house prices crash.  Once you put the money down, it lowers the value of the loan, but has no impact on the price of the home.  Remaining loan balance isn’t a factor for nearly any home buyers, and in many states is not known to potential buyers.  In the price history of my hometown, shown above, 20% of a $300,000 house is $60,000.  Your entire down payment plus an additional $75,000 was an unrealized loss if you sold ($60,000 down payment + $75,000 additional loss = $135,000 the loss mentioned above).

This is one of the assumptions of rent vs. buy calculators.  Conversely, if home prices come up, then down payments provide high returns and is one of the reasons owning properties is a staple in the financial world.  For example, if you put $20,000 down on a house that costs $100,000 and it goes up $50,000 in value in 3 years, then you made 250% gain with just $20,000 invested.  This “quick money” is what attracted so many investors to the housing market prior to the 2008 collapse.  Many banks started offering no-down payment or interest-only loans, so there was little-to-no cash outlay for people to make tens and hundreds of thousands of dollars in just a couple of years.

Renters experience an opportunity cost when there are rising home values.  If you look at the price history above, if you started renting in 2000 when the house prices were at $85,000, then you would’ve missed the rapid increase to $300,000 by 2006.  But still, the renter would’ve walked away with zero liability.  And this is the bottom line for renters perfectly said here on the MD Wealth Management site, “ Renting offers greater flexibility, both in a life sense (peace of mind knowing you aren’t responsible for the furnace when it breaks) and in a financial sense.”  One of the best parts about renting is not having to worry about paying for repairs, which in some cases can be extremely costly.

One of the real risks to renting, like I mentioned in the previous chapter (link), is the over-commoditization of properties.  Due to the interest rates being so low for so long, large companies called Real Estate Investment Trusts (REITs) have bought many properties and can provide subpar customer service to its renters because of how massive these companies are.

REAL ESTATE INVESTMENT TRUSTS (REITS) INTRODUCTION

I’m excited to announce a new feature of the website and that’s the Financial Genome Project stock tracker.  A key part of the financial genome are the companies and the shares they distribute (stocks).  We’ll go into what stocks are in a later chapter, but this is a good time to introduce the largest apartment REITs just to get a glimpse of the scale of the commoditization of properties.

REITs own approximately 511K properties across the United States.[4]  Now, these are whole properties such as an apartment building and I wasn’t able to get data on how many individual units that are owned by REITs.  In June of 2018, REITs owned approximately $3 trillion in real estate assets which is about 10% of the U.S.’s $31.8 trillion real estate market.[5]

10% doesn’t seem like much, but remember, 64.3% of all properties are owned by actual homeowners, which is $20.4 trillion of the $31.8 trillion total value.  This means that $11.4 trillion of that is people renting.  REITs own about $3 trillion of that $11.4 trillion or 26.3%.  So, 1 out of 4 properties for rent is owned by a REIT.

It would be unfair to say all rental units owned by large companies have poor customer service.  Like any purchase, you’d have to do your research.  And it would also be unfair to say all homeowners provide good customer service, especially, given my own personal story I shared in the previous chapter with an elderly, inattentive homeowner.

Here’s a new part of the website.  I predict that apartment REITs will see higher revenue and profits, even as rents fall, when interest rates lower the amount of property owners.  You can navigate to our new stock tracker and see the quality of my economic predictions.  For now, this is just me providing my analysis, but in the future, I’d like an economist forum to weigh in and provide predicative analysis for my readers.

The five largest apartment REITs according to Seeking Alpha are Avalon Bay Communities (AVB), Equity Residential (EQR), Essex Property Trust (ESS), Mid-America Apartment Communities (MAA), and UDR (UDR).[6]  You can track these stocks on my new stock tracker.

SUMMARY

Renting vs. buying is a big decision.  I hope this deeper dive into the rental market provided some useful tips before making the decision.  We also went over a brief introduction in REITs and introduced my new stock tracker.

DISCLOSURE:  I don’t personally own any of the REITs mentioned in this article.  These stocks are for information only and not recommendations.

[1] https://www.suzeorman.com/blog/4-signs-you-should-rent-not-buy

[2] https://www.census.gov/housing/hvs/files/currenthvspress.pdf

[3] https://fred.stlouisfed.org/graph/?g=I5G

[4] https://www.reit.com/data-research/data/reits-numbers

[5] https://www.zillow.com/research/total-value-homes-31-8-trillion-17763/

[6] https://seekingalpha.com/article/4124788-reit-rankings-apartments?page=3

Chapter 20 – Exploring the Rental Market

“As soon as the land of any country has all become private property, the landlords, like all other men, love to reap where they never sowed, and demand a rent even for its natural produce.” ~Adam Smith, Wealth of Nations

In Chapter 8 – Renting, we discussed reasons why renting makes financial sense: it’s for the short term, you may not have enough money for a solid down payment, or it’s the rare case that the cost of renting is cheaper than buying.  Additionally, some people don’t want the liability of a mortgage or they like the freedom of renting.  Either way, in this chapter, we’ll further explore the rental market.

Normal financial advice recommends all housing costs should account for/take up no more than 35% of your (post-tax) income. We discussed this principle in depth in Chapter 7 – Housing.  When you’re renting, the costs normally include the initial security deposit (usually amounting to the cost of one month’s rent), monthly rent, and utilities not covered by the property (or rental contract).  You don’t have to pay for any repairs except for some minor wear and tear, but renters should carefully read the details of the contract for specifics of repair responsibility.  Some renters treat the property like it’s their own, however, others may have little regard for the property.  For many property owners, having tenants destroying their property is their #1 fear of owning a property.

If you are a property owner, you calculate rental yield by 12 months of rent divided by the value of the home.[1]  If you plan on renting out your property, you should consider the average rental yields for your state.[2]  Rental yields are affected by interest rates, and the market’s supply and demand.  Most property owners look for passive income generated by renting their property, and capital appreciation of the property by using the rental income to pay down the mortgage and/or the home value going up over time.  If you’re a renter, you’re providing the rental income, while the house may or may not appreciate.  Property owners retain all the risk and profits of the rental, while the renter retains less risk but typically doesn’t “profit” by renting.

Although it’s rare, some cities with little demand for home ownership may see mortgage costs exceed rental costs.  In this case, renters profit off the opportunity cost (or gain in this case) by choosing the cheaper option.  This is a trade off between renting and buying: over the long term, renting doesn’t contribute towards the renter’s net worth, but there’s also a lot less risk or liability incurred.

Remember in Chapter 8 – Renting we discussed that there are different types of property owners.  You have an owner, which is an individual that owns one or several properties; private investors are companies that invest in properties to rent out; and public companies which invest in properties such as Real Estate Investment Trusts (REIT).

In Chapter 19 – Economic Power of an Individual we discussed that you have economic power in the financial genome.  As a renter, you have a lot of power over an individual property owner that owns a single property.  Bad renters can cause significant damage, they may not pay or be late on rent, or they can continuously call for repairs that are basic wear and tear.  For those who own many properties, risk is decreased as there are more properties that may have good renters, depending on how good the tenant screen policies are.  Without proper screen policies, the risk may increase if there are more renters.  Conversely, being a good renter to that individual with one property can positively impact the owner and contribute to his or her future financial goals.

We discussed that people can positively or negatively influence your financial goals as well.  As there are good and bad renters, there are also good and bad property owners.  For example, I rented a house from an elderly property owner who did not use a property management company and it was an unpleasant experience for my family.  He was unresponsive to maintenance issues and difficult to work through administrative processes.

Some property management companies professionally manage apartments or condos and can provide a pleasant, professional experience, while some company portfolios are so large that customer satisfaction is irrelevant to the company, leading to a negative experience for the renter.  Similar to my experience with my property owner, these companies can also be unresponsive to maintenance issues or have complicated contracts leaving tenants with outrageous miscellaneous costs.

MONEY OVERVIEW

I’d like to discuss the economic power and influence a property owner and a renter have on the financial genome separately.  But before I can do that, I want to discuss how money works.  This will be a subject discussed in many Financial Genome chapters in the future.

In most developed countries, we have central banks that uses fractional reserve banking.  This means someone deposits $100 in a bank and then the bank can use $900 in loans.  So, at any time, any bank in a developed country only actually has a fraction in reserves.  We as humans all agree that the $900 is real and is part of different types of money calculations.  Similarly, as a property owner, you gave a bank a deposit and they give you a loan to buy a property.  The only actual money is the initial reserve in issuing bank and the deposit the property owner gave the bank.

The bank uses a small amount of deposit (its reserve) to lend a large amount of money to property owners to give to other banks.  The receiving banks can then use that money to make other larger loans.  The real money is paid monthly with interest back to the banks.  All the other money is tracked with modern accounting, enforced by our laws, and our acceptance in the process.

THE PROPERTY OWNER

As mentioned above, property owners could be individuals, private companies that own many properties, or public companies (REITs).  The owner may or may not have a loan on the property, but will always pay property taxes.  Under ideal conditions, the rent charged covers the loan payment, escrow, taxes, possibly a property manager, and profit.

From an annual average high of 16.63% in 1981 to an annual average low of 3.66% in 2012, interest rates on loans and the down-payment requirements were so low that it was more financially advantageous to buy a house than to rent.[3]  Now that interest rates are increasing and down-payment requirements are increasing, renting may become more viable.  However, the biggest factor facing property owners is they own all the risk.

Property owner risk comes from the possibility of defaulting on the mortgage loan, property damage, and defaulting on taxes.  The traditional “American Dream” means owning a house.  While I believe home ownership is an essential part of financial planning, it must be at the right time and under the right conditions, or else comes with the risks I mentioned above, possibly destroying your financial plans.  Vanilla, mainstream financial advice often carelessly minimizes the real risk owning a property.

For example, if you buy a stock for $5,000, you face the risk of losing the entire $5,000.  But you are protected from losing more than that initial investment.  If you mortgage a property that’s overvalued, then you face the risk of losing money you never had in the first place.  For example, you buy an overvalued house for $300,000 and the real estate market drops, you may now own a house that is only worth $200,000, but you STILL have a $300,000 mortgage on a property that you can only sell for $200,000!  You just assumed a $100,000 loss on the mortgage loan.  You’ll remember that this reality came true for millions of Americans in the 2008 housing and financial collapse.

Owning properties allows you to exert influence on others in many ways, the first being by setting rent prices.  If you own only a few properties, then the rent charged is limited to what the market will allow for your location.  If you own many properties or own a company that owns many properties, then you can influence the overall market.  Large private and public companies can not only influence the local rent market, but they can drive the overall market, increasing or decreasing rent prices as they’d like to increase profits.

Some individuals, companies, and REITs do exactly this: they buy up as many properties as they can for a location and then choose the rent price they want for the type of tenants they want.  Some companies buy apartments or single-family homes, partnering with the United States Housing and Urban Development (HUD) office.  The intent is to provide low-cost housing for people in need.  This program is great, but comes with risks.  Sometimes the low-cost housing tenants have little regard for the homes or apartments.  Also, in the case of my own hometown, the affordable housing brings crime and entitlement abusers.

A 2016 Standford Graduate School of Business analysis shows that low-income housing installed in low-income neighborhoods can boost property values, while low-income housing installed in high-income neighborhoods can decrease property values.[4]  Housing availability is the main driver in prices.  When there’s limited supply, demand increases, so home prices increase.

Another way property owners exert influence is through Homeowner Associations (HOAs).  Many suburban communities have HOAs that allow property owners to control what happens in the neighborhood through voting systems, where property owners have one vote per property owned in the neighborhood.  When companies own many properties in one neighborhood, they are able to control the future, for better or worse, of the neighborhood.  This program may prove useful in maintaining the look, feel, and value of a neighborhood, but it too comes with risks.  Some companies have used their power and control to keep communities segregated or increase the rents so high that they control the demographics to upper-middle income households.  You can read examples of HOAs infringing the rights of homeowners at this link.

Renting out properties is a great way to earn passive income through the principle called other people’s money, and is a key principle of becoming wealthy.  You use a small amount of money for a down payment and then rent out the property.  The rent may earn you a profit and someone else’s money pays the mortgage.  The equity you’re building is yours to keep for savings or additional investment.

THE RENTER

There’s a lot of vanilla financial advice that I disagree with, and one of them is “renting is throwing your money away.”  Like I said in Chapter 8 (http://financialgenomeproject.net/2017/09/24/financial-genome-project-chapter-8/), there are several reasons why renting can make more financial sense than buying a home.  One of the reasons we’ve already explained above and that is home owners exposing themselves to liability.  When you rent a home, the initial cash outlay you have is the security deposit, usually one month’s rent, and any utilities you may have to turn on or transfer into your name.  Assuming you’re a good tenant, you’re likely get the security deposit back when you vacate the property.

Some jobs, like the military, require you to move frequently, and so renting can be a good option.  It’s important for the economy to have a healthy amount of renters; too much home ownership can over-commoditize the housing market.  This is where homeowners treat properties solely as profit-making investments instead of providing a basic human need for housing.[5]  Additionally, a healthy renting market empowers renters and ensures they have equitable rights.

Many financial planners compare effective retirement planning to a 4-legged chair.  One of the “legs” of the chair, is to retire with no mortgage and/or have some passive rental income.  If you rent too long, and don’t purchase property, that leg of your retirement plan may be missing.  If you’re renting and have a longing to invest in the housing market without actually buying a property, you can buy REIT stocks.  REITs have done relatively well because of the high-dividend yields they offer.[6]

UPDATED FINANCIAL GENOME

Below is the updated financial genome.  If you’re a homeowner, your rent should cover the mortgage and escrow which goes to your lender, property taxes, which often goes to your lender and are paid on your behalf.  Additionally, if there’s profit, it will come to you as income.  If you’re a renter, your rent goes to the property owner to be disbursed above.

The key takeaway is owning your own home is an essential part of a sound financial plan, but not always the best decision as determined by your personal financial position.  Renting can be a good option if you move frequently, are saving for a down payment, are uncomfortable with the liability, or the market is more favorable for renters.

[1] https://www.proteckservices.com/rent-to-value-ratio-the-economics-of-rental-property/

[2] https://www.gobankingrates.com/investing/real-estate/best-worst-cities-own-investment-property/

[3] http://www.freddiemac.com/pmms/pmms30.html

[4] http://www.chicagotribune.com/classified/realestate/ct-re-housing-myths-debunked-20170829-story.html#

[5] https://www.ecnmy.org/learn/your-home/homes-housing-economy/the-rental-market/

[6] https://seekingalpha.com/article/4152764-single-family-rental-reits-continue-defy-critics

Chapter 19 – Economic Power of an Individual

“You had said that you saw no difference between economic and political power, between the power of money and the power of guns…  You are learning the difference now.” ~Galt’s Speech, For the New Intellectual

In my first chapter, I told you that YOU, the individual, are the most important part of the financial genome.  Then we started the Financial Genome Project with you working and earning a salary, and some of the salary taxes taken out.  We spent the last several chapters discussing the various types of expenses you will have.  In the following several chapters, we’ll start to look at how we exert influence in the financial genome.  We’ll really dig into Individual Economic Power.

We can exert influence by having power and by how much wealth we have.  The more we understand about the financial genome, the greater the power we can have and/or the greater wealth we can amass.  The good news is that you can control the influence you have on the financial genome.  The bad news is that others can exert their influence on you.

WHAT IS INFLUENCE?

I consider influence as the ability to impact other people in the financial genome.  We do this by our daily interactions in our roles as laborers, consumers, savers, investors, and with the power our occupations and positions give us.

The entire financial genome is designed by humans.  We created the rules, the laws, and the systems.  It’s a giant, complex system built on trust, reinforced by the consequences of not following these rules and laws.  We give a single person an insane amount of economic power over hundreds, thousands, and millions of people.  If the system were to collapse, that person would not have any true power.  As money becomes completely digital, we rely on financial databases keeping track of, to many of us, an invisible financial ledger.  It’s a complete system of trust.

Power and wealth are not always mutually exclusive.  I think Showtime’s “Billions” captures the difference perfectly.  One person has immense power as the Attorney General, but he is not necessarily rich; the other person has immense wealth as a hedge fund manager.  People with power can exert influence on the financial genome by passing laws and changing systems and processes.  People with wealth can generate more wealth at a faster pace than the less wealthy, just because that’s how our system is designed.  Ever hear the saying, “it takes money to make money?”  This wealth can be used to influence those in power.

Showtime’s Billions
POWER

People in power can exert influence on you.  We give family members, peers, bosses, employers, businesses, CEOs, and politicians the ability to positively or negatively influence us.  The intent of this website is to give you insight on how others have power over you and how they can impact your place in the financial genome.

The most extreme example is the economic power the United States Federal Reserve Chairman has.  The Federal Reserve’s mission is to “foster the stability, integrity, and efficiency of the nation’s monetary, financial, and payment systems so as to promote optimal macroeconomic performance.”[1]  The Federal Reserve’s weapon of choice is decreasing and increasing interest rates.  The smallest fractional change in the US’ interest rates can cause ripple effects across the entire world.  The Chairman is usually not a wealthy person, relative to corporate wealth; yet, same may argue the Chairman is the most powerful person in the world.

WEALTH

We see the power of wealth everyday.  People with money live different lives than people without money.  The more money someone has, the more influence they may have on others.  An extreme example of wealth is when Warren Buffett invested $5B in Goldman Sachs in 2008, convincing America that the economy was still stable.[2]  Another recent example is LeBron James’ investment into a school program he calls iPromise in Akron, Ohio.[3]

Power and wealth have the ability to create and destroy.  The more power and/or wealth you have, the more you can influence others.  In most developed countries, the financial systems reward those with money and power with more money and power.  The good news is, if you understand how these systems work, you can get power and wealth in the same way.  Understanding how the financial system works is the first step and is my primary goal of this website.

SO, WHAT DOES THIS HAVE TO DO WITH ME?

No matter how little power or money you may think you have, YOU STILL CAN POSITIVELY INFLUENCE OTHERS.  Every dollar you spend or save is a vote on what you feel is important in the financial genome, and in your circle of influence.  Each dollar you save gets you closer to financial freedom and retirement.  Each dollar you spend is either consumed immediately, purchases a depreciating asset, or an appreciating asset.

Purchases like entertainment and travel are consumed immediately.  You receive nothing tangible in return for the exchange of your money.  You receive intangibles like memories and stress relief though.  Purchases like cars and clothes are depreciating assets.  You receive assets but they immediately depreciate, and for the most part, you can never resell them for more than you bought them for.  Purchases like houses and rental properties can appreciate.  If bought at the right time, these assets can be sold at a greater price than what you bought them for, thus increasing your wealth.

We discussed the economic multiplier in many different chapters, but we’ll cover it in more detail here.  An economic multiplier is when there’s a greater output than the original amount spent.[4]  In simpler words, when you spend money, it multiplies and has a greater effect throughout the financial genome.  This is one of the reasons why local businesses and your friends and family doing Multi-Level Marketing (MLM) businesses become overbearing when you choose to spend your money at a major store.

The multiplier is felt more for a local business or family member’s MLM.  When you buy something from a major store, your purchase is just one of millions or billions of sales, for a local business it could be the only sale it receives that day.  Local businesses and MLM operators feel the loss greater as well.  Unfortunately, MLMs like Pampered Chef, Scentsy, and Younique, offer goods that are more expensive than the major stores.

This is where you get to vote with your dollars.  This is where your power, and your wealth, exert influence on others.  If you buy a $2 wax candle at Wal-Mart, then you’re voting for bigger corporations with lower-cost goods.  If you buy the same wax candle for $8 from a friend with the MLM, Scentsy, then you’re voting to support your friend for a higher-priced good.  It’s a difficult choice.

For most of us, the influence we have on others disperses and grows weaker as it travels through the financial genome.  Where you decide to shop has a bigger influence on local businesses than it does on major corporations.  Amazon has had a negative influence on local businesses, but has provided us with cheaper goods and convenience.  We have voted for Amazon’s dominance over local businesses with the money we spend.

It’s the same with voting in elections.  Your vote has a big impact on your city elections, but it lessens as you vote on county, state, and federal elections.  Citizens are authorized to contribute $2,700 to a single candidate’s campaign.[5]  This $2,700 means a lot more to a town’s mayoral election than it does to the U.S. Presidential election.

GOING FORWARD

In the previous chapters, we went through the most common expenses that consume our income.  If you haven’t already contributed, read the Variable Expense chapter and add an expense you’d like discussed.  In the next several chapters, we’re going to explore each expense in greater detail.  We’re going to unravel and explore all the connections you have with each expense.

In some cases, you’ll have the ability to influence others with your power and income, and in some cases, you’ll have barely any influence.  For example, gas is a common expense for many people living in a developed country.  Gas is a homogenous commodity.  This is when the product is indistinguishable from other supplies, and we usually buy the cheapest product available.[6]  There is almost no brand loyalty, and as such, gas companies usually rely on rewards program to lure customers in.  Refer to my Rewards and Referrals chapter for more information.

It’s in the small details where I believe we can find the best personal finance lessons, and use positively use our influence.  It’s also in these small details where we can protect ourselves against others that may exert negative influence on us.  I look forward to the next several chapters, and I hope you do too.

[1] https://www.federalreserve.gov/publications/gpra/2011-mission-values-and-goals-of-the-board-of-governors.htm

[2] https://money.cnn.com/2008/09/23/news/companies/goldman_berkshire/

[3] http://time.com/money/5354265/lebron-james-i-promise-school-akron/

[4] https://www.investopedia.com/terms/m/multiplier.asp

[5] https://www.fec.gov/updates/fec-announces-2017-2018-campaign-cycle-contribution-limits/

[6] https://study.com/academy/lesson/homogeneous-products-definition-lesson-quiz.html

Chapter 18 – Variable Expenses

“Beware of little expenses. A small leak will sink a great ship.” ~Benjamin Franklin

In chapter 15, we discussed the difference between fixed and variable expenses.  We went through fixed expenses such as housing, food, and clothing.  Then we went through the fixed-variable expenses which should be fixed but can vary depending on lifestyle choices.  Examples include transportation and saving AT LEAST 10% of your income.  In this chapter, I’d like to discuss a variety of other expenses that are purely variable.  You have complete control over these types of expenses, and if your financial situation starts to get strained or you want to increase your savings rate, you can reduce or eliminate these.

TITHING

“Bring the whole tithe into the storehouse, that there may be food in my house.  Test me in this,” says the LORD almighty, “and see if I will not throw open the floodgates of heaven and pour out so much blessing that there will not be room enough to store it.” (Malachi 3:10)  I feel it’s important to talk about this initially because if you’re a Christian, then tithing is fixed, and it’s 10% of your income BEFORE any other expenses.  The point of this chapter is not to get into a theological debate, and we will dissect religious finances in much later chapters.  Just a quick fact to whet the appetite, the Vatican Bank has about $8 billion in assets.[1]  Religious entities are major centers of gravity in the financial genome.

ENTERTAINMENT

Entertainment may be the easiest place to reduce or eliminate expenses if you’re struggling with finances or looking to increase your savings rate.  I would caution eliminating all your entertainment.  Like we’ve discussed in previous chapters, budgeting can be like dieting, and it can be hard.  If you don’t allow yourself some entertainment, then you may find budgeting to be too difficult. Or worse, you may regress and spend more than you were originally.  Common examples are movies, video games, music, board games, and sporting events.  We’ll explore all of these in future chapters as each one of these is a billion-dollar industry.

INTERNET, PHONE SERVICE, AND TELEVISION SERVICES

Some would argue that living a normal, modern life requires internet and phone service.  This may be true, but you can certainly reduce your expenses for these variable expenses as well.  For many people, internet expenses have become akin to car or home insurance: they don’t understand what they’re paying for, and often end up spending too much for services they don’t use.  Sometimes cutting internet services to the basic package can save a lot of money.

The prices we pay are for the phone themselves (and sometimes the added insurance), data, text messaging, and on the seemingly rare occasion, actual cell phone service.  The phones and plans are incredibly expensive and mobile phone usage becomes ubiquitous for every human.

Not having the right plan can be costly.  If you exceed your data limits, the overage charges are punishing.  The type of plan needed is specific to each person and each family.  The author of Creating Commas blog saved $112 a month by reducing the plan.  The author also calculated that the total savings was $33,641 using a common “25 times your annual salary” calculation.  Most people save money by not upgrading to the newest phones and/or reducing data usage by maximizing free Wi-Fi or the Wi-Fi you already have at home.

Sometimes internet, phone, and television services can be duplicative, and we pay too much money for all of them.  It seems increasingly popular to reduce or eliminate the television or cable services first and just use streaming services like Netflix or Hulu.  The author of the Poorer Than You blog switched to streaming services back in 2009—probably saving quite a bit of money this last decade.  Television/cable providers are true oligopolies, where few companies control the majority of the market share and take advantage of rapid prices increases instead of pure competition which can reduce prices.  You basically only have the choice between DISH Network, DirectTV, or a cable provider.  These companies lure you in with small introductory rates then rapidly increase the prices and/or limit services.  It’s no wonder why so many people are ditching these companies and moving to streaming services.

DAYCARE

Daycare expenses can be costly.  For 25 years, daycare prices have outpaced inflation.[2]  While it may seem facetious, each year you wait to have kids, the more expensive they will be.  Often times, couples find themselves “working just to work.”  This means that when the second person gets a job, his or her pay is equal to the incurred expenses one has because of the job – meaning, daycare, transportation costs, clothing, and meals out with coworkers.  This shouldn’t stop people from getting a job because you can still gain work experience and compete for promotions.  Day care becomes fixed if both people of a couple are working or a single parent works, but having kids is an option so I put it as one of the variable expenses.  Once you have kids, the related expenses become fixed.  Here’s a great article on why and how the author of the Chief Mom Officer blog chose to save money on daycare.

VACATION SPENDING (Added: 7 Jul 18)

A reader suggested vacation spending.  Some may consider vacations as part of entertainment, but I feel it deserves its own section.  Vacations are important for mental health—especially when traveling to different countries is involved.  Traveling to foreign countries has been the favorite part of my military service.  The average vacation costs $1,145 ($4,580 for a family of 4).[3]  There are too many variables to specifically write about all the possibilities of saving money when vacationing.  Before you do travel though, do a quick Google search on saving money at your specific location (i.e., “Saving money on a Las Vegas vacation”).  There are hundreds, sometimes thousands, of articles on how to save money while traveling.

SELF CARE/BEAUTY PRODUCTS (Added: 7 Jul 18)

A reader suggested self care and/or beauty products.  As a male personal finance blogger, you may assume I would recommend eliminating self care or beauty products first, to save more money.  Full disclosure though, I spend nearly $50 on beauty products a month.  I take self care, healthy eating, and fitness seriously.  Just like investing, small investments when you’re young can pay huge dividends when you’re older.  Taking care of your skin when your young is easier than worrying about it when you’re older.  Our spending habits in America agree with that statement as well.  24% of those surveyed spend over $100 on beauty products when they are 18-29 years old; compared to 18% for 30-59 and only 8% for those 60 years and older.[4]  If you want to increase your savings rate, this is a good place to reduce expenses, but I don’t recommend eliminating it.

I NEED YOUR HELP!

This list is not inclusive, and I’d like to keep it updated with suggestions from readers!  What expenses do you consider variable?  Tell me about your variable expenses, and what decisions you’ve made to cut back on them by contacting me through this blog by leaving comments, or through my Facebook or Twitter accounts.  If you’d like to be featured, be sure to leave your social media information!

[1] http://money.cnn.com/2015/09/24/news/pope-francis-visit-vatican-catholic-church/index.html

[2]http://cepr.net/data-bytes/prices-bytes/prices-2016-08

[3] https://www.creditdonkey.com/average-cost-vacation.html

[4] https://www.statista.com/statistics/717757/average-monthly-spend-on-beauty-products-us-by-age-group/

Chapter 17 – Why Debt Is So Bad

Only when borrowers have access to efficient credit networks can they escape from the clutches of loan sharks, and only when savers can deposit their money in reliable banks can it be channeled from the idle rich to the industrious poor.”

~Niall Ferguson, The Ascent of Money

In the last several chapters, we discussed housing, food, clothing, and transportation expenses, as well as saving AT LEAST 10% of your income.  Based off the standard advice discussed in those chapters, you may/should have already spent 60 – 70% of your income on these expenses.  If you have debt (excluding your mortgage), you’ll have to add this as an expense as well.  So why is debt so bad?  Debt is so bad because it exposes you to many risks and can be like a noose around your neck.  As your debt increases, interest rates rise, your income reduces, or you experience an emergency, the minimum payments can increase and it will tighten the noose and may force you to reduce other expenses until possible bankruptcy.  Before we go too far, though, let’s look at what debt really is and how it started.

HOW IT ALL STARTED

Debt truly started when banks started using fractional reserve banking concepts.  This is an important concept to understand because it impacts interest rates.  Fractional reserve banking is where a bank has (for example) deposits and uses those as a “reserve” to issue loans in excess of its deposits.  People don’t often need immediate access to their money, so banks can take on additional loans.  These banks of deposit started as early as the 1200s with Alexander the Great in Damascus and Barcelona in the 1400s.  The true start of banking as we know it today started in Venice in the late 1300s.[1]

The banks loan you this money so you can buy things you may not have cash for.  The two types of debt are installment loans and variable-rate loans.  Installment loans are normally your mortgages, student loans, and car loans.  Variable-rate loans are normally your credit cards, adjustable-rate mortgages, and student loans.  Installment loans have a fixed rate and the interest is “front-loaded” into the loan, so the bank gets its money sooner.  This process is called amortization.  The amount of interest you pay upfront can be shocking to first-time home buyers.  I’m well read on the banking process and personal finances, and the mortgage process still shocks me.  Before buying your first home, Google an amortization calculator and see how little your mortgage actually goes to paying down principal for the first 5-10 years.

Variable-rate loans are assessed a monthly interest rate based off the current interest rates, and a minimum payment is required.  Your authorized credit is based off your income and credit score.  Depending on the type of loan, your interest may be front loaded or evenly split through the life of the loan.

Valueless instruments are given to another person for an exchange of goods that are valueless themselves.  Instead of exchanging goods like food for leather, a patron can give a seller something that is inherently valueless that represents value.  There is a long history of these exchanges going back to the prehistoric days where Mesopotamians used clay tablets to conduct trade.  Then coins were produced in the Roman times. Credit coins and charge plats were used in the 1800s and then finally credit cards in the 1950s.[2]

This is a very quick overview on the origins of banking and issuing debt.  We’ll dedicate several chapters on the banking industry once we’re done discussing most of the major expenses people typically have.  The key takeaway is, in the current banking system, we use fractional banking which allows a bank to loan out money above and beyond what it has in deposit reserves.  To keep deposits, banks pay interest to keep your money in the bank so they can loan out more money.  There is typically a large spread between the low amount banks pay in interest for deposits and the high amount banks charge in interest for loans.  This is called the net interest rate spread—the spread is never in your favor and is always in the bank’s favor.

SO WHY IS DEBT SO BAD?

Like mentioned above, being in debt exposes you to many risks.  The most common risk, and the one I’m most concerned with in the immediate future, is interest rate risk.  This is where rising interest rates limit your access to housing, cars, and possibly student loans.  This is also a concern for the people spending 100% of their paycheck at current interest rates—barely making it to the next paycheck and only making minimum payments.  If the interest rates rise, the minimum payments will increase as well.

Higher interest rates can make the cost of homes and cars go up drastically.  The U.S.’ long-term interest rate hit an all-time high in 1981 and then went down to nearly zero from 2008-2015.  The U.S. was even remotely considering a Negative Interest Rate Policy (NIRP) where we’re charged to keep our money in the bank.[3]  This is because our entire U.S. economy is dependent on people getting loans and immediately consuming things.  For us to get out of a recession our only hope was excessive consumerism and debt.  In 2016, interest rates started to increase.  Banks immediately changed their loans and interest rates to continuously keep the net interest rate spread in their favor.  So, the first reason why debt is so bad is because you’re exposed to interest rate risk, mainly with variable-rate loans.  Depending on the interest-rate environment, fixed loans can protect you from the risk of rising interest rates.  In the picture below, we see how rising interest rates increase your payments and can reduce the money you have available for other expenses and savings.

Interest Rate Risk

Another reason why debt is so bad is because you become dependent to the “system” of debt.  Once we get into debt, we must work and/or earn an income.  It’s the same philosophy behind taxes.  Once you venture out on your own, you must work and/or earn an income and pay taxes.  To become financially independent, you must make the money you save and earn make money itself from retirement plans, interest, dividends, and side job.  So we get a job and our income becomes our means.  We then voluntarily decide how we live from there.

Some live below our means, where our expenses are lower than our income and we save the discretionary income.  We become financially independent earlier than the “system” recommends.  Some live within in our means where our expenses (to include AT LEAST 10% savings) is exactly our income.  We become part of the system and retire when it allows us to.  Unfortunately, many people live above their means and rely heavily on loans and credit cards.  For example, in the housing chapter we discussed that all housing expenses, to include your mortgage or rent, should not exceed 30% of your income.  Below your means is well below 30%, within your means is 30%, and above your means is above 30%.  If you’re living within or above your means and something happens to your job, then you’re at risk of financial ruin.

Your job is always at risk no matter what industry you’re in and being in debt exposes you to this risk greatly.  To reduce costs, many companies outsource or automate operations.  Industries are always at risk to new technologies that can make entire industries disappear.  The economy can change and we can experience high unemployment.  There are hundreds of risks to any job in any industry.  If you live exactly within your means or above your means, then you’ll continually need to maintain those means.

And this is exactly why debt is so bad.  If you use debt incorrectly, like many people do, you basically become a battery to the system and can’t unplug.  Many of us accept this fate—but what if you hate your current job or what if an emergency in your life happens?  To clarify, mortgages and student loans can be considered an investment.  Wealthy people use debt as a tool, and when used wisely, can magnify your returns.  Mortgages within your means, or rental properties, can give us equity, and passive income, as time goes on and higher education can yield higher paychecks, better benefits, and more stable employment.  Home buying and choosing which degree (and its resulting debt) are lifestyle choices we can choose to make.

People who become debt free often claim that a weight has been lifted off their shoulders.  People who are in debt often claim to feel a heavy burden or, as I mentioned above, like a noose is around their necks which is slowly tightening.  The entire system benefits creditors, and fractional-reserve banking can create massive corruption and disruptions.  Being debt free allows you to unplug from the system (except for taxes).  As we discuss other expenses, know that increased debt payments, whether by higher interest rates or disruption to your income, can eat into your voluntary expenses such as entertainment, travel, and short- and long-term goals.

Financial Genome Project – Chapter 17

[1] https://seekingalpha.com/instablog/25783813-peter-palms/4549696-history-fractional-reserve-banking-became-model-federal-reserve-system-unbroken-record-fraud

[2] https://www.creditcards.com/credit-card-news/history-of-credit-cards.php

[3]https://www.investopedia.com/terms/n/negative-interest-rate-policy-nirp.asp

Chapter 16 – Transportation Expenses

“Cars are lousy investments; they never rise in value. ~Suze Orman

In the last chapter, we discussed the difference between fixed and variable costs and how budgets can help you track those. We’ll use the next couple of chapters to discuss various expenses. The first variable expenses you have almost total control over are your transportation expenses. Your first opportunity to influence control over transportation is the necessity. You have control over how much and what type of vehicle you need, or if you need a vehicle at all. The farther and more frequent you drive, the more reliable of a car you’ll need, and vice versa. Some people don’t use a car at all in locations where public transportation is readily available.

How much you should spend on your car? The vanilla, certified financial planning advice recommends the 20/4/10 rule.[1] This states that you should make a down payment of at least 20%, finance a car for no more than four years, and not let your total transportation expenses exceed 10% of your gross income. Another popular vanilla advice is the total value of your car should not exceed half your yearly income.[2] So if you make $50K a year, you should look for a $25K car or less. The most I’ve ever spent is 17% and my most recent car purchase was 8% of my gross annual income. It’s important to live within this framework or below, because making the wrong transportation decisions, like the majority of America does, can literally cost you millions. Check out this article in the blog, Modern Personal Finance, where the author shows you how continuously financing new cars can cost you millions.

The appetite for buying cars above our means is strong, and car dealerships and banks are more than happy to loan us the money to satisfy our appetites. The default rate is lower on auto loans than any other type of loans. As such, banks will even allow you to roll over loans above the value of a car by establishing negative equity. This is where you owe more than the car’s worth, and the dealer tacks more on top of the new car loan. For example, when he was 26, the author of the Chain of Wealth blog, bought a $30K car tacked with the $20K negative equity making him $50K in debt for a $30K car.[3] This seems like a high amount of negative equity to me, but the total authorized amount of negative equity for 2018 is $5,100.[4] States have various laws controlling how much can be rolled over each time you trade in a vehicle. This rolling over negative equity is a major contributor to the all-time record high for auto loan lending. Total American debt keeps reaching all-time, records highs at $1.22 TRILLION, at the end of the fourth quarter of 2017.[5]

BUYING VS. FINANCING

A big decision for many of us is to decide between buying a car outright or financing a car. My focus is not to help you make that decision, but just provide useful information, because there are too many variables. Plus, like we’ve discussed in many chapters, there is a behavioral aspect to financial decisions. Some people really like cars and keep them as their life’s major focus. For a good article about buying a used car, check out this article on the Hungry Being blog. Additionally, here’s 5 tips on how to buy a car from a former salesman on the Get Rich Quick’ish blog. Most people recommend the following order: 1) Purchase a reasonable used car in cash. 2) Finance a reasonable used car using the 20/4/10 rule. 3) Purchase a nice car outright, not to exceed 50% of your gross income. 4) Finance a nice car using the 20/4/10 rule.

Buying a car outright isn’t always the best return on investment. As we’ve discussed many times, all financial decisions come with an opportunity cost. Check out this article on why the author of the Win at Life Finance blog loves his car payment.  In the current low-interest rate environment, he’s able to get a higher rate of return on the money he invests than he would’ve if he bought his cars outright. As long as the return on investment is greater than the interest on the loan and the car’s depreciation, then investing the money can be a better investment. Cars depreciate quickly, and it doesn’t make sense to spend money on maintenance costs while also paying down a car loan. Banks now offer a 7-year (84-month) loan. According to Bankrate.com, the downside of these loans are a greater cost over time (more interest paid over a longer time), depreciation (9% percent immediately, 20% one-year later, 63% by 5 years), and paying for repair issues while still paying for the loan.[6] Like I said, there are too many variables for me to help you make a personal decision.

THE AUTO INDUSTRY

There are three ways people typically buy or finance a car. The most common method is to go to an auto dealership or its internet site. Auto dealerships are typically owned by franchisees. According to the National Automobile Dealers Association (NADA), the average franchise cost is $11.3 MILLION.[7] Most dealerships offer new cars directly from the manufacturer and used cars of all types. They buy the used cars when you trade them in or at special auctions. In this case, the dealership makes profit, and the manufacturer makes money.

The next most common way is to sell it yourself, known as a private purchase or peer-to-peer. Under normal conditions, sellers can get more money by privately selling a car versus a trade in at an auto dealership. You can see the price differences by going to Kelley Blue Book (www.kbb.com) and compare the Private Party Value to the Trade-In Value. Selling cars on websites is also becoming popular. Craiglist.com is the most commonly used website to sell cars privately. In this case, because of the rapid depreciation of cars, the seller doesn’t necessarily make a profit, but he or she receives money in exchange for the car.

These used to be the only two ways to purchase cars until Tesla Motors began selling luxury electric cars directly to consumers. This caused major controversy at the federal and state level, with many states banning the practice altogether. In 2015, the Federal Trade Commission supported Tesla, a new startup company called Elio Motors, and the direct sales model; however, also recommended regulating it closely. The FTC concluded, “Absent some legitimate public purpose, consumers would be better served if the choice of distribution method were left to motor vehicle manufacturers and the consumers to whom they sell their products.”[8] In this case, the manufacturer profits from the sale.

We’ll explore the auto industry in more detail in future chapters. The auto industry faced a crisis in 2008 at the same time as the housing market. Exactly like the banking industry, the auto industry consolidated as big companies bought smaller or struggling companies. We’ll explore the auto industry family in later chapters.

Automotive Family Tree

To implement the 20/4/10 rule, you need to track your expenses to ensure you’re not spending more than 10% of your annual gross income on transportation expenses. Some people confuse not having a car payment with saving money on transportation expenses, while they spend more than 10% of their gross income on repair costs. Here’s the current financial genome.

Chapter 16 – Financial Genome Project

[1] http://www.interest.com/auto/news/how-much-should-you-spend-on-car/

[2] https://cars.usnews.com/cars-trucks/best-cars-blog/2015/07/how-much-should-you-spend-on-a-car

[3] https://www.chainofwealth.com/blog/negative-equity-explained/

[4] https://www.edmunds.com/g00/car-buying/being-upside-down.html

[5] https://www.investopedia.com/personal-finance/american-debt-auto-loan-debt/

[6] https://www.bankrate.com/loans/auto-loans/84-month-auto-loan/

[7] http://smallbusiness.chron.com/much-cost-open-car-dealership-19181.html

[8] https://www.ftc.gov/news-events/blogs/competition-matters/2015/05/direct-consumer-auto-sales-its-not-just-about-tesla