Uncommon Cents

A few posts ago I discussed how that some of the same folks who were complaining about the dollar going south versus the Euro were freaked out when the Euro weakened dramatically. I wanted to add a bit to that–that there’s an upside to what are often seen as financial difficulties, if you’re in position to take advantage of them.

Sure, interest rates are paying next to nothing for CDs and money markets–but interest rates are also next to nothing for mortgages. If the Euro stays week, now might be the time to visit Europe–or buy Euros.

On the other hand, if interest rates go through the roof (maybe in response to wild inflation, which we don’t have at this time), look at getting some long term CDs and bonds. If the stock market bombs, look at it as a buying opportunity.

There’s an upside somewhere.

The overall effects of interest rates on the economy can be summed up pretty quickly–low interest rates encourage borrowing and help those who owe money; that encourages spending and therefore economic growth. On the other hand, high interest rates benefit those who like to save, as they’ll get better return on their money, and discourages spending, therefore discouraging economic growth. That said, on a micro level, who actually benefits from low interest rates?

The people who benefit most from low interest rates are those who owe money or are looking to borrow money. For instance, with the incredibly low interest rates on 30 year fixed mortgages available earlier this year, I refinances the mortgage on the house from the very decent 5.85% obtained a few years back to 4.25%, shaving hundreds of dollars off of the monthly payment. Also, if I wanted to borrow money to say, start a business, I could likely get a much better rate than I would have a couple of years back.

On the other hand, the very low interest rate climate hurts savers. My online savings accounts that were paying rates in excess of four percent are just over one percent now–and I’m afraid to check what the regular passbook savings account that my mother uses at the local brick and mortar bank is paying (not long ago it was paying a quarter of a percent when the online accounts were still above three percent). Folks who are looking for certificates of deposit as safe places to park money are having difficulty finding interest rates at three percent for almost any term (Bankrate says it’s possible to get 3.06% on a five year CD).

Remember that in recent years inflation has been about three percent per year, which makes it pretty clear that locking in a paying rate for a long period of time is a real risk if inflation shows up again with a vengeance; on the other hand, it’s a great time to refinance debt or buy a house if you can come up with a nice down and really can afford it over the long run. In any case, we all benefit from low interest rates if we owe money (or are looking to borrow), but all hurt by them if we’re saving somewhere.

I have quite a few online only (or close to online only) accounts. Some of these I have because they pay a higher rate of interest than I can find locally; others I have because they offered (or continue to offer) bonuses for starting a new account. In the case of brokerage accounts I may have them due to low cost or convenience. In any case, here’s a quick list:

Capital One, ING Direct, iGoBanking, and Virtual Bank: I have savings or checking accounts at these institutions. This is where I keep short term money and pay bills.

Treasury Direct: I buy I series savings bonds–which has recently been one of my best investments–through this account.

ShareBuilder: Now owned by ING (formerly part of Wells Fargo), this is an account that regularly invests money into a selected stock or stocks (or ETFs). It’s like dollar cost averaging, but is really just regular investing.

Firstrade: I have three accounts here–a regular, taxable brokerage account, a Roth IRA, and a traditional IRA. The low costs associated with this account make me quite pleased.

Vanguard: The folks who run my 403(b) chose Vanguard as the place to hold this large sum of money, and I’m very happy with them.

This is a lot more accounts than I thought I had! Suffice it to say I’m pretty happy with all of these. Are you using any great online financial services?

On Twitter (gee, I seem to be saying that a lot), one of my buddies and I had a quick exchange on the pros and cons of prepaying a mortgage, which I thought I’d expound on here.

This discussion assumes that you don’t have an exotic, difficult to deal with mortgage like an adjustable rate mortgage. If you do, you’d likely be much better off finding a fixed rate mortgage than worrying about paying beforehand. It also assumes you don’t have a mortgage with a prepayment penalty–yes, there are mortgages that will sock you with fees if it’s paid off early!

The question that was at the heart of the discussion is whether paying off a mortgage early made financial sense. The answer, as almost always, is, “it depends.”

In particular, it depends on the interest rate of your mortgage and the rate of inflation. Let’s take a quick look here.

Pretend you live somewhere (like Hawai’i) where the interest paid on the mortgage for your primary residence is deductible on both your federal and state taxes. Also pretend that inflation is in the “normal” 2-3% range. And let’s also pretend your mortgage rate is 5% (which is a pretty decent rate).

Start with your mortgage rate–right off the bat, you can deduct the inflation rate–you are paying off the mortgage with future, cheaper dollars. So 5 (your mortgage rate) minus 2.5 (right in the middle of the 2-3% “normal” inflation rate) equals 2.5.

Then consider you are deducting the interest you’re paying from your federal and state taxes, which might (depending on how much interest we’re talking about) give you the equivalent of about another 1-1.5% discount on that rate. That leaves us somewhere about 1.25% interest on that loan–we’re talking pretty cheap money. Financially, this would suggest that prepaying is not so hot of an idea–your money would better be spent in even a pretty low rate certificate of deposit if you wanted a “sure thing” or, given historical returns, the bond or stock market.

However, remember that the inflation rate is a key part of this! Right now, inflation is essentially zero, if not negative. So it’s hard at this particular time to give yourself that 2.5% part of the equation, although over time it’s likely to be true. If you can’t count on the inflation part of this scenario, the effective interest rate becomes considerably higher–an argument to prepay.

Alternatively, looking at a different part of the scenario: if you prepay the mortgage at 5%, it’s like investing your money at a guaranteed 5% rate, which is pretty darned decent these days–although about half the traditional return of stocks. If, however, you are a conservative investor, you could consider this similar to being like investing in a fixed income security such as bonds or CDs–in that case, it may be worthwhile to prepay the mortgage with the money you may otherwise use for fixed income investing. But be careful with that, because while you eliminate debt faster, you aren’t building any wealth.

And of course, the 5% mortgage rate is key to this; if your rate is, say, 7%, you just added two more points onto the equation, which would make the argument to prepay much stronger.

So, a few things to consider when thinking about prepaying your mortgage. This is, while much more comprehensive than what could be done on Twitter, just the beginning of a long discussion on some mortgage issues.

Interest rates being low is the bane of savers who like to put dollars away into money market, certificate of deposit, or high yield savings accounts. With the low interest rate environment we currently have, there’s not a lot of places for folks who like safe investments to make more than (or even equal to) the rate of inflation.

There are, however, some times when a low interest rate environment is favorable. When? Mostly when you have debt. I’ve blogged a couple of times about my quest to get the mortgage refinanced at 4.25% (which is not yet completed but work continues). Interestingly, however, I would be perfectly okay with the mortgage staying at 5.875% where it currently is; it’s a decent rate historically.

If a debt, however, is at higher levels and unlike a mortgage or student loans does not have tax deductible interest (think auto loans, personal loans, and credit cards), it’s really time to think about how to take advantage of the low interest rate environment and make it work to your advantage.

Low interest rates have their advantages; if you’re in a position where you can use them to your advantage, go for it! It’ll make your financial life much easier.

Welcome to your first Link Payday of the year, published on January 5, 2009! Like usual, I try to give you some of the best posts of the personal finance blogosphere of the last few weeks, so here are some posts that caught my eye:

Her Every Cent Counts covers a controversial topic when she discusses Sex: Who Pays? This isn’t just who pays for dinner, folks, but for the actual costs of some of the necessities of actually engaging in sexual activity. Not necessarily a topic everyone wants to look at, but certainly one that’s real.

Moolanomy teaches us about a site I’ve not heard of before when he writes a MoneyAisle Review. Folks, this site helps to get the user the best rates on CDs and high yield savings accounts by having banks actively bid for your business. What a great idea!

All Financial Matters covers changes in how your credit score will be calculated with the article Bureaus Roll out New Credit Score Formula for 2009. As someone who just applied for a mortgage refinance (and got blindsided by a credit card closure that wasn’t expected), this looks like even more potential for the consumer to end up on the short end.

David over at My Two Dollars does a great job of comparing two really important savings vehicles for ducational purposes when he writes on Comparing a 529 Plan and an Education Savings Account (ESA). This can be a tough choice for many, so David does a nice job of looking at the pros and cons of each.

Finally, my buddy Ron over at The Wisdom Journal lets you in on the Secrets to Effective Complaining. I don’t like to complain, but I probably do it more than I like, so it’s nice to learn how to do make it worthwhile.

And that’s your January 5, 2009 Link Payday!

Some people discover their risk tolerance is rather low, or lower than they thought, in stock market times such as these. If that is indeed the case, what options do these people have?

The principle of risk/return does not disappear just because someone can’t deal with somewhat higher risk; rather, it becomes very clearly in effect. If someone wants to take absolutely no chances with their money (or just shy of no chance), they can certainly do that, but the returns their money will gain will be quite low–but they will exist. This is unless it’s someone who would rather bury money in coffee cans in their back yard or stuff it in their mattress, of course–but that’s not investing.

Realistically, everyone needs a safe place to put at least some of the dollars they have. An emergency fund needs to be kept away from stock market risk, because emergencies don’t come on a schedule (some would say the market currently is in a state of emergency!). So “chicken money” is something everyone has at least some of–money we’re too chicken to put at any risk at all.

Savings or Share Accounts: These are your typical accounts at a bank or credit union. Right now the rates of interest on them are anemic–in the case of my mother’s bank account, one fourth of one percent of interest! That’s definitely not keeping up with inflation. However, since the account is FDIC insured and she’s well within the limits of the insurance, it’s as safe as the federal government’s word. If you’re going to use one of these, make sure you have insurance by the FDIC or the NCUA (in the case of a credit union). You won’t make much, but your money will be safe, and it’s really high in liquidity, meaning you can get at your money pretty much anytime (provided the bank’s business hours work for you).

High Yield or Money Market Accounts: These tend to be a lot like savings or share accounts but with a somewhat higher rate of interest and possibly more limits on accessing your money. For instance, I have a Capital One Direct high yield savings account that pays me 3.55% interest and allows check writing and ATM access–but limits how many checks I can write per month. Fortunately, it also allows electronic access, which is a bit more liberal. This is a nice place to stash an emergency fund, since it’s almost as liquid as a savings or share account.

Certificates of Deposit: CDs tend to have rates about the same if not a little higher than high yield or money market accounts. In return for offering a little more interest, you lose liquidity. Still, CDs you may be appropriate for an emergency fund with a little planning (having a CD mature every month with 5/6 of an emergency fund means at most you’d be one month away from access, and having that remaining 1/6 in something like a high yield account could do it) but for simplicity’s sake, you may not want to use these for that purpose. Make sure you are wary of the FDIC limits (which apparently will be increasing, at least for awhile) on how much they’ll insure if you really are concerned about safety!

Treasury Bonds or Notes: In many ways considered the safest of investments, there are lots of different bonds and notes you can get; some may offer tax advantages. I have a bit of my portfolio in I series bonds, for instance. There are also government issued bonds or notes from local or state governments that may be worth looking into as well. Again, the rates are not fantastic, but combined with possible tax advantages as well as safety, this could be a viable option.

Money Market Funds: Not quite the same as the money market accounts, these are mutual funds that invest in short term instruments. They are not backed by FDIC or NCUA insurance as they are mutual funds, although they recently had some temporary insurance offered to them with unusual circumstances that led to a “run” on them as a consequence of the Lehman Brothers bankruptcy. Money Market funds nearly always have a stable net asset value of $1 per share and pay a return based on how their investments do. Of course, since it’s a mutual fund, your initial investment will likely need to be more than you can put into a savings account, money market account, or CD, and you may have commissions to deal with.

Bond Funds: In bond funds, you have a ton of choice just as you do with stock funds. If you’re looking for safety, consider the quality of the bonds in the fund; “junk bonds” may offer higher yields, but more risk. Funds that are based on Government National Mortgage Association bonds–Ginnie Mae funds–tend to be both very safe and pay very nice returns. A fund like the Vanguard Total Bond Market Index has offered similar performance and safety to the Ginnie Mae funds over time. Again, these are funds, but unlike the money market funds which almost never move off the $1 per share net asset value mark, these do fluctuate a bit, but historically, nothing like stock funds.

There are some alternatives–from about as safe as you can get to pretty safe with some amount of risk–to consider for your chicken money, whether that’s just your emergency fund or your whole portfolio. Good luck in selecting one that might meet your needs!

Risk tolerance is a subject that’s discussed a lot in investing. It means how much you can live with in terms of taking a chance with your money, typically meaning that in order to have more potential gain, you have to live with more potential loss, and if you only want to avoid losses, you can, but sacrifice the potential for larger gains. Some people have virtually no risk tolerance in investing–those are folks who need to be in investments like Certificates of Deposit and government issued notes, bills, and bonds or to bury their money in coffee cans welded shut in the back yard. On the other hand some will take huge risks by investing in a single stock with everything they have. If that stock is the next Google, they’ll be incredibly rich! If it becomes the next Pets.com, they’ll lose everything.

The vast majority of people would say their risk tolerance is somewhere in the middle. Where on that continuum you are is easy to overstate when the market is doing well; lots of folks say they’re very comfortable with stock market risk when the market is having the kind of run it did in 2003-2007, with positive returns every year. However, when a year like 2008 happens–with virtually the entire market in a tailspin–those who really have the risk tolerance they state to stay in the market actually do that: stay in the market. Those who don’t start heading for the exits.

You can tell the low tolerance group easily: they’re the ones who are saying that if you stay in, you’re a fool, and proudly declare how they moved everything into cash. They said they have risk tolerance, but they really didn’t. Of course, history shows that cashing out and moving to cash after a market dump tends to be exactly the opposite of the best decisions, but that doesn’t stop them.

Times like this say a lot about how much risk you’re willing to stomach.

As for me? I haven’t sold anything since my usual bit of changes in April of this year. How about you?

While this is being listed under “Basics”, it may surprise some that the argument between which to do first: save for goals (retirement, a home purchase, college education, or other long term goals) or pay off debt.

The answer I have for this argument is a bit complicated, and includes a little of both, but the short version is: both are important.

When you’re at the point of dealing with this saving vs. debt reduction argument, it’s pretty much a necessity you’ve examined your baseline budget and gotten a handle on your cash flow. If you’ve not done these, do so first! Once you’ve got your cash flow positive from month to month, let’s go ahead and work on what to do with those positive dollars.

First off, start with an emergency fund. Consider a money market or high yield savings account (possibly with ATM card and check writing, like at Capital One Direct) for this money. How large of an emergency fund? We’ve discussed this before, but if you’re considering this choice, I’d suggest having at least $1,000 in there (if, however, you’re at the point that you’ve paid off all of your unsecured debt–basically everything but a mortgage–you’ll want to bump up that emergency fund to something between three and six months of your earnings). So the first part of this answer is, “save–for a $1,000 emergency fund”.

Second, consider your time horizon: if you are less than five years away from retirement, you will want to make saving a priority over debt reduction; however, if you’re on the opposite end of that timeline, debt reduction–and hopefully debt elimination–is certainly a priority.

Third, you are likely to want to do a bit of both at the same time, the question is how much of each you do. If you’ve decided debt reduction is your priority, make a plan and stick to it. Put the majority of your positive cash flow into paying down–and paying off–that debt. Consider the Debt Snowball or some of the other options we’ve written about previously. If you’ve chosen to concentrate on savings, put the majority of your positive cash flow into that (we will discuss some thoughts on how to put your savings dollars to best use at a later date). No matter which you’ve chosen, though, make sure you pay at least the minimums on your debt promptly–late charges and possible hikes in interest fees for paying late or insufficient amounts will make it even harder to overcome these debts.

Finally, keep at it! Persistence and perseverance are the keys to your eventual financial success. There will be many difficult moments along the way, but the sooner you start–and the more diligently you follow your plan–the quicker this will all happen. A journey of 1,000 miles begins with one step–so take the step of figuring out which to work on as your first priority: debt reduction or savings.

I received the following email from a reader:

“Any suggestions on what to do with money that I’d like to have earning at least a little interest but need to be able to access quickly? I’m thinking perhaps a money market, but I’m not sure where to find a good one.”

This kind of money, which commonly is an emergency fund, is what is called “chicken money”, a term I credit to Terry Savage of the Chicago Sun-Times. Chicken money is money that you cannot afford to expose to the risk of the stock market (or any other kind of similar fluctuation).

Chicken money is commonly in either money market (or similar high yield) accounts or certificates of deposit. The issue with using CDs is exactly what our reader cites–the need to be able to access it quickly. While you certainly can get money out of a CD, you pay a penalty if you do it when the certificate hasn’t matured.

That mostly leaves a money market or similar account. Local banks here have been paying pathetic rates; credit unions are a bit better, Internet only banks tend to be even better (to check out current rates as well as any special promotions, consult with Bankrate and Bankdeals). Internet only banks have their advantages, but due to their lack of physical branches that can make access difficult. Having a debit or ATM card associated with the account is beneficial (although there tends to be limits on how much you can withdraw during a day and the network of no charge ATMs might be limited), and check writing would give about as close to “full” access of an Internet bank’s account as possible.

Two options I have personal experience with are ING Direct and Capital One Direct. ING Direct’s Orange and Electric Orange accounts tend to have decent rates (and if you would like, I have bonus referrals available that will give you a few more dollars, contact me for details) and provides a debit/ATM MasterCard; they also have a network of “no fee” ATMs. The good news for me is that there’s such an ATM within two miles of home; the bad news is that there might not be such a situation for you. They do not, however, give you a checkbook (for my Electric Orange account I can have checks issued by them; they mail them out, which takes a few days). Like most online banks, they prefer to deal with money transfers online, which is instantaneous between accounts at ING Direct, but takes a few days to other institutions.

For accessibility, Capital One Direct adds a checkbook to its ATM card (which, unlike ING’s, is not a debit card). This is helpful for me, as I often make deposits from that account into a local bank. However, their ATM network seems very limited compared with ING’s–I cannot find a single no charge one within 75 miles of me, which is basically the entire island, and likely the entire state. The checkbook in many ways makes the money more accessible than the ATM card and does not subject the user to the typical $500 (or so) per day limit on ATM withdrawals. I was offered a special interest rate when I opened my Capital One Direct account as a Costco member but I was not able to find such an offer perusing Costco.com.

So there are two options for chicken money; both are quite safe, pretty liquid, and pay about as high a rate of interest as can currently be found. Capital One Direct has a checkbook which can be quite useful in terms of liquidity; both have ATM cards; ING Direct’s ATM card doubles as a debit card and they appear to have a larger network of no charge ATMs. Take a look at these (and other) options if you have a need to stash away these kinds of dollars.