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Financial Wisdom

"It is impossible to withhold education from the receptive mind, as it is impossible to force it upon the unreasoning." Agnes Repplier, American essayist

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“Kirk is the most knowledgeable and straight talking financial person I know. He is informed far beyond the headlines and sexy schemes of the moment. It is amazing how many trends he pointed to years ago that we are seeing in the headlines today. This is a man you want to pay attention to if you don't want to be surprised by the financial markets.”

~~ Markey

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CK Financial Resources
76 Forman Drive
Colchester, VT 05446
(802) 238-8187

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Posted on 3/28/2012 1:47:17 PM

April is Financial Literacy Month! 

 "Financial literacy refers to the set of skills and knowledge that allows an individual to make informed and effective decisions through their understanding of finances (money)." Source: Wikipedia 

In a recent FINRA (Financial Industry Regulatory Authority) survey “an overwhelming 97 percent of investors realized they need to be better informed about investing. And nearly half said they could have avoided a negative experience had they known more about investing.”

Investing is but one part of understanding money. For example, many consider “investing” and “saving” to be one in the same. They are not.

So to broaden this discussion, I’ve developed this list of 11 critical questions that everyone should be able to answer to have a more successful financial life. These answers are not intended to serve as recommendations, but rather they are designed to educate and provoke a broader understanding of money and help you start building your Financial Intelligence bank. As you’ll see, the answers to these questions are not discrete, but are very much interrelated. The intent is to show how a financial decision in one part of your life can impact, significantly, other parts of your finance life, your well-being and ultimate financial success.

The answers to these questions could be expanded in much greater detail, but for the purpose of this quiz, I have presented the “short form” version here.

Test Your Financial Literacy

1. What is your Federal marginal tax rate?
Understanding the difference between marginal tax rate and average tax rate can not only help lower your total taxes, but it is also important for good tax planning. The goal is to decrease the difference between the two as much as possible and legally allowable. This enables people to analyze the tax impact of additional income or additional deductions.

When considering investments, both qualified (retirement) and non-qualified (after tax money), the impact of your federal marginal tax rate should also be considered. Once you know your federal marginal tax rate, and the actual reduction in taxes you receive for every dollar deferred, you will then be able to determine if a contribution has merit. Plus, if you have debt such as a mortgage, credit cards, college loans, etc., it may not make sense to put money aside for retirement until these debts are paid off.

Income Tax Rate Table for 2011 - 2012 (consolidated version):
 
 
 
Single
Married - Joint
Head of Household
Married - Separate
10%
0 - 8,500
0 - 17,000
0 - 12,150
0 - 8,500
15%
8,500 - 34,500
17,000 - 69,000
12,150 - 46,250
8,500 - 34,500
25%
34,500 - 83,600
69,000 - 139,350
46,250- 119,400
34,500 - 69,675
28%
83,600 - 174,400
139,350 - 212,300
119,400 - 193,350
69,675 - 106,500
33%
174,400 - 379,150
212,300 - 379,150
193,350 - 379,150
106,500 - 189,575
35%
379,150 and Up
379,150 and Up
379,150 and Up
189,575 and Up
 
Source: See extended IRS version [.pdf]

2. For homebuyers, what’s the difference between being pre-approved and pre-qualified for a home mortgage?
Getting Pre-Qualified is usually the first step in the mortgage process. You supply your overall financial picture to the lender, including your debt, income and assets, and they’ll give you an idea of how much mortgage you qualify for. Getting an idea of what you can afford is smart planning.

Getting Pre-Approved is more involved. You'll complete an official mortgage application (and usually pay an application fee), and then supply the lender with the necessary documentation to perform an extensive check on your financial background and current credit rating. These checks will most likely include your financial statements, tax returns, pay stubs, credit card debt, other obligations (alimony), etc.

Home-sellers, or their agents/brokers, generally prefer Pre-Approved homebuyers. The perspective buyer(s) has gone through the financial vetting process and the sellers know that buyers have received a conditional commitment from the lender up to an exact loan amount.

3. What percentage of your income should you strive to save every year?
Conventional financial wisdom would suggest that you save 10% to 15% of every dollar earned. If you are not currently saving anything, it might be good to start small, say 5%, and grow from there. I suggest you do the calculation and start “paying yourself first.”

For example, if you (household) make $50,000/year and divide by 15% ($50,000 x .15), your annual savings would be $7,500 or $625.00 per month. Before tax or after tax does not matter. Saving anything is better than saving nothing.

Many financial people would say this 15% may include retirement investments as well. Remember, the words saving and investing mean two different things.

If you have credit card debt, college loans, unpaid medical bills, a mortgage, and little savings in an emergency fund (I suggest six months to one year), it makes little sense to invest for retirement with these looming costs, especially since most qualified plans limit access to funds you may need in an emergency.

4. There are only three types of asset classes (i.e., places to put money). What are they?*
The goal of this question is to begin to simplify and demystify investment choices. Wall Street firms are experts at creating (via marketing) confusion about money and investing, which only serves to enhance the need for their services.

When you realize there are only 3 (or 4) places you can put money—cash, bonds and equities—your financial decisions can become much simpler and more transparent.

Cash: short-term investments that can easily be converted into cash (paper money). They include savings accounts, checking accounts, money market accounts, negotiable money orders, Treasury bills, etc.

Bonds or Fixed Income: loans to institutions and governments, such as corporations, municipalities (cities and towns), the federal government and zero-coupon bonds, also called "accrual bonds".

Equities: investment instruments known as stock or shares. Equity investments are ownership stakes within corporations. Tangible assets, like your home, are also considered an equity investment.

*Some would say there are 4 types of asset classes. They separate real estate from the definition of equities.

5. What does it mean to be “upside down” on a loan – car or home mortgage?
Generally used in the context of car loans, the term “upside down” means that the car is worth far less than the amount of money owed on the loan. For example, let’s say that you owe $10,000 on a car that is only worth $3,000 – in this case, you are “upside down” by $7,000.

Being “upside down” also refers to a scenario where the owner of a home actually owes more on that home than the house would be worth if it were sold. In addition, it’s complicated further because you have to figure paying off not just the mortgage, but closing costs and real estate commissions as well.

6. What is the “Rule of 72”?
I’m a big proponent of using basic math to evaluate the soundness of financial decisions. One such piece of math I use is called the ‘Rule of 72.’ This rule is represented by the following formula:

# of years to double = 72/interest rate

Basically, it tells you the approximate number of years it will take an investment to double in value. Simply knowing the Rule of 72 will make it easier to identify quickly the likelihood of a rate of return seeming plausible.

7. What is your current mortgage interest rate? How many times in the last 20 years have you refinanced?
To be the most efficient and effective managing your money, it is important to understand your mortgage payments; the interest, principal pay-down and private mortgage insurance (PMI).

Refinancing to lower debt may be a good strategy, especially if you take the savings to pay down debt or add to your emergency fund.

It is also important to keep track of how many times you refinance because of the transactions costs (i.e., attorney fees, appraisal fee, lender fees, etc.). Sometimes these costs are buried in the loan or “rolled-over.” Regardless, they are real costs and represent earned monies that you have lost and the opportunity these monies could have had if they had been reinvested for your benefit– see question 11.

8. What has been your Actual Rate of Return versus your Average Rate of Return on investment(s)?
Most correspondence (i.e., monthly statements) about your investments is expressed as an average rate of return. Which of the following (actual or average) is more transparent? Which would be more beneficial for you to know?

Actual Rate of Return
(what you really received)
Average Rate of Return
(what rate of return you received expressed as a percentage)
2-year investment example:
Start in year 1: $1.00
Received in year 1: 100% return
New value beginning year 2: $2.00
Lose 50% in year 2: now back to $1.00
 
Actual rate of return: “0”
 
You are back to where you started with $1. It’s better to know exactly what you have!
2-year investment example:
Start in year 1: $1.00
Received in year 1: 100% return
New value beginning year 2: $2.00
Lose 50% in year 2: now back to $1.00
 
Average rate of return: 25%/per year
 
While a 25% average rate of return sounds impressive, in reality you are back to where you started: with $1.
 
The average rate of return is always expressed as an average. Averages can be misleading.
 
100% gain/50% loss = leaves 50%/2 years = 25% per year average.
NOTE: This comparison does not account for management fees, 12b-1 charges, or taxes, which would reduce the “rate of return” even more.

9. What is your outstanding debt on credit cards? What interest rate(s) do you pay on your credit cards?
It is important that you know how much credit card debt you are carrying and what rate of interest you are paying per card. Often people are paying just the minimum, and will have little success in paying off these cards.

Bottom line: Credit card debt is insidious. The lost opportunity costs (see Question 11) are tremendous and compound exponentially.

According to a survey by “The Survey of Consumer Payment Choice," Federal Reserve Bank of Boston, January 2010, the average US household credit card debt is $15,956. What is even more startling is the total U.S. revolving debt, of which 98 percent is made up of credit card debt, according to a Federal Reserve's G.19 report on consumer credit released February 2012.

How to calculate true credit card debt costs:

If you are carrying the average household daily balance of $16,000 in credit card debt, your minimum payment will be around $320 a month (assuming a 2% minimum payment requirement). If the credit card charges a 15% APR, interest could cost you between $2,400 and $2,450 per year.

Here's how to figure it out:
1) Divide your APR by 365 days per year. 15%/365 = (about) .04%
2) Multiply .04% by 30 days per month. .04% x 30 = 1.2 or .012%
3) Multiply .012% by the $16,000 original balance = $192.00 a month in interest

With a $320 minimum payment, $192 goes toward interest each month and $128 goes toward your $16,000 credit card balance (principal). So after you send your first $320 payment to your $16,000 credit card bill, you will still owe $15,872 ($16,000 - $128).

If you only pay your minimum balance due each month (2% or $30 minimum), it will take approximately 33 years (394 months) to pay off your $16,000 debt. During those 33 years of making the minimum payments, you will have paid $25,035 in interest, turning your $16,000 purchase into a $41,035 one, according to results from a minimum payment calculator on www.creditcards.com.

10. What is a “negative savings” rate?
The U.S. Commerce Department’s Bureau of Economic Analysis found that Americans spent more than they earned in 2005 (the first time since the Great Depression). This translates to a negative savings rate of 0.5% for the year.

Unfortunately the savings rate has not increased much since 2005. Inflationary items like food, energy (oil, gas, etc.), housing, clothing, etc., which are not part of the US inflation calculation (Consumer Price Index - CPI), continue to erode savings, and the value of our currency, even further.

If your savings rate is negative, it doesn't necessarily mean that you don't have any savings, it simply means you're spending more than you earn, so you're dipping into your savings or you're borrowing to pay for purchases.

Here is an amazing web site that compares inflation from 1800 to 2010. For example, “What cost $100 in 2000 would cost $125.33 in 2010.” And here’s a link to an excellent article entitled, “How inflation is turning breakfast into a luxury item.”

11. What is “lost opportunity cost”?

“When you lose money, you lose the potential of what that money could have earned you if it was invested.” Robert Castiglione

Lost Opportunity Costs are cumulative and one of the biggest eroding factors of money and building wealth. It is like a “stealth tax,” a euphemism often applied to inflation (see Question 10). And just like inflation, the effects can be just as significant.

Unfortunately, lost opportunity cost is a term many people have never heard. And it’s unlikely that you’ve discussed this with your financial advisor, as it is rarely assessed by them.

Financial losses (lost opportunity) may come in many forms—some are obvious, many are not. Investments with less value than at purchase, compound taxes, advisor/broker fees, non-deductible loans and credit cards, short-term and pre-paid mortgages, low deductibles, gifts to minors, etc., have the potential to create lost opportunity costs.

Talk about getting kicked while you are down. Losing your hard-earned money is bad enough, but when you lose the opportunity that money could have earned, you lose again.

Imagine an unrecoverable investment loss of $20,000. Not only did you lose $20,000, but you have also lost the potential of what that money could have earned (bought) elsewhere.

Using the standard “8% to 10% historical stock market average rate of return” scenario, what could you have earned had you not lost that money?

Here’s an example:
$20,000 earning 8% for 40 years = $434,490
$20,000 earning 10% for 40 years = $905,186

You can see how losing money today affects you in the future as well. Money lost today will erode your wealth tomorrow. Very few realize this because they don't think that money they could have had is a loss to them.

Building Your Financial Intelligence Bank
I hope this quiz has been interesting (and eye-opening). Keep in mind that many people delegate money decisions to others without fully understanding the implications of those decisions. As your financial literacy and financial intelligence bank grows, so too will your success in making fully informed financial decisions.

As always, get the facts and do the math!

Do you have any questions raised by this quiz? Chances are you are not alone. Please post your questions here!

Additional Resources:
Wall Street Pay: A Record $144 Billion

 


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