Three Steps to Wealth & Financial Security

by Gary Laturno

  Smart financial move: Before you buy a house, put a financial plan in place. How much should you spend each month on a house? Should you pay off other debt before buying the house? Are you investing in a 401(k) or IRA? When you talk to the bank, do not ask, “How much money can I borrow?” but ask yourself, “How much should I borrow?

  8. LESSONS LEARNED: FHA & VA LOANS

  “Consumers shouldn’t be set up to fail with mortgages they can’t afford. Our new Ability–to-Repay rule protects borrowers from the kinds of risky lending practices that resulted in so many families losing their homes”. Richard Cordray, Acting Director, Consumer Financial Protection Bureau

  “FHA’s low down payments and high loan limits encourage people to buy more home than they can possibly afford. Arguably, FHA has now replaced Countrywide as the nation’s largest subprime lender”.

  Jeb Hensarlin, (R-TX), House Financial Services Committee Chair

  The Consumer Financial Protection Bureau (CFPB) was created by Congress to ensure that consumers who applied for home loans had the ability to repay the loans. Effective January 10, 2014, mortgage loans will be prohibited where a borrower’s debt to income ratio (DTI) is more than 43% of gross monthly income unless the loan is guaranteed by the government. For further information, see the CFPB web site at consumerfinance. gov. Search for qualified mortgages and the ability to pay rule.

  Borrower Beware: In our experience few if any people are able to save and invest when their debt to income ratio is 43% of gross monthly income. If the loan is guaranteed by the government, however, a borrower could be approved for a loan where their debt to income ratio is greater than 43%. If a borrower obtained an FHA loan, for example, s/he could pay well over 50% of their net income each month on all debts including their mortgage. We are aware of a number of FHA loans in San Diego that were approved where the DTI was approximately 60% of the borrower’s gross monthly income.

  Beware of new home builders: Some buyers prefer new homes. Here is the rub: Developers typically overlook buyers’ credit and cash problems and lure them to more expensive homes. It is similar to going to a car dealer hoping to buy a good used car at a reasonable price but driving off the lot with a $50,000 shiny new SUV. How do developers overlook cash and credit problems and lure people to expensive homes? Answer: They use FHA and VA loans. See “Builders Fuel Home Sale Rise” by Robbie Whelan and Conor Dourgherty, Wall Street Journal, February 27, 2013.

  Not surprisingly, FHA in 2012 -2013 reported that one out of six FHA loans was in default. My bet: Few if any FHA borrowers save and invest with such high debt to income ratios. Recommended reading: “Tangled in Housing Bust, FHA Seeks a Hand” by Nick Timiraos, The Wall Street Journal, February 10, 2013; “FHA Losses Could Hit $115 Billion” by Nick Timiraos, WSJ, June 3, 2013.

  What is the situation with respect to VA loans? See Appendices K “VA Loan Guidelines,” contributed by Ken Bates, Military Home Programs, Inc., San Diego, CA. Mr. Bates reports that VA loans, unlike FHA, have low default rates. “Without any tangible reason for this, the conclusion drawn by most observers is that borrowers using VA are more committed to seeing their obligations through to the end. In essence, it’s a character and integrity issue military members live day in and day out manifesting itself in the lower default rate”.

  I have talked to dozens of active duty military people since 2007. Many had VA loans and high debt to income ratios; none had any savings. When transferred to a new duty station, given additional expenses, some said they had no choice but to default on their VA home loans. After relocation, some attempted to rent their old home often with poor results including negative cash flow and problems with tenants. Property managers, they learned, did not solve their problems.

  Question: Should one subject to transfer every few years be buying houses? “Since many people are more mobile as they advance their careers, buying may not be the best choice,” Stan Humphries, Zillow’s chief economist. I agree. As one who has owned investment properties in different cities in California, I quickly learned that investment real estate is a local business opportunity and that your chances of success with rentals are best when you personally manage the investment. One retired officer said to me: “I learned the hard way. After twenty years on active duty, I finally realized that I should not be buying houses unless I could live in the same community for many years.”

  Make Smart Money Decisions: Before you buy a house, ensure that you will be able to live in the community long term. Pay off other debts first. Do not spend more than 20 to 25% of net income on housing each month. When you buy a house, ensure that you will have money available to save and invest each month. See “Part 2, Sound Money Management & Financial Planning” for a discussion on how to create a financial plan.

  If you own or are thinking about owning rental properties, read Part 4 “Investing in Houses: Pros & Cons, Biggest Mistakes, and Guidelines for Investors”, as well as Part 3, Chapter 2 “Compare and Contrast Investment Options” and Chapter 3 “Houses versus the Stock Market”.

  9. LESSONS LEARNED: CREDIT CARDS

  “Overspending can be an addiction like alcoholism, drug abuse or compulsive gambling”. Sheri Stuart, financial educator, credit.org

  “By using credit cards, everyone will buy more than if using cash”. Arrangefinance.blogspot.com

  As a kid growing up in St. Paul, Minnesota, I recall that my parents lived within their means, did not use credit cards, and were able to save and invest. My friends commented that the financial situation in their families was no different. If their parents did not have money, they did not spend money. (For anyone interested in the history of credit cards, see “The History of Credit Cards” by Ben Woolsey and Emily Starbuck Gerson, as well as “50 Years Later, Credit cards in the Fabric of American Life” by Connie Prater - both at creditcards.com.)

  Fast forward to today. Many now believe there are benefits to credit cards and that credit cards can be used with discretion. That may be true for some people. Among those we have counseled, however, many were unable to use credit cards responsibly. Many of these people shared one thing in common: They had purchased too much house and then looked to credit cards as a way to maintain their life style and in some cases to pay their mortgage.

  So, do not be fooled. Credit cards can cause problems for many. If you do not have the money to pay for something, do not buy it. Best rule to follow: Avoid credit cards.

  If you do use credit cards, consider the recommendations of arrangefinance.blogspot.com:

  1.)Use a credit card only for items included in your monthly budget. If the item is not in your budget, do not buy it on credit.

  2.)Pay off the card every month. Do not pay interest on credit card debt.

  3.)Destroy the card if you are unable to pay the monthly bill. Do not use it or another credit card again.

  10. LESSONS LEARNED: CARS

  “What is the ultimate driving machine? It is a car owned free and clear”. Lyle Laturno, retired teacher

  “Don’t drive yourself to the poor house”. Taylor Larimore, financial mentor and co-author of The Bogleheads’ Guide to Investing

  Cars are a depreciating asset not a way to build wealth. Good news: cars now last 300,000 miles! You can buy a good used car for a great deal less than a new car. Bad news: many continue to buy new cars, paying an average of $450 per month over many years.

  Self-made millionaires pay cash for used cars and invest the money saved. Warren Buffet, America’s most successful investor, and John Bogle, creator of the low cost index fund in the 1970s and founder of The Vanguard Group, both drive used cars.

  Worried about car maintenance costs? In reality, car maintenance for a seven-year-old car averages 5 percent of your monthly budget versus a new car which is 15 percent of your budget.

  Imagine what you could earn if you bought a good used car for cash and invested $450 each month for forty years? Four hundred fifty dollars invested for forty years at 7 percent per annum would give you a
little over $1.2 million dollars - minus the expense ratio.

  Four hundred fifty dollars invested for forty years at 10 percent would give you almost $2.9 million dollars - minus the expense ratio.

  Recommended reading: “96 Month Car Loans Wreck Your Wallet” Jennifer Waters, Market Watch, Wall Street Journal, 4/12/1013

  For suggestions on transportation options other than cars see Part 2, Chapter 7, “Sound Money Management – Trim the Fat”.

  Part 2

  Steps 1 & 2 Create a Written Financial Plan Practice Sound Money Management

  1. WHAT IS WEALTH? HOW DOES ONE BECOME WEALTHY?

  “All that glitters isn’t gold”. Aesop, ancient Greek storyteller

  “I found the road to wealth when I learned that a part of all I earn is mine to keep forever”. George S. Clason, Richest Man in Babylon

  What is wealth? Answer: The true measure of wealth is a sense of financial security. Wealth is not what other people see. “Defining wealth by what you see can be very misleading”, Brian Parker, financial planner. “I’ve found that Ferrari owners can struggle to make payments, and multimillionaires may choose to ride their bike to work”. Brian Parker, as quoted by Andrea Coombes in the Wall Street Journal in “Mom and Money: Lessons I Wish She Had Taught Me”, May 12, 2013.

  So, how do millionaires become millionaires? How do they become financially secure? The Millionaire Next Door, written by Stanley and Danko, published in 1996, has contributed to our understanding of who the rich are, what they do, where they shop, what cars they drive, how they invest, and what we need to do to become one.

  See also The Millionaire Teacher by Andrew Halliman, a good case study showing how a teacher with minimal income saved, invested, and achieved wealth and financial security.

  Most self-made millionaires did not start rich. They typically started with nothing. Eighty percent are first generation affluent. That is, their parents were not rich. Their wealth is not measured by what they earn but by how much they save and invest over time.

  Self-made millionaires have a financial plan to build wealth. The average millionaire invests 20 percent of their income each month.

  Self-made millionaires pursue their plan with zeal, control their spending, live below their means, and avoid debt.

  Self-made millionaires acquire assets that work for them, for example, financial holdings and positive cash-flow real estate.

  Millionaires also marry right. Warren Buffet: “The most important decision you make in life is who you marry.”

  “The people who build wealth work for decades and abstain from buying the bigger house or the new car so they can contribute the maximum to their 401(k) or IRA. They defer gratification to build a nest egg to avoid becoming a burden on their kids or their fellow taxpayers”. Wall Street Journal, 4/14/13

  2. THE 25 – 50 – 25 PLAN*

  “To be successful, you need written goals”. Tom Lehman, highly successful professional golfer

  “If you do not have a plan for your money, then there are millions of people who do”. Robert Kiyosaki, author, Rich Dad Poor Dad

  Roger J. Brown, PhD, former instructor at the University of California, Irvine, and San Diego State University, taught his students that all successful companies articulate financial goals and objectives. All have a plan to make profits. All have a plan to take our money. “When you go out into the real world, spend 80 percent of your time trying to get people to give you money; or, prevent people from taking your money.”

  All of us are constantly bombarded with messages from companies trying to get our business or “take our money”. The lesson: Articulate personal and family financial goals and objectives. Run your family’s finances like a business. Be guarded with your check book. Do not spend money or let people take your money unless it is a part of your written financial plan.

  Of critical importance: Pay yourself first! Save a minimum of 10 percent each month by automatic deduction into an investment or savings account. You will not miss 10 percent from your monthly pay. Better: Save and invest 20 to 25 percent or more each payday. Start by investing in your company 401(k). If you do not have the option of a company 401(k), open and invest in an IRA. Then open and contribute monthly to a taxable investment account. Reinvest all interest and dividends. Let your money compound and work for you. Do not take the money out until you are ready to retire. See Part 3, “Invest in Low Cost Index Funds”.

  Spend no more than 50 percent of your income on necessities. Pay off debt. Provide for your family, give to church and charity. Maintain adequate insurance. “This list is surprisingly short: a place to live, utilities, medical care, insurance, transportation, and minimum payments on legal obligations.” Elizabeth Warren, U. S. Senator, Harvard Law Professor, co-author, All Your Worth

  Spend no more than 25 percent on discretionary purchases. “Once you get must haves and wants in balance, you can start to save automatically. You can do it without breaking a sweat. No more worrying. Just a simple, automatic plan for saving a certain portion of your paycheck each month.” Elizabeth Warren

  *Recommended reading: See “All Your Worth” by Elizabeth Warren and Amelia Warren Tyagi for their recommendations regarding this important topic. Another excellent book, a classic: The Richest Man in Babylon, by George S. Clason.

  3. COMPARE AND CONTRAST: CHINA VS. THE UNITED STATES

  “Most Chinese, even if their monthly income is less than $100, still manage to save quite a bit of money”. Hung Huang, Chinese television host, author and actress

  “95% of Americans need to learn to save better. Schools need to teach real life classes”. Email to The New York Times signed “MD”

  In China, savings rates as a percentage of income are one-third. Take note: the Chinese save one third of what they earn each year!

  The Chinese family that makes $60K per year saves $20K per year.

  Chinese buyers put a minimum down payment of 40 percent on a first home and 60 percent on a second home.

  In the United States, savings are typically low or zero, and many Americans are deeply in debt as well.

  Many nations aggressively encourage citizens to save. The U.S. government promotes mass consumption and easy credit. Our nation’s habits may not change, but if you want to achieve wealth and financial security, you must live within your means and save and invest each month.

  4. GET READY FOR A LONGER RETIREMENT

  “Retire based on your bank account not your birthday”. Joe Hearn, VP, Teckmeyer Financial

  “Prepare for a mix of work and leisure”. Marc Freedman, CEO, Encore.org, nonprofit promoting second careers

  Significant financial contributions starting at a young age are required to have adequate retirement income. “People vastly underestimate how much money it takes to have a lifetime income”. Steve Vernon, President, Research Fellow, the California Institute for Finance, California Lutheran University

  Assume you are twenty-five and your goal is to have one million dollars by the time you reach age sixty-five. How much do you need to save and invest each month to reach this number? Assume at twenty-five you have $5,000 invested in your retirement account and you expect an average annual return on your investment of 6 percent. A simple financial calculator will reveal the annual contribution needed to reach one million dollars at the target age of sixty-five. The answer: $6,129.23 or $511.00 per month.

  Note the expected rate of return is critical. If you expect an annual return of 10 percent, and obtain a return of 6 percent, you will be in trouble. Thus, for planning purposes, assume a more conservative rate of return. If you get a higher return, you will be thrilled. For example, if you invest $6,000 each year and obtain an annual return of 10 percent, you would have a retirement fund of $2,881,851.61 at age sixty-five. The expenses you pay to invest are also critical in terms of how much you are able to accumulate at retirement. See Part 3, “Invest in Low Cost Index Funds”.

  If you do not have a financial calculator, that’s okay. Go to
Bloomberg.com/personal-finance/calculators/retirement.

  The Bloomberg calculator is easy to use. Put in the numbers requested—target amount, current age, expected retirement age, and expected annual rate of return. Push the “calculate” button.

  Assume the goal is to have five million dollars by the time you retire. Your current age is twenty-five and you expect to retire at sixty-five. How much will you need to save and invest each month to reach five million dollars? If your average annual return is 6 percent, you will need a monthly contribution of $2,664.58. If your average annual return is 10 percent, you will need a monthly contribution of $898.75. Assume the more conservative return and invest accordingly.

  Biggest problem: Most do not start to invest early enough and may need to save two to three times more than what they are currently setting aside. There are options to address a shortfall: Consult your employer and possibly increase pretax contributions to your retirement plan.

  If self- employed, increase contributions to your IRA to the maximum allowed by law. Start an IRA if you do not currently have one.

  Invest on your own. Open a taxable investment account and purchase low-cost index funds. Contribute by automatic deduction each month. See Part 3 “Invest in Low Cost Index Funds” below.

  Work longer: Retirement may not be an option or even desirable for some. For each additional year worked, you will not make deductions from your retirement accounts, and you can continue to save and invest. What do you love to do? Continue to do it.

  Consider an annuity and a reverse mortgage. See Appendices for a discussion concerning both options.

  Recommended reading: “How to Get to Retirement? Practice!” Carolyn T. Geer, Wall Street Journal, February 17, 2013; “Retirement Savings: How Much is Enough?” Andrea Coombes, Market Watch, Wall Street Journal, February 16, 2013; “How to know if you have enough to retire”, Robert Powell, Market Watch, Wall Street Journal, May 25, 2013; “For Retirees, a Million Dollar Illusion”, Jeff Sommer, New York Times, June 8, 2013; “Suddenly, Retiree Nest Eggs Look More Fragile, Jeff Sommer, New York Times, June 15, 2013; “Money for Life” a book by Steve Vernon, longtime designer of corporate retirement programs, available on amazon.com.