Posted in Investing, Liabilities and Debt, Personal finance, Savings

The Five ways to SIP

SIPIn India, the mutual fund industry has popularized this term for drip investing, dollar cost averaging or similar. The full form is “Systematic Investment Plan” and allows normal people to invest in Mutual Funds gradually and is proven to build wealth over a long time. 

For me, there is a bigger SIP in Personal Finance – Sleep in Peace. 

It may sound like RIP – but lets keep life going strong in these trying times. We will do another article on that, and in personal finance terms we will call it Retire in Peace.

SIP is a concept that is important throughout your earning and retired life, and defines a way you can manage your Personal Finance to effectively “Sleep in Peace” every night.

As we know with the current COVID-19 situation, many people are losing sleep over their financial situation.

While some can still be corrected with discipline, those following the basic principles of SIP will be unaffected by such pandemics and sail through it.

The Five components of a SIP method

1. Emergency Fund – The sleep in peace fund

The Emergency Fund is the first of SIP rules. It can be called the Sleep In Peace Fund too.

In the current situation where everything is uncertain from jobs to ability of paying mortgages and bills to medical situations, there cannot be a better cushion than possessing an emergency fund.

People who have not been able to build this fund, are now feeling the brunt of their careless handling of personal finances.

One essential comfort zone

2. No Debt – borrower is slave to the lender (there is no good debt)

In US, due to low interest rates on some loans like mortgage and auto-loans, some experts justify using leverage to build your wealth. While that may sound smart in good times, in trying times like now even a so called good debt can nosedive to a bad debt.

For example, the government is now directing banks to suspend mortgage payments (for a short period, of course), giving stimulus to real estate investors and trying to bail out or let leveraged people and businesses go down.

So greed and over-smartness with debt are now taking the sleep away from people who have bought and financed huge houses, expensive cars, invested into rental properties with no-money-down. Here are 3 situations where not having an emergency fund and being over leveraged, is disastrous now.

  • You spend more than 30% of your income in mortgage payment. If you lose your income, even the emergency fund will quickly run out paying the mortgage.
  • You bought an expensive car with bank financing and very low down payment. The auto-loans will not get any relief from Government, and your car may be repossessed in case you fail to make the payments. Also the payments could have been used in more protective ways, if the car was bought with cash in the first place.
  • You invested in rental properties with low down payment (< 20%). What happens now when many tenants are refusing to pay rent due to financial hardship or even just taking advantage of the situation (evictions are deferred now). You still need to pay the bank their share of interest and principal.

The universal truth about Dave Ramsey’s 7 baby steps

3. Do the real SIP – invest in a disciplined way

Now we come to investments and the real SIP (Systematic Investment Plan).

This process addresses two damaging financial behaviors – fear and greed.

I will not rant about the philosophy behind SIP or DRIP investing, it is pretty well known and over-emphasized in investment circles.

The advice from the legendary investor Warren Buffet applies now more than ever.

Be fearful when others are greedy, and be greedy when others are fearful. 

However in the Sleep In Peace method – be neither, irrespective of what others are doing. 

Keep investing with a plan. I have rearranged my India portfolio recently (just before the market crash) and apparently could have done better.

  • In a zeal to restructure my asset allocation, I invested a large part held in cash into the equity markets in Jan 2020. Little did I know, the markets would come crashing down in another month or two.
  • However I was not overzealous on Equity. I kept a larger part in simple fixed deposit (bank CD), so as not to go overweight in one asset class, Equity. 
  • The current market situation does not affect my peace, since the money I invested into equity markets is planned to be held for a long time (possibly till I retire). 
  • I could have done better if I remained patient and deployed it in smaller chunks over several months  – the real SIP. 

So that’s from a recent personal experience –

If you want to Sleep In Peace, invest with SIP – the systematic investment plan. 

Know yourself and your investments

4. Define and invest in your goals

No matter what is happening in the world, nothing can derail you in personal finance if you manage your finances based on your goals.

Every person has life goals like buying a house, opening a business, travelling the world, educating your children and RIP (Retire in Peace).

If you allocate your money to the various goals and keep adding to the corpus month after month in your earning years, then in trying times such as now – you have nothing to fear. Some of your goals are funded and some are in the process of getting built-up.

Just continue doing what you were doing.

The worst case scenario can be that one or two goals may need to be postponed. For example, if you were trying to retire early and lost your job or income, you may have to work longer for a few years more. But that does not completely cripple you or force you to liquidate your retirement funds.

A simple method of asset allocation

5. Pay your taxes and file your return on time

Taxes and death are certain – everything else is uncertain. 

There is no way to avoid taxes (except the legal ways to reduce or defer it – consult a CPA) and hence every personal finance system has to take into account – taxes. Not paying your due taxes and trying to be over smart, can really take your sleep away.

Whatever it takes, plan for your taxes throughout the year and pay the legitimate share to Sleep In Peace. 

In the US, Internal Revenue Service and in India, the Income Tax Department are both quite aggressive in following up with cover-ups, non-payment and mistakes. And for working professionals like me, who has to deal with both – there is no other way than honesty, prompt action and discipline in keeping track of your tax liabilities and payment obligations.

Keep your documentation up-to-date and file away returns on time to avoid major headaches.

Five components of a personal finance system

Conclusion – Ride the wave and learn something new

While this is the time for great financial worries and the clouds of a multi-year recession looming over us, there could not have been a better time for us to introspect and re-organize.

This is the time to take a hard look at your financial and other priorities in life. Locked down inside our homes, with more family time and me-only time – when is a better time to introspect and find your real dreams? 

When the world was open and running, the rush of the morning and the fatigue of the evening left little for us to think beyond the next day.

If you want to sleep in peace when all this is over, maximize this opportunity and start something new.

I am working on starting a financial coaching business where I can help people with their finances globally. What better time to serve the world than now and next few years? 

Who moved my cheese? How to deal with changes in financial plans

sticky notes on board
Photo by Polina Zimmerman on Pexels.com
Posted in Budgeting, Investing, Liabilities and Debt, Personal finance, Savings, Spending

How to manage your cash flow

A company which is listed in the stock market has to publish 3 essential financial statements.

  • The balance sheet
  • The profit and loss statement
  • The cash flow statement

Briefly, the balance sheet shows the health of the company at the reported time, profit and loss statement shows how much profit the company is making after all expenses and taxes, and the cash flow shows how the company is generating the cash from its operations as well as investments.

Free Cash Flow (FCF) is an important metric that is used by investors to evaluate the real worth of a company. 

In personal finance, while balance sheet (Your net worth) and profit and loss (how much you are making and spending) are important, managing the cash flow is key to achieve your financial goals.

In this blog, we will talk about how to manage your cash flow – no matter whether you earn a lot or earn an average paycheck.

Most people do not manage their cash flow, forget about doing a budget or any other conscious form of tracking.

At the end of the month or year, we wonder where all the money earned went.

Conventional ways of managing cash flow

There are several techniques Personal Finance experts have championed time and again.

  1. Do a budget, track every dollar. 
  2. Create an envelop for groceries, utilities, fun etc.
  3. Use separate accounts. 
  4. New automated solutions like Stash, Digit etc. 

All of these are good methods, but the problem is sticking to the discipline of maintaining it day after day, month after month.

Isn’t that boring and worrying at the same time? Few issues with these approaches are:

  • Writing down expenses every day
  • Stuffing that envelop and counting the money every time before spending
  • Keeping track of multiple accounts
  • Not knowing how much the AI driven savings app is going to deduct next month

So is there a simpler and better way?

Just like most posts in this blog, I seek simplicity and automation.

The simpler way of managing your cash flow

There are 4 goals to managing the cash flow every month.

  • Invest for the future
  • Save for the short term
  • Pay your bills 
  • Spend the rest

In fact, any wind-fall is also a one time cash flow, and can be fit into the same framework.  Lets say you got a bonus of $1000, for example, the Govt is sending a check to all Americans. And if you want to keep it simple, allocate 25% to all the 4 goals.

  • Invest $250 in your long term (retirement, child education) plans. The market is down and you can invest $250 in a mutual fund or an ETF. 
  • Save $250 for any short term goals that you have. It could be added to your monthly savings goals, towards anything like vacation, buying that new phone, or simply emergency fund. 
  • If you have consumer debt, why not allocate some to pay it off? Use $250 to pay off the highest interest or smallest balance credit card. 
  • Now you have $250 to splurge on. Buy that favorite book, order the special meal or decorate your home. 

But how do we automate and manage the cash flow every month?

  • Invest – Direct deposit investments. In fact most employers have systems to auto-deposit 401-k investments or direct deposit to your chosen brokerage firm. 
  • Save – Auto transfer to a savings account from your checking account. 
  • Pay Bills – Setup auto-pay with your credit card or debit card. Set the bill payments mostly towards beginning of the month. 
  • Spend – Use your debit card to spend – it will tell you when the money runs out. 

Once setup, the only stress you have is the last bullet, where you have to make your spending within the limits, or rather the residue after all obligations are set aside or paid off.

How it can snowball into Financial Freedom

As you get consistent with stashing money away for investing and savings, those may generate additional cash flow or assets which will come back to bolster the spending budget.

Thus cash flow is a virtuous cycle once set up the correct way. Lets take some initials and approach this from a math perspective.

  • J – Job Income
  • R – Retirement
  • I – Investment
  • S – Savings
  • B – Bills
  • E – Expense
  • P – Portfolio Income

J + P = R + I + S + B + E

I can produce P in terms of interest, dividend or rental income.

silver and gold coins

In the wealth accumulation years, the goal should be to increase J, so that I can be increased, which when invested can increase P. P is added to J and a part reinvested, saved or used.

As you reinvest P, it will generate more P till at a point, J becomes less and less important. 

This cash flow situation is called Financial Freedom.

Conclusion

We just presented a simple and fully automated cash flow management system for personal finances. It does not take much discipline and will power to stick to it, once correctly setup.

This is also explained in more detail in the post The SAFE plan – Simple, Automated, Flexible and Efficient .

Photo by Pixabay on Pexels.com

woman standing on cliff
Photo by Min An on Pexels.com

 

 

Posted in Budgeting, Investing, Liabilities and Debt, Personal finance, Savings

Five metrics of personal finance

We all know the importance of metrics and data driven decisions. Specially in today’s world, everything is driven by data, big data or small.

Why should personal finance be left behind? Just saving and investing money does not mean much if we are not able to quantify our financial situation and be able to improve it year over year. So lets look at some of the metrics that we can develop or borrow from other financial scenarios.

There are many  financial terms and metrics for evaluating company fundamentals and corporate performance. We can take a small subset of that and use them to measure the health of our finances.

These ratios and metrics really give you a picture as to where you stand, what will happen in a worst case scenario (lets say the stock market goes down) or you lose your job.

It is like your annual health checkup, you may feel alright but you don’t know fully what your body is going through internally.

Without much more introduction, let me explain the 5 key metrics I use to keep track of my finances. They have told me stories that I did not know without calculating them.

Net worth

This is the most obvious and most popular one. There are different viewpoints regarding this, some people say its only a vanity number yet others think it summarizes your financial position.

In short, Net worth is all assets you have minus all liabilities you have to service.

So if you have $1000 of assets but owe someone $200, then your net worth is $800.

What to include in the assets is also controversial. Some people include their home value, while others will say home is really not an asset.

My view is if you are not going to stay in the home throughout your entire life, then you can count its present value (or at least purchase value) as the asset price. The liability section will account for the mortgage balance you have.

This Net worth number may sound like a vanity or it can give you a milestone to reach. For example, for many people reaching the first million in Net worth is a big deal.

A positive net worth signifies healthy finances, on the other hand a negative net worth means trouble as the person is over-leveraged.

The Net worth vs. Cash flow debate

Quick ratio

OK so you have a positive net worth and want to celebrate. Not so soon.

In reality, majority of your asset may be made up of not-so-liquid instruments like house, cars, jewelry etc. Moreover your liabilities may be mostly short term debt like credit cards. Lets take some numbers.

You live in a $300,000 house, and has only $1000 cash. You have a mortgage of $250,000 and $25,000 credit card debt. What is your net worth?

Net worth = $300,000 +  $1000 – $250,000 – $25,000 = $26,000.

So you have a positive net worth, mainly due to the Home Equity trapped in your house.

However the cash you have is not enough to pay your credit card bills or possibly even the monthly minimum amount (after other expenses). This can cause trouble or through interest charges can slowly eat away the net worth and push it towards negative.

Hence it is important to have a cash cushion to cover your short term obligations. And short term obligations may not mean only credit card debt, they could be impending quarterly taxes, property taxes, insurance premiums and any other short term debt. Typically all payments to be made quarterly or annually within the next one year can be added up as short term obligations.

The Quick Ratio is then calculated by:

Quick ratio = (Cash and cash equivalents) / (total short term obligations)

With a Quick ratio of above 1, you know your finances are well equipped to cover upcoming obligations.

One essential comfort zone

Debt/Equity ratio

Personal Finance Equity is really the Net worth that we calculated first.

Lets say in the positive net worth, you have a mortgage in terms of a long term liability.

But think of a dire situation, when you are asked to pay off the debt at a very short notice. Such emergencies can be losing a job and not able to pay the monthly payment. The lender may demand a complete pay-off or a short sale of the home.

For example repeating the earlier example in section Quick Ratio:

Net worth = $300,000 +  $1000 – $250,000 – $25,000 = $26,000.

Here the debt of $275000 cannot be covered with the Net worth.

But lets say you also have $350,000 of investments in long term accounts like retirement portfolios. Now your net worth is $376,000 which if worst comes to worst, can be used to pay off all your debts and save you from foreclosure or bankruptcy.

This can be measured by yet another useful ratio.

Debt/Equity ratio gives how much of your net worth is leveraged. In the above example with $350,000 of investments,

D/E ratio = ($250,000 + $25,000) / $376,000 = 0.73

D/E ratio below 1.0 is safer as you know you can be debt-free if you want, though you need not liquidate your investments immediately if they are earning more than the interest on your debts and you have a good Quick Ratio above 1.0 to cover your immediate payments and obligations. 

The Paid Piper of Hamelin

Emergency coverage

Since we are already talking about dooms day, it cannot be complete without the concept of emergency funds. Almost every personal finance book or article starts with this concept. But there is a large deviation in the range of the amount to be saved for emergency fund, some say 3-6 months, 1 year or even just a set amount.

Lets approach this as a scientific ratio like we have done so far.

We will calculate how many months you can survive covering your true expenses if you lose your income.

Emergency coverage = (Emergency fund value) / (monthly living expenses + monthly payments)

Note that monthly payments may not mean only mortgage or car payments, it should also account for monthly share of any annual obligations like taxes, insurance etc. Typically it should not affect your lifestyle (barring non-essential and lavish expenses) if you have to spend out of your emergency fund these many months.

The Emergency Coverage directly tells you how many months can be covered by the reserve fund. It is an individual choice to select the number, but typically 6 months is a good norm.

Budget – Grow the tree upside-down

Savings ratio

So far all the ratios indicate the current state or health of your finances. None of them talks about or helps grow the Net worth.

The savings ratio is pretty simple and easy to guess from its name. How much are you saving from your take home pay? It could mean saving for long term investments like retirement funds, children education fund or general investing.

However it should exclude savings done towards goals which are ultimately expenses in the short term – vacation, down payment of a car or house, or for meeting upcoming obligations.

The real savings should contribute to growing your Net worth on a year on year basis for a long term.

Savings ratio = (money saved away per month for retirement and investments +  principal part of mortgage payment) / (take home income per month)

If the numerator includes amounts which are deducted pre-take-home like 401k, then it may make sense to consider a gross income as the denominator.

The Savings Ratio indicates growing net worth, and can be turned into a goal – for example I will achieve a 20% savings ratio this year. 

Investing in the High Five portfolio

Conclusion

These five ratios can be used to monitor personal finance health, and growth of net worth in the long run.

Also the simplicity of these ratios make the math very easy, you can also set these up in Excel and just update the variables on a monthly or yearly basis.

Finally these ratios with the recommended values give you the peace of mind. The following set of recommendations are a good thumb rule.

  • Net worth > 0 [choose your goal or dream here]
  • Quick ratio > 1.0
  • Debt/Equity ratio < 1.0 [0.5 is even better]
  • Emergency coverage > 6
  • Savings Ratio > 20%
adventure athlete athletic daylight
Photo by Pixabay on Pexels.com
Posted in Investing, Liabilities and Debt, Personal finance, Savings

The universal truth about Dave Ramsey’s 7 baby steps

Who doesn’t know of Dave Ramsey? 

Even my 10 year old kid has been taught about Dave in elementary school mathematics.

Dave Ramsey is America’s trusted voice on money and business.

Well he is popular for a solid reason. In this post, I will describe why he makes perfect sense to me.

When I immigrated to US in 2017, I did not know who he is. I was trying to quench my thirst for new personal finance books, especially on the US system. Then I stumbled upon Dave’s Total Money Makeover.

As I read the book, initially his rant against debt was a bit overwhelming to digest. However thinking deeply, I realized that coming from an Asian country, I have unconsciously followed the same principle for decades.

Why this coincidence? Because the principles are universal and extremely healthy for personal finance, no matter which economy you come from.

If you do not know yet, here is a recap link to the 7 steps from his website.

Dave Ramsey’s 7 baby steps

Here are few points where I found an one-one match with how traditional Asian (India) household finances worked.

Have an emergency/contingency fund (Dave’s baby steps 1 and 3)

There are many names to this – emergency fund, contingency fund, rainy day fund. In many Asian households, it goes by the simple name of savings. Savings is in-built into the culture and an emergency fund is a default choice.

In a way, if you don’t have debt instruments (HELOC, Credit card) available to you, how else will you pay up for maintenance, car breakdown, education etc.?

Answer is simple, money socked off into a separate bank account – lo and behold, by end of the year, you have an emergency fund.

Use Cash – or debit card at the most (Dave’s baby step 2)

Before moving to US, my only credit card was a HDFC Bank Premium card. I was sold this card citing lots of benefits like reward points, airline miles, premier lounge access etc.

The truth is that I used it only for big purchases like appliances, electronics or vacation. And that too, because I knew I had to pay it off at the end of the month and just deferred the money being taken out of a CD (Fixed Deposit as named in India).

If I look back, except for getting a few discounts at clothing stores, I did not reap the reward points. Never had the idle time or need to figure out how to access the premier lounge. Once I tried to book a holiday trip through the miles, I found that I could get it for lesser by buying a cheaper economy ticket. Yet I paid an annual fee (or had to spend a minimum on the card to avoid the fee) for those unseen benefits.

Credit cards may work better in the US, but it is also a double edged sword. Americans are saddled with trillion dollar credit card debt. (source: Dave Ramsey) 

All my household daily expenses ran on either hard cash (lots of places in India do not accept any cards) or debit card.

Simply put, I never felt the absolute necessity to hold a credit card. Some people say its good for emergency situations, but then the previous step already solved that problem.

Oh there is one more reason – online shopping. In India, Flipkart has a C.O.D (cash on delivery) option. If that doesn’t work or not offered, you can pay using NetBanking which all online vendors provide with major banks. It is equivalent to using debit card, but without the card number. You are redirected to the bank website and you can authorize the transaction from your account, using login and password.

Retirement savings (Dave’s baby step 4) 

There are government retirement plans like Provident Fund (equivalent to 401k), Public Provident Fund (equivalent to Roth IRA) and now the NPS (National Pension System).

The first two are effectively tax exempt with the Provident Fund being tax E.E.E (exempt on contribution, growth and withdrawal). The only drawback is that the investment options are traditional – debt based with an interest rate guaranteed by the Government. The option of Equities has only come up as an option in NPS.

The Provident Fund or the NPS is now mandatory in most organizations for their employees. The amount you can invest from your paycheck typically hovers around 12% (with matching grant from employer), and is close to Dave Ramsey’s recommended savings of 15%.

There are of course private options from brokerages/banks to invest in mutual funds and stocks, as also R.E.I.Ts are now coming up.

Children’s education – use cheaper (sane) options (Dave’s baby step 5)

There is hardly any concept of student loans. Education is still affordable, though it is becoming expensive each passing year.

And despite the huge competition (owing to large population), there are no Ivy League schools to lose your shirt on getting a degree. Even the premier institutes like Indian Institute of Technology, or Indian Institute of Management are well affordable with their excellent career prospects.

I don’t have all the education expenses data, but I have not heard of any student saddled by student loan debt or carrying it well into their adulthood and married life.

Moreover in recent years, the growing start-up culture in India has also made an expensive education pretty much irrelevant.

Pay off your house (Dave’s baby step 6)

In US, people hold their mortgages for 30 years, and do not need to pay back earlier.

And it is more helped by the low interest rate regime that is sweeping the news everyday.

However in India, average mortgages survive for 3-5 years, before they are completely paid off. Both my mortgages in India were paid off in less than 5 years.

What is the reason for this? There are several factors.

  1. Interest rates are higher – typically 8.5-10%. This causes people to take mortgages with lower than 80% Loan-to-Value, to avoid big E.M.I (equated monthly installments).
  2. Higher down payment earns good discount from builders. One of the main sources of home buying in India is from builders.
  3. Floating rate mortgages – The interest rate by default is floating. Fixed rate mortgages have a much higher interest rate, typically 1-2% higher. Carrying a floating rate mortgage is risky, hence the tendency is to pay it off as soon as possible.
  4. Last but not the least – its a debt-averse culture. You don’t feel good till you actually own your home, free and clear.

Buying a house in India is stressful owing to the sector’s corrupt practices, less regulation and random mismanagement of funds by builders. Hence keeping low to no debt is prudent not to add on to the crisis.

Building wealth and Giving (Dave’s baby step 7)

The last baby step in Dave Ramsey’s plan is the absolute bliss.

This is where a lot of well to do families will be. With the above steps explained and if followed properly – they will be living in paid for houses, driving paid for cars (some with chauffeurs), have a good retirement corpus that is growing, children graduating from college without student loan debt, and an emergency fund stashed out in some savings account.

Now they can buy more investment assets like real estate, stocks and entire businesses.

You start building serious wealth and enjoy true Financial Freedom.

As Dave says, “If you live like no one else, you will live like no one else”. 

Now the last part is Giving. This may not be traditionally so popular in India, due to many factors. However lot of new initiatives are now trying to organize charity and reach to the real needy.

The huge wealth inequality throws up a lot of opportunities of giving. However if you are not careful and the non-profit organizations are not well researched, you will end up making some fraud people rich. I have ended up donating to NGOs (Non Government Organization), who started showing a suspicious pattern of corruption (sometimes irritating me with calls and messages for more). It becomes clear they want to milk you in the name of charity.

However with little diligence and online/offline research it is possible to select meaningful giving opportunities. 

Thus Dave Ramsey’s 7 baby steps are definitely a recipe for success with personal finance. I have only drawn a comparison with what I have lived and seen in India.

Dave’s success in getting millions of Americans out of debt and living their dream life is a testimony to the sound principles that the 7 steps represent.

Live like no one else. If you are not forced by the system, be intentional about the 7 steps. 

adult adventure baby child
Photo by Pixabay on Pexels.com
Posted in Investing, Liabilities and Debt, Personal finance

The Net worth vs. Cash flow debate

What is your net worth? Let me see, probably close to a million. So what? Are you financially independent? No. Why? ’cause I don’t have enough cash flow to replace my W2 income. Ok then, net worth is a worthless metric. But it projects my comfort into the future.

And so it goes on and on…

Does it sound familiar? There are two schools of thought. One says be conservative, save, invest for growth, have little to no debt and build your net worth slowly. The other school scoffs at this conservative approach, and instead propounds building wealth and cash flow through acquiring assets, leverage and working out deals.

None of them are wrong. However what is right for you (and me) is important. For that, it is extremely important to understand the benefits and risks attached with each approach.

In more practical sense, you will do both in the right proportions that you are comfortable with.

The Net worth approach: 

Here your main cash flow is your W2 income. Your ability to live below your means gives you the leverage to save and invest the rest.

Budget – Grow the tree upside-down

As you invest your money into stock mutual funds, CD, money market, bonds and a house of your own to live in, you are increasing your net worth slowly.  This is how most people start and someone starting off should. The difference between income and expenses, is the main contributor to your net worth. Additional is the appreciation and growth that your investments achieve. You also pay down mortgage of your house which builds equity, adding to your net worth.

In my opinion, this is a perfect approach to build wealth as long as you enjoy what you do in your W2 job and have a good work-life balance.

This is also the simplest since there is no extra debt burden (except probably your house, which you can pay down if you want). Your investments are also passive and takes hardly any time from your schedule, except occasional re-balancing and tracking.

Investing in the High Five portfolio

With a spreadsheet like Excel, you can easily calculate your projected net worth in “t” years in the future, assuming a “r” rate of interest (or growth).

cp_formula

However this approach takes a lot of time and patience, disciplined living on a budget and regular investments. You will not have something to brag about in a few years, but you will sleep in peace as you have liquidity, less or no debt and enjoy your work.

The risk of this approach is if you retire early and do not have enough corpus to live off for the rest of your retired life.

The Cash Flow approach:

The cash flow approach on the other hand, only focuses on generating cash flow. It means you have enough assets or mechanism (businesses, activities) which generate cash month after month, in a predicable fashion.

This can be achieved with several avenues for example:

  1. Rental property investing
  2. Commercial property
  3. Dividend paying stocks
  4. Passive income from books, royalty of other IP, YouTube videos etc.

There are many resources on Internet to give a list of passive income ideas.

However in the cash flow investing approach, I wish to draw attention to the big ones like Rental Property Investing and Dividend Stocks.

These are two ways which makes a very predictable cash flow stream if done right.

However to get this predictable cash flow, one has to do the investment right. For example, real estate has many hidden costs and running expenses, which if not taken into account will quickly convert an on-paper cash flow asset into a black hole for your money.

Similarly dividend stock investing, if not researched correctly can cause the principal investment value to go down. Same for income producing corporate bonds, where the ability of the company to make the regular payouts needs to be researched.

Last but not the least, income producing real estate is typically obtained through leverage, which means steadily increasing debt.

For example, if you want to generate $5000/mo in cash flow from real estate, you need to buy as many houses that will in total produce that much positive cash flow. Lets say each house produces $200/mo in positive cash flow after mortgage, taxes, insurance and expenses. Now you will need to manage at least 25 such properties to generate the requisite cash flow. Self managing 25+ properties is more than a full time job, and if you hire a property manager you will have to part with the cash flow (fees), and hence no. of houses under management will need to increase. This is all not to mention that now you have 25+ mortgages in your name. The risk – 10 out of 25 properties suddenly loses the tenants and remains vacant for 3 months. Now you have to be able to make 10 mortgage payments every month from other sources of income for an extended period of time. 

I am not saying Real Estate Investing is bad, lots of millionaires and billionaires have achieved their wealth creation through this. However you need to know yourself and act accordingly after you understand all the risks involved.

A combined approach:

 Is it possible to have best of both worlds? Sure there is, if you are not in a hurry to get out of your job and have the patience to slowly build both your net worth and cash flow. 

A few simple ideas which comes to my mind are below. I have done some myself and plan to do the rest.

  1. Increase your income and live below your means. This is very obvious, yet the most difficult to do consistently.
  2. Invest consistently 15-20% of your income into stocks, bonds and cash. See post: Emotional Investing
  3. Live in and then rent – Convert your existing house to a rental once you move out to another one. Or just rent out a portion of your house. This has the advantage that the mortgage you have is an owner occupied one (less interest rates typically), also it is paid up consistently as you spend more years and gets factored in your regular budget. See post: Don’t twist your ARM, fix it !!!
  4. Pay off your old houses completely but do not sell. Convert your equity play into a rental now. The paid off house will generate much better cash flow with substantially less risk, as there is no mortgage payments to worry about. See post: The Paid Piper of Hamelin
  5. Find sources of passive income which you can buy with your accumulated savings, like investing in a profitable business, crowd funded real estate etc. These have much less risk if you do your homework, at least there is no risk of foreclosure etc.
  6. Write a book or start an online course about your area of expertise.

In short, increase your net worth and cash flowing assets in a sensible fashion, with less to no debt and consistent action. 

Here are some of my previous posts which may inspire the above principles.

Know yourself and your investments

Shun that perfection

How a cassette player caused debt aversion

Enjoy the journey and the destination will follow. 

lake-balaton-sunset-lake-landscape-158045.jpeg
Photo by Pixabay on Pexels.com
Posted in Liabilities and Debt

Don’t twist your ARM, fix it !!!

Refinancing an existing mortgage is a major decision and there are many factors that you take into account, to ensure that you benefit in the long term.

I recently refinanced my mortgage from a 30 year 7/1 ARM to a 30 year fixed rate.

One of the straightforward reasons of refinancing is when you are on a fixed rate and you can refinance to move to a lower fixed rate.

The simple calculation is take the total of closing costs and any points you have to pay, and divide it by the monthly savings in payment. That would give you the time in which you will recoup the closing costs and points.

N = (C + P) / (OP – NP)

N = the number of months for which you must keep the mortgage or the home for the refinance to make sense.

C = total closing costs as provided by the lender’s disclosure statement

P = Points you may additionally pay to lower the rate further. Sometimes this may be included in C already.

OP = Old Payment, NP = New Payment [Use the calculator at bankrate.com]

Easy, right? The above formula also helps in figuring out how many points you should pay to lower your rate. Note that P and NP will vary accordingly.

But there are many people who are on an Adjustable Rate Mortgage (ARM) where either the rate already floats with market or will float after a fixed period.

adult arm fashion hand
Photo by Pixabay on Pexels.com

Typically ARM mortgage rate during the fixed period (7 years for a 7/1 ARM)  is lower than a 30 year fixed rate mortgage. But the interest rate risk is completely passed on to you in future.

Hence as the interest rates dip in the market, it may be wise according to one’s situation to refinance to a 30 year fixed.

I vacillated with this decision for a long time as I had a 3.625% 7/1 ARM since last one year. However since then the interest rates started ticking upwards and as the periodic dips came in, I was looking for an opportunity to move to a fixed rate.

But getting a 3.625% or lower fixed rate is not possible today. So I had to refinance to a 4.125% fixed rate. This is counter intuitive to the logic and calculation given above for a fixed->fixed refinance. How does one even justify a slightly higher payment and larger interest component post a refinance?

Here are the factors I considered. This is according to my financial situation and long term goals. Your situation may require to hold the ARM with no problems.

  • I want to keep the house for long term. This is the most important factor.
  • To save the uncertainty of interest rate risks in 7 years, initially my strategy was to pay off the mortgage as much as possible in the first 7 years and then refinance at the prevailing rates for the remaining balance.
  • To do above, I had to make substantial extra payments towards the mortgage, which skewed my asset allocation (see my earlier post on this: The Paid Piper of Hamelin) more towards Home Equity or Real Estate.
  • On the other hand, the fixed mortgage (and hence fixed payments) will give me the peace of mind and flexibility to invest more in other assets (instead of throwing extra money to the mortgage).
    • There is no risk of interest rates (and payments) going higher in the 8th year.

But how does the math add up? It is not as straightforward as the previous formula.

Lets take the following mortgage and refinance decision.

  • Starting balance – $100,000
  • Acquired at 7/1 ARM 3.625% ARM (lifetime cap at 8.625%)
  • After one year, refinance to 4.125% fixed for 30 years

Lets run the numbers in two scenarios. You can read my post on The Paid Piper of Hamelin to determine which below scenario/strategy will apply to you.

If I keep paying extra I can payoff the mortgage in about 11 years.

You can use the mortgage calculator at bankrate.com to calculate the total interest paid in both cases.

  • In the 7/1 ARM, I assumed the 3.625% in the first 7 years during which majority of the principal is paid off. For simplicity, the rate is assumed to be fixed till the mortgage is completely paid off in about 11 years.
  • In the fixed rate, the calculation is done with 4.125% on the current balance and assuming same extra payments per month.

Original principal on the 7/1 ARM at 3.625%.  – Extra payment of $465/mo, which is same as the monthly payment (thus effectively paying double).

Refinance-3

After one year of payoff on the 7/1 ARM, the balance will be $92000 and the interest paid will be $3500. Now lets say the balance is refinanced at 4.125% and the extra prepayment per month is kept steady.

Refinance-payoff-2

Since the 7/1 ARM was paid off quite a bit, the cost of remaining balance at 4.125% actually comes pretty close. If you add the interest already paid on the 7/1 ARM, then definitely the fixed rate is costlier ($25000 vs. $21369) simply due to the higher rate and the added refinance costs. However the above 7/1 ARM case also assumes that the rate does not increase at all between 8-12 years. So in reality, the savings of 7/1 ARM may cancel out in favor of the fixed rate, if the rate moves up steadily. 

Now what if I don’t pay extra and invest the rest?

This is tricky calculation but for the 7/1 ARM if I assume the interest rate will touch the maximum (8.625%), then the overall interest paid over 15, 20 and 30 years will be much more (nearly double) than the fixed rate mortgage.

Even with the slightly higher monthly payment, if I invest the extra money according to asset allocation, I should come out better over the long term. Lets run the numbers again.

In case of the fixed rate, the total interest payment in 30 years will be in the range of $72983. Lets add the refinancing costs of $4500 and interest already paid in first year of 7/1 ARM- $3500. 

  • Note that the balance after maintaining the 7/1 ARM for one year, without paying any extra is $98000. 

Total cost for fixed rate 4.125% = $72,983 + $3500 + $4500 = $80,983

Refinace-fixed-30yrs-nopayoff

Now assuming the full risk of the ARM (no refinancing), the calculation comes out to be (done in two steps):

  • First 7 years, total interest paid = $23,611 and balance = $85000

Refinance-4

  • For next 23 years, since the spread is 3.625%-8.625%, we take the median 6.125% and calculate the total interest to be paid on the balance $85,302.91 in 23 years.

Refinance-5

Total cost for the ARM at 3.625% = $23,611 + $73,669 = $97,280

Thus the total interest paid for the (3.625%-8.625%) 7/1 ARM will be much higher ($97,280) compared to $80,983 paid on a fixed rate of 4.125%.

Exercise: Try the above calculations if the 7/1 ARM is kept for a longer duration (than 1 year) before a refinance to fixed rate. I believe the savings will be more as you are paying down more at lower rate of the 7/1 ARM, but then you are assuming the risk of interest rates as you delay further. 

So there are both behavioral as well as mathematical consideration behind such a refinance decision.

The most obvious behavioral factor is that ARM is riskier than fixed rate. This is the general notion and with good reasons. With an ARM, the interest rate risk is passed on to you by the lender and with the US economy seen an almost zero interest regime for a long time now, the long term outlook could very well be higher interest rates.

The fixed one comes with the peace of mind, and leaves you with easier refinance decisions in future if the interest rates go down further.  

adult asian bald buddhism
Photo by Pixabay on Pexels.com
Posted in Liabilities and Debt

The Paid Piper of Hamelin

The title is from the childhood story where the Pied Piper helped a town get rid of the rats and drowned them in the river by playing his melodious music. The second part of the story is that after the rats were got rid of, the town did not pay him. So a very sad thing happened as he came back revengeful and wooed the children away.

I wish to relate this to the largest debt we take on in our lives, Home Mortgage.

One’s own home is a dream which everyone loves to live, but the mortgage is like the rat which becomes ubiquitous in our entire life (for 30 years and everyone holds one in his/her financial life).

The mortgage is usually a large amount (2-3x of annual salary) and the long period makes us imitate the Pied Piper with our finances.

The big question is should you pay up the mortgage, never have one at all, or let it continue while you build wealth by investing?

Mortgage has a number of factors – the monthly payment, interest rates, tax benefits, prepayment charges, points, refinance, fixed and adjustable, ARM and LEG and what not.

There are entire books on mortgage terms, strategies and nuances. Also there are countless arguments on which is better – paying off mortgage or investing the same money at higher risk/return.

The question is how do we become a Paid Piper from a Pied Piper? How do we get that relief when the rats are drowned? Or is life worth it when the rats are gone and the music has to stop? Will you feel betrayed like the Pied Piper once all your savings (hard work) are trapped between the walls?

This is a question I searched extensively for a solution but could not find any conclusive resources or guidelines.

Very recently as I bought a house in Texas, I have considered a number of strategies based on my prevailing financial situation.

I have no finance degree nor do I work in a bank or financial institution. But over the years I faced this question multiple times as I owned 3 houses (India and US), all bought with a mortgage and then paid up fully or partially.

This post is just to systematize this complex decision by taking into account a few personal finance factors. I hope this will help you make a better decision if you are grappling with the same question.

You can be in 3 situations that I have gone through and used all 3 strategies in the 3 real estate possessions.

  1. Lets call it A – The Paid Piper solution. You throw all your extra money towards the mortgage and pay it up as soon as possible. This is also the Dave Ramsey way, where Baby Step 6 says after you are consistently investing 15% of your salary and saving for kids education, you should throw all your extra money towards mortgage and become completely debt-free.
  2. Lets call it B – The Pied Piper solution. Here you keep paying the mortgage payment every month but also pay a little fixed extra, to keep chipping away at the principal. Although you can throw even more money, but you prefer to invest the extra money into stocks and REITs. Keep the music on and lead the rats slowly towards the river. Hopefully you earn from the residents of the town as they enjoy the music but gets rat-free as well. 🙂
  3. Lets call it C – The Rat Lover solution. Here the rat is kept controlled (by making regular payments only) and the music plays on for a long time and creates enough entertainment that the rat problem diminishes from the people’s mind. In other words, the mortgage is kept alive by making the payments while the investment portfolio (real estate or otherwise) keeps growing by acquiring more assets.

Now let us see what factors in your financial situation will or should make you follow either A, B or C strategies. These factors will never be exhaustive but the ones I am going to discuss are faced by me and used in my decision in all the 3 cases. You can apply them to your situation and according to your long term goals.

A – The Paid Piper of Hamlin 

  • The mortgage interest rate is very high compared to investment returns. An interest rate above 8% is almost always expensive as you will struggle to earn 8% on your money consistently from regular investments like stocks, ETF or mutual funds. It is a no-brainer that you should pay off as soon as possible, or refinance to a lower interest rate. If you manage to refinance, congratulations. You can follow B or C below.
    • This was my situation in the first house I bought in India where the interest rates were > 10%. I paid off the mortgage in little over 3 years as I absolutely hated the monthly payments and the stress on my budget. 10 years later, I still own the house which is now giving me a nice rental income with zero loan costs.
  • You have a decent rate 5-6% but not very low. You are not comfortable with debt and you really want to stay in the house for long term (10-15 years). This is your dream house and owning it free and clear will give you a peace of mind and pride too. By all means strive to pay it off.
    • This is Dave Ramsey way where he says wealth starts building up and you become generous when you have no more monthly payments.
  • But most important is to also look at your overall asset allocation if you have an affordable mortgage. How much do you have in Stocks and Bonds? A simple allocation is 33% Stocks, 33% Bonds and 33% real estate. You can modify the percentages according to your risk profile and age, but you get the idea.
    • Decide on an asset allocation and calculate where do your investments stand. Take into account the Equity you already have in this home as Real Estate. If putting more money into the Home is not going to disrupt your asset allocation and actually help build up the Real Estate Equity, go for paying up on the mortgage.
    • Be careful on this as you don’t want to be House Poor, where Real Estate allocation is like 80-90% and you are left with very little liquid investments. This can be really stressful when the economy is down and chances of emergency situations and job loss increase. Also not having cash means you will miss on the great investment opportunities that comes up during recession times.
  • All the above factors were justified in my case of my first house mortgage.
    • I had a high interest rate loan then and I did not see any way of refinancing. It was not so common those days or I did not bother.
    • I wanted to sleep better and own my first house. I happily stayed in the house for more than 10 years, paid it up and rented out when I moved to my second abode.
    • I was building my portfolio and paying it off just made the Real Estate part done. There was no REIT in India (they are coming now), and so the only real estate exposure was to buy a physical asset.

B – The Pied Piper of Hamlin

Here you play along but also have the task of paying off your mortgage in your plans.

This can be the real balanced approach and most financial advisers recommend this. You will read over the Internet about the biweekly plan, HELOC strategy, monthly extra payment etc. All these are good but lets see when you should employ this strategy.

  • You have a decent mortgage rate of 5-6% and you are a disciplined investor.
  • You budget every month and have the discipline not to blow up the extra money.
  • You are inspired by Dave Ramsey and you know after investing 15% of your salary into retirement accounts and investing for kid’s education, you have surplus that you can throw at the mortgage.
    • However this requires a lot of discipline and so Dave recommends a 15 year mortgage so that you are forced to increase your monthly payments.
  • I am a big fan of asset allocation. The beauty of this approach is that you can tweak the extra payments to balance your assets between Stocks, Bonds and Real Estate. If your real estate allocation is low, increase your extra payments and as the allocation comes closer to your desired one, reduce your payments and so on.
  • When I purchased my second house in India, I paid majority by cash (as interest rates are still high in the range of 8-9%) and took out a loan for the rest.
    • This let me continue investing in mutual funds and fixed deposits, while the mortgage payment earned me equity and further added to the Real Estate allocation.
    • I also paid extra every month due to following factors.
      • The house was brand new construction and my wife and daughter designed the interior beautifully. So we did not plan to sell it soon, but instead, planned to stay in it for the long haul like our first house. I eventually wanted to own it free and clear again.
      • The interest was high (typical in India) although the payment fit into my budget. The extra payment I could customize month to month and throw into the principal.
      • I could keep investing in mutual funds according to my worked out allocation, and at the same time apply for tax deductions on the mortgage interest.
    • However situations changed in about 3 years. We could not stay in this house for long, as my job required me to relocate to US.
      • Paying off suddenly became a priority if I had to keep the house.
      • Well I could have sent money from US every month, but that would have disrupted my other plans. More on that in later posts.
      • Due to complex international tax laws, I had to liquidate some of the mutual fund investments. It made sense to pay off the house than letting the money idle in savings accounts.
  • So if you have the discipline of working on a budget, you can chip away extra on your mortgage principal with two goals in mind.
    • Increase your Stocks and Bonds portfolio as you invest majority of your savings, thus keeping your asset allocation sane. The real estate down payment (typically 20%) itself creates a big skew in asset allocation. So you want to tune the extra monthly payments according to the asset allocation.
    • Eventually you want to pay off as you want to keep the house for long term.

C- The Rat Lover

Yikes!! Who loves a Rat? The investors of course… They love leverage and want their tenants to handle the rat, while they enjoy the music in terms of cash flow and asset appreciation. If you are really interested in this mode, I suggest read a lot of Real Estate Investment material to learn how to do it properly.

I have not done it intentionally but I have read a lot (I still scourge for such books and BiggerPockets.com).

In the USA, the real estate investing is popular due to the rent/value ratio being investor friendly in some regions and the overall mortgage rates are quite low.

So even if you maintain a mortgage, either the rent or your monthly budget can cover it. Of course, you should plan and budget well, and buy the house you can afford.

Now when should you play the Rat Lover? Dave Ramsey will not advocate this at any cost unless you are working on other high interest debt or you have no financial slack in your budget to pay off. The simple reason is this is risky and if you run into financial trouble, your beloved home can go into foreclosure.

But there is a deliberate situation of not paying off. I am not talking about real estate investing but as a homeowner like me. I bought my property in Texas in December 2017.

Here are the considerations and why I decided to adopt this 3rd strategy.

  • Since I did not have a credit score (no history in US), I could get a 7/1 ARM with a 3.625% interest rate. This was good as it perfectly fit into my budget owing to the low rate.
  • I did not then plan to keep the house for long term. It was a starting house in the US and everyone told me we will upgrade in a few years time (less than 7 years and hence the 7/1 ARM). So there is no point in driving down the mortgage with extra payments (except to save some interest).
  • Instead I should invest the surplus out of my budget in low cost index funds and increase my asset allocation. Note in my second house, as I liquidated some investments and paid off mortgage, my asset allocation is really screwed up hugely in favor of Real Estate.
  • Me and my wife renovated this house in Texas and brought the value up. I have not done an appraisal yet but I am sure it improved value by 10-15%. So now we want to keep this house for the long term. Even if we move out or move to another place, we can convert it to a rental as the mortgage interest rate is low.
  • Now there are two ways to hold this house long term.
    • I can focus on paying down the 7/1 ARM before it becomes adjustable and hits me with the interest rate risk (it will start floating in the 8th year). But this would have skewed my asset allocation further towards Real Estate.
    • I can refinance it to a fixed rate (now that I have a credit score and a decent one). I did exactly this and refinanced this month (the rates took quite a dip). Of course I could not get as low as the 7/1 ARM but very close to not affect the monthly payment too much.
  • Now I can invest entire savings every month and build up a portfolio of index funds. Once my asset allocation comes back in shape I will go back to strategy B and start paying off the mortgage.

Conclusion

Lets consolidate the factors and see if we can come up with a situational formula to decide what kind of Piper you will be.

Type A: The Paid Piper

  • You have a high interest mortgage. Always try to refinance to lower rates though.
  • Your asset allocation dictates you to increase the Real Estate portion. The principal payments towards your mortgage goes towards building the Equity.
  • You either have substantial liquid assets or are investing regularly to increase stocks and bonds allocation.
  • You want to stay in the house for long term and owning it free and clear will give you the peace of mind.

Type B: The Pied Piper

  • You have a decent mortgage interest rate (5-6 %) and can comfortably handle the monthly payments.
  • Your asset allocation is already balanced and real estate equity build-up is a part of your regular investment plan.
  • You plan to stay in the house for a longer duration, if not forever.

Type C: The Rat Lover

  • You have a good mortgage interest rate (< 5%). You obviously can comfortably handle the monthly payments.
  • Your asset allocation is already skewed towards Real Estate and adding more home equity will make your portfolio ill-liquid.
  • You have alternative plans of either converting this to a rental or you bought this property as an investment. Of course you should know how to manage rentals to generate positive cash flow.
  • You may move out of town or country in few years (the time is not fixed). You will have a choice then to sell it off or convert it to a rental. The fixed rate will not cause a change in your asset allocation or worry about interest rate movements.

Here are my 3 units portfolio.

 

So what do you think of the strategies mentioned? Let me know in the comments below!

Stay tuned for the next post on my blog about budgeting and executing these strategies.

Posted in Liabilities and Debt, Personal finance

How a cassette player caused debt aversion

I was very fond of music and used to break dance in my school days. We had a picnic some day and I wanted to arrange for music to entertain my friends.

But in my home, I did not have a portable music player except the turntable, which was not exactly portable.

So I borrowed my neighbor and cousin’s cassette player. I was very happy and proud at the same time to have arranged it. But I could not tell my father as he never approved of borrowing others’ material.

We started off for the picnic destination on bicycles and in midway, one of my friends wanted to play the music. So he started it (it was operating on battery) and the whole group was enjoying the music along the way to the picnic spot.

Now there is a saying in Bengali which means something like “When you fear the tiger, the sunset is imminent”.

As someone among my friends was fiddling with the cassette player, it slipped and came crashing down on the concrete road. The outer cabinet made of plastic were in pieces and I did not know what to do. There was no way it could have been put together and glued or taped to make it look like earlier. The only silver lining was that it was still functional.

Long story short –

We went from electronics shop to shop and everyone told us that this model is out of production. I still remember it was from Hitachi, the Japanese company and they were not making those any more.

Thus I was stuck with a broken cassette player that I cannot return to my cousin, nor get it fixed.

It caused me much embarrassment and punishment to go and hand it over (after a botched up attempt to fix it) to my cousin.

I learned another very useful lesson in my life: What is not yours is not Yours.

  • Leverage and O.P.M (Other People’s Material or Money) are buzzwords and better avoided.
  • Debt can reduce your self-esteem and put yourself into embarrassing and stressful situations.