Death on the Descent: Mount Everest and Retirement Accounts

January 5, 2014

Pretend for a moment that you’re preparing to go to work. You’ve completed your morning routine and are just a few moments away from departing for the office but this particular morning is a little different. You have the means to get yourself to the office but not to return home. You hear the conversation run through your mind: “How are you going to get home? You don’t have access to public transportation. You don’t have money for a taxi. Your coworkers are not able to bring you back. There are no friends or acquaintances that can pick you up. You have no money and just enough gas to get you there. What in the world are you going to do?”

Would you even travel to the grocery store without the ability to return home? How about a vacation, would you plan a trip without specific knowledge of your return?

Plan my descent down Mt. Everest? No, I’ll just wing it

The answer is simple to these somewhat rhetorical questions; however, I wonder if those who set out to climb Mount Everest spent any time developing a plan to get them off the mountain? I would be willing to place a wager that not one single expedition up Mount Everest, let alone any mountain, has ever failed to plan a way back down. Not once. Why? Because summiting the mountain is only half of the journey. Unfortunately, the descent down Mount Everest is the most dangerous.

In a story from Scientific American back in December 2008, 56% of those who have died on Everest have died during their descent after summiting. Another 17% died after turning back (i.e. descending). That’s a total of 73%. Only 15% died on their way up or before leaving their final camp. The remaining died through various accidents like avalanches and falling ice at lower altitudes.

The descent is by far the very most dangerous, treacherous, threatening, unsafe, formidable, perilous and risky phase of the Everest exhibition. If there is no plan in place for the descent then failure surely awaits.

Retirement is just like descending the mountain

How does this real life example perfectly reflect the financial planning being pursued by virtually 68% of the population (Figure 7.5 http://www.icifactbook.org/fb_ch7.html)? The answer is simple: pre-tax investments.  You’ll notice that the Figure 7.5 is titled “Many U.S. Households Have Tax-Advantaged Retirement Savings”. Wow, is that ever misleading. Pre-tax investments are not in any way tax-advantaged. What is the advantage? Many financial pornographers, like Dave Ramsey, profess that there is a mathematical advantage to investing pre-tax. Math proves him wrong. A couple of years ago I wrote a blog on this very topic so I won’t duplicate it here. So if you think I’m wrong then read this post first…and then feel free to comment.

How does Mount Everest tie into this tax debacle for the everyday American? Well, if you have money in an IRA, 401k, SEPP, or another government-run retirement plan (even Roth IRAs) then you have an enormous tax problem. You see, you are climbing the mountain with no knowledge of how to get down the mountain. What are the tax laws when you decide to retire? What are the distribution requirements? What are the tax rates? Do you know? Does anybody?

Only the financial planner with a crystal ball

There is not one single financial planner on the planet that can plan a retirement (using assets to provide income in order to maintain a desired lifestyle) for an individual when the majority of their portfolio is made up of government-run plans. The professional certainly doesn’t know the answers to the above questions and therefore has no idea how long the money will last. How much is the government going to take? If you have an IRA or any other pre-tax vehicle (the balance is irrelevant) then I have one question for you: how much of it is yours? No one knows. And no one will know until you’re standing on top of the mountain…and at that point you’ll only know one year at a time.  It’s just like climbing Mount Everest with no plan to descend until you’re finally standing on top…very dangerous strategy.  It’s actually worse than that because are the rules going to be the same when you’re 75 as they were when you started using the funds at age 65? It’s like only being able to plan your descent every 10 feet and having no idea what’s facing you at the next 10 feet. That’s not just dangerous but perilous.

Kelly, I’ll be in a lower tax bracket. You will? How? Why does the government put far more restrictions on after-tax positions (Roth IRA) – like income and contribution limits – than they do on the pre-tax (no income limitations and you can contribute a heck of a lot more). Seriously, why? Because they know that the only mathematical factor that determines the winner is the future tax rate and only they control that factor. You don’t control it otherwise your taxes would be zero. Roths aren’t even safe because they can change the rules at any point. Could they choose to tax the gains? Yep. Social Security was supposed to be tax-free forever but that changed.

The government is absolutely working in my favor…or is it?

Do you believe the government has your best interests at heart? Do you honestly believe that they are fine with you not paying taxes now so that you can pay less in the future? Do you feel the government will do everything it can to ensure the math lines up in your favor so you can get down the mountain? Me neither. Yet almost 70% of households are doing this very thing and unfortunately, virtually all of them will face a “tax descent” that will be immensely costly. Here’s a video that goes into some detail on this issue.

When did all this begin in the first place? Could that give us any insight? It sure can. Pension plans worked very well so why did all of that change in the 1980s when the government realized it had the largest working population in all of history (American history)? Why did pension plans fall out of favor to be replaced by the government-run retirement accounts? Who had lobbyists in that room?

Certainly the government was in that room because they could then control the largest portion of the citizens’ retirement assets. There’s an estimated $19,000,000,000,000 held in these accounts. That’s $19 trillion controlled, not by the citizens, but the government. The banking industry was certainly present in the lobbying for this because the rules with these accounts do not favor the investor having access to capital. Penalties, unfavorable loan features and simply the denial of access to the funds in these accounts (can’t access more than the loan provisions on a 401k while employed with the company – why?) mean that the investor will need the bank. Wall Street was also at the table because this would put the once untouchable pension now in the hands of the investment broker. It also would provide incredible job security for Wall Street because the investor can’t touch the money until they’re 59 ½ years old. If you’re 25 years old and contributing to a 401k then that represents 34 years of security for Wall Street. That’s awesome for them.

Turn the coin over. Look at the other side. Follow the history. Dig in. Let the light shine on this a little bit and you’ll realize that NONE of it is for your benefit. None.

There are solutions but you must be willing to have some conversations. You must be willing to plan a descent and not just for the summit! Our job is to ensure you get DOWN the mountain because, after all, that’s the goal.

Kelly O’Connor – kelly.oconnor@mtnfinancial.com

303.578.9708

Website  –  YouTube  –  Facebook

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How Financial Institutions Make Money #2

September 20, 2013

I can’t believe it has been almost four years since my first “how financial institutions make money” post. Crazy how fast things go by so quickly. This initial post continues to be one of my most active even today and the primary path that people come to this post is through Google. It’s interesting that so many people are simply Googling (love that this is now a verb) the question: How do financial institutions make money? Honestly, I believe many people are pretty fed up with how things have been going financially and yet the Big Three (IRS, Wall Street, Banks) keep making money hand-over-fist.

For the most part, people are finally seeking to educate themselves first before just following another opinion. Opinions drive me crazy. I’m mean, I certainly like mine but who cares other than me, right? Mint Chocolate Chip is the BEST ice cream flavor of all time. No Kelly, says you, “_____ is the best ice cream flavor!” Who’s right? Who cares? Seriously, no matter what you say I still love Mint Chocolate Chip.

When it comes to the title of this blog “How financial institutions make money” there are no opinions. There’s only truth and the truth could care less about opinions. All of us must understand that there are four rules which are deeply cherished by the IRS, Wall Street and Banks. These rules allow all three to work together.  They allow all three to ensure that they’re winning. They allow all three to redirect the risk of success entirely upon you. I thought we’d review these four rules today. You’ll find that they are extremely simple but they have huge implications. It’s interesting to me that even the Bible talks of a cord of three strands being unbreakable…these three (IRS, Wall Street and Banks – from now on referred to as “IWB”) are most certainly intertwined together and are so hard, if not impossible, to break.

Rule #1: They want and need your money

Now, before you pass this one off as too simple to carry any weight then please take a moment to think about the importance of this one (it’s #1 for a reason).  This one does not require much explanation. All three, IWB, want our money and need our money in order to both operate and turn a profit.

Rule #2: They want and need your money on an ongoing basis

What would happen to Walmart, Coca Cola, Pepsi, McDonalds, Budweiser or any other company in the country if beginning today every customer only bought their product(s) one more time? That’s it. Just one more purchase. They would obviously have a HUGE day if every customer placed their order today but come tomorrow the alarms would be blaring. Nobody shows up again and these businesses are out of business very quickly. Think of all of the employees that would be unemployed or all the buildings that would be vacant or all the farmers who would have no one to sell their produce to…the results would be devastating and felt by all.

Is this example any different for the IWB? No. They must have your money and they must have it on an ongoing basis. If they don’t succeed at this very simple truth then they fail as well. Now, we could dig in real deep to show how, unlike the above mentioned companies, it is virtually impossible for them to fail. They can’t. They won’t. If they actually do fail then along comes Joe Taxpayer to bail them out so that they don’t fail. No matter what happens, they get our money on an ongoing basis.

So how do they accomplish Rule #2? They create financial products that we buy and that we “need”. Banks offer checking and savings accounts, CDs, money markets, loans, credit cards, etc. Wall Street offers financial investment accounts that we contribute to and hopefully grow and the IRS controls the tax implications and the rules behind all of it.

Rule #3: They want and need to hang on to your money for as long as they can

Does the bank like it when you withdraw your money? Of course they don’t. Keep in mind; their liabilities are their greatest assets.  Your money on deposit with them is a liability to the bank – they owe you that money at a promised interest rate; however, they’re turning that money over and lending it to others at a higher rate. We must understand that there is a difference between liabilities and debt. Debt is no good and we must get rid of it but liabilities when managed properly can create a bunch of wealth for us just as they do for the banks.  What happens if everyone goes to the bank the same day to withdraw their funds? It’s called a “run on the bank” and the bank would have to shut their doors or be faced with bankruptcy. They are never in a position to get everyone their deposits back on any given day because they don’t have it. They need our money, they need it on an ongoing basis and they need to hold on to it as long as possible.

The government is the worse with Rule #3. Why do they have so many rules when it comes to you using (whether you simply need it or just want it) your funds in your qualified plan accounts (IRAs, Roths, 401ks, etc.)?  First, let’s make sure we get something very clear here – any funds in your government, qualified plans are not your funds. The government owns and controls that entire transaction. If it is truly your money then why are there so many rules around accessing the funds? Why do you have to wait until you’re 59 ½ to touch it without penalty? What if you choose to retire at age 50? If these accounts are truly in your best interest then why is there any penalty at all? Why are you required to take money out if you hit 70 ½ (Required Minimum Distribution)? What if it doesn’t fit your plan or it’s not in your best interest to access those funds at that point? The number of rules and regulations on these accounts are insane.  You have NO control over them ultimately. Plus, the government can change the rules at any point to serve their financial needs. So, the IRS loves Rule #3. The banks love it as well. Wall Street makes a killing off of it too because they get to manage the money within these products. Think about it: you’re 35 years old with an IRA and you can’t touch it without penalty for 24 more years! Wall Street has a client for a LONG time!

They want to hang on to your money as long as they can and the rules and the product design allow them to do so.

Rule #4: They want and need to give your money back to you as slowly as possible

This one is similar to Rule #3 but it has a slight twist. They want to hold on to our money for as long as possible therefore they create rules to give it back to us as slowly as possible. If this isn’t the case then please explain the 10% tax penalty for withdrawing funds from a qualified plan retirement account prior to being 59 ½ years old. It’s your money (after all, you’re the one who made the deposits) so why are there so many rules and why are there penalties for you if you choose to access your funds? Answer: Rule #4. The government does not want you to be in a position of control because that takes away from their control so they create rules. These rules are based around them maintaining control so they limit your access. What’s shocking is that people continue to fund these accounts. Wall Street loves it because it creates a great deal of job security because they know you won’t access this money due to the rules and penalties so they have your money under management for many many years. The banks love it too because you’re not in a position to access capital for large capital purchases so they offer you a loan…and we know how much banks love that one.

These four rules are always at the center. When you begin to plan your trek up the mountain of retirement planning you can always find these four rules working against you…if you just pay attention.

Mt. Everest – descending is the most dangerous

Are there options? Are there ways to minimize the effect of these four and create a more effective plan up the mountain? Yes there are. Remember, for those who die climbing Mt. Everest, 70% of them die on the way down. The descent is the very most dangerous part of that journey. It’s no different financially. People are just climbing up without an understanding of how these rules affect them and more importantly, how they affect them on the way down. What do I mean by that statement? Well, if you have a large sum in your qualified retirement account, or that’s your plan at least, then please tell me the tax implications on that money during your retirement? You don’t know. No one does…it’s impossible because you’d have to literally know the future. You see, any financial professional can only plan one year at a time with those types of accounts because we don’t even know what taxes will be or what the distribution rules will be for next year. If you’re in this position then you can truly only plan one year at a time and that’s a very dangerous position to be in. The descent will most likely not work out in your favor. You must not only plan to effectively get up the mountain top but also to get back down to base camp alive (i.e. be financially independent through your life expectancy). With this knowledge your trek up the mountain may take a different path and while others are falling off you’re holding on just fine. That’s our expertise. That’s what we do for our clients.

There are solutions. There are answers to minimize the Four Rules’ overall negative effect on your plan; however, you have to be willing to learn. I don’t care what financial position you’re in, you must be willing to have a few discussions with a student-type mentality.

Kelly O’Connor – kelly.oconnor@mtnfinancial.com

303.578.9708

Website  –  YouTube  –  Facebook


Inflation: devastating or full of opportunity. Which do you want?

May 25, 2012

Banks lending again? What does that mean for you and your money? More than you may think.

Did you notice there are some banks that have begun to lift their tight lending requirements? For example, Key Bank here in Denver is now offering 100% financing again. So, what’s the big deal? Before we take a look at what this means, let’s ask a few questions:

  • Have there been any bad times before in the history of the world financially? Of course.
  • During those bad times, even the Great Depression, were there any people who made money? Of course.
  • Was it the people who planned and prepared or people who just let stuff happen to them that were most successful? Obviously those who planned.
  • So which one do you want to be and when do you want to get started?
  • If you could truly put yourself in a position to take advantage of the opportunities you have to earn your family’s financial independence even in bad times, then shouldn’t you be thinking the current economic situation is an opportunity and not a “bad thing”?

Inflation is going to do some real damage to our money if we’re not prepared. Stop and think about this, if you had $1,000,000 and you lost $200,000, you’re down to $800k and that money just stays the same. If we have 7% inflation that $800k is only going to buy $400k of retirement, or $400,000 of goods and services a decade from now.

  • What’s your strategy to make sure that you don’t get hurt by this inflation?
  • More importantly, are there any strategies available that would help you actually take advantage of that inflation to your benefit?

There are strategies that have been implemented for over a century.

Now, let’s get back to the banks…like what Key Bank is doing. The banking system received an unbelievable amount of [printed] money (inflation Step #1) that our government created when TARP was passed. We’ve discussed before but do you remember Step #2 that is required for inflation to take hold? Step #2, the printed money has to be circulated. You starting to put this together?

  • Did the banks circulate those monies initially? No they didn’t, at least not very much of it.
  • Even though they didn’t circulate a lot have we experienced some inflation because of those funds? Absolutely, all you have to do is go buy a gallon of milk today to see it first-hand.

Here’s the bigger problem, banks are beginning to circulate more of that money (i.e. Key Bank offering 100% financing again!). This will have a huge impact over the course of the next decade. Huge!

  • What happens to interest rates when inflation begins to roar? They go up. Remember the early 80’s after the inflationary pressures from the late 70’s?
Historical rates of great opportunity
If you don’t remember what interest rates were at that time then take a look at this graph. Opportunity? You better believe it but only if you were in a position to take advantage of it. What if all your money was in your house (equity)? Look at this graph. In 1982 would you have borrowed money at 16.08% in order to earn 15.12% for one year? Of course not.

There are always those who plan and those who do not. Over the next decade and beyond, you have the opportunity to take advantage of these opportunities but it requires one very important characteristic.

  • You MUST have access to capital, more specifically, guaranteed access to capital no matter the situation with the ability to collateralize those funds and earn a spread in a GUARANTEED and PREDICTABLE environment!
If inflation was raging right now and guaranteed rates, like CDs, were flying high, are you in a position to take advantage of it or are you currently positioned to be hurt by it? It’s a choice, not a matter of chance.
Since I’m on a roll, here’s some more questions for you
I love questions so here are a few more; however, these questions are designed for you to ask other advisors who want to invest your money. Those advisors MUST be able to provide an answer for each one these and we challenge you to ask them because, after all, it’s YOUR money and YOUR future.
  • What are you doing to do to make sure I don’t lose any money? What’s your strategy?
  • If I do lose, what’s your strategy to make back any money lost to get me back ahead of the game? What are your recommendations?
  • What impact are taxes going to have on all of this and could taxes prevent me from having a successful outcome?
  • Do you believe taxes will be higher in the future? If so, please answer the third bullet point again.
  • What strategy is there in place to keep taxes off my back going forward?
  • If you are recommending my money be put in a taxable position then please explain to me the specific reason why (especially if you believe taxes will be higher in the future) and the exit strategy to minimize those taxes in the future.
  • How can I take advantage of the pressures caused by inflation with your strategy?
  • What impact will inflation have on your strategy?
  • What is the impact of fees over time to the performance of your strategy? How can I get rid of or minimize those fees?

I hope it’s obvious by now but we have an answer, and a specific strategy, for each and every one of those questions.

You better be able to address each and every one of those. If not, then you’ll simply be one of many who didn’t plan…again, it’s not a matter of chance but instead a matter of choice.

We’d be happy to show you.

Kelly O’Connor – kelly.oconnor@mtnfinancial.com

303.578.9708

Website  –  YouTube  –  Facebook


Inflation – the Stealth Tax

December 4, 2011

Inflation will be devastating in the next decade. Part of the problem is that inflation is hard to explain and it is difficult to measure the damage it can cause to Americans’ purchasing power. Many analysts are already predicting six or seven percent inflation as early as 2013 and low double-digit inflation by the middle of the decade.

Inflation’s two requirements

First, with all the money our government has printed, why has our inflation rate only risen to its current 3.9%? Inflation has two requirements: first, you have to print the money. Second, and this is important, inflation requires velocity. The money has to circulate in the economy to increase inflation. What did the banks do? They held the money. When that money is finally circulated into our economy we will have serious inflation.

Rules of 72 and 115

How can we easily explain the damage inflation causes? Use the Rules of 72 or 115. The Rule of 72 is an accounting rule where you divide the inflation rate into 72 and it tells you how long before you need twice as much money to live on. The Rule of 115 is how long before you need three times as much money to live on.

Two examples:

  • For ease of illustration I will round the current 3.9% inflation rate to 4%. Now divide 4 into 72 and it tells you that in 18 years you will need twice as much money to live on as you do right now. So in 9 years you will require 50% more income to live at the same standard of living. Two thirds of America lives on $50,000 or less. They will need $75,000 per year by 2020 to be able to buy and pay for all the things they do now. How will they get to that higher income if average incomes are decreasing?
  • If inflation increases to 7% (and it is likely that it will), by 2021 you would need $100,000 per year of income to maintain your current standard of living. It will be almost impossible for most Americans to achieve this increase. Our standard of living will drop dramatically; that is why inflation is so destructive.

To help families be successful we must first help them understand the serious challenges of inflation. Next, we must develop strategies to not be hurt by inflation. Only then can you actually take advantage of the opportunities inflation provides. Do it NOW!

Don’t just take our word for it:

Inflation logs biggest increase since ’08 (Chicago Tribune, October 20,2011: section 2, page 3)

The Atomic Bomb that is about to explode at the Federal Reserve (Economic Policy Journal, October 11, 2011)

Millions hit by inflation (Financial Times, October 21, 2011)

Kelly O’Connor – kelly.oconnor@mtnfinancial.com

303.578.9708

Website  –  YouTube  –  Facebook


Your Baby Is UGLY!

April 5, 2011

The majority of hard-working Americans believe certain financial myths.  To attempt to correct these myths is similar to telling a mother her baby is ugly. The “conditioning” that has been experienced is frustrating, to say the least, but understandable…especially when you realize who has been doing the conditioning.

For example: why are we constantly directed to focus on the average rate-of-return?  From investment brokers, financial planners, “experts”, to our financial statements, all of these reference “the average”.  If we truly add up the numbers for each year and divide by the total number of years, does our statement really reflect a return that is the same as the average?

YOU CAN’T SPEND “AVERAGE”

There’s a popular “expert” (he’s also a radio host, TV personality, and a creator of a curriculum that dominates financial classes in churches) who always quotes the average return.  In a recent article he took the inputs of the S&P 500 from 1990 to 2009 to get a 10% average. Mathematically he’s right.  He then claimed that your investments would have performed at 10% for each year during that time.  Mathematically he’s wrong.  Again, this is like telling a mother her baby is ugly.  It’s hard for most people to understand that the “average” is just a number but the “actual” return is what their statement reflects.

Let’s use the above example.  Between 1990 – 1999 the S&P 500 averaged 19% and between 2000 – 2009 it averaged 1%.  Add the decades together for a total of 20% and divide by two to get 10%…this is exactly what this supposed “expert” did to prove his point about how well you will do if you just “stay in the game”.  Now, let’s take $100,000 invested from 1990 to 2009 with an actual 10% rate of return (meaning you actually get a 10% return each and every year).  How much do you have?  You’d have a balance of $672,250.  Nice job.

THE ROLLER-COASTER

Now, what would have happened if you actually rode the roller-coaster, took the losses and took the gains during that exact same time period?  Your balance would actually be $473,000 which represents an 8.08% rate-of-return (this assumes no fees and no taxation of course).  You see, you don’t earn the average.  Look at this example: Year 1 = 100% gain.  Year 2 = 50% loss.  Year  3 = 100% gain.  Year 4 = 50% loss.  What’s the average?  25% (100-50+100-50 / 4).  If I follow the logic from our expert and I invest $100 for four years at an average of 25% then my balance should be $244.  But, if my money was ACTUALLY in the market then Year 1 my $100 becomes $200 because of the 100% gain.  Year 2 I take a 50% loss so I’m back to $100.  Year 3 I again enjoy a 100% gain and have $200.  Year 4 I take another 50% loss to get me back to $100…right where I started.

The above mentioned “expert” could look me in the eye and say “look, you averaged 25%” and he’d be right but yet I earned NOTHING.  Even worse than that but I probably had to pay taxes on my gains for Year 1 and Year 3 (since he only recommends mutual funds)…all this hurts me even more.  My money didn’t even keep up with inflation but in fact it lost!  Would you be surprised to know that if you take a very conservative tax calculation and only 1.5% in fees that your actual rate-of-return would equal 4.72%?  It’s true.  Your statement wouldn’t show $672,250 at the end of year 20 but instead $251,590.

YOUR BABY IS UGLY

Folks, you have to ask yourself two questions:

  1. Who’s teaching you to focus on the average rate-of -return?
  2. Do you truly believe that they have your best interests at heart?

Seriously.  If you say “no” then are you willing to be told your baby is ugly?  Would you maybe reconsider a rate of 6% with no fees and taxation?  Which would you rather have, the $100 after four years or $126?  It doesn’t take much once you understand the impacts of losses, fees, taxation, and most important, the lost opportunity costs of all three.

Ordinary people CAN create extraordinary wealth.  It’s not just a game for those “with the money”.  You just have to learn how to get control of your money and we can show you how.

Kelly O’Connor – kelly.oconnor@mtnfinancial.com

303.578.9708

Website  –  YouTube  –  Facebook


Owning A Home: The Most Misunderstood American Dream #5

January 25, 2011

I made the statement on a previous post that if you think proper mortgage planning is primarily about the amount of interest you pay (i.e. Dave Ramsey) then you’re hugely mistaken.  So what else is there?

Please read Ramsey’s link above. It is important to understand this type of conventional thinking.  It’s a wonderful mis-direction that ironically benefits the bank the most.

So, let’s look at it from the bank’s perspective: remember, they do NOT have your best interests at heart but instead their priority is to make a profit for their shareholders.  So, get ready for the “bigger box” here folks.  This is data that you must understand in order to properly address the answer to the question: “Which mortgage strategy produces the least amount of wealth transfer (a video link) for me personally?”

30 Year vs. 15 Year

This one is fun.  The old 30 year vs. the 15 year mortgage.

So let’s start with a couple of questions. You’ve heard this one already: do the banks have your best interests at heart?  If you answered that “no” (which you should have) then have you ever thought about why the bank offers you a lower rate on a 15 year mortgage than a 30 year?  Please don’t just skim over that question.

If they [banks] are in the business of collecting interest then why would they possibly provide an incentive to a borrower in order to bring in LESS interest?  This is the key component to Dave Ramsey’s advice (go 15 year because of the interest savings).  So please answer me that previous question.  Here it is again: Why would they give you an incentive to pay them LESS?

First, if you haven’t read our “Defining Moments” blog posts then please do because the first one plays a major role in this discussion.  We’ve even recorded some videos on this – watch this one: Banks and the Velocity of Money.

You see, Defining Moment #1 states that your money will never be worth more than it is today…due to inflation.

So, your money will never have as much buying power as it does today, and banks need money to move and recycle (preferably at a high value), and they offer a lower rate for you on a 15 year, and they advise you to pay it off by accelerating your principle payments.  Interesting.

Would you believe that banks make far more money on a 15 year mortgage than a 30?  They either collect interest for 30 years or they get your most valuable dollars sooner and spin that money out again and again about 5 to 7 times…note the discounted rate.

Math Behind Defining Moment #1

Let’s simplify this a little and use Dave Ramsey’s example from his link above.  If this month was your first payment on a new 30 year loan at 6% and your payment is $1,349, how much is that $1,349 worth when you make the last payment at month 360 assuming an inflation rate of 3.5%?

Only $481. How much is that $1,349 worth at month 180 (end of year 15) assuming the same inflation rate of 3.5%?

$805…over 65% more valuable than the last payment at month 360. You see, because of inflation, our fixed monthly payment slowly loses buying power.  Which do you think the bank would rather have?

  1. Your money stretched out over 30 years where the value and buying power of that fixed payment continues to decline as it comes back in to their coffers to re-lend? Or,
  2. Your money condensed over a shorter period where the money retains as much buying power as possible for them to use again and again and again?

Hmm.  Seems pretty simple to me once you apply some math and the first Defining Moment. But there’s even more.  Folks, this is where the real math gets good. I will provide links to spreadsheets, past blogs and even video to back up every calculation in this post so please check’em.  I always say that math proves Mr. Ramsey wrong and I’ll prove it to you so stay with me because this could be a little long…if anything, I ask you to challenge me. Actually, challenge yourself.

Life Happens

Okay, first a quick comment to Ramsey’s human behavior issue. In the link above, his first argument against the 30 year mortgage is the claim that “life happens”.  He says:

“You might decide to keep that extra payment and take a vacation. Or maybe it’s time to upgrade your kitchen. What about a new wardrobe? Whatever it is, you’ll find an excuse to spend that money somewhere else.”

First of all, if you don’t have discipline then you are not a candidate for any financial plan except a plan of failure.  Maybe this is why one of Dave’s top executives told me over the phone that 80% of you are financial idiots.  Here’s my issue, why wouldn’t Dave make the same claim about those who take a 15 mortgage and pay it off; after all, these people have to then make every equivalent “mortgage payment” to their savings for another 180 months (15 years).  Won’t this same “life” happen to them?  Won’t they decide to take a vacation or get a new wardrobe?  Ask any sociologist and they will tell you that you have to apply the same conditions and outside forces in your test in order to get an accurate result. The “life happens” issue is therefore a non-issue because it applies to both parties.

JACK and JILL

With that being said, here are the conditions: JACK has a 30 year mortgage, $225,000 loan amount, interest rate of 6% and a monthly payment of $1,348.99. JILL who has a 15 year mortgage, $225,000 loan amount, interest rate of 6% and a monthly payment of $1,898.68. Again, these are Dave’s numbers from above.

The monthly payment difference between the two is $549.69.  JACK invests the $549.69 each month beginning Month 1 until Month 360 in an account that earns 6% and JILL invests the entire $1,898.68 beginning Month 181 thru 360 (had to pay her mortgage off first) in the same account that earns 6%.  Who’s ahead at the end of 30 years?

Ramsey would make you believe that JILL is better off because she paid less interest and had more to invest.  The answer: they are identical at Month 360.  JACK would have his home paid off and an investment account balance of $552,171.  JILL would have her home paid off and an investment account balance of $552,171.

They are the exact same but who is in a better position along the way to ward off “when life happens”?  JACK. All of JILL’s money is tied up in her house.  “But JILL has an emergency fund.”  So does JACK and his is much bigger.  Let’s go deeper.

What happens if they could earn 8% in the investment account (also known as a ‘side fund’)?  Well, JACK would now pull ahead.  His account would total $819,234 at the end of year 30 and JILL would have $657,015.  That’s interesting. As the side fund begins to achieve a higher rate of return than the mortgage then JACK begins to win big.

Average vs. Actual Rate of Return

Now Dave Ramsey tells his followers that they can expect a 10% average rate of return (Average ROR is garbage by the way and you must educate yourself on this and understand the Actual ROR).

So what happens if JACK and JILL both get a 10% rate of return?  JACK ends up with $1,242,566 and JILL has $786,946.  That’s a difference of $455,620!  Wait, I thought we should be focused on what the bank makes on our 30 year loan?  Unbelievably unwise!  Let’s go even deeper.

You might be saying, “But Kelly, in all reality, I can get a lower rate on my 15 year loan so your math is wrong. “  First, that was Dave’s math since we used his example but let’s look at it using a lower rate.  Let’s use rates as of today (January 24, 2011) according to Yahoo Finance.  A 30 year mortgage is averaging 4.82% and a 15 year is averaging 4.09%.  Perfect. Now that is a serious discount provided by the bank that does not have our best interest at heart.

Seriously?  That Can’t Be Right.

Using these real market rates, what rate of return does JACK need to get between Month 1 and Month 180 (remember, he’s saving the monthly payment difference) in order to have enough in his side fund to write the check if he wanted to payoff his 30 year mortgage at the end of the 15th year?  Take a guess.  Come on, don’t read further, take a guess!

After 15 years, a side fund rate of return of 4.47% net after tax will provide an account balance of $151,413.  The loan balance on JACK’s 30 year mortgage after 15 years will also be $151,413. These results are for a tax bracket of 31%.  That doesn’t sound too risky to me…only 4.47%.

Now I know what most people say, “You should never put this money at risk because what if you lost it all?  What if the market tanked?”

They’re right!  What?  Yep, you should not play this game in a risk-based environment because you could lose it all and be stuck with a mortgage that you couldn’t afford if your savings was depleted.  This has happened and many people have lost their home.  I know Dave likes to say, “Only homes with mortgages go into foreclosure.”  So, how can we combat this point?

Here’s the kicker, what if you could get the 4.47% in a guaranteed and predictable side fund? Meaning you COULD NOT lose your money.  No risk.  Would that make any sense for you? Of course it would and it exists today.

Here’s a better question: assuming the side fund actually gets a return of 8%, when will its balance be adequate to pay off the 30 year mortgage? If we only need 4.47% then an 8% return should be much better.  It is.

JACK Wins!

If the side fund returns 8% net after tax it will be larger than the 30 year mortgage balance in 13 years and 3 months (a total of 159 months).

What about the tax savings?  JACK continued to save until Month 360 for a total of $62,297 and JILL stopped receiving her tax benefits after Month 180 giving her a total of $23,685. If you read enough of my blog you know it doesn’t end there. You see, a penny saved is not only a penny earned but also a penny that CAN earn.  JACK’s $62,297 (that he did not have to pay to the IRS) over the 30 years at 8%, earned his portfolio an additional $327,557.85.  JILL’s tax savings over 30 years (remember it stopped after year 15) earned her an additional $176,537.96.

Taxes are the largest wealth transfer anyone faces and the second is mortgages.  Now, I’m confident that you, the reader, do all you can do to minimize your taxes.  I’ve yet to meet someone who pays a tax they don’t have to pay.  I’m sure you’ve even hired a professional to help you pay as little as possible in taxes.  It’s time you took a look at the second largest transfer of wealth – your mortgage.  It can literally mean hundreds of thousands of dollars to your family…or, you can keep allowing the bank to win.  If what you knew to be true turned out not to be, when would you want to know about it?

Math proves every time that JACK can pay off his mortgage quicker with a 30 year mortgage than a 15 year using the exact same monthly outflow as JILL. It also proves that even in a guaranteed and predictable environment he comes out ahead. You see, you can accomplish this with no risk.

Malcolm Forbes very wisely said, “The dumbest people I know are those who know it all.”  Don’t be that person, it’s not worth it.

I’d like to end with this great bit of wisdom from my buddy Dave Ramsey:

“If you think you’re getting a better deal with a 30-year mortgage simply because you save a few hundred bucks each month, then you’re only thinking short-term.”

Seriously?  Short term?  Unbelievable.  Since when is 15 and 30 year time frames “short-term”?

My clients, friends and family learn the truth and are ahead of the game year after year.

I’d value your comments and challenges to the math.  More importantly, I just hope you decide to challenge your own thinking and be willing to look at your own situation.  After all, it’s only your financial future you’re dealing with here.

We call this Financial Caffeine because you get An Edge On Education.

Kelly O’Connor – kelly.oconnor@mtnfinancial.com

303.578.9708

Website  –  YouTube  –  Facebook


The Velocity of Money #2

September 13, 2010

Do you remember the scene in the movie “Miracle” about the 1980 Olympic Hockey Team when coach Herb Brooks told the young men that today was NOT going to be the day that the Russian team would win?  It was a defining moment for that team.  Well, we talk about financial Defining Moments.

I don’t care how successful you are, if you do not understand how these financial Defining Moments effect you as you accumulate, preserve, and certainly as you distribute your wealth…well, then today they’ll probably beat you.

Defining Moment #1 is, “your money will never be worth more than it is today.” That sounds really simple and if you think about it, you’ll agree that EVERY financial institution masters this one lesson. Because of this, they also understand the phrase “the velocity of money.”

Money that doesn’t move or have velocity is like money that is stuffed in a mattress; it doesn’t create wealth or profits. To give you an example, the average bank in the United States spends a dollar about five and a half times. Have you ever thought how they do that?

Wouldn’t you love to spend YOUR dollar 5 ½ times?  Well, it’s simple.  First they TOTALLY embrace this Defining Moment.  You see, they take money, and it is not even their money, that is deposited in their bank and lend it to other people.

These people who borrowed the money make payments back to the bank and pay interest. The bank then takes those monthly payments and lends that money out again, over and over. This process continues repetitively about five times on each dollar they touch.

The collection of interest alone is very profitable for the bank. But they understand one rule that creates more profit for them than just collecting interest. They understand that MONEY WILL NEVER BE WORTH MORE THAN IT IS TODAY.

Due to inflation the buying power of a dollar decreases over time. The buying power of $1,000 today with a 3% inflation factor built in will have the buying power of only $412 in 30 years. The banks and lending institutions understand this clearly and they may even encourage you to make additional monthly payments on the money they lent you.

Wait a minute Kelly, I thought that I should pay extra to lower my interest expense?

Well, if you understand and, more importantly, apply Defining Moment #1, then maybe you should ask some questions.

More Financial Caffeine coming your way.

Kelly O’Connor – kelly.oconnor@mtnfinancial.com

303.578.9708

Website  –  YouTube  –  Facebook