Financial Advice for All Life's Creeks

Category: Create a Clear Creek Financial Life

Basics of Life Insurance

Listen to anyone trying to explain life insurance to you and it can be confusing. Variable life, term, adjustable life, universal life, second to die, whole life. Which should you choose, do you need life insurance, and how much do you need? These are difficult questions to answer but we will try to capture the issues in a nutshell.

The concept of insurance is simple. It is designed to protect against a risk, plain and simple. In life insurance, the risk is death. Insurance is not an investment. Insurance policies may have an investment component, but insurance alone is a vehicle to transfer the risk to another party.

All the policies available can be broken down into two basic types, referred to as permanent insurance or temporary insurance. Insurance in its purest form is temporary insurance, or term insurance. With temporary insurance, you pay a premium and that premium offers you protection for a specified period of time, typically one year. After that period of time, the policy will expire unless it is renewed by paying the premium for another period. Temporary insurance is cheaper in terms of current cash outlays, but the lower cost does have its drawbacks. First, the cost of temporary insurance increases as one ages. Insuring a 25 year old is less of a risk than insuring a 50 year old. Second, coverage may no longer be available at a specific age, typically 65. Finally, temporary insurance offers no wealth accumulation, which is the primary difference between temporary insurance and permanent insurance.

Permanent insurance offers the basic protection of term insurance and includes an investment component, called cash value. The annual premiums for this type of insurance are higher than temporary insurance, but a portion of the cash outlay is invested in a savings vehicle. Over the years, the cash value increases due to additional contributions and investment earnings. Eventually the investment earnings are adequate enough to cover the premium associated with the insurance component, and at that time cash outlays can be reduced or eliminated and the insured is afforded “permanent” insurance protection. It is important to remember that the insurance component of permanent insurance is still a term policy. The premiums increase as the age of the insured increases.

However, if the earnings of the cash value are adequate, the cost of the premium is offset by the investment earnings. In theory, if all goes according to plan, the insured is left with an asset in the form of the cash value and insurance which is paid every year from the investment earnings. Two other benefits associated with permanent insurance deal with renewal and taxation. Permanent insurance policies can extend beyond the age when temporary insurance ceases, age 65. This provides insurance available for estate planning purposes. The other main benefit associated with permanent insurance is that the increase in cash value is not currently taxed, so the investment earnings are tax deferred. Finally, permanent insurance policies have varying features designed to increase the choices of the underlying investment and to provide the insured with flexibility in adjusting the premiums on an annual basis. These variations are known as Universal Life, Variable Life, or Adjustable Life.

Which type of insurance should you consider? As in all cases, the answer is “it depends”. One issue is whether or not you can afford the premium. Temporary insurance is cheaper and it is more important to have the insurance protection than the investment component. Another issue is how much insurance you require and whether you need that protection after age 65 for estate planning purposes. It can be argued that even though the premiums for temporary insurance increase as the insured gets older, the need for life insurance is less if the insured has accumulated assets during his lifetime. In effect, the insured becomes self insured. For example, if the life insurance needs to provide protection for the survivors are $500,000 and if the insured has liquid assets of $500,000, then the need for insurance is $0 (this, of course, ignores the dreaded estate tax consequences, if any). Another issue to consider is the underlying investment in the permanent insurance policy. The insured needs to evaluate that investment compared to other investments including commissions, expenses, risk and income taxes.

Now that you are understand all the issues, the remaining question is how much life insurance do you need. This is a separate discussion.

How Much do I Need to be Able to Retire?

We have talked about many retirement planning issues. It is time to determine how much money do you need in order to be able to retire. Many factors influence the retirement decision; however, we have assembled a table that will highlight some parameters and provide some guidance.

Assumptions:

Annual Income $70,000
Inflation 3.5%
Earnings Rate 12.0%
Life Expectancy 90
Years in Retirement 50 40 30 20
Total amount Needed Today $904,529 $883,107 $835,942 $732,095

The analysis assumes that at life expectancy (the last year of retirement), the balance in the savings account is 0. (You better hope you are not around.) Also, all assumptions need to materialize as expected (not likely). Finally, the analysis assumes that each withdrawal occurs at the beginning of the year (i.e. You need to eat during the first year of retirement).

You Just Received a Windfall – What Do You Do?

Putting together this article was really inspired by a friend of mine winning the lottery. There are scenarios that happen every day to a lot of people. They receive an inheritance, a big bonus at work, a raise or they win the lottery. There’s a lot of stress and anxiety that can accompany the joy of receiving a big chunk of money.

There’s a number of things that you need to do when you find out about the money. The first and most important thing that you should do is relax, take a deep breath and think about it for a bit. A year ago when I inherited some money from my father I went thru this. The amount that I got is a fraction of what my friend won in the lottery, but figuring out what to do is on everyone’s mind.

The first thing that you need to do is determine whether the amount that you are receiving is material. A material amount of money is really going to be different for everyone. Receiving a million dollars to Bill Gates or Warren Buffett doesn’t mean as much as it does to Joe the Plumber (for those of you that remember him). What you will end up doing with the money will be very different if the amount is a significant amount of money or just a ‘good’ amount of money. In all honesty, what I am going to recommend doing with the money really isn’t that different if it’s significant or not. The only real difference is the amount of risk that you take in step 3 below, not really in steps 1 and 2.

Step 1 is to look at your debt. There’s what we will call good debt and bad debt. Bad debt would be anything today that has an interest rate above 7%. At some point in the future what would be considered too high an interest rate might change but as of October 2016, let’s call it 7%. The first thing you should do is pay off as much of this bad debt as you can. In the short term it won’t be as satisfying as buying a new car, but from a personal financial perspective, this is the best thing that you can do. Having a mortgage and a car loan (depending on how much it is and how much you make) is perfectly fine and normal to have. With the low interest rates of today (sub 5% for car loans and sub 4% for home loans) playing with the banks money is a great use of your own money.

Step 2 has to do with your emergency fund. I agree with all of the financial advise that you need between 3 and 6 months worth of expenses readily available to cover any unforseen problems. My general opinion is more along the lines of 6 months rather than 3 months, so setting aside what you are comfortable with is your next step in easing your mind. If you’re unsure of what this amount might be and you want some rules of thumb, i would say that you should have 12 times your housing payments set aside. Again, every financial situation is different, but the cost of housing to most people is their largest expense that can take 1/2 of what an individual or family makes. The 12-times rationale takes this into consideration. Again, look at your situation and think about what you are comfortable with.

As much as I’m a finance guy, I also understand that there’s some basic human instincts that have to be considered here. Taking the above 2 steps might not make you feel good about receiving this windfall of money, so if you want to go buy yourself a present, by all means, go ahead. My only point right here is that you might feel good about things initially, but in the medium or long term, you might think otherwise.

Step 3 gets you to the ‘how do i invest‘ question. Here is where you have to stop and think about just how significant an amount of money this is to you. For arguments’ sake, I will say that if you receive in excess of $100,000 we will say that the amount is significant, anything less will be considered a ‘good’ amount. The reason that I will talk about these differently is because the more significant the amount of money, the less risk you should take with it. You should take less risk largely because you might not need to take as much risk to achieve your long term financial goals. When i was talking to Mr. Lottery, I had pointed out that if he had a portfolio of $1.5 million, he should expect to generate $30,000 a year alone in dividends — if they were to invest everything in an ETF that tracks the S&P; 500. This reflects the historic average of 2% per year return in dividends. [note – over the last 10 years, the actual return has been a little under 2.2%.] On top of this 2% per year is potentially another 5.2% in S&P; 500 returns excluding dividends for a total return of 7.2% per year (if you reinvest the dividends). This comes to $108,000 a year on that $1.5 million portfolio.

Let’s keep something in mind — your emergency fund that you set aside in step 2 above does NOT get invested. This stays in something like a money market fund, a CD or simply in a bank savings account.

With your decision for what to do when you invest, as a general rule of thumb, i typically recommend to people that they invest in ETFs (exchange traded funds) or Mutual Fund Index Funds with extremely low expense ratios. This allows you to keep as much money for yourself rather than giving it away to people that aren’t going to beat the market. For simplicity, I’ve found 3 ETFs that I find represent three different chunks of the US stock market – VB, VO and VOO. VB is the Vanguard Small-Cap ETF, VO is their Mid-Cap ETF and VOO is their Large-Cap ETF. If you know nothing about stocks or investing, I suggest you use these 3 funds and adjust your risk between them. If you truly know nothing — put 1/3 into each of them. If you’re young or can tolerate risk, put a little more into the small-cap fund and a little less in the large-cap fund. If you are inclined to invest in some bonds, which most financial advisors recommend, the iShares ETF AGG is an investment grade aggregate bond fund that can cover you on non-municipal bonds.

As I’ve mentioned, most financial advisors recommend certain asset allocations depending on your risk profile. This basically means that they recommend investing some in stocks (equities) and some in bonds. This helps you spread risk out. Many rules of thumb include 60-40 (60% equities and 40% stocks) is one of the most popular. If you’re younger and less averse to risk then maybe a 70-30 split is for you. This all depends on you and the only person that can really answer how things should be allocated is you. If you truly have no idea, then go with one of the two rules of thumb, 60% stock and 40% bond after age 45 and 70% stocks and 30% bonds if you’re younger is a good way to think about it.

So here’s what you do with your windfall (in a nutshell) — take 60% of the money and put 1/3 each into VB, VO and VOO, then take the remaining 40% and put it into AGG. I’ll get into some more complex asset allocation strategies in another piece soon, but for those that are getting started and dont have time to “think things through”, this is a fast and easy way to answer this question.

How to Invest in the Stock Market When You Don’t Have Money

Most people think the stock market is only for the wealthy. In fact, I felt the same way until recently. I thought I needed thousands of dollars to start investing. That’s what the movies tell us, right? Only people who have thousands of dollars lying around can reap the benefits of investing in stock.  

This myth holds many people back from making a responsible (and sometimes fun) financial decision. It’s understandable – why would you throw money into a black hole without knowing what will come out? Here’s the thing about that: You can make tiny, tiny investments if you want. Some stocks trade at just $5 a share. You won’t become a millionaire overnight with a small portfolio like that, but it’s a great way to start learning more about investing. Maybe, eventually, you’ll make larger investments, and then we can talk about becoming a millionaire.  

So, how do you invest in the stock market with limited discretionary funds? Here are a few tips. 

Work with What You Have 

The stock market will require you to save some money. Not necessarily thousands of dollars, but some. You don’t want to dip into emergency savings or cut your food budget in order to make a small investment. Keep your change for a few months and add it up. Cut a few subscription services out of your budget and see how much it comes to. You can invest on your own, with an app like Robinhood, with no minimum, but you’ll need to start somewhere.  

Ask Your Employer 

You know that 401(k) plan your employer helped set up? That’s the easiest way you can get into the stock market. It’s typically handled through the employer, and you can put investing on autopilot, but it’s a start. This is a great way to start investing with no money, and you can set up automatic payment transfers to ensure you’re contributing every month.  

Invest with an App 

Financial tech is making it easier to invest in the stock market without the help of a professional. These apps, known as micro investing apps, can help individuals invest small amounts of money in small stocks and index funds, growing wealth as passively or actively as you want. I’ve already mentioned Robinhood, but Stash Invest and Stockpile are similarly popular options.  

Don’t Give in to Excuses! 

Figuring out the stock market can be difficult, especially if you’re new to financial literacy. That said, this stuff is pretty easy once you get the hang of it. Start small and use it as a learning tool. Then, when you’re ready, make larger investments and see what happens! 

Quick Tips for Beginning Your Student Debt Payoff Journey

Close to 50 million Americans have some form of student loan debt, totaling close to $1.5 trillion at the end of 2018. For the first time in history, this debt is higher than credit card debt or auto loans. All of this is to say that if you have student debt, you’re far from alone – but that doesn’t mean you should ignore it. 

It can be easy to delay paying down debt. It might feel like you have so much to do that you’re unsure of where to go first. Confidence is key to any financial decision, and paying off debt is a huge, identity-shifting experience. That said, there are a few ways you can start the process, which will then turn into good habits. Eventually, you’ll achieve financial freedom.  

Start a Change Jar 

It sounds dumb, I know, but it’s a start. Set a jar out on your dresser and collect all your loose coins at the end of the day. That’ll eventually accumulate into something bigger, which you can then deposit at the bank. This is a great idea if you’re still in the grace period between graduation and debt repayment. Maintain this jar for those 6 months and use what you’ve collected to make your first loan payment. It’ll make the process seem easier and the payments themselves more attainable.  

Consolidate 

Interest is one of the biggest challenges to paying off student debt, but the less you pay in interest, the more you can put toward the balance itself. Consider consolidating your debt to achieve a lower rate. This will also make it easier to balance multiple payments, as you’ll have only one bill to deal with each month.  

Re-Work Your Budget 

It might not be fun, but you should prioritize your student loans every month (after household expenses, of course). Spend some time calculating your budget. If you can stand to cut a few dollars from going out expenses, or maybe food, put that money toward loans instead. There is always a cheaper way to shop. 

Cancel Unused Subscriptions 

There’s no sense in having a membership or subscription if you don’t use it, especially if you could use that money to pay off debt. Go through your bank statements to see how many subscriptions you have, then total them up. If you only use Netflix to watch a movie once every month, it might be time to cancel.  

What Determines a Mortgage Interest Rate?

As a matter of fact, it is universally accepted that the higher a person’s credit score is, the lower the risk that person poses to a lender and therefore the lower rates of interest that person will receive with credit. On the flip side of the coin, the lower a person’s credit score, the higher risk they pose and the higher interest rates will be for credit applications. 

The same rings true for all credit applications, whether it is for a car, credit card or mortgage. While different countries and credit agencies employ different credit ratings and scales to determine a person’s credit score, they all have the above risk to reward ratio in common with lenders credit terms. 

To find out the level of interest and monthly repayments on a particular mortgage for a certain individual, firstly a credit report should be ordered from one of the main credit agencies such as Equifax or Experian. Once the credit score has been determined, research on the Internet will uncover the typical APR rates from various lenders to people with similar credit scores. These, while not exact, will give a good indication of expected rates and terms. 

Using the FICO scoring model as an example; if a person’s credit score is between the 490 to 580 region, mortgage interest rates are likely to be about four points higher than the best rates available. At the 581 to 620 level, rates will improve to about 2.20 points higher than the best mortgage rates. From 621 to 660 there will be about a 1.5 point difference and then between 661 to 700 only a difference of 0.5 points, this lowers to 0.25 points at 701 to 760. At the maximum ‘prime’ section of the credit scale of 761 and above, the interest rate on a mortgage will be the best that is available on the market. Please note that the above figures are all approximate and to be used as a guideline only. 

Understanding a Deed in Lieu of Foreclosure

Should a person find themselves in financial difficulty for whatever reason, whether it be through redundancy, illness or another factor and they cannot maintain their mortgage repayments, that person may consider a ‘deed I lieu of foreclosure’ should they be unable to either sell their property or work out a plan to resolve the situation. 

If a deed in lieu of foreclosure is arranged, it negatively affects the borrower’s credit score by as little as 50 points to as much as 250 points depending on the credit bureau that it is reported to. This is a major deduction of a person’s credit rating similar to that of bankruptcy and will have short and long term consequences on the credit available in the future. When a deed in lieu of foreclosure is reflected on a credit report for seven years. The impact of the deed in lieu does diminish over time, however credit applications within the first two years especially could be difficult to come by and offer high interest if they are agreed. Once the deed in lieu is seven years old, the entry can be requested for removal by the client by notifying the relevant credit bureaus. 

A new mortgage is an unlikely scenario for a person with the deed in lieu of foreclosure within the first two to three years of the entry being added to the person’s credit report. However the credit file can still be repaired by keeping existing or new credit products in good stead. For example by making payments on time and not meeting or exceeding credit limits. By doing this in the duration of the initial two or three years since the deed in lieu, the probability of obtaining a new mortgage at that time will be higher and more favourable interest rates and terms will likely be offered. 

A deed in lieu of foreclosure could mean the single biggest significant drop on a person’s credit score. Even premier credit scores of 850 may reduce to a level of 600 should this happen and though a score of 600 would attract Subprime lending, due to the deed in lieu entry on the credit history, this could prevent lending altogether, even with an average credit score. 

Powered by WordPress & Theme by Anders Norén