By Bert Whitehead M.B.A, J.D. © 2012
Taxes are the biggest debate this election year. Will there be a change passed for next year? Looks doubtful, eh? And if there's no change, we go back to the tax rates of 2002. That means the top rate goes to 39.5% from today's 35%, and other changes reappear which will increase income taxes across the board. Even if a tax bill passes, it will likely include a tax increase.
For those who want to position themselves financially for a higher-tax world in the future, there are two items to consider:
1) The tax deduction for charitable contributions is likely to be reduced or restricted after 2012. This could affect the advantages of using a Donor Advised Fund (DAF) for philanthropy. The Wall Street Journal article, “Invasion of the Charity Snatchers!” covered this on Sat. June 6 and referenced me therein (http://online.wsj.com/article/SB10001424052702303296604577450451929765874.html).
2) 2012 will be the best year to convert IRA's to Roth IRA's for many taxpayers who are likely to be in a lower tax bracket now than future years.
The tax planning strategy consists of contributing highly appreciated stock to a DAF before December 31st of 2012. Under current rules, this will avoid the tax on all the appreciation and provide the taxpayer with a charitable deduction for the full market value of the stock. For example, suppose that a taxpayer purchased stock years ago for a low price of $2 per share and it is worth $42 per share today. There is an unrealized capital gain of $40/share. If you hold 1,000 shares, the capital gains tax on the $40, 000 based on current legislation (15% federal) will be $6,000. This tax is avoided by making the donation.
In addition to this savings, the taxpayer will also receive a charitable deduction for the full $42,000 market value of the stock. This will save a taxpayer in the top bracket (35%) $14,700 in 2012 income tax.
The taxpayer can simply save these tax dollars, or they can be applied against the cost of a Roth IRA conversion. If the taxpayer chooses to convert $42,000 of an IRA to a Roth IRA they can do so for no additional tax cost because the additional taxable income of $42,000 for the Roth conversion will be offset by the $42,000 charitable contribution deduction.
To review the full discussion on the current rules on converting IRA's to Roth IRA's, please see Bert's Blog on Roths from 3/2/10(http://bertwhitehead.blogspot.com/search?q=Roth).
Our analysis shows that the taxes saved by having your retirement money grow tax-free in a Roth would fully offset the taxes paid now to convert the funds in seven years. So by paying taxes on the IRA money now, you could increase your after-tax retirement income by 13% to 28% for the rest of you and your spouse's lifetimes!
There are still six months left to implement this strategy, and it is somewhat complex. If you are interested, call your Cambridge advisor to discuss it. All members of the Alliance of Cambridge Advisors (ACA) know how this can be set up and can assist you in the implementation.
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
Friday, June 15, 2012
Thursday, April 26, 2012
Faith and Fiat Money
By Bert Whitehead M.B.A, J.D. © 2012
"Fiat Money" is commonly defined as money that has no intrinsic value and cannot be redeemed for specie or any commodity, but is made legal tender through government decree.
I have heard "Faith" defined as the belief in the experience of others.
This sums up our long-term economic dilemma. Since Nixon ended the convertibility of dollars to gold to combat inflation, the U.S. has given up any pretense of backing the dollar with gold or any commodity. So the currency we carry in our wallets and purses is essentially only slips of paper with pictures of dead white guys.
U.S. dollars are nonetheless respected and used globally as the world reserve currency. This only persists because everyone believes the dollar has value and can be used by people to buy things. Thus, we have faith that we can spend dollars to buy what we want. So far, so good.
But what happens if people around the world stop believing this? How could this scenario unfold? What can you do to protect yourself? This is the scare tactic that gold advertisements trumpet to entice people to protect themselves by buying gold as an investment.
There are over a hundred instances throughout the centuries during which governments issued paper money and backed it by a commodity, usually gold. "Fiat" paper money has never, however, lasted more than a few generations. Gradually these rulers or their successors could not resist printing more money to increase their spending to finance wars, or cover desirable social objectives. By decree they declared an increase to the legal currency even though they did not add enough gold to their reserves. This became known as Fiat Money.
Once merchants realized that they couldn't convert their money and receive the amount of gold they expected, they raised their prices. Inflation results when too much money chases fewer goods and services. In the 1970's this global issue was addressed by allowing currency values of each country to 'float' against other countries.
Government overspending is a hotly debated topic. Some economists (Keynesians) insist that there are times when it is appropriate for governments to run a deficit. They argue that, unless the government 'primes the pump' by increasing national debt, the country's economy could spiral into depression. The other side provides evidence that a government can't be trusted to ever pay off its debt. Running annual deficits will gradually debase the money and the economy will inevitably be ravaged by inflation.
Both sides of the debate can point to situations as proof that their theory is correct. Take the Great Depression, for instance. Did FDR's social economic stimulus bring our economy back to life in the 1930's, or was it really our entry into World War II that rescued the economy? Was the inflation in the 70's a result of the oil cartel raising prices, or did it arise from Nixon printing more money?
In reality, economics is not, strictly speaking, a 'science.' We can never apply the scientific method to economics since we can’t suspend a complicated global economy in time and study the effect of controlling selected variables.
Modern economists insist that the soundness of a country's 'hard' currency is not determined by how it is “backed”, but rather by whether it is easily converted into other assets. Historically, gold facilitated this convertibility, but that has been replaced by a nation's productive capacity, or gross domestic product (GDP). This seems reasonable, though it can be argued that this is a purely academic paradigm. Alas, austerity is the only known antidote to runaway inflation: we never know when our money ceases to be convertible (or 'spendable') until we can't spend it any more!
Today, for example, people would surely be hesitant to accept Greek drachmas at whatever rates their government decrees. As Argentina nationalizes private property to support their government spending programs, they should expect that the rest of the world will increasingly distrust the value of their peso. All countries that ignore economic realities are eventually exposed as their 'soft' currency starts trading on an internal 'black market.' The 'black market' sets the true value of their currency, irrespective of what the government decrees.
The take-away of this blog is simple: Currencies today do fluctuate in value. Trying to guess which one will go up next is not investing: it is gambling. Gold can be comforting if you can't sleep, but don't bet your retirement on it.
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY
"Fiat Money" is commonly defined as money that has no intrinsic value and cannot be redeemed for specie or any commodity, but is made legal tender through government decree.
I have heard "Faith" defined as the belief in the experience of others.
This sums up our long-term economic dilemma. Since Nixon ended the convertibility of dollars to gold to combat inflation, the U.S. has given up any pretense of backing the dollar with gold or any commodity. So the currency we carry in our wallets and purses is essentially only slips of paper with pictures of dead white guys.
U.S. dollars are nonetheless respected and used globally as the world reserve currency. This only persists because everyone believes the dollar has value and can be used by people to buy things. Thus, we have faith that we can spend dollars to buy what we want. So far, so good.
But what happens if people around the world stop believing this? How could this scenario unfold? What can you do to protect yourself? This is the scare tactic that gold advertisements trumpet to entice people to protect themselves by buying gold as an investment.
There are over a hundred instances throughout the centuries during which governments issued paper money and backed it by a commodity, usually gold. "Fiat" paper money has never, however, lasted more than a few generations. Gradually these rulers or their successors could not resist printing more money to increase their spending to finance wars, or cover desirable social objectives. By decree they declared an increase to the legal currency even though they did not add enough gold to their reserves. This became known as Fiat Money.
Once merchants realized that they couldn't convert their money and receive the amount of gold they expected, they raised their prices. Inflation results when too much money chases fewer goods and services. In the 1970's this global issue was addressed by allowing currency values of each country to 'float' against other countries.
Government overspending is a hotly debated topic. Some economists (Keynesians) insist that there are times when it is appropriate for governments to run a deficit. They argue that, unless the government 'primes the pump' by increasing national debt, the country's economy could spiral into depression. The other side provides evidence that a government can't be trusted to ever pay off its debt. Running annual deficits will gradually debase the money and the economy will inevitably be ravaged by inflation.
Both sides of the debate can point to situations as proof that their theory is correct. Take the Great Depression, for instance. Did FDR's social economic stimulus bring our economy back to life in the 1930's, or was it really our entry into World War II that rescued the economy? Was the inflation in the 70's a result of the oil cartel raising prices, or did it arise from Nixon printing more money?
In reality, economics is not, strictly speaking, a 'science.' We can never apply the scientific method to economics since we can’t suspend a complicated global economy in time and study the effect of controlling selected variables.
Modern economists insist that the soundness of a country's 'hard' currency is not determined by how it is “backed”, but rather by whether it is easily converted into other assets. Historically, gold facilitated this convertibility, but that has been replaced by a nation's productive capacity, or gross domestic product (GDP). This seems reasonable, though it can be argued that this is a purely academic paradigm. Alas, austerity is the only known antidote to runaway inflation: we never know when our money ceases to be convertible (or 'spendable') until we can't spend it any more!
Today, for example, people would surely be hesitant to accept Greek drachmas at whatever rates their government decrees. As Argentina nationalizes private property to support their government spending programs, they should expect that the rest of the world will increasingly distrust the value of their peso. All countries that ignore economic realities are eventually exposed as their 'soft' currency starts trading on an internal 'black market.' The 'black market' sets the true value of their currency, irrespective of what the government decrees.
The take-away of this blog is simple: Currencies today do fluctuate in value. Trying to guess which one will go up next is not investing: it is gambling. Gold can be comforting if you can't sleep, but don't bet your retirement on it.
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY
Monday, April 9, 2012
Goldman Sachs Fiasco: What it Means to You
By Bert Whitehead M.B.A, J.D. © 2012
It is about time we called it like it is....The ethical standards of financiers across the board are notorious for being somewhere between lax and non-existent. This is so ingrained that most firms dealing don't even think that their behavior is errant.
Goldman Sachs is now the pimple getting squeezed by the feds. Their firm is notable in the acne scarred financial landscape only because their greed duped even their peers beyond prior boundaries. Their financial practices are held up as the cause of the current economic meltdown, but in fact Goldman's executives are not feigning surprise.
Looking back at who caused the current bubble is a charade of shady practices instilled in virtually all the players in the money game. The bubble was kicked off by the politicians in 1999 with the repeal of the Glass-Steagall act. This was pushed by Clinton and endorsed by the then-Republican congress to free banks to participate in the full smorgasbord of financial offerings. Instead of just providing savings accounts and direct lending, now they could offer brokerage services, securitize debts on the secondary market, act like venture capitalists, etc., just like the big wirehouses. It was expected that this would create more competition.
So our current tragedy was birthed by the best of political intentions which seemed like a good idea at the time. Instead, as often happens when the government tries to effectuate public policy, they accomplished the exact opposite of what was intended.
There was a strong social policy, backed by both parties (as well as Acorn), to make housing affordable to all Americans. The percentage of homeownership during the 90’s expanded to almost 70%, up from 62% in the 1980’s. Congress pressured Fannie May and Freddie Mac to loosen lending standards to accommodate the increased demand for families to own their own homes. These private mortgage companies had nothing to lose by taking more risk because they were essentially indemnified by the federal government.
Key to this was the bundling of mortgages to be sold on the secondary market. One problem, however, was there was no experience rating to judge the future performance of such an influx of sub-prime borrowers. Rating agencies over-rated these offerings using the inadequate information available, because they are paid by the folks selling these securities rather than the investors ultimately taking the risk.
This egregious conflict-of-interest has been an accepted practice for decades. Even when underwriters issuing stocks for companies were exposed, no meaningful changes were made. Instead, the brokerage companies (including not only Goldman Sachs, but Merrill Lynch, Smith Barney, etc.) simply started a new department within their firms for their ratings business. This was justified because these new departments would be insulated by a ‘Chinese Wall’ so that investors could rely on their ratings. This was not only proposed with straight faces, I’m convinced the financial executives really believed that it was ‘business as usual’ and it would still enable them to sell new offerings.
With their mortgage bundles now over-rated, it was a good time to become a mortgage broker serving sub-prime borrowers. To put it gently, most sub-prime customers are not very financially savvy. A predatory mortgage broker would befriend the customer and offer to turn their dreams into reality. The commissions earned on these mortgages typically ranged from 6% to 12% of the full amount of the mortgage. They were constructed so that they were affordable at first, and buyers were assured that they would be able to re-finance in a few years, and the home values would continue to skyrocket.
These over-valued securities started getting wobbly when investors realized that more than the expected 4-5% of sub-prime borrowers were defaulting; the actual default rate even at the beginning was 10-15%. Like a game of ‘hot potato’ financial firms rushed to offload their failing mortgage bundles, and sold them to one another, and any one else. It’s not that they actively mislead other firms, but they didn’t provide full disclosure as to the risks which were becoming evident.
But why should they have to disclose risks, or conflicts of interest? When you listen to a Goldman Sachs executive explain their innocence, it’s like listening to a life insurance or annuity salesperson explain their commissions:
“How much in commissions do you earn on this sale?”
“Why do you need to know that? It has no relevance as to whether this is a great investment for you. Letting me put your money to work will more than cover my commission!”
The real problem here is that the financial industry does not believe they owe a fiduciary duty to their clients. A fiduciary duty means they have to make full disclosure of their fees and compensation, any conflicts of interest involved, as well as all the risks involved.
Yes, I am very biased on this issue because I think financial professionals should be held to the same fiduciary standards as doctors and even lawyers. This has been proposed in recent financial reforms, but the lobbies of the institution as is see no need to change because ‘this is the way business is done!”
Good grief.
N.B. This blog was originally written two years ago. My colleagues cautioned that it was too vicious to send out, so I put it away. With Goldman Sachs back in the news in this context, I brushed it off and had some of my family, friends and clients review it again. They suggested I tone it down, but urged that it be published. So I am going ahead now.
It is about time we called it like it is....The ethical standards of financiers across the board are notorious for being somewhere between lax and non-existent. This is so ingrained that most firms dealing don't even think that their behavior is errant.
Goldman Sachs is now the pimple getting squeezed by the feds. Their firm is notable in the acne scarred financial landscape only because their greed duped even their peers beyond prior boundaries. Their financial practices are held up as the cause of the current economic meltdown, but in fact Goldman's executives are not feigning surprise.
Looking back at who caused the current bubble is a charade of shady practices instilled in virtually all the players in the money game. The bubble was kicked off by the politicians in 1999 with the repeal of the Glass-Steagall act. This was pushed by Clinton and endorsed by the then-Republican congress to free banks to participate in the full smorgasbord of financial offerings. Instead of just providing savings accounts and direct lending, now they could offer brokerage services, securitize debts on the secondary market, act like venture capitalists, etc., just like the big wirehouses. It was expected that this would create more competition.
So our current tragedy was birthed by the best of political intentions which seemed like a good idea at the time. Instead, as often happens when the government tries to effectuate public policy, they accomplished the exact opposite of what was intended.
There was a strong social policy, backed by both parties (as well as Acorn), to make housing affordable to all Americans. The percentage of homeownership during the 90’s expanded to almost 70%, up from 62% in the 1980’s. Congress pressured Fannie May and Freddie Mac to loosen lending standards to accommodate the increased demand for families to own their own homes. These private mortgage companies had nothing to lose by taking more risk because they were essentially indemnified by the federal government.
Key to this was the bundling of mortgages to be sold on the secondary market. One problem, however, was there was no experience rating to judge the future performance of such an influx of sub-prime borrowers. Rating agencies over-rated these offerings using the inadequate information available, because they are paid by the folks selling these securities rather than the investors ultimately taking the risk.
This egregious conflict-of-interest has been an accepted practice for decades. Even when underwriters issuing stocks for companies were exposed, no meaningful changes were made. Instead, the brokerage companies (including not only Goldman Sachs, but Merrill Lynch, Smith Barney, etc.) simply started a new department within their firms for their ratings business. This was justified because these new departments would be insulated by a ‘Chinese Wall’ so that investors could rely on their ratings. This was not only proposed with straight faces, I’m convinced the financial executives really believed that it was ‘business as usual’ and it would still enable them to sell new offerings.
With their mortgage bundles now over-rated, it was a good time to become a mortgage broker serving sub-prime borrowers. To put it gently, most sub-prime customers are not very financially savvy. A predatory mortgage broker would befriend the customer and offer to turn their dreams into reality. The commissions earned on these mortgages typically ranged from 6% to 12% of the full amount of the mortgage. They were constructed so that they were affordable at first, and buyers were assured that they would be able to re-finance in a few years, and the home values would continue to skyrocket.
These over-valued securities started getting wobbly when investors realized that more than the expected 4-5% of sub-prime borrowers were defaulting; the actual default rate even at the beginning was 10-15%. Like a game of ‘hot potato’ financial firms rushed to offload their failing mortgage bundles, and sold them to one another, and any one else. It’s not that they actively mislead other firms, but they didn’t provide full disclosure as to the risks which were becoming evident.
But why should they have to disclose risks, or conflicts of interest? When you listen to a Goldman Sachs executive explain their innocence, it’s like listening to a life insurance or annuity salesperson explain their commissions:
“How much in commissions do you earn on this sale?”
“Why do you need to know that? It has no relevance as to whether this is a great investment for you. Letting me put your money to work will more than cover my commission!”
The real problem here is that the financial industry does not believe they owe a fiduciary duty to their clients. A fiduciary duty means they have to make full disclosure of their fees and compensation, any conflicts of interest involved, as well as all the risks involved.
Yes, I am very biased on this issue because I think financial professionals should be held to the same fiduciary standards as doctors and even lawyers. This has been proposed in recent financial reforms, but the lobbies of the institution as is see no need to change because ‘this is the way business is done!”
Good grief.
N.B. This blog was originally written two years ago. My colleagues cautioned that it was too vicious to send out, so I put it away. With Goldman Sachs back in the news in this context, I brushed it off and had some of my family, friends and clients review it again. They suggested I tone it down, but urged that it be published. So I am going ahead now.
Friday, March 9, 2012
Financial Advisors' Hidden Conflicts of Interest
By Bert Whitehead M.B.A, J.D. © 2012
Fee-only financial advisers have long held themselves out as being more ethical than commissioned stockbrokers. Fee-only advisers claim to adhere to a fiduciary standard which requires them to act in the best interest of their clients, meaning they must set aside their personal interest and fully disclose all of their fees and any conflicts of interest.
Stockbrokers, by comparison, must meet a much lower suitability standard, meaning they must make sure that investments sold are suitable for a client. Certainly, charging a client a fee based on the percentage of assets under management reduces the conflicts of interest that a commission-based stockbroker faces when his livelihood depends on whether clients buy or sell securities. What’s more, it often appears that stockbrokers are prone to recommend investments that carry higher commissions, which need not be disclosed.
Charging clients on an AUM basis, however, often presents more serious conflicts of interests than those faced by brokers because the conflicts may involve much more money than the value of a trade. Here are some typical situations where asset-based fee compensation poses conflicts for advisers:
•When advising a client to roll over a 401(k) for the adviser to manage, even when the client has equivalent and less costly options if they leave their funds with the employer’s fund manager.
•When advising a client not to pay off a mortgage (thus diminishing assets), even when the mortgage carries a high interest rate.
•When advising against making a large charitable contribution to get a tax deduction (but decrease assets under management).
•When advising not to give large gifts to children to avoid estate taxes.
•When advising not to buy a larger home.
•When advising not to buy an annuity or set up a charitable annuity.
•When advising a client not to invest in real estate.
The most egregious conflict of interest inherent in the AUM compensation model is the common practice of charging a higher fee — often 1.5% — for managing equities than for managing bonds and cash, which typically are managed for 0.5%. Advisers routinely justify the difference by claiming that equities are more complex investments to manage, which I find self-serving: why not just charge 1.0% for a balanced portfolio? As a result of this compensation difference, clients are almost always over-allocated to stocks.
In all the cases mentioned above there may be good and impartial reasons for an adviser’s recommendation, but in all these cases and many others the temptation to protect or enhance the adviser’s own compensation is too great.
These conflicts are magnified when an adviser claims to be a comprehensive financial planner rather than merely an investment adviser. Comprehensive financial planning includes more than overseeing asset allocation and making individual investments; it encompasses all financial aspects of a client’s situation: estate planning, tax planning, insurance coverage, debt management (including mortgages) and more.
Many comprehensive financial planners who charge a fee based on assets under management often give a short shrift to other aspects of a client’s situation. After persuading a client to sign on, they may speak or meet with the client relatively rarely. This is what would be expected as people generally do what they are paid to do. If they are paid for gathering assets, that’s what they focus on.
The National Association of Financial Advisors (NAPFA) has long championed the importance of commission-free financial and investment advice. The media has recognized their contribution in exposing unethical practices fostered by commission-based compensation. Now, however, most stockbrokers and fee-only advisers (including NAPFA members) charge fees based on AUM. In terms of compensation the two types of advisers have become indistinguishable. As a pioneer and current member of NAPFA, I believe that advisers who charge AUM fees fall short what should be expected of true fiduciaries.
The current NAPFA fiduciary standard limits adviser activity to the ‘purchase or sale of a financial product’ rather than ‘any transaction.’ A clear standard should require that an adviser’s compensation not depend on any transaction where a client is relying on the adviser’s counsel. The examples of conflict of interest listed above all involve transactions that are not ‘purchases or sales’ of investments.
To avoid most conflicts of interest it is simple enough for advisers to charge a flat annual retainer fee that is not affected by a client’s decisions regarding any specific transaction. The structure of a flat fee — which may be more or less than an AUM fee — insulates the adviser from any taint of conflict attributable to compensation. This pricing model is now well established as the minority trend in the profession with hundreds of successful practices having adopted this approach.
Ironically, as common as AUM is for compensation, it is a terrible business model. By tying themselves so closely to forces over which they have little control, excellent advisers can see their annual revenue plunge by 50% in down markets even though their workload is much greater. If advisers are, in fact, providing comprehensive advice and are not being compensated directly for their services, they are providing them for free.
Nevertheless, AUM is an attractive pricing model, but for the wrong reasons. First, it is deceptive. “I charge 1.5% of assets I manage, so I only make more money if you do” is an enticing but misleading sales pitch. Most people can’t or don’t do the math, and don’t realize that 1.5% of $1 million amounts to $15,000 a year — a fee they likely would resist paying if it were transparently stated as a dollar amount rather than as a percentage. Moreover, AUM fees are deducted directly from a client’s account, and so the fee is seldom overtly seen.
A strict ethical approach would require that these potential conflicts be disclosed at the time of engagement, and again whenever an advisor’s specific recommendation may be construed as a conflict of interest. When a situation involves an egregious conflict of interest, such as advising an investment in the adviser’s own investment schemes, an adviser should be required to recuse himself and recommend that the client get a second opinion — a practice common in other professions.
If fee-only advisers want to hold themselves out as being the most ethical practitioners of their profession, they should commit themselves to adhering to the highest possible — and least conflicted — standard.
Bert Whitehead, the President of Cambridge Connection Inc. and Founder of the Alliance of Cambridge Advisors, is the author of “Why Smart People Do Stupid Things with Money” (Sterling, 2009). This was an editorial I wrote for Investment News Weekly which prompted a heated discussion in the on-line Wall Street Journal. I thought clients would find it interesting.
Fee-only financial advisers have long held themselves out as being more ethical than commissioned stockbrokers. Fee-only advisers claim to adhere to a fiduciary standard which requires them to act in the best interest of their clients, meaning they must set aside their personal interest and fully disclose all of their fees and any conflicts of interest.
Stockbrokers, by comparison, must meet a much lower suitability standard, meaning they must make sure that investments sold are suitable for a client. Certainly, charging a client a fee based on the percentage of assets under management reduces the conflicts of interest that a commission-based stockbroker faces when his livelihood depends on whether clients buy or sell securities. What’s more, it often appears that stockbrokers are prone to recommend investments that carry higher commissions, which need not be disclosed.
Charging clients on an AUM basis, however, often presents more serious conflicts of interests than those faced by brokers because the conflicts may involve much more money than the value of a trade. Here are some typical situations where asset-based fee compensation poses conflicts for advisers:
•When advising a client to roll over a 401(k) for the adviser to manage, even when the client has equivalent and less costly options if they leave their funds with the employer’s fund manager.
•When advising a client not to pay off a mortgage (thus diminishing assets), even when the mortgage carries a high interest rate.
•When advising against making a large charitable contribution to get a tax deduction (but decrease assets under management).
•When advising not to give large gifts to children to avoid estate taxes.
•When advising not to buy a larger home.
•When advising not to buy an annuity or set up a charitable annuity.
•When advising a client not to invest in real estate.
The most egregious conflict of interest inherent in the AUM compensation model is the common practice of charging a higher fee — often 1.5% — for managing equities than for managing bonds and cash, which typically are managed for 0.5%. Advisers routinely justify the difference by claiming that equities are more complex investments to manage, which I find self-serving: why not just charge 1.0% for a balanced portfolio? As a result of this compensation difference, clients are almost always over-allocated to stocks.
In all the cases mentioned above there may be good and impartial reasons for an adviser’s recommendation, but in all these cases and many others the temptation to protect or enhance the adviser’s own compensation is too great.
These conflicts are magnified when an adviser claims to be a comprehensive financial planner rather than merely an investment adviser. Comprehensive financial planning includes more than overseeing asset allocation and making individual investments; it encompasses all financial aspects of a client’s situation: estate planning, tax planning, insurance coverage, debt management (including mortgages) and more.
Many comprehensive financial planners who charge a fee based on assets under management often give a short shrift to other aspects of a client’s situation. After persuading a client to sign on, they may speak or meet with the client relatively rarely. This is what would be expected as people generally do what they are paid to do. If they are paid for gathering assets, that’s what they focus on.
The National Association of Financial Advisors (NAPFA) has long championed the importance of commission-free financial and investment advice. The media has recognized their contribution in exposing unethical practices fostered by commission-based compensation. Now, however, most stockbrokers and fee-only advisers (including NAPFA members) charge fees based on AUM. In terms of compensation the two types of advisers have become indistinguishable. As a pioneer and current member of NAPFA, I believe that advisers who charge AUM fees fall short what should be expected of true fiduciaries.
The current NAPFA fiduciary standard limits adviser activity to the ‘purchase or sale of a financial product’ rather than ‘any transaction.’ A clear standard should require that an adviser’s compensation not depend on any transaction where a client is relying on the adviser’s counsel. The examples of conflict of interest listed above all involve transactions that are not ‘purchases or sales’ of investments.
To avoid most conflicts of interest it is simple enough for advisers to charge a flat annual retainer fee that is not affected by a client’s decisions regarding any specific transaction. The structure of a flat fee — which may be more or less than an AUM fee — insulates the adviser from any taint of conflict attributable to compensation. This pricing model is now well established as the minority trend in the profession with hundreds of successful practices having adopted this approach.
Ironically, as common as AUM is for compensation, it is a terrible business model. By tying themselves so closely to forces over which they have little control, excellent advisers can see their annual revenue plunge by 50% in down markets even though their workload is much greater. If advisers are, in fact, providing comprehensive advice and are not being compensated directly for their services, they are providing them for free.
Nevertheless, AUM is an attractive pricing model, but for the wrong reasons. First, it is deceptive. “I charge 1.5% of assets I manage, so I only make more money if you do” is an enticing but misleading sales pitch. Most people can’t or don’t do the math, and don’t realize that 1.5% of $1 million amounts to $15,000 a year — a fee they likely would resist paying if it were transparently stated as a dollar amount rather than as a percentage. Moreover, AUM fees are deducted directly from a client’s account, and so the fee is seldom overtly seen.
A strict ethical approach would require that these potential conflicts be disclosed at the time of engagement, and again whenever an advisor’s specific recommendation may be construed as a conflict of interest. When a situation involves an egregious conflict of interest, such as advising an investment in the adviser’s own investment schemes, an adviser should be required to recuse himself and recommend that the client get a second opinion — a practice common in other professions.
If fee-only advisers want to hold themselves out as being the most ethical practitioners of their profession, they should commit themselves to adhering to the highest possible — and least conflicted — standard.
Bert Whitehead, the President of Cambridge Connection Inc. and Founder of the Alliance of Cambridge Advisors, is the author of “Why Smart People Do Stupid Things with Money” (Sterling, 2009). This was an editorial I wrote for Investment News Weekly which prompted a heated discussion in the on-line Wall Street Journal. I thought clients would find it interesting.
Tuesday, February 14, 2012
Kiss and Tell About Your Status
Bert's Guest Blog: By Erin Baehr,* CFP, CDFA, E.A. © 2012
It is estimated that 10 percent of all proposals happen on Valentine's Day — that's what the Internet says anyway, and if it's on the Internet it must be true, right?
All kidding aside, if it is even close to being true, that is a huge number of people getting engaged in the coming week. The pressure's on, guys. The world (aka the flower and jewelry industries, et al) expects an over-the-top proposal and two months' salary for her ring.
It's easy to be swept up in the romanticism of it all, but after the pictures are posted on Facebook and your relationship status is updated, you are left with two people planning not just a wedding together, but a life and all its not-so-romantic details. Financial compatibility is a big deal, and ideally should be assessed before the engagement, but it's still not too late. Here are several financial things you should know about your partner (and what your partner should know about you) before you marry.
Credit score: Your credit score is like your financial GPA, and largely determines your freedom of financial choice. A good score can open the door to the best interest rates, for instance, while a poor one can affect your chance at a new job. If your fiancé's score is less than stellar, find out why. Was it something out of his control, like a prolonged job loss or a medical issue? That's certainly understandable. Or was it from overspending and irresponsibility? If so, think twice about merging finances before those issues have been worked through, or you may be dragged down with him.
What does she own and what does she owe? How will you know your fiancé is really a rich princess in disguise unless you ask? While that's not likely, it is still important to know what she does own, and decide if those assets will be commingled as marital property or held separately. Of vital importance is the type and extent of her debt if she has any. Is she weighed down by credit card debt or large student loans? You'll need to discuss who will be responsible to pay those debts after marriage. And like the credit score, excessive debt can limit your options financially, or worse, be a symptom of financial dysfunction in your fiancé.
Employment history: Has your beloved been in the same position for a decent period of time, or does he flit from job to job, complaining about the unfairness of each position? Hmm, that may be a red flag. Pay attention to his work ethic and desire to work. Is there a large income disparity between the two of you, and if so, will that have an effect on the balance of power in your relationship?
Career goals: Where do you see yourself in five and 10 years in your career? Do your fiancé's career ambitions mirror yours, and if not, will that frustrate you or her? Does she plan to devote countless hours to earn a promotion, or take time off to complete a master's degree? If you have similar ambitions, you may be understanding of each other's drive, but if you look forward to relaxing over an early dinner, her late nights at work or school may leave you lonely.
Money personality: We all have a "money personality," or a style of relating to money. Which one we are depends on where we fall on a continuum of saver versus spender and operating out of fear or greed. Are you a miser type personality, thinking of marrying a shopaholic? I predict friction in your future. It's good to find out what personality you each tend toward, and understand if they balance each other out or are a toxic mess. For more information on money personality, check out "Why Smart People Do Stupid Things with their Money" by Bert Whitehead.
His money biography: What was money like in his family of origin? We tend to act in ways familiar to us, so if money was not ever talked about while growing up, it is likely we will be uncomfortable talking about it as an adult. If his parents tried to buy his love, it is likely that he will see spending as a measure of caring. Or if things were tight, he may now have an extreme fear of losing his wealth. Or, on the other hand, he may be a big spender as an act of rebellion against a restrictive childhood.
Unspoken expectations: These are tough to uncover, because we often don't realize we have them. For instance, in your family of origin, it may have been common for your dad to buy your mom a dozen red roses on Valentine's Day, regardless of the cost. If you marry someone whose expectation is that the two of you would save your money by cooking at home with a Red Box movie because his father thought it outrageous to spend that kind of money on flowers, you may be quite disappointed when he comes home empty handed and angry that he expects you to cook (and he will be blindsided by your anger). Or if he expects to have a wad of cash each week to walk around with and not account for it, while you expect to count every penny spent, that also can lead to anger and resentment. Without bringing these into the open you may be completely confused by your intended's behaviors and reactions.
Money motivation: What drives her uses of money? Is it a means to power, influence or notoriety? Or is it a way to show love to her family? Looking at what motivates each of you to earn, give, save, or spend money can predict some of your financial behaviors. Are your motivations compatible?
Lifestyle expectations: Does your fiancé envision one of you staying home with children should there be any, or does he expect that you will both work outside of the home? And how big of a home will that be? What kinds of vacations does he like to take? Again going back to the hidden expectations, if your family took a European vacation every year while your fiancé's family camped in the backyard, unless you talk about it, you may naturally assume he wants to save for that kind of vacation, too.
*Erin Baehr, CDFA, CFP, EA is the principal of Baehr Family Financial, LLC, and a member of the Alliance of Cambridge Advisors in Stroudsburg, PA (www.YourMoneyEveryday.com). She was recently named "Greatest Around the Poconos" in the financial advisor category.
It is estimated that 10 percent of all proposals happen on Valentine's Day — that's what the Internet says anyway, and if it's on the Internet it must be true, right?
All kidding aside, if it is even close to being true, that is a huge number of people getting engaged in the coming week. The pressure's on, guys. The world (aka the flower and jewelry industries, et al) expects an over-the-top proposal and two months' salary for her ring.
It's easy to be swept up in the romanticism of it all, but after the pictures are posted on Facebook and your relationship status is updated, you are left with two people planning not just a wedding together, but a life and all its not-so-romantic details. Financial compatibility is a big deal, and ideally should be assessed before the engagement, but it's still not too late. Here are several financial things you should know about your partner (and what your partner should know about you) before you marry.
Credit score: Your credit score is like your financial GPA, and largely determines your freedom of financial choice. A good score can open the door to the best interest rates, for instance, while a poor one can affect your chance at a new job. If your fiancé's score is less than stellar, find out why. Was it something out of his control, like a prolonged job loss or a medical issue? That's certainly understandable. Or was it from overspending and irresponsibility? If so, think twice about merging finances before those issues have been worked through, or you may be dragged down with him.
What does she own and what does she owe? How will you know your fiancé is really a rich princess in disguise unless you ask? While that's not likely, it is still important to know what she does own, and decide if those assets will be commingled as marital property or held separately. Of vital importance is the type and extent of her debt if she has any. Is she weighed down by credit card debt or large student loans? You'll need to discuss who will be responsible to pay those debts after marriage. And like the credit score, excessive debt can limit your options financially, or worse, be a symptom of financial dysfunction in your fiancé.
Employment history: Has your beloved been in the same position for a decent period of time, or does he flit from job to job, complaining about the unfairness of each position? Hmm, that may be a red flag. Pay attention to his work ethic and desire to work. Is there a large income disparity between the two of you, and if so, will that have an effect on the balance of power in your relationship?
Career goals: Where do you see yourself in five and 10 years in your career? Do your fiancé's career ambitions mirror yours, and if not, will that frustrate you or her? Does she plan to devote countless hours to earn a promotion, or take time off to complete a master's degree? If you have similar ambitions, you may be understanding of each other's drive, but if you look forward to relaxing over an early dinner, her late nights at work or school may leave you lonely.
Money personality: We all have a "money personality," or a style of relating to money. Which one we are depends on where we fall on a continuum of saver versus spender and operating out of fear or greed. Are you a miser type personality, thinking of marrying a shopaholic? I predict friction in your future. It's good to find out what personality you each tend toward, and understand if they balance each other out or are a toxic mess. For more information on money personality, check out "Why Smart People Do Stupid Things with their Money" by Bert Whitehead.
His money biography: What was money like in his family of origin? We tend to act in ways familiar to us, so if money was not ever talked about while growing up, it is likely we will be uncomfortable talking about it as an adult. If his parents tried to buy his love, it is likely that he will see spending as a measure of caring. Or if things were tight, he may now have an extreme fear of losing his wealth. Or, on the other hand, he may be a big spender as an act of rebellion against a restrictive childhood.
Unspoken expectations: These are tough to uncover, because we often don't realize we have them. For instance, in your family of origin, it may have been common for your dad to buy your mom a dozen red roses on Valentine's Day, regardless of the cost. If you marry someone whose expectation is that the two of you would save your money by cooking at home with a Red Box movie because his father thought it outrageous to spend that kind of money on flowers, you may be quite disappointed when he comes home empty handed and angry that he expects you to cook (and he will be blindsided by your anger). Or if he expects to have a wad of cash each week to walk around with and not account for it, while you expect to count every penny spent, that also can lead to anger and resentment. Without bringing these into the open you may be completely confused by your intended's behaviors and reactions.
Money motivation: What drives her uses of money? Is it a means to power, influence or notoriety? Or is it a way to show love to her family? Looking at what motivates each of you to earn, give, save, or spend money can predict some of your financial behaviors. Are your motivations compatible?
Lifestyle expectations: Does your fiancé envision one of you staying home with children should there be any, or does he expect that you will both work outside of the home? And how big of a home will that be? What kinds of vacations does he like to take? Again going back to the hidden expectations, if your family took a European vacation every year while your fiancé's family camped in the backyard, unless you talk about it, you may naturally assume he wants to save for that kind of vacation, too.
*Erin Baehr, CDFA, CFP, EA is the principal of Baehr Family Financial, LLC, and a member of the Alliance of Cambridge Advisors in Stroudsburg, PA (www.YourMoneyEveryday.com). She was recently named "Greatest Around the Poconos" in the financial advisor category.
Wednesday, January 25, 2012
Is It Time to Panic Yet?
By Bert Whitehead M.B.A, J.D. © 2012
Some days it seems like our economy is improving, then you turn the page and major world problems (Mideast, Europe, Korea, etc.) are just getting worse.
So what if you are a baby-boomer (or older) and are starting to think that your retirement isn’t going to be as joyful as you expected? Or maybe you are younger than that but wonder about your ability to take care of your parents, put your kids through college, and ever have enough money to retire yourself?
To evaluate yourself financially you need to answer four basic questions:
1)Are you living within your means?
2)Are you saving at least 10% of your gross income?
3)Are you covered for possible catastrophes in your life?
4)What is your ‘Plan B?’
You will note that these four questions have nothing to do with the worldwide currency crisis, the future of the stock market, or the political outcome of the next election. Instead, they refer to issues that you can directly control.
1)Are you living within your means? I have a short cut to figure this out. Do you pay off your credit cards in full every month? If you do, you are generally living within your means. If not, or if you have to take out loans (home equity, more credit cards, etc.) to pay off your credit cards, you are living beyond your means.
If the latter applies, you are probably spending more than your take-home pay and the shortfall shows up on your credit card. If you have tried to restrain your spending and have not been successful, it is usually because you have ratcheted up your standard of living beyond what you can afford. Being ‘house poor’ often causes this. That means that you have too much house, and to cut your spending you will have to downsize. Downsizing is much easier if you are relocating into another housing market.
2)Are you saving at least 10%? When we talk about ‘saving’ in this context, we are talking about long-term permanent savings, i.e. your investment portfolio. People sometimes emphatically assure me that they have been saving money regularly for years, but they have not accumulated an investment portfolio. They confuse ‘saving up to spend later’ with ‘saving for long-term investments.’
The financial objective of long term permanent savings is to invest enough during your working years so that later in life you can live off the money your money makes, rather than from the sweat of your brow. This is required if you are to be truly ‘free.’ Those without an investment portfolio are destined to have to work their whole lives, depend on the benevolence of others, or live in poverty.
3)Have you protected yourself against catastrophes? The best-laid plans can be derailed by unexpected calamities. Sudden medical conditions or disability, loss of car or home, unexpected death, lawsuits, etc. are all dangers than you seldom have to deal with, but they do happen and they can be devastating.
Basic insurance coverage and simple estate planning can shield you from these hardships. Although you might set these protections up, it is easy to forget about reviewing them. Then when you need them, they may be stale or inadequate. Make sure they are updated at least every five years, or whenever your life situation shifts (marriage, children, family deaths, etc.).
4)Do you have a ‘Plan B’? Even when people have done everything ‘right’ (i.e. #’s 1, 2, and 3 above), life can present unexpected challenges that they can never prepare for. Even with a college education, you will never be certain to have a job. You may take risks that flop, like starting a business. Shadowy medical conditions, like depression, might go unrecognized and can be debilitating.
For some younger people, Plan B is moving back with their folks. For some older people, Plan B is moving in with their adult children. Plan B might simply entail a willingness to drastically reduce your living standards so you can maintain your independence.
Sadly, my experience has shown me that many people live lives of quietly repressed panic, with an intangible sense of deprivation anxiety. They may not recognize it themselves, but a sense of financial foreboding shadows their lives every day. This can lead to behaviors like intense miserliness or as denial expressed by mindless spending. Others distract themselves by focusing on the possibility of widespread debacles due to economic and social issues. They spend their time playing “Ain’t it awful…” with their comrades in fear. They may overreact by radically altering their financial positions (“gold and canned goods.”)
I find that our present times have not changed much from past times. I recently saw the movie “The Iron Lady” which reminded me that we were dealing with the same issues 30 years ago as we are now. Somehow we, as a people, are able to rise up and defeat fear.
The real danger is not outside of us in the economy or the country. Our biggest danger lies within ourselves. We cannot control our individual destiny by anxiously reading the papers and watching TV. After all, magnifying the negative is much more profitable for journalists than reporting slow, steady progress.
Review your own situation and make the changes you need to make so that you can answer ‘Yes!’ to each of the four questions above. Then I can assure you, it is not time to panic!
=================================
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
Some days it seems like our economy is improving, then you turn the page and major world problems (Mideast, Europe, Korea, etc.) are just getting worse.
So what if you are a baby-boomer (or older) and are starting to think that your retirement isn’t going to be as joyful as you expected? Or maybe you are younger than that but wonder about your ability to take care of your parents, put your kids through college, and ever have enough money to retire yourself?
To evaluate yourself financially you need to answer four basic questions:
1)Are you living within your means?
2)Are you saving at least 10% of your gross income?
3)Are you covered for possible catastrophes in your life?
4)What is your ‘Plan B?’
You will note that these four questions have nothing to do with the worldwide currency crisis, the future of the stock market, or the political outcome of the next election. Instead, they refer to issues that you can directly control.
1)Are you living within your means? I have a short cut to figure this out. Do you pay off your credit cards in full every month? If you do, you are generally living within your means. If not, or if you have to take out loans (home equity, more credit cards, etc.) to pay off your credit cards, you are living beyond your means.
If the latter applies, you are probably spending more than your take-home pay and the shortfall shows up on your credit card. If you have tried to restrain your spending and have not been successful, it is usually because you have ratcheted up your standard of living beyond what you can afford. Being ‘house poor’ often causes this. That means that you have too much house, and to cut your spending you will have to downsize. Downsizing is much easier if you are relocating into another housing market.
2)Are you saving at least 10%? When we talk about ‘saving’ in this context, we are talking about long-term permanent savings, i.e. your investment portfolio. People sometimes emphatically assure me that they have been saving money regularly for years, but they have not accumulated an investment portfolio. They confuse ‘saving up to spend later’ with ‘saving for long-term investments.’
The financial objective of long term permanent savings is to invest enough during your working years so that later in life you can live off the money your money makes, rather than from the sweat of your brow. This is required if you are to be truly ‘free.’ Those without an investment portfolio are destined to have to work their whole lives, depend on the benevolence of others, or live in poverty.
3)Have you protected yourself against catastrophes? The best-laid plans can be derailed by unexpected calamities. Sudden medical conditions or disability, loss of car or home, unexpected death, lawsuits, etc. are all dangers than you seldom have to deal with, but they do happen and they can be devastating.
Basic insurance coverage and simple estate planning can shield you from these hardships. Although you might set these protections up, it is easy to forget about reviewing them. Then when you need them, they may be stale or inadequate. Make sure they are updated at least every five years, or whenever your life situation shifts (marriage, children, family deaths, etc.).
4)Do you have a ‘Plan B’? Even when people have done everything ‘right’ (i.e. #’s 1, 2, and 3 above), life can present unexpected challenges that they can never prepare for. Even with a college education, you will never be certain to have a job. You may take risks that flop, like starting a business. Shadowy medical conditions, like depression, might go unrecognized and can be debilitating.
For some younger people, Plan B is moving back with their folks. For some older people, Plan B is moving in with their adult children. Plan B might simply entail a willingness to drastically reduce your living standards so you can maintain your independence.
Sadly, my experience has shown me that many people live lives of quietly repressed panic, with an intangible sense of deprivation anxiety. They may not recognize it themselves, but a sense of financial foreboding shadows their lives every day. This can lead to behaviors like intense miserliness or as denial expressed by mindless spending. Others distract themselves by focusing on the possibility of widespread debacles due to economic and social issues. They spend their time playing “Ain’t it awful…” with their comrades in fear. They may overreact by radically altering their financial positions (“gold and canned goods.”)
I find that our present times have not changed much from past times. I recently saw the movie “The Iron Lady” which reminded me that we were dealing with the same issues 30 years ago as we are now. Somehow we, as a people, are able to rise up and defeat fear.
The real danger is not outside of us in the economy or the country. Our biggest danger lies within ourselves. We cannot control our individual destiny by anxiously reading the papers and watching TV. After all, magnifying the negative is much more profitable for journalists than reporting slow, steady progress.
Review your own situation and make the changes you need to make so that you can answer ‘Yes!’ to each of the four questions above. Then I can assure you, it is not time to panic!
=================================
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
Wednesday, November 2, 2011
How to Get the Best Mortgage
By Bert Whitehead M.B.A, J.D. © 2011
The most popular client questions these days are about what kind of mortgage they should get. If you are somewhat knowledgeable about mortgages and just want the bottom line, you can skip to the last paragraph of this blog. If you are interested in a more detailed explanation, please continue reading.
Not only are mortgages more available now for new homes, but current mortgage holders can also find great opportunities to refinance at a lower rate. The federal government has just announced a new refinancing program for homeowners who are “under water” on their homes (i.e. they owe more on the house than it is worth). The last two similar programs never got much traction, and it is doubtful that the new program will bring serious relief to many people.
To get a new mortgage or refinance at the lowest rates you have to be able to show that you “qualify” for the mortgage. Here is a quick summary of the standards banks seek:
1. Clean credit record (FICO = 700+).
2. 80% loan-to-value (LTV). The mortgage should be less than 80% of the value of the home.
3. Currently employed.
4. Monthly payments on current debts (including mortgage) less than 40% of income.
There are some exceptions to these standards, e.g. if you replace a mortgage on your primary residence and you have always made the payments, some banks let you refinance 90-100% of the home’s value. But, in general, you won’t get the best rates available unless you meet the above criteria.
Mortgage financing is a very competitive field so you should check with at least 3 banks or mortgage companies. Rates move daily, so it’s preferable to call all three institutions on the same morning. I suggest that clients request a quote on “a 30-year fixed rate mortgage with no points, no prepayment penalty, and with the closing costs rolled in.”
Be aware that even with no points and no prepayment penalty, there will still be certain costs that you are expected to pay at the closing. The appraisal fee, for example, is an out-of-pocket cost to the lender. Property taxes also have to be paid as well as interest payable from the date you close to the beginning of the next month. Many people prefer that property tax and insurance costs be “escrowed” so that an amount is added to the monthly payment to pay for these costs as they come due.
Having your closing costs “rolled into the mortgage” means adding any costs that are normally due at closing to your mortgage balance. The cost of those will be covered by your monthly payment. You should ask each lender to email you a “good faith estimate” of the mortgage they propose. Then you can verify that the terms offered are those you requested and compare the closing costs.
The most common stumbling blocks encountered by clients are:
1. The house doesn’t appraise high enough. You can get your own appraiser to see if the bank’s appraisal is wrong, but they won’t accept it to lend you money. If it is under-appraised significantly you might apply at another lender and they will have it appraised again. While there can be wide variations in appraisals, there are no guarantees.
2. Unanticipated black marks appear on your credit score. You have to contact the credit bureau to correct these.
3. Your income is insufficient. This often happens to retirees who live on investment income. We have clients set up a monthly transfer from their investment account to their checking account for the same amount each month on the 1st of the month. If you do this for a couple of years, lenders will accept these transfers as a reliable stream of retirement income.
Don’t let lenders talk you into a shorter-term or adjustable rate mortgage, which can be more profitable to the mortgage institutions. Other mortgage options may seem attractive have a lower interest rate. But a 30-year mortgage has three huge advantages:
1. You receive the lowest payments so you have more cash flow. If you regularly invest this extra cash, preferably in a retirement account, you will earn more in a balanced portfolio than you will save in interest when compared to other mortgage options.
2. Since mortgage interest is tax deductible, a longer mortgage provides more tax shelter than shorter-term mortgages at a lower rate.
3. Most importantly, a 30-year fixed rate mortgage is your best protection against inflation. If interest rates stay stable for the next 30 years, your worst case is that you break even plus a bit more. But if interest rates drop, you just refinance and your monthly living expenses drop. If we have a return of high inflation (as occurred in the 1970’s) – you win! You have borrowed thousands of dollars at a low fixed rate, your money market rate increases to 8%, 10%, or even 15%, AND you get to repay with cheaper dollars!
Summary: Call three different mortgage companies on the same morning to ask for quotes (we can suggest a couple and your Credit Union may be a good source). Get a 30-year fixed rate mortgage with no points, no prepayment penalty, and have closing costs rolled into the mortgage. Have each institution email you a good faith estimate. Each estimate should show no closing costs paid out of your pocket, except to fund escrow. By comparing the monthly payments, you can easily determine which is the best deal.
By the way, if any of the offers sound too good to be true, then that likely is the case. But be sure to pay attention to any offers made by your current lender. They want to keep their customers happy…so you might find some excellent offers made by a relationship that is already in place!
=================================
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
The most popular client questions these days are about what kind of mortgage they should get. If you are somewhat knowledgeable about mortgages and just want the bottom line, you can skip to the last paragraph of this blog. If you are interested in a more detailed explanation, please continue reading.
Not only are mortgages more available now for new homes, but current mortgage holders can also find great opportunities to refinance at a lower rate. The federal government has just announced a new refinancing program for homeowners who are “under water” on their homes (i.e. they owe more on the house than it is worth). The last two similar programs never got much traction, and it is doubtful that the new program will bring serious relief to many people.
To get a new mortgage or refinance at the lowest rates you have to be able to show that you “qualify” for the mortgage. Here is a quick summary of the standards banks seek:
1. Clean credit record (FICO = 700+).
2. 80% loan-to-value (LTV). The mortgage should be less than 80% of the value of the home.
3. Currently employed.
4. Monthly payments on current debts (including mortgage) less than 40% of income.
There are some exceptions to these standards, e.g. if you replace a mortgage on your primary residence and you have always made the payments, some banks let you refinance 90-100% of the home’s value. But, in general, you won’t get the best rates available unless you meet the above criteria.
Mortgage financing is a very competitive field so you should check with at least 3 banks or mortgage companies. Rates move daily, so it’s preferable to call all three institutions on the same morning. I suggest that clients request a quote on “a 30-year fixed rate mortgage with no points, no prepayment penalty, and with the closing costs rolled in.”
Be aware that even with no points and no prepayment penalty, there will still be certain costs that you are expected to pay at the closing. The appraisal fee, for example, is an out-of-pocket cost to the lender. Property taxes also have to be paid as well as interest payable from the date you close to the beginning of the next month. Many people prefer that property tax and insurance costs be “escrowed” so that an amount is added to the monthly payment to pay for these costs as they come due.
Having your closing costs “rolled into the mortgage” means adding any costs that are normally due at closing to your mortgage balance. The cost of those will be covered by your monthly payment. You should ask each lender to email you a “good faith estimate” of the mortgage they propose. Then you can verify that the terms offered are those you requested and compare the closing costs.
The most common stumbling blocks encountered by clients are:
1. The house doesn’t appraise high enough. You can get your own appraiser to see if the bank’s appraisal is wrong, but they won’t accept it to lend you money. If it is under-appraised significantly you might apply at another lender and they will have it appraised again. While there can be wide variations in appraisals, there are no guarantees.
2. Unanticipated black marks appear on your credit score. You have to contact the credit bureau to correct these.
3. Your income is insufficient. This often happens to retirees who live on investment income. We have clients set up a monthly transfer from their investment account to their checking account for the same amount each month on the 1st of the month. If you do this for a couple of years, lenders will accept these transfers as a reliable stream of retirement income.
Don’t let lenders talk you into a shorter-term or adjustable rate mortgage, which can be more profitable to the mortgage institutions. Other mortgage options may seem attractive have a lower interest rate. But a 30-year mortgage has three huge advantages:
1. You receive the lowest payments so you have more cash flow. If you regularly invest this extra cash, preferably in a retirement account, you will earn more in a balanced portfolio than you will save in interest when compared to other mortgage options.
2. Since mortgage interest is tax deductible, a longer mortgage provides more tax shelter than shorter-term mortgages at a lower rate.
3. Most importantly, a 30-year fixed rate mortgage is your best protection against inflation. If interest rates stay stable for the next 30 years, your worst case is that you break even plus a bit more. But if interest rates drop, you just refinance and your monthly living expenses drop. If we have a return of high inflation (as occurred in the 1970’s) – you win! You have borrowed thousands of dollars at a low fixed rate, your money market rate increases to 8%, 10%, or even 15%, AND you get to repay with cheaper dollars!
Summary: Call three different mortgage companies on the same morning to ask for quotes (we can suggest a couple and your Credit Union may be a good source). Get a 30-year fixed rate mortgage with no points, no prepayment penalty, and have closing costs rolled into the mortgage. Have each institution email you a good faith estimate. Each estimate should show no closing costs paid out of your pocket, except to fund escrow. By comparing the monthly payments, you can easily determine which is the best deal.
By the way, if any of the offers sound too good to be true, then that likely is the case. But be sure to pay attention to any offers made by your current lender. They want to keep their customers happy…so you might find some excellent offers made by a relationship that is already in place!
=================================
I appreciate the editorial review contributed by Chip Simon, CFP®, an ACA colleague in Poughkeepsie, NY.
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