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Tag: financial planning

Compound Interest Explained Simply

compound interest explained simply

Compound interest is a term that many have heard often but is rarely well understood. The definition on wikipedia is as listed:

Compound interest – is the addition of interest to the principal sum of a loan or deposit, or in other words, interest on interest.

Well, that sounds almost simple – the money you make, will make even more money in the future. But what exactly does that mean in practical terms? This may be where most of the confusion comes in from.

Compounding effect

In the above tables, we can see an assumption of different interest rates. These interest rates are tested on the growth of just $1 over different decades. What we’ll find is that the one dollar will grow to about $1.96 to $2.59, about double growth in 10 years for 7-10% interest rates. But by the 20th year, the growth is even higher, ranging from $3.86 – $6.72. The most astounding realization is that by the 40th year the dollar becomes $14.97 – $45.25, a 15 to 45 times return.

In effect, we can learn multiple lessons from this short example:

  • For every dollar we spend, we are not just losing only a dollar but we are losing all the future potential growth that the dollar would bring.
  • The amount of time that the dollar has to grow will have a huge impact. The difference between a dollar thats been invested for 20 years (at $3.86) and 40 years (at $14.97) is extreme. It’s better by a long-shot to have money to invest as early as possible than getting started later.
  • Small differences in interest rate assumptions can have a huge impact. Meaning if you are being charged large fees such as the financial industry’s normal of 1%, it can have a huge effect on your long-term gains. Thus, it is important that you assess whether there is a true premium of investment return if others manage your money vs investing the money into index funds.

There is also another large implication as a result of these calculations. If we know that the money can grow by a large amount, even with conservative expectations in long-term growth, then we shouldn’t fret over not being able to grow the “money fast enough”. For many, 7-10% growth per year sounds unexciting and even unreasonable. Why invest if we’re not going to go for the stars while doing so? The problem is that aiming for incredibly high returns is likely to increase the chance of risk as well.

Gains needed

If you look at the above table, there is an assumption that you could start out with $10 and take an 8% return for a comparatively small 80 cents that year. Sounds unexciting right?

Some may feel tempted to aim for much more in their returns. Let’s assume this person took a huge risk and as a result, they take a substantial loss, ranging from 10-50%. That would represent $5 (50% loss) to $9 (10% loss). Now this person will have to achieve incredibly high returns to even achieve the same 8% growth as the relatively conservative investor. This can become a losing cycle because to achieve such high returns in many cases would require high risk bets, which can cause further losses. To avoid such psychologically dire situations, it would have been better to start off relatively conservative from the beginning. Even one major loss after years of relatively strong growth can cause the investment portfolio to do worse than it should have.

If we know in the long-term there will be truly high gains (despite seemingly small returns in the short-term), it will be easier to feel peace of mind as we pursue our goals. It might seem boring to some but it is a better alternative to risky strategies that are unnecessary to achieve long-term goals that most pursue in their life such as retirement.

“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it. ” – Albert Einstein

 

How To Avoid Taxation On Your Investments

In America, we run on a ‘progressive tax’ system. This means that your tax rate will increase for each dollar that you are making. You won’t be taxed more on your “base amount” but you will be taxed extra for each additional dollar. Let’s say you are making $50k in wages a year for example. While each additional dollar you make will get taxed at 25%, parts of your original $50k will be taxed at 10% and 15%. The table below should explain this relatively well.

2015-Income-Tax-Brackets

While you are in the lower income tax brackets, you won’t be taxed as much. But taxation can become a problem for you once you reach 28%, 33% and even 25% marginal tax. The solution in these cases would require special tax-advantaged strategies that help you avoid having atleast a quarter taken out of every dollar you make.

4 ways to avoid taxation on your investments.

Growth Stock Funds

Instead of putting money into stock funds or stocks that return hefty dividends, and therefore, cause taxation, you can invest in growth stock funds. Growth stocks don’t give dividends and instead reinvests the company’s profits back into the company in hopes of continued and higher growth. This means that the value of your fund can keep growing without you being taxed for a long time. You will usually only get taxed when you sell, triggering capital gain taxes. However, if you are very intentional about when you sell, you can save alot of money in the long-term. For example, selling growth stock funds in retirement when your taxable income will likely be much lower will potentially save you thousands of dollars in taxes.

Municipal Bond Funds

While bonds offer relatively high dividends, the taxation of those dividends is treated just like any other ordinary income. However, if you were to buy public state municipal bond funds, you would be able to get decent dividends while avoiding state and federal taxation. While these bonds can offer great cash flow for high-income earners, it is important to note how inflation may erode the long-term value of the income without a growth hedge.

IRA / 401k

A very common option for many people to save for retirement, putting money away into an IRA (individual retirement account) or a 401k (a type of defined contribution plan) can help save a sizable amount of money from tax. When you contribute to a traditional IRA or 401k, money is taken away from your paycheck before your money is subject to tax and placed into these retirement accounts. This removes sizable money from taxation. With a Roth IRA or 401k, the contributions are taxed immediately but you won’t be taxed on the growth later on. There are disadvantages with these accounts such as not being able to access the money till 59.5 in age or later. However, this can be a great option for most people who should be saving for retirement in the first place anyway.

Tax Loss Harvesting

This is a relatively advanced investing technique. I highly suggest staying away from this unless you really know what you’re doing or if you find a robo-advisor that does this for you. At TFP, our investing partner Betterment For Advisors allows tax loss harvesting for clients.

Tax Loss Harvesting works by selling a security that has suffered a loss, which triggers a capital gains loss. Having a capital gains loss can be a good thing because it offsets capital gains, meaning less taxable income. While you shouldn’t actively search for capital gains loss, being able to take advantage of opportunities when they arise can be profitable. Assuming you don’t collide with wash sales rules which would remove your capital gains loss benefit and assuming that you maintain your asset allocation, this can cause gains with substantial impact in the long run. You could potentially take up to $3000 per year in tax deductions from income with this type of strategy.

These are four ways to avoid taxation on investments.

Three Financial Things For New Parents To Do

three financial things for new parents to do

Having a baby can change your life in many ways. But in the midst of it all, don’t forget these three important things you should be doing as a new parent.

#1: Get Life Insurance

If you don’t already have life insurance to cover your spouse, getting life insurance is now very important. Life insurance is protection against the risk that you die quicker than you should. If something should happen to you, your spouse and child would receive money that would ideally replace the income and services you brought to the house.

With life insurance, your family will not be in financial danger because of your lost income in the family. While you’re alive, life insurance gives you the confidence and peace of mind in your daily life to know that your loved one’s financial wellbeing would not change with you being gone. By failing to get life insurance, you put your spouse and child at risk.

Usually “term” life insurance is the best option for most young people, as it is one of the cheapest forms of life insurance. Your insurance agent may try to upsell you on other forms of life insurance, but if you’re below 40, chances are that ‘term insurance’ is your best choice of insurance.

As for the amount of coverage you need, it will depend on the level of income you need to replace. A good rule of thumb: if you make $40,000 a year, your family will need that amount divided by 4% or 0.04 to subsist. The coverage you would need to replace $40,000 is $1M. This amount will allow your family to safely use the money to create a perpetual income stream of $40,000 through investments. This isn’t an “exact” way to calculate a need analysis but you will be relatively close to the amount of coverage that you do need. This video below will get deeper into the calculation of life insurance need analysis.

The time that you’ll need life insurance is dependent on how long the need for risk protection remains. You don’t necessarily need life insurance forever. If you have enough money in passive investments to cover the needs of your family even if you weren’t working, then you don’t necessarily need life insurance. If your child reaches 21 years of age and is working, then you won’t need as much life insurance because there is no need to cover anything.

Pick out your life insurance agent carefully and make sure you can trust them. Or have your financial planner refer you to an ethical one from within their professional network.

#2: Set Up a Will

Setting up a will is important because it keeps you from dying ‘intestate’. This means dying without a will, allowing the laws of the state you live in, guide the process for how your assets will be distributed upon your death. Not having a will also makes your child vulnerable because they can potentially end up in custody with undesirable family members as a result of legal rulings within your state.

By creating a will, your intentions will be set on where custody of the child will go and allow you to control the distribution of assets in a way that’s desirable for you.

There are some decent will generators online that will completely work but if your situation is complex, then you will want to have a will created by an estate planning attorney who can make sure that the will is done properly. Your financial planner should also be able to refer you to an estate planning attorney from within their network.

#3: Set Up a 529 Plan

The best time to start funding your child’s higher education is not 1, 2 or 5 years before they are about to head off to college. It is as soon as possible because you will want to take advantage of compound interest, the benefits of which increase with time. If you’re interested in funding the best possible education for your child, you will want to get started on funding their college education as soon as they are born. This can be achieved with a 529 Plan, which offers extra tax benefits.

A 529 Plan allows you to contribute money into an investment account that will grow tax-free and can be used directly towards higher education expenses tax-free. This makes it much easier to fund an education that may not have been possible otherwise. If your child decides not to pursue higher education, the 529 plan funds can be transferred to another person within the family for their education without consequence.

When designing your 529 plan, you will want to pick higher growth investment allocations with a time horizon of 15-18 years away. But as the child gets older and closer to college, you will want to shift investment allocations away from riskier investments to safer ones. This process can be achieved with Target Date Funds, which are usually available and shift the allocation of funds for you over time. Your advisor should also be able to tailor the 529 Plan portfolio according to your family’s situation.

If you can get these three things done, you will be more prepared than most. Your risk will be lower and you will secure your family’s ability to navigate through life without a problem.

Home Ownership Is Not Necessarily Path To Financial Freedom

home ownership

There’s an ongoing misconception that if you ever did want to achieve financial freedom, that you NEED to own a home. The false idea that if you’re not owning a home, you’re just “throwing your money away”. But who is sending that message in the first place?

It’s the real estate industry that’s primarily selling you this message! And of course, they want you to believe it. They make money when you buy homes. There is a clear incentive for them to tell you that buying a home is always a good decision. They want you to believe if you buy a home, that you will surely be on the path to wealth. Of course there are regular investors out there who will swear by real estate, but there are clear disadvantages and problems that they normally don’t talk about. There are times when real estate makes sense but other times when it doesn’t make sense. I’m going to disprove common misconceptions and show you some numbers.

Home Ownership Is Not Necessarily The Path To Financial Freedom!

Misconception #1: You’re throwing your money away if you’re renting.

This is just plain wrong.

If you own a house, you’re responsible for more than just rent. You need to pay off interest, home insurance, taxes and property maintenance and the closing costs as well. This all means that not only will you be paying the mortgage (which is bundled with payment towards home equity + interest), you’ll be paying towards items that don’t add value to your net worth.

Normally, these extra items such as insurance and taxes will be around 50% more than the mortgage amount. So if it costs $1000 a month for a home mortgage, you can estimate that you will need to budget around $1500 a month for the entire year to cover the miscellaneous costs. But in that scenario, perhaps only $800 is going towards building true equity out of the $1500.

The other side of this: what if you had to sell the house early? If there’s a remote chance that you would need to move in the next 5 years for the following reasons, then don’t buy the house:

  • You found a new job at a different location, or your current job forces you to move locations.
  • You lost a high-paying job where you’ll never be able to get the same income again.

If you do move early, you will very likely lose money having bought the home. The “5-year rule” for housing says that you shouldn’t buy a home unless you expect to stay there for at-least 5 years. I would push this further. You should be in that home for at-least 7-10+ years before you make a real profit.

To explain why you don’t really make a real profit on the house in the beginning years, it’s because you pay more towards interest on the mortgage in the beginning years. So if the mortgage costs $800 in the first year, it would be fair to say that around 70% ($560) of that goes towards interest and the rest towards building home equity. By year twenty, the payments would be more towards principal payments and less on interest. Considering that renting is often cheaper than housing payments, you could have used the difference towards investments that create higher returns on the money. More discussion on this below.

Misconception #2: You can just buy a duplex (2 unit apartment), rent one out to someone who will pay the bills and you live for free.

I hate this advice, since it’s so naive and misleading. If it was really that easy, then everyone would be doing it. The truth is, in most real estate markets, especially the most competitive places like NYC or Los Angeles, the real estate firms have already scooped up these opportunities. These are professionals who build complex excel sheets on property cash flows and are searching for good deals on a daily basis. What makes you think that as an inexperienced first-time homebuyer that you’re going to be able to beat them on those deals? Those same real estate firms often sell those property “deals” to people at a premium. Most properties that you buy from these crowded markets will come at a cash flow loss to you in the first few years. You’re going to lose more than you make in the beginning.

Misconception #3: The house will appreciate and make me way more money.

In general, housing price increases keeps up with inflation, meaning you’re not actually making any real profit on your “investment”. If you happen to catch a “hot market”, then maybe your housing will outpace inflation by an extra 1-3% per year. But to really be able to bank on that kind of growth, you’d need to have that property for a long time because the housing market is unstable. The housing markets growth is not necessarily a graph where the prices are always going up in a linear fashion. It’s going to go up and down along with the economy. This means that at a certain time, your ability to sell at a profit will not necessarily be guaranteed. This is the same as the stock market, at some point, every asset out there will hit a down point. When you buy a house on the basis that it’s going to keep increasing, or that you can sell it at a gain for 1-5 years, it’s just plain wrong. It’s that kind of thinking that led to the real estate markets collapse in 2007-2009.

The other factor you need to consider are the closing costs. When listing the house for sale, you can expect to pay 5-7% to realtors, lawyers, etc. just to get the house sold. Whatever gains you make past inflation on the house in the short-term could easily be offset by those closing costs.

Misconception #4: A house will get you mortgage tax deductions that make everything completely worth it.

This is like looking at everything on a pennies vs dollars basis. If it costs 800 to rent an apartment, and $1500 for all the housing costs on the cheapest house available, and you save even $100-400 on mortgage tax deductions, you’re still paying more than you would have originally, compared to if you just rented and invested the difference.

I’ve been hinting at this, but the other option instead of buying a house, is to rent and invest the difference. Why would that be a better option? Let’s look at the math.

Let’s assume you were trying to purchase a $250k 2-unit house. With a 20% down payment of $50k and an assumption of 1% closing cost for buying, at $2500, you sacrifice an opportunity cost of $52.5k towards this house. Assuming you had an interest rate of 4% on a 30-year fixed mortgage, you’d be paying $955 a month. By factoring an additional 50% to cover the misc costs, you would need to budget $1432 a month.

Let’s also assume that you lived in one unit for “free” while you rented the other unit for 650, about 300 less than the mortgage price. Not bad to have your neighbor pay more than half your mortgage right? Your net loss per month, or essentially your “housing payments”, would be $782, leading to a yearly “rent” of $9390. Let’s also optimistically assume that the house will appreciate every year by 4%, above normal inflation rates of 2-3%. By year 5, the house will have increased from $250,000 to nearly $304k. After having payed 5 years of your bills, you owe $19,104 less on your original mortgage balance of $200k and will have paid $16,950 towards your “rent”. Factoring in the gains/losses of the house’s value appreciation, mortgage payments and debt reduction, you will have a face net gain of $26,318 after those 5 years. This is the kind of number most people look at and pride themselves on when talking about their investment, after the perfect scenario of higher-than-inflation home value increase, non-stop revenue income coming from a well-behaved renter who covers nearly all of the bills, and normal housing costs.

But this is the biggest issue. Remember that $52,500 you put in as a down payment towards the house? When you put that money away into the house, you actually sacrifice an opportunity cost of having been able to direct that money into some other investment. What this means is that instead of having put that $52,500 into the house, you could have just as easily put it into investments that returned a modest 7% on average after 5 years. This means you have lost the opportunity to see an increase of your money by $21,134 in that time. If you subtract that opportunity cost, your overall net gain from buying the house at $250k and selling at $304k 5 years later is around $5,184.

Let’s assume that instead of putting the down payment money into buying a house from the beginning, you had left it inside investments that returned 7% per year. You will also settle for renting a cozy place at $650 and reinvest the difference of $132.50 that would have gone into the mortgage. After 5 years, your money will have appreciated by $31,411. That’s way more than the return your original house would bring you. Keep in mind that you could easily sell portions of your investments away with favorable taxation rates when in need of quick money, compared to being stuck with a lumpy house that you won’t see tangible cash benefit from until sale.

However, this doesn’t mean home ownership is all bad to be fair.

In these instances, home ownership can actually make a lot of sense (but not always).

  • You are able to stay in that multiple unit house for more than 7-11+ years. If you can stay past 11 years while renting out a portion of the house to cover the bills, then it will have had a good chance to pass the profit point over normal stock market returns. If you are living in that house without renting a portion to others, it brings you no added income whatsoever, meaning there’s a good chance it never made sense to own that home over investing in the stock market.
  • You did the calculations, and you found a house that makes financial sense over the stock market, even if you did sell in less than 5 years. For example, if you come across a “fixer-upper” house that could greatly appreciate in value after it’s worked on. Be warned though, the time spent fixing this house may also be less valuable than working on a different project. You need to factor in your own time spent fixing that house compared to side income that would potentially earn you more.
  • It’s psychologically easier for you to pay off a mortgage bill of $280 or whatever amount, than to consistently invest that money away.
  • You just like real estate more than the stock market. Whatever your reasons are, you’re just not a fan of the stock market. In that case, you might as well pick any type of investment than none at all. Even if it isn’t the most optimal use of your money, well at-least you’re doing something.
  • You’re buying in a hot market. But be warned, this type of thinking where “the house will just keep going up” is what caused the Great Recession in the first place. Many people lost their homes and livelihoods because of this type of optimistic thinking.

If you can meet one of these conditions, then it probably makes sense to aim for a home.

Hopefully you now have a more comprehensive understanding of the kind of thinking that needs to go behind what will likely be one of the biggest purchases, if not the biggest purchase of your life. If you have any questions, feel free to ask.

The Difference Between an Investment Manager and Financial Planner

difference between investment manager and financial planner

One of the problems in the financial industry is the presence of easily interchangeable words. For example, when people think of ‘investment managers’ and ‘financial planners’, you might consider them to be the same thing. However, they are two very different occupational roles that need to be understood, otherwise you may end up spending a lot more money on the wrong service.

Investment managers focus only on investing assets. Their job is to make you money with the money you already have by investing in stocks, bonds, alternative investments, etc. This is more like what broker-dealers do, along with robo-advisors like Betterment and Wealthfront. Although some of these robo-advisors and other websites call themselves “financial advisors”, in reality, they are far from it.

A true financial planner has a much more holistic job. A financial planner’s role can include investment management but more often, they hold generalist roles that can breach a number of topics in a client’s financial life. Some other common topics that are discussed by financial planners include cash management, insurance, income tax planning, company employee benefits, credit cards, student loans and estate planning. The range of possible services is much more than the limited services offered by investment managers proclaiming to be “financial advisors”.

Branching off the last point, some of the sites and apps out offering investment management, include human services. You would be able to call up a “financial advisor” for an added fee but the largest limitation is that their advice is limited to the investments you are making with them. You wouldn’t be able to call them up for advice on insurance, company’s employee benefits or anything else outside those investments. Paying extra money to these “financial advisors” for a few conversations a year is not worth the cost and would better be spent on hiring a real financial advisor that would be able to guide you through your situation in a more complete manner.

If you are considering receiving assistance with your finances, be sure to look more closely at what services they provide when they say they are “financial advisors”. It could end up saving you a lot of money.