Friday, October 10, 2008

Feel free to skip this one

This is going to be long, so feel free to skip the whole essay. Anyway, today I composed a financial tirade.

Here we go.

I'll start by saying that this is my understanding of the situation. This is not what I do for a living, so if I'm wrong feel free to point it out.

What happened in the US?
We all know what a mortgage is - the bank lends a person/ business money to pay for real estate. The person borrowing the money pays it back according to the terms of the agreement. You can have a fixed rate mortgage for a period of time (say 5 years). The mortgage is typically amortized over a longer period of time (25 years), which means you would need several 5 year mortgages before the mortgage is paid off. You can also have a variable rate mortgage (where the mortgage rate fluctuates with interest rates.

In the US, banks started lending money for mortgages where the initial rate was low, but it skyrocketed to a high rate after a period of time. They were sold to consumers who were told that they could re-finance when the low rate expired. The "plan" was that when they re-financed, the price of the house would have gone up.

Housing prices started going down.

Let's say that you bought a house for $250,000 and put $10,000 down. You have a mortgage for $240,000.

Now let's say that house prices in your area dropped 10%. Your house is now worth $225,000. Since in the first years of a mortgage you pay mostly interest, you might have paid off $1000 of your mortgage.

So your house is worth $225,000, and you owe $239,000.

No bank is going to let you re-finance for $239,000, since that is more than your house is worth. That means you're stuck with your higher interest rate for your first mortgage.

A lot of people couldn't afford the higher interest rate (especially since fuel, and thus a lot of essential items like food, was going up at the same time), so the bank ended up foreclosing.

It gets worse.

Banks started to realize that loaning money that wasn't paid back was not, in fact, good business. As a result, they went the other way - they slashed credit card limits, and it was much harder to get a mortgage or other credit. This applied to both individuals and businesses.

A lot of people directly involved with mortgages & other financial services started to lose their jobs. Banks with more bad debt than they could handle started to go under.

Some unrelated businesses that needed short-term loans (for example, a store that has to pay for supplies a month before getting the money in for sales) were no longer able to get those loans. As a result, they started to close.

The situation gets worse when you consider how much of the world's economy is tied to the US economy (and how many other banks, etc. had invested in the sub-prime mortgages).

Obviously, the people losing their houses made bad financial decisions (committing to a contract based on the assumption that things will only get better). However, the banks bear a lot more responsibility for the situation - they took advantage of people's poor financial management, and, in some cases, lied on loan applications so that people would get approved for more money than they should have received.

What can I do to minimize the impact on me?
There are good financial decisions that everyone should be making regardless of the economy.

1) Set up a plan to have money taken automatically from your bank account every month & put into a savings vehicle. You want to have some money set aside in something that gives you interest, but that you can use in case of emergencies. Set a minimum amount you want to have set aside for unexpected financial hits (like job loss, medical/dental bills, an unexpected major repair, etc). Once you are over that minimum, you can use the excess money for major purchases if necessary. Obviously, everyone has different levels of what they can afford to put aside every month, but the key is that you want to contribute regularly and you want the money to be available, but harder than normal to get at. (Perhaps that means you don't put it the account on your bank card, perhaps it means it's in a mutual fund where it takes a couple of days to get at.)

2) Understand the difference between needs and wants. You need medical & dental care. You do not need new clothes (assuming that you haven't had a fire or something - in that case new clothes would be a need). Cable, cell phones, restaurant meals, a gym membership are all wants. A vehicle (& its related costs) is a want if you live somewhere where you can get to work without it.

3) Do not carry a balance on a credit card unless it's for a short-term need. (If it's a long term need, you need to figure out how to pay it off regularly). A lot of people don't seem to know this, but when you put something on a credit card, you have around a month to pay it off without owing interest. If you don't pay it off, every purchase you make from then on (until your entire balance is paid off) will cost you interest immediately. So let's say you buy something for $200 on September 10. The bill is printed September 15, & the payment is due October 4. On September 18, you put another $200 on your card. If you don't pay off the first $200 by October 4, you will owe interest on all $400 (even though you haven't got the bill for the Sept. 18 purchase yet). And credit card interest rates are high. You don't want to get into that hole.

4) Look at where you're spending your money and figure out if you're spending your money to match your priorities. Wants don't go on the credit card unless you can pay them off. But let's say you can afford them - do you want to afford them, and do you want the level of service you're paying for? Do you need voicemail on your cell phone? Do you eat out several times a week, and, if so, what will you save by cutting that level in half? Do you watch a significant number of the channels you get?

5) Contribute to your retirement fund. In Canada, you don't pay taxes on the interest generated within your RRSP, and you get a tax deduction. No point in passing that up (unless you are contributing money that would otherwise be used to pay off high interest credit card debt).

Make sure you balance your investments - generally the closer you are to retirement, the less money you should have in stock-based funds - and diversify so that one company going under doesn't destroy your investments. If you're years away from retirement and you have a retirement plan, you probably lost a lot of money (on paper) in the last month or so. It's hard to contribute more money when you've just lost a lot as the markets fall, but that's where dollar cost averaging comes in.

Here's how it works.
Let's say you invest $100/month in a plan.
Month 1, plan shares are currently $100, so you get one share.
Month 2, shares are $50, so you get 2 shares.

What is the average cost of your shares in this plan? No, it's not $75 - it's actually $67 (i.e. $200/3 shares). Basically, as the price goes down, you will get more shares - which means that when prices eventually get better, you will be better off.

6) Mortgages. If you want to buy a house, that's great - but make sure you understand all of the real costs involved. If you buy a house, you will owe money on your mortgage, you will owe money for property taxes, and you are responsible for maintenance & repairs. You don't want to be in the position of owing more money than your house is worth. That means you need a down payment. If the rules haven't changed, in Canada you need a 25% down payment to avoid having to pay for CMHC insurance. (I think if you put down 10% you need less insurance than if your deposit is < 10%.)

Anyway, once you have determined you want to buy a house & you've figured out what your down payment will be, go to the bank and get pre-approved. The bank will tell you how much they'll lend you. You do not want to borrow as much as they'll give you.

Instead, figure out what you can afford in payments each month (or, ideally, every 2 weeks). Then figure out how much you can borrow to get your payments at that amount - and then borrow less than that.

Remember how I said that the first few years of a mortgage you're paying mostly interest? Let's say you can afford $500/month. If you borrow an amount that puts your payments at $500/month, you will be paying off mostly interest. However, if you borrow an amount that puts your payments at $400/month and then increase your payments to $500/month, you will be putting an extra $100/month directly on the principle. That may not sound like much, but that's money that you won't be paying interest on for 20 years. An added bonus is that if your circumstances change (due to job loss, for example), you can drop your payments back down to $400 without re-financing.

7) Pay for maintenance. Very few things get better on their own, and failing to paint the siding or fix that noise the car is making can end up costing you far more in the long run.

8) Learn to say no to things that are not important to you. (Actually, this is a good idea in general, not just financially.) Decide what charities and organizations you want to support, and say no to requests from other ones. If you can't afford to go out to eat/go to a movie/go on a trip, don't go. There are lots of ways to socialize with people without spending a lot of money - suggest something else. Keep in mind that if you decide not to do something, all you have to say is "no". You don't need to explain why.

9) Don't assume anyone else will look after your financial future.


  1. Well thought out ideas.

    I was having a conversation with Son #2 a while back about the things his dad and I pay for that aren't really essential--like satellite service for the TV, Internet service for the house, and cell phones--well, except for mine, which is my business number :-)

    He got all indignant and said something about how we could afford all that stuff. My point was that yes we can-now-but all those could be eliminated if we had to. It's a huge chunk of change.

  2. wow...i really enjoyed this post. my hubby and i made lots of bad financial decisions when we were dating many years ago, but hopefully we'll pay of some of our credit cards soon. we have a hard time with that WANTS vs. NEEDS part though :)

  3. It's easy to make decisions that snowball - you sign up for cable, and they increase it by $3, then $4, and before you know it, you're paying $20 more than you originally were.

    I was unemployed for 7 months in 2007. It wasn't super stressful financially - I was lucky & had severance pay to live on - but it made me stop & re-evaluate some of my regular expenses. I hope I keep doing that regularly.

  4. I'm just used to having no money. I have my savings [and even though I'm only working part-time right now, I still contribute] that I never touch. I just don't spend a lot of money. And I don't think I ever will, even if I have the means. This is what happens when you get used to having no money...I don't even notice the financial crisis.