How To Not Blow 20k

…Over a decade and a half.  I know: bad trick, using the headline that way.

But seriously, lots of people talk about how using low cost investing options is a good idea.  Put your money in index funds rather than actively managed mutual funds or with an adviser.

Why?

One word: fees.

Unfortunately, the investing world does not operate on the, “You get what you pay for principle.”

And, over the long haul, those little fees add up to be a drag on your returns.  How big of a difference?  Let me tell you a story…

 

When I was 18, my Dad gave me a gift that I will never forget.  He started me (now us) on the path to financial independence.

When I was 18, I had my first W-2 job working as a sales associate in the electrical section of the regional hardware store.  (I worked for years before that, but I was always a small amount and paid in cash, so it was never eligible for taxation let alone retirement savings.)  At the then-minimum wage rate of $5.15/hr, I didn’t make much.  But, the little I made was reported to the government as earned income.  “Fortunately,” my earned income was so small, I was ineligible to pay taxes.

I was using the money I earned to pay for some of  my college expenses.  So, my Dad said he would match up to my earned income and put the money into something called a Roth IRA.  Of course, this became table stakes to hold a discussion on the general topic of saving for retirement.  We talked about the differences between a Roth and a traditional IRA.  We talked about contribution limits and the difference in withdrawal rules.  Once, we made it through the lecture, we got into the fun stuff: what to do with the money.  Pretty quickly, we ruled out a down payment on a car or storing it in my sock drawer.  Instead, he suggested investing in a mutual fund, The Growth Fund of America (ticker: AGTHX).  AGTHX is, you guessed it, an actively managed fund.  Its annual expense ratio (one of several potential charges people pay to invest their money) is 0.6%.

So, why is that a problem?

If a typical index fund charges ~0.1% in fees, the observation is that actively managed mutual funds at ~.6% or a human adviser at ~1-2% don’t make you enough extra money in the long run to justify their cost.

Compare AGTHX to Vanguard’s S&P500 index fund (Admiral shares because we’re over $10,000).  The Admiral shares have an expense ratio of 0.04%.  While the Investor shares (minimum of $3000) have an expense ratio of 0.14%.  Last, I checked, 0.6% is more.

But, wait!  You say, “don’t the hotshot fund managers get a better return for their customers?”  How else can they justify charging more?

Maybe…

 

Let’s look at the numbers.

I used Morningstar’s portfolio analyzer to get a bit more information.  Note that it only looks at changes in share prices (no capital gains/dividend reinvestment included).  I simulated buying $100,000 of each fund on Jan 5 of 2001.  How have the two funds done over the past ~15 years?

Source: www.morningstar.com

If you look at a Google Finance image of the two mutual funds’ values over time, it looks kind of like this:

AGTHX vs INX

So, what gives?  For much of their history, AGTHX outperformed VTSAX (the blue line is higher than red line). But, something called “reversion to the mean” seems to have kicked in.  That’s fancy talk for an idea that most investments eventually delivery average performance.  They may out/under perform for years or a decade and a half, but eventually, they produce average results.  This is one of the core reasons for selecting low-cost index funds as your primary investment vehicles.  Over the long haul, if most funds perform similarly, then the lowest cost fund wins. You can read a lot more about this from John Bogle, inventor of the index fund, founder of Vanguard, and personal hero.   While AGTHX may have outperformed VTSAX for many years, in the long run, the two funds have had roughly equivalent performance for over 15 years, yet AGTHX consistently charges fees that are almost 10x higher.

By the way, those fees are pretty insidious.  If you look at your statements, you will not see actual dollar values coming out of your account.  Instead, the fund management team takes them off the top before they show up in any individual statements (I spent a few hours looking through some pretty arcane sections of both American Funds and Vanguards websites before I convinced myself of this).

So, now the conundrum.  I admit, it’s an emotional one.  Math says, roll everything from AGTHX into a lower cost fund (e.g., VTSAX).  Our goal is not to tap these funds for at least a few decades.  So, shedding the fees should be the right decision.  But emotion says maybe those über-smart folks at American will outperform the index once again.  And, what about diversification?  If hackers get into Vanguard, they may not simultaneously get into American.  And besides, my Dad is the one who got this ball rolling, even if I’ve done the vast majority of the contributions.  I feel some (totally irrational) guilt at moving away from this fund.

 

So, what to do?  I’d love some other perspectives…drop me a line in the comments.

 

Upgrading Our Home … To a Duplex

We’re in the market for a new house/rental property.  A friend of ours passed along a community for us to look into.  I figured it’s worth showing our evaluation approach (OK, it’s my evaluation approach.  My wife is much more interested in the big picture rather than how the math is done).

The community is in Fulton, MD.  (Montgomery county for those of you that read my last post on growing counties in MD). Fulton is a planned community under construction.  It has a Town Center with a community area complete with exercise facilities, a pool, and common spaces.  There’s a mix of neighborhoods, ranging from apartments, condos, and townhouses to single family “estates”.  The community is in the southern part of Howard County MD, so it definitely checks our box for good schools.

In a previous post, I talked a bit more about our requirements.  So, I’ll talk more about the math of evaluating a mixed use rental property where we live in one part, and rent out another.  While we’re not explicitly looking for a duplex, that’s essentially how I’m approaching this topic. Here’s two of my favorite bloggers weighing in on general rental property evaluation: Afford Anything, and Financial Samurai.  Finally, here’s an article specifically about duplex investing on bigger pockets, one of the biggest real estate blogs out there.

Let’s start with cash flow.  For a typical owner un-occupied property, cash flow must be positive to even think about moving forward (rents must be higher than expected costs).  For your personal residence, total costs should be less than some % of your gross income.  For better or worse, we’re looking to blend the two.  See how this seems different: we’re looking to buy a place with a portion of the costs offset by a renter.  If it was a classic duplex, we’d likely want to “live for free” such that the renter covers not only their portion of the costs but 100% of ours as well.  Somewhere between “live for free” and rents subsidize our lifestyle is the trade space we’re looking into.

With that said, the math ends up being pretty straightforward.  Here’s a link to the spreadsheet I’ll be using to evaluate potential properties that fit into this kinda-sorta-duplex.

  1. We can estimate what an individual property will cost us to own and operate/maintain as our primary residence.
  2. We can estimate market price point for a rental property that looks like ours.
  3. We can subtract the two to find out what our net cost of living will be.

Next, appreciation.  Zero (this one is easy).  I never assume we’ll benefit from any appreciation on a rental property.  There’s some good reasons for this: real estate tends to appreciate with inflation.  This keeps the math simple when evaluating prospective properties, and keeps me conservative.

Finally, taxes.  I figure out what the estimated property taxes will be so I can factor them into cash flow.  The source foe the tax information is either based on the listing (if available) or the historical tax records…You know those are all public records, right?  Here’s the MD website.  And, here’s a link to an online public records search site so you could look start your search anywhere in the US.  After that, any deductions, expenses, etc are all gravy.  I would never advocate buying a rental property just because of the tax benefit.  The underlying investment needs to be sound first.
So, how does Fulton stand up?

Here’s a nice 4 br/2.5ba single family home in this area.  It’s not built yet, so there’s some opportunity to increase costs.  Let’s just assume we stick to the builders “vanilla” house and get all 2894 sqft for ~750k (yowza)!  Median rents for a 1br/1ba are ~$1,900/mo.  Let’s assume that the HOA will take kindly to us turning this into a duplex.  Then, let’s run the numbers based on the information in the listing:

Fulton MD 4br/2.5ba single family purchase and recurring financials

Let’s start with the biggest red number on the sheet: $168,747.75.  Say it with me: one hundred sixty eight thousand, seven hundred forty seven and seventy cents.  If we were to put 20% down, that’s the amount of cash we would need for the down payment and for estimated closing costs.  Ouch!  Next, that big number to the right of Monthly Recurring Costs: $5,612.19.  Every month for ~30 years we would owe, escrow, insure, or maintain this sum in order to afford this lovely home.

Now the good news.  A 1 br/1ba in this neighborhood is also a pricey affair.  I saw $1,900/mo as the nominal rent for such an apartment.  So long as we don’t mind neighbors downstairs indefinitely, we could end with a net monthly cost of $3,468.19.  That’s still a big number, but it helps to illustrate why I’m so keen on having a rental property baked into whatever becomes our next home.  Note that I took a wild guess to arrive at ~20k to convert part of the basement into a rental unit.  Here’s hoping that’s in the realm of reasonable!  Because these numbers are still pretty big for us, I’m leery of making this kind of commitment without doing some serious homework.

What do you think?  Would you ever accept a long-term rental situation in order to afford a big honkin’ house?  Is there another way to make this kind of move and keep it affordable?

Investing With Leverage: Whose Money Is It Anyway?

As the year starts to wind down, I spent some time reviewing our financial books for the condo.  I was adding up the income earned to date, paying required expenses, and thinking about what distributions we should take.  Then, it struck me: Once rental payments started coming in, we haven’t spent any more of “our” money.  Effectively, our tenants have been paying our mortgage, covering condo fees, and building our maintenance reserves.

So, let’s explore how much of our actual cash we’ve spent. I’ll use some rounded numbers to help illustrate this.  We spent about $65k to acquire the condo and get it rented.  Now, that includes all of our closing costs and renovations as well as our initial equity.  Npw, let’s break things down a bit further:

  • Down payment ~40k
  • Closing costs ~10k
  • Renovation costs ~15k

The down payment is not really gone assuming we sell at some point.  It’s counted as part of our initial equity in the property. But that cash is currently tied up, and we cannot use it for any other purpose (More to come on that). If the condo appreciates at all (we sell it for more than we bought it), that will be considered an increase in our equity also known as a capital gain.

The 10k in closing costs are essentially gone.  The allowed ones went into our business expenses and will be helping us to offset current and some future income.  So, these were “real” expenses to us.

We also spent about 15 k to renovate.the unit. You could argue that we had to spend real money to pay for countertops, appliances, and a new HVAC system.  Or, you could consider them as increases in the base value of the property.  Where applicable, that’s what we dis.  The big items were counted as increases in our cost basis, and they are being depreciated over their IRS directed lifetimes. So, an accountant might say the money is not technically gone.

That means we bought an income generating asset that meets the 1% rule.  And we did it for a total of 10k of real expenses.

Baring any major disasters requiring cash above our reserves, every other nickel  from fixing the garbage disposal to putting in new floors (again), will be paid for with other peoples’ money .  Now that’s exciting!

So, we have this great problem…what do we do with the excess cash once we’ve fully funded our reserves?  Pay down the mortgage?  Save for rental property number two?  Invest in Wells Fargo?

I Have a Dollar. What Should I Do With It?

George Zoomed

It depends.

Of course.  Smart A$$.

No, really. It depends on a ton of different individual factors that are unique to your specific situation.  Funny enough, I’ve been taking about this very question with a bunch of folks. One friend has retirement savings that need a new purpose. Another is debating between adding debt to purchase a rental property vs. pay down their home mortgage.  And, we’re asking a similar question about how we could move closer to our work locations and acquire a second rental property.  My point is simple: everyone faces these kind of trade off decisions routinely.  I don’t think I could or should answer the question for anyone else, but I think there is a framework that folks can apply to their own situation.

At the heart of this topic is the concept of opportunity cost.  (Hold on to something solid; this gets heavy quickly.)  Opportunity cost is what you give up when you commit.  Just got married?  Congratulations; you just gave up your chance to date Claudia Schiffer (Or Justin Timberlake).

Bought a CD?  For the money you invest in CDs, you’re giving up on the chance to buy Amazon stock with those dollars.

Bought Amazon Stock?  Those dollars won’t be buying into the Uber IPO.

Bought Uber?  Those dollars won’t be buying a rental property for you.

To get more technical:

…opportunity costs are used to measure the differences in returns between a chosen investment and one that is forgone. For example, consider a person who invests in a stock that returns a paltry 2% over the year. By placing his money in the stock, the investor gives up the opportunity to invest in another investment, such as a risk-free government bond yielding 6%. In this situation, the opportunity cost is 4%, or 6% – 2%.

Read more: Opportunity Cost Definition | Investopedia http://www.investopedia.com/terms/o/opportunitycost.asp#ixzz4HBW1h1hG

Follow us: Investopedia on Facebook

Sounds easy doesn’t it?  Let’s take a more personally  relevant example to understand some of the nuances of this kind of decision.  Say that I have an extra  $1000 sitting around.  As cash, it might as well be under Aunt Bertha’s mattress.  What should I do with it?  I see a couple of options.

  1. Pay down bad debt: one of our car loans
  2. Pay off our other car loan and start a “debt snowball
  3. Save/invest it for our next rental property

Option 1

This one is pretty straightforward.  Say our loan balance is about $5000.  The interest rate is 2.25%.  We’re a few months into this one due to the untimely demise of my beloved Scion xB.  Of course, our first car loan doesn’t change at all.  So, by paying down Loan #2,  we payoff the loan 14 months earlier, and avoid about $80 in interest over the life of the two loans. Our total interest paid for Option 1 would be $743.02.

Option 2

After almost 4 years, we have about $1000 left on our first car loan.  Let’s say our payments are $100/mo.  So, by paying the loan off now, we save a whopping $11 in remaining interest and free up $100/ mo to apply to the other car loan.  This is the start of the “debt snowball” popularized by folks like Dave Ramsey.  In short, it’s an emotionally satisfying way to pay down your debt.  Although, it’s not financially optimal(this is an awesome tool; check it out for your specific situation).  After paying off the first and applying the payments towards the second, we  find the total interest paid for Option 2 is $689.60.  Sounds a bit better.

Option 3 

This is the most complex of the three. We carry the existing two loans without avoiding any interest.  The rates are pretty low, so maybe it’s OK.  Now, a low cost bond fund has historically returned 3% (Vanguard’s has been a bit better with all the craziness going on over the past few years).  We’re looking to invest the money for three years.  If we assume past performance is indicative of future (possibly a BAD assumption), we’re looking at a potentially life changing $91.32 in distributions.  Our net interest paid for Option 3 would be $651.70.

So, how do these three options compare?  Someone play the “wah, wah” trumpets.  OK, I’m hoping that while our numbers aren’t terribly exciting, this concept is.

Opportunity Cost

Trade-off between paying down one loan, debt snowballing another, and investing funds instead.

It looks like Option 3 provides us with the best overall benefit.  What if we were willing to wait a few more years? What if we consolidated our car loans into a lower cost HELOC?  What if …?  And, that’s why I said, “it depends” way up front.  Your specific situation will vary.  Maybe you have higher rates or larger balances.  Maybe  you’re questioning weather or not you can afford to make extra payments each month.

The point is, you can use math to help make the best decisions possible with your limited dollars.  Those dollars can be the seeds of your future.