Types of Personal Bankruptcy

Personal bankruptcy is something that is talked about more lately as people lose their jobs, debt levels remain high, and the news media is enthralled with financial pain.

So I have taken the time to briefly discuss the two types of bankruptcy for individuals and how they both work.

There are two types of bankruptcy: Chapter 13 (similar to Chapter 11 for companies) and Chapter 7.

Chapter 7

Chapter 7 bankruptcy is also known as liquidation, and is where almost all debt is discharged and the individual gets to reset their life with little to no debt. The liquidation part is because the individual is required to sell or liquidate all their assets except retirement assets and certain allowable assets, usually cars, and basic living items. The courts can force liquidation of homes, stocks, excess living assets, etc. The money raised from sale of these assets is used to pay off debt and the remainder of the debt is written off by the bank.

Chapter 13

Chapter 13 bankruptcy is restructure, where not all debt is written off by the banks but it is restructured under a court imposed repayment plan that repays some of the debt but with usually substantially lower interest rates and in some instance substantially lower debt. The courts allow the individual to keep major assets such as homes, cars, etc as long as payments can be made on secured assets. While the unsecured banks might have to write-down a portion or all of the loan.

In both instances it depends on your income and debt levels as to whether you qualify for Chapter 13 or Chapter 7. I can answer questions to that regard if you want to leave a comment. Also, I will discuss the advantages or disadvantages of bankruptcy in my next post.

-Thor

Where is my money?

While I don’t dare try to answer something as weighty as what is money, I have a story from over the weekend that is still being sorted through but really made me think about what money is. I mean is money just numbers on a computer screen, or is it a pile of currency, or is it gold, or is it something else?

The reason this hit home for me was because my brother and I were talking about what we do with our money. We discussed at length where it goes once it comes into our bank accounts, needless to say we hardly use cash for anything anymore as that requires a laborious trip to the bank which we as the internet savvy people do not do. But I mean if I had $1 million dollars what does that mean? If I used it to buy a house is that house a representation of money in anymore of a way than $1 million dollars stacked to the sky would be?

The great debate becomes even more interesting when you need money or have debt and do not have enough currency or enough figures on your computer screen (bank account). For example if you had a nice house worth about $300,000, a lexus worth about $20,000, a sailboat worth $40,000 but you also had $50,000 in credit card debt and $280,000 in house debt and the cash flow that you have coming in does not support the repayment of that $50,000 in debt.  So the real question is where is the money? I am suggesting that the money or the debt translates into goods, such as the car, the boat, the house, etc. This seems very obvious to some but oblivious to others. Some people see the credit card debt and think that there is no way for them to pay off that amount because their cash in the account is less than $50,000 and their cash flow coming in cannot support the repayment of that debt.

However, if you could sell the sailboat for $40,000 and use that money to repay the debt then repayment becomes much easier. While this could obviously impact the recreation of the person, the money is locked up in the assets and to become money again it is as simple as selling it.

-Thor

How long do I have to work for this?

An interesting thought has struck me in the last few days. There are two ways to think about large purchases such as cars, homes, etc. I know previously I have broken down purchases into hours but for large purchases lets think about years.

For example if you are making $100,000 a year and want to buy a $500,000 house then you would need to work for 5 years straight (assuming you actually took home your whole paycheck which you obviously don’t). But that really put it in perspective for me. In order to really justify a house you would need it to be a LONG term decision if you wanted to spend a large multiple of your income.

You could do the same thing with a car purchase. Say you bought a car for $20k and were again earning $100k. Then you would be working 20% or about 2.5 months of your year just for a car. That might be more worth it.

All of the above assumptions are just simple thoughts with no analysis done on interest, etc that would make the payback longer. I just find it interesting that people are willing to work so long and hard for physical goods.

-Thor

New Blog – Thorism

Just as a heads up I will continue to post on this blog but I am also putting up a new blog called Thorism. THe first post is here: http://thorism.wordpress.com/2009/04/01/ultimacy/

-Thor

Finance is just not that simple

It has been ages since my last post. In fact it has been approximately three months since I last posted on this site. It has been due to vacation, work, and general shock and awe of the financial upheaval in the world. The stock market has zoomed all over, my bank has seen a lot more work in new deals, workout of old deals, and continued credit tightening in the market that has made it more difficult for companies to get credit and for us to work with banks to get companies credit. Overall, a very exciting time but a tough one.

So with that short intro…this post is really going to be about capital allocation or how finance forces us to make choices in life.

Essentially the concept is the same for companies and individuals. However, with companies it is much easier to explain. But the concept is that if spending money garners a return above your requirement or expectations than you should spend the money (make the investment if you will).

For a company the easiest example would be whether the price of a new piece of equipment is worth it based on cost savings, efficiency improvement leading to higher revenue, etc that would mroe than offset the return on equipment. Also, this can be appleid to any project or spending for a company. If a new product is expected to earn more than the investment would in another place than it makes sense to take on the project. Remember the caveat to all this is that the project would need to return over 10% if the money could be invested for 10% somewhere else or another way to think of it is that your investors and debt holders want a return higher than some other investment they can make. So any project that returns higher than your cost of capital (the cost of debt and equity) should be undertaken. It really is that simple, you want to invest in higher returning projects/investments. The only problem is that the future is unknown and more importantly not every project can be undertaken as capital resources (money) can be scarce at times. So if you have only enough money for one particular project you invest in whatever you deem will return the most. This is why some companies have great ideas that  never come to market. They simply do not have all the capital required for all their projects so they pick the one they think will return the most.

Individuals should make a similar assessment, but rarely do. The problem is that there is no simple way to calculate the return of most spending by individuals, and all the emotional advertising and instant gratification takes hold and obscures the real return of the lack of capital allocation required. For example individuals that spend within their means, which means no debt, have only their income to spend and have to choose between a new car or a used car, a small house or a big house, renting or buying, big screen television or laptop computer. However almost all of these items does not have a financial return to the buyer. It is extremely difficult to compute the dollar return on most consumer items and therefore it is not as simple to assess the return. But it is easier to look at your capital resources and determine what you can afford. If you make $2,000 per month you can only spend $2,000 per month for anything unless you take on credit or if you have savings to spend that would meet the additional expenses.

So if it is so simple to look at your capital and calculate what you have to spend, why do so many people take on debt?

-Thor

What are Interest Only Mortgages and Do they Make Sense for you?

I have been wanting to post this for awhile, and I am finally getting around to fill everyone in on the details of how to look at some basics of mortgage financing, specifically the interest only loan compared to a normal fully amortizing loan.

Fully Amortizing Loan

So what is a fully amortizing loan? Well amortization on a loan is the amount of principal or loan repaid. So if you had a $100 loan with a monthly interest rate of 10% and you made a payment of $50 at the end of the month the interest paid would be $10 and amortization or principal of $40, so the next month you would have a loan of $60.

Obviously people are not buying homes for $100 but the above example was simple to explain amortization. So take that example and add fully amortizing and it means that a loan will be fully paid off at the end of the agreement. So if you have a 30-year fully amortizing loan it would mean that the amortization of principal amount paid down after 30 years would be equal to the original amount of the loan. This would mean that the loan is paid off and you would own your home fully.

This was traditionally how homes were bought, with 30-year fully amortizing home loans.

The transaction would occur as follows: A house would be bought for $625,000 with a mortgage for $500,000 and a down payment of 20% or $125,000. The monthly payment would be $2,998 (based on 6% interest and not including taxes or insurance). At the end of 30 years the home would have no loan against it and the monthly payments would be zero.

(Please note: the principal paid down is initially small as the interest portion of the payments accounts for approximately 90% of each monthly payment in the first 5-10 years).

Interest Only Loan

Interest only loans are not as straight forward as they sound. The initial prospect of an interest only loan is that a borrower would only pay interest. So with the same $500,000 loan at 6% the monthly payment would be  $2,500 or $498 less per month than a fully amortizing loan. So of course that sounds great, in fact with an additional $500 you could put a lot of food on the table, pay for a car loan, etc.

The problem resides in the fact that these loans are not interest only forever. Eventually the bank will require some amortization or principal repayment so that the loan is repaid. A typical interest only loan is between 5-10 years of interest only with 20-25 years of amortization to finish off the loan.

So if you took out a 10-year interest only loan with a 20 year amortization on the back end the payments would be as follows. For the first ten years you would have a monthly payment of $2,500 and in year eleven the monthly payments would jump up to $3,582 or an increase of over $1,000 (or an increase of about $584 compared to the fully amortizing 30 year mortgage). This occurs because you are repaying the same $500,000 loan over 20 years instead of 30.

The other risk is what happens if after 7 years you want to sell the  home and the value has declined by 25%. If this occurs the home would be worth $468,750 and the loan balance on the interest only would be $500,000 forcing the home seller to come up with $31,250 to repay the loan.

If the fully amortizing loan was used than after seven years the home value would be the same $468,750 but the loan to be repaid would be $446,680. So the home owner would receive $22,070 in cash after the sale of the home and repayment of the loan. So while the initial down payment amount of $125,000 would have declined substantially in either case the interest only loan would require additional money to repay the loan while the fully amortizing loan would allow some cash to be received in the sale of the house even with a substantial 25% decline in value.

The flip side of the above argument is that in the first three years the fully amortizing loan only pays down principal by just under $20,000 which is just under the $21,024 saved by lower payments with the interest only loan. So if a house did not decline in value and was sold than you could have used the additional savings with the lower monthly payments to make better investments.

Should You Consider an Interest Only Loan?

There are instances where it might make sense to take on an interest only loan.

1. You want to purchase a home and are confident your income will increase to meet the increase in payments when the interest only option decreases

2. You have a feasible alternative investment for the savings garnered by a lower monthly payment.

3. A large percentage of your pay is given in the form of annual or quarterly bonuses and want the flexibility of a interest only option where you can pay down principal with the large bonus payments and have lower required monthly payments.

4. Although dubious, if you are very confident that home prices will go up, it could make sense to have an interest only loan. (Please note that I would never advise this as a reason to take out an interest only loan as no one can tell the future for sure, especially in a 5-7 year time frame).

Conclusion

I hope that helps discuss how the interest only mortgage works compared to a fully amortizing (traditional mortgage). I have an excel worksheet that you can use to calculate loan payments (including insurance and tax) if you are interested. I can also answer questions about negative amortization loans, adjustable rate mortgages, etc if people are interested. Just leave me a comment and I will get back to you.

-Thor

What does the minimum credit card payment mean?

I always thought that the minimum payment on credit card balances was based on the interest expense or the pay off the credit card balance over a period of time say 5-10 years or less. However, I just found out that is not the case at all. I did not know this because I have never carried a credit card balance and I have never made just the minimum payment. In fact I have always paid off my credit card bills every month.

So anyways, how is it calculated and what does that mean for someone trying to payoff the credit card?

It is calculated as a percentage of the balance on the credit card. For example my credit card carrier requires that you pay 2% of the balance per month if you carry a balance. That would simply equate to 24% during the year. However, it doesn’t take into account the interest charges on the card which are approximately 12% per year.

So what would this look like? While if you were carrying a $5,000 balance on your card and you just wanted to make the minimum payment every month it would require a payment of $100 (2% of $5,000) and the credit card company would add $50 per month to my balance for interest charges of 1% per month or 12% per year.

So over a year the transactions would appear as follows:

Month	Credit Card Balance	Monthly Interest Rate (12% Annual)	Minimum Payment (%)	Minimum Payment ($)	Interest Charges Added to Balance
1	$ 5,000.00	1.00%	2%	$ 100.00	$ 50.00
2	$ 4,950.00	1.00%	2%	$ 99.00	$ 49.50
3	$ 4,900.50	1.00%	2%	$ 98.01	$ 49.01
4	$ 4,851.50	1.00%	2%	$ 97.03	$ 48.51
5	$ 4,802.98	1.00%	2%	$ 96.06	$ 48.03
6	$ 4,754.95	1.00%	2%	$ 95.10	$ 47.55
7	$ 4,707.40	1.00%	2%	$ 94.15	$ 47.07
8	$ 4,660.33	1.00%	2%	$ 93.21	$ 46.60
9	$ 4,613.72	1.00%	2%	$ 92.27	$ 46.14
10	$ 4,567.59	1.00%	2%	$ 91.35	$ 45.68
11	$ 4,521.91	1.00%	2%	$ 90.44	$ 45.22
12	$ 4,476.69	1.00%	2%	$ 89.53	$ 44.77

So at the end of the year the balance would be $4,431.92. You would have paid $1,136.15 in payments and only reduced the principal by $568.08. So the $568.08 paid would have cost you over $1,0000. So that can be very expensive over time just paying the minimum payment.

In fact to payoff the entire balance would take over 30 years and require payments of over $9,500 or almost double what the initial purchase cost someone.

I hope this helps illuminate just how dangerous making the minimum payment really can be to your financial health.

Thor

Financial Leverage for an Individual

I post a week or so ago about using leverage in a business and how that can help or hurt depending on the situation. The real issue becomes whether it makes sense to purchase something now with borrowed money or wait to buy it using saved/earned money. My easy rule is that financing an asset/investment might make sense but financing anything else is probably not a good idea. This is true for both business and individuals. Below I will provide a couple of examples of how leverage can work.

In particular I want to highlight 8 scenarios (I know it is a lot but I will summarize at the bottom, so you can skip the ones you are not interested in.

Scenario #1: Purchasing a house (all loans in all scenarios are for 7% and 30 year amortization) with 10% down & selling it 8 years later assuming 3% a year appreciation

Original Cost of Home	$ 260,000
Down Payment (Invested Money)	$ 26,000
Loan Amount at Purchase	$ 234,000
Value of Home at Sale	$ 296,424
Loan Amount Left at Sale	$ 209,075
Cash Received at Sale	$ 87,349
Interest Paid On Loan	$ 124,864
Rate of Return excl. Interest	16%

When you use leverage in this scenario it allows you to put a minimal amount down ($26,000) to own a much larger asset worth $260,000 than you would have been able to purchase on your own. Therefore as the asset increases in value over time you get cash back after the sale of the home and your return is 16% a year over 8 years because your small initial investment was enhanced by the use of leverage in a growing asset. However, the return would be much less after you factor in the interest costs during the period would actually be negative as you had paid $124,864 in interest costs over the tenor of owning the house. However, you would likely have paid some amount to rent and thus I excluded this from the return calculation.

Scenario #2: Same as #1 with 3% per year depreciation.

Original Cost of Home	$ 260,000
Down Payment (Invested Money)	$ 26,000
Loan Amount at Purchase	$ 234,000
Value of Home at Sale	$ 183,396
Loan Amount Left at Sale	$ 209,075
Cash Received at Sale	$ (25,679)
Interest Paid On Loan	$ 124,864
Rate of Return excl. Interest	N/A

In this scenario you were able to purchase an asset worth much more than your initial investment, but the rate of return was below zero and you actually had to paid the bank additional money even after the sale of the house because the value had depreciated 24% or 3% a year. This means that taking on greater leverage can really lower your rate of return if an asset does not go up in value.

Scenario #3: Purchasing a house with 20% down & selling it 8 years later assuming 3% per year appreciation

Original Cost of Home	$ 260,000
Down Payment (Invested Money)	$ 52,000
Loan Amount at Purchase	$ 208,000
Value of Home at Sale	$ 329,360
Loan Amount Left at Sale	$ 185,845
Cash Received at Sale	$ 143,516
Interest Paid On Loan	$ 110,990
Rate of Return excl. Interest	14%

This is used to contrast to scenario #1 and exhibits the impact of leverage. As you put more money down and assuming the same appreciation rate as #1 you saw a lower absolute return. This is the positive impact of leverage and enhanced your return by 2% per year.

Scenario #4: Same as #3 but with 3% per year depreciation.

Original Cost of Home	$ 260,000
Down Payment (Invested Money)	$ 52,000
Loan Amount at Purchase	$ 208,000
Value of Home at Sale	$ 203,773
Loan Amount Left at Sale	$ 185,845
Cash Received at Sale	$ 17,929
Interest Paid On Loan	$ 110,990
Rate of Return excl. Interest	-12%

This is used to contrast to the first three examples and generates a negative return on 12% per year. While not as bad as scenario #2, it does show that with a larger down payment and less leverage you were at least able to get some cash at sale and not have to pay extra to get out of the loan.

Scenario #5: Purchasing a home with 20% down and keeping it for over 30 years assuming 3% appreciation (no downturn scenario it is highly unlikely that the value of the home will decrease over a 30 year period but if appreciation is less than the return would be lower).

Original Cost of Home	$ 260,000
Down Payment (Invested Money)	$ 52,000
Loan Amount at Purchase	$ 208,000
Value of Home at Sale	$ 631,088
Loan Amount Left at Sale	$ -
Cash Received at Sale	$ 631,088
Interest Paid On Loan	$ 290,179
Rate of Return excl. Interest	9%

Although this has become less normal in the U.S. today, it used to be more ordinary for people to stay in their homes for a longer period of time. In this scenario it just goes to show you that over a 30 year period you can get a 9% return on investment with only a 3% annual price appreciation. Assuming that you have fully paid down the loan. If you took on more leverage and put less down you would get a higher return if the home appreciated and of course if the home depreciated you would get a lower return.

Scenario #6: Using credit card at 20% to buy a big screen television.

Original Cost of Television	$ 2,600
Down Payment (Invested Money)	$ 100
Loan Amount at Purchase	$ 2,500
Value of Television at Sale	$ 100
Loan Amount Left at Sale	$ -
Cash Received at Sale	$ 100
Interest Paid On Loan	$ 1,474
True Cost of Television	$ 3,974

This scenario is analyzed a little different than the prior scenarios as the television is unlikely to have much resale value down the road (but I put in $100 just for reference) and as there is not an offset to the interest expenses (as rent offset the mortgage payment) I put in the total cost of the television and the interest to generate what you really paid for the television. This allows people to purchase a product without having the entire amount of money on hand, but it would cost you an additional 50% when you figure in the interest costs associated with the loan which really makes your return on investment negative. This is more obvious to those of us who do not see televisions, stereos, etc as assets or investments but rather non-durable sources of fun.

Scenario #7: Purchasing a new car with a 100% loan and sale in 3 years.

This scenario assumes you purchased a 2009 Toyota Camry for $24,000 put nothing down and received a loan with 8.5% interest over a 7-year time frame.

Original Cost of Car	$ 24,000
Down Payment (Invested Money)	$ -
Loan Amount at Purchase	$ 24,000
Value of Car at Sale	$ 11,800
Loan Amount Left at Sale	$ 15,420
Cash Received at Sale	$ (3,620)
Interest Paid On Loan	$ 5,103

Again as a brand new car loses so much value in the first few feet off the lot, much less the first few years it has a large impact on your return which in this case is negative similar to scenario #2. This occurs because there was no down payment and the car is not an appreciating asset but a depreciating asset overtime. Therefore unless you want to keep a car for as long as the loan is than you run the risk of having to pay down the remainder of the loan when you sell your car. Again, this is what happens when you take on too much leverage.

Scenario #8: Purchasing a car with no loan and sale in 3 years

Original Cost of Car	$ 24,000
Down Payment (Invested Money)	$ 24,000
Loan Amount at Purchase	$ -
Value of Car at Sale	$ 11,800
Loan Amount Left at Sale	$ -
Cash Received at Sale	$ 11,800

This scenario generates that while you had to put in $24,000 to purchase the car you were able to use it for 3-years and then get some cash at the end of those three years. You could than use this $11,800 to purchase another car or for a sizable down payment on another car.

The last two examples really highlight the reality of purchasing a car new before some of the value has depreciated and what happens when you sell a car after only a few years of ownership. Cars are likely essentials in the modern U.S. lifestyle but the above scenarios present the harsh reality of debt and purchases that will not grow in value.

Conclusion: The positives of leverage as exhibited in these scenarios you can gain a higher return on investment with leverage, as long as the asset increases in value. Also you can purchase something now that you could not otherwise afford. The negatives of leverage is that when an asset declines in value than the return is negatively impacted with leverage and in the long term it costs you more to purchase something than it would if you had saved to buy an item. Therefore as said above financing an asset/investment probably makes sense as most assets go up in value over a long enough time period but financing anything else is going to cost you more in the long run.

Dilbert Advice – But Smart

The Motley Fool just did an article that covered an interview with Scott Adams the creator of DIlbert. THe full article can be found here: Dilbert FInances.

It offers superb personal financial advice and is summed up as follows:

Dilbert Advice
Adams has nine steps that he says, when performed in order, can help you to generate — and protect — your wealth.

1. Make a will.
2. Pay off your credit cards.
3. Get term life insurance if you have a family to support.
4. Fund your 401(k) to the maximum.
5. Fund your IRA to the maximum.
6. Buy a house if you want to live in a house and can afford it.
7. Put six months’ worth of expenses in a money market account.
8. Take whatever money is left over and invest 70% in a stock index fund and 30% in a bond fund through any discount broker, and never touch it until retirement.
9. If any of this confuses you, or if you have something special going on (retirement, college planning, tax issues), hire a fee-based financial planner.

Read the whole article if you can but I think that is great advice.

-Thor

How much do I budget?

I am not an expert on personal budgeting but I ran into a great article on cnbc this morning that takes a crack at helping people budget. The article can be found here: Budget Article.

In short the percentages should look like this:

• Housing – 30%: This includes a mortgage or lease, taxes and insurance.
• Transportation – 18%: If you drive, make sure you count gas, insurance, maintenance and parking. If you use public transportation, include your commuter pass or rail card.
• Debt – 10%: If you’re lucky enough to live debt-free, use this slice of your pie toward something else, like savings or toward an emergency fund.
• Food – 14%: This is tricky, because as food prices go up you will see that it becomes harder to keep this expense flat. It also includes toiletries and other things you need on a daily basis.
• Household – 7%: Energy, phone and cable bills. Don’t forget to plan for what will likely be a massive heating bill this winter.
• Savings – 10%: You can either use this money for short-term items like vacations or longer-term goals like retirement. 
• Everything Else – 11%: Whether it’s charity, clothing, childcare or additional medical costs, make sure to leave some room for miscellaneous monthly expenses.

I have also created a worksheet on budgeted/proposed spending compared to actual spending. email me if you would like it.

-Thor