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

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

How does leverage really work? Why can it be good?

Leverage has been discussed a lot lately, especially in a negative light in relation to the financial crisis and the indebtedness of America. I am going to do a short post on leverage at companies and when it makes sense. Now this is common sense for those business majors out there, but for those who have never really seen leverage used in business let me explain how it works. (Note: I will do another post on consumer leverage in the next few days/weeks as time permits.)

I will describe four scenarios in which leverage was used and explain what happened with the company in each case. In each case I assume that all sales and expenses are in cash, so that at the end of the year the net income would either be reinvested in equipment to increase sales or would be saved as cash. In the debt scenarios the net income would go to the items mentioned above after the repayment of principal on the equipment debt.

Scenario #1: No Debt (leverage)

	Year 1	Year 2
Cash	$5,000,000	$ 5,000,000
Equipment	$1,000,000	$ 1,500,000
Debt	$ -
Equity	$6,000,000	$ 6,500,000
	Year 1	Year 1
Sales	$ 500,000	$ 750,000
Expenses	$ 250,000	$ 375,000
Interest Expense	$ -	$ -
Net Income	$ 250,000	$ 375,000

In this scenario the business owner made $250k in the first year and was able in year 2 to increase sales due to increased equipment capacity (which was purchased with cash at the end of the year, and no debt). Therefore in year 2 the owner was able to generate $375k in cash just by reinvesting in the business without debt. So at the end of the day the business income grew and the return to the owner was positive without debt. However as seen below you can use debt to grow faster.

Scenario #2: Debt with Sales Growth (based on using debt to buy equipment)

	Debt w/ Growth
	Year 1	Year 2
Cash	$5,000,000	$ 5,000,000
Equipment	$2,000,000	$ 2,750,000
Debt	$1,000,000	$ 850,000
Equity	$6,000,000	$ 6,900,000
	Year 1	Year 1
Sales	$1,000,000	$ 1,375,000
Expenses	$ 500,000	$ 687,500
Interest Expense	$ 100,000	$ 85,000
Net Income	$ 400,000	$ 602,500
Principal Repayment	$ 150,000	$ 150,000
Net Income – Principal	$ 250,000	$ 452,500

In this scenario the owner felt that the market was strong and that purchasing equipment would generate capacity that would really increase (double in fact) sales. So with debt the owner purchased $1M in equipment and generated cash flow (net income – principal repayment) of $250k (the same as net income in scenario #1). However in year two with the increased equipment the owner was able to generate $452.5K in cash flow because of increased leverage. Therefore the owner was able to effectively use leverage to grow the company by purchasing equipment and growing sales, so even after the cost of debt (principal and interest) the debt added value to the business.

Scenario #3: Debt with no sales growth (as purchase equipment did not increase sales)

	Debt without Growth
	Year 1	Year 2
Cash	$5,000,000	$ 5,000,000
Equipment	$2,000,000	$ 2,000,000
Debt	$1,000,000	$ 850,000
Equity	$6,000,000	$ 6,150,000
	Year 1	Year 1
Sales	$ 500,000	$ 500,000
Expenses	$ 250,000	$ 250,000
Interest Expense	$ 100,000	$ 85,000
Net Income	$ 150,000	$ 165,000
Principal Repayment	$ 150,000	$ 150,000
Net Income – Principal	$ -	$ 15,000

In this scenario the owner purchased equipment with the debt thinking sales could grow (similar to scenario #2) however the equipment remained unused as the sales team was unable to sell more goods.  This caused the net income to be lower (because of interest expense) and cash flow to be much lower than scenario #1 and #2. This also crimped the ability of the owner to purchase more equipment to grow sales in year 2, because all the cash had gone to principal and interest.

Scenario #4: Debt with declining sales (as equipment was purchased but sales decreased due to a bad economy.)

	Debt w/ Slowdown
	Year 1	Year 2
Cash	$5,000,000	$ 4,987,500
Equipment	$2,000,000	$ 2,000,000
Debt	$1,000,000	$ 850,000
Equity	$6,000,000	$ 6,137,500
	Year 1	Year 1
Sales	$ 475,000	$ 400,000
Expenses	$ 237,500	$ 200,000
Interest Expense	$ 100,000	$ 85,000
Net Income	$ 137,500	$ 115,000
Principal Repayment	$ 150,000	$ 150,000
Net Income – Principal	$ (12,500)	$ (35,000)

Scenario #4 is what happens when someone takes on debt and sales decrease and there is no corresponding decrease in debt. This scenario exhibits an owner who took on debt to purchase equipment in order to sell more goods but in fact fewer goods were actually sold. This caused net income and cash flow to decrease lower than the other scenarios and not only crimped the ability of the company to purchase equipment but in fact it lowered the amount of cash on hand. If this scenario continued it could cause the company the inability to pay interest expense and principal (both of which are contractual fixed obligations) and could leave to financial ruin of a potentially otherwise sound company.

These four scenarios are very simple and not the only reason to use debt (there are innumerable reasons to use leverage in companies), but they should give you a basic idea that leverage can be a very good thing.

-Thor