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Archive for March, 2007

Interest and Compounding Interest

Thursday, March 29th, 2007

First of all, what is interest?
Interest is the cost of borrowing money. The person doing the lending gets a fee for allowing the borrower to use their money for a set rate of time. The original amount that is loaned to the borrower is called the principal and the percentage of that original amount which is paid over a period of time is called the “interest rate.” That percentage times the principal is the interest. For example lets take Dave and John.

Dave: John I need to borrow $10 to buy a qdoba burrito. I will pay you back tomorrow…
John: Why would you buy a qdoba burrito?
Dave: It tastes good.
John: Ok, here is $10 but I will charge you 10% interest per day on that.

…..Next Day…..

John: Ok that will be $10 + (10% X $10) so, that will be $11 please.
Dave: whoa $11?
John: Yeah, you should learn what interest means.

So what is compounding interest?
Compounding interest means that whenever interest is calculated, it is based on the original principal AND also any interest that has been earned. So the more often that that the interest is compounded, the faster the total (principal + earnings) grows.

What is this important for me?
Compounding interest is what allows something now to be worth many times the original investment many years from now (say, retirement age). Check out my retirement section for a bunch of examples of that.

How can I calculate compounding interest?
There is a rule called the rule of 72 that makes this fairly easy. It’s not exact, but it gives a pretty good approximation. 72 divided by the interest is equal to the number of periods needed to double the principal. So:

72/i = n

What is a typical example of this?
The stock market. Over the past 75+ years the stock market has averaged a rate of growth of around 11% per year. So if we say 12% just to make dividing 72 easy, thats 72/12 = 6. So at 11% per year it would take just over 6 years to double your money. Thats why people always talk about 6-7 years to double your money investing. It’s based on the average market return.

Roth IRA Basics

Thursday, March 29th, 2007

What is a Roth IRA?
Its an individual retirement account named after William Roth Jr of Delaware, the chief sponsor of the legislation that created it. It is a relatively new entity, it wasn’t established until 1998. A Roth IRA, unlike the 401(k), is not something that is employer sponsored, it is an extra retirement account the government will let you create (if you make under $99,0000 per year). Just like the 401(k) you must be 59.5 to withdraw your earnings without penalty.

What are the advantages of a Roth IRA?
-Because you contribute money after the government has already taxed it, withdrawls of contributions are tax free. Even better, the earnings grow tax free. In other words, if taxes are higher in the future, your Roth IRA doesn’t care. At retirement you still get to withdraw your money without paying higher taxes on it.
-It is very flexible in how it can be managed. In other words, you can have a big mix of investments in it.
-Because you have already paid income tax on it, you can pull out your contributions (not your earnings) at any time. This is a huge advantage over the 401(k).
-Most people will be in higher tax brackets as they get older, meaning that you will pay less on your contributions now than you will when you retire.

What are some disadvantages?
-You still have to be 59.5 to withdraw earnings without heavy penalties.
-It is not tax deductible
-There is always the risk that congress will decide to tax earnings on Roth IRAs between now and your retirement.

What is this about restrictions on how much I make?
You can only contribute to a Roth IRA if you make less than $99,000.00 per year.

What is this about restrictions on how much I can put in?
As of right now you can only put in $4000.00 a year if you are under the age of 50, and $5000.00 if you are over the age of 50.

Should I max out my Roth IRA or my 401(k)?
First max out your employer match of 401(k) and then max your Roth IRA and then back to the 401(k) if you can afford it. This is an effective way of hedging your bets on paying taxes now versus in the future. Roth is taxed now, 401(k) in the future.

People have their priorities wrong when it comes to retirement saving

Tuesday, March 27th, 2007

Yesterday I was browsing around various personal finance forums and I just could not get past how many people were giving terrible terrible advice. Not just bad advice, we are talking the kind of advice your friends give you after 14 or so beers. Whats worse is that a lot of these people eat up the advice like they’re plastered too. Here is a direct example of a question asked:

“I am 33, my husband is 36. As stated above, we save $29,200 per year for retirement. Add our company match and our retirement savings reach about $35K per year. We hope to retire in our mid 50’s. My husband will have a pension, I will not. We don’t have credit card debt, but have a mortgage (200K), one car loan (18K) and student loans (16K). Should we be paying down this debt instead of maxing out our retirement savings? Basically, is it foolish to save for retirement and have current debt???”

So what is the very first response to this?

“The first thing you need to do is pay off debt. I would stop contributing to the 401(k) and Roth IRA at this time.”

The poster then went on to say some other crap which I ignored because it was all I took not to register and post a reply. (Later I noticed the thread was over a year old.) In any case this is a great example of 1) the wonders of the interwebben to spread false information and 2) people being so debt-phobic that they fail to really analyze financial situations. In this case the student loans and car loan were both around 4%. Lets see, tax deferred compounding interest with company match or pay down debt at a 4% interest rate?

Roth IRA and 401(k) retirement saving versus debt pay off

Here is my suggested flow as far as money allocation:

401(k) max company match —> High interest debt —> Max Roth IRA —> More 401(k) —> Low Interest Debt —> other investments

Lets break this down a bit becaues you might be wondering about my priorities. There is a specific reason for each step here.

401(k) max company match – If your company matches every dollar up to say, 3% then you are getting a raise of 100% on that money contributed. Lets take Joe Graduate who makes $60,000.00 a year. That 3% match is $1800.00 per year.

High interest debt – This one is fairly self evident. If you are paying 25% on your credit card that is a ton of money down the drain.

Max Roth IRA – Its important to contribute to the Roth IRA while you can. There are contribution limits (currently $4000 if you are under 50, $6000 if over 50) as well as income limits ($99,000.00 currently) to be able to contribute. For more information read my Roth IRA basics.

More standard 401(k) – Tax deferred? Compounding interest? What a deal!

Low Interest Debt – The truth is you could probably come out with more money doing various investment strategies rather than using the money to pay off low interest Debt, especially considering things like student loans and mortgages being tax deductible. However, things like low interest car loans/credit cards are good things to pay off because they are liabilities, and missed payments could mean interest rates rise. Plus there is the peace of mind factor.

Other investments – If you are a young professional and still have money left over I applaud you, you’re way way way ahead of the game. This means its time to save up an emergency fund and if you’d like, find a discount broker and ease your way into buying some other securities.

The Money Tree does actually exist

Saturday, March 24th, 2007

And I’m not referring to the bonsai.

Bonsai tree


Or to this. Though if someone finds one of these, please let me know.

A false money tree

Instead a money tree would look a little more like this:
real money tree

Ok so the graphic isnt very good. But its what it represents that is so mind numbingly awesome that it deserves its own post. Two words: compounding interest. What does this have to do with a money tree? Well think of your initial investment as planting a seed to your money tree. Assuming the market returns at 10% your tree grows another branch with your money on it. Whats better is that every new branch has twice as much money fruit as the branch below it. Then when you are ready, pick away, free money from your very own money tree.


Bond Basics

Saturday, March 24th, 2007

What is a bond?
A bond is basically just an official IOU. Everyone has had to borrow money at some point in their life. Well, the same goes for corporations and governments. When you buy a bond, you are lending money to some entity like the government. The problem is that when a government or coporation needs to borrow money, it is usually more than they can get from a bank. So what do they do? They issue bonds to the public. In return for the loan the entity promises to pay you a rate of interest over the life of the bond and to repay the principal after a set time. The interest rate is usually referred to as the coupon and the date that the entity has to repay the principal is called the maturity date. The bottom line is that a bond is just a loan for which you, the investor, are the lender.

What is the difference between a bond and a stock?
Though they are both investment related they are actually very different things. Stocks are equity in a company where as bonds are debt that a compay owes. When you invest in a stock, you buy a piece of the comany. When you buy a bond, you loan a company money. The bond is basically the less sexy younger sibling to stocks. Bonds are especially boring compared to stocks during bull market times because they offer much lower returns than stocks.

What is an advantage of bonds?
There are a few advantages of bonds. The first is that if a company files bankruptcy, a bondholder has a higher claim on assets than a shareholder. Secondly, a bond is fixed income. When you buy a bond you know the exact amount of money you will be getting and when you will get it.

What are the disadvantages to bonds?

The main disadvantage is that generally they do get much lower returns than stocks do. Also, if a company does very well, it makes no difference, you get paid the same no matter what. The bond is a very safe choice.

Another reason to keep tabs on your 401(k)

Friday, March 23rd, 2007

For a long time I had been meaning to have a look at my girlfriend’s 401(k).  She knew she was putting money into it but other than that she hadn’t looked at it much.  Both of us assumed that it was just chugging away piling up and doing what it should.  She is a very smart woman with good financial sense but doesn’t have the interest in personal finance that I do…so when we got online and looked at her current portfolio we both had a bit of a surprise.  Her money was doing almost nothing.

 In fact, it was automatically putting her money 100% in a default money market fund.  Oh it gets worse.  I did the calculations and she returned around a whopping 3% for the year!  Thats right, a little over half of the return on high yield savings account.

To put this in perspective if she had been index fund that is available through her company she would have returned roughly 10%.  When I showed her the difference in cash she was uh, “not pleased” to say the least.  I went ahead and reallocated her funds into a mix of the index fund, a small market cap fund, and an overseas fund.  The latter two just being a small portion for fun.  Just for fun I showed her a scenario of what we might have just saved her.  At her current rate of return, versus a 10% return on JUST the money that was already in there (ie not counting any new contributions) off the top of my head, she would have had about $70,000 more by age 60.  I should have told her I will be charging a 10% fee.  Hey, that’d buy a boat…and when I retire, I would like to have a boat. 

Also as it turns out she was also not maxing out the company matching so we added her extra 2% to get the extra company 1%.  What difference did this all make in the end? To take it one step further, with continuing contributions, if she never got a raise in her life, and worked until 60, with proper allocation (assuming the market keeps rising at its average that is has risen at for the past 100 years) it made literally a million dollar difference.  Thats right $1,000,000.00.  Talk about a change in personal finance.   

There are lessons to be learned here:
 
1) Just because you are contributing to your 401(k) does NOT mean you are doing your due dilligence toward having a good retirement.  Don’t assume that the company is doing the right thing for you.  If you are young you should not be completely invested in a low risk portfolio.

2) Max out your company match.  It is free money, and compounded over 40 years it is a TON of free money.  It’s a truckload of free money. 

I imagine a truckload of free money to look something like this:

Personal Finance Money Truck

Just in case you are wondering, and since the name of this blog is The Penny Saved …that truck is a standard 18 wheeler and if you do not count the weight of the truck itself, it could legally carry about 14,514,955 post 1983 pennies.  That comes out to $145,149.55

So really that million dollar savings would take more than more than 7 of these trucks full of pennies to haul. 

Five reasons why getting rich is NOT immoral

Thursday, March 22nd, 2007

Along the same lines as “Why do you want to get rich?” is the question of “is it immoral to get rich?”

Quite simply it is not. If you can’t figure it out for yourself, maybe you don’t deserve to get rich, but I will help you out anyway. Here are some reasons that it is not immoral to get rich.

1) The market does not care if you invest in it. It couldn’t care less. If you are not making money then you are wasting your opportunity, and someone else IS getting rich.

2) If you do not like a companie’s ethics, then don’t buy their stock. It’s that simple. Hell, buy their competitor’s stock!

3) Charity. Get rich, and donate your money to charity. Is helping thousands of people with food donations….or better yet spending millions to help people setup systems to feed themselves immoral? I think not.

4) Volunteer. The less you have to work, the more you can volunteer.

5) Being rich does not mean being greedy.

I might add more later, and there is a lot more to dive into but I am sick of hearing about people talking about “living in poverty” as if its the only way to be a good person. Give me a break.


Mutual Funds Basics

Thursday, March 22nd, 2007

Introduction to Mutual Funds

Most people have heard of mutual funds….or at least seen those investment TV commercials with the proper looking dude who promises to make you a whole bunch of money with your investments.

What is a mutual fund?
The concept is actually very simple. It is a collection of stocks and or bonds. The easiest way to think about it is that it is a group of people that have come together to invest their stocks. Each person owns shares which represents a portion of the fund. A mutual fund might invest in 20 stocks or it might invest in 200. It just depends on the fund. Mutual funds are managed by professionals that it is their job to manage everyone’s money.

What are some of the advantages of mutual funds?
Its Simple – Its very easy to set one up through a local broker or online and a lot of places have automatic transfer so you don’t even have to do anything….it just takes say, $100 per paycheck out.
Diversification – Mutual funds allow you to logically put your money in one place, but physically have it spread out, lessening risk.
Low Trading Cost – Because the manager moves all the money in big amounts, there are not the huge costs of moving money around that can pile up with piecemeal stocks.

What are some disadvantages of mutual funds?
Less Money Control – What is an advantage is also a disadvantage. You do not get to pick the exact stocks that your money is buying.
Costs – Mutual funds take some of your profits as a price for being in the fund.
Management – Professional managers don’t necessarily know anything more than an average Joe off the street. I saw an article recently in Men’s Health where they picked stocks by throwing darts at a paper and then compared it against a few different peoples picks and funds. Guess what? The dart won, HANDILY.
Most Funds SUCK – Ok so this is somewhat biased, but the VAST majority of mutual funds (80%) actually under perform compared to the market!


Joe Graduate Entry #1

Thursday, March 22nd, 2007

I decided to make a series about a fictional character (though he is based on a conglomeration of people that I know). The idea is that he is the typical guy coming out of college with some various debts and a shiny new job. I think this reflects a majority of college grads at this point. I will set his starting salary a little higher than average (roughly 5k a year over average) for the simple reason that I will be using my own spending habits which due to job related duties and the fact that I don’t mind spending extra money to eat healthy at home might be higher than average. This is scalable as well. For instance you might make 45k a year but only have student loans and no credit card debt. The idea is more to take “theory” and make it into “reality”….something I haven’t seen done anywhere, except with people using their own situations. The blogs I have seen of this have tended to be poorly kept and irregularly updated. My goal is to be consistent so as to get a good picture of just how quickly your finances can change.

Joe Graduate

Age: 23
Weight: 180 lbs
Height: 6’0

Debt:
Student Loans: $18,000.00
Credit Card Debt: $5,000.00
Car Loan: $14,000.00
Monthly Set expenses:
Rent: $600.00
Car Payment: $300.00
Utility Payment/Cable: $300.00
Cell Phone: $40.00
Car Insurance: $80.00
Total: $1420.00

Capital:
Retirement: 0
Investments: 0
Savings: 0
Assets: $20,000.00

Joe estimates that his assets total about 20k. His car is worth 16k, and he has a laptop that he bought with student loan money. He also has a nice guitar and some other odds and ends that add up to about 4k.

Joe is starting his first job. He got lucky, he landed a job with IBM doing java software development. His salary will be $60,000 a year. For the sake of making things easy we will say he received his first paycheck March 1.

Joe’s company does a standard 401k match, where they match every percent up to 3%. Joe decides to put 5% of his salary toward his 401k. He also enrolls in their health insurance plan, which costs him $100 per month and is automatically deducted from his paycheck.
His per paycheck donation is $125.00 to 401k. His per paycheck total taxes are $623.00 (based upon Fed + Colorado withholding). This leaves him with $1752. Take out the health insurance and it becomes $1702. We will round this to $1700 for the sake of my (fairly small) rounding errors in tax calculation.

So here is where we start: on march first, Joe has received his first paycheck, and paid half his monthly fixed bills. He will pay the other half mid month (as I generally do). This leaves Joe at $990 on March first in his bank account.

Here is how his financial situation looks like right before his first paycheck (February 28):

Current Networth:
-17000.00


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Stock Basics

Tuesday, March 20th, 2007

When people think of personal finance, a lot of times one of the first things they think about is stocks.  We hear all sorts of things about the stock market, the DOW Jones, the NASDAQ and Wall Street but very few people have anything but a vague idea about what any of these things actually mean, other than “stock market is down, that is a bad thing.”

So what exactly is a stock?

A “stock”, or “equity” or “share” is the money and other capitol that is raised by a corporation through the issuance and distribution of shares.  Lets break this down a bit because that sentence in and of itself is fairly confusing.  What is basically is, is that corporations sell pieces of themselves to raise money for growth.  These pieces are stock.  If a company does well, it is worth more, thus it’s stock goes up.  They also pay out pieces of company profits to shareholders (people who own shares of stock); this is called dividends.   Its an interesting arrangement because lets say you buy a share of stock in Hewlett Packard.  You now own a piece of everything in HP.  A little piece of every contract, computer, desk,  and pen.  (The skeptics amongst us would even say the workers, but that’s a whole different conversation).Just because you own a share of stock in a company doesn’t mean you get to say what happens in day to day operations, but you do get a vote per share in electing the board of directors.    However, this is a minor detail.  Most people don’t WANT a say in the day to day operations of the company, they just want the company to do well.  As a shareholder you get a piece of the companies profits, and a claim on some of the assets.  The profits are sometimes paid out as dividends or it might be reinvested into the company for growth.  It all depends on the company. 

How is Stock Valued (How is the price decided)?
The value of a stock is loosely based on what investors feel a company is worth.  However this is not the same as the value of a company.  That is what is called its market capitalization…basically, the stock price multiplied by the number of total shares of that company.  Confused?
Well here’s the first grade math formula to clear it up:

Total worth of company = (cost of 1 share of stock) X (total number of shares of stock of that company)

For example, a company that trades at $10 per share and has 10,000 shares is worth $100,000.
What makes things even more complicated is that the price of stock just include what the company is currently worth but ALSO the growth that investors expect in the future. 

A lot of the so called “value” of stock prices are based on the simple concept of supply and demand.  If the stock is in high demand, the price goes up.  If the company seems to be doing poorly, less people want it, so the price goes down.  Not such a hard concept after all!

So how do people know whether the company is doing well or not?  The single most important factor that affects the value of a company is its earnings.  Earnings are the profit a company makes.  This is why public companies have to report their earnings four times a year.  These times of year are called earnings seasons and it has the guys on wall street scurrying around like mice in a cheese factory.  Companies have to (or are supposed to *cough enron cough *) be honest in their reportings.  If a company does well, the price of their stock usually goes up, if they do poorly, it usually goes down.
There are some other factors that can change the value of a stock.  Sometimes there is hype for a company when it hasn’t done anything to prove itself.  The absolute best example of this was the dot com bubble in which online companies that were supposed to make a ton of money …pets.com anyone?…  made absolutely no profit.  Their stocks were artificially high, and then they came down to realistic levels, it left a lot of people out a lot of money.  There are a ton of other factors in stock price, but the fundamentals matter the most.