Sensible Lending Standards
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Showing posts with label Mortgage. Show all posts
Showing posts with label Mortgage. Show all posts
Saturday, April 26, 2008
Saturday, April 19, 2008
Thursday, July 19, 2007
Subprime, Spending and Lending Laws
In a news story, Bernanke: Subprime hit could top $100B, Bernanke says that if prices drop consumers could cut back spending as much a 9c for every dollar of lost wealth.
So, a half million dollar home declines to $400,000 and the person would cut spending by $9k. A $200,000 home to $160,000 and they would cut by $3.6k.
It looks like businesses of non-essential items are going to be in for a hit.
They also state they are working to strengthen lending regulations. I'm sure they will be marginal at best. Having worked in the banking industry during a period where people lost their homes and were left with further debt to pay back, over the years I have thought dearly about this topic, and I have previously on interest rates, Low Interest Rates - As Destructive as Usury.
I have been a private advocate of strong laws and regulations around lending as interest rates decline due to the crazy amounts that people can borrow based on income. It makes no sense mathematically to apply a fixed standard to borrowing rates that have increasingly leveraged effects on the amounts that people can borrow as rates decline.
Legislation that would protect the consumer would be lending laws that limit the amount a consumer can borrow based on a fixed evaluation of income, down payment, amortization period and interest rates.
I have a 4.4% interest rate mortgage.
Qualifying for a mortgage should not be based on current interest rates. The leverage of the potential increase in payments is utterly enormous when interest rates are down, and the amount of money people quality for at low interest rates is insane. I qualified for 53% more mortgage that I borrowed for interest rates at 4.4%. If they'd been 3%, well, then I'd have qualified for 76% more than I borrowed. Based on the payments I chose to make I'd have qualified for 85% more at 4.4% and 115% more at 3%.
Qualifying for a mortgage should be based on being able to afford the payments with 30% of your income with 25% down and 8% interest for a 25 year mortgage. I'd have actually only qualified for 10% more than what I borrowed with that criteria.
So, then comes the fudging factor on how to change that to change with difference in individual's financial situation. Zero down loans are actually fine, if you afford them with 30% of income at 10% interest. I would not have qualified for my mortgage with this criteria. The maximum I would have qualified for would have been 6% less than I borrowed.
And there's nothing wrong with having it go the other way, say 30% of income at 6% if you have 50% down. Under this criteria I would have qualified for about 30% more mortgage that I took based on the interest rate, but I would not have qualified for the mortgage because I did not have half down.
The actual length of the mortgage should be based on the criteria given. You have a repayment schedule based on a 25 year mortgage at 8%, but with current interest rates you will pay it off in x-years. This criteria would have me paying off my mortgage in 13-14 years. With nothing down my smaller loan qualifying amount with larger payment would be paid off in 12 years. If I had the half down the last example would have had me paying off the mortgage in 19 years.
Anyway, these are guidelines that I've come up with from thinking about the issue over the years. I think qualifying based on fixed criteria, such as 30% of income to cover 8% at 25 years, is how lending should be regulated, but how this fixed rate criteria is set should be open to debate.
Sunday, July 01, 2007
I'm a banking bear
Over on Motley Fool I was asked why I rated Citigroup, a banking stock that is paying a 4.2% dividend and has a P/E of 11.39 as under perform and I thought it a question exceptionally worthy of an answer.
I do not usually rate under perform for a stock paying a good dividend and having a low P/E, however, I do not believe any financial institution will ride out the subprime fallout very well and I think the consequences of the sub prime lending market will be felt for years. These mortgages have been repackaged and sold and repackaged and sold again. They are hiding everywhere in financial institutions and investors would be very hard pressed to figure out any individual institution's exposure to risk.
I think there will be more than one wave of people in trouble with their sub prime mortgages, estimated to be at about 30% of mortgages. First wave is those that are not meeting interest payments now. Their mortgages are essentially increasing every month as unpaid interest is added onto principal.
There are lots of people who have bought on plans that offered lower interest rates the first 1, 2 or 3 years. These people are at risk as their interest rates readjust.
There are people who were barely able to make their payments and may be increasing credit card debt every month right now just due to the increase in the price of gas alone, and so many other costs have gone up. Expenses are increasing faster than wages and they lack any buffer zone in their income.
There are people who have been living off equity, borrowing more as their equity increases. If they've put the money into other investments they'll probably be ok. If they've been doing this to pay off their credit card debt that gets out of control every 2-3 years, well, obviously they already have money management problems and this is going to be big trouble for them.
Many have variable mortgage rates and coming into the market at a low rate and then finding the rate increases is an enormous negative leverage for the household budget. I worked out that each $100,000 of mortgage costs $474.21 per month at 3% for a 25 year mortgage. It costs $527.84 at 4%, or an increase of $53.63/month per $100k of mortgage, and that is an 11.3% increase in mortgage payment. I don't know about you, but that eats up 4.5 years of wage increases for me.
I do not believe that any banking institution will ride this out without taking some pain, as will the shareholders of banking stocks.
I would also like to point out what I believe to be a difference between Canadians and American because of public policy. In Canada you can not deduct mortgage interest from your taxes and if you buy a home with less than 25% down you must pay up to 2.5% mortgage insurance.
I believe that you are ultimately better off by paying off debt even if you get a tax exemption on interest paid, but I think there is a perception of getting something for nothing, or getting more if you have more debt, almost stick to the government, taxes are so ultimately evil and I figured out how to pay less. That's probably an exaggeration, but ultimately this policy that allows you to deduct interest has lead to a higher acceptance of debt and even a strong shift towards public perception that a level of debt is ok and perhaps even a level of debt relative to assets is wise... (Ekkk!!!!...)
Canadians are more motivated to pay off debt as there is no perceived benefit from holding debt and they are also much more motivated to try and have a larger down payment. That isn't to say they manage the 25% down, but what will typically happen is they might come up with say 15%-20% down, find another 5-10% through short term debt and finance their first home with a highly aggressive debt repayment plan for the first 5 years or so as they work to pay back that 5-10% in a short term. If they can only come up with 10% down they just fork out that 2.5% insurance because they don't have hope of paying back that short term debt in a reasonable time line. It is difficult to get a subprime mortgage with Canadian law. You have to have 5% down and have to pay that 2.5% insurance.
I don't believe the differences in behaviour is universal, no people or countries are monolithic in all things and I didn't say this is a universal thing, but I do believe that if you look at the facts you would find a greater percentage of Americans borrowing against their equity than Canadians, and this is one of the ways that public policy affects behaviour to the detriment of the economy as a whole.
And even another point, the policy of allowing interest to be deducted has leveraged an ever higher level of hyperinflation in the housing market, but that's another topic.
Sunday, May 06, 2007
Low Interest Rates - As Destructive as Usury?
I was 17 when I first got a job as a teller in a credit union in 1979. This is where I first studied mortgages.
Qualifying income was such that no more than 30% of your gross income would be needed to pay the mortgage. Mortgage rates were about 10-12%. You needed qualifying income of $36,345 to qualify for $100,000 of mortgage at 10%. Most mortgages at the time were under $50,000, and people in their 30s were paying off their mortgage on their house, not a condo or a townhouse, but a house with a yard.
The credit unions had technology far ahead of the times and they had a program where I could change the variables in mortgages and view amortization tables, much like you can do today.
The changes intrigued me. I studied how much money a person could save by increasing their payments by relatively small amounts. For example, at 10% the payments on $100,000 mortgage would be about $909 per month over 25 years, and 10% was about what mortgage rates were before they spiked. Increase the payment by 10% and you would have saved 7 years, or 28% of your payments. The table below shows what happens with each 10% increase in payment.
Effects on Amortization Period of increasing payments at a fixed rate of 10%Example A: $100,000 @ 10%
Payment Amort (months) Months Reduced (+/- 0.5 months) Increase in Payment - (total) Decrease in Months to Repay - (total) Total Interest Paid Interest saved from last 10%* $908.62 300 N/A N/A N/A $172,600 N/A $999.48 216 84 10% - (10) 28% - (28) $115,900 $56,700 $1090.34 174 42 10% - (20) 14% - (42) $89,700 $26,200 $1181.21 147 27 10% - (30) 9% - (51) $73,600 $16,100 $1272.07 128 19 10% - (40) 6.3% - (57.3) $62,800 $10,800 $1362.93 114 14 10% - (50) 4.7% - (62) $55,400 $7,400 $1453.79 102.5 11.5 10% - (60) 3.8% - (65.8) $49,000 $6,400 $1544.65 93.5 9 10% - (70) 3% - (68.8) $44,400 $4,600 $1635.52 86 7.5 10% - (80) 2.5% - (71.3) $40,700 $3,700 $1726.38 79.5 6.5 10% - (90) 2.2% - (73.5) $37,200 $3,500 $1817.24 74 5.5 10% - (100) 1.8% - (75.3) $34,500 $2,700
The leverage of how much you could save rapidly declined as you increased payments. Where that first 10% increase brought the number of years from 25 down to 18, increasing by 20% saved an additional 3.5 years, or 14%. By increasing payments by 30%, the number of years to pay back the mortgage was cut by more than half.
Furthermore, the interest saved with that first 10% increase is enormous, 56.7% of the original mortgage amount -- about 1/3rd of the interest overall. And even more amazing, double the payment and you pay only about 1/5th the interest and can pay it off in a little over 6 years.
Effects on Payments of changing interest rates for fixed amortizationExample B: $100,000 over 300 months
Interest Rate Change in Interest Rate Payment Increase/ Decrease % Change in Payment 9% -10% 839.14 -69.48 7.65% 9.5% -5% 873.62 -35.00 3.85% 10% 0% 908.62 0 0% 10.5% 5% 944.09 35.47 3.9% 11% 10% 980.01 71.39 7.86%
At those interest rates, 0.5% changes did not make huge differences to payments. When 10% is the current mortgage rate, a 1% decline or increase means the interest rate has changed by 10% (change in rate/rate*100%). The relative payment changes by less than the change in the interest rate. Interest rate increases cost more, but are manageable.
If you look at percent of that family income, a 1% increase would cost 2.36% of qualifying income. For most households income would have increased by at least that amount by the time a mortgage needed to be renewed.
Something not shown on the table is that if interest rates went down by 1%, and you kept your payment the same, the amortization would decline to 19.5 years, and you did not give up an ounce of lifestyle. If interest rates cut in half, to 5%, the amortization would decrease to 12.25 years.
The other thing I "played" with was how much would you have to change the payment to reduce amortization by a year at a time?
Effect on Payment of Reducing Amortization Period Example C: $100,000 @ 10%
Amort (years) Monthly Payment ($) Increase to reduce 1 year ($) Total increase ($) % Total increase Total Interest Paid ($) 25 908.70 N/A N/A N/A 172,610 24 917.39 8.69 8.69 0.96% 164,208 23 927.18 9.79 18.48 2.03% 155,902 22 938.25 11.07 29.55 3.25% 147,697 21 950.78 12.53 42.08 4.63% 139,597 20 965.02 14.24 56.32 6.20% 131,605 19 981.26 16.24 72.56 7.99% 123,727 18 999.84 18.58 91.14 10.0% 115,966 17 1021.21 21.37 112.51 12.4% 108,327 16 1045.90 24.69 137.20 15.1% 100,813 15 1074.61 28.71 165.91 18.3% 93,429 14 1108.20 33.59 199.50 22.0% 86,178 13 1147.85 39.65 239.15 26.3% 79,064 12 1195.08 47.23 286.38 31.5% 72,091 11 1251.99 56.91 343.29 37.8% 65,262 10 1321.51 69.52 412.81 45.4% 58,581
When interest rates were 10% small changes to a family's overall budget to increase mortgage payments brought in enormous financial reward in terms of reducing the number of years to pay back the debt - - it explains how the economic conditions enabled so many people to be paying off their mortgage in their 30s.
For simplicity, $100,000 was used, but when I first started working in the bank few mortgages were over $50,000 and I remember we were shocked when someone applied for and took out a $100,000 mortgage!
I worked in the banks through the period that interest rates doubled. There were two groups of homeowners, those that had gotten into the market recently and those who had been homeowners for a while.
It certainly made things harder for those who had been home owners for a while, but few lost their homes. For most, income had dramatically increased through the 70s, so although it hurt for that renewal period, wages had kept up enough to enable them to keep their homes.
Many who recently bought found themselves over extended and with insufficient income to cover the huge increase in mortgage payment. In Vancouver it was complicated by a housing price bubble. People who bought at the high point lost their homes, their down payments, and in some cases stilled owed money after the home was sold. In retrospect, the lucky ones failed to qualify for a mortgage.
The usurious interest rates were hard, and very, very destructive for some.
Low Interest Destructive?
Low interest rates have been looked at as a good thing for homeowners, but I beg a difference.
No question that if you owned your home, had a mortgage and interest rates decline, you gain, or if you live in a region with emigration. But what happened if you did not own your own home before interest rates declined, live in a region with population growth, and interest rate went down to 4%? First one must compare what changes on low interest rate mortgages look like.
Effects on Amortization Period of increasing payments at a fixed rate of 4%Example D: $100,000 @ 4%
Payment Amort (months) Months Reduced (+/- 0.5 months) Increase in Payment - (total) Decrease in Months to Repay - (total) Total Interest Paid Interest saved from last 10% $527.84 300 N/A N/A N/A $58,351 N/A $580.62 257 43 10% - (10) 14.3% - (14.3) $48,925 $9,426 $633.41 225 32 10% - (20) 10.7% - (25) $42,199 $6726 $686.19 200 25 10% - (30) 8.3% - (33.3) $37,142 $5,057 $738.98 181 19 10% - (40) 6.3% - (39.7) $33,191 $3,951 $791.76 165 16 10% - (50) 5.3% - (45) $30,016 $3,175 $844.54 151 14 10% - (60) 4.7% - (49.7) $27,405 $2,611 $897.33 140 11 10% - (70) 3.7% - (53.3) $25,218 $2,187 $950.11 130 10 10% - (80) 3.3% - (56.7) $23,360 $1,858 $1002.90 122 8 10% - (90) 2.7% - (59.3) $21,761 $1,599 $1055.68 115 7 10% - (100) 1.3% - (60.7) $20,369 $1,394
There is no question that increasing payments reduces the interest to be paid back, but the benefit of increasing that first 10% increase in payment is about half of what it was as a percent in example A, and look at the difference in overall interest savings, $56,700 versus $9,400, about 600% more savings in interest. The leverage of what you can do to improve your economic position by increasing payments and paying is severely compromised when interest rates are low.
Doubling payments resulted in reducing the amortization to 74 months or 6 years and 2 months, but at 4% interest doubling only reduces the amortization to 115 months or 9 years and 7 months. With low interest rates when you double your payment you have to pay for an extra 41 months or 55% longer to pay off the mortgage.
Effects on Payments of changing interest rates for fixed amortizationExample E: $100,000 over 300 months
Interest Rate Change in Interest Rate Payment Increase/ Decrease % Change in Payment 3% -25% 474.21 -53.63 10.16% 3.5% -12.5% 500.62 -27.22 5.16% 4% 0% 527.84 0 0% 4.5% 12.5% 555.83 27.99 5.30% 5% 25% 584.59 56.76 10.75%
The one percent increase from 4% to 5% results in the payment going up 10.8% when interest rates are low compared to 7.8% when interest rates are higher. Overall, that comes to about 3.24% of qualifying income. It does not sound like a lot, but compared to the 2.36% in example B, the overall relative increase is 37% more.
If interest rates go down to 3% and you keep your payment the same the amortization would decline to 21 years 5 months, 35% less benefit than when when interest rates were higher.
Effect on Payment of Reducing Amortization PeriodExample F: $100,000 @ 4%
Amort (years) Monthly Payment ($) Increase to reduce 1 year ($) Total increase ($) % Total increase Total Interest Paid ($) 25 527.84 N/A N/A N/A 58,351 24 540.69 12.85 12.85 2.43% 55,719 23 554.75 14.06 26.91 5.10% 53,111 22 570.18 15.52 42.43 8.02% 50,527 21 587.18 16.91 59.34 11.2% 47,969 20 605.98 18.80 78.14 14.8% 45,435 19 626.87 20.89 99.03 18.8% 42,926 18 650.20 23.33 122.36 23.2% 40,443 17 676.39 26.19 148.55 28.1% 37,984 16 706.00 29.61 178.16 33.8% 35,551 15 739.69 33.69 211.85 40.1% 33,144 14 778.35 38.66 250.51 47.5% 30,762 13 823.12 44.77 295.28 55.9% 28,406 12 875.53 52.41 347.69 65.9% 26,076 11 937.67 62.14 409.83 77.6% 23,772 10 1012.45 74.78 484.61 91.8% 21,494
In the last example, to reduce the amortization period by one year you must increase the payment by 2.43%. Overall, this is an enormous difference in comparison to example C where the payment was increased by 0.96%, relatively speaking about 2.5 times as much.
The big difference is to look at the change for paying back the mortgage in 10 years. In example C if you increase the payment by 45.4% the mortgage is paid off in 10 years, where as when rates are 4% the payment has to be increased by 91.8%.
Enter Housing Costs
On the surface, lower interest rates look like win-win. On $100,000 payments start at 58% of what payments were at 10% interest, and that is an enormous savings. However, the big problem is that in many cities housing costs have increased far beyond the rate of inflation, to the point that people buying are often qualifying for their mortgage with the same parameters as those that first bought when mortgages were 10%.
There are tons of examples that could be used, but I will use what I know. In 1976, after my mother passed away, her two bedroom condo in Kitsilano lay fallow for more than a year for not being able to sell it for about $30k. In that over a year period it ate all of the equity she had built into it as well as the equity of her 3-year-old car. Indeed, when the bank foreclosed on it, her estate owed more than it had. So, $30k for a two bedroom condo in 1977 is what I know to be true.
Today the cheapest two bedroom condo I could find is priced at $379k. This represents an annual rate of return of 8.8% over the past 30 years. Minimum wage at the time was $3/hour. To put it into perspective, if minimum wage had kept up with the increase in housing cost for that period, minimum wage would be about $40/hour, but that's another issue.
To keep things simple, I'll ignore down payments, maintenance fees, property tax, etc. and just do a comparison on the two condo values.
To qualify for 30k at 10% you would have needed about $11,000 of income, or a wage of $5.64/hour. Monthly payments would be $272.61. Total amount paid would be $81,783. Interest is 63.3% of the repayment amount.
To qualify for 379k at 4% you would need $80,000 of income, or a wage of $41.03. Monthly payments would be $2,000.50. Total amount paid would be $600,150. Interest is 36.8% of the total.
On a side note, something that is utterly amazing about this to me is in 1977, as a 15-year-old, I worked part-time as a waitress and with tips I was making about $6/hour. I wonder how many 15-year-olds today could get a part-time job that would pay them $40-45/hour? In light of this enormous economic difference, no wonder so many 30 something year olds were able to pay off their mortgage!
Principal must be repaid, interest repayment is flexible
Ignoring the gross decline in wages relative to housing costs, a serious difference in the two examples is the amount of interest in the payments. By comparison, today's new buyer is grossly under privileged in their ability to get ahead by accelerating payments because the majority of the amount to be repaid is principal. When the majority was interest, that repayment could be drastically reduced by modest compromises in lifestyle.
I would further suggest that had interest rates remained higher, housing prices would be lower because less people would qualify for mortgages, and housing prices are determined by supply and demand.
So had interest rates only declined to 7% that 35-year-old $379,000 condo might be for sale for $283,000, a price that would also require $80,000 of income if interest rates were 7%, only in this case 53% would be interest. The increase in the price of the condo would still be way ahead of inflation at 7.7% per year.
If interest rates had remain in the 10% range one would only qualify for $221,000 with $80,000 of income and 63.3% of the repayment would be interest, and rate of increase in the price of the condo would be 6.9%.
Low interests rates have enabled housing prices to increase beyond reasonable levels and drastically reduced a new home owner's ability to reduce their repayment burden as most of the amount to repay is now principal.
Low interest is a function of inflation
Probably the most important disabling point for newer buyers is that low interest rates are a function of inflation. Low interest rates mean inflation is lower, which means wage increases are lower. When interest rates were high home owners could count on wage increases of 5-8% and the housing burden in their budget rapidly declined, enabling them to make far more discretionary income decisions. With low interest rates inflation is low and wage go up slowly. Indeed, many workers have experienced years with no wage increase. Increasing repayment of mortgage debt is not so easy when wages remain relatively flat.
So, Are Low Interest Rates as Destructive as Usury?
The usurious interest rates cost most people a couple hard years. Newer buyers will have a lifetime of hard years repaying their mortgages because flat wages disables them from being able to increase payments very much, if at all, and since most of the repayment amount is principal there is little power to improve financial position from leverage of increased payments. Furthermore, it isn't likely that new home owners will enjoy wealth creating due to appreciation of their home values. They have significant downside risk.
Very few who had been a home owner over 3 years lost their home from usurious interest rates of the early 80s. Housing prices doubled from the late 70s to the early 80s and it was the ones who paid the high prices who lost their homes and were left with massive debt to repay, the rest had to tighten their belts and deal with loss of lifestyle.
So, it depends on who you ask. There is no question they were a boom for people in the housing market early and that today's buyers will never enjoy the wealth creation it gave to generations before.
Saturday, January 27, 2007
Saving for Retirement
The article copied at the bottom caught my attention. Could it be possible that you are saving too much for your retirement? Such an idea would fly in the face of almost every exhortation to a nation of spendthrifts that saving more is an imperative. After all, even as people are living longer, corporate pension plans and Social Security can no longer be relied on to ease most Americans through their retirement years. Fidelity, the nation’s largest provider of workplace retirement savings plans, says the average 401(k) account balance is only $62,000. Beyond that, the national savings rate — the difference between after-tax income and expenditures — is actually negative, government statistics show. Nevertheless, a small band of economists from universities, research institutions and the government are clearly expressing the blasphemy that many Americans could be saving less than they are being told to by the financial services industry — and spending more — while they are younger. The negative savings rate, they say, is wildly distorted. According to them, the financial industry, with its ostensibly objective online calculators, overstates how much money someone will need in retirement. Some, in fact, contend that financial firms have a pointed interest in persuading people to save much more than they need because the companies earn fees on managing that money. The more realistic amount could be as little as half the typical recommendation made by Fidelity, Vanguard or any number of other financial institutions. For a middle-income couple, that could mean trading $400,000 in retirement money for about $3,000 a year more during prime working years to spend on education or home improvement. “For a middle-class household, that’s a lot of money,” said Laurence J. Kotlikoff, a Boston University economics professor, who is on the forefront of this research into spending and savings, and is selling his own retirement calculator. Andrew Behla is a case in point of someone who is not saving enough. Mr. Behla, a Los Angeles graphic designer and consultant, is at age 38 just starting to think about retirement. He and his wife, Michele Krolik, a payroll manager, together have just $70,000 squirreled away for their old age. “I think we will have to save a lot more,” he said, a point on which the economists and the financial planning industry would agree. Even so, the couple recently bought a house and put extra money they had into improving it, figuring that over their lifetimes it will add handily to their net worth. But other people like Beverly Alexander, 49, an energy consultant in Marin County, Calif., might be able to slow down. Her financial planner has her retirement finances mapped out to age 105 (her parents are still alive in their 90s), a plan that gives Ms. Alexander, a former utility executive, the freedom to quit her corporate job and live on her consulting income. “One reason I could retire,” she said, “was that I saved and I always lived below my means.” The findings of the economists are being met as most challenges to orthodoxy are: with stony silence or extreme umbrage. “I count myself as deeply skeptical,” said Christopher Jones, the chief investment officer at Financial Engines, a financial planning software company. The big financial services companies refused to comment on the research but they did say that their use of simple rules of thumb keeps the process of retirement planning less complicated, and thus, less daunting. John Rother, policy director with AARP, says the economists are “not doing anyone a service because of the tremendous amount of effort it takes to get people to save.” Nevertheless, the loose confederation of well-regarded economists, who have not been working in concert, say their research points to the startling conclusion that many Americans are saving too much, not too little. Indeed, their studies of the savings and spending habits of the generation born between 1931 and 1941 revealed that at least 80 percent had accumulated more than enough wealth for retirement. While they have not studied the baby boom generation as closely, they believe that the greater wealth of that generation should also leave those retirees secure. A study last October by another group of economists, including two working for the Federal Reserve Board, found 88 percent of retirees age 51 and older had adequate wealth. “Even the most casual reading of the popular press will have you convinced that Americans are heading like lemmings over a cliff,” said John Karl Scholz, an economics professor at the University of Wisconsin at Madison. “Going into this, I had no idea that we’d find any results anything like this.” The argument between the sides is similar to the classic debate between the hardworking ants and lazy grasshoppers of Aesop’s fable. The financial planning industry says saving, even too much, provides a safety net and peace of mind, and possibly a gift to heirs at the end. Mr. Scholz said he and his co-authors of a study, “Are Americans Saving ‘Optimally’ for Retirement?” found oversaving across all economic and education levels and most ethnic or racial groups as well. (It found that Hispanics tended to save less.) Those who were not saving enough were usually missing their target by only a small amount. The one exception to this optimism involves people who enter retirement single, either because their spouse died early, they divorced, or they never married. The studies found this group did not save enough. “If they are worried about end-of-life medical expenses or they don’t mind leaving money to their heirs,” Mr. Scholz said, “then oversaving is fine.” The dispute revolves around how financial planners determine how much a person should save. That amount will vary depending on age, income and assets. To simplify the calculations, computer programs resort to rules of thumb. The starting point for most retirement plans is the so-called replacement rate. It says an American needs an annual income in retirement equal to 75 percent to 86 percent of what he or she earned in the final year of employment. Someone making $100,000 would typically plan for about $85,000 a year in retirement. Coupling that with a second industry rule of thumb that says retirees should spend no more than about 4 percent of their assets each year to make them last, a typical couple with that level of income should enter retirement with at least $2.1 million in assets, including 401(k)s, I.R.A.’s, stocks and bonds, real estate, cash value life insurance, pensions and Social Security benefits. Not so, says Mr. Kotlikoff. It may be simple, but he argues it is more important to look at how people spend their income while working to determine how much they will need when retired. Mr. Kotlikoff’s calculations showed that Fidelity’s online calculators typically set the target of assets needed to cover spending in retirement 36.4 percent too high. Vanguard’s was 53.1 percent too high. A calculator offered by TIAA-CREF, one of the largest managers of retirement savings, was 78 higher than his calculation. Fidelity’s Retirement Quick Check calculator says that a 50-year-old person making $100,000 a year with $700,000 stashed in retirement accounts, saving $15,000 a year, would still fall short of the $2.8 million goal that would provide the necessary monthly retirement income of $7,408 that it sets. Its calculations do not include Social Security payments. Fidelity actually recommends saving about $1,000 a month more. It also encourages this person to save more even when more than enough has been saved. It recommends putting away up to $9,749 a month on top of the $15,000 a year already being saved, an impossibility since that would more than consume the person’s entire gross income. Mr. Kotlikoff’s ESPlanner software, taking real estate holdings and life insurance into account, says the person could cut back on savings by $10,000 a year and still have enough for a monthly income of $6,000 at retirement, the amount his calculations deems adequate to live on given prior consumption patterns. Mr. Kotlikoff is trying to sell his software, called ESPlanner, to large employers as well as to the financial services industry. He has made no major sales so far. It is also available to individuals at www.esplanner.com for $150. The financial planning industry prefers to characterize itself as cautious. William Ebsworth, chief investment officer of Fidelity Investments’ Strategic Advisers division, which runs retirement programs, said, “We take a very conservative approach,” preferring to err on the side of having money left over at death rather than risk running out before then. “We believe in the research we’ve done and that others have done that Americans aren’t saving enough,” he said.
I've questioned the economic advice of those that have pumped retirement savings at peril of debt repayment and lifestyle much of my adult life.
Housing: A big priority.
My view is somewhat different in that I have always considered that the first priority was to secure a home, so that when you retire you no longer have mortgage or rent costs, and once you've secured your home, you put the money you would have paid towards the mortgage to retirement savings, and once you retire, your income needs decline by the rate of savings, and the costs of going to a job. They increase by the cost of what you do to fill all that extra time.
Currently with the high cost of housing, I do not think entering the housing market is a good idea, but certainly saving for a better entry point is still a wise money management decision.
If you are not living the lifestyle you would like to live in your retirement, then you will need to save more.
I have also always looked at down sizing the home as a part of retirement planning. In Canada there simply isn't any capital gains taxes for your home.
So, my retirement plan has included buying double the home I need and RRSPs. It holds protection against currency devaluation. I down size at around retirement and I have a nice nest egg to live off. When it comes time to look for some kind of support living arrangement, I sell off the rest of my home and that finances that extra cost.
As the home is the biggest investment, it is extremely important to pick a good entry point into the market. When it seems like housing prices are going up, and up and up and if you don't get in now you will never get it, well, that is the worst time to buy. A decision to buy in these conditions will compromise lifestyle and ability to save for retirement for life. Choose to buy in these conditions is choosing to ensure that your economic future is much harder than it needs to be.
I know the economy where I live, and from 1986 to 1992/3 we had a bull run on our housing market. People that got in around 1986 to 1988 won the quarter million dollar, or better, housing lottery. Their economic future was secured by triple or quadrupile, or even more, increases in the price of homes. Add in the leverage that a down payment could have been as low as 10%, well, that is as much as a 5000% return on investment. People that got in around 1989-1990 have done ok, they also secured homes that appreciated far in excess of what they paid, and are better off for buying when they did, and still had lifestyle preserved.
Those that bought in 1991-1995 paid peak prices and many saw their homes worth less than they paid for them, or relatively flat in valuation for the next 5-8 years. Mortgage payments were such that it ate up the ability to save or have lifestyle, and wage increases have been poor through that time line as well, so there has also not been the increase in income to provide more disposible income. My home was selling for 10% less in 1998 then it was in 1995. I know many people who sold homes they bought in the 1993-1996 years for less than they paid for them in the 1996-1999 years.
Prices were relatively flat and in some cases declining until about 1996-1998. Somewhere around here was again good entry years. From 1998 to around 2000 were very good entry years again and 2001-2003 have also been reasonable entry years. Prices are up from 2004, but prices were also grossly crippling to lifesyle, and they may decline back to 2004 levels.
So, with respect to housing, the market is high, be patient, save your money, and if you plan to enter or upgrade, look to do it around 2010-2014. It is probably still a good time to downsize. Check out the housing market prices and trends in your area over the past 30 years and look at that and take it into serious consideration about when to buy. In general, about 4-7 years after a peak is a better time to buy. An investment into a home is so enormous, it is worth doing this kind of analysis, and to be patient.
Savings: How much to save and when depends on interest rates.
When I got into the housing market interest rates were around 10% for 5 year mortgages. In Canada mortgage rates are renewed at the end of a choosen term, which can be as short as 6 months. Five years is considered a long term. I saw many lose their homes when interest rates increase dramatically in the early 80s. New homeowners lack equity in their homes and it is wise for them to secure longer term financing, even if they end up paying more. It is especially wise with today's low interest rates as if you consider the past, interest rates have been as high as 20% or more.
The low interest rates do suggest that there is opportunity to gain a better rate of return on savings with careful investment. All investments that earn a better rate of return than a mortgage have downside risk, so it is very risky for a new home owner without much equity in their home. Paying down mortgage guarantees a rate of return equal to the mortgage rate. After taxes, investments need to bring in at least double the mortgage rate to be worth the risk. I believe it is better to wait and pay down the mortgage until you can afford your mortgage should interest rates again increase to the 10% range. But then, I have the experience of seeing many people lose their homes because of increasing interest rates and I am cautious that way.
How much do you need?
This entirely depends on pension income. If you have a pension worth 60+% of working income, that along with government pension, extra tax breaks and savings from work related expenses means that income level will remain relatively constant going into retirement without any savings, or downsizing.
Those without a work-place pension need to provide about 50-60% of their working income to maintain lifestyle. Saving for retirement stops at retirement, as do work related expenses.
Down sizing can give a good boost to retirement income. Every $100,000 dollars in savings can provide about $6,000 of income per year, using 6% per year. Say you want $50-60,000 per year from retirement savings, well, that's $800,000-1,000,000 in retirement savings.
This, with government pension, taking off 10% for savings, would give you a lifestyle comparable to if you earned $75,000 per year while working.
I put these numbers into a financial planner on https://www.fidelity.com/frameless_pr_A.shtml.
The results were that if I made $75,000 now, and had about that in savings, I would have to save $29,000 per year to have about $1.9 million for retirement. Notice that I'd be living on $46,000 per year if I saved at that rate? Obviously, along with my government pension, my lifestyle would more than double at retirement following their advice, and like the article below suggested, I'd have no lifestyle.
What do I calculate?
Assume the starting point is age 45, retirement savings so far is $75,000, you invest wisely and earn 10% return, and you can afford $7,500 savings per year, and you save in a tax sheltered RRSP. At age 65 you would have $934,000.
This example does not take into account inflation. With 20 years of 2% inflation, you'd need about 1.25 million for an income of about $75,000 per year, rather than $50,000. To compensate for inflation you'd have to save about $11,000 per year and increase savings by 2% per year.
But neither of these examples uses any home equity. With inflation, down sizing would provide for increased income needs due to inflation.
So, I calculate saving at a rate of $7,500 per year for 30 years and investing wisely would provide enough for someone without a pension. But you do have to be proactive about investments to make 10% per year.
http://www.nytimes.com/2007/01/27/business/
27money.html?ex=1327554000&en=d8c9b4a0bec7f24c&ei=5090&partner=rssuserland&emc=rss
A Contrarian View: Save Less, Retire With Enough
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