So you want to be in the top 5% of income earners?

There is always something cool about numbers in a spreadsheet. You can figure out normal for certain characteristics.

The U.S. Department of Commerce – Census Bureau has tons of tables aggregating all these characteristics across the population. For this post I will refer to table HINC-05.

Where do the top 5% live?

By percentage to the entire population (so the likeliness of running into them on the street) they are concentrated in the suburbs at 6% and in the northeast at 6.5%. Which if you think about it is obvious as the northeast is well known for high incomes. As for the suburbs, the 5% have an average age of around 50, which means when they were buying a house about 30 years ago during the continued shift to suburban life.

What is the family situation of the 5%?

The majority of the 5% is married (81.4% of the 5%, i.e. you know they are a 5%er and this is the likelihood that they are married) with both (or even more) of the couple working (76% of the 5%) fulltime (73.5% of the 5%) living in a home they own (89.1%). They are nearing at their peak earning years and beginning to worry about retirement at 45-54 years of age (30.5% of the 5%).

Finally of the 5%they are most likely to be white at (86.8% of the 5%). However, the interesting thing is that if you pick any random person of a race off the street it would actually be the those of Asian ancestry that are most likely to be in the top 5%. (9.3% of all Asians being in the top 5% vs 5.4% of Whites (including Hispanic), 2.1 of Hispanics and 1.7% of Blacks).

So what does this mean? I don’t know but numbers are fun.

Results of the 401k Loan

So as I mentioned from the previous post A Good Reason to take a 401k Loan I took a 401k loan for 1 year to refinance my mortgage. I was able to lower the mortgage from 4.5% to 2.5% and the term from 30 to 15 years. This left the monthly mortgage payment at roughly the same amount as before but it will save about 150k in interest over the life of the loan. So from the mortgage side, yes this was worth it.
But the real question is, was the 401k loan worth it? That takes a bit more investigation since I could have sold off additional investments, just waited until I saved up enough or used a Peer-to-Peer Loan or Second Mortgage to cover the rest.
NOTE: I actually paid off the 401k loan in 6 months instead of a year so these analysis will only cover that period

Selling off investments

If I had decided to go with the selling of investments I would have incurred the short term capital gains taxes which would be 25%. So I would have to sell 133% of the lacking funds to cover taxes as well (133% * 75% = 100%). In addition I would have missed on those investments a 20% gain which means this move effectively costs 160% of the needed cash. This results in a “loan” APR of 156%.This would have been the most expensive option… well payday loans might have been more expensive.

Saving up the cash

This would have delayed the refinance by 6 months so looking at the historical rates the best rate around that time would have been 3%. Not too bad, just a 0.5% higher though that means that I would lock in about 21% more interest paid over the life of the loan. That seems like a lot but that amount in interest was only 60% of what I was borrowing from the 401k over 15 years which results in an “loan” APR 3.2%.

Home Equity/Peer-to-Peer Loan

We could have also gotten a 2nd mortgage at the rate of 5% to cover the lacking amount however that would have resulted in a loan with the APR of 5.05%

401k Loan

Minus the $45 in fees, all interest was paid into the account resulting in a 11.4% gain over the period versus the 11% gain for the market. I was also able contribute to the 401k while having the loan thus I didn’t lose the employer match. So due to taking out the loan before the market went down (which was pure luck) and repaying the loan as the markets climbed I effectively got to borrow the money for free. The effective “loan” APR is -6.9%.

So in this case everything worked out beautifully for the 401k loan. It not only was not a disaster, but actually the best choice I could have made. So to wrap it up, yes usually 401k loans are horrible, but there are real life examples of when it pays off nicely. Just remember to keep the term as short as possible and continue to contribute to the 401k during the loan.

What do you think? Was there another option that I overlooked? Do you disagree with my calculations? Leave a comment below.

A Good Reason to take a 401k Loan?

The common advice we get is that you should never take a 401k loan. They give multiple reasons but the basic point is that you stand to lose a ton of money (from penalties if you cannot pay it all back to lost gains because you aren’t in the rallies). However, my question is there ever a good reason to take a 401k loan? In my situation I believe taking the loan was a good idea.

Backstory

So in back in September we noticed that the rates on mortgages had continued to drop from our previous refinance a couple years ago and decided to look into refinancing again. Of course wanted to be out of all debt as soon as possible we started looking into what would be needed to not only refinance to a lower rate but also a shorter term. Our current mortgage was a 30-year fixed (28.25 years remaining) FHA loan at a rate of 4.5%. The other thing we wanted to get rid of was the FHA loan’s Mortgage Insurance Premium (MIP) that was costing us around $160 a month.

Issues

The first issue we ran into is getting our mortgage down to the 80% LTV needed to avoid Mortgage Insurance. We knew that the house had appreciated a bit and using both Bank of America’s house worth estimator and Zillow’s Zestimate we found that we would need to bring to closing 5-16% of the new mortgage. The other problem was reducing the loan length would potentially increase our mortgage payment and we needed to adjust our monthly budget to account for that.

How it all went down

So knowing that we would need at least 5% and the stock market doing so well we were able to sell off some stock to get about 6% after removing some for the capital gains tax. We then went around to all the financing institutions (BECU, Well Fargo, Bank of America, Tech First, ING, RMC Vanguard, etc.) asking for their quotes. We also did them all on the same day as that is important not only to get all the inquiries marked as a single inquiry on our credit report, but to make sure the rates were comparable as each day the mortgage rate changes. In the end we went with RMC Vanguard (found through Costco’s Home Mortgage Program) since they had the best rate. They ordered up the Home Appraisal and we waited to find out the results. A week later the appraiser came by and low and behold the value almost matched Zillow’s exactly which meant that we needed to raise the entire 16%.

Note: The Appraiser did mention that if one of the two additional houses on market sold then the value of our house would jump up another 20-40k in value, but they had already been on the market for quite some time. 

So in addition to the 6% gain in sale we did have another 5% in savings (Mostly E-Fund related (4 months of mortgage payments in one account and 12 months of non-mortgage living expenses in the other account). This left the problem was coming up with an additional 5%. The bank offered to finance that 5% as a second mortgage with a 6.5% interest rate but then I noticed that my 401k has an option to take a loan out. Hearing all the bad things about 401k loans (relatives of mine who used one but wasn’t able to pay it all back so got hit with penalties, lost gains, missing the employer match, etc.) I was very cautious to take one out. However after much deliberation we decided to take the loan and cover the rest of the closing costs. Here is how we determined to take the loan.

First we reviewed next year’s budget to see what we could cut back. Already we were saving about 0.4% (not including 401k contributions) a month towards various goals that could take a break or reduction for a year. So cutting additional spending would allow us to be able to repay the 401k loan in a single year while still being able to contribute (thus not losing the employer matching).

Second, the rate on the 401k loan was the same as our previous mortgage so we wouldn’t be trading cheaper money for more expensive money.

Third, with the duration of the loan only being a single year I doubted the economy would move enough to amazingly beat the 4.5% return on the loan. Which happened to be quite fortunate as after taking the loan the stock market faltered and the remaining 401k balance went from 18% PROR (Personal Rate of Return) to 12% PROR for the year.

And forth, we wanted to avoid having to borrow such a large sum from relatives which might strain our relationships with them.

Final Answer

So was this a good reason to take a 401k loan? Well I am only a quarter of the way through my repayment plan but so far we have been handling the situation quite well. It also has given us insight into what in our budget was really just fluff and could be reduced if need be. Perhaps you can give your insight in the comment section.

Entryway Closet

HPIM6823We purchased our home as a short sale and it was in need of some TLC. One of the things that needed to be worked on was our entryway coat and shoe closet. It was just an empty space with bi-fold doors and when we moved in we had filled is with boxes. Problem is where do you put your shoes and coats when you come in if the closet is full of boxes? Anywhere in the house! This of course was not helpful in keeping clean carpets or having the kids shoes in the same spot every time, which resulted in missing the bus occasionally.

HPIM6931So with getting the carpets cleaned professionally by Michael’s Professional Carpet Cleaning (which did an outstanding job, even removed the blackberry and printer ink stains) we wanted to keep these carpets clean from dirt, mud and food. So I departed to Home Depot for some basic supplies, 1×4 pine boards, 3/4” red oak plywood (cut in 3 equal pieces), oak edge veneer, closet rod, shelving clips, shelving standards and stain. So I took the boards over to my dad so we could dado the pine boards to receive the plywood and dado the plywood to receive the standards so that they were flush.

With the boards dado’ed, it was time to stain them. I used two different stains, classic oak for the plywood and jacobean for the pine as they accepted the stains differently and these two colors actually complemented each other quite well. I also added a coat of polyurethane as there will be wet coats and shoes potentially in contact with the wood and I didn’t want the wood to get ruined. Entryway ClosetOnce it was stained I glued the plywood to the pine and added a few pin nails to hold it while the glue bonded. Then it was the simple task of finding the studs and screwing the pine back boards to the studs.

Now we have a place for all those coats and shoes along with games, BOBs (Bug Out Bags) musical instruments, biking gear, shoes, coats and even playdough! The carpets are thanking me already!

Budgeting for the Credit Card User

So let us say you are the type who wants to take control of your finances but no matter how many budgets you created, spending plans architected or purchases tracked you are unable to get control. Well here is a simple way to make a budget that you will follow from day one through day 365. Since you use a credit card all your purchases are tracked, now how many credit cards do you have 1? 3? 25? 486? Each card usually will send you an end of the year summary of all your purchases. Go find those summaries. Now they break down your purchases into categories add up the amount from each category from each statement. Got the total for each category? Good now divide the total by 12, that is how much you spend on average each month to the category and thus your monthly budget. Congrats, you have a budget you can follow since you already have been following it!

Now go get your paystub and look at the NET pay. Add up the total for each category, is it more or less than your net pay? If it is more then you need to earn more (side hobby, moonlighting, selling matchsticks, etc.) if it is less than congrats you have a surplus (assuming that you paid solely with a credit card) that you can put towards emergency savings, retirement, pay down debt, etc.

Now that you have this information set up a bunch of savings accounts for each category with auto transfers on the day after your paycheck is deposited for the monthly amount (or if you are paid twice a month, half the monthly amount, or if you are paid weekly, a 52ed of the yearly amount). Personally I will add a little buffer if I can afford it so that I end of saving for an unexpected expenses in each category. Now that you have your accounts set up and you are saving money to pay the expenses, before the bill is due go through each item and total up each category for the month to transfer into you checking account to pay the bill. Remember if are carrying a balance this will just pay off what you purchased that month so pay as much as you can towards paying off the balance of card (but not with funds from the category accounts), eventually you will be paying the balance in full each month.

Inflation, Deflation the FED and you

A couple months ago I was reading Linsey’s post at WiseBread “5 Financial Holidays I’d Like to See”and one of them was FED Day. Well that started me down a path to learn more about our banking institution and how the Federal Reserve (FED) tries to manage the economy. So to share what I have learned we need a few definitions to get us started.

Inflation – A progressive increase in the general level of prices brought about by an expansion in demand or the money supply or by autonomous increases in costs. (Dictionary.com)

Deflation – A reduction in the level of total spending and economic activity resulting in lower levels of output, employment, investment, trade, profits and prices. (Dictionary.com)

Central Bank – A public institution that usually issues the currency, regulates the money supply, and controls the interest rates in the country. (Wikipedia)’

Fractional Reserve Banking – A type of banking where depositors invest base money into a bank and the bank uses it to maintain highly liquid reserves to repay expected customer withdrawals and pay for bank operations and gives a credit to their account which the bank ensures the customer can use as money. The bank only needs to keep a fraction of the money in reserve and so the rest can be used to make loans (though it appears that the depositor holds the full amount due to the credit). (Wikipedia)

Fractional Reserve Banking

The part I found most interesting to read is the Fractional Reserve Banking which explains how money is “created” by the banks. Really what happens is that you give your money to the bank, the bank puts an IOU in your account and then loans out the money up to the amount that they need to keep in reserve to satisfy the withdrawals that normally happen.

NOTE: In the case of the United States the reserve requirements are 10% for checking if your bank holds more than $58.8 million in deposits and 3% for institutions with more than $10.7 million but less than $58.8 million. (Federal Reserve) Note that Savings accounts and time deposits (CDs) are not the deposits they are talking about and actually these deposits have a reserve rate at 0%.

So to see how this works in life let us take a person that has a checking account at a large (more than $58.8 million) bank and our person deposits $100 into the account. The bank is required to keep %10 of that $100 as a reserve (they may keep more to satisfy the demands of a normal person though). So they then loan out $90 to someone. Well our original person still believes he has $100 that he can use whenever and his friend got a loan of $90 so it appears that there is $190 in the system. Now if the depositor writes a check for $50 the bank has to pay it, but of course they only have $10 in reserve of which only $5 is available. So the bank goes to the Federal Reserve (or another bank) and borrows the $45 additional dollars they need cover their IOU and pays the check written by the person. Of course they might be able to sell or call the loan of the $90 they gave and also pay the check.

Of course banks have a lot of depositors and people with large balances usually will use less than the reserve requirement which the bank can use to cover other people’s withdrawals and they usually keep more in reserve than the required amount anyway. Take Bank of America for instance in their Annual Report you see that they are holding $117 billion dollars in cash (page 244) and $1 Trillion in deposits (page 238) or a ratio of around 11.7%. So they would have to have people withdraw without any deposits, around $17 billion dollars before they would need to raise money to reach their reserve requirements, and that is if ALL the deposits were in checking accounts (which they are not).

Inflation

Now inflation is very simple, the increase in price due to more perceived money, more demand or increase in raw components. Take a bushel of corn (about 1.25 cubic feet) for instance, corn requires water, sun, correct temperatures, and nutrients to produce. As water becomes more scarce the price of water increases as people are willing to pay more for water (it just takes a few to raise the price). Also as the price of oil increases the fertilizer used by farmers also increases since oil byproducts are used in fertilizer. So as these raw resources increase in price the raw cost for a bushel of corn increases. Farmers still need to make a profit similar to the previous crop and so they increase their price and thus the price of corn increase. In addition as more people demand 2nd tier foods (beef, chicken, or other foods that use corn to produce) the greater demand rests on corn. Finally it is also easier to acquire money as interest rates for loans are low and you don’t have to think on how much it costs when you swipe your credit card. Also you remember that a CC purchase is a loan so remembering that in Fractional Reserve Banking we get that money you just used from a person’s bank account that did not decrease, thus the money supply increased because you used your credit card.

Deflation

Now deflation in the common usage is the reduction in price. However it can be an indicator of reduction in the economic activity. For example if a factory produces a widget and less people start buying that widget the company might reduce prices to sell all the widgets it makes. This reduction in price to generate the same volume usually results in a lower income resulting in the company needing less people and so it fires its workers to trim costs (or the head management takes a pay cut). This results in those workers no longer having the ability to buy products and so more people lose their jobs and the cycle repeats.

YOU

So with this overview of the financial system hopefully you can start making your own decisions to get the results you want. For example if you want to make the dollar stronger you need to remove dollars out of the system. One way is to withdraw them and stuff them into a mattress (since that cash can no longer be loaned out with an IOU in your account) or you can look for banks that hold a high reserve of their cash so the multiplicative effect is reduced.

Note: For the scenario where you take out cash you will need a large portion of the population to withdraw the cash for the banks to reduce their loan/investment holding to bring the reserves back.

In the end the more you understand the system the better you are at managing your financial welfare in that system. And remember we ALL are responsible for the rising prices. Smile (Of course this is excluding the one person who doesn’t have money in the bank, doesn’t use credit, hunts/grows their own food and basically doesn’t use or affect the financial system).

What if… Emergency Preparedness

With the recent disaster in Japan and others including the BP oil disaster, middle east revolutions and more each day more and more people bring up disaster preparedness. Being a member of The Church of Jesus Christ of Latter-day Saints, preparedness has been talked about for years especially centered around have a year’s worth of food storage. However, the best way to be prepared is to actually practice disaster drills. Think about fire drills at work and school. They can be very disruptive but if a fire broke out there do you know what to do? Can you do it in near automation mode? If the answer is yes then you know why drills are important.

There are many good preparedness blogs though one of the best for the average person I believe is from one that survived Katrina and posted about the experience with worksheets on his blog, “Listening to Katrina.” He gives a great outline on getting prepared in your own region

The important part of preparedness though is to practice. Have a drill every 6 months on getting out of the house in 30 seconds or packing the car for evacuation in an hour. Turn off the power and see if you can hook up the generator if you have one or just see how you would manage without power or water. These practices can be as short or as long as your family wants to tolerate. One way to make sure you always practice is whenever the fire alarm goes off practice the fire drill. If you are like me the occasional burning of the food will provide you with at least a drill every 6 months. Smile

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