Small Claims, Big Problems

The financial world has changed dramatically in the last few years and it seems virtually no area was left untouched.  Most of these changes can be traced back to the tumultuous events of the mortgage crisis.  The homeowners insurance industry on the other hand was re-shaped by a much different, but equally devastating force – Nature.

At a time when insurers were already struggling financially hurricanes pounded the south-east creating record damages.  Seven out of the ten most expensive hurricanes in history landed between August 2004 and October 2005.  Insurers have adapted to this new world to survive and homeowners should too or risk making costly mistakes.

The most notable change is that insurers are dropping customers who make several small claims.  That’s right, small claims (under $1,000)!  It’s no longer safe to file small claims just because they’re covered under your policy.  Because most companies offer a “claim free discount,” making even a small claim could end up costing you more in premium increases.

Worse then that, submitting even a few small claims could get you dropped entirely!  Paying small claims gets expensive fast for insurance companies and so insurers are dropping the people most likely to file them.

Nowadays insurance companies share information about customers through the Comprehensive Loss Underwriting Exchange (CLUE) database.  That means getting dropped by one provider will make it much harder (or more expensive) for you to even get coverage with another.  In a California Insurance Department study 62% of the top 13 insurance companies refused applicants with only one or two claims in the past three years.

So if you aren’t going to be making small claims (and I hope that you aren’t after reading this) then you should carry a deductible that reflects this.  Kimberly Lankford, Kiplinger’s Personal Finance columnist and author of The Insurance Maze, recommends only filing claims in excess of $1,000.  Therefor your deductible should be no less then $1,000 also.  Of course that means you need to keep at least that much money in your liquid emergency fund (but you probably already knew that didn’t you, loyal reader).

Making adjustments to your policy is quick and easy.  Review your coverage today and make the necessary changes if need be.  And the next time you hurt yourself at a friends house be sure the damages exceed $1,000 to avoid causing them future insurance grief.

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Where to Keep Your Emergency Fund

When it comes to maintaining an emergency fund there’s often one major mistake people make – where to keep it.  Often people co-mingle their emergency savings with their regular savings.  Worse yet, many of us invest the funds to make a little money on the side.  A misplaced emergency fund is certainly better then no emergency fund at all, but doing it right will pay huge dividends (especially if you’re married).

One of the most tempting ways to mismanage your emergency fund is to invest it.  This of course is very popular with the guys.  Putting hefty chunk of change in a money market fund just seems to go against everything guys like to do.  It’s not fun, sophisticated, or cool.  It could be earning a much better return in stocks, bonds, or even CDs so why not make the most of this idle savings?  I hear you, I really do.  For a long time I felt the same way, but still reluctantly kept my emergency fund in a money-market account until I finally began to understand WHY we do it this way.

The biggest reason is that you have to think of your emergency fund as insurance, not an investment.  You buy home insurance to protect your house in case it burns down, and car insurance to repair your car if you get in an accident.  Insurance costs you money, it doesn’t make you money, and you pay for it to protect your assets.

That’s exactly what an emergency fund is for; to protect your assets.  If you lose your job and need to make ends meet for a while it keeps you from going into debt (at the worst possible time).  It keeps you afloat.

The other big reason to keep your emergency fund in a savings or money-market account is crucial if you’re married; It’s because of your wife.  Some wise financial counselors taught me that women and men view money differently.  Men tend to view money as a score-card and so we always want to be racking up the score (see the above reason for evidence).  Women tend to view money as security.  When you have 10, 15, 20 thousand dollars sitting in a bank account that you never touch except for emergencies your wife will find a secure place deep inside her that y’all probably never knew she had.  It’s part of your job as the husband to provide for your family, and a wife who feels secure is an incredible start.

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You Are Not Your Credit Score

Ben Stein is in a commercial right now where he talks about how your credit score determines the difference between becoming wealthy and a life of debt.  Man I hope that’s not true!  The truth is your credit score has no bearing on wealth at all yet commercials like this and financial experts treat your credit score as if it’s the most critical piece of the puzzle.  Your credit score is computed based on the following information from your credit report:

• 35% repayment history (how reliable you are)
• 30% amounts owed (your credit utilization)
• 15% length of history
• 10% new credit
• 10% types of credit

Do you see anything in there about how much money you have?  NO!  Dave Ramsey has a better name for credit scores, “I Love Debt scores.”  Essentially that’s all it measures – how much you use debt.  Pay off all your debt?  You’re going to get punished in the credit score department even though your cash flow is like Niagara Falls.

Sadly our society has latched onto this arbitrary number as a way of measuring ourselves.  Creditors use it to make a brainless decision about risk.  People use it as a sort of measurement of richness potential.  Thank goodness you’re smarter then that!  As you pay off debt your scores will drop, and eventually there won’t be enough information to compute your credit score anymore.  There are only two situations that I know of where this can be a problem:

Insurance – Most reputable insurance companies use your credit score as a factor in your rate.  It’s true, you might wind up paying a bit more for insurance then your debt-ridden peers.  Many people use this as a good reason to keep using credit.  It’s your call.  Who do you think is coming out ahead in the long run?

Mortgages – In December 2008 the mortgage lending industry changed dramatically in the wake of the credit crisis.  Conventional mortgages adopted the Loan Level Pricing Agreement (LLPA) which combines your credit score with the loan-to-value ratio to determine your interest rate.  This means your score can impact your interest rate or your ability to get a loan.  If you don’t have credit there are ways to have alternative credit added to your credit report.

I have found tremendous peace in forgetting about this cryptic arbitrary metric.  I no longer spend time reading about how this or that will impact my credit score, or how changes in the way the score is computed will impact my daily life.  I’m not going to borrow money again so for the most part it’s not relevant to me.

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When To Invest

I love the scene from Meet The Parents where Ben Stiller is chatting with Owen Wilson, the rich ex-fiance of his girlfriend.  “How’s your portfolio right now?” Wilson asks.  “Oh… I’d say strong… to… quite strong…”  Our culture has put your investment portfolio center stage as the single most important wealth building asset.  But how are people going to be able to build these monster investments when they don’t have cash?  What’s the point of starting to invest when you can only chunk a few bucks a month on the pile.

We got it half right:  your investments are crucial to your wealth building strategy, but it’s not step one.  It’s not step two or three either.  Working on your investment portfolio while you’re still in debt or without an emergency fund is putting the cart before the horse.  Your investments will be the gilding on your home (so to speak), but what good is that if the roof is leaking and the foundation is cracked?

The average car payment for Americans is about $420 a month.  How much faster could you be building wealth if you were investing $420 a month instead of repaying banks?  That’s over $5,000 annually in savings!  If your goal is building wealth then you’ve got to build it on a strong foundation; debt free with money in the bank (emergency fund).  Building on this foundation will not only make everything stronger, but you will be able to build it much much faster too.

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FDIC – who does it really protect?

In 1933 President Roosevelt signed the Glass-Steagall Act establishing the FDIC.  The intent of the government corperation was to restore public confidence in the banking system.  Basically the FDIC insures deposits at member banks.  Since it’s creation no depositor has lost a single cent due to bank failure.  With a record like that what’s not to like about the FDIC?

I agree that the FDIC provides a valuable service.  One hundred forty banks failed in 2009 alone and the world would be a much different place without the confidence the FDIC provides depositors.  What’s in question here is exactly who the FDIC is really protecting.

Suppose Bank One (fictional) is paying a generous savings deposit rate of 4%.  They’re pushing the limit and keeping only the required 10% of reserves to meet demand-deposit requests.  In a booming economy Bank One made big bets with it’s depositors money and was easily able to pay the 4% interest rate to it’s depositors.  Human nature being what it is, Bank One continues to push the envelope to make more and more money off it’s investments.  That’s when trouble strikes.  It loses big.  Then again.  The economy is crumbling and Bank One is losing much of it’s depositors money along with it!

Now of course the depositors aren’t too concerned about the performance of Bank One.  They’re resting soundly knowing the FDIC will make them whole no matter what happens to Bank One.  Days later Bank One fails.  The FDIC steps in to clean up the mess and refund the deposits of the banks customers exactly as it was designed to do.

So what’s the problem with this scenario?  Well for one where do you think the FDIC gets it’s money?  That’s right, the tax payers.  And two (this is a big one), what do you think happened to the bankers who gambled away all the money?  Nothing.  So let’s recap:

I know what you’re thinking.  Banks pay fees to be FDIC members and those fees are used to insure the deposits.  In the first quarter of 2010 the FDIC deficit widened to 20.9 BILLION dollars.  So when the FDIC actually does have to step up and replace deposits (rather then managing an acquisition) it can’t do it.  American’s will pay via taxes or inflation.

During a booming economy Bank One enjoys gigantic profits successfully gambling with depositors money.  The executives and stock holders take home the winnings and live high on the hog.  Later tragedy strikes and Bank One loses much of it’s investments.  As the economy crumbles so does Bank One.  Everyone breathes a sigh of relief as the American Taxpayer agrees to pay for the debacle.

Still sound like a good system?  Where’s the responsibility for being smart with the money you were intrusted?  Why are banks regularly relieved of their irresponsibility?  What would things be like if banks were judged not on the interest rates they pay out, but on their stability?

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Run on the Bank

What would happen if suddenly your bank were to fail?  You go to get some cash or swipe your debit card at the gas station and there’s no money.  I’m not talking about it being stolen or your account frozen for some reason.  I mean your money is gone because the bank is gone.  Nothing.  Not coming back.  This was the reality for many during the bank failures of The Great Depression and I can’t imagine how that must have felt.  So what about now?  Why don’t we even think twice about this grim possibility?

Let’s back up just a minute and talk about how banks work.  When you deposit $1,000 in your account the bank doesn’t just let it sit there waiting patiently for you.  Our fractional reserve banking system means the bank is only required to keep a small fraction in reserve to meet withdrawal requests.  The bank could have as little as $100 in reserve from your $1,000 deposit.  How could this possibly work?  Banks rely on the statistical improbability that a large number of depositors will want their money back at the same time.

For example:  Suppose 100 people all deposit $1,000 at the bank.  The bank keeps 10% of the deposits in reserve which is $10,000.  At this point 10 of the accounts could demand their money and leave and the bank would survive.

But what about the eleventh guy who wants out?  Now we have a problem! Word will likely spread quickly that the bank couldn’t give guy #11 his money which will likely cause guys 12, 13, 14, 15, and 16 to demand their money back because it’s not safe!  This is a classic “run on the bank” and it’s what happened to many banks during The Great Depression.  Bank failures are a thing of the past though right?  Wrong! In 2009 140 banks failed and over 100 have already failed in the first half of 2010. Here’s a list of all the bank failures since 2000 (pretty long huh!).

The difference between then and now is that the FDIC guarantees member banks (pretty much every bank) that depositors will be able to get their money back (up to $250,000) in the event of a bank failure.  This safety net was put in place in 1933 as part of the Glass-Steagall Act.  The idea is to give the public confidence in the banking system and also provide some standards for banks to operate under.

It seems to have worked too.  Odds are you never worried a day in your life that your bank could fail and you’d have nothing.  There’s a good chance the 140 bank failures in 2009 didn’t make you cringe in fear for your savings (odds are you didn’t even notice!).  So do we consider this a successful government program?  Does the FDIC’s deposit insurance provide the much needed oil in the machine?  The answer may surprise you… (stay tuned)

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How Banks Create Money

Ever wonder really happens when you deposit your paycheck in your bank account?  Or what about your car loan or home equity line of credit, where did that money come from?  You probably get paid interest for having your money on deposit with a bank or credit union, but why would the banks care about your savings?

The big confusing word behind how all of this works is “fractional reserve banking.”  Our banks operate on this system which requires them to only keep a fraction of their deposits in reserves.  For example let’s say you deposit $1,000 in your account at your bank.  The bank takes the $1,000 out of your account and replaces it with a bank IOU for $1,000 (this is all invisible to you).  Then they take the 90% of the deposit ($900) and lend it out in the form of car loans, mortgages, or anything other debt product.  The remaining 10% ($100) is put in the banks reserves.  Sounds crazy right?  Well it’s about to get a lot crazier…

Continuing with the above example, the total money supply has increased from $1,000 to $1,900.  Where did the extra $900 come from?  The bank created it out of thin air! Summarizing the current example, the bank has put $100 of your deposit in reserves, lent out $900 of it, and created $1,000 by giving you an IOU for the amount deposited.  In fact, your deposit at the bank (called a “demand deposit”) is legally considered a loan to the bank repayable on demand.

In practice the $900 lent out would find it’s way to another bank as a demand deposit.  That bank would then keep 10% in reserves, lend out 90%, and the whole process would repeat again and again.  Yikes!

So what if you want your $1,000 back?  No problem… at least if everything goes according to plan.  The fractional reserve system relies on the statical improbability that a large number of depositors will want their money back at once.  If they do it’s called a run on the bank and the bank will likely collapse (now days we have the FDIC to guard against this, more on that later)!

By putting 90% of demand deposits to work the bank is able to make a tidy spread on what it pays in interest (your savings rate) and what it collects in interest (your mortgage rate).  Think about it, you deposit $1,000 and the economy is $900 richer.

Hungry for more?  Check out the long-winded version on Wikipedia.com

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All In – Committing to Debt Freedom

There’s a moment in surfing where time seems to stand still.  One of those “make it or break it” moments where it’s too late to turn back.  As you paddle nervously into the wave it begins to rise up higher and higher and higher; and in an instant you find yourself staring straight down a wall of water with your heart in your throat.  It’s this precise instant that dares you to be great.  It’s this precise instant I want you to experience.  This is how to live like no one else.

When you make a commitment to living debt free you’ve got to huck yourself over the edge.  Cut up those credit cards and close those “emergency” lines of credit.  Cut cut, done.  Gone.  Forever.  It’s a rush isn’t it?  What if my car dies?  What if I lose my job?  How am I going to pay for it when life comes along?  That’s it.  That’s the moment.  There’s really only two choices:  You can crash and burn or you can find a way to ride it out.

I’m not saying it’s going to be easy because it’s not.  But taking an “all in” attitude ensures you’re going to get moving in the right direction.  For me the hardest part was using what little cash I had saved to start my debt-snowball (Step-2).  I felt insecure without cash in the bank even though I had a pile of debt.  Committing to this plan made me feel uncomfortable at first, but that discomfort fueled my intensity to keep progressing through the steps.  It built discipline and accountability.  It forged the foundation that keeps me focused today years after paying off my last debt.

It’s simple, but it’s not easy.  If you’re staring this step in the face I encourage you to take it.  Harness the anxiety you feel now to accelerate you in the right direction.  Find a support network to keep you focused on the next step and encourage you along the way.

Have you experienced this yourself?  Share your experience in the comments below!

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Successful Budget Meetings

When you’re getting your budget together those first few months, odds are it didn’t go off like Steve Jobs unveiling the iPhone 4.  Take heart though because we’ve all been there and figuring out what works best for your family is part of the process.  If you stick with it, you’ll find not only an improved financial situation but also improved communication and security in your marriage.

To borrow some observations from Dave Ramsey: every couple has a nerd and a free spirit.  The nerd is the one organizing the budget in a carefully formatted spreadsheet.  There’s a space for everything, and everything is color coded and cross referenced so you can ‘effortlessly’ determine a variety of monthly statistics in a single glance.  The free spirit is easy to spot.  They’re the one asleep next to the nerd during the presentation.  I’m the nerd in my family so I’ve had some learning to do about how to hold a successful family budget meeting.  Here are my favorite tips that work for me and my wife:

The Meeting:

• Keep it short, twenty minutes tops.  As Dave Ramsey says, “it’s not a weekend long budget summit.”
• Turn off the TV, put the kids to bed, be completely focused on the budget.

For the Nerd:

• Spend all the time you want making a spreadsheet that you’re proud of, but do it on your own time (don’t make the free spirit suffer through it!).
• Use your passion for organization to make most of the budget before the budget meeting.  During the meeting you won’t have to waste time on the mundane pieces.
• Understand that you need the free spirit’s input and observations to create a budget that works.
• Approach the meeting with a positive tone.  If the free spirit feels it’s a safe and encouraging environment they’ll be more likely to engage.
  • Pro Tip – Try: “That could work really well. I hadn’t thought of that.”  Not: “Don’t mess up my spreadsheet.”
• Although your budget is perfect already, insist that the free spirit change something.  This won’t work unless you’re both actively involved.

For the Free Spirit:

• You have to show up to the meeting and be engaged.  There’s a 20 min time cap on this so hold on, and it’ll be over soon.
• Come with a positive attitude and understand that your voice is equal.  The nerd doesn’t have everything figured out no matter how colorful the spreadsheet is.
• The phrase “whatever you think” is not allowed.  You both need to decide together and understand your decisions.
• When the nerd insists that you change something know that it’s nerd-love.  Now get involved.
• Now I know fancy spreadsheets aren’t your thing, but be encouraging to the nerd and show your genuine appreciation for the efforts.

As a fairly newly married guy (two years) I’m still learning each month about the best ways to communicate with my wife about money and the budget.  The important part is we get better each time and we’re actively improving our communication.  I’d love to hear from the more experienced readers about any wisdom they’ve learned over the years (I’ll add your recommendations back to the post).

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Balance Sheets Explained

Calculating your net worth is a great metric to measure your personal finances over time.  It can give you a quick overview of everything you own and everything you owe on one simple sheet.  These sheets are called Balance Sheets and they can be as detailed or vague as the preparer wishes.  It’s important to know exactly what you’re looking at when preparing or reading a balance sheet because their simplicity can be deceiving.

Financial Speak

First let’s go over some “sophisticated jargon” you’ll often encounter when looking at financial statements.

• Assets – property owned.  Examples include cash, investments, personal residences, and cars.
• Liability – money owed.  Examples include bank loans, student loans, car loans, credit card debt, mortgages, and taxes owed.
• Liquidity – The ability to convert an asset into cash quickly at a known price.
• Current Assets – Assets that are able to be quickly converted to cash (liquid).  Sometimes also includes assets that will be converted to cash within the year.
• Current Liabilities – Liabilities due during the current year.

Traditionally a balance sheet lists all the assets on the left hand side and all the liabilities on the right hand side.  To compute your net worth you simply subtract the total owed (liabilities) from the total owned (total assets).  Here’s an example:

Reading a Balance Sheet

Seems simple enough right?  Stuff you own on the left, stuff you owe on the right.  Throw some quick formulas in and out pops the net worth.  That’s pretty much true, but a bit more comprehension of exactly what a balance sheet is telling you will go a long way toward turning you into a financial power house.

First of all a balance sheet is a photograph, not a video clip.  It was created at a particular moment in time and can tell you little else other then the status at that moment.  It can’t show you where money is flowing or whether it’s rising or falling.  With a little practice you can make inferences about motion, but you won’t see it represented on a balance sheet.

Balance sheets balance, that’s it.  They make no judgement about the potential future value of an asset or the costs of liabilities.  In the eyes of a balance sheet a brand new $25,000 car is worth just as much as $25,000 in stocks (even though the car will hardly be worth $20,000 in 12 months!).

Balance sheets don’t account for risk, that’s your job.  For example let’s say you borrow $500,000 to buy a sweet beach house valued at $490,000 (putting in $10,000 of your own money).  Now add the vacation pad to the asset column and the $490K mortgage to the liability column.  How did your net worth change in this example?  It didn’t!  But now you’ve got a gigantic liability!

As one last example let’s look again at the example balance sheet above.  This person has a net worth of around $65K and a pretty fun looking asset list!  Now let’s look at another balance sheet also with a net worth of about $65K.

Which one of these two people (who have the same net worth) do you think is in a better financial position?  Hopefully you said this second guy!  He’s got twice the current assets and a fraction of the liability.  My bet is the second guy has a lot higher cash-flow to start really piling on the wealth (because he’s got low debt payments).

Learning how to properly create balance sheets can be a great way to annually measure your progress and create a snapshot of your estate.  Knowing how to properly read one is vital to your financial education!  Hopefully you’ll think of these two examples the next time an impressive asset blows by you on the freeway!

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