Archive for October, 2007

Date: October 5th, 2007, Filed under Bank bankruptcy, Foreclosure

Zion, IL
By A.B. Dada
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Fresh news this morning as the FDIC reports on another bank, the third one in this credit bubble crash, going under. Miami Valley Bank, in Ohio, is now in receivership with close to US$90 million in deposits. According to the Reuters report, the bank has deposits totaling over US$14 million that don’t qualify for FDIC insurance due to being over the US$100,000 cap on deposit insurance per depositor. This is a lot of money for people left holding the bag, who become “creditors” instead of depositors. If you’ve ever had a borrower declare bankruptcy on a loan you’re holding, you know how much you usually end up with: zero.

For the average depositor, this means as much as 19% of their deposit value wiped out. For the rest of us, it could mean a hit in our own deposits if the Fed needs to print away to cover the losses. Usually, when the FDIC declares a bank insolvent, other member banks pick up the loss and cover it themselves. If we continue to see banks go under, we might see member banks unwilling or unable to pick up the hundreds of millions, or even billions, in losses that could flow out of the insolvency.

I’m not a fan of FDIC insurance. It creates an undue burden on well-run banks to pick up the trash of the badly-run banks. This means that investors in a well-run bank have their return decreased from the premium of the bank having to worry about being forced to be the first step insurer to other banks who go belly up.

When you put money in the bank, rarely are you a depositor. A depositor puts money into an account to secure it: in a full reserve banking system, this means that you specifically tell the bank to protect your money, not to loan it out. Today, even your checking accounts and small saving accounts are not deposits, but investments. The bank quickly finds a short term to medium term loan product for you so that they can make money, and giving you a piddly 1-1.5% return for your risk. Most “depositors” are unaware that fractional reserve banking defrauds them of their security in a deposit, with the bank making the profit and the depositors having to spend countless hours worrying about how much of their deposit is insured, and how much that insurance is actually costing them.

We don’t have any full reserve banks in the world today, because they are uncompetitive. If a bank told you they’d charge you 1% a year to secure your deposit, you likely wouldn’t go near them, even if they’re really just putting your cash in a vault. You’d rather deal with a 0.5% return than pay someone to watch your money. Most of us would feel wiser with the cash under our mattress than lose 1% plus whatever loss inflation puts on the value of our money.

In a full reserve bank, banks would give you two choices: pay them to secure your savings (they wouldn’t re-invest them), or accept some risk and let the bank invest your money in a variety of loan or credit products. I believe a full reserve bank makes the best sense for a free and truthful society, because the owner of the money has full control over how that money is used. You may be willing to give up 1 year of access to your money so the bank can make a 1 year loan to a business or homeowner — this would give you a nice return if the bank was charging 8% for that loan, with competitive forces giving the investor 5-6% of that profit back. Many banks could exist just fine on a 1-2% profit, considering the billions that would accrue that small percentage.

The Reuters report is just a drop in the well, with a future fear of torrents of banks going insolvent due to bad loans and risking too much for too little. When you include the derivatives market, there is an even bigger fear of massive loss.

Here’s a question, though: when a bank goes insolvent, it goes under because borrowers can’t pay them back for money they borrowed. The money they borrowed was spent, so it exists, somewhere. When billions of dollars worth of value get wiped out, we still have to understand that the money exists SOMEWHERE: maybe a home developer, maybe a kitchen rehabber, maybe a car manufacturer, or a furniture retailer. The money is there, it isn’t destroyed and it surely isn’t lost forever, never to be seen again. This means that another bubble, somewhere, is waiting to rear its ugly head.

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Date: October 1st, 2007, Filed under Mortgages

Ft. Atkinson, IL
By A.B. Dada
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A regular reader of this site asks an important question:

When you say a mortgage payment shouldn’t exceed 28% of gross salary, and when Dave Ramsey says it shouldn’t exceed 25% to 33% of net pay, do you (and he?) mean a mortgage payment of:

P & I: Principal and interest?

or:

PITI: Principal, Interest, Tax, and Insurance?

Ramsey is more correct in this case, because he’s putting the more conservative viewpoint ahead of the “maximum” viewpoint I hold. In my calculations, and from going over more than 100 friends’ and family’s finances over the past decade, the 28% gross salary is a serious cap, not a recommended number to hit. 33% of net pay for mortgage payment is FAR smarter (and 25% even moreso). If it were up to me, and the Federal Reserve wasn’t destroying affordable housing, I’d cap a monthly mortgage payment + insurance + taxes at 33% net pay. Due to the housing market always being overpriced at some level, I feel my numbers make sense from a historical perspective in the research I’ve made.

For me at the current time, I think mortgage payment should mean P&I, not necessarily including tax and insurance.

This is because I believe that many homedebtors are WAY overinsured for home, health and vehicle insurance. I consider insurance a hazard-only plan, not something that you should ever use if possible. A few weeks ago we had a toilet overflow, shorting out an entire leg of our home’s electricity and causing some minor damage. Total cost to fix was under $1000, but my father said I could (not should) file a claim. For minor damages, I consider this part of the maintenance and overhead of owning a home. Over the next few years we hope to have a deductible of at least $10,000 on our home insurance, and maybe double that. We have that same deductible for our cars and our health, because we have “savings” set-aside as a deductible payment, if needed.

If for any reason we have to use that specific savings towards a deductible, it would mean an immediate shutdown of any discretionary spending (including clothing, food beyond basic absolute needs, entertainment and travel) until we have that savings secured again. Dipping into savings to cover an emergency means all non-emergency spending can’t be performed until we’re back in the black for a future emergency.

Most people have smaller deductibles because they (a) don’t have signficant emergency savings, and (b) they file claims without thinking. Health insurance for us is for real emergencies (over $30,000 lets say). I can’t think of a single claim we filed in a decade other than when the wife had a glass explosion on a past Christmas that almost killed her. Other than that, we pay cash, ahead of service, and get a significant discount on that health service.

Because of this outlook, the insurance cost is not as high as if we had a $500 or a $1000 deductible and filed claims on every toilet explosion or minor accident.

If you’ve visited my True Mortgage Calculator site, you’ll see that the biggest impediment, in my opinions, for most homedebtors is the lack of a decent down payment. If you can afford 20%, you’re 99% ahead of the rest of the country. After that, personal debt (credit cards, auto loans, personal lines of credit) are the next reason why people overbuy. The actual mortgage payment (P&I) is insignificant in terms of the barrier to entry that personal debt and no savings produces in terms of a realistic mortgage.

That being said, you SHOULD take considerations if you live in an area with an indecent property tax bill, or one prone to flooding or other regular natural causes that would mean you can’t insure against all disasters. I always recommend looking over flood plains and river watersheds in the area to see when they last flooded or caused misery to local homeowners.

In terms of property taxes, it is also wise to do a little research into what long term debts the town you’re researching has. Many local villages with reasonable property taxes may have huge long term pension liabilities that could be paid off with property tax hikes or other unreasonable future cost adjustments.

Why don’t I include property taxes in the mortgage calculator? I might, because this is a common question, but my reason for the mortgage calculator is to look at renting versus owning, and in every case, property taxes are already factored into the rent you would likely pay, so while not a net zero sum, it is part of the cost of living anywhere that you should factor in under your “maintenance” costs of home debtorship or renting. When I help people consider rental costs in their budget, I _always_ have them look up the landlord’s property tax payment, then divide it into the total square footage of their units and multiply it by the square footage they’d use. For example, if your landlord pays $10,000 a year in taxes, and has 22,000 square feet of which you’d rent 900, your portion of taxes is $10,000 / 22,000 * 900 = $409 per year, or $34 per month. If your rent is $700 per month, I recommend putting $666 (doh) under housing cost, and $34 under maintenance-propert taxes. This allows you to do a better comparison for purchasing in the future, but is a cost you must budget for.

Remember a few points in my mortgage recommendations:

1. If you’re working to secure financing for a 30 year mortgage, don’t take a mortgage that you feel you can’t pay off in 15 years. This means run the mortgage calculators for both 30 year and 15 year loans, at the interest rate you can get. If you look at the 15 year payment and it is too much, don’t jump into the 30 year payment. When you close on a loan, either make the 15 year payment as best as you can, or at least put into savings the difference between the 30 year and 15 year payment. If you do a form of savings instead of paying it down faster, I recommend a combination of gold bullion and ladder CD purchases.

2. If you get a bonus from work, use it to pay off your mortgage faster. Don’t budget with an expectation of a future bonus. I used to recommend putting all raises towards your mortgage payment, but with rampant price increases due to money supply inflation, most wages don’t keep up with the cost of living increases each year.

3. Re-assess your insurance plan EVERY YEAR. You’d be surprised how much you can save if you switch insurers upon getting a better deal. Also, re-assess your deductible based on new emergency savings value (especially if it is in gold, or if there is a large penalty for withdrawing from a ladder CD plan). If your savings value has gone up more than 10%, you might get a decent reduction in insurance costs by increasing your deductible. If your value has fallen, you might need to adjust your deductible lower. This is one area where I do believe that having a credit card with a credit line as large as your deductible makes sense (use it monthly for vehicle gasoline purchases to keep it active, but pay it off every month). In an emergency situation, that credit line give you time to liquidate any savings to cover the deductible, and also is there if another REAL emergency pops up before you can replenish your savings during your “reduced expenditure” lifestyle after an emergency.

4. Be aware of short term maintenance needs that can keep your long term costs down. We’ve been discussing starting a “roof maintenance” group in our area, where we take 3 spring weekends a year to fix each others’ roofs together faster than any of us can do it alone. By reducing your long term maintenance costs by making inexpensive short term maintenance repairs and upkeep, you can save significant money over the long term.

Lastly, here’s my example of why long term mortgages are terrible:

$100,000 loan, 8% interest

30 years, interest paid: $164,155 (monthly payment: $734)
15 years, interest paid: $72,017 (monthly payment: $956)
10 years, interest paid: $45, 594 (monthly payment: $1213)

By paying the minimum ($734) you lose $164,155 in interest over your mortgage. Yes, making an additional $479 payment a month is painful, but you save 20 years of payments and a total of $118,561 in interest alone. You’re free in 10 years, so you’re just paying $57,480 extra in 10 years but getting rid of a total of $176,160 in payments over 20 years later in life. Of course, if we have RAMPANT hyperinflation, mortgage debt is a good thing to be sitting on since your actual payment goes down in dollar-value.

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