Soldier of Finance (17 page)

Stocks can give tremendous profits, but they also carry much greater risks than the other investment vehicles we have discussed. A Soldier of Finance weighs the risks involved and then acts accordingly.

Most people have been told they should diversify, which means they should have a variety of investment vehicles in their portfolios. In other words, don't put all your eggs in one basket. If you invest everything in a single stock and it goes wrong, you will lose everything. Better advice would be to simply be aware of your situation and your opportunities. There is wisdom in spreading the risk around, but if you're just starting out, it seems a little silly to buy one share each of twenty different stocks. A young couple putting $50 a month into their investments doesn't need a lot of diversity. They need to build up some capital. For that kind of investor, I would likely recommend just two funds, a large stock company and an international stock fund. They might add a bond fund as their portfolio grows, adding a little stability.

Once you reach $10,000 in your accounts, diversity becomes more practical. Even then, you shouldn't just blindly diversify because some rule said you're supposed to. Steve Jobs wasn't diversified—he was Apple. Later he added Pixar. The risk is greater, but that doesn't mean you should automatically reject the possibility.

For most people, the amount of diversity needed depends on the size of the portfolio. Set some basic benchmarks. Start with a couple of investments until you have $10,000. Then add two or maybe three more. Once you hit $25,000, branch out a little more. The bigger your account, the more you have to lose, so do stay within your comfort range. Only you know how much risk you are willing to take.

The object is to accumulate a pool of money that allows you to retire comfortably and do the things you want to do. There are a multitude of investment opportunities, and unless you devote your full time to them, it's very difficult to keep up with all the options. These guidelines will give you a place to start, but ultimately, you will benefit by consulting an investment professional.

As we discussed in
Chapter 12
, you should not just sign with the first person you see. Check the advisor's track record. Make sure that person's investment philosophy matches yours. If he or she likes aggressive portfolios and you are more conservative, it might not be a good fit. Above all, take as much time as you can to educate yourself about various investment vehicles. The more you know, the better your decisions will be.

Go / No Go

• The most common long-term investments are Roth IRAs, traditional IRAs, and 401(k) accounts.
  
• Long-term investments carry higher levels of risk, but generate greater profits.
  
• A Roth IRA is an ideal investment vehicle for people starting out. Many recommend starting with a 401(k), but there is a tendency to open the account and then ignore it, leaving the investments to be put into default funds and thereby limiting profits.
  
• A Roth IRA allows greater control over where the money is invested. It creates a more active involvement in the account, resulting in a greater awareness of details regarding the investment. It also allows the money to grow tax-free.
  
• The disadvantage of a Roth IRA is that there are limits on how much can be invested.
  
• The advantage of a 401(k) is that most accounts have a portion of your investment matched by your employer, basically giving you free money. There is also a much higher limit on how much can be invested.
  
• The disadvantage of a 401(k) is the limited selection for determining where your investments go. You have relatively little control.
  
• A traditional IRA is similar to a Roth IRA, except the money is taxed when you withdraw it.
  
• The stock market provides the greatest potential for profit but also the highest level of risk. Stock prices can fluctuate widely in a very short period of time. Investments in stocks should be limited to extra money that you can leave in the market for long periods of time.
  
• Stock purchases should be made after you familiarize yourself with the company that issues the stock. You should know something about the company and believe in its product before you invest.
  
• Most people say that you should diversify your portfolio. However, if you have relatively little invested, too much diversity is an unnecessary complication. The larger your portfolio, the greater the need for diversity to reduce the risks of losing it all.
  

Phase Three is designed to consolidate and expand your initial campaign. The attack has been launched. In order to organize and expand the territory taken during your financial campaign, it is necessary to understand the basics of real estate and insurance.

By the end of the Consolidation Phase, you will be well on your way to completing some of your short-term goals and you will have a clear vision of your lifetime goals and how to accomplish them.

War is a terrible thing. The first time you see a human being wounded and bleeding, it leaves a lasting impression. You understand it is serious business. Why would anyone subject himself to the pressures and risks synonymous with combat? I don't know that I ever thought about that question at the time. Looking back, I realize the answer would have been different at different periods in my life.

When I enlisted, my real goal was to get the government to pay for my college education. There was some nebulous concept of fighting for home and country, but most of us who enlisted never really thought we would have to fight. Not for real.

In combat, you do have that sense of fighting for the folks back home, but the truth is, most soldiers fight for other reasons. The camaraderie that builds between brothers in arms is most important. You fight because you don't want to let your Battle Buddies down. You learn to depend on each other, and nothing else matters.

Of course, if you asked us, we would maintain that we fought to defend the American Dream. The only thing is, we often weren't sure what that meant. The phrase is vaguely associated with equality and the opportunity to achieve in life according to your ability. Life, liberty, and the pursuit of happiness are part of the American Dream. Happiness and stability for your family might be the general idea. I believe that most people pursue this fuzzy dream without really thinking too deeply about it. Yet, when asked to describe it, most people include a house as part of their vision. Owning your own home is essentially inseparable from the American Dream. You know you are a success when you buy a house.

The reality of that dream became evident with the collapse of the real estate market in 2008. The ease with which people could obtain mortgage loans meant that many thousands of people purchased houses they could not afford. Eventually, the difficulty of keeping up with payments and maintenance expenses beyond their income caught up with them and foreclosures skyrocketed. The American Dream became a nightmare for many.

My mom is a good example of what happened to a large number of people. At the peak of the market she sold her home in Los Angeles and decided to move to Las Vegas, where she was able to pay cash for her retirement home.

Had she left it at that, she'd have been set for life. However, she wanted to invest in real estate. At the time, real estate prices were steadily rising and many were making a fortune flipping houses.

The story did not turn out that way for my mom. She had declared bankruptcy within the previous seven years, so her credit was not good. I refused to cosign for her, but that being the heyday of Freddie Mac and Fannie Mae, when almost anyone could get a mortgage, she managed to use the surplus cash from the sale of her LA home as a down payment on three investment properties.

Unfortunately, when the housing bubble burst, she was unable to sustain the investments. All three properties dropped to 30 percent of their purchase price and she was unable to find either buyers or renters, which eventually forced her to short-sell all of them. Like many others, she didn't think through the details of property purchases and she lost heavily. The fact that most of the nation shared her experience didn't make it any more pleasant.

Reflecting on the American Dream, I've come to realize that the most important thing you fight for is the relationships you have built. Your family's well-being and financial security are far more important than the place where you live. If you can afford a house, that's great. If you can't, it doesn't mean you never will be able to. It's a worthy goal, but you must approach it with the same deliberate planning and common sense you would any other mission. It's only a worthwhile goal if it doesn't cripple your finances and leave you struggling to pay for it.

Personal finance blogger J. Money, of
www.BudgetsAreSexy.com
, shared some of his experience and opinions with me. Offering insights that run a little contrary to the usual advice you are likely to hear about the American Dream, his story asks some important questions. In spite of the fact that he regularly blogs on finance issues, he made the same mistakes as most people. He jumped into a house purchase without thinking it through very well:

“I
wasn't in debt or in any financial trouble at all, but I also wasn't saving a lot, nor did I have much of an idea of where I wanted to be financially (besides ‘wanting to be a millionaire,' as we all do). And the same went with my career. I had recently been promoted a few times within the start-up company I was working for, but other than that I was humming along regularly without much thought of what I actually wanted to DO with my life. I was playing by the rules as most other Americans do, and when the idea to buy a house came up we figured ‘why not?'.”

Like most Americans, there was no thought of running the numbers or really considering how difficult the responsibility of owning a house would be.

“We talked with the financial department of the realtor we were using at the time, and we knew we were somewhat financially sound, but we never really played with the numbers much or had a REAL budget at the time. Unless you count the ‘fake' ones in our heads that most of us have. It literally came down to them saying, ‘You can afford X amount' and us using that as a gauging point. Which makes me shudder just thinking about it.”

With that they started looking, found a house they loved, and closed the deal. They literally took a wrong turn and came across their “dream house.”

“It was such a nice place on a gorgeous lake that all we could think back then was, ‘WOW! If only we could afford this!' And forty-eight hours later we were putting in a contract.”

The story had a good ending, but not without problems that could have been avoided. I asked J. Money at what point he realized that living the American Dream wasn't all it was cracked up to be.

“When I realized that I would have to keep working my a$$ off in order to live this lifestyle we created for ourselves at that moment. Going from a one-bedroom apartment to an entire townhouse with three levels made me realize over time that (a) we didn't need all of that room, but even more so (b) that now we were forced to continue earning X amount in order to keep up with the house and everything else that came with it (maintenance, homeowner fees, insurance, etc.). And after deciding to be more minimalistic than I had been my entire year before that point, it irked me even more
.

I now had to pay a ton more money just to keep things going! And not only that, but due to the market crashing all around us at the exact same time we bought, we weren't free to just ‘get up and go' anytime we wanted anymore. Which really struck me hard. Yeah, it sucked our house was losing value when everyone said it was a ‘great investment,' but more so was the feeling of being stuck. It was a hard pill to swallow having lived a military lifestyle my whole life, and it made it worse knowing I brought it all on myself! Because I didn't think and just figured it would all work itself out because everyone knows buying a home is the American Dream. HAH! It may be for most of society, but it's definitely not for everyone. And I was a dummy for falling for it.”

 

The great thing about the American Dream is that anyone can grow into it. The single biggest investment that most Americans will ever make is their home. You want to make sure it's a sound investment and that you can actually afford it.

Keep in mind that banks make their profits by lending money and charging interest. In the current economic climate, in which we have regularly seen guaranteed mortgages and bank bailouts, banks have no real incentive to manage their risk. The more they can get you to borrow, the more money they will make. If you default, the government will take care of their losses. The one who loses will be you.

With that in mind, approach qualifying for a loan with some caution. Since the collapse of the housing market, loans are much more difficult to get, but that doesn't mean you should trust the numbers the bank gives you. If they tell you that you qualify for a $500,000 loan, that doesn't mean you have to use all of it, or that you should use all of it. That number means nothing more than what it says. The bank will give you that much.

What usually happens is that buyers see the amount they qualify for and immediately start looking at homes in that price range. Before you go that route, take the time to run your own numbers.

Bank calculations are based roughly on a comparison of the price of the house with your total income. That's the same thing you should do. As a general rule, when you compare the median home prices to your income, it should be a ratio of three or below. That means that if your combined household income is $100,000, you should look at houses less than three times that amount, under $300,000.

Another way to calculate how much home you can afford is to calculate the ratio of your income to the expenses involved in owning the house. Taxes can vary considerably from place to place, so use your net income for this calculation. According to this method, you should spend no more than one-third of your net income on total housing costs. These costs include:

• Mortgage payment
  
• Property taxes
  
• Insurance
  
• Electricity
  
• Fees (such as homeowners association)
  
• Maintenance costs
  

If the monthly expenses are greater than a third of your net monthly income, you will struggle to keep up with the cost of your house.
Do not trust the bank alone to tell you how much house you qualify for. Work your own numbers.

Mortgages are secured loans using your house as collateral. The loans can be structured as fixed rate mortgages, adjustable rate mortgages, and a variety of hybrid loans that combine features of both. Here is a brief look at each type:

• Fixed Rate Mortgages.
  The term “fixed rate” means that you lock in the interest rate for the entire duration of the loan. Typically these loans are for thirty or fifteen years, though they can be for as little as ten and as many as forty.
      With fixed rate loans, you gradually pay down the principal. In the early years, most of the payment is interest. The longer the loan goes, the greater the percentage of payment that is applied to the principal. Most fixed rate mortgages allow you to make additional payments on the principal at any time, reducing the total loan and saving on interest down the road.
      One disadvantage of a fixed rate loan is that if interest rates drop five years from the time you bought your house, you are stuck with the higher rate. The advantage is that you know the rate will not increase.
  
• Variable Rate Mortgages.
  As suggested by the name, a variable rate mortgage has an interest rate that fluctuates over the duration of the loan. A variety of indexes affect the rate changes, such as the Certificate of Deposit Index and the prime rate. Most adjustable rate mortgages have caps to protect you from enormous increases, but when the interest rates go up, so does your monthly payment. The advantage is, if rates drop, you will likely be rewarded with a lower payment.
  
• Hybrid Mortgages.
  A wide variety of options are available through creative financing. Usually this results in monthly payments that increase over time. For example, it is possible to have a very low payment for five years, followed by rapidly increasing payments for a few years.
  

Which type of mortgage you use depends on several factors, including the amount you can afford for payments and how long you expect to stay in the house. If you plan to be in a house for just a few years, and then sell it and move to another location, a graduated payment might be a good option. This is where the initial loan payment starts low and gradually increases over a specified time frame until it reaches the full payment level. If you plan to stay for a long time, ten years or more, a fixed rate will usually be better in the long run. If the interest rates are high when you purchase, a variable rate mortgage would be a good choice, although there is no way to predict what future rates will be.

Real estate is a complex decision; take plenty of time to consider all the factors involved. I can only offer a basic guideline.

There is a lot to think about when buying a house. Here are four important points that are often overlooked:

1. Don't take anyone's advice about what you can afford.
Your agent is paid by commission on the sale and so has no reason to care whether or not you can afford the house. And if the loan is guaranteed by the government, the bank won't care if you default on it. The more house the bank gets you to buy, the more money it will make. Do not take anyone's advice except your own. Take an honest look at your income and debt load as well as the price of the house and the expenses associated with it, and then decide what you can afford. Does the house need repairs? Take that into consideration. If it's an old house, it will probably need a lot more work. Is the house in a downtown area? Consider what your property taxes will be. Take the time to consider
everything.
You will have a lot of money tied up, so don't be rushed into anything.