Issues with Family Transfers of Real Estate

We live in (A California city). In a 2 bedroom 1 bath home on approximately a 20,000 Sq. ft. lot. It is easily worth 500K to 600K with a current mortgage of $116,000. The mortgage/Title is in the name of my father and his wife 90% and myself and my wife with a 10% interest.

My father who is 75 and retired wants to take out about $80,000 cash which would create a new loan of approximately $200,000. He currently has a very small income from investments and lives in a paid off home in (out of state).

He would like to gift this (California) home to us and we would like that also.

Based on your expertise what is the best way to transfer the property to my wife and I and at the same time obtain a cash out stated income loan. How will a lender expect this to be handled? Do we all qualify together and the lender then allows my father to transfer/gift title at the close of escrow?

I realize that whatever lender wants to make the loan they will want to have my wife and I qualified to be on title. Since we have a 10% interest I would assume that we could all be asked to show assets and income. This might be complicated. I am a realtor but I haven’t made much money in the last two years because I’ve worked on a business startup currently breaking even with no income.

My wife has a terrific long term (16 yr) job with a law firm. Gross income $85,000. All of our expenses are very low and the last time I looked our credit was a 785 FICO score. When I do the front end ratio 28 with only my wife’s income it appears to be no problem at all. When I do the backend it’s a little more snug but definitely doable. I’ve racked up some credit card debt funding the startup business. I can pay it off but I would like to retain working capital handy for my business.

I believe a stated income loan would be the best way to go.

Here are the assets and documentation I would be willing to show, and the lenders exposure to the property.

1. We would have approx. a 36% LTV at the end of the transaction. 300k+ equity
2. Assets in a 401K of $200,000 +
3. Approx. $30,000 in savings accounts
4. Approx. $40,000 in negotiable stocks
5. I will of course provide credit reports.
6. Employment documentation for my wife only.

I believe my father and his wife have approximately $200,000 in mutual funds plus social security and she has a part time job doing a water district’s billing.


This one is fairly complex on the surface. Issues that I see right off:

-family transfer

-documenting current interest

-structure of transaction

-Will your father be selling you some of his interest as part of this transaction?

-likely the cash out quitclaim issue

-Who is going to be primarily or completely responsible for new loan

-verification of rent/mortgage.

You say that you are already on title of record, and that the desired end state is to have you and your wife owning the property outright.

The best way to structure this is probably as an actual sale

transaction. Your father selling you and your wife a larger interest. Because this is a family transfer, you still would likely qualify to continue having it taxed based upon original acquisition price, but that needs to be checked, either through the county or your title insurance company for the transaction. You also need to scrutinize the current owner’s policy of title insurance to see if it will continue coverage. There have been changes in the industry since the property was bought. If it doesn’t, you’re going to want to buy a new policy.

Now there is a standard policy with every lender I’ve ever done business with. If someone is brought onto title via quitclaim, you can’t get cash out for six months after that date. This prevents several sorts of fraud. I am going to presume that you’ve been on title longer than six months.

Now, there are three ways that suggest themselves to structure this transaction. Each have their potential advantages and disadvantages. First though, we need to take a look at another issue.

In all real estate transactions, and for all loans, the method of evaluating the property is the so-called LCM, or “Lesser of Cost or Market,” method. Market is what similar properties around yours have sold for within the past twelve months, and that is what it is, and is computed by the appraiser.

Cost is the purchase price. In refinances, there is usually no purchase to consider, because the value has changed since purchase. In purchases, there usually is.

Whichever of these two numbers is less determines the value of the property, as far as the lender is concerned. It doesn’t matter if similar properties are selling for four million dollars – if you buy yours for one hundred thousand dollars, the lender will loan as if the value was $100,000. It can’t be any higher than that, because the seller willingly sold to you for that amount. If the property was worth more, they would have required you to pay more.

For family transfers (and indeed, any related party) this presumption goes out the window. Parents do all kinds of stuff for their kids that they wouldn’t do for anyone else, and vice versa. Lenders still won’t loan money based upon a number above nominal purchase cost, however.

Furthermore, there have been a sufficient number of scams over the years that they will take additional measures to protect themselves. The presumption of willing buyer and willing seller is violated on both ends of these transactions, and many times it has been A selling the property to B for an overinflated price for the purpose of getting a loan and departing at midnight, leaving the lender holding the bag. Remember, I told you in my very first article here, is that because the dollar values are so large on real estate transactions, every single one is heavily scrutinized for fraud. There’s a reason for that. These additional measures differ from lender to lender, and some lenders will not undertake related party transactions at all. When I’m getting loan quotes from lenders, if it’s a related party transaction, then words to that effect are the first words out of my mouth. It saves a lot of time and effort.

Now, I mentioned there being three ways I can see that make sense to approach the transaction?

The first is a full price sale with upfront gift of equity. You buy the property for $600,000. They sell it to you for $600,000, but give you $340,000 in equity in addition to the $60,000 you already own. You get a loan for $200,000 (actually a bit more to pay for costs), the old loan gets paid off, your father gets his $80,000. This has the advantage of being a true picture of what’s going on. The problems are that to the lender, this screams fraud. They’re not likely to be too worried that its for below market value, but $340,000 is a lot of money. They are going to want to see evidence that there’s not some loan going on under the table between you and your father, because that would affect whether or not you qualified for their loan. Furthermore, estate tax isn’t completely dead yet and could be ressurrected even if it does die, and this would have significant estate tax implications.

The second is full sale price with subsequent gifts of equity. Sell it for full price, from you and your wife as ten percent and your father and his wife as ninety, to you and your wife as twenty-five percent and your father and his wife as seventy-five. They can then give you a gift of forty thousand of equity each year. You can even combine this with the initial sale, making your interest thirty percent, which might make the loan easier. In this case, you are all four probably going to be on the new loan to get the best rates, as $200,000 is about thirty-three percent of $600,000 – a larger amount than the equity you and your wife currently have under this scenario. There is a further major difficulty with this lies in the possibility that the complete equity may not be gifted in your father’s lifetime.

The third way is to sell the full property at a reduced sale price. Approximately $300,000 would probably be sufficient. Everything here is like the full price sale, but they’re only giving you about $40,000 in equity upfront – which is within the IRS single year limits. The bank has less difficulty believing that (although they’re still going to want a letter stating that it is a gift!). The downside is still that family transfer thing, and the fact that if you wanted to refinance within a year there would be appreciation issues on whether or not the bank would believe you.

All three ways have their bumps and walls which you very well might run into. Each lender has their own anti-fraud measures, and sometimes these run afoul of the best ways to structure it

Now, as to the loan itself, I have good news and bad news. I’m going to start with the bad. Verification of Rent/Mortgage is going to rear its ugly head no matter what you do. The bank is going to want to see some kind of evidence that you and your wife have been making rent or mortgage payments every month, and from all that I can see in the email, there’s no evidence to support this. The only person who appears to be in a position to verify that is your dad – unless you’ve been writing the checks for the mortgage and can prove it. The lenders may or may not accept your father’s word for it, and they are going to want evidence. If you’re actually on the current mortgage, this would be extremely helpful.

The good news is that with an income of $85,000 per year which your wife alone makes and you should be able to document, you have a monthly income of about $7083. This means that the back end you’d qualify for on A paper, thirty year fixed rate basis, is about $3180 (about $2690 if we’re talking about an A paper ARM). Picking a random A paper lender, I get about 6.25 percent rate thirty years fixed full documentation, which translates to a monthly principal and interest payment of a little less than $1232. With the yield curve inverted right now, the five year ARM is about the same rate, meaning there’s no reason to do that instead.

Take $1232. Add $600 per month, which is about the worst case scenario for property taxes that I see (as I said earlier, you can probably preserve the current tax basis). Add another $150 per month for homeowner’s insurance, which is a high estimate for most urban locales. This is still less than $2000 per month, leaving you almost $1200 of other allowable payments before you would not qualify full documentation. You can probably do stated income if you want, but that’d be giving the bank money that you don’t need to.

Because of the multiple concerns, of which the most important are family transfer and verification of mortgage/rent, there are many reasons why the best way to approach this might change, but when you separate it all out, it certainly looks doable.

Caveat Emptor (and Vendor)

Impound Accounts Facts and FAQs

I’ve seen a fair number of questions on impound accounts in the last several months. An impound account, also known by the confusing term escrow account because the lender is holding it in escrow, is money that you give the lender in order to pay the property taxes and homeowner’s insurance on the property.

The first thing to note and emphasize is that money going into an impound account is not a cost of doing the loan. It is your money. You own it. It will be used solely to pay your property taxes and insurance. At the conclusion of the loan, whether you paid it off with cash or refinanced or or sold the property, you get unused money back. The lender is required to send you the check within sixty days of loan payoff.

An impound account is meant to address any lender’s two largest worries in regards to a loan: Uninsured destruction of the property or losing the property to an unpaid property tax lien.

The problem with an uninsured destruction should be obvious. The structure is destroyed or heavily damaged and no money exists to rebuild. The borrower doesn’t have it and the bank isn’t going to throw good money after bad. Here in California, the average property is worth maybe $500,000 or so, but without the home sitting on it, the property may only be worth fifty to a hundred thousand. Within ten miles of my office sit hundreds, probably thousands, of new homes that sold for $700,00 and up even though they sit on a lot that’s less than 5000 square feet (0.115 Acres). Many condominiums are over $400,000. Given the location, a 5000 square foot lot may be $200,000, but it’s not $500,000, and the lender will take a loss even on the $200,000 because they’re not in the business of real estate. They loan $500,000, it burns down without insurance, they lose $350,000. People also lose their jobs over this.

Property tax liens are a major issue as well. They automatically take priority over everything else, and the rules about what the condemning governmental entity has to do are much looser than they are for the bank. They will usually do quite a bit over the minimum, but they will sell the property most of the time, no matter how minimal the best bid. Minimum auction amounts, etcetera go out the window. Many times this situation can require the lender to step in and pay the property taxes, intending to turn around and sell the property themselves merely to take a smaller loss.

A lender wants you to pay property taxes and homeowner’s insurance, and they want to know you’ve paid them. They encourage this via the method of impound accounts. The theory is simple. Every month you pay the lender, in addition to your actual loan payment, an amount equal to your pro-rated property taxes and homeowner’s insurance, and they will pay these when they are due.

No lender is perfect about these, and some are less so than others. A large percentage of the biggest and worst messes I have ever dealt with came about as the result of the lender somehow messing up the inpound account. Others have arisen because even though the lender acted within the law, the client got angry about something. Sometimes it’s for a good reason, sometimes it’s not.

Because lenders want you to have them, however, they are ubiquitous, and every lender I know of charges extra on your loan if you do not want to do an impound account. Usually this amount is about one quarter of a discount point. On a $500,000 loan, this amounts to a charge of over $1250 just to not have any impounds.

On the other hand, in places where property values are high, you can have to come up with $5000 or more at loan time just to adequately fund an impound account. Here’s a computation of how much you need to fund it works. The lender will divide the annual property taxes and homeowner’s insurance by twelve. This will be the monthly payment. The lender is legally able to hold up to two months over the amount required to make the payments, and they want this reeve. So they will look at the projected payments for the next year and figure out how many months they need up front to always have two months worth in reserve. I’m writing this on February 3, and California taxes were due on the first even though they are not past due until April 10th. But the lender uses February first to calculate even though they won’t actually make the payment until early April (they earn interest on the money, whether or not they pay any. Some states require that interest be paid, but it is typically something small and worthless like two percent).

February first is usually when the lenders here in California figure will be the low point of the account for the whole year. But if you closed on a loan today, February 3rd, you wouldn’t make your first payment on that loan until April first, and of course, they cannot count on you making your February payment right on the first. So they are going to figure that you will make payments on the first of every month April through January, ten months, before they have to pay your property taxes. Since they have to pay twelve months, and they get to keep two in reserve, that’s fourteen months of payments they want to have on February first. Fourteen minus ten is four months that you will have to come up with in advance, or have rolled into the cost of your loan. On a $500k property, that’s about $2000 for property taxes even in a basic tax zone, and if your insurance is $1200 per year, you’ll have to come up with another $400 for that. $2400 into the impound account.

It gets better. Because the property taxes are due within two months of your purchase, you’re going to have to come up with your pro-rated share right up front as well as paying for an entire year of insurance. Since California requires six months property taxes at a time, that adds almost another five months taxes and twelve months insurance up front. Total cost of this in the example given: $3700. Actually, this is due whether you have an impound account or not. Total you need just for property taxes and homeowner’s insurance: $5900.

It can be worse. Suppose you were closing on a refinance in October. You originally bought in February. You are only going to make two payments (December and January)before the insurance is due, so your impound total for the insurance alone $1000 for insurance. You are going to have to come up with $3000 to pay the first half of your property taxes, plus because you only have two payments before the second half is due, another $3000, or six months payments for that. Total due, $7000.

There are really only two methods for coming up with the money for an impound account: Bring in the cash from somewhere else, or have the lender loan it to you, adding it to your loan balance. Except in rare circumstances where you are refinancing the same property with the same lender (and usually not even then), existing impound accounts cannot be used to “seed” the new account. This is because it’s your money, held in trust. The rules for these accounts are rigid, and I’m not certain I understand well the rules about whether a bank even has the option of rolling one impound account into another.

This typically means that you have to come up with a good chunk of change out of your pocket for a short period, or add the additional amount into your loan, where you’ll be paying for it as long as you have a loan on the property. Every situation is different, but most often I prefer to either come up with the money myself or not have an impound account. The extra charges may be sunk as opposed to refundable, but I’m not paying interest for thirty years on thousands of dollars.

Furthermore, if you are adding the money to create the new impound account to your loan balance, since it’s going in before the computation of points, it can add another $50 to $100 to your costs of the loan per point you’re paying. Minor in and of itself, but adding insult to injury if the loan has points involved. More to the point is that adding impound creation it to your loan balance means there may be a couple years before your balance gets as low as it was before the refinance, just from this. Indeed, the fact that it raises your loan balance is the worst thing about the impound account issue. On the other hand, unless you have a “first dollar” prepayment penalty, what you can do is turn around and put the check for the previous impound account when it arrives into paying down the new loan. It typically won’t bring you even, and it won’t reduce your contractual payments on the new loan (although that is usually a good thing), but it will ameliorate the damage to your loan balance.

Initial loan closing is not your only opportunity to start an impound account if you want one. If you don’t have one to start with, the lenders will be very happy to let you start one later. I’ve literally never heard of a lender saying anything but “YES!” (usually with a pump of the fist) to a request for an impound account. Why? Because now they know that your taxes and insurance will be paid, and get to use your money, and after you paid a fee for no impounds. Oh, happy banker!

If you want to cancel an impound account, expecially within a year of whenever the loan was funded, you can expect to pay the “no impounds” fee, possibly prorated, but usually just the whole thing. Roll thousands of dollars into your loan balance where you’ll be paying interest on it and then pay a lender’s charge for no impounds? Ouch!

Can you force the bank not to do any of this? Not really. They don’t have to lend you money. Yes, they are in the business of lending money, but if they don’t loan it to you, they’ll find other uses for it. Somebody else is always willing to accept the bank’s terms. You try to violate guidelines that lenders have established in order to lend you the money, and you’ll be told, “Sorry but you don’t qualify.” The golden rule of loans is that those with the money make the rules.

Furthermore, those lenders who didn’t require this would be at a competitive disadvantage as regards rates, because their loan portfolio would be a significantly riskier one, and they would have to increase their rates to compensate for this. You could qualify for a better rate or lower closing costs somewhere else. Better to not argue. Assuming that I already have an impound account, all the extra I lose is a maximum of sixty days interest. Two months interest on $5000, even at ten percent, is $83. That’s a lot cheaper than either of any of the alternatives.

Caveat Emptor

Fear and Greed, or How Did The Housing Bubble Get So Big?

(This was originally posted in 2006)

One of the occasional questions I get from people has to do with why the housing bubble got so big (or if you’re one of those still in denial about it, how prices jumped so far so fast).

This has to do with several factors. Legislation made real estate investments more attractive. Interest rates got low, and nontraditional loans proliferated. People took their money out of the stock market, and wanted to invest it somewhere. The feeling that the housing market could never go anywhere but up. And I will address all of these issues in the coming paragraphs, but the largest factor is and was psychological. People were simultaneously scared that if they didn’t buy now, they would be locked out of the American dream, and avaricious in anticipation of buying and flipping properties for multiple tens of thousands of dollars profit.

The first enabling factor happened in 1996. President Clinton sponsored legislation giving huge tax exemptions to the sale of personal residences. There were and are good arguments for doing so, nonetheless it had the effect of making real estate a more attractive investment. When a married couple can make up to $500,000 tax free over their basis every two years, that’s a major incentive to start moving into a new house every two years in order to fix it up, or at least hope for a gain in fast growing areas. By itself, this was a minor factor initially, but by making real estate such an attractive investment (literally the best there is, considered in a vacuum), it started the bubble off. Since it hasn’t been repealed yet and may never be, the value increase from this aren’t really a bubble component, but the value increase for what was a one time systemic shift whetted appetites, even while the dot com boom (itself a fear and greed phenomenon) was going on.

The second enabling factor was that interest rates got low. This meant prices had the leeway to rise, as most people buy homes (and other property) based mostly upon the payment. When 30 year fixed rate loans go to 5 percent, the same payments buys a lot more house than it does at 7.5 percent. If you could have afforded a loan for $100,000 at 7.5 percent, you can afford a $130,000 loan at 5 percent. Instead of a $300,000 loan, you can afford $390,000 for the same payment. $500,000 becomes $650,000. Even though rates haven’t been quite rock bottom for almost two years now, this helped start the phenomenon.

The third enabling factor was that people had gotten burned in the stock market as the dot com boom deflated, and the real estate market was doing well. With both sides of “fear and greed” working the equation, this amounted to quite a bit of incentive to chase returns in the real estate market. “I just took a bath in tech stocks, but look at how the real estate market is going!” This is known as chasing last year’s returns, but large numbers of people do it. Consequently, quite a bit of personal wealth was dumped into the real estate market. This had negative consequences on the stock market, exacerbating that decline, and for the real estate market, dumping a couple trillion dollars into the demand side of the equation didn’t exactly hurt real estate prices. Supply and demand are always working. The important trick is to separate fear and greed, which are real but have mostly short term effects, from real long term changes to the market.

Members of my professions, meanwhile, did absolutely nothing to slow the madness. Indeed, they added as much fuel to the fire as they could. As I have said elsewhere, buying a home really is a fantastic investment, all things being equal. It literally clobbers renting and investing over the long term, with those last four words being the critical part. There are limits, and most agents and loan officers went over them and three states beyond. Anybody who takes any real estate agent’s unsupported word for investments and sustainability probably needs a guardian. Reality check: Here’s a person who makes thousands of dollars if they tell you you can do something, and nothing if they tell you you can’t, and has very little responsibility in the law for telling you lies. They’re not financial advisers, after all. What do you think the average person will tell you in this position? (And before anybody sends me email or comments about the “superior ethics of Realtors®” they were just as bad statistically and worse morally, because they were holding themselves out as ethically superior, thus using the propaganda to allay legitimate concerns. I’ll believe Realtors® offer some ethical advantage when I start seeing the Boards of Realtors® imposing some real disciplinary measures upon significant numbers of scumbags that the state regulators don’t. Aside from advertising to build brand awareness, I haven’t seen anything that the Boards of Realtors® contribute to the ethics of real estate practice.)

So there we are, with four factors doing everything they can to drive values up. This goes on for a little while, and now psychology starts becoming a real factor. “They’re not making any more land!” making a scarcity argument. “Real Estate always goes up over the long term!”, making a safety argument, and ignoring any number of past bubbles and downturns. Heck, I remember four previous ones in southern California! “You can always sell for a profit!”, ignoring transaction costs, which are significant, and flat out misrepresenting liquidity. Real Estate can beat anything else, investment-wise, but it is certainly the least liquid class of investment that comes to my mind, as well as being sensitive to many factors beyond your control.

Couple this with a couple of years worth of twenty percent returns, and the feeding frenzy really kicks in. There starts being a real fear factor – people get afraid that if they do not buy now, they are never going to be able to afford a home. When prices rise by 50 percent in two years and wages rise by six, who can really blame them? Most people do not have the economic background to sit back and consider who buys houses, and what controls housing prices. So the mentality of “buy now or rent forever!” took hold, further exacerbating the rise. People were willing to do literally anything they could to qualify for a home, lest they be unable to qualify forever. And with the thinking detailed in previous paragraphs, they were told that “Even if you have to sell in a year, you’ll still come away with a huge profit!” Yes, that’s greed again, rearing its ugly head.

Into this situation stepped the lending community, particularly the sub-prime lending community. Starting about 1997, more and more lenders started being willing to loan 100 percent of the value of the home. “Hey, why risk your own money when the bank will lend theirs?” This drove market leverage to never before seen heights. Furthermore, in an effort to sustain volume, lenders started a trend of competing ever harder for the most marginal case. Stated Income, Interest Only, and short term hybrid ARMs proliferated (The most common sub-prime loan is only fixed for two years). Finally, lenders started pushing the Negative Amortization loans, for those borrowers who couldn’t really make even the payments required on the short term interest only alternatives.

Lest anyone think otherwise, the community of real estate agents was fully on board with this. Always higher, and fast increasing, prices meant they made more money in commissions from selling the same number of homes, and the apparent virtues of real estate as an investment of the moment kept seducing those who did not know any better. Those few voices of sanity were drowned out, and many left the business. There just aren’t that many people who really qualify to buy homes these days based upon the tradition metrics, even relaxed as they have become, and if you won’t put them into something they can’t afford, somebody else will. Furthermore, during this period, more and more real estate agents were starting to do their own loans, further isolating any voices of sanity in the loan community. Speak the truth that a client probably cannot afford a loan once, and the real estate agent will never bring you another client again, and will try everything they can to pry any clients they might have away from you. After all, you cost them a commission once. Interest only, and negative amortization loans further proliferate, as agents try to persuade prospective clients that they “really can afford those payments.” Forty year loans start making a comeback, where they were all but extinct. Sub-prime underwriting standards are loosened until they ignore what happens when these hybrids adjust (or Option ARMs recast) and concern themselves only with the minimum starting payment. A larger and larger portion of purchasers is forced into the sub-prime market if they want to qualify. And still property values rose.

Or, more correctly, prices rose. The actual property value certainly wasn’t growing that fast, only the common perception of value, aka price. People were getting away with these terrible loans, complete with prepayment penalties, because even though they weren’t able to make their payments in many cases, prices were still increasing fast enough such that even if they sold relatively cheap, in order to unload the property in a hurry, and paid a prepayment penalty, they were still coming away with money, further aiding the illusion that there was no way not to make money. When workers are making more money buying a house and holding it for two years then selling than they are at their jobs, that’s an incentive to keep doing it. That’s an incentive for more and more people to get in on the act. And the feeding frenzy builds. Fear and Greed. When someone holds a house for two years and sells for a huge profit despite the fact that they did nothing to enhance the home’s value, that has the appearance of easy money. When people start buying with the intention of short term flipping without doing any work (We call this “Hoping for a bigger fool”), and when they’d call to see if I knew of any such properties and hang up when I’d start telling them about properties that really were good investments but needed work, I knew the end was coming very soon.

The first group to holler “enough!” was not the lower income folks who were getting priced out of stuff even at the lowest end of the market. It might be what you’d expect, but it wasn’t the case. My theory is that those people simply don’t know any better, and didn’t think they could afford to wait. It was the better paid, more economically savvy buyer at the higher end who first called “Bull****!” At least here locally, higher end McMansions and such were the first to start sitting on the market. These prospective buyers made plenty of money, and knew they weren’t on the verge of being priced out completely. If they were right, they’d buy a better property when things fell apart. If they were wrong, such is life, and they could still afford something. Meantime, they were going to rent.

Lessons here: Always separate psychological factors from real market shifts. The general rule is that once they find something that appears to be working right now, the crowd always overreacts. Many times you will make more money in the long term by bucking the obvious trend, particularly if that trend is Fear and Greed driven.

If you are in an untenable position with your loan right now, whether because it’s negative Amortization or interest only or just about to start adjusting: Either sell now for what you can get, refinance into something fixed for at least five years right now, or be resign yourself to disaster. With the yield curve inverted right now, there is practically no spread between the five year ARM and the thirty year fixed rate loan. Even someone who is as huge a fan of the 5/1 ARM as I am has to admit that, at the moment, the thirty year fixed rate loan is looking very attractive by comparison. When you get a much better guarantee of the rate not changing, for the same price, and the the loans are otherwise identical, what’s not to like? As I’ve said before, you can survive and prosper when you’re upside down on your home, as long as you have the right loan for it.

If you can make the real payments on such a loan, I would do it now while appraisers still have the ability to appraise your property for near peak values. If you lose the ability to appraise for near peak values, then you may well be a member of that rather large group in many parts of the country where the market will no longer bear a price greater than the loans on your property. When you owe more on the property than the market appraisal, then for all practical purposes you are stuck in your current loan. If it adjusts, amortizes, or recasts, you’re suddenly going to be making much larger payments. If you qualified under one of the less sustainable programs I noted earlier, when this happens you are going to be in a world of hurt, and probably unable to refinance. Most common result: Losing the home, credit ruined for years, and a 1099 from the lender that says “we lost money on you!”, for which the IRS will demand taxes. If your loan is going to start asking for higher payments soon, and you can not refinance, or cannot afford to refinance, it’s time to sell, right now.



Caveat Emptor (and Vendor)

Facts Of Life On Buying and Selling “Without an Agent”

I saw your article on on Searchlight Crusade about exclusive buyers agents and I have a couple follow up questions pertaining to my own situation that I am hoping you could shed some light on.

I don’t have any buyers agent (currently). However I have spotted 2 houses in an area that I think I would like to make an offer on. Both of these houses are listed by real estate agents. I am obviously eager to save as much money as I can and think it would be great to try and save on the agent undefined if at all possible (I have bought FSBO before, so I am familiar with the process and I don’t see much value add with an agent since I have already found the properties).

However I just don’t get it – if I make an offer on the property by working with the sellers agent then the sellers agent gets both commissions? Is there a way to just take the buyers agent commission off the sales price? If there isn’t then I guess there is no reason not
to go and find a buyers agent to assist me? Seems like a waste of money.

I have found an buyers agent that who said he will give me 50% of the commission if I sign an exclusive buyers agent contract with him however I am worried that my hands are tied if I don’t end up purchasing one of these properties I have already identified (ie I could end up paying 1/2 his typical commission if I found a FSBO).

Any insight you could provide would be of great help – I love reading your stuff.

Thanks,

The first thing I need to clear up here is the nature of listing agreements. The standard listing contract form gives the listing agent the full commission for both buying and selling, and if someone other than them represents the buyer, then they agree to pay the buyer’s agent a portion of that. If there is no buyer’s agent, they keep it. Since you have to make your offer through the listing agent, the listing agent is get that commission, and that is as it should be. Note that I feel it is stupid to act as agent for both parties in the same transaction because seller’s interests and buyer’s interests are often at impasse, and when you’re acting as agent for both sides, there are many potential issues which, if they happen, are lawsuit material one way or the other no matter what the agent does. If I find a buyer for my own listing, I’ll find another agent I trust to do a good job, and that way there is no conflict of interest. But greed is a powerful motivator, as you yourself are illustrating. The fact is that if the listing agent wants the full commission, they will probably end up with it, and justifiably so, as they found the owner a buyer, didn’t they? That’s what the contract says the seller’s commission is for. You saw their sign, you saw the house they listed, you made an offer through them, the house got sold through their efforts. According to the terms of the listing contract, they found you, whether you realized it before now or not. The buyer’s agent commission is for an agent who has a buyer who sells them that property, as opposed to the one down the street.

Many agents make side agreements to rebate part of their commission in certain circumstances. But that potential rebate contract in this case is with the seller, not you, and is none of your business. Unless the agent has a release to discuss it with you in writing, they are violating confidentiality to do so. The seller may sell to you cheaper because of such a clause, but they are under no obligation to do so.

Now before you dismiss this with, “That’s Stupid!” or something worse, because it appears that things are stacked to cost you money, consider that this has evolved over many years as the best and cheapest way to preserve everybody’s best interests. Without these forms, there would be a lot more lawsuits filed over commissions, with the side effect that the lawyers get rich, and the money ends up getting paid anyway on top of that. The listing agent commission is partially a hold over from the old single listing days of half a century ago. Over time, the buyer’s agent commission evolved as a way to open the system up, so that homes sold faster and those agents and offices without a large, pre-built client base could break into the business. But it’s still intentionally structured that way as a way to motivate that listing agent to advertise the property far and wide and especially in all of the most effective venues. It costs money for that sign in the yard. It costs money for MLS access. It costs money for advertisements in the paper. It costs money for all the trappings that enabled someone to go find that agent and list the property in the first place. It costs that agent money just to stay in business whether they have any clients or not. It costs the agent money for the advertising to attract clients in the first place. And chances are, if they hadn’t spent that money, you wouldn’t have found that property, and the owner wouldn’t have sold it. People think agents are making money hand over fist, when the reality is that unless they’re putting in the long hours and hard work to make multiple transactions happen every month, they’re just barely scraping by. Most of the successful agents I know put in sixty hours or more per week, and if they are putting in less than forty, I’ll bet money on no other data that they’ll be out of business in a year. This is not a cheap business to be in, or an easy one.

Put yourself in the shoes of a seller. You have a property, but you want cash. Real estate is not liquid, a property interchangeable with billions of other shares in planet earth that you can call a broker and sell over the phone because there’s a ready market for shares in planet earth which are all interchangeable. Each and every property is unique. This means it is bought and sold on the basis of those unique individual characteristics. You want results, you want your property sold, and it costs money and it takes work to make buyers want to buy your property.

Sometimes the agent gets lucky, and it sells quick. Sometimes the agent works hard – and they really do work – for months with no offers despite all of it. We’re coming off of a market where a monkey could have sold a residential property within a week for more than the asking price, and entering a difficult period. This requires an adjustment in thinking if you’re going to do well. Average total commission paid is up locally in the last few months, from five to six percent. Particularly in a rough market, if the seller tries to sell it themselves, it will statistically take longer, and they will statistically net less money from the sale, not to mention what they spent on the property in the meantime. Some few get lucky. People win lotteries and casino jackpots, too. Betting that you’ll be one of them is a sucker’s game. Any number of studies and statistics show this fact, and many brokers make a good living buying FSBOs to then resell for a hefty profit. My supervisory broker, for instance. We’ve sold four properties he bought from FSBOs in the past month, all for a substantial profit, even in this market. Sellers tried to think like you do, and it cost them over $150,000 net of commissions, and these were all fairly quick sales. Had we tried harder to get maximum value for his money, we could likely have gotten more, but he’s not complaining.

Now, with that said, let’s look at your current situation. I’ve already covered the fact that the listing agent is entitled to that commission. Now let’s put you on the other side of the table from a guy whose responsibility it is to get the best possible price for the property, and his commission depends upon how good a job he does. He does this constantly, for a living. He’s set up with information to ensure that he gets the highest price. It’s cost effective for him, in a way that it isn’t if you aren’t doing it constantly. Betting that you’re better at his profession than he is would be like him betting he’s better at your profession than you are. My money is on “you end up paying more than you have to.”

Here’s a dead giveaway that an agent’s job is trickier than you think it is: That you’re even talking about an exclusive buyer’s agent contract in this situation. So long as you already have the property in mind, there is very little risk and only a minimum amount of work for him in the situation. He’s not going to have to drive you around to four million properties over the next twelve months to maybe find one you want. This is a buyer’s agent’s dream situation – cut straight to the bargaining, no preliminary work. If this one falls through, he can either look for more or blow you off, depending upon what he has time for. Offer him a general non-exclusive buyer’s agent agreement with a fifty percent rebate if you find the property yourself, as you did in this situation. This motivates him to do his best bargaining and looking out for your interests without sabotaging the transaction. If this one falls apart, he’s still got motivation to find you something on your terms, and you’re not bound to him unless he introduces you to the property or you use him for negotiations, etcetera. You get a negotiator who knows your market and should know most of the tricks and is working on your behalf, and if this one falls through you have someone who’s motivated to find your something with better tools and more relevant skills at his disposal than you have. He gets a commission which, if smaller, is also easier and walked its own self in the door rather than him having to go out and spend time and money to drag it in. Everybody wins. If he won’t do it, find someone else in your area who will.

(Before anybody asks, I don’t propose client contracts that I wouldn’t accept)

Caveat Emptor

Dammit Jim, I’m a Real Estate Agent Not A Doctor!

(With apologies to the late great DeForrest Kelley)

Just got off the phone with an agent I know who had an interesting experience today. One of this agent’s listings called. Actually his significant other did, because the guy fell down in pain. Still somewhat conscious, but in lots of pain.

Now, if I were in a situation like that, my real estate agent would not be high on the list of people I would call. And in Agent X’s defense, the first thing he said was, “Call 911!”

“I don’t want to do that because it’ll cost $800!”

Okay, first guess goes to stroke – as in brain damage. Call 911: You’re more likely to live. Call your real estate agent: You’ll be dead, but your corpse will be $800 richer. Or in the case of a stroke: You may live through it, but your vegetable will be $800 richer, thereby requiring all kinds of expensive care.

Not wanting to offend a client, Agent X told me he quickly relented, drove down, bundled the client in his car, and took him to Emergency. Guess what the diagnosis was? Heart Attack. The Universe only knows what would have happened had he been further away or if it was rush hour.

Of course I told this around the office, names filed off to protect the insane. It’s making its way around the real estate community. I’ve already had another person call and ask, “Did you hear about…” Now it’s here, where everybody can laugh. This is too good not to pass on.

(And no, there’s no violation of confidentiality here)

Just goes to show: You can pay one way now, or pay another way later.

Live Fast. Die Cheap. Leave a stupid looking corpse.



Caveat Emptor

Looking For Loans In All The Wrong Places

No, I’m not turning into a country western singer. Just got a search for “no closing costs no points loan cheapest rates loan”. The visit (to this article) lasted less than a full second. The obvious implication was that it wasn’t what that person was looking for.

As I have said before on many occasions, cheapest rates or lowest rates do not go with no points or no closing costs loans. Period. One of these things does not go with the others. Rate and total cost of the loan are always a tradeoff.

This is not to say that one loan with no closing costs may not be cheaper than another loan with no closing costs. The point is that there will be lower rates available with some closing costs, progressively more as you get higher closing costs. Then if you start paying points, there will be still lower rates available. There is a reason why they are paying all of your closing costs – you’re choosing a loan with a higher rate than you otherwise could have gotten.

No cost loans can be and often are the smart thing to do. Because they are the only loans where there are no costs to recover, they are the only loan that can possibly put you ahead from day one. Consider the zero cost loan as a baseline, and compute what lower rates will cost you in closing costs. Consider: If the zero cost loan is 6.75 percent at $270,000, your new balance should be $270,000. If you can get 6.5 at par with closing costs of $3500, your new balance is $273,500. Your monthly interest in the first instance is $1518.75 to start. Your interest charges in the second case are 1481.46. The lower rate cost you $3500, but saves you 37.29 per month. Divide the cost by the savings, and you break even in the ninety-fourth month – not quite eight years. So in this example, if you think you’re likely to refinance or sell within eight years, you’ll be ahead with the zero cost loan.

If the loan has a fixed period of less than the breakeven time, you also know that the costs are not a good investment. If this loan were only fixed for five or seven years, well even if you decide to hang onto the loan after it adjusts, the rates go to precisely the same rate after adjustment. If you haven’t broken even by then, you never will.

So whereas a true zero cost is often the best and smartest way to go, it will never be the lowest rate available.

Caveat Emptor

Variable Annuities: Debunking the Ignorant Press

Found an annuity article in the local paper with an error so glaring that I had to debunk it. Here’s the article:Income for Life



And here’s the critical error, conveniently in the first two paragraphs:

Interested in annuities? The type known as an immediate annuity may pique the interest of some investors. But the first step is to clearly distinguish between an immediate annuity and a variable annuity.

Both are insurance products. A variable annuity is used to invest for a future need, such as financing retirement, and the benefit comes after years of compounding. An immediate annuity converts a chunk of cash into a monthly income guaranteed for life, with the payments starting right away.


BUZZ! Thank you for playing, and be sure to pick up our wonderful parting gifts. Of course you won’t be any good at the home game, either.

When considering annuities there are two main categorical choices you need to make, and they are completely independent of one another, as five minutes of research would have told this person.

They two main categorical splits of annuities are immediate versus deferred, and fixed versus variable. Whatever your choice on one axis, it has nothing to do with your choice on the other axis. I can name annuity products in each category of immediate fixed, immediate variable, deferred fixed, and deferred variable.

The immediate versus deferred choice has to do with whether or you start getting monthly (or yearly) checks immediately or at some point in the future. Actually, this is a less bifurcated choice than it appears on the surface, because the difference between deferred annuities and immediate annuities is that you don’t have to annuitize a deferred annuity today when you buy it – but you can annuitize it tomorrow, or you might wait fifty years or more. Annuities in general are designed to convert a fixed sum of cash into a stream of income, whether right away (immediate), or after they have received tax deferred income for some period of time, which can be days or decades (deferred).

The fixed versus variable choice has to do with where the money is invested. In fixed annuities, the money is invested in the general account of the insurance company carrying the annuity. In variable annuities, the money is invested in subaccounts that work very much like Mutual funds. I go into moderate depth of explanation of pros and cons in this article on Annuities, Fixed and Variable.

“Well, how do you annuitize a variable annuity?” you ask. You’ve got all of the same payoff options as a fixed annuity, of which “life with period certain” is the most common, and the most common of those are life with ten years certain, which makes payments at least ten years or however long you live, whichever is longer, life with twenty years certain (as before, except the minimum period is twenty years) and joint life with twenty-five years certain, which pays as long as either member of a couple is alive, or a minimum of twenty five years. The account balance is still invested in the subaccounts, although there is less than complete control over the full balance. Then they make use of what is called an “assumed rate of return” of which 4.5 percent is probably the most common.

“That’s a rotten rate!” I hear you cry, and correct you are. Nonetheless, it not only is very little below the guaranteed return of the fixed account of the company, which varies from about five to about six percent depending upon company, recent market experience, and other factors, but it is intentionally lower than the rate of return you will most likely earn.

This means you’re likely to start off with a lower payoff from the same amount of money in a variable annuity than in a fixed annuity, but the cute thing is that this is typically a minimum guaranteed payout for then and forevermore (or at least until the end of your payout period), guaranteed by the insurance company. When your actual rate of return exceeds your assumed rate of return, your payout goes up. It can subsequently go down as well if you have adverse investment results as will happen, but over time the stock and bond market have a lot more eight and twelve and twenty percent years than they do zero percent or minus five percent years. The average over time is somewhere between about ten and thirteen percent, depending upon who you ask and how you frame the question and when you ask it. So given the gap between an assumed rate of return of 4.5 percent, and actual rates of return that average somewhere about ten percent, what usually happens?

If you guessed that over time, your periodic payout tends to increase at a more than the rate of inflation, then DING! DING! DING! DING!, you win the grand prize – knowledge of how the system really works, and how you can manipulate it to your advantage. Which answers these paragraphs below from the article, wherein the author makes another error that could also have been avoided by that same five minutes of research:

Keep in mind, though, that if you live for decades, the fixed monthly income may lose buying power due to inflation. A few insurers offer products that raise payments to keep up with inflation, but they start out paying much less. A $100,000 premium might get a 65-year-old man only $464 a month, about 30 percent less than with a fixed-payment annuity.

Also, this may not be the best time to get an immediate annuity, even if one would make sense for you eventually. Interest rates are relatively low these days, keeping these products’ returns low. In 1999, when rates were higher, the 65-year-old man could get a return of around 8.6 percent.

As you’ve just seen, payoffs for variable annuities can and do increase over time, even after annuitization. The downside is that only the original minimum payoff is guaranteed, but most folks have better experiences over time

Now the article does have some good information in other particulars. Women receive lower payouts than men of the same age because they tend to live longer. The older you are when you annuitize, the higher the payout per month (although this can be a trivial difference if you’re choosing a long period certain).

However, I cannot finish this article without mentioning the worst abuse of the public trust. The last line of the article recommends a website that I just refuse to link, among several other reasons, because they are apparently trying to sell fixed annuities only. Why? Because they are more profitable for the company and therefore pay a higher commission. I tried seven different scenarios looking for one variable annuity quote, and despite the fact that several of their listed companies offer variable annuities, got not one quote based upon a variable annuity. Variable annuities also have somewhat smaller and shorter withdrawal penalties and periods that said penalties are in effect (I should mention that most annuities will waive any withdrawal penalty if you actually annuitize). But an idiot could and should have spotted the fact that it’s a commercial website looking to sell annuities rather than looking to provide information to the consumer (there isn’t an online Frequently Asked Questions or any education on what an annuity is and is not, instead, you are told to call a toll free number that shills for a sales appointment), and from what I can tell, the author did all of the minimal research he did at this one website shilling for the fixed annuity industry. He would have done better to check with a few people with actual experience in both fixed and variable annuities.



In short, whereas I cannot prove that anyone was paid by the companies involved to write or print this article, in my opinion it should have been labeled an advertisement for fixed annuities.



And people trust these writers for financial advice?

Thoughts on Abolishing Estate Tax

I have never liked or favored the estate tax, and yet I am very much of two minds about actually abolishing it. I’m glad of the benefits to the individuals involved, and yet it is only one of the issues involved in planning for what happens to all of us eventually, and abolishing it removes the most obvious motivation for handling the rest.

The benefit of abolishing the estate tax is obvious: people don’t get taxed, so their heirs get what they earned rather than the government. This is a good thing, and I favor it for that reason.

On the other hand, there were so many mechanisms varying from outright gifting to 529 accounts to life insurance to trusts, each of which except the first can be used to retain control and benefits of assets while avoiding estate tax liability, that estate tax is and always has been essentially voluntary. You have to just not plan in order to pay estate tax, and some of the mechanisms available actually increase your available estate over what would have been its original gross value otherwise. Since we know that death is something each of us is going to have to face, there can be no reason except stupidity for not undertaking to plan for it. Estate tax was a voluntarily paid tax on stupidity.

Furthermore, there are other estate and contingency planning options that people need to take care of, and fewer people are doing so as estate tax was one of the primary levers that moved people to do it. All of this planning is just as necessary as estate tax planning, and usually taken care of at the same time.

Here are just a few of the other issues:

Will: The will probably should not be used for financial purposes, but resolves other functions such as who gets custody of minor children. Please note that a will is not necessarily binding upon the states where your will is probated, and can be challenged. Many wills are challenged, a large portion of them successfully, and even if your estate wins the battle it will be diminished in the process.

Durable Power of Attorney for Health Care: if you can’t make health care decisions, this tells who you delegate that power to. If there’s a court case brought, it’s going to be very short and abrupt. Case closed.

Trusts, revocable and irrevocable. I’m not certain it’s possible to successfully challenge a well-constructed trust where the assets that are actually transferred to it are concerned. You didn’t own them. The trust does, and the trust didn’t die. The instructions live on, like a corporation. The named successor trustee also usually gets the ability to manage the trust’s assets if you are alive but incapable. Assets in a trust can avoid not only estate tax, but probate as well. If you want to be certain of the disposition of what you leave, particularly in a speedy manner, this is probably the way to go. Many estates are not finished with probates for years, and until they are, your heirs don’t get control of the assets. Nor are we certain that estate tax is going away forever. Probate is also expensive, time consuming, and lucrative for attorneys. Seven percent of probated assets seems to be about the minimum cost, and it can easily top thirty percent. I haven’t investigated, but I suspect the trial lawyers would be solidly behind banishing estate tax for this reason.

Business operations: many small to medium sized businesses have no plan to keep them going in the event the owner-operator dies or becomes disabled. Certainly nobody else working there has the knowledge, the experience, and often the necessary licenses. If the business closes because the proprietor isn’t there, it’s worthless. If there’s a plan of succession to keep it open and operating, however, you or your family can likely sell it as a going concern with consistent profit.

Retirement plans: If you have certain types of tax deferred retirement plans, they can be expensive to convert to assets in your heirs’ possession, even without estate tax. Better to draw these down and keep other accounts available.

Life Insurance: There are going to be expenses when you go. These vary from taking care of the body you leave behind to probate to keeping your business running if you have one. The people doing these things want cash. Life insurance is usually the cheapest way to pay them. Your family is also likely to need something to replace your income in many cases. Life insurance is about the only choice.

One hopes you begin to get the idea. Consult an attorney and financial professional in your area to find out how it works, but all of this needs to be taken care of, or your family will wish you had.

Caveat Emptor

The Prerequisites of Investing

It shouldn’t surprise anyone that there are things you should do before you make your first investment. The SEC, NASD and all of the various other financial planning organizations all explicitly list three things that should be in place in most cases prior to making your first investment in anything.

The first of these is an operating reserve. This is a fund of ready cash outside of any investment account, that you can use for emergencies. The minimum is three months of your normal expenditures, but six months is better. People lose jobs, have accidents, have health problems, things come up – you get the idea. Unless your job is rock steady, your cash flow predictable, and you can live on less than fifty percent of your take home pay, you really want to have living expenses for six months saved up, and for some self employed situations where your cash flow is uneven (like say, financial planner or real estate), twelve months is better. Having this much cash on hand gives you a certain security, and you likely won’t have to cash in your investment for some minor emergency.

The second of these is a life insurance policy. This isn’t from any deep-seated desire to sell you a life insurance policy. Investment professionals have only been getting insurance licenses since about 1980, and this recommendation is far older than that. Almost everyone is going to need a life insurance policy at some point in their life, and it is cheaper and more effective to purchase while you are young. and especially before health problems are likely to develop. As I’ve found out, sometimes things happen to you that prevent you from obtaining life insurance (as in no company will issue you a policy, or will only do so on prohibitive terms), and if you want a family eventually, it is wise to take care of this now. Furthermore, certain life insurance policies are among the very best investments you can make, and more effective the sooner you start them. This is not to say that life insurance is for everyone. I have a client who’s older, has no dependents and never will, has plenty of assets to cover final expenses, and those assets are titled so that they will pass immediately and correctly to his heirs. A life insurance policy would still be of benefit if he had certain goals, but he doesn’t. So we’ve decided it’s not for him.

The third of these is estate planning. This is actually in the requirements as a will, but there are other elements such as durable power of attorney for health care, living trusts, and so on. These do cost a certain amount of money, but it’s money well spent. If something happens to you without doing this planning, every state in the US has a different law as to what happens to your assets, your minor children, your pets, etcetera. These are all cookie cutter approaches, and that cookie cutter was likely enacted a long time ago, to where the societal assumptions that the legislature made at that time are no longer valid for any large proportion of the population. The majority of your assets should not be transferred by a will, anyway – wills can be and are challenged successfully every day. Trusts are far better.

If the person you work with is any kind of financial planner, they should add two additional concerns to the list. They are disability income insurance and long term care insurance. The need for both goes away as you become more affluent. Remember, that insurance companies exist to make a profit and if you can afford the risk of losing what they insure, you shouldn’t buy a policy. So if you’ve got a couple million somewhere, and if you never made another penny you would be comfortable, there is no need for disability insurance. The same applies to Long Term Care, albeit probably requiring more affluence. Average base per diem cost in California is $180, with another $60 or so in supplemental charges. So when you can afford $240 per day (between $85,000 and $90,000 per year) for a period of several years in addition to what ever else you may need for your family to live, you are not a good candidate for long term care insurance. On the other hand, long term care facility prices keep rising, and as medical capabilities for keeping you alive get better, you can expect to spend longer in such a facility.

(For all the money and research we throw at prolonging lives, you’d think we could spend more on making it a robust life, or allocate more of what we already spend towards that end. More and more, we are statistically tending towards living longer in an increasingly frail, helpless and joyless condition. As long as people are enjoying life, more power to them. When it becomes a miserable painful existence, as I have seen too much of, I just don’t see the point. When I see what so many people put themselves or their loved ones through, I’m making certain I’ll always have a “check out” option under my own control, and if I don’t have control to exercise, my wife and I are agreed that neither one of us wants to hang around).

The Biggest Risk

If you’ve been around the financial planning business any length of time, you’ve likely run into the saying “The biggest risk is not taking one.”

It is endemic to all financial instruments, indeed, all investments, that return is the reward for risk. It is axiomatic that the entity that takes risks gets the rewards.

Generic stock market returns are between ten and thirteen percent per year, depending upon who you ask and how you frame the question. Contrast this with the five or six percent that insurance companies will guarantee. You invest, you get five to six percent guaranteed. They use your money, they get the difference.

If you invest $100 per month at 5.5% from the time you are 25 until the time you are 65, the insurance company has guaranteed you about $174,000. If you annuitize that in a fixed annuity on a “Life with ten years certain” basis, you’d get somewhere between $1000 and $1100 per month if you’re male. Ladies and gentlemen, that won’t buy very much now, much less forty years from now with average inflation. Matter of fact, it’s only about a 1.67 times overall return net of inflation.

Now $100 per month is a lot less than people should be investing for their own future, but it’s indicative of the problem. Even if you contributed $1000 per month, which is more than most people can commit, between however many tax-deferred investments it takes, it’s $1.74 Million, which goes to a payout of $10,000 or so per month if you annuitize at 65. Sounds like a lot of money today, right? But you’re spending those dollars all in an environment where, at 3.5 percent inflation, $10,000 per month is about the equivalent of our $2500 per month now – and every year that passes in retirement, your money buys less.

Suppose, instead, you were to invest $500 per month – half what you had to come up with in the previous example – and invested it in the broader market, earning a 9 percent return, well below historical average market returns, and then in the final year you lost forty percent of your money due to a market crash? Think you’d be better off, or worse?

Slightly worse off, in raw numbers. $1.40 million ($2.34 million before the crash). For half the effort to save. This despite a major investing disaster at the worst possible time. But then let’s say you manage to retain your intestinal fortitude, and instead of annuitizing on a fixed basis, you simply withdraw the same $10,000 per month we had in the previous example, while leaving it invested and generally earning 9%. Your money keeps increasing, and if you live to age 95, you leave 2.23 million dollars to your heirs, a sum that, if not so great as it sounds, will still buy a decent house in most areas of the country sixty years from now under our assumptions.

Now let’s say that you want to live the same lifestyle, equal to $2500 per month now, that you have at retirement, so your monthly withdrawals increase by 3.5 percent per year. You didn’t even have this option in the fixed rate examples. Your money lasts 19 years 3 months (plus a few thousand left over). Once again, for half the effort to save.

This is not wild risk taking. This is simply doing exactly what the insurance companies are doing, and assuming the investment risk yourself. Do not think for a minute that banks and insurance companies are insulated from failure if the market conditions go sour enough. They aren’t getting the money to pay you from some kind of transdimensional vortex. If their investment results are bad enough so that they can’t pay you, they won’t. Government bailouts are also limited, and the government’s guarantee programs are likely to undergo severe modification in the next forty years, as they deal with problems such as social security and medicare payouts that are much larger than what their pay ins will be. States, which generally stand behind insurance company guarantees, will not likely be in a stronger position than the federal government. Not to mention the kind of impact this sort of financial crisis will have upon government budgets.

Speaking of the banks, let us consider a hypothetical four percent CD, on a “taxed as you go” rather than tax deferred basis. Assume 28 percent federal tax rate, and 7 percent state and local. $1000 per month invested, every month for 40 years. How much does it turn into?

$842,800. As opposed to $1,044,600 just to break even with inflation at 3.5 percent per year and being able to buy the same stuff. I’d snark that you might as well bury it in a mattress, but in point of fact, that would only get you $480,000.

The point I’m trying to make here is that the so-called traditional “conservative” investments are anything but. If you aren’t putting your money into investments where there is some market risk, then the only guarantee you have is the guarantee that it won’t succeed, the guarantee that you will be living in poverty.

So in financial planning, the biggest risk is in not accepting some.

Caveat Emptor.