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.

The Consequences of Not Shopping Multiple Lenders

Minorities get higher rates.

They add that the fact minorities are more likely to borrow from institutions specializing in high-priced loans could mean they are being steered to such lenders or that some lenders are unwilling or unable to serve minority neighborhoods.

What they describe is called redlining. It is illegal. HUD really gets their panties in a bunch over it, too. Mostly what actually happens is that the lenders simply aren’t chasing certain kinds of business. If any comes to them, they deal with it like anyone else. This is standard marketing procedure. Figure out who you’re trying hardest to serve, and really chase that segment. If anyone else wants to come to you, that’s wonderful and you serve them the same as any other customer, but they’re still not someone you’re going out of your way to attract.

One thing that the article explicitly said: This does not include/compensate for credit scores. Working with people in the flesh, I have experienced the fact that there is a difference between how various groups handle credit. Often, the urban poor have some difficulty in meeting the requirements for open and existing lines of credit. They are more likely to have failed to make the connection between credit reporting and future qualifications for credit, having at some point made a decision not to pay a creditor. Often, they are more pooly educated about their options or think they’re a tough loan when they’re not. This extends into the general population, although it’s less prevalent. I have a friend I went to high school with. He and his wife make over $160,000 per year between them in very secure jobs they have held for over a decade each. Their credit score is about 760. The loan officer they were originally working with told them they were a tough loan to try and scare them into not shopping with anyone else. The reality is that the only question is what loan is best for them because they easily qualify for anything reasonable. This is far more common than most people think. The current standard is that if you have two or three open lines of credit and your credit score is above 640 – sixty plus points below national average – I can get 100 percent financing, and the possibility doesn’t disappear completely until you go below 560 (whether it’s smart is a question for the individual situation, but I can get a loan done if it is). With increasing equity, I can usually get a loan done even for credit scores below 500 (two hundred points below national average!). Now, the better your situation, the better your loan (e.g. rate, terms, closing costs, etc.) will be, but the question is not usually “Can I do a loan for these folks?” but “Can I find them better terms than anyone else?” and “Should I do this loan or is it really putting them in a worse situation than they’re in?”

Quite often, the loan provider that urban poor go to is the one who advertises where they see it – basically, the lender who chases their business, usually by advertising in that area or in that language. Every other lender is still available to them, but they go to the place whose advertising they see. They think “This guy wants my business. He does business with people like me all the time. He can get me the loan.” The problem is that all too often, this loan provider has chosen to chase this market precisely because the people in it, most often urban poor, do not understand they’ve got other choices, and do not understand effective loan shopping, and so this loan provider makes six percent (the legal limit in California) on every loan plus kickbacks and arrangements under the table. They make more on one loan than I do on half a dozen for roughly the same amount of work, and the loan they do are not as good for their client as others that can easily be found.

Most people are better loan candidates than they think they are, and qualify for better loans than they think they do. It’s more often the property they have chosen that creates an untouchable situation than the people themselves. Even then, there are usually options available.

(I got a ten minute lecture a while back from a nice young couple telling me they “deserved” a rate of four to five percent on a 100% loan for a manufactured home sitting on a rented space, because it was “the same rate everyone else is getting”. Well, if it had been on a regular house sitting on owned land I could have gotten them that loan on very desirable terms, but nobody does 100 percent on manufactured homes, and if there’s no ownership interest in the actual land involved then it’s a loan secured by personal property, not real estate, and it becomes a personal loan, for which the rates are much higher.)

So keep this in mind if and when you’re in the market for a real estate loan, and shop multiple lenders, and shop hard. Remember that all of the times your credit is run in a two week period for mortgage purposes only counts as one inquiry, whether it is just once or whether it’s five dozen times. A loan provider does not have to run credit themselves to get a quote, but the information must be complete, accurate, and in a form they can use.

Keep in mind that the loan market changes constantly. A quote that’s good today almost certainly will not be good tomorrow. If it’s not locked, it’s not real, and a thirty day lock is not valid unless extended on the thirty-first day, for which you will pay an extension fee if necessary. So shop hard, with a real sense of urgency, get it done quick, and make your loan provider get it done quick. Any additional stress will more than pay for itself (and the longer the loan takes, the greater the opportunity for stress, too). Apply for a back-up loan, and if it’s ready first, it’s probably a good idea to go with your backup. Sight unseen, I will bet money that a loan done in thirty days or less from the time you say that you want it is a better loan than the loan that takes sixty days or more.

Caveat Emptor.

Life Insurance – Proper Prior Planning Prevents…

Life Insurance is something that nearly every adult should have, and almost every adult who buys goes about purchasing it the wrong way, at the wrong time, for the wrong reasons, and buys the wrong policy.

Is that an indictment of the system or what?

Let’s start with what life insurance is. Life insurance is a bet that you make with an insurance company that you will or will not live. The idea is that if you die, while nothing can replace you, your family will get money to replace your salary. If you die while the policy is in force, the insurance company loses the bet. If you live for the full time the policy is in effect, congratulations for being alive, but you lost the bet. If you die after the policy stops, not only did you die, but you spent all that money and your family got nothing. Now it is critically important to understanding life insurance to understand that nobody gets out of life alive. Unfortunately, everybody has to die sometime. As of this writing, the chances of you missing out on this one final life experience that practically everyone wants to avoid forever are zero. So you might as well make plans that include anybody you leave behind benefitting from it, because (I have it on excellent authority) dying stinks. (Yes, I’d use a stronger word except that I try to keep the language here family safe as much as possible)

There are two major types of life insurance, term and cash-value, and the latter type has several subtypes which I will explain in due course. Term can be thought of as “renting” life insurance, while cash value can be thought of as “buying” it. Like owning versus renting a home, there are arguments on both sides of this story as to which is better. I will attempt to cover the pros and cons of all of the major camps, and there are people for whom each makes sense, but like buying a home, if you choose the right policy, cash value life insurance is a losing proposition in the short term while becoming fantastically remunerative after a few years. The vast majority of all people would do better to consider cash value, particularly when you crank the actual numbers and consider the alternatives.

Another thing that needs to be crystal clear is that life insurance is the second most tax advantaged investment you can make, right after buying a home. In fact, it’s better in many ways although it requires more planning. If you plan properly, and die while it is in force, the death benefit comes to your heirs tax free. Furthermore, all investments in the cash value of a life insurance policy earn money tax deferred, and any money withdrawn from the cash value of a life insurance policy gets “first in, first out” treatment – something no other investment can say. There is no legal dollar limit on this tax treatment for life insurance. There are no income limits for this tax treatment of life insurance. Literally anyone who can qualify for a policy can receive these tax benefits, and so long as you comply with federal guidelines to retain this treatment, there are no dollar limits to the amount you can invest. Even if you violate those limits, the only consequence is that the tax treatment on actual withdrawals flips to “Last in, first out,” and since there is no limit on the number of policies you can have, either, there aren’t many reasons to violate those guidelines.

You can also take loans against the cash value of any life insurance policies you may have, and loans are not taxable. Let’s say that again. Loans are not taxable. Remember that. It’s going to be important later. When put together with the other parts of the tax advantaged nature of life insurance, it’s an awesomely powerful tool if used correctly.

Now I’m going to violate one of my cardinal rules for this site: no graphics. The reason is that this picture is too darned important to the essay. It’s graphic of some features of a life insurance policy. The vertical axis is money – dollars – and the horizontal axis is time. And the reason I’m putting it up is to illustrate a generic life insurance policy. It doesn’t look like much at first, but here it is:

(Restored! Thanks Chris!)

Now I’m going to explain it. There are three areas: red, yellow, and gray. Grey is just background – dollars above policy value. Like the altitude above an airplane, it’s useless, unless you climb into it later, as some policies can, painting ever larger numbers first red, then yellow. Red, or actually, the top of the red line, is the total dollars your family (or other heirs) will receive when (not if) you shuffle off the mortal coil. Yellow is the cash value of the dollars in your policy. The difference between the two is the amount of insurance you’re actually paying your hard earned money for at any given time. Get it? Got it? Good.

Now it is necessary to note and remember that the cost of the red dollars – the difference between the top of the red curve and the top of the yellow curve – get more expensive with time. Sometime in your sixties, dollars of actual life insurance start getting expensive. Mind you, they are always getting costlier from the first day you buy any policy of life insurance out there. But in your sixties, this process accelerates rapidly, and this has all kinds of implications later in the essay as well as later in life. And now that we’ve covered the basics, it’s time to cover policy types.

Term life insurance, as I said, is like renting your life insurance. It’s like the red line, without the yellow curve in there at all. For the entire time your policy is in effect,you are going to be buying the full amount of insurance dollars every time you make a payment. This means that in an unaltered term policy, your premium goes up every year; sharply so once you’ve hit your sixties. If you are initially purchasing at a young age, most companies will give you the option of paying more starting right now, so that for a certain period your premiums will not increase. If you buy young enough, most companies have at least a 30 year fixed term product. It’s very difficult to find a company that will sell you a policy allowing this fixed period to go later than your sixty-fifth year, however. In all cases, once the fixed term is over, it converts to yearly renewable term, where you can expect the yearly bill to go higher every year. What happens when people start getting these suddenly much larger bills? They cancel. This is what the insurance companies want. Fewer than three percent of all term policies ever pay a death benefit because they are canceled. When you cancel, you’re letting the insurance company off the hook on your bet, and all that wonderful money you spent on their pretty policy bought you some peace of mind for a while, but now it’s gone, and you have nothing. Term is very expensive insurance, when you talk about real cost to the consumer in aggregate, and very profitable to the insurance companies. It doesn’t require writing a check for nearly the number of dollars now, but it doesn’t provide nearly the benefits either. Remember that stuff I told you about how tax-advantaged life insurance is? Term makes almost no use of this fact. It’s kind of like buying a Ferrari body, and putting a Yugo engine into it.

Now we’re going to move into cash value life insurance in all its variants. They’re called cash value because they have one. Now we’re putting the yellow curve back into the picture above. What these policies are calculated to do is endow at a certain age. This used to be 100 for all policies, now the companies are trending more towards 120. This is a good thing because with more people living to 100, they are getting checks when they really want life insurance. Policies endow when the yellow curve rises to meet the red line, off to the right of the rest of the picture above. If it’s your policy, you get a check for the amount of the red line in exchange for your policy of life insurance. This ends the tax benefits, and can have adverse effects upon your tax liability, too. So most folks want to get their policy value as a death benefit to their heirs, not as a check while they’re still alive. Confused? Follow me.

The first major variant of cash value is whole life. This is what that default picture above is all about, because that’s pretty much what a policy of whole life insurance looks like. The difference in dollars between the cost of the term insurance and the cost of the policy is invested with the general account of the company. It earns about eight percent or so, and they pay you about three, which is pathetic. Nonetheless, that three percent is tax deferred, tax free, First In First Out, so it’s probably close to an effective 5 percent for most folks. Like all cash value life insurance, there are provisions for tax free withdrawals and zero percent effective rate loans and all of that. Also like all cash value insurance, to an ever increasing degree over the life of the policy, this moves from paying the cost of the insurance from the check you are writing, which is after tax dollars, to money already within the policy, which is before tax dollars. Finally, like all cash value life insurance, over the life of the policy you are buying progressively smaller amounts of actual life insurance (the difference between the red curve and the yellow one), which means that your actual cost of insurance is less, particularly later on when the cost of that actual insurance goes up. Because of this, cash value policies are likely to stay in effect your whole life and not get canceled. Nonetheless, this is a putrid return and makes the insurance company even more money than term insurance. Many people would have you believe that whole life is the only variety of cash value life insurance out there. It isn’t. But you would not believe the number of straw man arguments against cash value life insurance I have read in the financial press that did their best to read as if that claim were true. For someone who is supposed to make their living informing consumers about the financial industry, this is either fundamentally ignorant, or fundamentally dishonest.

Sometime around 1950, some bright young person working at an insurance company realized that the need for life insurance may not be constant throughout life, and so came the first major addition to the choice of “whole life or term.” This was Universal Life. The concept was simple. You could decrease the amount of insurance in set units, or increase it in set units, up to a certain value, and the initial underwriting would still cover it. This was really cool at the time, because it meant that you didn’t have to apply again for life insurance and go through the underwriting and health insurance exam and health insurance questions all over again, and possibly get “rated” for some new health problem that wasn’t there last time, or possibly even turned down. Unfortunately, in Universal Life Insurance, you’re still investing your money in the general account of the life insurance company, and they are still only paying you about four percent. Once again this has all of the neat tax advantages, but even an effective six percent return is nothing to write home about. To most folks, it’s almost embarrassing. Nonetheless, Universal Life Insurance has broad applicability to small dollar value policies, mostly for older folks. The return is guaranteed, the company assumes the investment risk, and the policyholder gets peace of mind for the rest of their life, knowing that whatever expenses they had in mind are covered.

Not too long after the enterprising young person had the idea for Universal Life, another one had the idea for Variable Life. This is a truly different product, but it really didn’t go anywhere until the late seventies, when inflation was rampant and things were generally going south in a hand-basket until Ronald Reagan et al brought them back under control. The concept is simple: Instead of investing in the general account of the company, you have the opportunity to invest in a certain number of sub-accounts that act a lot like mutual funds. These sub-accounts are basically comparable to the ones in variable annuities, having roughly the same advantages and disadvantages except that most people do not have qualified money in life insurance because the interplay of withdrawal requirements with funding requirements gets nasty complex.

Now in those articles that do admit the existence of variable life, they most commonly write against it because “They have this expense and that expense and the other expense,” ad nauseum, with the strong implication, never proven, that they are somehow more expensive than other policies. The fact is that these are expenses associated with all life insurance. The only additional expense that the variable life insurance policy has that the term life insurance policy (or any other) does not is the expense of running the mutual fund-like sub-accounts, which actually average a bit lower than the equivalent mutual fund upon which these are usually based. Every other expense is part of every life insurance policy – indeed, most of them are part of every insurance contract of any sort. Administration, Insurance, etcetera. They buy the stuff that makes the cash value life insurance policy an interesting and potentially worthwhile investment – the death benefit, that wonderful tax treatment, among other things. But because you’re dealing with something regulated by the SEC, the agent and the company have to tell you about them in variable annuities, whereas with every other insurance policy, they are a “black box” into which money goes and insurance comes out.

Variable Life Insurance, like Variable Annuities, requires not only a life insurance license, but also an NASD Series 6 or Series 7 license to sell. This means that it is generally sold through financial planners, not “pure” insurance agents. These folks are competition for the financial “do it yourself” press, and if you are working with a professional you trust, you’re not nearly as likely to go back to the bookstore or magazine stand for generic drivel with no fiduciary responsibility towards you. Admittedly, some advisors abuse it – and when they are caught, they are prosecuted and the insurance they are required to carry pays. The generic advice in books, newspapers, magazines and websites never has this responsibility in the first place. They are specifically exempted by the Investment Company Act of 1940. But Variable Life Insurance has all of the advantages possessed by all cash value policies that I listed above, and it also has the advantage that you are getting market returns, which the tax advantages leverage significantly in your favor.

Finally, in the early 1970s, another bright young person had the idea of combining the features of Variable Life Insurance with Universal Life Insurance. This product, called Variable Universal Life Insurance, is about the most flexible, most versatile financial investment there is, because you can do so much with it, and it facilitates changes in plans like nothing else. You get market rates of return via the mutual fund-like sub-accounts, effectively augmented several points above market rates because of favorable tax treatment. You can withdraw your principal tax free, and take loans at zero effective interest rate against the earnings after that. Remember, loans are not taxable. You can increase or decrease the dollar amount of insurance within limits. Actually, variable universal has the unique ability that both the red and the yellow areas in the graph above usually start climbing into the gray area somewhere about twenty-five to thirty years in, getting to the point where the cash value of the policy can be multiple times original issue value. All of this amounts to things like you can start saving for your children’s college as soon as you decide you’d like to have some someday. You can save for literally anything, because of all of the options you have for putting money in and taking it out. Matter of fact, you get the biggest advantage from overfunding the policy, putting more money in than you have to, although there are federal limits on how much and how fast you can overfund and retain the most important tax advantage, that of “First In First Out” tax treatment. (It is to be noted that there are “single payment” policies that intentionally throw this benefit out the window, and are still an excellent investment in a lot of circumstances.)

There is one danger to variable life, and to a lesser extent variable universal life. It is possible that through inopportune timing of market declines and/or excessive withdrawals that there will not be enough money in the policy to keep it in force. This is, to use Orwell speak, double plus ungood. Let’s say you took invested some number of dollars as principal, and later withdrew them. Then you took loans of $30,000 per year every year for ten years. But then your investments went through a market decline, and you kept taking the full $30,000 per year for another ten years. If you die with the death benefit still in force, it’s all just a loan against the death benefit and therefore nontaxable because the death benefit is nontaxable. But if the policy self-destructs, now you have to pay the taxes on that $600,000 of income I’ve just described. The IRS is utterly unimpressed by “blood from a turnip” type arguments. They can usually figure a way to get their money a way that you won’t be happy with.

The oldest of these policies are still only about fifty years old, and there were a lot of improvements made in the early years, so there’s no experience, as yet, with the first generation they were really designed for as lifelong financial instruments. The first people who bought them in their twenties are only just now starting to turn sixty, approaching retirement age. Going back via market performance in the last century or so, there does not appear to be major danger of self destruction on policies given time to mature and prudently advised, but there have been people who withdrew more than the market could really support, who had major adverse experiences as a result. Especially with the variable universal policy, there are alternatives to prevent losing the policy completely, but it’s still not something you want to have happen. I will point out, however, that the same danger exists for investors of any stripe, it’s just that the sword here is especially terrible. This is one of the good reasons why these policy require dual licensing to sell – to insure that there’s someone involved who should understand the structural limitations of the policy, and can help you avoid the lurking gotcha! by keeping your withdrawals and loans to a sustainable level.

One strategy many people, particularly in the self help financial press, advise is “buy term insurance and invest the difference.” This isn’t a bad strategy, especially if you plan on dying while the fixed term period is still in effect. But most people in their twenties and thirties are going to live well past their sixty-fifth birthday, and the fact is that most people who are young today are going to work well past it, as well. The reason why insurance premiums start to climb then is largely because that’s when folks start dying off in larger numbers. Investing in life insurance is something best begun while you are young, with few health problems and lots of time. Whatever the strategy you begin while you’re young, you’re typically stuck with the decision, even if you do figure out what’s wrong with it around the time you’re fifty. At that age, your effective compounding is marginal in most cases, even if you’re planning to delay retirement a few years. But I encourage everyone with a potential life insurance need to look at projections of not what’s likely to happen for merely the next thirty years, but for the entire rest of your life. Buying variable, or better yet, variable universal, especially while you’re young is a better way to end up with more usable money later on in life for most people. And that’s the whole purpose of retirement planning, right?

Caveat Emptor

Lenders and Insurance Proceeds

The question that inspired this was

can a mortgage company use the flood insurance claim money towards homeowners mortgage loans?

This is equally applicable to every other form of insurance on your home – earthquake, regular homeowner’s insurance, and any others that you may have or require.

The short answer is yes.

The reason that the lender requires being added to every policy of insurance you have on your home is so they have a claim on the policy proceeds. Let’s say you buy a $500,000 home for nothing down, and the value of the structure is $150,000 while the value of the land is $350,000. Let’s say the house burns down next week. If they weren’t on there as beneficiary, you could theoretically take that check for $150,000 and split, leaving them with a $500,000 loan that they’re maybe going to net $270,000 for by selling the property that secured it – after all the time for foreclosure, et al, which means they’re out all those costs plus thousands of dollars in interest. If you’re a lender, you’re going to suffer this loss once at most before you decide not to trust anybody.

On the other hand, the lender doesn’t want the property or a partial repayment. They want the loan repaid in full. What they’re going to do is sit on any funds they get and make certain they’re used to rebuild, unless they have some reason to believe that rebuilding is a bad risk. Banks don’t throw good money after bad, so if this is the case, they’re going to keep the money. On the other hand, if you’ve been keeping your payments up, they’re going to want you to rebuild. Their taking custody of the money is a way to make certain that you do.

Caveat Emptor.