Debt Trap--part 1

Debt has become ingrained in American society.  Thus issue of government debt is a subject of another discussion but now, let’s focus on private debt held by individuals.  There is a lot of information so let’s focus solely on credit cards here.

A September 2011 study by the BlackRock Investment Institute sheds some interesting light on this issue:

Currently, 70% of US GDP is driven by personal consumption activity. So the social and financial condition of households is critical to the US economy and has economic impacts as well as personal as most of us know people (probably several) that have serious debt problems.  Since the mid 1970’s, the percentage of two-income households has increased from 50% to about two-thirds.  Recently, the great recession has caused median household incomes to decrease.  Between June 2009 and June 2011 (the recession was announced over in June 2009), the median household income fell by 6.7% to under $50,000 according to recent census research.

Credit cards- While some form of systems permitting several payments over time has been around for centuries, the modern form of “credit cards” as we know it is a relatively knew phenomenon. Diner’s Club, Inc. issued the first credit card similar to today’s in 1958 but it was intended  mainly for traveling businessman at restaurants and other such places—not for frequent household use.  Magnetic strips in 1979 allowed the easy swiping that we know today with credit cards. 

And how we have fallen for these dangerous pieces of plastic.  Federal reserve data shows that 609 million credit cards are held by households today and among those that do, the average balance is $15,956 and the total debt balance is  $801 billion.  Along with this balance, there is a high interest rate of over 12.78% on these debts and 46% of households in the US carry a credit card balance from month-to-month.  Just think-banks pay you under 1% when you put your money there (a subject for a different discussion) but charge you over 12% when you borrow money from them.

Sometimes lost in the discussion of credit card debt (like any debt) is how much you will pay in interest as opposed to the original cost of the good or service you are using your card to purchase.  For example, say you have a balance of $10,000 and you are paying the minimum balance which will be $200 in this case (all that many families can afford to pay with low incomes) it will take you 26 years to get it paid off and you will pay $10,687 in interest payments which is more than the cost of the goods/services to begin with.

So, what is the real interest you are paying?  Technically we might say its 12.78% right? Well, in this example, you would pay $20,687 for a $10,000 balance which is 206%!!!  So, tedhnically your interest rate is in fact 12.78%, the cumulative total rate is 206%. Do you think most people would pay more than double what something was really worth if they realized this?  Of course not.

What’s the solution?  First, you must decide that you will not become a debt slave.  Next, you must learn to live within your means.  American civilization survived without credit cards until the 1950’s and it’s fair to say we don’t have to have them.   They are a two-edged sword—they can help you establish a high credit score but also can lead to misery.  Debt snowballing which will be discussed in detail at a later time is how to tackle the existing debts.

To sum it up, remember our example earlier.  A $10,000 balance actually cost you over $20,000 or over 200% of the original balance.  You have to look at the big picture and realize this when making decisions because the banks are not looking out for you—they want your hard earned money to be funneled into their possession.

Can You Really Afford a Guarantee--Part 2

Last time, we looked briefly at the historical returns of the stock market verses FDIC insured vehicles and clearly, the evidence suggest that when inflation is factored in, so-called "secure" investments are not so risk-free when you consider how much you will have to spend when the time comes to purchase goods or services.

Now, let’s look at what exactly “risk” is when it comes to investing.


Business risk and market risk is the risk that an individual investment or a diversified portfolio, respectively, will decline in value.  A recession usually brings to light what market risk is.  Think of Lehman Brothers when it comes to business risk.


Liquidity risk is the risk that when you need to turn your investment into cash, you won’t be able to as fast as you want and you may be stuck selling at a price worse that you wanted.


Interest rate risk applies mainly to bonds and prefered stock.  Changes in interest rate impact the value of the bonds or prefered stock.  Just like a declining market will decrease the value of a generic stock portfolio, rising interest rates will decrease the price/value of bonds and prefered stocks.


Regulatory and legislative risk applies to the idea that agencies may impose stipulations or penalties on an organization or that changing laws will hurt an investment, respectively.


Purchasing power risk is the risk that the buying power of your investment will be less than at time of original investment.  For example, if a portfolio of CDs has gone from $10,000 to $10,200 but the inflation rate has been at 4% then the value of the portfolio has actually decreased by 2% because you would have to have $10,400 just to keep up with inflation!


Different types of investments are for different purposes. Short term savings for things like a new car and emergency funds are great in money markets and similar vehicles but for longer term retirement savings, purchasing power risk has to be kept in mind.



The bottom line is that we have to keep in mind the different types of risk that exist.  Many people are scared of the market because of the volatility (market risk) but purchasing power risk is a risk as well and over the long-run it is much more prevalent in lower yielding investments like Treasuries and money markets than in stocks.

Can You Really Afford a Guarantee--Part One

Market volatility.  The Dow fluctuating over 4% in one day.  Enough to make investors near retirement cringe and lose sleep and even younger investors with many years left before touching the investment still become apprehensive.  Continuous news reports of impending disaster in Europe and maybe a double dip in the United States.  Recent history reveals a flat market over the last 10 years or so.

Seemingly good reasons to sit out of the investment game. Despite historically low returns on CDs and FDIC insured deposits, some investors have pulled their money out of anything touching stocks and bonds and are sitting in the sidelines.  But is this the right move?

Of course, investing is an individual one-on one process and strategies vary depending on age, risk tolerance and many other factors and this analysis is not meant to give investment advice but to examine a couple of misconceptions about supposedly “safe” investments.

FDIC (federal Deposit Insurance Commission) which was created in 1934, covers up to $250,000 for one owner at an insured bank for CDs and checking accounts.  For joint accounts, the total coverage amounts are higher.

First let’s look at historical data—while no guarantee of future performance, we can at least establish what has happened in the past.  Let’s take a look at the period from January 1967 through December 2010.

The S&P index had an annualized average return of 9.87%.  During this time, the return on 3 month certificate of Deposits as measured by the CODI index was 6.25%.  But inflation during this period was 4.4%.  This means the real returns (nominal return minus inflation rate) is 5.47% for the S&P index and only 1.85% for the 3 month CDs.

	S&P	3 Month CD
return	9.87%	6.25%
real return	5.47%	1.85%

                                                 

So, 1.85% is all you would have pulled out in actual growth in CDs.

Recently, there is a strong argument to  made that the federal Reserve has been keeping interest rates below the rate of inflation which means negative real interest rates—but that’s a topic for a different discussion.

Not to mention the tax implications as regular accounts are taxed at ordinary income rates as opposed to tax benefits for certain plans such as IRAs—traditional and Roth.

The “guaranteed”  returns don’t seem too impressive when you consider the inflation rates.