Tuning up your personal economic engine

[Velociryx]

In another thread, I outlined the simple two-step process of economic advancement in this country, and while those two steps are absolutely true and fool-proof, there are lots of particulars that can be gone into….lots of expansion on those basic ideas.

If you didn’t see it in the aforementioned thread, the two-step process for economic advancement is:

1) Spend less than you earn,
And
2) Buy (invest in) something that will increase in value over time.

And that’s it. That’s the secret (big “secret,” huh?). Do that, and you absolutely WILL improve your economic status. No maybes, no doubt about it whatsoever. 100% of the time.

Along the way, pursuing the very strategy outlined above, I have discovered that some stuff works better than other stuff. Among the tips and tricks that I have discovered are these:

The “B” word – everybody groans when they hear the word “Budget,” but it is truly the cornerstone of economic advancement. Finding out exactly how much you got coming in, and where it goes each month, and it can be illuminating! I break my budget into four categories: Essentials, Extras, Debt Service, and Discretionary (savings), with notations about the % I am spending in each category. For illustrative purposes, my budget as it is currently laid out looks like this, percentage-wise:

Essentials (mortgage, lights, gas for the truck, insurance, phone, and ‘net access) = 47.1%

Extras (spending coin, movie rentals, a place to park my domain name collection, and misc) = 15.2%

Debt Service (I got my hands on some groovy low-interest credit cards, and transferred all my girlfriend’s debt to them to save her money….previous to that, I had paid all my debts, so this category, as a percent, was 0) = 16%

Discretionary (savings rate) = 21.7%

Right now, all the “discretionary” money each month is getting poured into paying the existing debts down, and they should be gone within a year’s time, at which the “Savings Rate” category will be back up to a healthy 37.7%

It is this last category that is the most important consideration in terms of improving your economic situation, because it is with this money (at whatever % savings rate you can personally manage) that will be used to actually go out and do step two of the abovementioned two-step (buying stuff that will increase in value over time).

For me, my interests run to real estate. I don’t know why, they just do. I like the thought of owning lossa houses. Maybe I played too much Monopoly as a kid or something, but that’s where my interest is, and that’s what I’m looking to acquire.

I started by buying a place for me. Nice place, too. One I knew I wouldn’t mind staying in for a good while.

Next step will be to buy some investment property for rentals.

Property: Single family houses LOOK attractive, but they can be tricky. For one thing, if you don’t keep it rented, you get to eat the mortgage. Not a very good way to invest. As long as the place stays rented of course, you’re fine. The property will tend to appreciate in value over time (historically, expect 1-3% appreciation per year), and assuming a sufficient down payment on your part, you will be making more money from rent each month than the mortgage payment + insurance. (this is key, do your homework in advance if you are an aspiring rental property owner, and find out what the market rate for home rentals is in the area you are considering buying into….armed with this information, you can set your monthly profits at whatever you wish, simply by increasing the size of your down payment—which equates to a smaller monthly mortgage payment, which = higher monthly gains for you.

Much better for the first time investor, however, is a multi-unit building (Duplex, Triplex, Quadraplex….on up to a small apartment building with 8-15 units in it). This is better for you than a single family dwelling because it spreads your risk out….it would be quite rare, statistically, for your 8-unit apartment building to be completely devoid of renters (unless the building itself is gone, which is why you carry insurance!), meaning that you’ll always have at least some money coming in from the property—lower “carrying costs” for you. That’s smart investing.

The above, however, must be balanced by turnover considerations. One unit apartments have notoriously high turnover rates, and each time you lose a renter, you must perform cosmetic (and sometimes, more than cosmetic) maintenance on the unit, thus, an 8-unit apartment building, consisting of 1-bedroom units would NOT be a favorable investment (in general), because although it succeeds in spreading your carrying costs, you will suffer from high turnover, so be picky.

Pricing: If you pay more than 7x-8x the annual rent (this varies from area to area….closer to 8 where I live), then you paid too much for the property. Don’t buy it at that price. Offer less, and if they won’t budge, don’t buy (that’s the beauty of investment property….you needn’t be in a big rush….just wait till a better offer comes along!). Alternatively, you can raise rents to bring things back into balance, but again, you are somewhat restrained by what the prevailing market will bear.

If investing in a duplex or bigger, and you’re not planning to live in one of the units, expect to pony up 25% down. This brings to light one advantage of the single family home, because even if you don’t plan to live there, you can get into a single family investment home for 10% down all day long, with few problems (faster….riskier in terms of carrying costs, but cheaper to buy into).

Closing costs: Expect to pay ~3% of the total purchase price of the property in closing costs (so, for a 65k single family home, expect about 2k in closing costs, with a 6500 (10%) down payment).

Holding: Given that the property appreciates in value, you can either buy to keep, or buy to resell down the line, and if you do the latter, plan to hold it for at least five years….the longer the better, but unless you get an inside scoop on the new highway being built right thru where your property runs, five years is about the minimum amount of time needed for the $ appreciation to surpass the various fees associated with buying and selling.

Financing: Given the low interest rates being offered right now on mortgages, buying NOW is better than waiting, but banks like to make sure you’ve got the money in the bank (and are not borrowing the money for the down payment) – here’s a useful tidbit in that regard….banks check your records back three months. I found myself slightly short with regards to being able to pay all the closing costs on my house, so I wrote a check from one of my credit cards and just quietly dropped the needed funds in the bank account four months before contacting the bank. They looked at three months of bank statement data and gave me the nod. Problem solved.

If you have no debts to speak of, you can do the same thing, financing the entire down payment with your various credit sources to get in NOW, and make paying them off a priority (works best if you have some juicy low-interest rate credit sources already lined up, and that was, in fact, my first priority).

Also, don’t bother with keeping a ready cash reserve to handle big expenses for your rental properties…ties up money better used in other places. Just keep one of your credit sources untapped and at the ready, so if you have to replace a roof or an AC, or some other big thing, you can do it in an instant, without having to scramble for the money. Odds are extremely in your favor that if you have multiple properties, the AC won’t go out everywhere at once, so you need not have to have a huge line of credit standing ready (I use a 10k credit line for that purpose).

Lots of others, but that’s enough for starters….it’ll be interesting to see what else crops up here in terms of ideas (and no doubt, the communists will descend on the place in droves, telling us how evil we are, but….whatchagonnado? )

-=Vel=-

[Velociryx]

Oh...forgot something....if you wanna play "hands off" and let someone else take care of all the grunt work involved with managing the properties, great! There's companies around that specialize in that very thing....expect to pay 10-15% of each property's annual rent for the service....easy enough to build into the equation if you know in advance that's how you wanna go (and less headaches for you)

-=Vel=-

[Japher]

Great post Vel

Couple questions...

Can you explain this:

If you pay more than 7x-8x the annual rent (this varies from area to area….closer to 8 where I live), then you paid too much for the property

What do you mean by 7-8x the annual rent? Do you mean if you get $6,000 a year from the rent that you shouldn't have paid more than $48,000? That's sounds like a good rule of thumb... Don't the like to see it as a debt to earnings ratio? So more along the lines of how much you borrowed to how much you charge, thus it would be fine to do so, but you would have to put up more money... did I get the ratio right?

---

I like your monthly money management divisions. I do the same thing, but I also split my discretionary into 3 brakets; long term savings (retirement, 401k, IRA), short term savings (vacation, new toy, etc.), and comfort savings (house fund, personal savings, stocks, etc.)... This just gives me more of a direct sight on my goals, and how I am doing in order to reach them... Sometimes I have to adjust the percentages one way or the other.

Yet, I too agree that budgeting as the big key, and is also the most taboo word in the world.

Currently, I use Excel to manage all my finances. I have set up some very good spreadsheets using my own personal formulas for projections, monthly management, and comparisons. I think the projections is the most fun... Would you recommend any packaged software for this?

Also, for your own house, not an REI, how much would you suggest your montly mortgage to be? Some say 34-35% of your yearly income, while others say at least 30%. I know it is arbitrary, but there has to be a balancing point...

Uhmmm... post is getting long I will think on this some more and post again later...

[DanielXY]

In Case you are not too much interested in family and stuff. + Considering as you get older your payments are likly to rise, whats the point in saving and investing money, other than pension plan? (serious)

[Japher]

Good question Daniel: apart from pension plans what is the purpose for saving and investing money?

I don't get paid enough in one month, or even a year around here, to buy or even put enough down a house in order to afford the down. In order to create a cash flow and possible returns I invest the money I have set a side for the house, knowing that it will be sometime before I will have enough I am willing to take the capital gains hit.

Savings are also good if you never wish to buy a house and don't care about this family stuff (as you put it) since as you put your expenses will increase as you get older, and unless you want to work for the rest of your life you will need to capture the "time value of money" so that your current dollar is worth a dollar in the future (less depreciation). If you do plan on working until you die, then don't bother investing. However, there may come a time when you can't work.

[Velociryx]

Hiya Japher, and thanks! As to those questions!

The 7x-8x thing
You nailed it exactly…it’s mostly a good “in the field” rule of thumb to go by when you’re looking. If Nancy and I are out to dinner and browsing thru a house book while waiting for the main course, we might spy a house that looks interesting. If so, here’s how I use that figure in my head:

List price of 68k – offer 65(?) (and I automatically start pricing it out….$6500 down payment, ~2000 in closing fees), 65,000 divided by 8 (maths done on a napkin, of course!)$8125, rent estimate is $675 a month.

Next step then, is to call around that area to find out what houses are renting for to see if the estimate is close, high, or low….if rents run higher than that in the area I’m looking, I’m in!

With regards to the budgeting thing, and specifically the more refined breakdown of your savings percentage, I like it! I stopped investing in my 401k ‘bout a year ago so I could pour money into my property hobby (which is where 100% of my savings now goes, trips and such being paid for out of general spending coin and such), but I can definitely see the value in doing it that way!

Software: I’m like you, using word and excel….I’ve heard good things about personal finance software, but have never felt any need to invest in any….my antiquated spreadsheets work good enough for me!

As to the ratio of Mortgage: Total income….I’ve seen those same percentages bandied about, but in general (and having lived most of my life in crap neighborhoods), if mine’s under 50%, I’m comfy with it—could no doubt save more had I invested in a smaller house for myself, but….I decided to splurge…I’d eyeball it tho, at a normative rate of ~35%.

To Daniel – the older you get, the more you wanna look at safer investments (volatile ones might not recover any losses incurred before you die!), however, as Japher pointed out, the main reason for still investing in something is simply that you may not be able to work your whole life, and given the condition of the social security fund, don’t count on having that available!

-=Vel=-

[Provost Harrison]

I turn a blind eye, but fortunately I seem to be earning marginally more than I spend...but not enough to do anything with whatsoever...

[Velociryx]

Nahhh....even a smidgeon is enough to get you started, Provost! When I started out, my "investment money" was less than $50.00 a month....you could concievably do it with even less (if stock picking is your thing, there are several quality, low commission sites where day traders lurk by the legion), and if you'd rather keep it hands off, there are a number of no-load, low or no minimum mutual funds out there....

-=Vel=-

[Az]

As soon as I get a real job, I know I will make a budget.

[Japher]

What do you consider living above one's means?

Me?

I think if one can't or doesn't save at least 15-20% of their take home each month than they are living above their means. Maybe I'm harsh, but I don't think I am being unrealistic. I live in the Bay Area after all, and my rent and cost of living is a lot higher than most. Yet, if you are having troubles with setting this as a goal you should probably see a financial advisor.

[Japher]

Provost: You don't need money to invest in your most important asset... you. Sounds cheesy i know, but it's true. As you continue work, earn experience in your job, you will begin to climb the ladder and make more and more money. Yet, what you decide to do with that 'extra' money will be up to you. What you should be doing is educating yourself on economics, personal finance, sales, law, and buisness. Not sure how it is around there, but around here there a plenty of associations, clubs, and groups that one can join to learn these types of things. They have dinners, discuss their current ventures, get guest lecturers, and even pull money to put towards their investments. They are good places to meet mentors, learn the tricks-of-the-trade, and to even find yourself on the ground floor of a REIT, which is a lucrative investment indeed... Imagine be able to turn that 50$ to 5000$ in just a couple of years! Network and learn, that is free, or cost small membership fees, or a dinner out once a month.

---

Vel; you ever think of investing in commercial real estate?

[Provost Harrison]

Of course Japher, I have always been fairly prudent anyway...at the moment I am saving some money aside for when I move out of my mother's house and when I need to move away...which would come with a pay increase anyway if so...as soon as I can get somewhat settled down financially after that point, then I will begin looking at saving money, sorting out pensions, etc, etc...job hunt depending I would hope to be up and running very shortly after that - although I would have to rent initially, I should be able to manage but if the job I get is stable I would look at trying to buy somewhere after then, but am just keeping my eye on the property market for now.

[Velociryx]

Japher: Commercial real estate....been considering it....seems like the mechanics of it would work out about the same (renters = shop owners)....slightly different language, but it looks like about the same game, so yeah....I'd definitely bite if I came across the right property!

As to living above means - living here in the laid back south, I'd peg the number at anything beyond 90% of income, but I can surely see why you'd play it more cautiously....the Bay is....'SPENSIVE!!!!! Too rich for my southern blood....

-=Vel=-
(with the salary I get here, I'd prolly not be able to afford a cardboard box where you live! )

[Japher]

with the salary I get here, I'd prolly not be able to afford a cardboard box where you live

Ain't got much better

[Velociryx]

Come south, good sir! We got people tripping all over themselves selling cheap houses here, and Vel fires up the grill every Saturday for a feast!

-=Vel=-

[The diplomat]

#1 would be great advice for the federal government!

[Japher]

Where are you located?

[Japher]

Tops on my 10 year plan is to get out of dodge... so to speak. I have 1.5 years to do so... uh, more like 1.25 now.

[:) Smiley]

Hmm, what % of US Fed budget is in essentials and what % in Extras?

[Japher]

The Fed doesn't budget, they just hand out money

[Velociryx]

Back from home, storage (still in the process of moving the last few things) and dinner, so apologies for the delay. Japher, I'm in Columbia, SC, and the cost of living here is waaaay lower than Cali....among the lowest in the nation, actually, so if you're looking to relocate, you could do a lot worse (if you don't mind putting up with a couple of months that will make Dante's trips to the Inferno look like the arctic circle! Aside from July and August, however (during which time, the entire state feels rather like a Sauna set in the depths of Hell), the rest of the year is marvellously mild, and if you love the notion of a slower-paced life....this is your bag!

As to the big, top-secret two-step...good advice for everybody, and I totally agree, government included! Sadly, aside from defense, interstate highway maintenance, and the maintenance of our "social safety net," pretty much everything else the government does would have to be categorized as an "extra", which is an awful lotta green, I'm sorry to say.

-=Vel=-

[Velociryx]

Oh...and Japher....just for the amusement value, you should grab a copy of the home-buyers book in your area and pick a house you can afford out that way....let me know what it's specs are, and what it lists for, and I'll pick up a copy of that same book here as an illustrative example of:

a) A comparable house to the one you select here, to compare pricetags

and

b) A home priced the same as the one you picked, to show you what all you could get for your money out this way....

Did that with another friend of mine who lived in San Jose a few years back and he wound up moving here!

-=Vel=-

[Japher]

I love the slower pace of life; B-B-Q, camping, lounging... in fact I consider myself a gold medal Power Lounger!

I'll pick up one of them books, I see them at the store now and then...

Q: How much will insurance cost for an investment property?

[Velociryx]

In that case, I'll save you a lounger! (and the south is almost as famous as the mid-west for BBQ!)

IIRC, a single-family home in the Bay area of decent size runs ~$300,000 (~2000 square feet, 3-4 bedrooms, garage)....for that, you'll be....shall we say, "very pleasantly surprised" at what you could get here, but more on that later!

As to insurance....rates will vary widely from state to state....here, it's a drop in the bucket tho ....I keep all my insurance thru the same company and get a slight (15%) price break for doing so, and wind up paying less than a hundred bucks a month for everything.

-=Vel=-

[Japher]

You would be hard pressed to find a place with 2k square feet for that price... More along the lines of 1200 and it will be a place built before the civil war!

All I know is that I need to get out of here. Columbia looks cool, but there isn't much of a market for Chemical Engineers out there (from my quick 5 minute peep), though my wife would love it, as it looks like there is a lot of Animal related jobs...

Also, I got my credit increased, yesterday, on one of my credit cards I never use. My other card, which I always keep around a zero balance on, also got hiked about a month ago. With my savings and those credit lines I realized that I have about 35-40k that I could use. Yet, even that, would barely nick 10% of a down on the places around here... That is why I need to move

One good thing; my wives company is in Bankruptcy, so if we decide to leave it will only be me having to brake some ties with an employeer... I always hate walking away from a good job.

She wants out too...

[Velociryx]

Hmmm....:: pondering for a bit::

Chemical engineer....I'm not sure what they do, but there's a wampum BIG Allied Chemical plant in town, Dow has a place here where they make Mylar and other strange materials, and a couple of Paper Mills (the nearest one does make use of you chemical types, using an Oxygen bleaching process and some other wizardry that I don't understand). Not a horde of jobs in that field, no....

As to the houses....hold onto your jaw...for that kinna money here, you're looking at either:

* An "Executive Home" in an exclusive neighborhood (4k square feet, 4-5 BR, with the works)

or

* A more modestly sized (2k-2.5k square feet) on the lake, with a private dock for a boat, lakeside or pool side cottege, etc.

The so-called "starter home" (ideal for investment purchases) run in the 60's (you can find them in the 40's-50's, but the neighborhoods aren't great), with the "top-end" starter homes in the 70's and 80's (all of these will require at least some work to be in move-in condition--paint, carpet, misc. stuff like that)

Moving slightly higher, you can find homes in the 2k square feet zone, nice, established neighborhoods, good schools, move-in condition for 95k and up (the house I just moved is a fairly typical example of this, 2k square feet, 4br, 3 bath, privacy fence in the back (no garage, it's only slight negative, IMO, but garages are not particularly common 'round here), nearly an acre lot, listing in the home-buyers book at 106k.

If you're seriously considering a move tho (and more specifically, looking southward), one thing....when you find a place you like, make the offer on it immediately! LOL...the housing market is jumping out here, and even a 24 hour delay can cause you to miss the house! When you go looking, bring your wife, G/F, and (unless you're an architectural ace too, a friend who knows what to "look for" as far as potential problems go)....that way, if you like what you see, you can pen the offer on the spot....

-=Vel=-
(and btw, with that kind of credit, you'd have nooooo trouble putting enough down in these parts!)

[Saras]

--"The best solution to all financial hardships is to make more money."

My friend.

[Velociryx]

Indeed, and that is a crucial part of the equation. In terms of increasing your economic position, however, making more money won't necessarily do it, alone (if you blow that money on toys, as opposed to investing it in things that go up in value over time).

-=Vel=-

[Saras]

If you blow all the money away, you're not making enough of it, so get off your arse and be productive

[Japher]

Thanks for the advice

For those prices I might just move out there and peddle real estate for a living, forget this whole engineering thing!

I Will debate that.

Currently, I am in the pharma industry and I have a lot of opportunities to move within my Company to the east coast... Am considering some of those places (Florida, Mass., NJ, Indiana) and am also considering a change in career and go where ever I like...

Another thing about personal financing that I delight in is online options. They make it so easy to track daily expensises, debts, and earnings that you pretty much don't have to do anything. With all the tools and services out there no one should have an excuse not to budget.