Saturday, August 4, 2007

Retirement Planning and Debt: Depreciation

Retirement Planning and Debt: Depreciation

How often have you heard someone say that as soon as you drive a car off the lot, it is no longer worth what you paid? There is a lot of truth to the statement but some of it is exaggerated. Yes, it does lose value but not as dramatically as you might think – at least in those initial moments anyway.

Depreciation happens to things with a fixed life span. We know that cars do not last forever. While they aren’t exactly disposable, many vehicles have a fixed life from an accounting point of view.

While you can have an effect on that life span – unusually hard driving might create more wear and tear on a car than accounting calls “normal”, generally speaking, depreciation allows for a systematic lessening of the value of the property over the course of time. In the case of cars, five years is considered by many to be the best number to use.

Another term you may have heard of – GAAP or Generally Accepted Accounting Principles is the method used to adjust the book value of the asset downward in a systematic way. When you buy an asset such as a car, the price you pay is considered the historic value. The book value is considered a contra asset account, each entry lowering the price of the asset.

Autos use straight-line depreciation. This assumes two things. The first is the historic value; the second is referred to as the salvage value. As a math sentence, it would like this:
Cost of the car ÷the salvage value = the annual straight-line depreciation.

In the book, we look at the difficulties of getting you right side up in an upside down car loan. To be “upside down” suggests a car loan that continues long after the depreciation that as brought the car’s value to zero.

One of the key factors in such a mistake is the attraction of “the right price”. Too often we are drawn by the amount of the monthly payment and not the cost of financing the purchase. Had we calculated the debt service (the amount of interest paid) and the depreciation (how much the car will be worth at a given point in time) against the balance owed, we might have had second thoughts about a loan that lasts longer than five.

For instance, which would you find more alluring: a five year loan on a car worth $30,000 at 6% would cost you $579.98 or a seven year loan – not unheard of these days at the same interest rate and a payment of $438.26? Admit it. The lesser of the two would be the most attractive option.

Key to keeping this happening is buying a car you can afford – not the car you want and use the money saved to finance that under-funded retirement.

Thursday, August 2, 2007

Retirement Planning and Debt: Liquidity

Retirement Planning and Debt: Liquidity

No one can downplay the importance of debt in your financial plan. While I am guilty for frequently mentioning the concept as a negative influence on your plan, we are besieged with information offering us a contrary view.

We are encouraged to keep the economy going by spending. Savings on the other hand, is actually portrayed as a negative influence. An economy can slow the flow of goods if consumers keep their cash close.

While this may be true, it is overspending or buying on credit that has propelled these markets on a global scale. And that movement is based on the availability of money.

What motivates equity markets is liquidity. This is a financial terms that in its simplest form refers to the availability of cash to borrow. Let me explain how liquidity works, often differently depending on where and who you are.

On a corporate level, liquidity can be incredibly deceiving. It acts as a reward for savvy business acumen. And because of so many people are using their skills to find this excess capital where little to none exists, we have these stock market levels (over the month of July, the DJIA hit 14,000, then gyrated wildly downward in fits and starts losing five percent of its value).

Liquidity in its purest form comes from the banking system. The Federal Reserve Board fixes the overnight short-term interest rates for the best borrowers. When it does this, it is suggesting a rate at which it believes the marketplace has just enough cash at the right price to keep the corporate engines fueled. That rate is then passed on to each subsequent lender, who increases the rate in small increments right on down the line.

This gives the average borrower like you and I the impression that the Fed controls the economy with each pull of its purse strings. And you would be right, to a degree. The flip side of making money inexpensive to borrow is having enough available in adequate quantities to those willing to pay the price. But liquidity offers business and consumers different opportunities but similar punishments.

In order for the borrower to qualify for a sizable loan, whether it be business or consumer related they often need to have some sort of underlying asset that they are willing to “put on the line” for the amount of money they seek. With business, it is often money borrowed for reinvestment in production or to expand a product line. With the consumer, it is often their largest asset: their home.

Most of the time this borrowing is at the heart of how a business grows, tapping inexpensive money that gives them additional competitive opportunities.

Each asset the company owns acts as collateral. But what happens when the borrower wants money not for the usual and traditional purpose of expanding the business but to reinvest it? On the surface, it creates an illusion of economic health.

A business can borrow cash to buy back its own stock. The net effect of such a maneuver suggests two things: the company thinks its stock is fairly valued and is taking some of it off the table, making it unavailable for buyers and secondly, it believes that the markets will reward just such an action by increasing the share price. But what happens when the interest rates (called debt service) rise faster that the return on the stock? Nothing until someone begins to realize that this whole debt structure might be nothing more than a house of cards.

The housing analogy is not accidental. For well over three years, I have wondered how consumers would react if their ability to extract money from their homes dried up. For over two years I have been wondering what would happen if all of those creative mortgages, the ones done with adjustable rates and fancy, no-documentation paperwork, became too burdensome for the borrower.

As money becomes too expensive to borrow, opportunities to make money in market places like stocks begin to seem risky and after they calculate the debt service, not too affordable. Businesses, instead of growing and creating new markets find themselves facing the possibility that they may just have painted themselves into a corner.

Consumers, no longer feeling as though the cost of borrowing is worth it, will spend less. This of course has a domino effect disrupting economic growth.

That is the simple explanation. There are global forces at work as well but these will only have an effect on you if your liquidity has dried up. With debt, liquidity is based on your ability to borrow and pay the cost of that transaction and, most importantly, you feel as though the risk and the cost are worthwhile.

If you have no debt, your liquidity is based on your ability to tap cash when you need it. In the book, I fall back on the old stand-by, the emergency account as the base for a good retirement plan. Creating just such an account allows you to have more than just enough money to get you by during times of income disruptions, it gives you peace of mind knowing that the money comes without a cost if you need it and you were able to save it.

It also has the effect of immunizing you from any economic fallout as a result of nefarious corporate and marketplace shenanigans or because other consumers over-extended themselves in unwieldy loans.