March 2007

This is in context with a movie “Thanks Anyway” (not yet released) [via Guerrilla Innovation]

The free-of-charge service is generally not welcomed by those receiving it. Instead Matthias is - not surprisingly - met with hostility and bureaucratic suspiciousness.

Although the performance is focused on public systems, it exemplifies how we tend to react with mistrust when offered something for free by someone who has no other agenda than being friendly.

Are you in tune with this thought? do you mistrust someone who offers you stuff/service for free?

Personally, I have mistrusted a lot of *free offers* myself. Initially I didn’t believe that people could make *free* money out of credit card arbitrages…it took me quite a while to convince myself that arbitrage really works. I have refused a lot of free subscription offers from newspapers and magazines thinking that there must be some kind of a catch in those offers. When Arbitron sent me 10 crisp $1 bills…my first reaction was to check on the internet if it’s some sort of a scam!

Probably it’s the rogues like the commercial below that make me mistrust free stuff. You must have seen this on TV a thousand times:

Click here if you are not able to play the YouTube video above. This links to another site that runs a Quicktime version of the same commercial

Towards the end, one lady says “They let you try it free? It must be good!”. Do you subscribe to such logic about free stuff? or do you subscribe to “free? there must be a catch”?

Here is a report on Federal Trade Commission’s website against the advertising claims made by the marketers of “Focus Factor”. I am including this link just in case someone really falls for the sales pitch from the guy. Don’t laugh…may be you could not digest the Focus Factor’s logic of “if it’s free, it must be good”, but the very fact that the Federal Trade Commission had to intervene in this matter is a testimony to the effect that many people must have been suckered into the getting the product. A Google search for “Focus Factor” will provide you with enough entertaining stories (mostly complaints) for a weekend.

Probably, the mistrust is because of those Amway guys who offer *free over-friendliness* to make you a part of their evil scheme. Or probably, it’s those dudes at the local pizza place who give a free pizza if you sign up for a credit card. Or probably, it’s those *free* $10 checks that Chase sends (and then charges $119.99 on your credit card). Or probably, it’s those free Xbox offers that make you sign up for a million trial offers and refer them to a dozen friends.

What’s your experience with free stuff?

Since yesterday, I have been reading a number of articles on the recent subprime lending fiasco. Personally, I feel there are a lot of fundamental issues at play in the whole mess. The more I read about it, the more I am convinced that it’s not *subprime lending* that is at fault. It’s more about our ignorance, attitudes, and our constant tendency to keep finding loopholes in a given “system”. Here is my take on the issue (couldn’t resist writing about this). Towards the end, there is a list of all the articles (by fellow bloggers and from others sources) that I referred.

Subprime lending isn’t supposed to be bad

There are some people who blame subprime lenders for “lowering their lending standards”. But, isn’t that the whole point of subprime lending? The concept is to make housing *affordable* to people with not-so-great credit. It’s for people who wouldn’t have qualified for a mortgage with the regular lending criteria. According to the US Department of Housing and Urban Development, subprime lending can be summarized in two sentences as:

Typically, subprime loans are for persons with blemished or limited credit histories. The loans carry a higher rate of interest than prime loans to compensate for increased credit risk.

There is an increased risk associated with subprime lending (remember credit is equivalent to financial responsibility in the money world), but it’s not really a bad business model (ideally)…the loans are designed in such a way as to take into account the higher probability of delinquency. So ideally, it was a system that was supposed to work.

So what went wrong?

Flat out reason: the human tendency to abuse an established system. Don’t we love to hunt for loopholes in order to get more than what we need or deserve? In this case, ignorance (or stupidity) and greed on part of the consumers, and dishonesty and greed on part of the lending system are the medium through which the subprime lending system is being abused. I will highlight some of the issues by the way of examples below.

What are people with annual income of $54,000 doing in a house that costs $543,000?

I first stumbled on this piece of news at SVB’s post on the subprime lending issue @ The Digerati Life:

Two years ago, Luis Mapula was living in a converted garage with his wife and two daughters and earning $54,000 a year as a fence company construction worker. Then, almost like magic, he became the owner of a $543,000 home with no down payment.

This is an example of greed and stupidity on part of the consumer (in my opinion). Agreed that the their real estate agent told them some lies, fudged their numbers, and made it look rosy. But, how hard is it to realize that the house is just beyond their means? If you have just $1 and someone claims that you can buy an iPod with that kind of money, wouldn’t there be some amount of doubt in your mind about the authenticity of that claim? Wouldn’t you ask a few people about their opinion on such a claim before you give your money away? In this case, there are two reasons why you would give your money to the $1 iPod guy: 1. Your greed wants an iPod in just $1, and 2. Ignorance (or plain stupidity) convinces you that it’s really possible to get an iPod in $1. Then, when the guy sends you a bill for $499 *shipping charges*, who will you blame? Complaining against the $1 iPod guy does not absolve you of your lack of personal accountability….you should have done your homework well before falling for the shady deal.

Similar concerns about consumer attitudes are expressed by JLP @ AllFinancialmatters; by Paul @ Extreme Perspective ; and by Gaming the Credit System.

Cases of cheating

Here is an excerpt from a quoted piece of a Wall Street Journal article on JLP’s post:

In 2001, Ms. Smith, living on $540 a month in government benefits, was encouraged by a contractor to apply for a loan to finance home repairs. After two loan applications were rejected, a broker submitted a third showing that she had monthly income of $1,499 and was employed at a senior-citizens home though she had actually retired 10 years before, she said. The $36,000 mortgage that First Union National Bank (now part of Wachovia Corp.) approved for her required a monthly payment of $360.33 for 15 years followed by a “balloon” payment — when she would be over 80 — of $30,981.48

and an excerpt from SanLuisObispo.com:

Though Mapula signed the loan application that was submitted to Long Beach Mortgage, his lawsuit says he learned later that it falsely claimed he was making almost $100,000 a year from two jobs and receiving an additional $16,800 a year in rental income. The application also said he had $19,700 in the bank, owned a $22,000 Acura and had $28,000 in furniture and personal property. Mapula said none of that was correct.

These are examples of greed and dishonesty, supposedly on part of brokers (or middlemen) and/or subprime lenders. Consumers’ greed and desperation only encourage such behavior. In some cases, fraudulent information may have been filed without the full knowledge of the borrower….but I think there may be a lot of cases in which the borrowers connived with the middlemen to file false information in order to qualify for something that is beyond their financial means. And, they are taking advantage (disadvantage) of the loopholes in the system that allow the flow of fraudulent information.

Laws and regulations can patch the loopholes in the system…but I am not sure what will remedy our greed and stupidity. Forgive me for being naive, but wouldn’t “living within your means” potentially solve most of the subprime lending problems?

There is certainly much more to subprime lending than what I have mentioned above…however I am just trying to point out some fundamental reasons behind the issue in a simplified manner. For detailed analysis and more examples, read through the following list of references.

Resources and more reading

• Allfinancialmatters: QotD: Subprime Mortgage Mess - Who’s to Blame?

• Gaming The Credit System: Re: JLP’s Subprime Lender Mess Question

• The Digerati Life: How To Kill Your Credit Instantly With Mortgage Fraud And Subprime Borrowing

• Extreme Perspective: Scammers and Personal Responsibility

• US Department of Housing and Urban Development: Subprime Lending

• Wikipedia: Subprime Lending

• Mortgage Professor: What is a Subprime Mortgage Lender?

• Silicon Valley Real Estate Blog: When Not to Buy a House

Got a letter yesterday from Citibank in the mail with the subject “Notice of Change in Terms and Right to Opt Out”. The letter informs that the maximum transaction fee limit for balance transfers on Citibank credit cards will be removed effective April 3rd.

Earlier, the upper limit on transaction fees was $75 (I think…I forget whether it was $75 or $100).

Balance transfer transaction fees (usually 3% of the amount transferred) are never good deals, so generally people opt for $0 fee offers. However, at times, because of the upper limit on the fees, certain with-fee balance transfers were also attractive for large amounts. For example, before this change, a person looking to transfer a $10,000 balance from a high interest credit card to a low interest credit card would have paid only $75 as fees because of the upper limit. But now, he/she will have to pay 3% of the entire amount transferred, which will be $ 300 in this case. That’s not very happy.

For people who indulge in 0% APR credit card arbitrage, this is going to be a bit discouraging. Consider the usual scenario of availing a 0% APR balance transfer offer, and then putting the money in an online savings account at about 5% rate of return. After this change, arbitrage enthusiasts stand to gain only 2% (only 0.75% if taxes are taken into account!!…assuming a 25% tax bracket) of the transfer amount in a year, if there is a 3% fee with no upper limit. A person transferring $10,000 will gain only $200 in a year. This will sort of make small balance transfers not worth the trouble. Start looking for fee-free balance transfer offers. I have a feeling that even the fee-free offers are on their way out if this thing sticks around.

Other credit card companies won’t be far behind…(probably some of them may have already implemented a similar change).

Btw, I don’t understand the “Right to Opt Out” terminology. There is no *opting* out…you either accept the change or they will close your account. Here is what the letter says about opting out of this change:

“If you opt out of this change you may use your credit card(s) under the current terms until the end of your current membership year or the expiration date on your card(s), whichever is later. At that time your account will be closed and your must repay the balance under the current terms”

Long time back, I wrote a post on the calculations behind the rule of 72 with regards to estimating the time it takes to double your initial investment. The focus of that post was to understand exactly how the rule of 72 works and whether it is accurate for all rates of return (ROR). I did not explicitly show the answer to question “how long will it take to double your money at a given rate of return?”. That’s what I will do in this post by giving you a lookup table…just look up the rate of return/interest on your investment and see how many years it will take to double the initial amount (without any additional contributions to the initial investments). Of course, you could use the rule of 72 as a rough estimate..but the table below is far more accurate, and I wanted to do this in spite of the rule of thumb.

To get this lookup table, I have used this relation between time and rate of return (read here for details on how this formula is derived from compound interest formula):

In this formula, t is the time in years and r is the rate of return (rate of interest) in decimal form (5.10% => 0.051). Since I have assumed that the frequency of compounding is annual, r becomes analogous to APY if you are considering a savings account (or a CD). Graphically, this is what the formula tells us about how much time it will take to double the initial investment:

Here is the corresponding lookup table (rounded to the nearest number of months):

Another quick and crude way to estimate the time is to “double rate and half time”- meaning, if you double your rate of return (interest rate), it will take half as much time to double your money. For example, at 1% interest rate it takes about 70 years to double your initial investment, so at twice the interest rate (2%) it will take about 70/2 = 35 years; and if you double it once more (4%) it will take about 35/2 = 17.5 years.

I should point it out (although mathematically it is very obvious) that the graphical representation is very instructive. A rise of rate of return from 1% to 4% (a difference of 3%) has a drastic effect on reducing the time (from about 70 years to about 17.5 years), however, a rise from 17% to 20% (again a difference of 3%) reduces the time from 4 years and 5 months to just 3 years and 10 months. Instinctively, I think the risk increases much more rapidly in going from 17% to 20% than in going from 1% to 4%. I am almost tempted to overlap the above graph with some kind of risk curve (towards pointing out some sort of a *comfort zone*), but I was not able to find enough information on risk-return relationship. I will appreciate any input in this matter.

I am also trying to generate a similar (but more useful) lookup table that will incorporate regular additional investments on top of the initial principal amount….that would prove to be an useful tool to convince some people to save money..as in “look…saving just $X.XX per month will double your money is Y.YY years!”

• Going To Vegas? Play The Games With The Best Odds! by Jonathan @ My Money Blog. Jonathan is planning to go to Las Vegas and refreshes his gambling hacks. Check out this post to find out which games will increase the probability of you returning richer from Vegas.

• The cure for “Hon, Let’s Eat Out Today” Syndrome by ISPF @ Grad Money Matters. A post for the busy couples. ISPF shares some nice tips on how to encourage yourself to cook at home.

• My Foolish Money Mistakes: Moves That Cost Me More Than $1,000 Each by SVB @ The Digerati Life. Learning from your mistakes is a good way improve your financial situation…learning from other people’s mistakes is an even better way of doing it. Look for some priceless stuff like this:

We lost money because we tried to be landlords for far flung properties without hiring a property management company to represent us locally. In the end, we were defrauded by some tenants who refused to pay the rent for a few months and who decided to trash our property before vanishing.

• Shop and Save for College: UPromise vs. BabyMint by Sun @ The Sun’s Financial Diary. This post carries some encouragement for people like me; over the last few years, I have managed a mere 35 cents in my Upromise account. Sun has managed to save $400 !

• Revealing the Keys to Prosper Success by Lazy @ Lazy Man and Money. Lazy spills the beans on how to make Prosper work for you. In an earlier post, Lazy mentions that he is earning something like 12%~16% rate of return on the money he puts in Prosper. From my rule of 72 calculations (rather a rule of 74 for this case), Lazy will double his money in about 5.28 years at an average rate of return of 14% .

• Maintaining a Margin of Safety by Super Saver @ My Wealth Builder. By way of examples, Super Saver gives some rules of thumb on how thick our safety cushion should be. Thicker cushion means lower returns and thinner cushion means higher risk…and a hard fall (if you do fall). It’s always the balance that’s difficult to manage.

• How to Put Your Deceased Loved One in the Ground for Under $1,000 by Jeremy @ Generation X Finance. A frugal thing to do when you are dead - make your death easy and economical for your near and dear ones. the excerpt below voices Jeremy’s sentiments.

Sometimes we get caught up in saving pennies on our electric bill, worry about correct tire inflation for gas mileage and even make a big issue about a fraction of a percent expense ratio on a mutual fund, yet we are completely unprepared when it comes to one thing that is absolutely certain in life.

• Invest in the Sun and the Wind by Matt @ Binary Dollar. With the world going green, Matt points us towards the increasingly rewarding prospects of investing in green technology.

• How to Ace a Job Interview by Ben @ Money Smart Life. Ben shares 10 practical tips for a successful interview. While we are on this topic, let me also recommend a related post by Trent @ The Simple Dollar titled “17 Essential Tips For Getting That Dream Job“.

Links to the week’s carnivals:

• Festival of Frugality (66th edition): A Carnival of Money & Poetry hosted by Sharon @ The Frugal Duchess.

• Carnival of Personal Finance #92 hosted by Lazy@ Lazy Man and Money.
  

When it comes to buying cars, one needs to be careful before drawing any *economic* conclusions based on the sticker price of cars. Generally, we are fixated towards the sticker price because that’s what comes into limelight when we start thinking in terms of auto loans, interest rates, and monthly payments. All our efforts are focused towards comparing things like “which car has the lowest drive-out price”, “which dealer is offering the best deal”, “which bank is offering the best interest rate for my car loan”, etc. Inadvertently, our thoughts are drawn away from long term factors such as depreciation, and cost of operating and maintaining the vehicle. In other words, we tend to pay more attention to the “initial cost of ownership” rather than the “true cost of ownership” of the vehicle in the long run. Not good.

Comparing cars on the basis of the true cost of ownership (which includes depreciation and operating costs in addition to the initial costs) gives a better feel for the economic implications of your car deal and could potentially save you thousands of dollars down the line.

To highlight this point, I have used an instructive screen shot from Edmunds.com below:

Notice that the Honda Civic, priced at $21,588, is the most expensive car among those compared above. However, it turns out to be the cheapest of the lot when you compare the true cost of ownership ($32,236) over 5 years. As an example, compare the Civic with the Chevrolet Cobalt which has an initial price of $19,439 and the true cost of ownership of $37,182. In this case, you could potentially save $4946 over 5 years by choosing the Civic over the Cobalt, although Cobalt’s price tag is about $2149 cheaper than the Civic’s price tag. That’s equivalent to a difference of about $82 per month for 60 months. Also, the savings will probably keep accumulating beyond 5 years considering the fact that the Cobalt will continue to depreciate at a faster rate than the Civic. Apparently, cars that appear to be cheaper at first glance may sometimes turn out to be more expensive in the long run.

I should mention here that the above numbers are specifically based on Edmunds.com’s assumptions/calculations and they may or may not accurately reflect reality (plus, there will be some geographical variation too). However, for comparison purposes, these numbers are good enough (in my opinion). An example of how the “True Cost to Own” is calculated is shown in the image below (it’s for the Honda Civic that we discussed earlier).

Although, all the data above are for new cars, it would be somewhat fair to extrapolate the relative costs comparison (based on the nature of depreciation and operating costs) to used cars as well. Just keep in mind that, as cars age, their maintenance and operating costs (and sometimes their depreciation) are increasingly determined by how people use them…this calls for more caution when comparing used cars.

So, the next time you are looking for a new or used car, make sure you address the issue of the true cost of ownership, in addition to whatever other cost-reducing measures (like low interest rates, more down payment, buy with cash, etc) you may employ…and see if you can save some major dough.

Of course, we could also discuss about saving money by buying used cars (or not buying cars at all), but that’s not the point here…we will do that some other time.

Btw, I had to obtain a copyright permission from Edmunds.com for publishing the data in this post, and should probably mention a small statement that they emailed back to me with their approval:

Please note True Cost to Own^sm and TCO^sm are proprietary service marks of Edmunds Inc., for which we have applied for Federal trademark registration.

Here are links to a couple of interesting articles I was reading today morning.

• Yes, You Can Live Rent Free @ Kiplinger.com: There is some discussion about concepts like “house sitting”, “roommate bartering”, and “home sharing” from a point of view of reducing (or eliminating) your rent. The article points towards some resourceful websites like SabbaticalHomes.com, RoommateExpress.com, and National Shared Housing Resource Center regarding these concepts.
• Financial Fundamentals - Tip Top Tips for 2007 @ KeyBank: The link points to a PDF file. There are a dozen common sense tips in the document; not in great details, but in a succinct summary format. Pretty handy if you want to print and keep it as an easy-access reminder. (print it and may be stick it in your restroom…in such a way that you will read and understand it everyday )

Also, I want to remind you all of the $100 “anything you want” giveaway that’s currently running on this blog. Don’t miss your chance to ask for that personal finance book or magazine that you always wanted, but never bought. Entries will be accepted till Thursday, 29th March.

In other news, things are getting a little busy around here, and it’s taking a bit of an effort to get to the keyboard. Teaching sleepy undergrads @ 8:00 am in the morning is incredibly exhausting.

I have been digging up information from a lot of sources on the subject of investing in gold after my last post “Gold as Investment: The Basics“. I have to admit that it’s a bit intimidating to find stuff about gold investing that really makes sense for a rookie like me. I constantly came across many articles that say something to this effect: “gold is a hedge against inflation” or “gold is an insurance against inflation”. However, I had difficulties in understanding some of these terms, and most articles raised more questions for me like “what do you mean by insurance against inflation” and “what has gold got to do with it”? I will try to address some of these questions in this post in an overly simplified manner.

Gold prices: First and foremost, it is important to understand that gold is a *global* commodity. The price of gold is set by considering the global supply and demand. The term “supply and demand” incorporates the difference between annual gold production from gold mines and annual demand, as well as, the changes in public sentiments. This is slightly different than other commodities like onions or gasoline. Gold is not *consumed* in the same way as most other commodities. Till date, about 155,000 tonnes of gold has been already mined (as compared to just about 2500 tonnes produced annually) and almost all of it is still lying around with people (or governments) in some kind of physical form (usually referred to as “aboveground stock”). Because of this huge aboveground stock, gold prices can change in two ways: 1. gold prices can rise or fall if the production from the mines is decreased or increased, and 2. prices can also rise or fall if people (or governments) suddenly start buying or selling gold (even if gold production is held steady).

In addition to the supply-demand factors, the price of gold also depends on the value of the currency with which you are buying the gold. This is a bit complicated and I will try to explain it in the following section, while I explain why gold is considered as an insurance.

Before I end this section, I want to quote an interesting take on why gold is something more than just a commodity (this may also explain why gold prices are more difficult to understand than other commodity prices). The excerpt is from an article titled “Understanding the gold price” by Paul Van Eeden:

If gold is a commodity like rice or aluminum, then it should be priced as such. It would seem that under such circumstances, gold is the most overpriced commodity in the world. The value of gold as a commodity stems from its physical properties: electrical and thermal conductivity, resistance to corrosion, malleability and ductility. The biggest market for gold will be in the electronic industry where it will compete with other metals, notably copper. If gold were to truly compete with copper in mass production of electrical components then the price of gold would have to be competitive with the price of copper. Copper trades for around $0.80 a pound and gold for more than $4,000 a pound. This means that the gold price would have to drop to less than $0.06 (six cents) an ounce to be in the same region as the copper price. Obviously gold is not being priced as a commodity. There is a demand for gold that inspires people to pay substantially more for it than its commodity value. Gold is money.

Gold as insurance: On one of the gold trading websites (Austin Rare Coins and Bullion), I read this:

In the case of the most severe circumstances like high inflation or currency deflation, gold offers you both safety and security.

To understand what such statements mean, let’s consider a hypothetical situation in which the value of 1 Australian dollar (1 AUD) is equal to 1 US dollar (1 USD), and you can buy 1 ounce of gold in 1 AUD or 1 USD. Assume that there is some kind of a supply-demand equilibrium and gold prices are not affected by it. At this time, the price of gold as perceived by a person in the US is $1 (USD) per ounce. Also, it is the same $1 (AUD) per ounce as perceived by a person in Australia.

1 USD = 1 ounce of gold = 1 AUD

Now, assume that the US dollar falls in value (inflation happens - you need more dollars to buy a certain thing/commodity than what you needed before inflation) against the Australian dollar. Let us say that now it will now take you 2 USD to buy 1 ounce of gold or 1 AUD. This has nothing to do with the *global* price of gold and the equation will look like this:

2 USD = 1 ounce of gold = 1 AUD

When this happens, for a person in the US, the price of gold has suddenly shot up by 100% to $2 per ounce, whereas, for the Australians, it is still $1 per ounce. This is where the *insurance* comes into play. If you had just kept your 1 USD as paper money, you buying power would have been reduced to half after the inflation. Whereas, if you had bought 1 ounce of gold before the inflation, you could get 2 USD in return for that one ounce of gold after the inflation…so basically, you could keep up with the inflation by buying gold. This is what is generally meant by “gold as an hedge/insurance against inflation”.

Also notice that for a person in the US who bought gold before the inflation, there is an apparent gain in the net worth due to rise in the gold prices. But, in our example, the global gold prices did not change (Australians are still paying 1 AUD per ounce of gold) so the rise in the prices is just US specific….just goes towards showing that one has to be careful in interpreting historical gold price data based on US dollars.

Btw, sometimes the US dollar gains strength globally in spite of inflation (from what I have read) and makes it even more difficult to understand gold pricing…but things/concepts like those have “not-for-rookies” stamped all over it …so I am not even daring to go in that direction.

That’s all for this time.

In the next post of this series we will start with some pros and cons of gold as investment…in a way that will be useful for a someone who is just interested in buying some gold…and doesn’t care much about the dynamics of gold economics (people like me).

Feel free to suggest any corrections/modifications/additions to the above write up in order to make it more useful for people who are starting out in this area.

If you are interested in reading details about gold pricing and it’s relation to inflation and related concepts, here are some references (these are also the references I used for this post):

• Understanding the gold price - by Paul Van Eeden
• Gold as an investment - Wikipedia
  
• Gold and inflation - by Eric Hommelberg (it will take you a while with this one )
• Gold a commodity? - by Paul Van Eeden
• Gold and inflation by John Lee
  
• Gold an inflation hedge? - by Robert Blumen

Image source: www.everythinginvestment.co.uk

I found this garment label on the road, just outside my workplace. Couldn’t resist a chuckle.

This is by far the easiest and the cheapest way to get slim as far as I know.

And don’t worry, if you don’t get slim within a period of one year ..there is a *one-year full warranty* on it. Just go ahead and return the garment for a full refund.