Friday, August 25, 2006

About Mortgages

What is mortgage? A mortgage is a legal contract that says that if you don't pay your loan to the lender, the lender can repossess your home and sell it. So it is very important to know whether or not you can afford paying the monthly payment before deciding what kind of house you want to buy.

What does the monthly mortgage payment made up of?
1) Principal. This is the total money you are borrowing from the lender (after your down payment).
2) Interest. This is what the lender charges you for the loan, which is the percentage of the total amount of money you are borrowing.
3) Taxes. This is property taxes. Money you pay into the property tax are usually put into an escrow account, which is handled by a third party. A portion of your property tax is added to your mortgage payment and are held in an escrow account until it is time to pay the state the property tax (which is usually once a year).
4) Insurance. These are usually just hazard insurance to protect your home against fire, flood, wind, theft, etc. It may include a PMI (Private Mortgage Insurance) if you did not make a down payment of at least 20%. PMI protects lenders in case you default on your loan.

How do payments work? In the first several years, majority of your payments are paid toward the interest. As time goes on, more of your monthly payment will go toward the principal.

Before you go out and look to buy a home, you should first see if you qualify for a mortgage. There are two types of the qualification process. One is called "pre-approved" and the other is "pre-qualified." While these two words sound similar, the qualification process is different. When you are "pre-qualified," that means you given the lender your income level, your credit and debt information, and the lender ESTIMATES what you can afford. When you are "pre-approved" this means that the lender has done the extra work to put you CLOSER to the loan. Pre-approval process consists of: Credit report check, debt-to-income ratio check, and in depth analysis of your current financial situation.

In the next few blogs, I will talk about various types of mortgages. These are:
1) Interest Only
2) Balloon Mortgage
3) Adjustable Rate Mortgages (ARMs)
4) Fixed-rate mortgage
5) Government mortgages such as FHA or VA

Monday, August 07, 2006

About credit cards and budgeting

Credit cards or what I like to call "plastics" can come quite handy when you don't have lots of cash on you. It is important to know that credit cards are not money. It is more of a loan that you must pay back. If you don't pay the minimum balance, which is usually around $10 to $30/month, this will be reported in your credit report and will stay there for a very long time. Not only would it be reported, your credit score will go down as well, which is used by financial institutions and lenders to see what interest rate you qualify for.

There are two types of credit cards: fixed credit and revolving credit.

What is fixed credit? This means whatever you buy today, you must pay off the whole balance by the end of the month.

What is revolving credit? This means as long as you pay the minimum balance on your credit card, you can continue to use the credit card for next month. Any remaining balance on your credit card will be charge an interest. This is the most common used form of credit cards.

You might of heard or read the news that consumer debt is in the trillions. This does not include mortgages, which is too big of a number to say. My theory on how this happen is that Americans are spending freaks. We like nice things and we sometime go overboard that is well over our spending limit. If we max out one credit card, we can always apply for more. While spending is good for the economy, spending more than what you make is really bad for you because you are going to find yourself to be in debt for a very long time.

To avoid putting yourself in big debt, spend what only you can afford. Make a budget or put up a spending limit. To do this, figure out how much money you make each month. Then deduct bills you have to pay such as mortgage, utility bills, maintenance, etc. Then deduct how much money you want to save toward retirement. And from that, this is how much you should spend and divide that by 4 or 5 to see how much you can spend each week.

So here's a typical example on how a budget should look like (you can add more if you want to the list):
Let's say you make $42,000/year. Divide that by 12, that's $3500/month.
You have a mortgage bill of $950/month,
utility bills (phone, electric, water, heat oil/gas) of $400/month,
maintenance (such as your car, including gas) of $200/month,
and insurance (life, car, home, health) of $1000/month.
This leaves you with $950/month to spend. Let's say you want to save 10% of that ($95), so you now have $855/month to spend on food, clothing, supplies, and other things.

If you decide to buy an expensive item such as $2000 TV, then deduct your monthly spending by whatever percent you like (such as 20%) so that you can pay off this $2000 TV faster. If you finance the TV where you don't have to pay it for another year, then open a 12 month CD and then use it to pay off the TV.

The goal in life is to not be in debt for a long time and at the same time be able to save for retirement. I wish you all best of luck on creating a successful budget and on your goal on reaching financial independence when you retire.

Sunday, August 06, 2006

Cash value life insurance vs Term insurance

What is life insurance? Life insurance is an insurance contract that pays your beneficiary (which are usually family members) a sum of money upon your death. Main reason why people purchase life insurance is to protect the family from financial loss, otherwise known as "income protection." There are currently two types of life insurance out there available to the public. One is known as "cash value" life insurance and the other is known as "term insurance." If you have life insurance right now, it is important that you read your policy. The information given in this blog comes from my life insurance text books and from experience of reading many of my client's life insurance policies.

What is cash value life insurance? It is a term policy to age 100 that contains a savings vehicle in it. Cash value comes in many forms, such as whole life, universal life, variable life, or a mixture of those words together such as variable universal life or universal whole life, etc. The advantages of having cash value life insurance is that you are protected until age 100, you can use the cash value anytime for any use such as paying your premiums, and interest on your cash value is tax-deferred.

The disadvantages of having cash value life insurance is that you are paying lots of premiums for low amount of coverage, no cash value is accumulated during first two years of the policy, rate of return is very low, and if you use any of the cash value, you will owe monthly interest on it. This interest does not go back into the cash value, but rather kept by the insurance company because the money you taken out of the cash value is treated as a loan. In many policies, if you were to die, your beneficiary will receive the face amount and all cash value will be kept by the insurance company. Keep in mind, if you use any of the cash value and you did not pay it back, this amount will be deducted from face amount upon your death.

Another disadvantage of cash value life insurance is that they are riddle with insurance fees. The most noticeable fee is the surrender charge. This is clearly stated in the policy of how much cash value you will get if you surrender the policy. Then there are fees you don't see such as administrative fees, policy fees, maintenance fees, and all these other operating fees. If your cash value life insurance is a variable policy, that means your cash value is invested in the stock market. Investments too have their own operating fees. If you combine investments and life insurance together, now you have so many different fees that eats away the returns on your investments.

You are probably asking, why would anyone buy this kind of life insurance? First reason is that many people do not understand how this policy works. Second reason is that people don't buy life insurance, they are sold on it. The agent who sells cash value life insurance does not care about you or your family. All he/she cares about is how much commissions he/she is getting paid and they going to use whatever deceptive sales tactic to make you buy it.

So, what is term insurance? It is the type of insurance that provides a level death benefit for life. Just like car insurance, if you don't pay your premiums, you will lose coverage. Advantages of having term insurance are: premiums are very low during the term, you have more flexibility to invest your money in a savings vehicle (hence the phrase, "buy term and invest the difference"), and if you were to die during the term, your beneficiary will get the face amount and all your investments. Another advantage is that you can change the amount of coverage without affecting your savings and vice versa. (In cash value life policies, you are stuck with paying into both.)

The disadvantage of term that while premium remain fix for certain amount of period (10, 15, 20, 25, 30, or 35 years), the premium will go up when it is time to renew. Majority of term policies provide renewable term coverage up to age 100. But there are some term policies that stop coverage after the level term expires because the insurance company wants you to convert it to whole life or universal life.

Why would people buy term insurance? First, premiums are very low and remain fix during the term. In the early stages of your adult life, you probably have lots of debt to pay off such as your mortgage, you probably have kids to support, and you probably don't have much money saved for retirement. So you need lots of insurance coverage to protect the family. As you get older, your kids are all grown up, your mortgage is or almost paid off, and you better have lots of money saved for retirement. As you get older, you probably won't need life insurance or need as much coverage as you did 20 to 30 years ago.

What happens when the level term expires? When the level term expires, you enter the phase of the contract called "Annual Renewable Term." That means you have the right to renew the term without having to provide proof of insurability. The premiums will go up every year or so (check the policy on how often the premiums goes up after the level term). Depending on your policy, you are usually given several options when the level term expires.
(1) You may convert it to a permanent whole life policy (which I don't recommend).
(2) You may exchange it to another level term (I recommend that you significantly lower your coverage amount to a minimum of $20,000). You may need to provide proof of insurability.
(3) You may refuse to pay the premiums to cancel the policy (if you do this, I highly recommend that you allocate the money toward your retirement).
(4) You can change the death benefit to the amount you really need. In most cases, the amount of coverage you need is usually lower than what you needed years ago. In fact, you probably won't need life insurance as long as you enough money saved.

If you have cash value life insurance right now and are probably pissed off about having it, you should figure out what you want to do. Do you want to cancel it or should you replace it with term? It all depends on your current needs. If you have a problem with or questions about your life insurance policy, don't call the agent to get your answers because an agent's job is to sell life insurance, so they won't say the bad things about your life policy. Call the company's phone number that is listed in your life policy (which is usually on the cover page).

If you are going to replace it with term, don't cancel your current life policy yet. First, you want to see if you qualify for term insurance, which you probably will if your health is not that bad. When you get your term policy, then you want to cancel your old life policy. There's a couple things you can do with your cash value. First thing you can do is that you can surrender it. You may have to pay surrender charges on it and you will owe income taxes on it, but at least you have choices on where you want to put this money. The second thing you can do (and is probably the best way to do it) is do a 1035 exchange, which moves the cash value into an annuity product or another cash value life insurance without any tax implications.

I have always sold term insurance and help clients invest their money 100% of the time. That way they are protecting the family's income for a low cost and at the same, building wealth for the future. It does not make any sense to bundle life insurance and savings together. Life insurance's main purpose is to protect your family's income in the event of your death, not as a way to build tax-deferred savings. Since term insurance is so inexpensive, I show clients on how to effectively build wealth. One way is to open an IRA, either Traditional or Roth. Money in an IRA grows tax-deferred. If they max out their contributions to an IRA, then they should put more money toward their 401(k) or 403(b) or whatever retirement plan they have at work. If they don't have an employer's retirement plan, then a variable annuity would be the next choice, not a cash value life policy.

If you are going to meet with your agent to go over your life policy, you want to record everything he says. That way you can review it with your attorney or send it to your state's insurance department to find out if he is telling the truth. If he is lying, you can take lots of legal action against him and his company.

Other facts:
What is a dividend in an insurance policy? It means that you are over paying your premiums and the life insurance is returning (or refunding) it as a dividend. Keep in mind, this is not the same as receiving dividends on mutual funds. Dividends in mutual funds are only paid out if profits are recognized that year, so shareholders will get a share of that dividend.

Getting separate insurance policies will cost you lots of money in the long run. Each policy cost about $100 to maintain each year. If you have multiple policies on yourself, you should immediately change your life insurance agent and probably the company as well. There is no reason why you should have more than one policy on yourself. It is best to add "riders" to the policy such as spouse rider and child rider. That way the whole family is protected under one policy.

Some of you seen the word, "unit" on TV commercials. A unit represents one-$1000 worth of coverage. I seen commercials for retire people where one unit cost $8.75/month. In your mind, you are thinking thats very cheap. If you do the math, you will find out that's very expensive! If you wanted $100,000 coverage, thats 100 units. 100 time 8.75 = $875.00/month you need to pay for life insurance. I have a 30 year term of $500,000 coverage when I was 30 years old and I pay $475/year for it. Notice I wrote "$475/year" not $475/month.

All life insurance policies are term life policies. They all provide protection up to a certain age (usually age 100). Whole life insurance is a level term with a savings plan attached it. Let's hypothetically say you pay $100/month, $25 goes toward insurance and $75 goes toward cash value (supposedly, but all insurance policies has some sort of fees, so its not really $75).

Universal life is an increasing term with a savings plan. Continue with the hypothetical example, next year, $30 goes toward insurance and $70 goes toward the cash value. As years goes on, all your premiums goes toward the insurance and none goes toward the cash value and the premiums will continue to increase. That's why a universal life policy gives you two different payment option. You can either pay the minimum premium or pay the target premium.

Cummings, William H and Spears, J. Mac. The L.I.F.E. System. Indianapolis, IN: Pathfinder Corporation, 2003.

"ACLI Fact Book 2006." American Council of Life Insurers. 1 Jan 2006