Liquidity Preference, Opportunity Costs, and Arbitrage: Home Mortgage Edition

I was at a social outing last week, and during the conversation the subject turned to mortgages. The host averred his strong preference for not carrying a mortgage. “Just pay it off, and then you don’t have to worry about making that payment every month. Besides, I can’t stand paying all that interest every year.”

Now, most Americans do not have the wherewithal to pay off their mortgage 100%. Indeed, for most people paying off a car loan would be a stretch. But I could, and yet I continue to carry both a car loan and a home mortgage. So I thought I would write about why it can be a good idea to continue carrying debt, when you have enough assets to pay it off.

First and foremost, cash keeps your options open. Let’s say you have $100,000 in debt. Also suppose you have $100,000 in cash. You could extinguish all of your outstanding debt. But then, you would no longer have any cash on hand. You better hope the transmission in your car doesn’t go out, or the roof doesn’t leak, or any of a hundred possible contingencies does not occur. Because then you’ll wish you had held on to more of that cash.

The desire to keep cash on hand to cope with life’s curve balls is what finance professors call liquidity preference. Personal finance experts recommend you keep three to six months worth of cash on hand for just that reason. Okay, but going back to our hypothetical example, unless you’re a member of the 1%, you probably do not need $100,000 on hand to fund your lifestyle for six months, or even a year. Why not pay down the mortgage?

You give up the chance to do something better with the money, what economists call opportunity costs. Let’s run a more complicated version of our original scenario. This time we’ll start from the same place: a $100,000 mortgage and $100,000 in cash. Now we decide to hold $50,000 in cash for emergencies. We can use our remaining $50,000 in one of two ways. We can either pay off $50,000 of our mortgage, or we can pay $50,000 of Verizon stock. Verizon currently has a dividend yield of 5.15%, so our fifty grand would give income of $2575 a year. There is a little risk with holding the stock, but unless people stop making phone calls it is a pretty safe bet.

For the mortgage, assume a 15 year fixed rate mortgage at 3.5%. If you borrow $100,000, you will pay $3418 in interest the first year, and have dividend income of $2575. The net cost of the borrow and invest strategy is $843.

If you down debt and only have a $50,000 mortgage, you will pay $1709 interest the first year. Paying down debt will cost you $866 over the alternative strategy. Since the interest payments will drop each year of the mortgage, but the dividend payment should remain constant, the borrow and invest strategy will outperform the pay down debt strategy by a greater amount every year. By the fifth year, you will be $1152 ahead with the borrow and invest strategy.

Borrowing at a low interest rate and investing at a higher rate is an example of arbitrage, and it is one of the ways that the big boys on Wall Street earn their huge bonuses. They add a lot more zeroes to their numbers, of course.

I’m not saying you shouldn’t pay down debt, and there is something to the psychological lift you can get from not owing any money. But being debt free is not necessarily the best strategy for maximizing your financial well being.

2011 Goal Setting

I let other people make New Year’s resolutions. I do goal setting. I had a lot of success with my goals for last year, hitting the mark on eight out of nine. My targets for the year ahead will be pretty similar to last year’s, with some tweaking around the edges. The objectives fall into three rough categories: personal finance, professional development, and private life.

Personal Finance
Save 20% from earned income. The heavy lifting on this goal is done by salary contribution to a 401K, with accompanying company match. That combination gets me to 15%, with the last 5% done the old fashioned way—not spending all of my take home pay.
End the year with less than $70K in debt. The deleveraging that started in 2010 will continue in 2011. Working against that is my plan to buy a new car before the end of the year. Since I pay off my current car loan in March, every month I defer that big ticket purchase allows me to build a bigger down payment on the new vehicle. Meanwhile, I will continue to make extra equity payments on my home mortgage. The goal of $70 K is actually $10 grand more than 2010’s goal, but I’ll be trading a fully depreciated asset for a new one.
Earn $2000 from outside sources. Last year the target was to earn $2 grand from tax prep with H & R Block. I was only able to get halfway there. If tax preparation isn’t enough this year, I will have to find some other kind of moonlighting gig to take up the slack. Needless to say, my day job comes first.

Professional Development
Take 9 credit hours of graduate accounting classes. With the classes already taken, accomplishing this goal will get me 2/3 of the way towards finishing the prerequisites for a Masters degree in accounting.
Build two new Access databases. One of the classes taken last year was a course in database programming. The student project is up and running, although it still needs some tweaking. The goal here is to deepen and extend that knowledge by building two new projects.

Private Life
Run 60K of road races. I’ve upped this from last year’s goal of 50K. At least one race will be at the longer 10K distance.
Entertain at home at least once a month. This encompasses everything from private dinner parties to blow out barbeques with thirty guests.
Read Proust’s “Remembrance of Things Past.” I’ve only got 3700 pages left to go. In addition to Proust, I’m going to continue with my Shakespeare reading group for at least another six plays.

I keep these goals written on a Post-It note on my desk, to keep them present for all year long. I’ll post on my progress around the mid year mark.

2010 Goals: Progress Report

We’re a little past the halfway point of 2010, so I thought it would be a good idea to review the progress so far towards my personal goals for the year. It is an axiom of management that you don’t get what you want, you get what you measure. This is as true in one’s personal life as it is in business.

Goal: Run 50 kilometers of road races.
Status: Complete.
A heavy race schedule in March, April, and May, including one 10K, let me complete this goal by early in June. No races are set for the hot part of the summer, but they will pick up again in September/October time frame. I clearly low-balled this goal. Next year I may have to commit to a half marathon.

Goal: Complete three authors from The New Lifetime Reading Plan.
Status: Complete.
I tackled the English Lake District poets first: Wordsworth and Coleridge. Then I jumped forward forty years and read selected works from the American essayist and philosopher Emerson. Having plucked the low hanging fruit, I have started in on The Story of the Stone, a massive Chinese novel of the late Ming period. At 2500 pages in four volumes, this will keep me occupied until the end of the year. If I get through that this year, next year I may decide to take on Proust’s Remembrance of Things Past, all seven volumes of it.

Goal: Entertain at home 12 times throughout the year.
Status: Ahead of schedule.
Man does not live by money alone. A recent study showed that people who had a bigger network of friends tended to live longer. Within my experience, I would argue that they also live better. We are social animals, happiest in a group setting. So far this year we have entertained at home eight times. These have ranged from intimate dinners with another couple to outdoor barbeques with 30+ attendees. Party on, dude!

Goal: Save 20% of earned income.
Status: On-track.
Due to a larger than expected income tax refund, I was able to fund my Roth IRA with the equivalent of 5% of estimated earnings in the first quarter of the year. Between my contribution to the company 401K and the corporate match, another 15% is being added to my retirement funds. Now if only the stock market would recover and start growing again.

Goal: Reduce total debt to less than $60 K.
Status: Ahead of schedule.
Including the payments made at the end of July, I am now down to $62 K in debt from mortgage, car loan, and line of credit. I am paying down principle at the rate of $800 per month, including tripling the equity payment on the monthly mortgage. Debt reduction and savings rate are linked. I could apply a higher percentage to savings, and slow down on debt reduction. But I get a guaranteed 6.5% return on capital by drawing down my mortgage faster, and in today’s market that looks pretty good.

Goal: Earn $2000 at H & R Block.
Status: Failure.
I only made about $1000 during tax season this year. Including the training hours I put in, my hourly rate was very little better than minimum wage. After peak season was over, walk in traffic dropped down to zero, and I dropped my hours down to zero. No point in coming in just to sit in the office. I need to take certification tests to increase my compensation rate, but even then I don’t see myself hitting this goal next year. On the other hand, doing taxes does provide good blog fodder, so I’ll give it at least one more year.

Goal: Take 9 credit hours of graduate level accounting classes.
Status: On track.
My original plan was to take one class (3 credit hours) in Spring, Summer, and Fall semesters. After completing one class in Spring semester, I wasn’t able to find a summer class that fit my schedule. So I have doubled up, and am signed up for two classes starting in September. This is about half a standard academic load, and is more than I have ever taken since I started working. So we’ll see how this goes in the fall.

Goal: 60+ blog posts.
Status: On track.
Seven months into 2010, and I have kept my average of 5 posts a month. I need to focus on posting at least once a month for the balance of the year.

It is easy to focus on goals, and lose sight of the reality that the milestones and measurements are intended to represent. So, to put this progress report into a different perspective: I am healthy and fit, and enjoying time with a wide circle of friends and family. I am continuing to grow both intellectually and professionally, while storing up resources against the vicissitudes that inevitably come to everyone. Life is good!

A Favorable Omen

After the backyard barbeque and fireworks on the Fourth, I had a holiday today to recuperate. Later in the afternoon, I decided to go to the gym and try and work off some of the bratwurst and baked beans.

Walking up to the entrance of the gym, I noticed a small pile of change sitting on one of the platforms holding the faux columns that frame the entry. Three quarters, two dimes, and four pennies. Thinking that it could be some kind of trap, I restrained myself from grabbing the money on my way in the door.

After finishing my workout, I saw that the money was still there when I came out. Well, you don't have to tell me more than twice about free money before I go and see for myself. Half expecting some kind of hidden camera stunt to materialize, I snatched up the coins and pocketed them.

No one jumped out and accused me of stealing their money. So far, so good. Not only that, but as I walked across the parking lot, I spotted more change: a quarter here, a nickel there, a couple more pennies. My mama not having raised no fool for a son, I pocketed them as well.

Due to the long weekend, the coming week is going to be a short week at work. And now I'm up $1.31. Is this going to be a great week, or what?

New Year's Resolutions

I went to the gym this week, and the place was packed. Every machine had someone using it, and many of the machines had at least one person waiting their turn.

It’s always crowded this time of year. I attribute it to New Year’s resolutions. Folks get done with the holidays, resolve to lose some weight, and start going to the gym to work out. The crowds usually thin out by early March, as willpower gives in and old habits resurge.

I don’t really make New Year’s resolutions. My process is more like goal setting for the year. I start with areas of my life where I have commitments, than I develop tangible goals that relate to those commitments. It’s the underlying commitment that keeps me going, not the goal itself.

For 2010, my goals are based on three commitments. First, I want to push back against the decrepitude of the aging process. I’m committed to maintaining my physical capability to the greatest extent possible. Second, I’m going to increase my level of fiscal security. It is still a pretty dicey economy, and no job is certain in today’s world. Still, if I have to swim against the economic tide, I want to be the guy with fins on. Third, I’m committed to living as rich a life as I can, subject to the constraints of health and finances. Family, friends, and experiences enrich our lives, and I want as much of all of them as I can get. After all, you could move to a mountaintop in Idaho and subsist pretty cheaply, but who wants to live on a diet of potatoes?

In the area of health and fitness, my goal is to run 50 kilometers of road races throughout the year. When I run a 5K, I’m not competing against anyone but myself. I am not going to be the fastest runner, although I can win my age group if I’m the only one who shows up. However, the mere act of getting out there with other serious runners on a regular basis forces me to maintain a higher training level than I would without the road races. So far I’ve kept my body mass index below the 25 that is the threshold for overweight, and I intend to keep it that way.

In terms of economic security, I plan to work the problem on both defense and offense. By defense, I mean building up my cushion of assets in case I have to make an involuntary job transition. By offense, I’m talking about increasing either my current income, or my marketable skills.

On the defense side, my savings goal for the year is 20% of my earned income. Most of that will be automatic. Between salary deduction for my 401K and the matching corporate contribution, I’ll get to 15%. The last 5% will take the day to day discipline of saying no to temptation. Do without if you don’t need. Make instead of buy. Repair instead of replace. Since I am the least handy guy in North America, most of the heavy lifting in this category will be under the heading of “do without if you don’t need it.” I’m not planning on doing my own plumbing, or even changing the oil in my car.

I’m also going to continue the deleveraging project I started last year. By making extra equity payments on my mortgage (a guaranteed 6.5% rate of return), I hope to get my total indebtedness down below $60K, split between primary mortgage, home equity line of credit, and car loan. My credit cards will continue to be paid in full every month.

Increased savings improves my long term economic security. In the short term, I’m also taking steps to increase earnings and boost my marketability in a crummy job market. Tax season is starting, and I’m working for H & R Block again to make a little side money. The goal here is to pick up $2000 in additional income. This is just about what I pay my lawn service every year. Basically, I’m hoping to trade knowledge work in a climate controlled office for dirty, physical work outside. Based on last year’s results, $2000 will be a stretch. I may have to develop a Plan B to make up the balance of what I don’t earn doing taxes.

I’m also going back to school again. Post-MBA, I started taking graduate level classes in accounting last fall. My intent is to pick up 9 more credit hours in 2010. By taking one class in Spring, Summer, and Fall semesters, I’ll only need one more class to have enough credits to teach at the college level. Also, if the worst occurs at my current job, more accounting knowledge will help me stand out from the other job seekers out there.

But man does not live by bread alone. I could easily save more money by sitting at home watching television, only venturing out to work, jog, or attend classes, but that would be boring. Besides, my wife would only take so much of that before she snapped and smothered me in my sleep. So in addition to struggling to get rich, I’ll expend considerable energy and time into enriching myself in ways other than monetary.

It has been a few years since I’ve been out west on vacation. It’s a big country, and I want to see more of it. So one of my 2010 commitments is to visit one of the National Parks that I haven’t seen yet. The documentary maker Ken Burns calls the National Park system “America’s Best Idea.” I’m leaning towards Yosemite in Northern California, maybe in combination with a trip to the wine country.

There is an old saying: “No man is poor who is rich in friends.” I don’t have too many friends who will volunteer to pay my light bill, but I still cherish them. To celebrate and enjoy my friends, I’m committed to holding 12 in-home entertainment events this year. This covers everything from formal dinner parties to backyard cookouts to our annual Christmas party (even if I do end with the Chia pet playing “dirty Santa”).

The last of my enrichment projects is internal. Along with the formal education I’ve addressed above, I’m continuing to read authors from “The Lifetime Reading Plan,” a book I first discovered in my father’s library over thirty years ago. My goal for this year is to tackle three of the selections in 2010.

Finally, I’m going to continue posting in this blog. The goal here is a minimum of 60 posts over the course of the year, at least once a week.

After all, everybody deserves my opinions. And now back to our regularly scheduled productions.

Happy New Year, Part II

In my last post I discussed the theme of deleveraging for 2009. By deleveraging, I mean reducing the ratio of debt to equity on both household and corporate balance sheets.

There are a number of ways an individual household can reduce leverage. Probably the most painful is to have your house foreclosed on. Since a home mortgage is typically the largest source of debt for a family, losing your home means losing most of your debt all at once. Not recommended, but if your mortgage payment is greater than market rent, moving into a rental will free up your cash flow.

A bankruptcy is less effective at reducing leverage than foreclosure. Most states protect your home equity during a bankruptcy filing. You can drop most of your credit card payments, but you still have the debt associated with your mortgage. Foreclosure and bankruptcy have got to be the two most painful ways of deleveraging.

The least painful way to reduce debt is to reduce current consumption and divert more of your cash flow into paying off debt. Whether paying off credit cards or making extra equity payments on a mortgage, either way you are reducing household debt.

Actually, it may be even less painful to increase income and put that extra money into debt retirement. Start up a sideline business or get a part-time second job. But in today’s market, those options may not be as readily available as they were even a year ago.

In the struggle to pay off debt, there are two schools of thought on which debts to pay of first. One school holds that the best idea is to focus most of your effort into paying down the debts with the highest interest rates. That way you lower the burden of finance charges faster. The other school of thought is to pay down the smallest debts first. This technique gives you small victories as you eliminate one debt after another.

Whichever technique you use, I’m more interested in the timing of the payoffs. Unless you are paying truly outrageous interest rates, the best response to an uncertain employment outlook is to build your cash position with additional savings.

Consider: both foreclosure and bankruptcy are not a function of the amount of debt carried. They are a function of cash flow. If you do not have enough cash to make all of your payments every month, you start to fall behind. It is the inability to make payments that drives people into bankruptcy. Exacerbating this is that most lenders pile on late fees and higher finance charges once you have late or missing payments.

Let’s say you are doubling up on the equity payment on your mortgage, and have been for years. The extra equity payments have shortened the term of the mortgage. You will pay it off in 15 years instead of 30. In the meantime, however, you have to keep making your payment every month.

Now you lose your job. If all your extra cash went towards paying down the mortgage, and you don’t have a substantial cushion, you are one month away from being delinquent on your mortgage. The fact that you made all those extra payments won’t cut any ice with the bank. They still want their payment every month.

So my plan is to continue making all my payments every month while I increase my cash reserve. Once I have enough extra money put away to extinguish a debt like a car loan, then I’ll pay it off all at once. It will require more discipline to hold onto the cash, rather than funneling the money directly to the lenders on a month by month basis. I may have to pay more in finance charges. But I’ll sleep better at night knowing I have the ability to ride out any unforeseen financial storms.

In a world of rising unemployment and falling real estate values, cash really is king.

Happy New Year!

At the beginning of the New Year, I like many others, make resolutions for the coming twelve months. Sometimes these resolutions actually come to fruition (2008: start a blog), sometimes the hard realities of December bear no resemblance to the wishful thinking of January (2008: increase the value of my portfolio by 15%). Nonetheless, I find value in the exercise of goal setting. It helps define my priorities for the coming year.

Sometimes as you take stock at the end of one year, and you review progress against your goals, it becomes an exercise in shoulda, woulda, coulda. For example, I sure wish I'd gotten 100% into cash in the first half of 2008. Ah well. I'll just keep telling myself that I'm investing for the long haul. That makes it feel okay. Really, it does.

Anyway, I've decided that my financial theme for 2009 is deleverageing. My spell check doesn't like the term, so maybe deleverageing isn't in the dictionary yet. By the term the current financial crisis is in the history books, it will be.

In financial terms, leverage is a way of expressing the ratio of debt to equity. For example, if you buy a house with a 20% down payment, and take out a mortgage for the other 80%, you have leveraged your equity four to one. As you make your mortgage payments, your reduce the leverage as you build equity. This happens very slowly in the first years of the mortgage, than picks up speed as a larger and larger percentage of your mortgage payment is focused on paying down the principle balance.

The current crisis in the financial markets was brought on by excessive leverage during the housing bubble, both by consumers and institutions. Consumers bought houses with no money down (essentially infinite leverage), or they extracted all of the equity from their houses through home equity lines of credit. After all, if the value of housing had kept going up, they would have created equity out of thin air. Why not borrow against that? It seemed like a good idea at the time.

On the institutional side, banks were dumb enough to make those loans. The investment banks on Wall Street were dumb enough to repackage those loans and resell them, and institutional investors like insurance companies and pension funds were dumb enough to buy them. After all, if the home owners stopped paying their mortgages, the collateral (the houses) would be worth more than the original loans. Why not loan against that? It seemed like a good idea at the time.

It seemed like such a good idea that the Wall Street investment banks borrowed hundreds of billions of dollars to amplify the returns on the firm's capital. After all, bonuses were paid based on returns on capital. These guys were capitalists, says so right on the brochure. So when the housing market started to turn downward, a lot of the banks and investment banks were highly leveraged, 20 to 1 or even 30 to 1.

The upside of leverage is that when you are making gains, those gains are amplified by the amount of leverage. The downside of leverage is that when you are taking losses, the losses hit your capital by the same degree that gains boost it. So if you are leveraged 20 to 1, that means you have 20 dollars of debt for every dollar of equity. A 5% loss on the value of your assets is enough wipe out your equity.

Picture a bank holding most of it's assets in residential mortages. Foreclosure rates have more than doubled since 2007, and housing prices have dropped an average of 18% in the last year. Banks are taking losses of way more than 5% on their loan portfolios. When your debt is greater than the combination of your assets and your equity, that is the technical definition of insolvency, also known as bankruptcy. Ouch.

Financial institutions have spent the last year trying to raise capital, either by selling shares of preferred stock or by selling assets or by raising cash by cutting expenses like dividend payments. If leverage is the ratio of debt to equity, having more capital lowers leverage. For consumers, leverage is also being reduced. When you mail the keys to your house back to the bank, and move into a rental, you have reduced your personal leverage by the amount of your mortgage loan.

The bottom line is that when you reduce debt, you deleverage your financial position. So the process of reducing debt is deleverageing, however you spell it.

The thing about deleverageing is that it is a lot less painful when you do it willingly, before circumstances force you into it. It is a lot easier to tighten one's belt and build your rainy day fund, than it is to deal with foreclosure, or even escalating late payments because you missed a credit card payment.

Having established the theme of deleverageing for 2009, the next question is whether it is better to pay down debt or build up cash. I'll take up that issue in another post.

Ed McMahon

“Call no man happy, until he’s dead.”—Herodotus

Every so often real life intervenes in an argument, bringing a concrete example to an abstract argument so spot on that you could not make up a more telling example. Such an event can be pulled from last week’s news stories.

For those who missed the story, Ed McMahon’s house in Beverly Hills is being foreclosed on. Yes, that Ed McMahon. “Here’s Johnny!” “Send in your reply to Publisher’s Clearing House. You may already be a winner.” That guy.

Ed McMahon earned millions annually as a top ranked television personality and pitchman. Make that: he earned millions annually for decades. He is now over $644 thousand in arrears on a $4.6 million mortgage is took out only a few years ago.

When asked about why he is in arrears, his response is that it is because of his inability to work for the last eighteen months due to a neck injury.

The dude is 85 years old! Who the heck goes through life thinking that having to work in your eighties to keep from getting evicted is a workable game plan?

I have been arguing that true wealth is not related to your lifestyle, or to how much you earn. True wealth starts when you have the financial security to continue with your current lifestyle, even if you can no longer continue working. Exhibit number oneof how not to do this is Ed McMahon. I rest my case.

The Three Zones of Wealth

In my last post I talked about wealth, and how you could define being wealthy. Being wealthy is not defined by your earned income, and is certainly not defined by your lifestyle. With the collapse of the housing bubble, we are seeing plenty of people who are not only losing their jobs, but whose lifestyles were supercharged by pulling equity out of their homes and spending it. The lifestyle was never sustainable over the long term, and the job loss just accelerated the crash.

For me, wealth means passive income. Loosely defined, passive income is money that comes to you with little or no work on your part. Another way of putting it is with the old saying “Have your money work for you, instead of you working for your money.”

Just because you have passive income doesn’t mean you’re wealthy, however. You have to have enough of it. I’ve got both interest and dividend income that I list on my tax return, but I’m a long way short of being able to retire.

And that brings me to what I really want to write about today. I view wealth as happening in three zones, each of which defines a different way of looking at what it means to be wealthy.

The first of these zones is what I call retirement wealthy. Sometimes I hear this being described as financial independence. You enter this zone when you have enough passive income to pay for your current lifestyle. Once your dividends (or royalties, or rent, or bond interest) are enough to cover your expenses, you’ve got a choice: keep working for income, or retire and do what you want to do. I think this is what most people would define as being rich.

To achieve this state, you have to work both offense and defense. Offense, in terms of increasing your passive income (maxing out your 401K, e.g.) and defense, in terms of decreasing your living expenses (drive used cars, clip coupons).

The next zone of wealth starts where considerations of defense can fade away. You want to go to Tahiti for a week? Charter the jet! Seventy-two inch TV catch your eye? Buy it! This is the level of wealth where you have people to handle the mundane details of daily life. You don’t sit around the house all day waiting for the cable guy. That’s what the housekeeper is for.

Once you have entered the first zone of wealth, the longer you keep working, the closer you get to the second zone. After all, if you are not spending all of your passive income, then it will continue to compound on you. Money is the only animal that will only breed in captivity.

The third zone of wealth is what I call Future Old Money. I saw an interview with the country singer Garth Brooks once. One of the things he said was “I have more money than my children’s children will be able to spend.” Future old money. Fifty years from now, Garth’s grandkids will be toasting him at their dinner parties for making their lives of leisure possible.
Most personal finance writers concentrate on the first zone of wealth. After all, that is the zone that all of us can reach. It only takes time, discipline, and a modicum of knowledge. And most of the focus is on what I call defense, reducing expenses, if only to free up capital to invest.

To get into the second and third zones, however, you’ve got to win big. Even if we saw a way to do that, most of us don’t have enough appetite for risk to get there. I certainly don't.

Card Wars

I realized something today. I don’t know the interest rate on either of my two credit cards. I use an American Express card for most purchases, and I have a Visa for the places that do not accept Amex.

The topic came up because I was talking about personal finance with a coworker at lunch today. We were discussing how people can get in over their heads with credit cards, and how that can force people into bankruptcy. She told me that she didn’t understand that, because she had a low rate on her credit card. “It’s only 2.9%, but I don’t even pay that because I pay off my balance every month.”

I also pay off my balances in full every month. And because I have been doing that for as long as I can remember, the interest rate on the card is irrelevant to me. What is relevant to me is that I get air line miles from my credit card.

The important thing to remember about the credit card industry is that they make money from two income sources. First, they make money from the interest charges paid by cardholders. But a more reliable source of income is the fees they charge merchants to process the transaction. These charges can be upwards of 2% of the cost of the item being charged.

So let’s say you’re American Express. Most Amex users are businesses who pay their bills in full every month. When I charge something using my card, Amex pays the merchant 98% of the purchase price right away. I pay Amex 100% back, on average a month after I buy the item. If you are getting 2% a month for the use of your money, that becomes a 24% rate of return on an annual basis.

Since American Express is raising capital in the public markets, their cost of capital is (just a guess) around 6% a year. With borrowing money at 6%, and getting a return of 24%, the differential is an 18% return. If you are making that kind of return, you can offer considerable rewards as part of your marketing plan.

But not considerable cash back. If Amex offered 1% cash back, that would lower the differential to 6% a year, which doesn’t leave a lot left over after operating and marketing costs are taken out. So the card companies that offer that kind of cash back are depending on the first source of income: interest charges paid by cardholders.

So far, I know of only one credit card company that would let me check out the tradeoffs involved in getting rewards such as cash back. So I checked out the Capital One Card Lab, which you can find here. With excellent credit, a menu of options pops up. Choosing one option, like 1% cash back, removes other options, like some of the interest rate choices.

Ohhhh, a game! Let’s play!

After playing a few rounds, I settled in on 2% cash back on gas & groceries, with no annual fee. If I agreed to a 20% APR, they’ll set the APR at zero for the first year. So I could use their money for a year, while my cash was earning interest in a money market account. All I have to do is remember to pay it off in full at the end of the year, and every month thereafter, and I never have to pay that 20%.

A 2% reduction in gas and grocery costs, paid for by someone else? This is a game I just might play.

Pennies From Heaven: An Update

In the weeks since I first posted about picking up pennies off the ground, I've managed to find one penny lying around. Then on Friday I picked up a dime outside of the movie theater, and Saturday morning I spotted a quarter in a public park. That got me thinking about the subject again.

For the last month I'm up about forty cents. Clearly picking up change is not going to make a meaningful difference in one's financial status, whether you make the effort to bend over and grab, or not. So if there is going to be any value to the practice, it lies in the metaphorical realm. That is to say, that picking up loose change becomes a shorthand expression, an encapsulation if you will, of your entire outlook towards your finances. By defining who you are, the metaphor can then influence your financial behavior in other areas of your life.

The simplest way of expressing the metaphor is "I'm so cheap I pick up pennies in the street." Viewed that way, the practice becomes a physical reminder of the importance of frugality. If the memory of the effort expended to gain every penny is actually imprinted in into your muscles, you are less likely to be extravagent with your dollars.

I want to take the metaphor to another level, however, and view the practice as a expression of how we look for opportunity. I think there is a risk for searching for pennies on the ground. That risk is that we can become focused on looking on the ground, to the exclusion of keeping our eyes looking at where we want to go.

I prefer to take a more positive take on the situation. I like to think that although my focus remains on where I'm going, I have expanded my attention to take in more of what's going on around me. This expanded focus allows me to spot opportunities that might otherwise seem to humble to be worth pursuing. Sometimes those opportunities pay off bigger than you expect.

Like looking for pennies, and spotting a quarter.

Energy Saving Tip: Wash Your Car

I washed and waxed my car this weekend for the first time in months. The weather finally cooperated, with clear skies and a warm sunny day. When I finished, I felt extra virtuous: not only did the car need a bath, but I improved my fuel efficiency at the same time.

Here's the science part: A dirty car has a rougher surface finish than a clean, freshly waxed car. That rougher surface finish creates more wind resistance, forcing the engine to work harder to overcome the drag. Hence, washing your car gives you better mileage.

Frankly, I'm not sure that the gain is all that significant. You probably get a much bigger mileage boost by driving with the windows closed. Driving with the windows down turns your car into a giant wind scoop, which can increase drag by up to 10%. But every little bit helps.

Besides, I was going to wash the car anyway. I think that one of the keys to saving money is to find ways to save by moving in a direction you were headed anyway. If you see a coupon for something you use regularly, cut it out. You don't have to be looking for pennies on the ground, but if you spot one, pick it up. (I picked up a penny today on the floor of my gym.) Saving money doesn't always have to be about sacrifice or struggle. Sometimes it can be about spending a pleasant hour or two outdoors on a spring day.

By the way, my ride looks great.

Pennies from Heaven

As I was walking from my car into the grocery store this afternoon I saw a penny lying on the pavement. I picked it up, and that started me thinking: What a country! The streets may not be paved with gold, but they are paved with copper clad zinc slugs!

Yes, I am one of those people that picks up pennies that other people have dropped. I know that most people will not bother. Not worth the effort, they say. Heck, obviously the people who were the owners of the coins didn’t think it was worthwhile to retrieve the pennies they dropped.

My feeling is that it is a worthwhile activity. Taking a second or two to bend down and gather money up off the street is a way of reminding myself of the importance of frugality. If I will expend the effort to bend down and pick up a penny, than I should work that much harder to save real money by avoiding unnecessary expenses and getting better deals.

In addition to being a physical reminder of the need for fiscal vigilance, a sort of metaphorical value, I also receive real value from this habit. They may only be pennies, but it’s still money, after all.

If it takes me two seconds to bend down, pick up the penny, and regain my stride, that works out to a pay rate of $18 per hour. My compensation at work is at a higher rate than that, but it’s more money than I would otherwise make while running errands.

This makes me curious about how much money I can actually pull off the streets. So as part of this blog, I am going to start keeping track of how many pennies I pick up. Last week, there was one in the parking lot at work, three coming out of the movie theater on Friday night, and then the one going into the grocery store this afternoon. So far I’m up to 5 cents.

Mmmm. Maybe I shouldn’t quit my day job just yet.

In Praise of Lattes

In the area of personal finance, I am an atypical blogger. I have always had an emergency fund and I have never had any student debt (I went to college on an ROTC scholarship). I have also always paid off my credit cards in full every month. I've read enough PF blogs to know that makes me a little unusual. I also suspect I'm longer in the tooth the the average blogger.

I 'fess up about these things because I'm about to go against the grain of most PF bloggers.

I love going to Starbucks. I'll go in, check out the newest CD's, order a tall latte. Sometimes I banter a bit with the staff, who usually seem to be in a pretty good mood. When my coffee comes, I sit in the padded chairs and lounge around sipping while I listen to jazz and read the New York Times. It's a wonderful experience. For half an hour I feel like a hip, upper-class urbanite.

The prevailing wisdom is that buying expensive coffee is a waste of money. David Bach of "The Automatic Millionare" fame calls it the Latte Factor: stop buying lattes and use the money you spend to fund your 401K. I understand the need to get out of debt and prepare for retirement, really I do. But you should not put off living until retirement.

The beauty of the near luxury experience is that for a few dollars you can feel like a million bucks, even if you don't have a million bucks. The key is to strike that balance between preparing for an uncertain future and enjoying the present.