Real Estate Investing

ELI5

Real estate investing – you might watch HGTV in your spare time and see shows like Flip or Flop or Property Brothers that make real estate investing seem exciting and very hands-on. All of this can be true, but it’s important to note that there are many ways to participate in real estate investing (REI). The two primary types are passive and active REI.

However, it is important to note that your primary residence should not be considered a real estate investment. Why? Your home’s primary purpose is not a store of money that appreciates – it is to provide you a shelter for you and your family. Unlike rental properties, you won’t capture monthly rental income, and you can’t assume appreciation on the property (i.e. 2008-2009 Great Recession).

In a normal “market” the price of real estate increases at the price of inflation. The floors on real estate prices are set by interest rates, housing shortages, income levels (affordability), desirability and rent control policies.

Passive REI includes investing in real estate investment trusts or owning a rental property and hiring a property manager to assist with the operational and maintenance aspects. REIT’s or real estate investment trusts enable individuals to invest money into real estate developments or other real estate assets. Investors typically receive a steady dividend as a form of payment. REIT’s are safer than stocks to some extent, but are equally exposed to recession cycles.

Active REI includes purchasing a rental property and gaining a steady cash flow through rental income and, ideally, equity appreciation. People can build large rental portfolios through the concept of leverage – where investors tend to put a small down payment down on several properties. The tenants for the rental properties ends up covering the mortgage assuming rent is priced appropriately. Over time and many (or a few) tenants later, the property is paid off and you end up owning these rental properties outright!

At the same time, you are the landlord of these properties and are responsible for maintaining the property, dealing with finding responsible tenants, and covering the mortgage payments and property taxes when the unit is vacant. This can be a time consuming endeavor and can turn into a full-time job depending on the size of your rental portfolio. Real Estate Investing may come with tax benefits for the landlord which should be factored into valuing rental real estate.

Flipping properties is another common form of active real estate investing. In this case, you end up purchasing a property for a short period of time – typically a run down apartment or home. You’ll realize that properties around the area are selling for significantly higher and that all this one needs is some renovation. With a crew of contractors you end up sprucing up the place for a reasonable cost and listing it back on the market at a premium as quickly as possible. The key is holding the property for as short a time as possible since that will eat into your profits.

Detailed Definition

Real estate investing is the go-to option for many investors all over the world for good reason. A more detailed examination of some of the principles behind it reveals why.

Investing in Rental Property

Rental properties, when managed right, can produce a nice, healthy income stream. Properly investing in rental properties is a matter of balancing three main factors: leverage, cash flow, and property management.

Leverage involves using other people’s money to purchase properties to rent. Typically, this involves acquiring a loan from a bank or a private investor to buy a property. You effectively “leverage” a small amount of money by investing it in the down payment. The rest of the cost of the property is thereby covered by whomever you borrowed the money from.

For example, if you only have $35,000 to invest, you likely aren’t going to find a property to purchase and rent out at such a low price. But you can leverage that money by using it for a down payment. You purchase a property for $350,000 using your $35,000 as the down payment. You are then able to rent the property out for a total of $2,100 a month. This ends up giving you a monthly profit of around $400 a month. While this isn’t necessarily a large amount of money, this is what leveraging your $35,000 has gotten you: $400 a month in profit and a property worth at least $350,000. As a result, you now have a higher income stream, and if property values increase, more material assets. These also can be leveraged in order to help you buy another rental property. You simply repeat the process. After a few years, you can leverage your initial $35,000 into a portfolio of properties with a gross value well over a million dollars and a significantly higher income stream.

Cash flow is whether the money is coming in and out of your account. Rental income serves as the primary source of income while renting and to increase cash flow you can increase rent in a healthy rental market. There are other ways of improving cash flow — such as building niche rentals. This could either be by allowing pets, providing free laundry, renting out an extra room, etc. Due to the use of leverage, be aware of all operating expenses while renting including apartment maintenance – it’s important to build a budget to understand cash flow. Examples of operating expenses include property damage, occupancy rates, property taxes, and insurance costs. It is important to have a firm grasp of your own non-real estate assets which can be used to service property related expenses in an economic downturn when the rental market is weak and vacancies are high. The last thing you want to do is sell rental properties in a weak real estate market.

Property management is one of the most overlooked aspects of investing in rental properties. Properly managing your property (or properties) should be seen as part of the job. Furthermore, the money involved in property management should be viewed as part of deal. It is important to consider how much time you’re going to have to put into the upkeep of your property as well as making sure your tenants are happy. Because this can be so time-consuming and intricate, many investors hire property managers to give their renters quick access to solutions and to give themselves peace of mind. The cash flow would have to justify such a move, however, so you are going to want to assess the property management needs well before making an offer.

When done right, property management can itself become an indirect source of greater income. Each time a renter leaves, you face the possibility of losing income due to the apartment or house being empty while you locate another tenant. When a property is well-managed, renters tend to stay longer. Having consistent renters equals consistent income, so many investors use good property management to their advantage.

Flipping Houses

As mentioned earlier, flipping houses has gained popularity in the media and entertainment world as of late. This is because when well-executed, the flipping of a house can provide very nice profits. On top of that, the time spent in the investment is minimal when compared to many other investment strategies. We’re going to examine two key concepts of house flipping: how profits are made and how losses are incurred.

Distressed properties are properties that need work in order to be either sellable or have significantly more appeal, resulting in a higher sales price. A distressed properties blessings are also its “curses.” A house may have undergone a tragedy, natural or otherwise, making it a relative steal on the market. If you can repair the house without investing too much capital, you may be able to flip it for a solid profit. Also, a house may be deteriorating due to age. It may look unappealing on the outside and even upon first glance when inspecting the inside, but the basic structure, or the “bones” may be good. Most aesthetic aspects of a home such as drywall, paint, or landscaping can be vastly improved without spending a lot of money.

Sweat equity is the work you personally put into a house you want to flip. The value of sweat equity is realized most dramatically when a line item you had earmarked funds for becomes something you do yourself. For example, if you had decided to hire professionals to do the drywall and painting of the bedrooms, you may be able to save all of the labor costs by devoting a couple of weekends to doing the work yourself. In effect, you have added equity to the house.

Curb appeal refers to how a property is viewed when a prospective buyer passes by. While it sounds superficial, the value of curb appeal cannot be overstated. Regardless of where you are in the world, you see the place you live as a representation of who you are as a person. Even though a well-kept lawn doesn’t necessarily make a house more livable, we often see it as a reflection of who we are. By the same token, chipped paint, missing roof shingles, or unruly landscaping can make a prospective buyer shy away from an otherwise nice home. They don’t want to be associated with those traits of the house. Enhancing curb appeal is often the best way to maximize the bang you get for your buck. This works both ways. Not only can you raise the value of your property by upping its curb appeal. You should look for properties with poor curb appeal because they may be selling at a discount. And if you add some curb appeal, you add value.

ROI as it Applies to Flipping Houses

ROI, or return on investment, has to be calculated carefully when flipping houses. It’s not as simple as the selling price minus what you paid. The cost of holding the house until it sells as well as any maintenance required factors in as well. Some of the expenses are less predictable than others. Here is a brief list of a few of the major line items affecting your ROI:

  • Mortgage paid until the house is flipped
  • Real estate agent fees
  • Cost of upkeep
  • Variable interest payments
  • Appreciation or depreciation after changes are made to the home

How Losses Are Incurred: An Example of How You Could Lose Money Flipping a House

You buy a distressed home right now for $300,000. To make it sellable, you need to make $70,000 of repairs. This brings your total cost for the house to $370,000. You hope to make a $10,000 profit by selling it for $380,000.

After a 10% down payment, the mortgage payment and property taxes are factored in, your monthly payment is $1,890. Further, after adding in the cost of maintaining the home, you have to spend around $2,010 each month.

Most of the $2,010 goes to paying interest and not to reducing the principle, or how much you still owe on the house. This means for the first year, each month, on average, you only decrease the amount you owe on the home by $890. At the same time, you’re giving the bank $1,120. That is money you never see again and that doesn’t help give you more equity in the house.

Before you know it, selling the home for $10,000 more simply isn’t enough to make the overall deal profitable. And if the buyer offers less than the sales price, you would make even less money. You also have to pay the real estate agent 5% of the sales price. And your relative loss is further exacerbated if the market cools.

All-in-all, in this situation, if it takes you 5 months to sell the house, you could easily lose $15,000 or more even if you sell the house for $10,000 more than you paid for it. This begs the question: How can you make money using short term real estate investing?

How to Profit from Flipping Houses

The key is to focus on your profit margin. Factor in the cost of the real estate agent, the repairs, and the cost of paying the mortgage for a conservatively estimated amount of time. Then take that number and add 15% to it. So if all that equals $25,000, add 15% to it or $3,750, to get $28,750, and that gives you the cost of holding the house. Now decide how much profit you want to make and add that to the cost of holding the house.

For instance, if you want to make $20,000, your total number will be $20,000 + $28,750 = $48,750. That’s how much more you have to sell the house for in order to make a decent profit. Because you have factored in the extra 15%, you have some leeway. If the sale prices in the area aren’t high enough to get you a profit margin that big, this isn’t the deal for you. If the length of time it takes to sell a property looks close to or even a little more than what you calculated, you’re better off looking elsewhere to invest.

Because real estate investing is relatively high risk, you need to be as conservative as possible when it comes to calculating your possible returns. Conservative estimates can help offset the riskier elements of real estate deals. But if you are able to find some great deals with strong profit margins, you can make a handsome profit from flipping houses.

Real Estate Investment Trusts

A popular variant to traditional real estate investing is doing so using a real estate investment trust (REIT). An REIT is a lot like a common stock or an ETF. It is essentially a fund that is traded on the open market but it is comprised of real estate investments. The portfolio of an REIT can consist of rental properties, land, houses, apartment buildings, commercial rental space or virtually any other facet of the real estate market.

For investors who want to take advantage of growing real estate markets or strong rental markets without assuming the risks of low liquidity, REITs can be an ideal solution.

REITs provide steady income. Real estate investing has less variables than investing in stocks, and it is therefore more stable. The enemy of real estate investing is an economic downturn or a localized downturn that affects property values. These things can often be predicted. In comparison, a drought, an employee strike, a hostile takeover, or other things that affect stock prices are far more difficult to foresee. A well-designed REIT portfolio will have a diverse offering of rent-producing properties and appreciating real estate. If the appreciation is lackluster, the rental income can offset it and vice versa.

REITs are liquid. If you purchase a home, to sell it for a small profit or to break even takes months of hard work. It takes at least as long to offload a property that’s losing you money. However, with an REIT, selling your shares is as easy as selling a stock. It’s the same with buying shares of an REIT.

REITs present convenient diversification opportunities. The more diverse your portfolio, the more insulate you are from adverse market fluctuations.  Some of the elements that cause stock prices to drop have little effect on a REIT. A bond investment could also be easily offset by an REIT. If you purchase a municipal bond based in one location, you can buy shares of an REIT in another location with a different economic contributors. If the value of your bond starts to drop, no problem, your REIT will likely remain unaffected.

Property Appreciation & Depreciation

Whether you’re invested in properties you own and/or manage or an REIT, it’s important to understand the principles behind property appreciation and depreciation. Your bottom line, and, as importantly, your liquidity is directly impacted by the ebb and flow of property values.

When a property appreciates, its inherent value increases. Think of Tickle Me Elmo as an example. This toy, although cute, was certainly not worth $500, $600 or even more—at least not until a lot of people wanted it. As soon as the need arose, the price skyrocketed. Did it make sense to a lot of people? No. But it didn’t matter because the demand was there. It’s very similar with real estate. In the Bay Area in California, particularly near the cities and their suburbs, it isn’t uncommon to find a 2,500 square foot home selling for $3,000,000—or more. The same building, if transported to a beautiful lot in North Carolina, would fetch a fourth of the price. The basic reason why is simply because people want that house. The reasoning behind that desire is slightly more complicated but simple to understand.

Property depreciation is when the value of a property goes down. And just as it’s the opposite of appreciation, its causes are the inverse of those behind appreciation as well. All over the United States, there are examples of property depreciation. More often than not, these are the result of a shift in the job market. When an industry leaves an area, the jobs go with it. Hence, fewer people want to live there and property values drop as a result. The same goes for the disappearance of conveniences and the appearance of what some would consider to be undesirable neighbors.

As you can see, it’s not as cut and dry as it looks on TV. But that’s the nature of investing, and real estate investing is one of the more lucrative and stable investments out there. The profits are fairly predictable, and as long as you’re more realistic than optimistic, you will only invest in good deals.

Location

A home itself is a flexible asset. You can improve its appearance with a little bit of time and money. The area in which the home is does not have the same flexibility. Therefore, a very simple, basic home in a great area will have a higher property value than its inverse: a beautiful home in an undesirable area. You can change your home, but you can’t change the area.

Also, some aspects of where the home is have straightforward, concrete value. For instance, the cities and the suburbs of the northeast U.S. have thousands and thousands of jobs in a wide array of industries. Hence, their value is high. Property appreciation can happen anywhere where there are new jobs either present or on their way. People also want certain types of neighbors. Fair or not, this affects how much a property is worth. When the people you want to live next to are in the house next door, down the street, and around the corner, you’re much more likely to purchase the property. People are also attracted to conveniences. This is why an apartment complex with a supermarket has more value than one that’s even a short drive away. Buyers like convenience. If conveniences increase in an area, the value of the properties are going to rise.

You can benefit from property appreciation by identifying trends in the above areas. Whether found individually or in combination, their emergence will increase the value of a property you already own or are considering purchasing.

Renting

Oxford Dictionary

Renting [noun] A tenant’s regular payment to a landlord for the use of property or land.

ELI5

Renting is the main alternative to buying a home – it’s when you agree to borrow an apartment or house for a fixed amount of time with the person who actually owns the property, landlord. The agreement that is signed for this period of time is normally known as a lease. The benefit of renting is that you have greater flexibility compared to homeowners. When homeowners lock themselves into a mortgage, they have to pay the required monthly payment or will face defaulting. Renters generally don’t face the same level of punishment for missing or being late on a payment.

Let’s look at an example of the power of renting. Imagine knowing that you and your family plan on moving to another state in the near term, let’s say 3 years – it makes more sense to rent for these couple of years than buy a house. You can sign a lease for a # of months necessary and move out with no strings attached.

Instead if your family purchased a house, you’d have to worry about buying the property, maintaining it, and eventually selling it. You are responsible for the mortgage payments upkeep of the property, paying homeowners insurance, property taxes and a commission on the sale of the property. In addition, if the property value declines over the course of 3 years – you end up losing a good bit of money.

Detailed Definition

Renting involves fewer steps than purchasing a home. Let’s do a quick walkthrough of the process to shed light on some renting terminology.

1/ Determine the following — price range, location, apartment size (# bedrooms, bathrooms), amenities desired (washer/dryer in unit). Apartments come in many different flavors and forms – and are more widely available than homes. Coming up with a list of necessities vs. wants can be useful in pruning down the apartment search.

2/ Either walk around to find apartment complexes that have units available or use sites such as Apartments.com, Zillow, Padmapper to contact landlords and property managers. A property manager tends to be the individual you interface with during the course of your rental period. Many landlords don’t actually manage the property due to the time it takes, and they contract out to third party property management companies. In some cases, the landlord may also act as the property manager — so it’s generally useful to develop a good relationship with them in the early stages.

3/ Narrow down the apartment search list and fill out a rental application. There is a small fee associated with the application normally (< $50 per applicant usually). It is important to know that property managers generally do a soft pull on your credit history – which functions as a background check. Soft pulls don’t affect your credit score, unlike a hard pull from a prospective lender.

4/ If the application is approved and the property manager signs off, they prepare a lease containing all the contractual information. Once this is signed and the security deposit are paid, you are ready to move-in. Typically the lease contains:

  • [Rental term and rent amount and form of payment] – How long the lease is for (most are from 6-12 months) and how much it is per month. Also, check for how rent should be paid, it’s typically cashier’s check, personal check, and online payment are the most common.
  • [Security deposit] – Property managers will typically request you pay a security deposit upon moving in. This deposit is an advance payment that does not go towards rent, but rather a form of protection for the landlord or property manager if the tenant aborts the lease. The security deposit is also used towards cleaning and repairs at the end of the lease and the leftover amount is returned to the renter. Security deposits are limited to 2x rent for an unfurnished apartment and 3x rent for a furnished apartment.
  • [# of tenants] – make sure all tenants are included in the lease. Otherwise having more people than allowed is a breach of contract.
  • [Details on repairs and maintenance ]- you aren’t responsible for calling a plumber when the toilet breaks down…unless the damage was intentional. Typically, a maintenance request is submitted to the property manager, and they’ll handle the repairs Read these carefully to see what is and isn’t allowed during your rental term.
  • [Code of conduct] – noise levels, being respectful of other tenants, and rules regarding usage of common areas in larger apartments.

At the end of the day, the choice between buying a home and renting comes down to a handful of points. Typically renting is cheaper in the short term since no down payment is required and the monthly payments are less than a mortgage. Maintenance, insurance costs are also less. You have greater flexibility – if you don’t like your apartment you can move out after the lease. If there is a long-term problem with a house, you’ll sink more money into solving it. With a rental, it’s generally not the renter’s responsibility to fix the issue, the property manager should take care of the big-ticket items.

The big counter is the equity that you accrue when paying a mortgage – you are actually not ‘spending’ money when paying a mortgage, but rather acquiring a chunk of equity in the property with every payment. In renting, you are spending the money and not gaining anything in return — other than a place to live. Another significant counter is that homeowners have full creative freedom to redesign, renovate, and modify their abode (barring HOA requirements). Apartment owners have limited abilities to make the home their own – no repainting walls, changing appliances, etc.

In this day, with house prices at record highs, many demographics including young adults and families as well as middle-aged adults are less likely to be homeowners and more likely to rent. After growing up during the 2008-2009 Great Recession, people are hesitant to jump into a real estate market with such high prices — preferring to rent instead.

Mortgage

Oxford Dictionary

Mortgage [noun] A legal agreement by which a bank, building society, etc. lends money at interest in exchange for taking title of the debtor’s property, with the condition that the conveyance of title becomes void upon the payment of the debt.

ELI5

A mortgage is a type of loan where the borrower is purchasing a property and needs money from a lender, typically a bank, to do so. If the borrower fails to pay back the loan, the lender has the right to take ownership of the property (the lender has a lien on the property). There are a handful of important topics of a mortgage including – principal and interest, mortgage types, and foreclosure.

As with any other loan, the principal has to be repaid with some interest rate. There are two major mortgage types – fixed-interest rate and adjustable-rate mortgage (ARM). They sound fancy, but they really aren’t! For the first, it means you pay a fixed interest rate for the entire term of the loan — typically 15 or 30 years. With ARM, the interest rate stays fixed for an initial variable fixed period of the loan and then will fluctuate with market-based interest rates. The first one is not affected by future changes in mortgage rates, the second one can be beneficial typically for more advanced buyers who can manage their interest rate risk.

The other piece of the puzzle is foreclosure. When a property is foreclosed upon, it means the buyer is not able to or has stopped making the required loan payments to the lender and the lender has the right to repossess the property.

An example would be if Mary and her husband want to purchase a $350,000 home. They have saved a down payment of $50,000, and are targeting a fixed-interest rate mortgage of $300,000. They go to a handful of commercial banks in the area presenting their mortgage request — and are evaluated based on credit score, down payment amount, and employment history. They go with the bank that provides the best interest rate, and Bank ABC gives them a 4% interest rate on a 30-year fixed-interest rate loan. Over the next 30 years, they will pay off the loan in fixed payments and assuming they don’t miss or stop making payments will fully own the house in 30 years.

 

Detailed Definition

There are a handful more terms that are covered when talking about mortgages, let’s dig deeper into some of the aforementioned topics and learn a couple more.

Fixed-interest rate mortgages — where the interest rate on the loan is constant for the period of the mortgage. This is likely the most logical option when buying a house since a buyer has a consistent loan payment that will not fluctuate for the term of the loan. In the process, they are able to plan and budget more consistently and have a peace of mind.

A strategic advantage would be to capitalize on a fixed-interest rate loan when the interest rates are low. In doing so you essentially lock in a low interest rate even if the benchmark interest rate fluctuates. 

For the Adjustable-Rate Mortgage (ARM) – you have a fixed, typically lower than benchmark interest rate for an initial 3-10 year period and after that the interest rate is tied to a benchmark interest rate. The initial lower interest payment proves enticing for many homebuyers making the loan more appealing, but after the initial interest rate expires these loans can become rather expensive. Typically, you will see 3/1 (or 5/1, 10/1, etc.) ARM loans — with the first number indicating the length of the fixed interest period and the second number signifying the interval between interest rate adjustment periods after that (so annually for a 3/1).

Situations where an ARM is more advantageous includes when you know you are going to sell the house or flip the house (as an REI) before the fixed interest period is up. Imagine you are on a 2-year contract for a job and have a family – in that situation it might make sense to sign up for a 3/1 or 5/1 ARM mortgage since you understand there’s a real chance you will leave after the job contract is up.

There are a handful of other loans, but we’ll save them for another day. When dealing with mortgages another term that is commonly thrown around is the amortization schedule. Amortizing a loan is the process of paying off a loan in a series of regular fixed payments composed of interest and principal. As mortgages are a type of loan that involves a series of consistent payments — an amortization schedule is an easy way to understand the interest and principal for each monthly payment for the term of the loan. Key concept in the first ten years of a 30 year mortgage, your payments are all going towards the interest and very little towards paying down principal. You can reduce the payments on a 30 year mortgage to 20 years by making one extra monthly payment at the beginning of each year.

Even though your monthly payment is constant, the ratio between interest and principal in that payment will change during the term of the loan. In most cases, the amortization schedule consists of a higher portion of the payment going towards interest during the early installments while the principal is chiseled away at towards the end.

Last but not least, we have to confront the worst part of mortgages — that is what happens when a homeowner fails to pay them. When the homeowner fails to pay or defaults on their loan – either due to difficult circumstances (sinking under heavy debt obligations, laid off and can’t afford mortgage payments) or neglecting payments, the bank has the right to foreclose and seize the property. Typically, a bank doesn’t want to hold property due to its illiquid nature, and holds an auction to receive cash for the property. If an individual has their home foreclosed upon, their creditworthiness drops significantly and being able to secure another mortgage (or loan) becomes much more challenging.

An example tying together some of the above concepts include the Great Recession of 2008-2009. Several lenders were providing unrealistically low interest rates through ARM’s and interest-only loans (discussed later), so people were capitalizing and scooping up property that they might not be able to afford in the long term. People with low credit scores who likely shouldn’t have received the loans were getting multiple loan offers from bank. Ultimately, by the end of 2008, these people began to default on their loans triggering the start of the downturn.

Bank Products

ELI5

Banks offer three main types of investment products – savings accounts, money market accounts, certificate of deposits (CDs). In the world of investing, these three are generally the safest forms of investments with varying amounts of interest opportunities.

The biggest benefit regarding savings and CD’s are that the money is insured by the Federal Deposit Insurance Corporation or FDIC. The value is dependent on the type of account you have, but we can delve into that later. For single accounts, the total deposits across checkings and savings accounts (in the individual’s name) are insured up to $250,000.

Savings accounts are the most basic account types offered by banks. They have a fairly low, minimum deposit requirement and offer decent liquidity. On top of that, they offer a small interest payment on the principal that is typically compounded. An individual can also withdraw money without any restrictions or penalties.

Money market accounts offer similar privileges to a savings account but typically have higher interest rates. They also have a minimum deposit, but can offer interest rates ranging from 0.1-1.0%. However, there are limits as to the amount of money and frequency that money can be withdrawn from an MMA.

Certificate of deposits are similar to the above accounts, but are an example of time deposits. They exist for a fixed period of time (3 month to multiple years) and pay interest regularly until time is up (or the CD is matured). The money is illiquid, so nothing can be added to or removed from the CD during the active term. So why buy a CD? Interest rates are higher compared to standard savings and money market accounts.

 

Detailed Definition

In order of savings accounts to money market accounts to CD’s they have progressively higher interest rates with decreasing liquidity. Let’s dive a little deeper into each type of account.

The main takeaway for savings accounts is that they generate interest, just not very much — the average APY is around 0.06%. Certain online banks offer higher interest rates (such as Ally) with rates almost as high as 2%. They can afford to do this since they have significantly less operational costs compared to brick and mortar banks. Another exception is that individuals can capitalize on promotions when opening a new account as banks offer better rates to attract new customers.

With savings accounts, it is important to make sure the minimum deposit is met typically on a monthly basis. If the account holder fails to do so, they will be charged a penalty fee. The other main downside is that though you can typically deposit money freely, withdrawals tend to be limited on a monthly basis.

Other than that, the main philosophy of a savings account is to keep the money and in theory not touch it, which lends itself to being a good investment vehicle for an emergency, or rainy day, fund. Savings accounts are the de-facto choice for risk-averse investors.

Money market accounts typically provide higher interest rates, but they come with a handful of downsides. As mentioned before, they have even tighter withdrawal abilities when compared to a savings accounts and also typically require a higher account minimum balance. Ultimately this higher balance is what enables the banks to offer the higher interest rates.

The money deposited is invested in conservative financial instruments – certificate of deposits, government securities (US T-bills) to name some.  Money market funds are regulated by the SEC and are mandated to only invest in short-term, highly rated debt. MMA’s are seen as a sound alternative to a traditional savings account assuming the person is willing to bear a nominally higher risk level.

Last but not least certificate of deposits tend to provide high interest rates that are (normally) static during the term of the investment, but provide no liquidity. By that, you can’t write a check or withdraw money from a CD account, unless you are willing to incur a penalty.

Another typical fact about these accounts – the longer the term, the higher the interest rate you’ll receive. Why? The individual is exposed to higher risk when holding onto this investment for a longer period of time, so they expect to be compensated proportionally. At the end of the CD’s term, you have the option to withdraw your money or roll it over into another CD.

Budgeting

Oxford Dictionary

Budgeting — [noun] An estimate of income and expenditure for a set period of time.

ELI5

Many people associate budgeting with something that needs to be done when money is tight – which is true. However, there are many people including those making more than the median income that choose to budget as well. Lifestyles will vary based on your job, your family, and other needs and budgeting is a useful way to help maintain that.

A budget, for personal finance, is setting a limit in spending in various categories of life expenditures – whether short-term, mid-term, or long-term. A monthly budget, for example, would include an expected spending limit for rent, food, utilities, insurance, etc. Another budget could be a savings budget for the downpayment on a house. The term is used quite flexibly, but it’s really a method to help someone gain more control of their finances and understand what’s coming in and what’s leaving.

Even though building a budget seems like an added burden – keeping track of income and expenses closely, it can provide greater freedom and flexibility in the future. Preparing to purchase a new car, house, or putting a child through college are events that generally require patience to save for — and something a budget can help expedite. In addition, by ensuring you have money in the bank, i.e. an emergency fund, you can spring back from sudden mishaps or unforeseen accidents such as a hefty medical bill, car maintenance, etc.

 

Detailed Definition

There are some basics steps to budgeting that include: understanding what you are saving for, estimating income and expenses, building an emergency fund, and growing a nest egg.

Like mentioned before you can have different types of budgets – a monthly one to understand how money is flowing in and out of your account or a long term budget to help save for a car or child’s college tuition. Depending on what you are saving for and the timeline, the strategy for how aggressively you budget will vary.

For a medium term item, such as saving up for a downpayment for a car, building a budget will help an individual think about what expenses can be pared down to facilitate the savings growth. After reviewing the last couple months, you might notice that a great sum of money is spent on eating out. By switching to a home-cooked diet you can shave off a couple 100 dollars and be able to get that brand new Tesla that much sooner without breaking your wallet!

Now that you’ve thought about what your budget is for, the next step is to do a deeper dive into the money flow. Hopefully, you have a good idea of how much money you are bringing in per pay period — this counts as income. Disposable income is the money left over after taxes. There are typically two types of expenses in personal finance – fixed and variable.

Fixed expenses are recurring costs such as rent, insurance, and subscriptions that you can expect on monthly or annual basis. These payments are useful while budgeting cause they stay constant, but also inflexible since most individuals have little control over them once they are set.

Variable expenses are dynamic costs that tend to change month-month and these include food, utilities, entertainment, and discretionary spending. Given our gig-economy with great services such as Grubhub, Doordash we quickly can find ourselves overspending on delivery for example. Unchecked variable expenses can quickly place people in tight financial situations. At the same time, people have more control over variable expenses — instead of doing delivery every night, they can save some money on groceries without too much added effort.

It’s a useful exercise to review the last couple months expenses to figure out what your fixed expenses and variable expenses are. There are fantastic services such as Mint and YNAB that enable people to quickly gain an understanding of their finances by connecting bank, investment, and retirement accounts in one centralized location — so you don’t have to keep track of receipts and credit card statements.

In the world of budgeting, a critical concept is being ready for unforeseen, mandatory expenses — i.e. a hospital bill for an injury or a sky-high car repair. An emergency fund is generally agreed to be 3-6 months of living expenses saved in a highly liquid account (checking or savings) so it can be withdrawn almost immediately. Having this allows an individual to not take out an emergency loan with high interest which can quickly place a person in a tricky financial state.

Credit & Debt

Oxford Dictionary

Credit — [noun] The ability of a customer to obtain goods or services before payment, based on the trust that payment will be made in the future.

Debt — [noun] A sum of money that is owed or due.

ELI5

Credit is a concept which exists through a handful of more practical ideas. This includes credit cards, auto and home loans to name some. Ultimately, utilizing credit can enable you to access something now that you can’t entirely afford with the money you currently have. This can be useful when you want to buy a house or purchase your first car. These items might not be attainable with the limited cash one has. However, by engaging in a credit contract where you agree to borrow the rest of the money needed from a creditor (or lender) and agree to pay them back at some point plus some extra amount (known as interest), you can acquire the desired item. At this point, you are in debt and are responsible for paying back that money to the creditor. It is important to not overuse credit and end up violating the payment terms of the credit contract.

There are many types of credit – mortgages, automotive, student, etc. A standard example would be a first-time car buyer. Let’s say John is going to buy a blue Honda Civic for $19,000. He only had $5,000 to put down, so he will have to go to a bank to get the other $14,000 (known as a loan) needed for the car. In doing so, he is using credit to acquire an item of value now, and he will have to repay the $14,000 plus the interest (which ranges from 3-10%, so $420 to $1,400 in this case).

The information above focuses on the personal finance definition of credit. When dealing with accounting, credit has a slightly different definition we’ll discuss later.

Detailed Definition

Credit, more formally, is an agreement where a borrower receives an object or item of value and agrees to pay back the lender (or creditor) at a future time typically with interest. Interest is the additional fee or charge the lender requires the borrower to pay in exchange for using the item of value at present. As mentioned above, credit allows you to stretch from your current cash position by letting you use money or gain something you don’t have at the present.

Credit Score – How It’s Calculated

To make things more concrete and useful — practical indicator of credit involves an actual ‘score’ or your creditworthiness. This conveys how safe of a borrower you are to a lender, i.e. how consistently and quickly you are pay off the debt you are in.

This number is calculated from a variety of factors with some weighing more heavily than others. Typical factors that weigh on your credit score: payment history, credit utilization ratio, length of credit history, credit inquiries + new accounts, and type of accounts.

Payment history (~35% of score) demonstrates how consistently you can pay a loan over time. Generally, people who engage in some form of credit and pay off the loan in a timely manner have higher credit scores than someone with no credit history.

Credit utilization (~30%) is the other heavy-hitting component of your credit score. It is the ratio of your total credit card balance divided by your total credit card limit. A lower credit card utilization is typically better – it means you are more likely to be able to pay off your balance and less likely to default.

Length of credit history (~15%) of your score. The longer an individual’s credit history the more trustworthy lenders view the individual. This consists of how long certain credit accounts have been open and how frequently they are used. Type of accounts (~10%) can also cause your score to fluctuate — there are two types of credit accounts installment credit and revolving credit. Installment credit is like an auto or home loan that has fixed payments every month (typically). Revolving credit tends to be more risky as you are allowed to borrow up to a certain limit and forced to pay interest (i.e. credit cards).

Credit inquiries (~10%) can adversely affect your credit score. If a lender or landlord inquires about your credit this is recorded on your credit report. When this occurs several times, it will hurt your credit score. New accounts are trickier — while it is good to have a handful of credit accounts that are being paid regularly and not accruing too much interest, opening several in a short time span will hurt your credit. Imagine someone is short of money and they need to access credit to pay off a large new boat. They could acquire multiple credit cards and max out their credit limits on each, and then be charged significant interest on those cards quickly placing them in a tough financial situation.

Public records that contain information about filing for bankruptcy or being repossessed can negatively affect your score.

How is a credit score used?

The credit score provides a quick way for a bank or lending institution to evaluate you as a reliable borrower — if you will pay back the item of value with interest. Before you buy a house or a car, the bank will examine your credit score to assess how reliable you are with credit and will give you a lower or higher interest rate on the loan. Third party agencies such as FICO, Experian, etc. will provide approximations for a credit score. Scores typically range between 300-850, with 300 being a very poor score and a total credit risk and 850 being extremely high and no credit risk. As a lender, the higher the score for a credit applicant, the more likely you are to let the individual borrow money.

What is money?

Oxford Dictionary

Money — [noun] A current medium of exchange in the form of coins and banknotes; coins and banknotes collectively

ELI5

Money – we use it everyday and barely think about it other than trying to figure out how much to tip the waiter or how much to pay a roommate for rent. It is an object that has some agreed upon value and can be used to exchange for other goods or services.

In the old days, the barter system was the primary form of getting your groceries. I’ll give you 5 bananas for 10 apples. Now, let’s say you are looking for some rope as well, and the craftsmen will only accept onions. You have the 5 bananas I gave, but they are useless in this situation, and without this rope…things aren’t looking good for you. This is where money comes in — it acts as a middle-man by everyone agreeing that it is of some worth and can be easily exchanged. One note – apples, bananas, and onions are all forms of money actually, but they are considered commodity money.

Now let’s switch the previous example to coins. I’ll pay you 20 coins for the 10 apples. The rope is only 10 coins which you can directly give the craftsmen instead of trying to find these precious onions — it makes the whole system much more efficient. In the case that the rope is higher quality — you might have to pay 15 coins, thus the price in coins indicates value of the good as well.

Detailed Definition

Money ultimately has three major purposes in the world today: medium of exchange, value indicator, store of value.

Commodity Money

We most commonly think of money as (typically) round pieces of metal or paper notes containing some inspiring or historical information about a country or government. Several millennia ago, farmers would utilize their surplus to trade for other goods. The grain or wheat that they would trade for fruit and vegetables is a form of a different type of money called commodity money — since the item being used as money has significant intrinsic value. Traveling from one area to another with a cart full of grain or livestock only to haul back some other unwieldy good proved inefficient and inconvenient. There are still many downsides to a commodity based coin system since the worth of the coin is inherently tied to the commodity it is comprised of.

Permanent Store of Value

King Alyattes of Lydia (modern day Turkey) was likely the first to introduce a coin based system of money. The coins contained a lion’s head emblem providing guarantee of value by the government and a level of accountability. The Lydian staters, as they were known, were composed of electrum – a naturally occurring gold-silver alloy diluted by copper which actually gave them the gold hue. Both gold & silver are trusted and valued commodities so people had faith in the coins retaining a more permanent store of value. This was extremely convenient compared to commodities – imagine several silos containing your surplus of grains getting spoiled due to a large flood, etc. The stater were easily transported and could be stored in a safe place to protect against weather or robbers.  

Value Indicator

Another critical aspect of this system was that each coin was standardized to a weight of about ~220 grains of wheat. When going to the market, a farmer didn’t have to spend time weighing gold and silver ingots as done before coinage was developed — a merchant knew that the Lydian stater represented this fixed amount providing an indication of value.

Lydians are the first known group of people to use a coins, but similar systems were developed in China [necklaces with bronze pendants — essentially creating a wallet while also showing off how wealthy you are] and India [where shells were used instead of coins].

TRANSITION TO FIAT MONEY

The next big transition in money comes during the transition of commodity money to representative or fiat money. Fiat money holds no significant intrinsic value unlike a commodity — a copper-plated zinc coin (i.e. a penny) or rectangular piece of paper with values and pictures printed on them isn’t worth more than a few cents. However, when the government issues these notes and decrees “This note is legal tender for all debts, public and private,” it makes things more interesting. If the entire US government sees these pieces of paper as worth some value — businesses and individuals are more incentivized to use them.

In fact up until 1971, in the US every dollar was backed by some gold or silver by the government. This forced the government to accrue a larger supply of gold whenever it had to print out more notes — self-limiting the supply of currency. That means based on the price of gold or silver, you could exchange a certain amount of your greenbacks for a physical commodity. After 1971 when Nixon officially seized the ‘gold standard’, that piece of paper can’t be exchanged for anything — but since such a large quantity is in supply today and widely accepted as a form of exchange with a store and indication of value it’s challenging to imagine it not being worth anything.