Do you need LIFE INSURANCE? Yes, No, and Maybe

Should you buy life insurance? Why? and Why not?

Over the years I have bought a number of life insurance polices - term life, whole life, adjustable life, variable life. Some are a basic insurance policy - a bet that you will die - and a means of protecting loved ones should you die prematurely. Others are investment vehicles of varying degree and usefulness. The following comments are based on my experiences.

1. TERM INSURANCE

For most people, there will be a time in their lives when a simple term life policy is appropriate. Term Life is the cheapest life insurance there is, the one with the fewest benefits to you directly.

Simply stated, a term life policy is a bet. You are gambling the monthly premiums, on the premise that before the policy expires you will die. The payoff is in the face amount to your heirs. The insurance company is betting that you will not shuffle off the mortal coil so quickly (the will to live is strong, after all) and will take your premiums and pay out nothing.

If you are young and have financial responsibilities to others, a term policy may be in order. For example, my friend John had a wife and child and a mortgage to pay. At age 30, he had hardly built up much of an estate yet. He had little to leave to his wife and child should he die. He bought a $100,000 term life policy. The premiums cost a few hundred dollars a year.

Tragedy struck, and he was killed in a car accident. The payout from the life insurance meant that his wife could pay off the mortgage and raise their child while only working part-time. If he hadn't bought that policy, his wife would have been destitute, and had to work full-time while raising a child. In his situation, a term life policy makes sense.

Shop around on term life. Rates are very competitive, but many agents mark up the policies a lot. Like extended warranties, it is easy to convince the customer that they are getting a "lot" (potential huge payout) in exchange for a relatively small amount (the premium). But since the odds of young people dying are long, the premium may be no bargain. Shop around.

Many associations, credit unions, and other organizations may have term life policies that may or may not be a good deal. In some cases they can be quite competitive. I have a policy through the American Bar Association. The only downside is that I have to pay dues to the American Bar Association to qualify, and the dues are quite hefty.

Most term policies are for a specific period - 10, 20 years or the like. Once the term is up, that's it. You walk away with nothing. That's why it is called "Term Life Insurance". As you get older, the odds of you dying approach 1:1, so the insurance company doesn't want to insure you forever.

Many term policies have level premiums, but most increase premiums over time as you get older. Eventually, you may have to make the decision to drop coverage, as the premiums become too large. Hopefully, by that point in your life, you will have some Estate to leave to your spouse and child (401(k), house, etc.) so that the life insurance is unnecessary. Figuring out when to drop coverage is hard to do. After all the payout seems so large compared to the premiums paid, right?

Some policies, like my ABA policy, pay dividends, but it is rare. Dividends are paid when the premiums taken in are more than the amounts paid out. Organizations may ask you to donate the dividends to them (as the ABA does) requiring you to request, in writing, every year, the cash equivalent of the dividends if you want them.

Note also that as you get older, term policy premiums can get more and more expensive.  Thus, eventually I had to drop my ABA life policy as it became too expensive to maintain.

As I noted, when you get older, you are going to die, period. So life insurance for older people makes no sense whatsoever. Yet television commercials abound for "Senior Life" insurance, for folks too dotty to figure out that you can't get something-for-nothing. These "burial policies" basically provide little in benefits (maybe a few thousand dollars) for relatively high premiums. There is little bargain in these policies and I would advise staying away. Life insurance is a young man's game, and if you didn't buy it when young, then forget about it when you get old.

2. WHOLE LIFE

Whole life is an interesting concept. Originally, the idea behind it was to increase the premium beyond that needed for the insurance itself, such that the excess premium could be invested and the policy "paid up". "Paid up" means that no more premium is due and the policy is completely paid for.

Since part of the premiums paid are not going toward the insurance, they act as an investment vehicle. And the tax code has a "loophole" ("loophole" is a lazy man's term for the law) that allows you to take out money invested in a life insurance policy in the form of a loan or annuity, tax free. You can also "cash out" a policy and take the money, but you may have taxes to pay if the amount taken out exceeds the amount paid in.

A whole life policy is a complicated financial instrument, and my mantra that "the more complicated a financial transaction is, the easier it is to fleece the mark" applies here. Like a car lease, it pays to read the fine print - or in many instances, just walk away. And as I noted in my previous article, don't make the mistake of assuming the insurance agent is your friend acting in your best interests. He is on commission and gets paid to sell polices. Verbal representations he makes are worth nothing. Read the policy before buying.

For the first few years you have a whole life policy, it seems like a waste of time. You pay into the policy and the cash value remains flat, or increases slightly. In terms of an investment, it is a lousy one. Many people drop out of such plans at that point, not seeing any rate of return and figuring their money will do better elsewhere. After a decade or so, the policy is no longer "upside down" and the annual increase in cash value will exceed the premiums paid that year. For my whole life policy, this is the case - each dollar I put into it in premium equates to nearly two dollars in increased cash value.

Whole life policies generally pay dividends, again based on the profitability of the company - how much is paid out versus taken in. These dividends can be used in a number of ways. Your agent (again NOT your buddy!) will suggest you use them to buy more insurance. He gets a taste of this and the company make more money this way, so naturally he suggests it. But most policies allow you to take the dividends as cash or apply them to reduce your premiums. After a number of years, the policy may be self-funding based on dividends.

Again, your agent will suggest you don't do this, but rather buy more insurance with the dividends. Buying more insurance will increase the size of the policy and also increase the cash value more quickly. However, you may find that you already have enough insurance and would rather invest the money in other areas (tax-deferred accounts such as IRAs).

In fact, you may encounter extreme resistance from your agent if you try to change the option in your policy to use dividends to reduce premium or take them in cash. For example, such a policy change may only be available during a window period on the anniversary date of the policy. The Agent will conveniently forget to tell you this, and hope that by the time of the next anniversary date, you will have forgotten all about it. Or the policy may not allow you to use dividends to reduce premium until the dividends exceed the premiums - but you can still take the dividends in cash, of course. My Northwestern Agent told me that on one policy I could not use dividends to reduce premiums. He conveniently "forgot" to tell me that I could take them as cash.

You have to read the policy carefully to understand how it works, and keep in mind the various rules and anniversary dates. Like any financial instrument, you have to be proactive and get involved.

Most policies also have a loan provision, allowing you to borrow against the policy cash value at a predetermined fixed rate. If you took out the policy during a time of low interest rates, this can be a good deal later on if rates go up. But if (like me) you bought a policy when rates were high (8%) then the loan provision may be no big bargain, except as a lender of last resort.

On the "back end" of whole life, you can take out money when you retire. You can do this in one of a number of ways. You can borrow against the policy and spend that money, with the proceeds of the insurance (when you die) paying off the loan. Since this is a loan, the money you spend is tax-free (life insurance proceeds are not taxable). Others have annuity provisions, that pay out X dollars per month (e..g, $5) for every $1000 in insurance. So, for example, for a $100,000 policy, you may get an annuity of $500 a month, if you retire at a certain age. Again, you have to read the policy to understand these options.

You can also cash out the policy at any time, although this usually is the least profitable thing to do, as the cash value is usually worth far less than what you paid in, and there may be tax consequences.

Is whole life right for you? Probably NOT. If you have an IRA, 401(k), SEP or other tax-deferred retirement plan you can participate in, such plans are probably better use of your investment monies. You can control (to some extent) where the money is invested, and when you retire, you take the money out as cash, without hassles.

However, a small whole life policy can be a good way to diversify a portfolio. During the recent downturn in the stock market, my whole life policies did fairly well in comparison to my other investments. But as a primary investment vehicle, they are a bad choice, as the rate of return is far less than in equities. I have maybe 1/10th of my net worth in Life Insurance at the present time, and that is probably a good amount.

Bear in mind that life insurance is a contract, and is not guaranteed in any way. If the company goes bankrupt, you can lose everything, although such incidents are rare. Life insurance companies generally invest their proceeds in commercial Real Estate and the like, and thus can be subject to downturns in the Real Estate market, as particularly happened in the late 1980's.

Note also that a whole life policy is a forced investment. You have to pay the premiums, like clockwork, for the life of the policy, or the policy lapses and you'll get back only your cash value. Thus, if your life circumstances change, you may find that you want to scale back on some investments. But a life policy can't be scaled back in many cases.

For that reason, don't buy more whole life than you can easily afford. Limit the premium to an amount you are comfortable with. When I was 29, I bought a $100,000 life policy for about $99 a month. I figured that no matter what happened in my life situation, I could swing $99 a month from then onward. If you buy too much insurance, you'll be more inclined to drop the policy if you need the money later on.

3. MUTUAL OR STOCK COMPANY?

When selecting a company, you should understand the type of company you are investing in. Stock companies, like the name implies, sell stock and pay dividends to shareholders. As such, they have to bosses to answer to, the shareholders and the policy holders. Both want to get paid, and the proceeds have to be divided in two.

In a mutual company, the policy holders ARE the shareholders, so any dividends or profits are paid back in the form of policy dividends to policy holders, not in stock dividends to shareholders. Thus, a mutual company is preferred if you are purchasing whole life.

4. ADJUSTABLE LIFE, VARIABLE LIFE

There are other forms of whole life which are interesting vehicles for investment. These types of polices allow for the investment vehicle to comprise a larger part of the policy, or allow the amount invested to vary over time. The IRS has stringent rules on the ratios of investment to insurance, lest the whole concept of whole life be turned into nothing more than a tax avoidance sham.

Some of these policies are almost like a investment account, in that you can direct the surplus funds into one or more of a number of investment accounts (mutual funds and the like) and can control, to some extent, the amount invested over time.

These are more complicated polices and it pays to read the policy and understand it and also understand how and when you can take your money out. Again, the more complicated a financial transaction is, the greater the chance it works to your disadvantage. You may find your agent strangely less-than-helpful in helping you understand these polices. The Agent will want you to take actions that result in a higher rate-of-return for the company and himself. He will not volunteer useful information to you.

I would not recommend these more esoteric investment vehicles for the average investor. I have one of each, and while they have done OK, I probably would have been smarter to put the money into my 401(k) or IRA.

5. A NOTE ON BENEFICIARIES

The beneficiary is the person or persons who will receive the proceeds of your life insurance, should you die. You can leave the money to your spouse, children, a friend, or even a total stranger. It doesn't matter. Or, could leave the money to your estate.

If you leave the money to your estate, the money would then be dispersed according to your Last Will and Testament, or according to the State law, should you die intestate (without a Will). Leaving the money to your estate can be handy, as the money can be used to pay debts of the estate, and also you can change who gets the money by changing your will.

However, the money, when left to your Estate, may be taxable to the recipients or may be taxed at the State level.  Contact your local tax expert in your jurisdiction for more information.   The other disadvantage of designating your Estate as beneficiary is that it puts the money into probate, and thus delays payout and also raises the specter of hateful relatives who decide to sue for "their share" of your Estate.   If you designated Joe Blow as your beneficiary, the money goes directly to him (all he needs to do is file a copy of the death certificate with the company and wait for his check) and it is tax-free and the hateful relatives can't touch it.

Designating a child as a beneficiary can be a bit tricky, as insurance companies will not pay money out to a child under the age of 18. Any child under 18 can renounce any contract upon reaching majority (age 18). So if you pay out to a child, at age 18 they can say "I changed my mind, pay me again! the first time didn't count!".

Thus, if you designate your children as beneficiaries of your life insurance, someone will have to be appointed as custodian of the money on behalf of the child. Alternatively, the life insurance company will keep the money (with or without paying interest, depending upon the terms of the policy) until the child reaches age 18.

6. SO.... Do YOU NEED LIFE INSURANCE?

Short answer: For a young breadwinner starting out with a family and no assets, a small term policy is probably a good idea. Whole Life is an interesting toy to play with, but don't let the agent talk you into investing any major amount of money in a whole life policy, as it really isn't the most effective investment vehicle.

And never, ever, trust an Insurance Agent. They are salesmen, plain and simple, and they will do anything and say anything to make a sale and to cover their ass.

See Also:

http://livingstingy.blogspot.com/2014/11/should-you-cash-in-your-life-insurance.html

http://livingstingy.blogspot.com/2013/11/whole-life-insurance-after-20-years.html

 http://livingstingy.blogspot.com/2011/05/life-insurance-over-50-hell-no.html

http://livingstingy.blogspot.com/2010/12/convert-to-paid-up-life.html

http://livingstingy.blogspot.com/2010/11/my-20-years-with-state-farm-insurance.html

http://livingstingy.blogspot.com/2009/12/my-experiences-with-nml-after-two.html

Beware of Financial Advisers!

Financial Advisers - the next big rip-off

A few years ago, Republicans proposed "privatizing" Social Security. It sounded nice, in theory, but it is probably a good thing the idea died a quick and silent death.

In the next 10 years we will see the first wave of retirements for the Baby Boomer generation, and the first effects of the 401(k) generation. And we will see a number of stories, I predict, about rip-offs from financial advisers and institutions.

I live on an island where the average age is 74. It is interesting to see how retirement works out for some people, and not for others. For those with government jobs or secure pensions, retirement is no big deal. They live large, with money in the bank and a secure retirement with no worries. They travel, buy new cars every few years, and relax and enjoy life. But for others, having to manage their own funds, well, it can be more stressful worrying about money. And for some, retirement can be a real nightmare.

Back in the 1980's and 1990's some folks took cash incentives to retire early. They were "bought out" and given lump sums in lieu of retirement pensions. In effect, this converted their traditional fixed benefit pension plans to a 401(k) type self-funded retirement. For many, it did not work out very well. And this experience is a precursor to the millions who will retire shortly under the 401(k), IRA, SEP and related plans.

Those "early out" people illustrate one problem and one fallacy with the 401(k) or Social Security privatization theories - most people simply don't know how to handle money, particularly huge chunks of money.

Think about it. Your average "salary slave" in America receives his income in little drips and drabs, in the form of a weekly or bi-weekly paycheck - sort of like an allowance from Dad. And Uncle Sugar already took out his taxes (because God forbid, if we waited until the end of the year to collect, no one would every pay!). We are coddled and we are treated like children, because if were indeed handed a huge paycheck in one lump sum, most of us, like children in a candy store, would squander it in short order.

Many folks taking "early out" do just that - investing in schemes and businesses that don't quite pan out. A lifetime of work can end up on the trash heap in short order. Others entrust these large sums of money to financial advisers, often with similar, although less tragic results. Huge sums of money invested over the years, often at great risk, ends up yielding a rate of return not much higher than a safe bond or even an FDIC-insured savings account at the local bank. Fees and "loads" and other charges are never clearly disclosed to the consumer.

A big part of the problem is that people simply do not know how to manage money - as they are not trained how to do so. Respect for money is not taught in school, and is not a cultural value for most folks. So in part, yes, it is the "fault" of the consumer for making bad choices. But financial advisers are supposed to be there to help us make better choices. Unfortunately, in many cases, they are simply salesmen selling products on commission - and the great "financial advice" they want to give us is based on what product generates the best commission for them.

Don't act so shocked. This is America, after all.

It seems everyone is getting in the financial advice game these days. Banks, insurance companies, everyone it seems - even the local donut shop - posits itself as a "financial network". My Dad, when he lost his job, became a "financial adviser" for a brief time. Anyone can do it. Why not? It is a booming business. The generation of defined-pension benefits is dying off, and a new generation of 401(k) boomers is coming up, with billions of dollars to invest and no idea how to invest it. It is a goldmine of opportunity for smart people with no scruples. All those mortgage brokers need to find work somewhere, right?

We are already starting to hear stories on the wire about crooked financial advisers. These are just the initial tremors precursing the shockwaves to come. For example, in one recent published incident, a financial adviser sold an annuity to an elderly gentleman suffering from the early stages of dementia. Nothing wrong with annuities, per se, but this one tied up his money for 20 years before paying anything out. When you're 70 years old and looking at assisted living, an annuity like that is not a sound or wise investment. Thanks to all the bad publicity involved in that case, the company in question quickly refunded the money. But how many other cases like that are there out there that we don't hear about?

Another typical example that pops up with all-too-frequent regularity is the "churning broker". The broker is given trading authority by the client (bad idea) and he starts trading the client's stocks - buying and selling several times a day. Oftentimes he ends up selling and buying back the same stocks. Each trade is a commission for the broker (and this is not a "discount commission" firm, either) and pretty soon, the value of the client's account starts to drop. By "churning" the account, a broker can convert hundreds of thousands of dollars in equities into commission fees for himself, and leave the client destitute.

Again, in both examples, the temptation is to blame the client - the investor - for making bad decisions by letting the financial adviser talk him into bad ideas. But for many folks unsophisticated in the market, they have no way of discerning good ideas from bad. They trust their financial advisers to give them good advice. And that level of trust is a very bad idea.

But those are egregious examples of crooked financial advisers - the ones that are just plain crooks. There are many others (perhaps most of them) who merely give bad advice or squander a large portion of the client's money on their own fees and commissions.

For example, the other day I went to my local Insurance Agent (who is now a "certified financial adviser" which is a crock, because there is little or no regulation, training or certification required to become a financial adviser). I had a question about a whole life policy I had. Fresh out of her adviser training and hoping to make "President's Club" in sales, she offered to do a financial analysis of my portfolio for me. I said "Sure, why not?"

The "advice" she had to give me was simple: Cash in all my investments, including life insurance policies, and invest them with her - often in the same funds. The reason given? "Convenience," she said. The cost? 5% of my portfolio. I said "no thanks" although perhaps in stronger language than that. (I believe what I actually said was, "How do you sleep at night?").

The problem is, a lot of folks I know think their financial advisers are their friends. They think they really do get paid to give out good financial advice. They don't understand the commission structure, which encourages even the most scrupulous adviser to steer clients toward certain products.

For example, a good friend of mine always speaks so highly of "that nice young man at (brokerage house)". "He always has such good advice for me, and he calls me up several times a year!". During the recent downturn in the economy, my friend lost nearly half of their portfolio in stocks. At my friend's age, they should not have been so heavily weighted in stocks in the first place and should not have lost so much.

One rule of thumb bandied about these days is that your age should reflect the percentage of money you have in low-yield safe investments (such as a CD or money market in an FDIC insured account at the local bank). At age 30, this should be 30%. At age 50, 50%. At age 75, 75% of your investments should be in "safe" accounts such as banks or bonds.

My friend, unfortunately, had 75% of their money in stocks - the reverse of most good financial advice - and as a result took a big loss - a big loss they could ill afford. Why were they in such a risky porfolio at their age? Their adviser told them to invest this way. Everyone is making money in stocks, right? Might as well jump on the bandwagon. And so long as everyone is making money, everyone is happy and won't notice the commissions and fees eating away at their rate of return.

And unfortunately, in response to such losses, many folks panic and do two of the exact wrong things. Some of my friends on "retirement island" decided that after losing huge chunks of their portfolios, to sell off their stocks and get into bonds. They sold their stocks at a low point and bought bonds when they were at a high point. Sell low, buy high, the sure recipe for disaster.

Others, such as my friend, did an even worse thing: they doubled-down their bet. "I want to see my money increase in value, I don't care what it takes" my friend told their financial adviser, who was all-too-happy to hear that. My friend didn't understand that you can't dictate to the market what your rate of return will be. The broker sold the risky stocks and put the money into even more risky higher-yield stocks. If it works out, great for my friend. But if those stocks tank (and they do!) they will end up with nothing. Either way, the "nice young man" at the brokerage house gets a commission. Did he explain the risks to her? Did he really try to steer her to a safer harbor? Maybe. Or maybe he didn't try all that hard.

You see, that's how these things work. You make money, they make money. You lose money, they make money. Yes some funds reward the fund managers for high profits. But to some extant, that's even worse, as it encourages the fund managers to take huge risks with other people's money, hoping to win big. If they lose, however, they still take home a nice salary. Ask anyone who invested in a hedge fund in the last decade how that worked out. It was a "heads we win, tails you lose" situation. The real winners were the hedge fund operators, in many cases.

So what is the answer for us "little people" out there? I really wish I had one. Investing money is really a crap shoot these days. Brokerage houses and funds advertise heavily to promote brand awareness. Many folks invest with a particular brokerage house or mutual fund based on such brand awareness. But the reality is, we have little or no way of monitoring what goes on behind the scenes. Even with a degree in Accounting, it is difficult to discern from the annual statements what is going on.

The financial products we are being sold are a pig-in-a-poke. You can look at rates of return for years past, but as the prospectus always disclaims, "past performance is no guarantee of future returns".

You can take the bull by the horns and start a self-directed IRA, but even that is fraught with peril. I recently decided to roll over a small IRA with Fidelity into an eTrade account (we had too much with Fidelity for my comfort level). Rather than trust a number of different fund managers to manage our funds, I thought it would be an interesting experiment to invest my money myself in stocks of my own choosing. It was an interesting experiment, with mixed results. While my Fidelity account dropped in value by nearly 1/3 last year, my self-directed account pretty much stayed the same, mostly because I put a big chunk of it into an FDIC insured money market account (good thing it was FDIC insured, too, because it was with WaMu. WaMu went bust, I didn't lose a cent).

The problem with stock investing, as with mutual fund investing, is that the average investor does not have sufficient time or energy to fully investigate stocks to buy. What was "blue chip" material just a few years ago (GM for example) became worthless penny stocks (GM liquidation corp) in a real hurry. Unless you really have your hand on the pulse of a company and know what is going on (which would be insider information and thus illegal) you really can't make an informed decision.

And, unfortunately, that's the nature of the stock investment game. It's fixed. The insiders get the best deals (regulations notwithstanding). The big players even get to trade faster and sooner and before the market even opens (although the government is trying to shut that down as well). The little people (and there are a lot of us out there with our 401(k)s) are left to feast on the crumbs.

The only practical advice I have is as follows:

1. DIVERSIFY: Don't put all your eggs in one basket. The really heartbreaking stories out there usually involve someone who invested all their money in Enron, or put all their money with one brokerage house, or with one financial adviser. While it may be "convenient" to use one source for your investments, if that one source turns sour, you are really in a bad place. Invest in a number of different places, both in terms of brands, as well as types of investments. Putting everything into a single mutual fund through a single brokerage is not a good idea.

2. TAKE ADVICE WITH A GRAIN OF SALT: When your broker or insurance agent or investment adviser calls you, bear in mind they probably want to sell you something. Rarely, if ever, will they tell you what they are making out of the deal (I am not aware of any law requiring them to disclose this information, either). My insurance agent, for example, calls me once a year trying to sell me a new insurance policy (nursing home insurance, lately). When I told him I was not interested, he stopped calling. When I call him for advice on my existing policies, he either doesn't return my calls or refers me to an untrained assistance. No, he is not (and was not) my "friend" but merely a salesman. Salesman will act friendly, but don't confuse their salesman skills with real empathy for your situation. Their commission is their bottom line. And never, ever take the verbal promises of any salesman at face value. Read the actual documents or papers you are signing.

3. TAKE CHARGE OF YOUR FINANCES: By this, I don't mean churn your account, or invest in dubious get-rich-quick schemes. But what it does mean is to read all your statements carefully and think about what you are invested in and whether that investment is appropriate for your age and stage in life. Do the research. Unfortunately, this may mean having to read all those financial statements more carefully rather than just stuffing them in a drawer. And it may also mean you have to go to the library and learn more about finances.

4. FIND SAFE HARBORS: Once you reach a certain age, don't be shy about cashing in those stocks an putting the money into a CD or money market account at your local FDIC insured bank. Your financial adviser will tell you not to, of course, as that works against their interests. But at age 70 onward, playing the market is not necessarily a swell idea, no matter what the folks at the Motley Fool (remember them?) say. At any age, you should have money invested in a safe place that you have direct control over.

The marketplace is a battlefield, and getting more so every day. You cannot trust anyone. People who fall for schemes and scams and get sold a bill of goods always fall victim to trusting someone who is selling them something. This may sound harsh, but it is a basic truth. You can whine and complain about the unfairness of it all, or strap on your armor and go in and do battle. Take charge of your life, be proactive. Don't let these people walk all over you.

Coupons - Are they worth it?

I touched on the issue of Coupons before in an earlier post. Are they worthwhile, or just a gag to encourage us to spend more?

What prompted my reflections on this subject was the arrival in the mail of yet another "coupon book" from BJ's Wholesale, a big-box discount warehouse. After reading the coupon book, I had several questions:

1. Why not just lower the prices for the time period indicated by the coupon, instead of keeping the price high and offering a coupon?

2. Is the coupon book merely an advertisement disguised as a discount promotion?

The answer to the second question is "Yes" and that, in turn, answers the first question.

In economic theory of pricing, the optimal return for a retailer occurs when each consumer market segment pays what they feel to be is a fair price for a product. Thus, if you can get a rich person to pay $100 for an item, a middle-class person to pay $75 for the item, and a poor person to pay $50 for the same item, then you have maximized your market revenue. Each person in each social class has paid what he thinks the product is worth, and provided that amount is more than the cost to you, you make money. Selling to all three customers at the bargain price of $50 makes no sense, as you are leaving money on table, when it comes to wealthier customers.

Such economic theories have been used in the past to explain pricing schemes such as coupons, rebates, and the like. For someone who is not price-sensitive (i.e., wealthy) the product is sold at "full retail price". More price-conscious consumers might wait for the item to go on sale, or be discontinued or closed out, or maybe moved to the scratch-and-dent section. Coupons and rebates are another way of targeting the price-conscious consumer. By offering an effective lower price for those willing to spend the time looking for it, the retailer maximizes his income, right in line with economic pricing theories.

Another theory is that manufacturer's coupons encourage consumers to try brand-name products by offering them at attractive prices. The theory is, if the consumer tries Wheaties just once, they will change brands forever. Thus, the coupon is a loss-leader that entices the consumer to switch brands.

Another theory is that coupons can be used to gather market data. By tracking coupons (and yes, I wrote a Patent on this) marketers can determine which people from which zip code (and thus demographic area) buy which products. Since zip code is tightly linked to income and educational level, one can tell a lot by how many coupons are redeemed in certain areas.

Another theory is that coupons, when used in advertisements, encourage consumers to go to a store to seek out the alleged bargains. Similarly, offering double or even triple coupon discounts (remember those days?) encouraged consumers to go to a particular store over a competitor.

But the coupons from the wholesale club fail to fall into these patterns. To begin with, these coupons are mailed out to all members, so everyone has access to them. Moreover, when entering the store, racks of such coupons are available to the consumer. In other words, very few, if any, members of the wholesale club are paying "full price" for the coupon-discounted items, as the coupons are available to everyone, and the members are trained to look for the coupons before buying.

As I noted in my earlier blog on big-box stores, the coupons at BJ's Wholesale end up being little more than clues to an in-store treasure hunt - directing consumers to seek out certain purchases and impulse buy items they did not intend to buy when entering. And even stranger, many of the coupon "deals" are more expensive than comparable goods on the adjacent shelf. Not only is the consumer not saving money using these coupons, often they are the worst deal in the store (well, the only worse deal is paying full retail for the couponed item).

Stranger still are the "instant coupons" proffered on some items. You purchase the item and then scan a coupon attached to the item for an instant discount. Only a brain-dead person would fail to ask for the discount that is so freely offered. Why these "instant rebates" are offered in the first place is an interesting question. No market research data is accumulated, the consumer is not encouraged to go to the store, and no optimal pricing takes place.

Why not, instead of offering an "instant rebate" just lower the price instead?

I think the answer lies in what I call "Bob's first law of Economic Transactions" which states as follows:

"The more complicated you can make any economic transaction, the easier it is to confuse the consumer and thus hide the actual price or other terms, and thus make more money."

Or to put it more succinctly: "The more complicated a deal, the greater chance it is a rip-off".

As I have noted in the past, car leasing is a perfect example. By hiding the purchase price and interest rate and selling only monthly payment, the car dealer can more easily deceive the consumer into paying too much in terms of both price and interest on the car he has bought (and he has bought it, believe me).

Similarly, the coupon acts as a confusing agent, skewing the mind of the consumer, who may be blinded by the bombast of "bargain" and thus make a poor choice.

Instant coupons loudly declare their existence. The consumer subconsciously thinks they are getting a deal, when in fact they are not. The bag of potato chips with a "50 cent instant rebate" is no bargain if the competing brand is a dollar less. And the bag is certainly no bargain if the consumer originally had no intent to buy the product when entering the store (the impulse purchase).

Similarly, the "coupon book" mailed out by the wholesale club is merely an advertisement and an inducement to go back to the wholesale club. If labeled as an ad-sheet, most consumers would merely toss it in the trash, along with the ad-sheets for competing markets. But when the ads are couched as valuable discount coupons, the consumer reads them and saves them, and makes a mental promise to visit the shopping club soon.

The Wholesale clubs, as I have noted, do have some good bargains, provided that:

1. The products you are buying are what you intended to buy and not impulse purchases;

2. The products are actually cheaper than competing markets; and

3. The bulk size of the product does not encourage over-consumption and waste.

The coupon book attacks premise #1 with a vengeance and does good damage to premise #2. By offering "discounts", the coupon book encourages you to think about buying things you had not previously considered. And by acting as a confusing factor, they get you to pay more for a product than you should.

So are coupons a total waste of time? For the most part, probably YES. Simply shopping based on price comparison alone will likely yield a similar if not superior result to "coupon shopping". No matter how strong your resolve is, chances are, you might change your shopping list to include a couponed item, merely because it is a perceived bargain. Regardless of whether it is a bargain or not, if you did not intend to buy it originally, it ends up only being an additional expense.

And yes, the couponing industry does promote couponing - they hype it. As I noted before, local television stations (often starved for real news) will do human interest pieces about a local couponing consumer who goes to the local Safeway and walks out with bags of groceries for a dollar.

But such stunts (which is often what they are) are often staged and often rely on the couponer simultaneously spending a number of valuable manufacturer's coupons at once. The average "take" for the couponer may often be far less. And again, if you end up buying things you didn't want in the first place, is couponing such a bargain?

Of course, this is taking aside the amount of time and effort needed to obtain, sort, store, and use coupons, which can consume hours. Of course, it makes no sense to turn away a coupon for a staple item that you ordinary buy. And of course, at the warehouse store, it makes no sense not to use their coupons, as the entire price structuring system is based on it. The hard part is to resist the temptation to buy something you did not initially intend to buy, based solely on the presence of a "coupon".

The Problem with Mini-Mansions

Above: The great American Mini-Mansion. Do you really need all that? Yuk.

UPDATE:  You might want to read this article on homes as investments.  It turns out that buying "more home" means just spending more money.  You don't make a profit by purchasing a larger home, you just spend more money, over time.  Buy the home that is appropriate for your needs, not what some Real Estate Agent says is appropriate for "your income bracket".  And never fall into the trap of "buying as much home as you can afford!" as the events of the last decade have proven the folly of that approach.  A home is a place to live, it is not a bank account!

* * *

I just finished a home remodeling project, finishing off an unfinished basement room. It was an educational experience, and a lot of hard work.

The overall cost of just finishing and furnishing this 14' x 24' room was over $5000. And this included doing all the labor myself, and also buying much of the furniture secondhand.

The cost breakdown was as follows:

2x4, sheet rock, insulation, electrical, construction materials: $500

Paint, trim, finishing materials: $250

Lighting, ceiling fan, etc. $250

Carpeting: $1000

Furniture: $3500

Total (conservative estimate): $5500

I learned several things from this exercise:

1. Just finishing a basic room (not a bath or kitchen, with no cabinets, plumbing, or major electrical) is a staggering amount of labor.

2. The cost of remodeling projects, particularly Do-It-Yourself projects, is a lot higher than you might think. Each trip to the local home-improvement store costs $100 to $300, and it takes many trips to complete even a "simple" project like this (with little plumbing and basic electrical).

3. If you multiply the cost of finishing a room from top to bottom - carpet to draperies to paint, to furnishings, it will run a few thousand dollars for most rooms.

4. If you have a 5-bedroom mini-Mansion with a den, a studio, a family room, an exercise room, etc. the cost of fully and properly finishing and furnishing such a place would be staggering.

5. For reasons 1-4 above, many Mini-mansions are only partially furnished, or if furnished, poorly furnished and finished.

And the conclusion in #5 ends up being true more often than not. During the Real Estate boom of the last decade, middle-class Americans were told to "buy as much house as you can" - and ended up buying houses that were far larger than they really needed.   Being house-poor, they could not afford to properly finish and furnish such houses.

We've been in more than one mini-mansion where entire rooms are vacant of any furnishings, or just used as storage for boxes. Worse yet, we've been to enormous houses where the only furnishings were worn-out sofas and milk crates. The occupants apparently moved directly from the dorm room into the McMansion.

One wants to say, when walking into such a house, "Call the Police! Someone stole all your furniture!" But it turns out the owners choose to live this way.

The cost of properly finishing (i.e., painting or papering rooms beyond "builder white") and furnishing each room in such a house can be staggering - particularly if you have to hire a decorator or contractor or painter or electrician, or all of the above.  As a result, few people take on such a task.

However, purchasing small items on a credit card seems "affordable" as each purchase is "only a few bucks" or a couple of hundred at most. So, rather than invest several thousand dollars on legacy furniture, the McMansion owner has a garage full of cardboard boxes for items bought at "big box" stores - small appliances, exercise equipment, clothing, gifts and tchotchke, and things of that nature.

Owning more house than you need not only means you have to pay more money every month in mortgage payments, property taxes, insurance, and utility bills, it also means you end up with a house you cannot really live in. Many McMansion owners are really just camping out in their investments.

Of course, this is a personal choice for them, and like so many consumer products sold these days, they are sold on emotional needs rather than practical ones. The McMansion is an opportunity to display status and the appearance of wealth. Of course, the key word here is appearance, as many owners are in hoc up to their eyeballs. Moreover, since every other middle-class schmuck on the street has the same house, the idea that such homes convey "status" is questionable.

Moreover, to the trained eye, the cheap construction techniques and fittings are all-too-readily apparent. A large home can be built that will appear "expensive" to the average person, but screams "cheap" to those in the industry. It takes little extra to build a cheap home on a large scale.

In Florida and many areas in the South, expensive looking stucco exteriors can be inexpensively applied using a material called Dry-vit and a small army of migrant laborers. Houses can be made to look expensive without really being expensively made houses. Over time, as the house weathers and fades, the underlying reality of the construction is exposed, and the owner needs to spend more money in continual overhauls to keep it looking new.

Thanks to modern technology, vinyl windows and siding can be installed very inexpensively (and last a long time). Wall-to-wall carpeting is the cheapest floor covering available. The additional amounts of lumber and roofing to build a larger home do not add significantly to the bottom line.

In other words, it doesn't take twice as much money to build twice as much house. There is a basic bottom-line cost to building any home, regardless of size. So ramping up home size is a good way for a contractor to make a lot of money. They can charge twice as much for the home, while increasing their expenses maybe by only 50%. Big sells. Big is profitable. Big works. Or at least it worked.

As we move forward into the new Century, one wonders what will happen to these mini-mansion neighborhoods. In some respects, we are seeing the effects of this in some suburban areas, such as in Washington DC. During the 1990's it was trendy to talk about "edge cities" and the ever expanding exurbs. But just as the middle class housing boom has moved further and further from the city center, it appears that the problems of the city are chasing the suburban dwellers further and further out - to the point where many middle-class and upper-middle-class folks are moving back into the center of cities (or at least the near suburbs), discovering value in these closer-in areas.

We are now seeing suburban ghettos forming in places like Dumfries and Woodbridge Virginia, as the new-home set moves further out to Fredricksburg and the like (or inward to "infill" developments). Suburban sprawl breeds discontent and malaise. Children of wealthy and successful middle-class parents often end up bored and listless - and as a result end up overeducated and underemployed. Suburban crime rates are starting to rival those closer in to the "big city".

Will home buyers still look to places such as "Inlet Cove Mews Estates" as a desirable place to live? Or will these exurban sprawls devolve into far-flung Ghettos, turning into de-facto apartment houses (many already provided with separate "inlaw suites."

People do not need a lot of space to live in. Our parents and our parent's parents raised entire families (often far larger than today's 1.8 child families) in two- or three-bedroom houses. How they did it? We scratch our heads and wonder.

But again, back then, perhaps we were more of an outdoor people - and spent more time in public space. Television watching, creeping up to an average of 5 hours a day per person, consumes more and more time (as does commuting). Each family member, of course, needs their own space to watch their own TeeVee, as no one can agree on one channel to watch. Americans are becoming more sedentary, spending more time indoors and less time outside. So naturally, we are seeing an increase in demand for indoor space.

Of course, one has to wonder if this is one of those chicken-and-egg type situations. Does having more indoor space encourage people to spend more time indoors, or does spending more time indoors encourage people to demand more indoor space? It is an interesting question to ponder.

The bottom line, though, as I noted in my previous post, is that buying more home than you really need is not a smart economic move. A home should be viewed as a place to live, first and foremost, not an "investment vehicle". Buy the amount of home you want or need. So long as it is appropriately sized for the neighborhood, the size will not significantly affect market value. But again, market value should not be the determining factor in home ownership in the first place. The era of home ownership madness is behind us, or at least hopefully it is. After two Real Estate bubbles in 20 years, perhaps people will finally get the point.

FWIW.

The Dream of Home Ownership, or Nightmare?

The Dream of Home Ownership - or Nightmare?

It seems that everyone in the Federal Government wants us to buy a house. Politicians, when running for election, speak of the "American Dream of Home Ownership" as if were the holy grail or the ne plus ultra of living.

The tax code has been skewed to encourage home ownership, both for individuals and for investors. If you make any amount of money at all, it seems the best thing to do, tax-wise, can be to buy a house. And financial advisers are quick to make that recommendation. But remember, as I have stated in the past, you can't deduct your way to wealth. Even the $8000 first time home buyer tax credit is no bargain, if the house ends up being a financial nightmare.

Home ownership is not for everyone, nor should it be. And whether or not you should own a home or even "dream" of home ownership depends a lot on your life circumstances and individuality. For many people, renting a home is a perfectly acceptable alternative and even a superior economic one. The Government would do better to get out of the home-selling business and let people make their own economic decisions without tax incentives.

In the wake of the Real Estate meltdown, many people are struggling to rebuild their finances, after getting sucked into the investment market or after jumping on the home ownership bandwagon, too late in the game. They are asking themselves why and how this "dream" became such a nightmare. Often these were the most unsophisticated investors or home buyers who were encouraged by this "dream of home ownership" talk or the promise of quick profits to invest in a market that was incredibly overheated.

Is Home Ownership right for you? Let's explore the history of home ownership and whether or not it is best for your circumstances.

Owning a home is no big deal, really. After owning several, both as personal residences and as investment properties, I can say that it is no "dream" at all, jut a series of obligations and maintenance chores. If you have never owned a home or never owned investment properties, it may seem exotic and desirable. But like a high-performance car, once you own one, it is just, well, a CAR, and a rather expensive one at that. Sometimes, most times, wanting is better than having.

And as others have pointed out, owning a home really means only that you eliminate one landlord. All Real Estate in the US is taxed by local authorities. So if you "own" a home, you still have to pay "rent" to your local Government landlord. Don't believe me? Stop paying your taxes and find out how quickly you'll be evicted from the home you thought you "owned".

If you go back a few decades, you'll find the idea of home ownership as being the "American Dream" was laughable. The "American Dream" was to become successful and make money, not buy a place to live. Before the Great Depression, home mortgages were nearly non-existent for most buyers. For those who were able to get them, the terms were pretty onerous. The term for repayment was often less than 10 years.

As I have noted in other articles concerning "funny money" such as Student Loans, once you make more credit available a funny thing happens - prices go up. In the late 1930's new home loans, guaranteed by the Government became available, with terms up to 15 years or more. Suddenly, owning a home seemed like a possibility to more and more people.

And since you could borrow for longer periods of time, you could buy larger and fancier homes. Back then, most homes had one bathroom. By the 1960's the idea of two, three, or even four bathrooms became quite normal for many middle-class families. So as more money became available, prices went up and houses got larger. But the monthly payment, in terms of percentage of income, remained about the same. Suddenly, the home became this huge investment, rather than just a place to live.

After World War II, mortgages were extended to 20 and then 30 years, and down payment requirements loosened. Not surprisingly, a housing shortage started, as returning GI's wanted to buy houses with this new funny money. Developers scrambled to build suburban tracts, while traditional city dwellings (often rental apartments) devolved into slums. You could take a suburban farm, chop it up into tiny little lots, put cheap houses on them and double or triple your money in a matter of months. Raw land was cheap, but packaged home units could be sold to individuals at relatively high prices because mortgage money was available.

Interest was deductible from your taxes, so having a mortgage or other debt was, in some respects, a bonus, as you could deduct the interest from your income and not pay taxes on it. Buying things "on time" flourished. Home ownership increased dramatically, but for a large segment of the population, mostly the poor, renting was the norm. Down payment requirements were still fairly hefty, and as a result, most poor people could not afford to buy houses.

The very rich tended to rent as well. Downtown luxury apartments were rented to wealthy tenants - the idea of the "condominium" had yet to catch on in a big way.

In the early 1980's, however, the tax deduction for non-mortgage interest was eliminated. Overnight, credit card interest, car loan interest and consumer debt interest was no longer deductible. It took a number of years before the market figured out how to deal with this new landscape. At first, people merely took it in stride, deducting only the interest on their homes and then biting the bullet on other credit.

But by the early 1990's, as interest rates fell and credit became more readily available, something new happened - the home equity loan. People started using their homes as a source of credit. A home equity loan, "secured" by the equity on the house, could be used to purchase a car or other item, or used to pay off other consumer credit. Of course, the IRS rules limited home interest deductions to only to debt for the purchase price of the home. At first, this limited deductions to those who had paid down the balance on their home. But since the IRS did not have the manpower to check everyone's mortgage balance and purchase price, many homeowners took the deduction, sometimes unknowingly or encouraged by their lender.

At the same time, requirements for some mortgages became increasingly lax, including down payment requirements and documentation requirements. In addition, frightening new financial instruments were created to allow people to buy homes with nothing down and make low payments - at least for a limited time.

So the funny money faucet was turned on FULL, and we had Real Estate bubbles. First in 1989 and then again in 2009. Twenty years apart almost to the day. No one ever seems to learn.

Like in any bubble, the people who jumped at these bad bargains, right before the bubble burst, were the least educated. They saw all their friends buying houses and making money and decided to wait, their instincts telling them that something wasn't right (always listen to your instincts). But eventually, something in them snapped, and too late, they decided to "jump on the bandwagon" and buy, only to have it all go horribly wrong. This pattern is not atypical. Often the most conservative investors end up getting fleeced as they succumb finally to a moment of madness after years of stingy living.

For investors, the tax code provided similar inducements to invest. For an investment property, you can depreciate the property every year on your taxes. For many people, this seems confusing, as Real Estate generally appreciates in value. But what the term means is that you take about 10% of the cost of the property off your income every year when figuring your taxes. If you can get past the meaningless term "depreciation" it is not hard to figure out (just as understanding entropy and enthalpy is really easy once you stop trying to understand them and just figure out how the equations work).

So, if I buy a $100,000 condo, every year, I can deduct $10,000 from my income, which saves me about $3500 in taxes every year. The exact numbers are different of course (consult a tax counselor for details) but you get the main idea. Buy a few investment properties, and pretty soon your tax bill is dropping in half.

When I started buying investment properties, I used the "old school" method of mathematics. I figured that the rental income should pay for the mortgage and all expenses and hopefully leave a dollar or two left over. The Depreciation Deduction was a bonus, in my figuring, and then the appreciation of the property a long-term investment goal.

When the market went nuts, new investors entered. They figured in the tax deduction as part of the break-even picture. Or worse yet, they took on deals with negative cash flows, on the theory that the overall appreciation in the property would dwarf the monthly negative drain. And of course, we all know now how that worked out for them. By the time the madness had started, I sold out, thankfully.

So where does that leave us today? Well, back where we started. Real Estate is going back to its roots as a rather mundane "investment" that is not for everyone. When I started buying Real Estate, the philosophy was very conservative. I would read Real Estate columns such as "Ask Bob" in the Washington Post, or House Calls by Edith Lank (http://www.arcamax.com/edithlank). These writers reflected the common sense of the era, common sense that should be applied today. I have boiled down this common-sense advice to six simple Rules.

1. It takes 5 years or more for appreciation in Real Estate to exceed the transaction costs in buying or selling, so if you plan on staying anywhere for less than five years, rent. 

2. You should put down 10% or preferably 20% as a down payment to secure the best interest rates, avoid mortgage insurance, and insure you are not "upside down" on a loan, should the market go down. You should always seek out a fixed-rate mortgage at the lowest possible rates, even though it requires more documentation and is harder to get. 

3. Never buy a house that is beyond your means. A buyer with mortgage payments exceeding 33% of their income is considered "stressed". 

4. When buying investment properties, the cash income from rentals should equal or exceed the cash outlay in mortgage, taxes, insurance and repairs. Assume a 10% vacancy rate. 

5. A home is nothing more than a series of components that wear out over time. Each lasts approximately 15 years or so. Budget for repairs of these components and avoid the temptation to replace perfectly good parts to "update" a home when more mundane things will wear out first. 

6. Owning should not cost more than renting.  Does renting make more sense for you?  Home ownership is fine and all, but if it costs more to own than rent, maybe the market is overheated.

If you play by rules like these, you will likely never get burned in Real Estate. However, Rules like these often mean you can't afford to buy a home or investment property at all - or that you can't afford that "dream home" mini-mansion.

So, is home buying right for you? Let's apply these five Rules and see how they work.

1. It takes 5 years or more for appreciation in Real Estate to exceed the transaction costs in buying or selling, so if you plan on staying anywhere for less than five years, rent.

Karl Marx once said that land or home ownership was a bad idea, as it tied workers to the land, preventing mobility of the workforce. Everything else Karl Marx said was a load of hogwash, but the was onto something with that comment.

We see today in many impoverished places like Flint, Michigan, or Central New York, that people are clinging to these areas, hoping that "the jobs come back". In many cases, they are invested in the area, literally, through home ownership. They cannot leave the area without walking away from their modest investment (losing it entirely or making very little). So they stay, hanging on to what little they have, rather than migrating to where there is work and money to be had.

Mobility is a very useful thing, and if you are tied to a house or location, you often have to pass on opportunities that involve mobility. I remember being offered a job in Japan once, only to turn it down, as I felt I could not give up my house and garden and other "things" that tied me to Virginia at the time. It probably was the right decision for other reasons, but mobility should not have been a consideration.

If you are working at a job, consider your future there. If you are working for a government agency and plan on staying there 10 years or more, then owning a home might make sense. But if you plan on changing jobs or transferring, then it may not. In a normal Real Estate market, it takes 5 years or more to recoup your transactional costs just to break even.

When you buy a house, you have to pay closing costs, points and other transaction fees. When you sell, you have to pay a 6% real estate agent fees as well as other closing fees. Combined, these fees can amount to nearly 10% of the sales price. In a normal Real Estate market, where home prices appreciate 2% a year, it may take 5 years or more to "break even" on owning Real Estate.

So, if you've moved to the big city for a job opportunity, think hard before buying a place. You may be moving sooner than you think, and you could lose your shirt. See also my article "Never Buy a Condominium!" which details the particular pitfalls of that genre.

2.  You should put down 10% or preferably 20% as a down payment to secure the best interest rates, avoid mortgage insurance, and insure you are not "upside down" on a loan, should the market go down. You should always seek out a fixed-rate mortgage at the lowest possible rates, even though it requires more documentation and is harder to get.

Leveraged deals are never good deals. If you have bad credit, it doesn't mean you can't borrow money, only that the terms you pay will be onerous. The car dealer who advertises their "bad credit specialists!" is not trying to help you, only themselves.

Large down payments result in lower monthly payments and lower interest rates, as the risk of default is far less. You are better off saving up for a down payment than trying to take advantage of one of these crazy leveraged deals. Or even better off walking away from the idea of home ownership.

Yes, if the market goes up, you can refinance, it is true. But then you incur yet more financing charges and closing fees.

The same is true for variable-rate loans and other exotic financial instruments. Home ownership should be a long-term proposition, so you should be thinking long-term in terms of financing. Getting into a house with a low "teaser" rate is no bargain if a higher rate could later force you into foreclosure.

3.  Never buy a house that is beyond your means. A buyer with mortgage payments exceeding 33% of their income is considered "stressed".

Granite counter tops and three-car garages are nice and all, but not necessary to daily living. Most modern homes are designed not for the occupant's physical needs, but for their emotional need to impress people they don't know. The status kitchen and status bath are the norm, these days. Useless whirlpool tubs, for example, are designed to impress those who tour the home, but don't really provide any real value (and waste huge quantities of water). So-called "gourmet" kitchens are often owned by people who microwave all their pre-made meals.

A couple with no children has no real need for a five-bedroom house. But Real Estate agents will always push the idea that you should "buy as much house as you can" to "maximize your interest deduction".

Again, you cannot deduct your way to success. While an interest deduction is a nice thing to have, it does not create wealth. And looking at your home as this mega-investment rather than a place to live is one sure way to get into trouble.

One reason homes in the USA have exploded in terms of size, cost, and amenities, is that people buy things they don't want themselves for "the resale value". So, the theory goes, buy a home with five bedrooms, because someone else might want five bedrooms. But unless you have four children (increasingly rare these days) chances are you don't need all that space. And chances are, there are a lot of other people who don't as well.

Smaller homes can cost less to own, less to maintain, and less to heat and cool. The idea of the smaller home is starting to catch on, but the "buy as much as you can afford" mantra is hard to kill off.

4.  When buying investment properties, the cash income from rentals should equal or exceed the cash outlay in mortgage, taxes, insurance and repairs. Assume a 10% vacancy rate.

Do the numbers, as they say. If you don't have a positive cash flow with a rental property, chances are, owning it will make you poor in the short run, as you run out of cash every month trying to "carry" the property. Factor in vacancy so you won't be surprised when a tenant moves out (hint: Make your rents attractive so tenants stay. Higher rents often lead to tenant churn, which negates the increase in income).

I have seen situations where a Real Estate agent will advise an investor to charge maximum rent for a property, and after it sits un-rented for six months, suddenly has a buyer for the now-distressed landlord - at a bargain price, of course.

5.  A home is nothing more than a series of components that wear out over time. Each lasts approximately 15 years or so. Budget for repairs of these components and avoid the temptation to replace perfectly good parts to "update" a home when more mundane things will wear out first.

I sold a home to a fellow a few years back. He had rented all his life and had no idea how to even fix a bent paperclip. A year later, there was a puddle of water in the basement and he called me, asking me to "fix the basement".

I was flabbergasted. "I'm not your landlord," I replied, "You own the house now." He protested that he should not have to pay for repairs to his house.

"Well, when I owned it, I put in the new furnace, the new air conditioner, the new hot water heater, the new roof, the new windows, the new wiring, the new kitchen, the new carpet, the new driveway, and the new porch. Guess what? Now it's YOUR turn!"

It turns out he had never cleaned the gutters on the house ("Why do I have to do that?" he asked) and the water poured over the tops and did not drain away from the foundation. The idea that you have to spend a few Fall days on a ladder cleaning out dead leaves was alien to him. After all, at his apartment, the maintenance man did this.

But in addition to basic cleaning and maintenance, a home requires repair over time. Roofs leak, appliances die, furnaces break down. Plumbing bursts, wires fry. It all goes bad over time.

Most components on a home require replacement every 15 years or so. Appliances have a design life of 15 years, so factor that in when buying a home. If all the appliances are 10 years old, figure on buying new ones in a few years. And this is also true for furnaces, hot water heaters, and other built-in machinery. You can nurse along older appliances and fixtures for a few years, if you are handy. But eventually, they all go South and require replacement.

Shingle roofs last 15-20 years and require replacement. Some might go as long as 30 years, but that's not the norm. Floors need to be refinished, carpets get worn. Eventually, the whole house gets replaced over time. It is merely a collection of parts that wear out.

And after 30-50 years, other things wear out. Plumbing goes bad. The main sewer line cracks. Wiring becomes obsolete or hazardous. Foundations settle or leak. As the home owner, you have to fix these things. It is your responsibility.

Many people getting into the home buying game during the bubble didn't understand this, as these were the hard-core renters who jumped on the "home ownership" bandwagon after reading about it in the paper. The failed to budget for repairs, and this came back to haunt them.

Worse yet, many Americans try to "update" a home and replace perfectly good appliances and kitchens (and baths) to "increase value" of the home, while failing to budget for repairs of older items later on. I've seen perfectly serviceable kitchens, maybe 5-10 years old, torn out and discarded because the color of the appliances was not considered "trendy". Later on, when the furnace breaks, the homeowner is broke.

Real Estate Agents love to say things like "You'll get the most bang for your buck in a kitchen or bath remodeling". But what they fail to mention is that what this really means is that for every dollar you spend on these items, you will get the most back (usually 75% or less) compared to say, a den remodeling (30% or less). Like deducting your way to wealth, you cannot remodel your home into a mansion. Remodeling is expensive and the increase to the value of the home is usually less than the costs of remodeling. This has always been true, but in the age of television shows such as "flip this house", a rule that has been forgotten. So forget the "dream kitchen" and focus on doing regular maintenance. Remodel the kitchen when it is worn out - and not before.

And when remodeling, consider carefully before going with "trendy" kitchen and bath designs. In the 1980's the tile counter-top was all the rage. But by the 1990's they looked dated before their time (all that grout!). Similarly today, people are jumping on the "stainless steel appliances" bandwagon, which shows signs of petering out already. A dated-looking kitchen will make your home hard to sell later on and may decrease its resale value. However, a basic kitchen with sound appliances in neutral decor may neutrally affect value, while providing years of reliable service.

Some folks bought new construction, on the premise that if everything was "new" they'd have a few years of "no maintenance". But new homes can have their own special problems - like a new car the first year it is under warranty. Usually the home builder makes repairs if there are problems. But sometimes, they don't. And in the last bubble, many went bankrupt, leaving homeowners with no recourse to chronic repair problems, such as Chinese sheetrock, or defective roofing.

Personally, I'd prefer to buy a house that is a few years old than "brand new". The hassles of home building and the "punch list" are not worth it.

6.  Does Renting Make Sense for You?

I have friends who have rented all their lives. They have moved from apartment to apartment, usually with a fabulous view. They have good incomes and can "afford" to own a home. But they prefer to rent. Why?

Well, for starters, they have no maintenance to deal with. Something breaks? Call the maintenance man. No gutters to clean, no furnace filters to change.

And unlike a Condo, no Condo Board to deal with. The landlord makes the Rules - for everyone - and they are not subject to endless debate. And the rent is set by the market, not based on some deferred maintenance nightmare created by a Condo Board.

They have a smaller space, but enough for themselves to live in. They have a fabulous city view and an indoor place to park their car. No lawn to mow. No gardens to mulch. No tree limbs falling through the roof after a storm. No basement to flood when the power goes off.

Not a bad deal, really.

But what about the rent? The fear many have is that "the rent will go up and up" over time, and that they will be forced out of an apartment. A home sounds like a sure deal - a fixed-cost living arrangement that is also an investment. Neither are necessarily true.

While a fixed-rate mortgage may insure the monthly principle and interest stay the same, there are other factors, such as insurance, maintenance, and especially taxes, that can increase the monthly carrying cost as surely as a rent increase.

The economic meltdown has left States scrambling to balance their budgets. Many States are doing this on the backs of homeowners, by forcing more expenses on the Counties, which in turn increase property taxes.

Property taxes of $3000 a year on a modest house in a modestly taxed State are not unusual. In some States, such as New York or Florida, taxes of $7000 or even $12,000 are not unheard of - for homes that are decidedly "middle class". At the present time, many people are trying to sell such homes in my area, after being socked with tax bills as high as $15,000.

Imagine paying $1200 a month in property taxes. It is not far-fetched. And historically it has been a problem. Most jurisdictions have tried to attack the tax problem by offering discounts for Senior citizens or "homestead" exemptions. The problem has been (and continues to be) that many older folks end up being taxed right out of their homes - often homes that are "paid for" after 30 years of mortgage payments.

So the idea that "owning" a home (remember, you don't really own it outright, you only rent it from the Government!) as a means of having "level" payments over time is flawed. Increases in property taxes and maintenance costs over time will increase the cost of home ownership over time as well.

And the idea that the home will increase in value..... well..... do I even need to address that? If you are lucky, it may go up a few percentage points a year, in a normal market. We are returning to a normal market.

And speaking of market, guess what sets the price of rents? Yup, supply and demand. Contrary to popular belief, rents have not skyrocketed over the years but have remained relatively flat. During the housing bubble, many investors bought properties to speculate - and rented them out. This increased the amount of rental property available and drove down prices. Now that the bubble has burst - well, you guessed it - more properties are going on the rental market. Being a landlord these days sucks. It is a game of margins, and not very good ones, either.

Yes, in some areas and regions, rents can increase dramatically due to certain events. But the renter always has the option of moving to a cheaper area. The homeowner can find themselves stuck in an "upside-down" or unsalable house, if the property taxes shoot up. As a renter, you at least always have the option of moving. The homeowner only has the option of walking away and ruining his credit.

My friends who rent are doing all right. No, they did not make a lot of money during the recent "bubble" - but they didn't lose any, either. They've traveled all over the world and generally enjoy themselves. They've never been "house poor" (and there is no such thing as "apartment poor" when you can move). They can move at the drop of a hat to new places when new opportunities arise.

And a funny thing, too. As renters, they tend to accumulate a lot fewer "things" than home owners do. When you rent, there are fewer places to store "junk" and as a result, you buy less and get rid of more. Home owners with their mini-mansions tend to fill up their three-car garages with boxes of crap.

So many the "Dream of Home Ownership" is not a dream after all. It is just having a place to live - a place that can go down in value, requires a lot of maintenance and upkeep, and can make you "house poor" and keep you tied to one spot.

For many folks, renting just makes sense. Once we strip away all the hoopla about "The Dream of Home Ownership" the reality is just basic dollars and cents. And if we stripped away all the tax incentives, I suspect many more people would choose to rent rather than buy a home.