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Investing Blog Roundup: Election Surprise

Admittedly, I was surprised as anybody by the result of the presidential election. I’ll be sharing my personal-finance-related thoughts on that matter on Monday, while doing my best as always to keep the discussion nonpolitical.

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When Does it Make Sense to Buy a Home Rather than Rent?

A reader writes in, asking:

“Do you have any advice for how to determine when it is better to buy rather than rent? I’ve heard rules of thumb regarding ‘price to rent’ ratios and breakeven points. But I’m trying to move beyond rules of thumb so I can be a little more sure of my decision.”

Looking at price-to-rent ratios can help you to quickly get an idea of locations in which buying is likely to make more sense than renting (or vice versa). But when it comes time to make an official decision, I think the best way to assess the situation is to compare your expected total economic cost of housing over the period in question under each scenario (renting and buying).

To be clear, this is purely a financial analysis. Most people will have significant non-financial preferences in one direction or the other as well, and it would be a mistake to ignore such preferences.

How Much Would It Cost to Rent?

The simpler side of the analysis is renting. For example, if we assume that you will be living in the location in question for 7 years, you would want to tally up the total cost of renting (i.e., rent plus renters insurance) over those 7 years. Be sure to account for the fact that your rent will typically increase over that period.

How Much Would It Cost to Own a Home Over the Period?

On the “buy a home” side, you would again want to tally up all of the monthly/annual costs you would incur over the period. Things like:

  • Mortgage payment,
  • Property taxes,
  • Homeowners insurance,
  • HOA fees if applicable,
  • Estimated maintenance costs (making sure to account for the condition of the home in question), and
  • Any interest/dividends/capital gains that you’re missing out on as a result of having made a downpayment.*

Then you would want to add the one-time costs:

  • At the time of purchase (e.g., mortgage application fees, escrow fees, and other closing costs), and
  • At the time of sale (e.g., realtor commissions and other closing costs).

But then there are two “negative costs” to include as well:

  • Any tax savings you receive as a result of the mortgage interest deduction, and
  • Any equity that you build up in the home as a result of paying down the mortgage and appreciation in home value.

Of course, almost all of these inputs will be estimates. That’s simply the nature of the beast. It is important, however, to try a few different scenarios (e.g., one in which the various estimated costs related to buying turn out to be lower than you’d anticipate, one in which they’re normal-ish, and one in which they’re higher than you’d anticipate) to see how much the overall result would be affected.

Similarly, most people probably aren’t exactly sure how long they’ll be living in the location in question. If that’s the case for you, I’d suggest running the analysis using different lengths of time (e.g., 4 years, 7 years, and 10 years) to see how the math changes.

Looking at the Results

What this analysis will generally show is that the longer you stay in the home, the more likely it is that buying will make sense, for a few reasons:

  1. You’ll often find that the annual costs of owning a home (i.e., the costs excluding the one-time buying/selling costs, but including the negative costs of tax savings and equity buildup) are cheaper than the annual costs of renting. As a result, the longer the period you look at, the better buying will look, as there’s a greater length of time for those savings to overwhelm the one-time costs.
  2. The greater the length of time, the faster the rate at which equity builds up, as a smaller portion of the mortgage payment is dedicated to interest.
  3. Rent increases over time whereas mortgage payments do not (assuming we’re talking about a normal fixed-rate mortgage, that is).

*For people with a background in finance or a related field, rather than including forgone earnings on the downpayment, if you want to be as precise as possible with your analysis, you would actually want to discount all of the costs in this analysis (i.e., calculate their present value in order to account for the fact that dollars today are worth more than dollars in the future).

Evaluating the Vanguard International High Dividend Yield Index Fund

Quick housekeeping note: My wife and I are in the middle of a move from Colorado to St. Louis. As a result of that and a minor medical issue (nothing to worry about, but it’s taking up a fair bit of time), there will be no articles until Monday 11/7, at which point the publishing schedule will resume as normal.

A reader writes in, asking:

“Have you looked at the new international high dividend yield index fund that Vanguard released earlier this year? I think it looks appealing, but it’s new so hardly has any track record. I’d be interested to hear your thoughts.”

With regard to dividend strategies in general, there’s no economic advantage to receiving dividends rather than an equal amount of price appreciation. (And in fact, there’s a disadvantage, if the fund is held in a taxable account because the dividends will be taxed immediately whereas capital gains tax isn’t incurred until holdings are sold. And capital gains tax can sometimes be avoided completely if the holdings are left to heirs.)

So a dividend strategy is only useful if there’s some reason to think that dividend stocks will outperform other stocks of similar risk.

Overweighting high-dividend stocks relative to their market weight often results in a portfolio that is heavy on value stocks — because value stocks tend to have higher than average dividends.* And both Vanguard and Morningstar do classify the new Vanguard International High Dividend Yield Index Fund as an international “large value” fund.

So how does the new fund compare to Vanguard’s existing foreign large value fund (i.e., the Vanguard International Value Fund)? The following chart (made with the Morningstar website) shows how the two have performed since the inception date of the new fund. The blue line is the new International High Dividend Yield Index Fund, and the orange line is the older International Value Fund.

international-dividend

As you can see, they have tracked each other very closely.

As far as differences, the new fund does have a slightly lower expense ratio (0.30% for Admiral shares, as opposed to 0.46% for the International Value Fund), which is certainly a good thing.

And, unlike the existing actively managed fund, there’s no possibility that the new dividend index fund will experience outperformance or underperformance due to good/bad individual stock selection. Personally, I see that as a good thing. But others may disagree if they’re more optimistic about the value of low-cost active management.

In other words, if you’re looking for an international large-cap value fund to add to your portfolio, the new Vanguard International High Dividend Yield Index Fund looks like a perfectly good choice. I would not say, however, that it is anything particularly groundbreaking compared to Vanguard’s older offerings.

*Brief tangent: I recently encountered this article by Rick Ferri, which does a great job explaining why the value premium may be directly tied to dividends.

Investing Blog Roundup: Reverse Mortgage Spending as a Last Resort

Reverse mortgages have a terrible reputation — possibly even worse than annuities. Despite their very real drawbacks, a reverse mortgage is often the best way for a retiree to tap into their home equity in order to fund spending without having to move out of the home.

This week, Dirk Cotton compares the pros and cons of two reverse mortgages strategies: taking out a reverse mortgage early in retirement and using that money to reduce the amount that is spent from the portfolio each year, or again taking out a reverse mortgage in early retirement but holding off on actually spending the money until it becomes clear that it’s needed (i.e., using it as a last resort).

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Social Security Inflation Adjustments (COLA and Wage Indexing)

In the last two weeks I’ve received an assortment of questions about how, exactly, Social Security inflation adjustments work.

In brief, there are two types of inflation-indexing that occur with Social Security: indexing of your earnings history and indexing of retirement/disability benefits (and other benefits based on retirement/disability benefits).

Indexing Your Earnings History

When calculating your “average indexed monthly earnings” (i.e., the earnings history that is used to determine your retirement or disability benefit), all earnings that occur prior to age 60 are indexed to age-60 dollars.* This indexing is not based on price inflation but rather on wage inflation, as measured by the national average wage index.

For example, if the national average wage was twice at high in your age-60 year as in your age-40 year, your earnings from age 40 would be included at twice their actual dollar amount when calculating your earnings history.

Earnings after age 60* are not indexed. As it turns out, this usually lets them count for more than if they were indexed (because if they were indexed, they’d have to be indexed to age-60 dollars, which would be a downward indexing in most cases).

Cost of Living Adjustments (COLA)

Beginning at age 62 (or, if earlier, the year in which you die or become disabled), your primary insurance amount (i.e., the amount of your monthly retirement benefit, if you were to file for it at exactly full retirement age), begins to be indexed upward each year for price inflation, as measured by the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W).

Specifically, the calculation is done by comparing the average monthly CPI-W from the third quarter of the current year to the average monthly CPI-W from the third quarter of the last year for which there was a COLA.

There are two key points about this cost of living adjustment.

First key point: Because the COLA is an adjustment to your PIA, it also affects the benefit of anybody else who receives benefits on your work record, such as a spouse or child.

And second: Your PIA will begin to receive a cost of living adjustment at 62 regardless of whether or not you have retired and regardless of when you file for benefits. (I’ve encountered many people who thought that you had to claim benefits in order to get your COLA — making it a point in favor of claiming early — but that’s not true at all.)

*In the event of death or disability prior to age 62, rather than using age 60, the calculation uses the year that is two years prior to the year in which you die or became disabled. That is, earnings prior to that particular year will be indexed to that year, and earnings after that year will not be indexed. For example, if you become disabled at age 47, earnings prior to age 45 would be indexed to age-45 dollars. Earnings after age 45 would not be indexed.

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Investing Blog Roundup: Planning for a Legacy

As many people enter retirement, they intend for their portfolios to fund two goals rather than just one. First and most obviously, the portfolio must fund their desired standard of living for the remainder of their lives. And second, they want their portfolio to actually outlast them so that they can leave something to their heirs. (If it wasn’t for these dual goals, lifetime annuities would be much more popular than they are.)

In financial planning, it’s helpful if you can be as specific as possible about your goals. This week, Darrow Kirkpatrick explores the topic of figuring out how much you want to leave to your heirs.

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