How often should I rebalance?

I was originally going to write this post on how to maximize returns through rebalancing.  My underlying assumption was that rebalancing helps your portfolio by “buying low and selling high,” and that I only needed to figure out the best rebalancing interval (monthly, yearly, etc.) that would maximize my returns. Through my research, however, I was able to have some sense knocked into me by a couple of enlightening articles, and one fantastic quote by a Vanguard research report “Best Practices for Portfolio Rebalancing”  July, 2010:

“It is important to recognize that the goal of portfolio rebalancing is to minimize risk (tracking error) relative to a target asset allocation, rather than to maximize returns.”

This was such a great reminder for me.  The whole point of rebalancing is to make sure your portfolio reflects the level of risk that you are comfortable with.  If at the outset, you say you want 60% stocks and 40% bonds, then even a slight 0.1% shift towards stocks means your portfolio has more risk than you want it to.  Rebalancing for any other reason than to minimize tracking error is a form of active trading, which by now, it should be pretty clear I am against.

Should I rebalance every day then? Theoretically, Yes.  In reality, No.  In reality, it usually costs money to make trades.  Even if it doesn’t (like if you have a Schwab account and only buy Schwab ETFs), making these trades takes time.  So the real question is how much tracking error are you willing to accept in your portfolio, and how much time are you willing to take to maintain it.

How often should I rebalance in reality?  The industry standard is to rebalance every year, and that is a perfectly good approach.  In the Vanguard report linked above, Vanguard has a slightly more nuanced approach that I think makes the most sense.  The report suggests that you monitor your portfolio semi-annually or annually, and only rebalance when an asset drifts more than 5% from its target percentage.  They go on to say that this approach “is likely to produce a reasonable balance between risk control and cost minimization for most investors. Annual rebalancing is likely to be preferred when taxes or substantial time/costs are involved.”

I would also suggest that you rebalance every time you add money to your account. Recently I’ve been putting money into a “house downpayment” account where I buy a number of index funds.  Since this is the type of account that I don’t make automatic deposits from my paycheck every month, I usually wait a few months and make a large contribution to portfolio and use the contribution to buy more shares of the 5 different ETFs that make up the portfolio.   Since I have to place orders anyway, I might as well make sure that my portfolio will reflect my preferred asset allocation after I finish the new trades.  This is an easy way to rebalance more than just once a year without requiring extra effort.

Does rebalancing help you get higher returns?  Ok, lets say you agree to the basic premise that rebalancing is only for the purpose of minimizing tracking error.  But does rebalancing actually get higher returns?  Is there is a rebalancing time interval (or threshold) that historically offers the best returns?  If so, then you would want to know, right?  The  answer  unfortunately depends on who you ask.

In the Vanguard study (mentioned twice and linked above), the summary states that, “Our findings indicate that there is no optimal frequency or threshold when selecting a rebalancing strategy. This paper demonstrates that the risk-adjusted returns are not meaningfully different whether a portfolio is rebalanced monthly, quarterly, or annually; however, the number of rebalancing events and resulting costs (taxes, time, and labor) increase significantly.”

Another financial advisor explains it in a different way.  The author says that when rebalancing, you are just as likely to “buy high and sell low” as it is the other way around.  He says that rebalancing can increase your returns – but only if you get the timing right.  In other words, you either have to be lucky, or trying your hand at market timing, which from my perspective is a losing proposition.  Two great posts explaining this can be found here and here.

Other researchers have tried to empirically prove that a certain method of rebalancing can increase returns, like this study by a Managing Director at TD Ameritrade. This study shows that there are “significant advantages of opportunistic rebalancing (look frequently and rebalance only when you need to) over traditional annual or quarterly rebalancing.”  In this approach, there is a complex method to determine whether you should initiate a rebalancing.  The approach outlined in the study is time consuming (it requires frequent portfolio checking) and borders on being an active trading strategy, but at least makes for an interesting read.

These three different takes are by no means an exhaustive inventory of all the views on rebalancing, but I think they are representative of the types of research you will find.  While you might find a complex method of rebalancing that can add a few basis points on your annual return, don’t forget that the point of rebalancing is simply to reduce your risk.

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How often do Vanguard Target Date Funds rebalance?

I’ve been doing a lot of research lately on portfolio rebalancing and it got me wondering about Vanguard’s rebalancing strategy for its own target date funds.  After reviewing the fund’s prospectus, I decided to give Vanguard a call directly using their customer service line and ended up speaking with a representative named Robert.  I asked Robert two primary questions:

How often does my target date fund (VFIFX) rebalance?  Robert first searched through the prospectus and couldn’t find anything there so he had to place me on hold and speak with another department.  When he came back he told me that Vanguard rebalances daily just by properly managing the money coming into the fund from new investors/re-investors and the money going out of the fund from withdrawals.  He also told me that if the portfolio skews more than 2 or 3 percent from its target allocation, the fund will actively buy or sell shares of its underlying holdings to rebalance.  I pressed Robert on this point by asking him if it was an automatic 2% trigger or if the fund would only make an active adjustment during set time periods.  In other words, did the manager check the fund every quarter and only rebalance if the assets were more than 2% off, or would the manager rebalance any time the the assets were 2% off – even if it meant making trades every other day (like in a volatile market)?

Robert’s response to this was interesting – although in retrospect unsurprising.  He said that Vanguard does not release that information because of the potential for abuse.  If it was public knowledge that Vanguard rebalanced its funds on certain dates, then traders could take advantage of that fact by manipulating the price of the underlying funds that the VFIFX would have to buy in order to rebalance (In this case, VFIFX has 3 underlying funds: the Vanguard total stock market index, the Vanguard total international stock market index, and the Vanguard total bond index).  I’m not entirely sure how someone could benefit from this knowledge, but I’m guessing it is related to the ways in which a hedge fund manager can manipulate stock prices.

Does my target date fund shift its asset allocation on a continuous basis?  Robert pointed me to the graphic on the Vanguard Target Retirement fund site (which I’ve also linked to in previous posts).  When you click on a fund under the heading  “Decide which fund is right for you,” you will see a graphic similar to the one below.  This particular graphic corresponds to the 2050 fund (VFIFX).

As you move the slider left or right, it will tell you the asset mix that the fund will have at that time.  My question to Robert was whether the asset allocation changed continuously as the graph indicates (meaning a smooth line), or if it changed at stepped intervals – like every five years that corresponds to the Target fund offerings (there is no target date fund for 2051).  Robert said that the graphic essentially represented how the allocations would change, but didn’t go into much further detail.

I took a screenshot below showing the allocation change that occurred by moving the slider slightly to the right.  From what the graph tells me (by playing with the slider for a few minutes) the asset allocation changes every year. Presumably that is the answer – Vanguard Target Date Funds adjust their allocation every year.  Although, conceivably Vanguard could adjust the allocation daily by hundredths of a percent to create an even more continuous risk reduction instead of adjusting just once a year.

What is the best way to invest money for 5 years?

Like many people around this time of year, I received a nice little check from the IRS for my 2011 tax return.  I started thinking of all the things I could do with the extra money – a 47″ plasma TV, maybe an iPad, or  some new ice hockey goalie equipment.  You know, the important things in life.  Also on the list of things I want, however, is a luxury condominium with a sweet view of downtown.  Except that costs more than any tax return that I will ever see.   I figure I’ll be ready to buy a home in about 5 years (because 5 year plans never go wrong) and as a result, it is probably about time that I start saving for it.  So I decided to put my big screen TV hopes on hold and put the tax return money towards my future home.  But that was as far as I got before I realized I didn’t know where to put it.

Where should I put money that I need in 5 years?  The 5 year investment is tricky, because it is short enough that you can’t afford the stock market risk like you can with a 20 year investment horizon, but long enough that it would be silly to let it sit in a non-interest bearing account.  There are a couple of basic options out there.  There are your standard savings and rewards checking accounts, Certificates of Deposit (CDs), and finally, investment accounts.  These days savings accounts won’t get you much more than 0.75% APY, and even the best 5 year CD will only get you 1.80% APY – all according to bankrate.com.  (Also check out Smartmoney.com’s take on the best short term investments).  These options don’t even keep up with inflation, so 5 years from now your spending power will actually be reduced as a result of putting your money in these low yield accounts.  If you want the chance of earning interest greater than inflation, you are stuck with investment accounts – which is kind of scary.

At least with the savings accounts or CDs you know that in 5 years your money will actually be there.  But if you invest in stocks and the market goes bad… that luxury condo you’ve been dreaming of quickly turns into a suburban town home.  Just because you open an investment account, however, doesn’t mean that you have to invest in all stocks.  In fact, you probably shouldn’t.  As described in the my asset allocation post, a sound retirement portfolio will include bonds and treasury notes in addition to stocks.  Those who are 40 years from retirement can afford to take on much higher risk (because they have a long time to make up potential losses) and are recommended (according to Vanguard’s target date funds) to invest in 90% stocks and 10% bonds.  Those who are only 10 years from retirement are recommended to invest 66% stocks, 32% in bonds and 2% in cash. You can see the increase in bonds (in blue) as you get closer to the retirement goal in the graphic below from Vanguard’s website.

What asset allocation is best for a 5 year investment?  When I started thinking of the Target Date Fund’s progression to less risky assets, it suddenly hit me.  The 5 year investment is an awful lot like your target date fund investments when you are in retirement.  And think about it: When you are in retirement you certainly can’t afford for your nest egg to take a big hit in the market, but you need continued appreciation to try and live off the nest egg’s interest.  So what exactly does an in-retirement asset allocation look like?  I went straight to Vanguard’s website and copied down the asset percentages for the 4 funds shown below.  On the chart, the risk and expected rate of return decreases from left to right.  I’ve included two target date funds that have a target retirement date close to 2012 just as a comparison, but it is the allocation percentages from the Vanguard In-retirement fund (VTINX) that you will want to use.  While I was looking on the website I came across Vanguard’s “Life Strategy” funds, which believe it or not, have a fund specifically designed for 3-5 year investment horizon (VASIX).  This would also be an reasonable asset allocation, though it is more conservative than VTINX;   likely due to to the fact that that it is meant to be used to save for something as soon as 3 years away.

What kind of return can I expect from these funds? Keep in mind that because this is an investment in the stock market and bond market, there is no way to predict your annual yield over 5 years.  BUT, based on the asset types in each fund we can make an educated guess about what kind of returns to expect over the long run – like 20 plus years.  I know in some ways that is not helpful because we are looking at a 5 year window, but that is the best we can do; it is impossible to predict an investment’s 5 year return with any accuracy.  With that said, over the long run, I figure that these funds will average a 4% return annually.   Why is that? The goal of most in-retirement funds (at least Vanguard’s) is to get a 4% return.  The idea is that while in retirement, you can spend 4% of your nest egg every year, but by earning 4% through investments, your nest egg never loses value.  Since Vanguard advocates for using the 4% rule in retirement planning calculations, I have assumed that their retirement investments (such as VTINX) are structured to provide roughly the same return.  As it turns out (see graph below) VTINX has actually averaged a 5.30% average annual return since its inception (which was only 8 years ago so the numbers don’t mean that much).

Morningstar.com provides the actual (not average) annual return in each year since 2003.  This look shows how volatile the annual yield can be, ranging from  negative 10.93% in 2008 to a positive 14.28% return in 2009. What I’m trying to say is this:  if you invest in VTINX and keep it for 30 years, your average annual return would probably be around 4%.  However, it is entirely possible that for the 5 year window between 2012-2017 (when you own the fund) the fund would have an average annual return of 10%, or even 1%.  It is riskier than a CD, for sure,  but it is certainly well managed risk.  And besides, 4% return on my investment sounds pretty good to me, especially when I can only get 1.8% with a CD.

OK. You’ve convinced me.  But I don’t have an investment account, so what do I do? It is pretty easy:

  1. Open a Vanguard or Schwab investment account.  Make sure that you are opening an investment account and not a retirement account like an IRA, Roth IRA or 401(k).  Why those two firms? Both Vanguard and Schwab allow you to buy their brand of ETF index funds (which have the lowest expense ratios) for free.  FOR FREE!  There are no other investment firms out there with this kind of access to index funds, and as explained in my Target Date Fund Series, I think buying index funds (not individual stocks) is the smartest thing you can do.  In addition I’m consistently impressed with the advice and service that I get from both these firms (yes, I have accounts at both).
  2. If you open a Vanguard account and are going to invest more than $1,000, then you can simply buy the VTINX ($1,000 minimum) or VASIX ($3,000 minimum) fund mentioned above.  If you are starting out with less money you will have to buy 3 or 4 index fund ETFs to mimic the asset allocation of either VTINX or VASIX.  But don’t worry, I’ve made it easy for you – take a look at the chart at the bottom of the post.  It gives you the symbol of the ETF you should buy (right hand side) along with the percentage of your investment that you should spend on each ETF.   Two quick notes if you want to mimic the VTINX asset allocation: First, To put 5% in cash, you won’t have to buy a particular fund, just leave 5% of your savings unspent in the account.  Second, if you have a Vanguard account they don’t have an ETF for inflation protected securities, so just put that extra 20% in the BND fund.
  3. Keep adding to your investment account (use the same percentages detailed in step 2).
  4. Rebalance every year.
  5. Buy a home! (or whatever else you have been saving for)

What percent of my income should I save for retirement?

I recently got an email from our HR department at work saying that I should be saving for retirement (Thanks guys!).  The email included a nice little graphic which seemed to suggest that I should save 6% of my salary.  Based on the assumptions (annual return of 7%), if I am 30, earn 40,000 a year and put 6% away for 30 years I will have $234,860 (in today’s dollars).  If I retire at 60, and expect to live until 80, that means I’ll have about $17,400 to live on per year in retirement.  (Its more than $11,700 (234,000/20 years) because I earn interest on the money that I haven’t taken out yet).  Either way, 17,400 isn’t much – especially considering the fact that I plan on living past 80 and $17,400 is less than half of the salary I would be used to.  Clearly 6% is not enough.

How much is enough? If 6% is not enough, then what is?  This is such an important question because it should be the foundation of your monthly budget.  If you are trying to do things right, you set aside money for your retirement first, and then see how much you have left to spend on everything else.  Again, its that old expression, “pay yourself first.”  So, what is a good percentage of gross income that you should be saving?  The typical rule of thumb is that you should save 10% of your salary for retirement.  But as the linked article suggests, even 10% may not be enough.  You may be 42 years old with no money saved for retirement (you’ll need to save much more than 10% of your income) or 25 and trying to retire early.  So while 10% of your income seemed like a good place to start as a minimum, it was clear to me that I needed to do some extra research to come up with a percentage that was more than just a rule of thumb.

I started playing with the zillions of online retirement calculators out there (just google “retirement calculator”) and quickly realized that “annual savings as a percentage of income” was just one of many variables in their complex retirement equations.  Fortunately,  Vanguard’s retirement calculator was simple enough to allow me to easily isolate the “savings as percentage of income” variable.   Even with its simplicity, however, the Vanguard calculator still required me to make some assumptions about retirement.  I’ve included a screenshot of what they look like in the Vanguard calculator as well as an explanation of my assumptions below.  In general, the assumptions are set for the average 25 year old who is thinking about retirement for the first time.

  1. How old are you and when will you retire?  25, 65.  Unless you have visions of jet-setting at age 50, the standard answer is age 65.  I can see the argument to use age 70 since we will probably be living longer than the current generation and social security benefits might not start until 70 when we are in the year 2050. It is much easier, however, to plan to retire at 65 and later decide to work until 70 than it is the other way around.
  2. What is your current annual income? $50,000.    This number is only relevant because it is used to determine the actual dollar value of how much money you will spend per year in retirement.  According to Vanguard (and most other retirement calculators), the typical retiree spends 85% of his pre-retirement  annual gross income in a year.  The blue bar in the chart at the right displays the result of this calculation; ($50,000 * 85% / 12 months = $3,542 a month).
  3. How much do you save annually for retirement?  To be determined.  This is the variable that we are trying to figure out, with the focus on the percentage of annual income and not the actual dollar value.  Note that it should include your personal contributions to an IRA, as well as any work contributions (including employer matching) in 401(k)s and 403(b)s.
  4. How much have you already saved for retirement?  $0.00.  I am assuming that you are just starting out.  If you have some money already saved, I encourage you to input all your information into calculator to get a personalized look at your retirement plan.
  5. What’s your market risk approach (In other words what will the average annual return of your investments be)?  Somewhere between 4% and 8%.  Part of this will be determined by the investments you select.  If you have a more conservative portfolio with a heavy percentage of bonds you can generally expect a lesser return than a more aggressive portfolio consisting mostly of stocks.  But even if I assumed that everyone had the same retirement portfolio, I still can’t predict how it would perform over the next 30 years. In the past your investments may have made 7% a year, but what if over the next 30 years it only averages 6%?  Click here for a great graphic from the New York Times that depicts the variability in 20 year returns.
  6. Will you receive any money from social security or pension? Maybe… If you are lucky enough to be in a profession that still distributes pensions, then great, you can include that income here.  Most of the private industry jobs out there now, however, do not distribute pensions, so the standard answer is $0 from pensions.  Whether or not you will receive any money from social security, however, is the bigger question.  There are countless articles out there detailing the unsustainable state that the social security system is in.  This article was the best I’ve found explaining the situation, and even offers some actionable advice.  If no policy changes are made, social security benefits will eventually have to be cut by one third.
  7. How long will you live in retirement?  Doesn’t matter.  This is not explicitly asked on the Vanguard calculator, but it is used in the behind the scene calculations.  Some retirement calculators use an equation that ensures you spend all your retirement money by age 85 (the standard guess for how long you will live).  Vanguard however uses the 4% rule.  The idea is that once you are in retirement, your nest egg will be put into more conservative investments where 4% is a typical return.  If you only take out 4% of your nest egg every year to live on, then that 4% will be replenished by investment gains and your nest egg will never lose value.  By using the 4% rule, you reduce the risk that you will run out of money if you live longer than you expect.  The “downside” is that when you die you might not have used all of your money up.  By using the Vanguard calculator and its 4% rule, the amount of money they recommend you save for retirement may be higher than the other calculators, but I think it is a much smarter approach than trying to guess how long you’ll live.

How can I plan for retirement if I can’t predict my rate of return or if Social Security will exist?  You’ll notice that I have answers for all of Vanguard’s questions except for two: “Will I receive money from Social Security?” and “What will my average annual rate of return for my investments be?”  Without knowing the answers to these two questions it is impossible to come up with an educated guess on what percent of my gross income I should be saving for retirement.  Because I don’t have a crystal ball, I settled for the next best thing – a spreadsheet that lets me test different scenarios.

In the interest of full disclosure, you should know that this spreadsheet is simply a recording of the values taken from Vanguard’s retirement calculator.  So for example, to get the 10% value at the bottom right of the chart, I set the “market risk approach” slider to 9.5% , set my social security benefit to $833 a month (20% of $50,000 / 12 months), and then adjusted the “how much do you save annually” slider until the green bar was equal to the blue bar.

So what does it all mean? First of all, saving 10% of you gross income is not nearly enough.  The only way that would work is if you received a significant amount of social security benefits, and your retirement portfolio earned a ridiculous 9.5% return per year.  Personally, counting on a 6% – 7% return seems much safer to me.  If you read my post on target date funds, you know that the investment style starts out very aggressive (90% in stocks) and gets more conservative as you get closer to retirement (65% stocks with 10 years to go).   So even though I have an “aggressive” portfolio, I’m still not counting on getting any returns out of the ordinary.

What percent of my income should I save for retirement? So here we are, finally back to the original question.  The answer is about 20%. If you are expecting a 7% return on your investments (a reasonable/slightly conservative guess) then you’ll need to save between 17% and 22% of your gross income every year – depending on how much social security you expect.  If you are making $50,000 a year and retired today, you could expect to receive social security benefits that would cover 37% of your current income.  As noted above, however, it is highly unlikely that social security will be around in the same form when you retire.  If it is still around, a safe bet is that you can expect to get 1/3 of the benefits you would receive today.  In other words, you could expect social security to cover 12% of your current income.  If thats the case, you would need to be saving about 20% of your annual income per year.

I guess what I’m saying is that 20% should be the new rule of thumb.  Now, I’ll be amazed if any of my friends saves anywhere near this amount.  I mean, lets face it, 20% is a lot of money.    But that is the reality these days; because unlike our parents, we can’t rely on pensions or social security or even a US economy that is growing like crazy.  Obviously, it would be great if the market continues to grow and all of the asumptions prove too conservative.  And if thats the case then that means you can travel to your hearts desire or even leave a little extra to your kids.  I don’t see a downside there.  But if you only save 10%?  Anything other than great returns and lots of social security means you wont have enough to retire.  Its a tough pill to swallow – having to save 20% of your income – but it is the only way that the numbers work.  Its honestly kind of hard to believe that the advice I was given was to save 6%…

The example is only for someone making $50,000 a year.  I make more (or less) than that, what percent should I be saving?  For our purposes, the annual income is irrelevant because everything can be depicted in percent of income.  The actual amount of your current income does not matter when figuring out what percentage of income to save.  If you make $100,000 dollars a year, you will have a higher standard of living in retirement ($85,000 a year) but by saving 20% of $100,000 you’ll be saving enough money to account for the higher standard of living.  The only thing that changes when you make more money, is that your expected benefit from Social Security decreases (as a percentage of income).  Here is a chart explaining this (All data is from SSA.gov).

If you make $50,000 a year and retired today, social security would pay you about 37% of your current income.  If you make $100,000 and retired today, social security would only pay you about 26% of your current income.  The take away here is this:  if you assume that you will only get 10% of your income in social security benefits, then at $50,000 a year that represents a much larger cut from current benefits than at $100,000 a year.  If you don’t assume any social security benefits, then your current income has absolutely no affect on the  “Percent of Annual Income Needed to be Saved” chart.

How long does a mutual fund transaction take?

Last week was a crazy week for the stock market (it feels like they all are recently). And since you might be reading this a few weeks or months after the fact here is a nice little summary from Forbes.com.  On Monday August 8th, 2011 – the first trading day after S&P’s downgrade of the United States’ credit rating – the S&P 500 index lost a whopping 6.7%.  On Monday night, after catching up on the day’s stock market news I had two thoughts:  1. SELL EVERYTHING NOW! and 2.  BUY MORE STUFF NOW!

This, I think, is probably pretty representative of how most people reacted to the news.  Ultimately, levelheadedness prevailed and I decided to put more money into my retirement fund – aka. Option 2.  But by the time I came to that decision the trading day had long been over and I was faced with the unpleasant realization that mutual fund transactions do not get completed instantaneously.  I clicked the “buy” button anyway – even though I had no idea when my transaction would be processed. And after a few days of nervously checking my mutual fund account, then the stock market, and then the mutual fund account again… I can finally answer the post’s initial question:

How long does a mutual fund transaction take?   Mutual funds differ from regular stocks in that you can’t buy and sell mutual fund shares instantaneously during the day.  Mutual fund share prices do not fluctuate throughout the day.  Instead, their share price is calculated once at the end of every trading day.  This is due to the fact that mutual fund prices do not reflect investor perceptions, but rather a simple accounting of the fund’s actual Net Asset Value (NAV).  As a result if you click the “Buy” button at 10:00AM on Monday morning, your transaction will not be processed until the market closes at 4:00 PM Monday afternoon.  In addition, the price that the mutual fund is listed at when you start the transaction will probably be different than the price you will eventually pay at the end of the day (because the NAV will be recalculated at 4:00PM).  The bottom line is, no mater when your mutual fund transaction is initiated, it will be processed the next time your clock reads 4:00:00 PM.

I’ll use the actual scenario that occurred last week as an explanatory aid.  As you may already know, I am the proud owner of a Vanguard Target Date Fund. I’ve included a screenshot  of the chart for my fund (VFIFX) spanning the last 20 or so days, including the crazy last week.

On Monday, August 8th, around 10pm (after the trading day closed) I initiated a transaction to buy more shares of VFIFX – when it was listed at about $19.25 a share.  At 4:00 PM on August 9th – when my transaction should have been completed – the price was about $20.00 a share.  This means that because of the mutual fund transaction delay, I would be getting less for my money than I would have if I managed to buy the shares before the close on Monday.  Fortunately for me, my transaction took a day longer.  Because I don’t keep any money in my vanguard account (besides what is in the VFIFX fund), when I clicked “Buy” I was actually initiating a transaction to transfer money from my checking account to the vanguard account and then to buy mutual fund shares.  As it turns out it took a day for the money transfer to occur (this may take longer/shorter with your specific accounts), which meant I bought shares at the close of Wednesday August 10th.

Why do I care how long it takes me to buy a mutual fund?   The answer is that you shouldn’t.  If nothing else, last week’s experience was a good reminder to me that investing in mutual funds (and retirement investing in general) is not about timing the market.  It is about putting money in your account consistently, trusting the market’s historical performance, and not worrying about market fluctuations.  But, just in case you find yourself trying to get an edge by buying mutual funds on a downswing, it is important to know beforehand how long your transactions take.  This way you can properly assess the risks associated with the transaction time delay.  I know that this is not a post with ground breaking investment strategy, but it took me long enough to find this information on my own that I thought it was worth sharing (and writing down for my own future reference).

Apartment Hunting 101

It is that time of year in Boston when everyone and their mom is out looking for an apartment.  And I mean that literally because all those undergrads who are starting their Freshman year at one of the many Boston area schools really are apartment hunting with their moms.  With so many people looking for apartments, it is definitely not a renter’s market and you have to do your research before jumping in.  Over the past four years I’ve moved five times within the Boston area, and I like to think that I’ve learned a few things about apartment hunting in the area. I figured it was worthwhile to devote a post to answering some of the financial questions that I struggled with along the way.

How do broker’s fees affect my monthly rent? One of the first things you’ll notice when you go on Boston’s craigslist is that everything is sorted by “fee.”  Generally, there are three categories: no fee, half fee, and whole fee.  In order for a landlord to list an apartment with any real estate service, the real estate service charges a “fee” that is equal to one month’s rent. Sometimes the landlord will pay this fee himself (no fee), sometimes he will pay half (half fee) and sometimes will pass the full cost on to the future tenant (whole fee).  Obviously, finding an apartment with no fee is the best situation, but you would  really be limiting yourself if you only looked at no fee apartments.

Because this fee is paid upfront, it doesn’t really affect your monthly rent, but it does affect how much you will pay for that apartment over the course of the year.  I wanted to be able to compare apartments “apples to apples” regardless of whether they had a fee or not.  In other words, I wanted to incorporate the broker’s fee into the monthly rent as an easy way for me to see how much each apartment really cost.  This can be pretty easily estimated for apartments in the $1,200 a month range (adding a whole fee will increase your rent by $100 dollars a month), but I hate doing mental math – especially when I’m under pressure – so I made this spreadsheet to take along with me while I was apartment hunting.  (I know – Dork alert!)

How should I compare apartments with included utilities?  You’ll notice in the spreadsheet above that I’ve added columns for apartments that include “heat and hot water” and that include “internet.”  Many of the area’s brownstone apartments (i.e. non triple decker houses) include heat and hot water in the rent.  This is an important factor because it can reduce your monthly rent by $100 (my approximation).  Now I’ll admit that its rare to find apartments with internet included, but it is not uncommon in some luxury rentals.  I’ve come across craigslist ads for $2,000 a month luxury apartments with heat, hot water and internet included AND no fee.  When you take all that into account, you are really only paying $1,825 a month.  That would be slightly cheaper than an apartment advertised at $1,700 a month with a full fee and nothing included (actual rent would be $1,842). The lesson here is loosely define your “maximum” in the search parameters because you may find a good deal on an apartment that initially seemed to be out of your price range.

How much money should I have available for apartment hunting?  One of the most important things about apartment hunting this time of year is that you have to be able to act quickly.  If you see an apartment you like, you need to be filling out the application and signing a lease and within an hour.  Bring your check book, because the up front cost of renting an apartment can be quite high – check out the spreadsheet below.  At a minimum, all landlords will require either first and last month’s rent, or first month’s rent and a security deposit (equal to one month’s rent).  That cost can double though if you have to pay a full fee along with first month’s rent, last month’s rent AND a security deposit.  While you technically get everything but the broker’s fee back, it can be hard to get all that money into your checking account on short notice, so make sure you plan ahead.


What happens to my security deposit?
  As a responsible adult (and no longer a cleaning impaired college student), I fully intend to receive my entire security deposit back at the end of my rental period.  Because I expect to get it all back, it was upsetting to think that my money was just going to sit under the landlord’s mattress when it could be earning interest in my bank account.   But as I was carefully reading my lease before signing (which stated that I am required to help the landlord with snow removal…), I found this little gem:

“As required by law, the security deposit is presently or will be held in a separate, interest-bearing account.  If the security deposit is held for one year or longer from the commencement of the tenancy, the Lessee shall be entitled to interest on the amount of the security deposit at the rate of five percent (5%) per year, or such lesser amount as may be received from the bank, payable at the end of each year of the tenancy.”

And right below that paragraph (this is all from the Greater Boston Real Estate Board standard lease form) is another paragraph stating that the tenant is also entitled to 5% interest on the last month’s rent as well!  The caveat here is that if the landlord puts the money in a bank that gets .01% interest, then that is what you are going to get.  But, in the standard form lease, there is a line that requires the landlord to enter the bank name and number of the account in which he or she is depositing the money.  I have a hunch that many landlord’s do not fill this part out completely, and if that is the case, it seems like you should be entitled to the 5% interest – if you feel like calling them on the technicality.  Regardless of what happens, its nice to know that the Commonwealth of Massachusetts is looking out for your best interest… (ha ha).

Credit Utilization and Your Credit Score

One of my favorite things about credit cards is that I get 30 days to make a payment after my statement becomes available.  I love waiting 25 days to pay – not because I don’t have the money, but because I consider it a 25 day interest free loan. Instead of paying immediately, the money sits in my savings account and earns interest.  I am fully aware that the interest I am earning is pretty insignificant (we are talking a few dollars over the course of a year), but its free money and it makes me happy.

The only drawback to doing this is that my credit utilization rate will be higher, and if that rate is too high it can affect my credit score.  A credit utilization rate is simply the ratio of money owed vs. available credit.  Here’s an example:  Lets say I spend about $1,000 a month on my credit card which has a credit limit of $8,000.  At the end of May I will have a balance of  $1,000.    If I pay my statement immediately, I will start June with a $0 balance.  The largest balance I will ever have on my card is $1,000, meaning at most I will be using 12.5% (1,000/8,000) of my credit limit.  (Credit utilization rate is 12.5%)  If, however, I wait 30 days to pay off my statement, I will start June with a $1,000 balance and by the end of June my balance will be close to $2,000.  My payment of $1,000 for May’s statement at the end of June will be on time, but at the end of every month I will be using 25% (2,000/8,000) of my credit limit.  (Credit utilization rate is 25%)  I wasn’t sure how much was too much in terms of credit utilization so I did a little research.

How does credit utilization affect my credit score?  As most people will correctly tell you, the number one rule of establishing a good credit score is to make your payments on time.  Unfortunately, paying your bills on time accounts for only 35% of your credit score.  According to most sources (including the Consumer Federation of America, and Bankrate.com) credit scores are comprised of five basic categories:

  • Payment history (35%)
  • Money owed vs. available credit (30%)
  • Length of credit history (15%)
  • Recent credit applications (10%)
  • Mix of credit types and other factors (10%)
The second most important category is money owed vs. available credit, or credit utilization.   According to most financial experts, the lower your credit utilization the better.  The following chart from Credit Karma is an excellent depiction of this trend and is the best explanation I could find on what is the most advantageous credit utilization percent.  As you can see from the graphic, your best bet is to use less than 10% of your credit limit.  It is important not to infer that credit utilization is the only driver for credit scores.  Check out the original article for more details.

Should I be measuring credit utilization for each card or for total available credit?   I have one other card with a $4,000 credit limit that I rarely ever use (because I don’t get cash back).  If I use that card in my calculations, my total credit limit is $12,000.  At most I will have a 16.6% (2,000/12,000) credit utilization rate, which sounds much better than a 25% utilization rate.  So which is it?

According to this article from creditcards.com, “the [credit score] scoring formula also looks at utilization on the individual cards that make up the overall utilization percentage.”  So while the most important thing is to keep your total credit utilization rate below 30%, you should also not ignore high utilization rates on each of your cards.  By spreading around your spending on multiple cards, you can also avoid having your unused card have an unexpected credit limit decrease.  So for now, it looks like I’ll start paying my bills sooner until I can get a credit limit increase…