FICO: Is Your’s Fabulous or Fading?

We all have credit and most of us use it daily. It has become ubiquitous in our society, but most users don’t fully understand how it is created and how it is best maintained.

Credit supports the foundation of our economy. The upheaval that we all lived through in 2008 was the unraveling of credit. Most people don’t realize that the credit markets are many times larger than the stock markets. Typically, we see stock market corrections every few years, but corrections in the credit markets are rare, more serious, and take much longer to repair. Healthy credit markets are important to us all.

Establishing and maintaining good credit is essential to creating and protecting your wealth. The process of consistently improving your credit or maintaining it at a superior level is one of the best financial disciplines you can develop. It requires balancing expenses with income and reward with risk.

Our largest purchases are typically made using credit. Your credit history will largely determine whether you qualify for a loan and what interest rate you will pay. Your credit history has two main components, the credit report and the credit score.

Your Credit Report

Your credit reports are created by the three main credit bureaus: Equifax, Experian, and TransUnion. Each credit bureau receives information about most of your credit uses. Generally, they have similar information, but there may be some lenders that report to just one or two of the bureaus. Since your FICO score is calculated using the data on your credit reports, in reality, you actually have three FICO scores – each one based on the reported information from one credit bureau.

Recent surveys show that nearly 80% of credit reports contain an error, and almost 30% contain a serious error. It is very important that your credit reports do not contain any errors that will damage your credit history, and errors will likely stay on your report until you fix them. To verify the accuracy of your reports you must obtain all three reports and carefully examine each one. Challenge any errors you find, first through the credit bureau and, if unsuccessful, through the lender. This often takes some hard work, but it is worth the battle.

Your Credit Score

It is critical to know how your score is calculated, how it is used by lenders, and how you can improve it. Your credit score (also known as your FICO score since it was developed by the Fair Isaac Corporation) is a number between 300 and 850. This number (higher is better) quantifies your credit risk to lenders. It is generally used along with a few other pieces of information, such as income and age, to determine the interest rate on a loan. A 100-point difference in your FICO can cost you $10,000 in interest per $100,000 of mortgage or $1,000 in interest per $10,000 of car loan over the lifetime of the loan.

Your goal is to get your credit score into the highest level, 760-850. Rumor has it that a 761 is just as good as an 849, so don’t go overboard trying to max it out. Fair Isaac Corporation sorts the information on your credit report into 5 categories with varying weights to calculate your score (see table). Hopefully, most of the work you’ll need to put into raising you score will likely be focused on debts other than your mortgage and car loans. Revolving debts such as credit cards and lines of credit are where most people, with a little management, can improve their FICO score. They are called revolving debts because you can run them up and then pay them down repeatedly.

Weightings	Factors
35% - Payments	Do you always pay on time?
30% - Balances	How much do you owe? - Utilization rate in total and by account
15% - Duration	How long have you had credit? - Longer is better
10% - Applications	Do you maintain accounts for a long time? - Older accounts are better
10% - Mix	What is the mixture of credit sources? - More are better

Your payment history counts for 35% of your score, so paying on time – all the time – really matters the most. Credit duration counts for 15% of your score, so the longer you have had credit the better. Thus, it can be a good idea to help your child establish credit as soon as they turn 18, and then teach them to manage it effectively. Your credit mix weighs in at 10% of your score. Your FICO score improves as you responsibly take on varying types of debt, such as car loans, lines of credit, and mortgages. The remaining two categories are more complicated, require some ongoing management, and will be the areas where most people can improve their FICO scores.

Your balances count for 30% of your score, and you must manage both your total credit lines and your “utilization rate.” First, your total credit lines must be reasonable, so be very discerning about the credit offers you accept. Generally, your credit card lines should not be more than 2-3 months of your gross salary. Second, your utilization rate is the amount of credit you’re using versus your total credit – in other words, your current balance divided by your credit line. Thus, your utilization rate is 25% with a credit card approved for $40,000 carrying a $10,000 balance. Lenders want to see a utilization rate below 50% on each card and in total. Thus, even though you might save money by transferring several balances onto one lower interest rate card, your FICO score will go down if your utilization rate on that new card is over 50%.

Last, but not least, credit applications impact 10% of your score. First, it is a good idea not to apply too often for credit as multiple applications or credit inquiries hitting your credit file lower your score for awhile. Second, the age of each account is also important as older credit is favorable. Thus, if you close an old card or open a new card, your FICO score will go down for awhile because the “average” age of your credit decreased. To protect your score when you no longer want a very old card, ask to decrease your credit line, but keep it open until you have had other cards open for many years.

Conclusion

For many families, this recession has caused some real belt tightening, or at least more thought is being given to debt than ever before. These adjustments can be painful, but they are healthier in the long-run for each of us and for our economy. While it has always been important to maintain the right amount of good credit, Americans are now more aware of what can happen when too much bad credit meets a serious recession. A healthy FICO score safeguards your wealth by protecting your available credit during recessions and improves your wealth by allowing you to access better loans in any environment. A few hours a year goes a long way to saving you money and protecting your wealth.

Helpful Sources

Obtain your credit score at myfico.com

Get a free annual credit report at annualcreditreport.com

Stop junk mail credit card offers at optoutscreen.com

Research competitive credit offers at bankrate.com

Compare your credit cards at mint.com

Analyze your credit score at creditkarma.com

Find help with credit problems at nfcc.org

For a Fabulous FICO

Pay on time

Keep utilization rates under 50%

Pay off monthly, if possible

Establish credit at age 18

Apply for new credit infrequently

Don’t close old accounts too often

Open varying types of credit over time

Get all 3 credit reports & correct errors

MARKET UPDATE -- Winter 2010

We would like to tell you everything is fine and there’s nothing to worry about. However, we must accept the present reality which is not all that pretty. The housing bubble, which was created by an incompetent government and fueled by Wall Street greed, has led to hundreds of bank failures, real unemployment near 17%, and many cities and states near bankruptcy. So, what now? We can continue to debate whether all the government involvement was prudent or even necessary (mostly not), but this will not help in positioning your portfolio to take advantage of what has been created.

Knowing how we got here, and what constitutes a bubble, is important in order to know what to look for to avoid getting caught in the next one. Most bubbles are associated with strong growth in money and credit, but this time the opposite is true. Bank lending continues to contract as banks are very happy to maintain large cash reserves. With near-zero interest rates, the government is forcing money out of safer investments paying near nothing into riskier investments. Why would they do this? Because when we collectively decide not to take risks the economy grin to a halt. Our government, through the Fed, has adopted a strategy of making it so uncomfortable to play it safe that investors will move into riskier assets in order to obtain the returns that they need. Unfortunately, by doing this they increase the risk of fueling speculation somewhere else and creating a new bubble – especially with the Fed making it clear that rates will stay down for “an extended period.” Ultimately, the piper will need to get paid—this will lead to much higher interest rates and a drastic reduction in value of US Treasuries somewhere down the line.

Worldwide, the extreme policy actions of the past couple of years are creating all kinds of distortions. These pressures could be alleviated by a tightening in monetary conditions in China and other growing economies that are coming out of the recession in better shape. However, they currently have very little incentive to back off the throttle on their growth engine as they attempt to provide their citizens a greater standard of living. The seeds of prosperity that used to be the domain of the USA now have a passport full of overseas destinations.

Going forward, we believe this recovery will be meek. The Fed will be tolerant of further gains in all asset prices as long as inflation expectations are calm and US economic growth remains near zero. With such a weak recovery, we do not expect the Fed to raise rates until 2011. Early last year we stated our preference of corporate bonds to stocks for 2009, and we weighted portfolios quite heavily that direction. Despite what turned out to be a decent year for the stock market, the bond positions did substantially better for the year, some even doubling the stock market. We continue to see value in corporate bonds, several foreign markets and technology stocks. While not as cheap as they were a year ago, they still offer good yields or the prospect of further growth during 2010. As always, we are monitoring the changing economic landscape and will strategically adjust your portfolio as warranted.

To Roth, or Not to Roth: That is the Question

The Beatles’ George Harrison wrote these famous lyrics in “The Taxman” when he realized his earnings were pushing him into the 95% tax bracket in England:

Should 5% appear too small, be thankful I don’t take it all,
‘Cause I’m the taxman, yeah, I’m the taxman.

It may sound far-fetched today, but it was not too long ago, and I believe much higher taxes are coming sooner than any of us wish to believe. During the “Roaring 20’s” taxes were in the 25% range for top earners. Due to lower tax receipts at the onset of the Great Depression, our Congress increased the tax rate in 1932 to 63%, and then steadily pushed it up to 91% by 1963. It was still has high as 70% in 1980, before President Reagan slashed it down to 28%. With today’s top tax rate near 40%, and government budget deficits soaring, we are likely to experience a wave of new taxes and deduction limits.

Over the past 40 years as tax rates have fallen, it has been better to stash money into a retirement account during high tax years, and then withdraw the money at lower tax rates many years later. This 40 year trend is about to swing in the opposite direction, making the misunderstood Roth IRA your best tax friend.

What we don’t Understand, we Avoid
Most articles written about Roth IRAs are filled with complicated tax jargon – sometimes trying to be technically precise, but more often in an attempt to impress the reader. Either way, the information is too complicated and boring, making it virtually useless. While the actual tax rules are complicated, and include many deadlines, amounts, limits, and exceptions, the essence of the rules are very simple. What you need to know is…if, why and how a Roth IRA is to your advantage.

Why Me?
1. Age: The younger you are, the more a Roth is a great retirement tool for you.
2. Wealth: The more likely you are to leave some of your IRA to your heirs, the more a Roth is a great estate planning tool for you and your heirs.

Why Now?
1. Never before available to those earning over $100,000
2. Pay the tax at today’s lower rate
3. Advantageous IRS rules only available for 2010

Why Care?
1. Tax-free withdrawals
2. Lower estate tax
3. More spendable income
4. Lower tax on Social Security
5. No required withdrawals

What’s an IRA?
I imagine you have heard the term, but what is it? It actually stands for Individual Retirement Arrangement, of which there are several types, but the Individual Retirement Account is the most common since its creation in 1975. Money contributed to an IRA is tax deductible, it grows inside the IRA over the years with no taxes due on the increasing value, and then tax is due on each withdrawal. To avoid confusion, many people now use the term “Traditional IRA” to avoid confusion with a Roth IRA. I should note that 401(k), 403(b), SEP, Simple IRA, Profit Sharing Plan, etc., all work similarly to an IRA.

What’s A Roth?
Created in 1997, the Roth IRA works differently than a Traditional IRA when money is contributed or withdrawn. Money contributed to a Roth is not tax deductible, it still grows inside the Roth with no taxes due on the increasing value, but no tax is ever due on withdrawals. In the long-run, Roths are better than IRAs in generating more spendable income, because the taxes are paid early and then never again. This allows the power of compounding returns to work their long-run magic for younger savers and older, wealthier investors leaving money to their younger heirs.

What’s A Conversion?
Roths can be very beneficial, and since so many people already had money in IRAs and the like, the IRS created a process to convert IRAs into Roths if desired. Thus, a Roth Conversion allows you to convert some or all of your IRA into a Roth and pay the tax on the converted amount now, resulting in no future taxes.

A Break for the Wealthy…Really?
Yes, but only because Uncle Sam is desperate! Prior to 2010, the only people who could have a Roth were those making under $100,000 per year. Why? Because the government realized that Roths allow you to pay some tax now, versus lots more tax over the decades ahead, which is better for you and worse for them. Therefore, Congress initially decided to limit the number of people who could have a Roth in order to maximize the amount of taxes paid over the years. However, with our government’s budget out of control, Congress has decided to let you win in the long-run. They are willing to take less of your money if they can have some of it right now. Furthermore, a Roth Conversion makes even more sense with current tax rates being relatively low and likely moving much higher – you will be paying at today’s lower rates, and never again!

Beginning in 2010, two things change. First, everyone can now convert. Second, to sweeten the deal and entice more people to convert in 2010, you can elect to pay the tax due in 2011 and 2012. If you believe your tax rates will be higher in those years, you can still pay all the tax in 2010.

What’s A Recharacterization?
Sorry! I hate to bring up another term (especially this ominous sounding one), but it is important since it provides you an easy out and some great tax and investment planning opportunities. Put simply, a recharacterization reverses a conversion. Thus, if you convert your IRA to a Roth, and later need or want to move some or all of the money back to your IRA, you perform a recharacterization.

One useful strategy for recharacterization is if you convert and the Roth later drops in value. Unfortunately, you paid tax on the higher converted amount. Amazingly, the IRS allows you to pretend that you never converted. By recharacterizing your Roth back to an IRA, you get your taxes back. Then, if desired, you can again convert to a Roth, but at the lower value and pay less tax, keeping the difference. This is just one of many great strategies that use this tax provision to your advantage.

Conclusion
The IRA & Roth pool of required knowledge is deep and wide with new rules being added almost weekly. A great resource is www.irahelp.com. There are so many great planning opportunities, but an advisor must expertly apply the rules to benefit your personal situation.

1. 2010’s new Roth rules provide a unique planning opportunity that should not be ignored.
2. If your retirement account values are lower now than they were last year, then conversion or recharacterization strategies could improve your long-term results.
3. Roth Conversion or Recharacterization strategies involve investment, tax and estate planning considerations. It is important to work with an advisor that understands the interplay of these three areas and who will concisely analyze and simply explain to you how you would benefit.

The bottom line is…IRAs are tax deductible, then merely tax deferred, whereas Roths are not tax deductible, but tax-free for you and your heirs. Roth IRAs are a very powerful retirement and estate planning tool and 2010’s new tax rules are exciting. With increasing income tax rates on the horizon, it’s time to seriously consider a Roth Conversion.

NOTE: This material provided for general and educational purposes only, and is not legal, tax or investment advice. For each strategy or option mentioned, there are detailed tax rules that must be followed.

This Article appeared in the Jan/Feb 2010 issue of Westlake Malibu Magazine

Insuring Yourselves Before Disaster Strikes

There have always been risks, and Lloyd’s of London began insuring them in 1688. They’ll provide coverage for just about anything under the sun from body parts, to voices, natural disasters, and even kidnappings by aliens. Celebrity leg insurance is one of the more well-known policies, starting in 1940 with Betty Grable purchasing $1 million of coverage to our modern day David Beckham, with a reported $70 million policy.

Most people, however, lead much more normal lives and merely carry homeowners and auto policies. These types of insurance are package policies, meaning that they cover both damage to your property and your liability should you or members of your family injure or cause property damage to someone else. The next most common type of insurance for Southern California residents is earthquake. This insurance is easily available and regulated by the state of California. Another common form of insurance coverage is an umbrella policy. This coverage is often overlooked, because it requires that you maximize your home and auto coverage before it can be purchased. It is quite inexpensive, however, and I highly recommend that you talk to your insurance agent about its benefits.

Most people’s awareness and exposure to insurance ends right there. However, there is a nearly endless array of specialty policies available. Let’s look at a few that are typical for this local area and its demographics.

Wildfire

While insurance policies are known for the clever exclusions, fire is one of the most basic areas of coverage and included in most standard home, renter, business and auto policies. Where people come up short on their coverage is failing to account for code changes, your renovations or add-ons, or today’s higher building costs. It is also important to have coverage for the contents of your home at replacement value. For example, if your old computer is worth $100, your current policy might not cover the $1,000 to replace it, but merely cover the $100 current value. Also, make sure your policy covers your landscaping and the extra cost of living in an hotel and eating out while your house is being rebuilt. One of the areas not covered is the land value. If a neighborhood is ravaged by a fire and the property values drop because of the extensive damage, homeowners are not covered for this loss in value. To secure the highest reimbursement, it is a good idea to video-record your home and all its internal contents. Store this in your safe deposit box or remote office (not at a neighbor's) in case you need to prove your claim.

Mudslides

While most Americans only read about mudslides, we Californians need to seriously consider them. With homes often built on, or near, hillsides and the combination of wildfires and El Nino, we need to be mindful of the risk. The standard homeowners policy does not cover flood, mudslides and landslides. If you desire such insurance you generally must purchase it through the federal government’s FEMA program. Further, you can’t just pick up the phone and secure the coverage. It takes time to purchase, and there is usually a waiting period until the coverage begins – so plan ahead.

Vintage Wines

If your wine is covered solely by a traditional homeowners policy, you may be surprised by the meager coverage. Further, if your wine is stored away from your home, your coverage may be even more limited. To obtain full value coverage for fire, theft, earthquake, breakage, water damage, and more, you generally need a special policy. Many specialty policies even cover accidental dropage or unauthorized consumption.

Aviation

Owners and operators of an aircraft both share liability. It is generally the aircraft operator that obtains the insurance policy. Most owners require that the insurer have an “A” rating or better from A.M. Best. Further, the owner should review the policy, making certain that it covers their key areas of liability. A last important step for the owner is to make sure to periodically request a certificate of insurance to make certain insurance is in place and evidencing that the necessary protections are in place.

Bloodstock

High value horses have problems all their own and specialized insurance is available to cover their risks. The main risk is generally mortality – the animal dies due to accident, illness, or disease. However, theft and loss of use are also typical. Since many of these animals are transported around the world for shows, races, or breeding, transportation coverage is also common. Additional coverage can be purchased for stallion infertility, broodmare barrenness, and even the unborn foal.

Directors

Most businesses and non-profits have insurance that covers their risks, but many fail to provide adequate coverage to those who serve on their boards. While most companies do provide traditional Directors & Officers insurance, it may not be enough in today’s litigious world. Independent directors and board members should consider additional personal coverage designed specifically to protect their personal assets.

Fine Art

Collections can range from paintings to antique weapons to taxidermy. Specialty insurance can be obtained to cover your personal fine art or collectibles. Additional coverage is available for any portion of your collection that may be part of an exhibition or on loan to a museum. Many insurance companies are even happy to send a specialist to evaluate and suggest better ways to protect your fine art from theft, fire, water or light damage.

Kidnap and Ransom

The U.S. Department of Justice states that there are over 1 million cases of forcible entry of residences, almost 1.5 million stalking cases, over 50,000 carjackings, and between 3,000 and 5,000 cases of non-family-related abductions that take place annually. The average cost of a carjacking, stalking or home invasion is $38,000, yet ransom demands can run into the millions. Several insurance companies offer policies that address all of these threats. Kidnapping is a billion-dollar industry around the world, frequently run by well-trained teams. Some policies not only cover the ransom cost, but also provide an experienced response team to work with you for the safe return of your loved one. Americans traveling overseas, especially in eastern Europe and Latin America, are often preferred targets. Demands as high as $20 million are not uncommon, but ransom settlements are often 10-20% of the demand.

So while you may not be one of the 40,000 people who have purchased alien abduction insurance (you’ll need to pass a polygraph, have photographic evidence, and a witness to collect the money), I’m sure there are areas of risk exposure in your life for which you should consider additional or specialty coverage.

Robert J. Katch is the founder of Manchester Financial, an Investment Counsel/Wealth Management firm located in Westlake Village. For more information call 805 495 4405

This Article appeared in the Nov/Dec 2009 issue of Westlake Malibu Magazine.