Lesson 15: Liquidity

Gold
I use this image whenever I can. Just look at that sheen.

Imagine I come up to you and allow you a choice. Because I am a very generous, benevolent man I offer you either $100,000 in cash or gold bars worth $100,000. Which offer makes more sense to choose? The time value of money is not relevant in this instance as you will gain the assets at the same time.  Your gut may be leaning towards the cash. Ignoring the obvious allure of shiny gold, you may realize that gold isn’t that useful in terms of purchasing everyday goods and services. You may also realize that there are additional steps you will have to take to turn that gold into cash such as finding someone to buy that gold and give you cash in return.  This concept of transforming an asset (gold in this case) into cash is known as liquidity.

Key Points

  • Liquidity is defined as the ease in which an investment can be converted into cash with little to no loss of value.
  • Cash is the most liquid of all assets.
  • There is a hierarchy of liquidity when it comes to investments.
  • Markets play a key role in maintaining liquidity of investments.
  • Imbalanced markets can create liquidity problems.

What is Liquidity?

Liquidity is a characteristic of investments that describes how easily an investment can be quickly converted into cash with little to no loss in value. An investment which cannot be easily converted into cash or can only be converted to cash quickly with loss of value is said to be illiquid.  Though there is no established scale for measuring liquidity, a rough hierarchy can be built to compare different assets’ liquidity.

Cash is the Most Liquid Asset

River
The other “liquid asset”. Image courtesy of nature.org.

Cash is commonly like water in the world of finance. When valuing a company you may create financial models that measure future cash “flows”. Keeping with this comparison cash is the most “liquid” asset and thus is used as the basis for measuring liquidity

Why is the cash the most liquid asset? As I referenced to earlier if you walked into a shop or a restaurant and tried to pay with gold coins or a very valuable, rare painting, you may find yourself in an undesirable situation. Cash is the most liquid because it is the currency we use in everyday commerce.  If we instead used shells or cigarettes (both of which have been used as currencies in certain economies) as currency, the shells/cigarettes would be the most liquid asset you could possess.

What is the Hierarchy of Liquid Assets?

As we established above cash is the most liquid of all investments. The diagram below places other common investments along a rough scale of liquidity.

 

tri2
What Links Liquidity and Markets ?

These rankings beg the question “What determines whether an investment is liquid or illiquid?” The answer is really simple: Is there a well functioning market that puts buyers and sellers together to exchange the investments?

Near the top of the liquidity scale are assets that have large exchanges and are traded frequently (stocks, bond, ETFs). Further down the scale you come across assets that are not as widely traded or are highly specialized (financial derivatives, commodities, real estate). The least liquid assets are incredibly specialized or lack a centralized market (rare art, antiques, cars).

The presence of a market is not enough to make an asset liquid. The market must be efficient with relatively equal supply and demand. Said differently the market cannot be buyer or seller dominated. In this instance the investment may be sold at a high premium or a deep discount due to the abundance or scarcity of the investment.

Gold diamond
A gold diamond…close enough. Image courtesy of vivalididiamonds.

For example let’s assume there is a new type of gold discovered called “diamond gold”. Furthermore let’s assume that Diamond Gold Inc. is the sole supplier (seller) on the diamond gold market.  In this instance because Diamond Gold Inc. controls the supply of diamond gold it can charge a high price for the diamond gold, reducing the trading of diamond gold, and rendering it illiquid.

What happens to an asset’s liquidity if the market is dominated by people wanting to sell a certain type of asset? This question was answered in the real estate crash that accompanied the 2008 Recession.

Liquidity and Risk: A Lesson from the 2008 Recession?

Foreclosure
Now imagine an entire street full of these things. Image courtesy of vinafengshui.

While the 2008 Recession is deserving of its own website, let’s look at a small aspect of the 2008 recession: the real estate market.  When home values began to plummet home owners were desperate to try to get rid of the “hot potato” that was their
homes.This flooded the real estate with homes (many of which were previously foreclosed on). As simple economics would dictate with this flood of supply buyers could pay a deep discount for homes that under normal circumstance would have a much higher value.  

Remember the aspect of liquidity in which the asset is converted “without significant loss of value”? In a market flooded with supply this tenant is violated as assets can only be sold at significantly lower cash values. Though this is a simplification of the complex 2008 Recession the effect of illiquidity was easily noticeable in the pummeled real estate market of the time.

Definitions

  1. Liquidity: a characteristic of investments that describes how easily an investment can be quickly converted into cash with little to no loss of value
  2. Illiquid: a characteristic of an investment in which an investment cannot quickly or easily be converted into cash without loss of value
  3. Currency: a medium of exchange that has value and is used to purchase goods and services

Further Reading

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10 Resume Tips To Make Your Resume Shine

 

Resume Pic
Image courtesy of UPenn.edu.

A large aspect of personal finance is having a paying job so that you have income (have to invest with something). Without a decent resume an individual’s job prospects can suffer.  Recently a lot of resume have been coming my way.  As someone who has had his resume looked over  by a lot of people and has seen a lot of resumes I’ve concluded a lot of people could do with a bit of resume help. The following are a few suggestions to ensure your resume gets to the top of the stack.

There are a few assumptions I make when making these suggestions. You can check out the bottom of the text to see if you are an exception to some of the suggestions.

Key Points

  1. Incorrect grammar or misspelled words is a resume death sentence.
  2. Have a logical flow to the resume.
  3. Keep the resume length to one page.
  4. A mission statement is not necessary on the resume.
  5. Be prepared to explain anything written on the resume.
  6. Use action verbs instead of passive verbs.
  7. Quantify statements and accomplishments.
  8. Fit the resume to the position applied to.
  9. Add some interesting flavor.
  10. Formatting can be difficult.

1.Incorrect Grammar or Misspelled Words is a Resume Death Sentence.

BadJobInterviewPic
It says here you “Are great at speaking and dealing with the pubic.” Image courtesy of jobvite.com.

Imagine you have an in-person interview with a company. Now imagine you show up in your underwear and expect to be taking seriously.  This is very close to the impression made when your resume has an obvious typo or is poorly written. Namely it makes you as a candidate hard to take seriously and will ensure your resume ends up in the recycling bin.

2. Decide on the Order of Your Resume.

A resume is like a good story with you being the main character.   It should flow in some logical order and describe where you’ve been (your prior experiences) and hint at what direction you are wanting to travel.  The most common ways to organize your resume are by chronological order (e.g. the most recent jobs and experience appear earlier on the resume) or by relevancy (the most relevant experiences appear first).

 

3. Keep it To One Page.*

StackOfPapers
No…just no. Image courtesy of turbosquid.com.

A resume is to be short and sweet.  Most hiring professionals would quietly chuckle at a twenty-one year old with a two page resume.  The point here is not to discredit what you have accomplished as a person (No, it’s great that you were the treasurer of that club in college). The point here is that the HR professional reading resumes only has so much time. Therefore it is your job to make a resume that is succinct and effective.

 

4. A Mission Statement is Generally Not Necessary.

Mission statements always have seemed pretty silly to me. Why tell a company “I am applying to the position of XYZ” on your resume? By submitting the resume it is self-evident what you are trying to accomplish.  If you feel you want to expound on why you are applying, write a cover letter.  Having a mission statement on your resume only occupies valuable space on a paper that should be only one page in length. Wasted space equals less lines about yourself to wow the reader.

 

5. If It’s on your Resume, It’s Fair Game.

I’ve heard horror stories of a candidate writing that he had “proficient Spanish speaking ability” on his resume only to have the interviewer come into the room and attempt to conduct the entire interview in Spanish. The candidate did not get the job.  The message here is not to exaggerate your abilities and accomplishments.  If something is written on the resume, the interviewer has every right to ask for more detail about it.  Your resume is your story; know your story.

 

6. The Importance of Imagery: Action Verbs.

Which of the following appeals to you more: 1. The boy went to the school. 2. The boy triumphantly marched to the school.  I would venture to say that the later example paints a more vivid picture in your mind. Apply this logic to your resume.  Avoid “passive verbs” such as “went” “did”, “was”, “is”, etc.  Instead use action verbs at the beginning of sentences to create a clearer picture for the reader the action you were performing.  Ex. “Processed invoices”, “Calculated valuations”, or “Formulated solutions”.

 

7. Quantify if Possible.

Numbers
Numbers can be pretty too. Image courtesy of truebloggedfiles.com

Did an idea you suggested save the company money or generate more revenue for the company? How much? If you told me it “saved the company money” technically you could have saved the company $1 and that would be a valid statement.  Here lies the importance of quantifying.  The best things about quantifying amounts is that the numbers speak for themselves.  If you brought in 100 new clients or cut costs by 20%, no one can argue with the objective numbers.  Though the numbers may speak for themselves be prepared to explain how you accomplished a feat you have written. (Remember if it’s on the resume, it’s fair game).

 

8. Fit Your Resume to the Job Applied To.

Depending on the job you apply to it may be necessary to slightly adjust a few details on the resume. This is not to say you should be rewriting your resume for each job you apply to. This is saying you may want to move around a few experiences to highlight the more important details. For example if applying to a role in which customer relations is vital, make sure one of the first things on your resume is customer intensive.

 

9. Make It Interesting!

interesting
Think this guy. Image courtesy of rightwingnews.com

This is a commonly overlooked suggestion. Remember how I keep mentioning how your resume is your story? Would you want to read a boring story with a boring character? I wouldn’t imagine so. Include an area on the resume related to your interests. Have you done charity work? Traveled to different countries? These things add depth to you as a candidate. Be careful not to include accomplishments or skills that may put you in a negative light. (No, for God’s sake do not put that you can belch the alphabet or partied with LMFAO In Los Angeles).

 

10. Formatting is the Bane of Many.**

From seeing over 100+ resumes the most common issue I see is actually not content related, but format related. This point actually is composed of a few mini points:

  1. Use a “tame font” with a font size no less than 11. Times New Roman and Georgia are examples of classy, professional fonts.
  2. Set the margins of the page to 1” each. The margins should be no less.
  3. Divide the content into relevant sub-areas (Education, Work Experience, Skills, etc.)
  4. Separate the sub-areas with one line of white space to
  5. Keep everything left aligned. Your resume should allow a reader to “scan” going top to bottom.
  6. Create a “header area” that should display your contact information and name in the top center or top left of the resume.  It should be slightly larger than the rest of the information on the page (You want the hiring professional to remember your name, so make it noticeable but not obnoxious).

 

An Example

You’ve read all the way through! Congratulations! I feel you are deserving of a prize. Below is a picture of a pre-formatted word document for a resume. All you have to do is click the drop box link, download the file (it’s in Word .docx format),  and fill out the relevant fields with your information. You now have a job submission ready resume.

Note that this is a business field related template but can easily be adjusted to fit many types of entry jobs.

Screen Shot 2016-04-10 at 4.58.01 PM
This is the Resume Template.

Link to Resume Template

*This is assuming you are applying to entry jobs or have no more than 10 years experience working. If you are in your mid-30s and have a large number of experiences and accomplishments, by all means go to two pages. For most people, though, one page suffices.
**These formatting pointers may not apply to marketing or creative content positions as in these instances your resume itself must be a reflection of your creative ability.

Lesson 14: Financial Derivatives

L13.1 Chart
Image courtesy of investspec.com

Up to this point the assets discussed have been “real” assets.  Said differently the assets (stocks, bonds, commodities) had some level of intrinsic value because they represented some sort of claim either to ownership of a business (stock), debt to be repaid (bond), or some physical good (commodity). There are other assets that have value because they represent a claim to these “real” assets. These assets are known as financial derivatives and are some of the more interesting and colorful financial instruments.

Key Points

  • A financial derivative is a security whose price is determined or derived from the price of the underlying asset.
  • Common types of financial derivatives include options, swaps, futures, and forwards.
  • Financial derivatives are traded either on exchanges or in over-the-counter (OTC) markets.
  • The role of financial derivatives in the market is to help mitigate risk from entities who do not wish to bear risk to entities better suited to manage that risk.

What is a Financial Derivative?

Financial derivatives are a type of financial security whose price is derived from the price of the underlying asset it represents. As opposed to “real assets” whose value comes from the perceived increase in value or the cash flows generated by the real asset, a derivative represents some sort of claim on the real asset. By existing independently of the real asset, the derivative can be traded separately while its value is largely related to the value of the underlying asset.

A Story of Opals and Options

Behold the opulent opal. Image courtesy of stephen-universe.wikia

Let’s assume I, a rare gem seller, have a rare opal (a physical asset) for $1,000.  You want to purchase the gem but are concerned that you may not be able to sell the gem at a higher price and thus will not profit off of the transaction.

Along comes a man who doesn’t know whether the gem is worth more or less but thinks it is worth less than you bought it for. Let’s call him the Pessimistic Guy.  The Pessimistic Guy is willing to sell you a piece of paper saying that he will buy the gem for $800 despite what it’s true price is.  The cost of this piece of paper is $100.

The paper in this situation is commonly referred to as an option as it gives you the option (but not obligation) to sell the underlying physical asset.

So what are the possible outcomes in this scenario?

There are quite a few depending on whether you buy the option and whether the gem is worth more or less than the price you purchased it for as seen by the table below.

Opal table

One of the most notable trends in the table is that if the option is purchased the most you can lose is the difference between the agreed upon purchase price ($800) and the
original  purchase price ($1,000) minus the additional cost of the option ($100).

In this case having bought the option the most you can lose is $800 – $1,000 – $100 = -$300

Though a simple example this reveals one of the main uses of derivatives. In the situation where you bought the option there was an absolute limited loss. The concept of unlimited/limited loss will be discussed in the future as it is both key to understanding the role of derivatives and is a fascinating concept.

What are the Common Types of Financial Derivatives?

There are four primary types of financial derivatives. Though only briefly discussed here, each will receive a more in depth analysis in future lessons.

1.Options: As seen in the example an option is a type of contract that enables the holder to exercise an option (usually buy or sell) on an asset. In the example above you purchased a put option. A put option enables you to sell an asset (the opal) at an agreed upon price ($8) before a predetermined maturity date. In the example we did not set a maturity date for the sake of simplicity. The opposite of a put option is called a call option as it enables you to buy an option at an agreed upon price.

2. Swaps: A swap is a type of financial derivative in which two entities exchange some sort of financial good or instrument.  Though it may seem like commodities may commonly be used in these swaps the most common instrument involved in financial swaps is interest rates.  An interest rate swap is a derivative in which two entities exchange cash flows in order to guard interest rate risk or to participate in speculative finance.

3. Forwards: A forward is a contract in which two entities agree to buy/sell an asset at an agreed upon price at a future date.  Forwards are commonly thought of as the simplest of the derivatives, though with modification can become complex. Forwards are commonly used in the commodity market and are used to hedge against price fluctuations.  For example I could agree to buy 1,000 bushels of wheat in three months for $50/bushel regardless of the market price of a bushel of wheat at that time.

4. Futures: A future is a highly standardized contract in which two entities agree to buy/sell an asset at an agreed upon price at a future date. A future may seem very similar to a forward. It is! A future is simply a highly standardized forward that is traded on an exchange instead of an OTC market (as forwards are).  The purpose of futures is to eliminate a risk known as counterparty risk that is present in forward contracts.  This will be addressed in more detail but for now just know that with more standardization comes the ability for a future to eliminate a type of risk that forwards inherently possess.

How are Financial Derivatives Traded?

Like stocks and bonds financial derivatives trade on both exchanges and over-the-counter (OTC) markets.  The OTC is the larger of the two for trades involving derivatives because of its looser regulatory standards.  Derivatives traded on exchanges (mainly futures) are predetermined and standardized to eliminate counterparty risk. Counterparty risk is the risk that the opposing entity in an agreement will be unable to fulfill its contractual obligation.  This risk is present in OTC contracts as the agreements are private agreements and lack an intermediary that can ensure the fulfillment of the contract.

Why Do Financial Derivatives Exist?

These very interesting and colorful financial instruments exist to satisfy one of the most important goals of finance, to minimize risk.  Through different arrangements an entity (business,person, bank, etc.) is able to essentially sell off some of its risk to some other entity that desires that specific risk.  This may seem abstract now but after some concrete examples in the next few lessons it will make sense why some entities benefit from the use of derivatives and why they have a place in the financial world.

Should I Invest in Financial Derivatives?

TwoPennies
These guys are back with advice.

Here’s the area where I throw in my $0.02 into the ring.

I DO NOT recommend most derivative trading for the average everyday investor.

The reasoning is very simple. Most individuals do not have the time or expertise to understand and dissect these at times incredibly esoteric investment vehicles. That being said there are a few derivatives that do make sense in some instances (a covered call option strategy is an example of one) in which a simple derivative can help minimize and hedge against risk. These instances will be covered in a later lesson.

Definitions

  1. Financial derivative: A type of financial security whose price is derived from the price of the underlying asset it represents
  2. Options: A type of financial derivative that enables the holder to exercise an option (usually buy or sell) on an asset
  3. Swaps: A type of financial derivative in which two entities exchange some sort of financial good or instrument
  4. Forward: A forward is a type of financial derivative in which two entities agree to buy/sell an asset at an agreed upon price at a future date
  5. Future: A type of financial derivative in which two entities exchange some sort of financial good or instrument
  6. Counterparty risk: The risk that the opposing entity in an agreement will be unable to fulfill its contractual obligation

Further Reading

The MyRA : A Retirement Account for Millenials

confused1
“What is this “retirement” you speak of?” Image courtesy of FutureTraining.org

If you’ve read my posts on traditional IRAs or Roth IRAs you may have walked away a bit confused. That’s ok. Retirement accounts are a confusing topic for the majority of Americans.  The U.S. Treasury picked up on this intimidating complexity and has very recently released a simple alternative for those wishing to save for retirement. This new type of account is called a MyRA. Let’s explore this new invention a bit further.

Key Points

  • A MyRA is a starter retirement savings account that enables those with low income or those new to investing to begin saving for retirement.
  • The benefits of of the MyRA include near guaranteed appreciation, account is linked to you, no related fees, and simplicity
  • The limitations of the MyRA include max contribution limits, limited returns
  • The MyRa is best for those earning low income, or someone just starting to save for retirement.

What is a MyRA Account?

Eggs
Behold the eggs of your financial future. Image courtesy of USNews.com.

A MyRA account is a specialized Roth IRA account that invests and holds only United States Treasury retirement savings bonds.  These savings bonds are backed by the full faith and credit of the U.S. Treasury meaning unless the U.S. government defaults on its debt, you have a riskless investment.  In addition the MyRA is relatively simple to set up and has no fees or costs associated with its operations.  The MyRA account is best suited for those who do not currently have access to an employee sponsored retirement plan (such as a 401k or IRA) or those who currently have low income employment.

Benefits of a MyRA Account

1. Guaranteed Risk Free Appreciation: Arguably the best part of the myRA is that you have risk-free appreciation. This means that there is no risk you will lose value in your investment.* When you invest these funds into the MyRA account, the U.S. Treasury then invests these funds in United States Treasury bonds.  The average annual return over the past ten years has been 3.19%.  A good assumption when calculating future returns would be to err on the side of pessimism and predict an annual return of 2.5% ( Which is much more than the 0.5% most people earn on savings accounts in banks).  Though this return may barely outpace inflation, a 2.5% return is better than a 0% return or a 0.5% you would earn in a standard bank savings account.

*Assuming the U.S. Treasury does not default on its debt.

2. The MyRA is Tied to You: Most retirement plans are employer sponsored (meaning that your employer manages most of the account and may match your contributions) and thus are attached to that employer.  This is not the case for the MyRA.  A better way to think of the MyRA is that instead of being attached to your employer, it is attached to you. What this means is that should you change jobs and get a new employer, it is very simple to have this new employer direct funds to the MyRA for you.  Another option is to set up a recurring or one-time contribution from a checking or savings account.  This added flexibility makes the MyRA great for younger adults or those who are switch
ing jobs or locations frequently.

Simple_pic
Image courtesy of susanlazarhart.com

3. Simple Setup:  Set up for these accounts are free and can be completed in a few minutes.  The simple setup is  on myRA.gov, clicking the “Sign Up” option, and going through the step by step process. The instructions are pretty straight forward and you will have a functional retirement account setup pretty quickly.

4. No Associated Fees or Minimum Balance Required: From a cost perspective the MyRA is a great choice. There are no maintenance fees (fees for a third party to handle the account) and no penalty for contributing too little funds or having a low balance in the account.  As the investor you have total control over how much or how little you wish to contribute.

 

Limitations of a MyRA Account

1. Contribution limits:  Similar to the Roth or Traditional IRA the MyRA has a annual contribution limitation.  The max contributions to all IRAs combined cannot exceed $5,500 ($6,500 if age 50 or older).  The example below illustrates what this could look like.

Ex. Let’s assume I have three IRAs, a traditional IRA ,a Roth IRA and a MyRA. In 2015 I contribute $2,000 to my Roth IRA and $3,000 to my MyRA. How much could I contribute to my traditional IRA?

$5,500 – $2,000 – $3,000 = $500

Thus I could contribute $500 to the traditional IRA without going over the contribution limit.

2. Max Value Limitations: As the MyRA is designed to be a “starter” retirement account, there is a limitation on the max value the account can reach.  Once an account reaches $15,000 in total value (principal + interest earned), the account must be transferred to a private sector Roth IRA.  Before this point is reached the investor is contacted and informed how to transfer the funds to a private sector Roth IRA where the principal and interest can continue to compound.

3. Interest Withdrawal Limitations:  The MyRA does have a strikingly similar limitation to the Roth IRA in the way of withdrawal.  At any point you may withdraw the money you personally invested into the account with no penalty. However, the withdrawal of the interest earned can be taxed if it is not distributed in a qualified distribution.  A qualified distribution is only allowed after five years of the first contribution and you are 59 ½ years old or meet certain criteria (buying a first home).  The purpose of this is to encourage savers to treat the account as an account for retirement and thus save for the age of  retirement.

Ex. Let’s assume December  2015 I contribute $1,000 to a MyRA account.  The account earned a 3.00% return over the year and thus the account is now worth a combined $1,030.  At December 2016 I can withdraw any to all of the $1,000 I personally contributed. However if I withdraw the $30 earned in interest, the $30 will be subjected to additional taxation.

$1,000 * (1+3%) =   $1,030

4. Limited Returns: The final limitation of the MyRA is related to one of my initial lessons on risk and return. The risk of the MyRA is close to zero. As a result the return on the investment should be relatively stable and low around 3.00%.  Though this may not seem like a great return, it does beat inflation and is a higher return than most bank savings accounts.

 

How To Get a MyRA Started

Nestegg_Pic
This is your nest egg. There are many like it, but this one is yours. Image courtesy of protectmyid.com

If you are a young or low income earning individual who wants to start saving for retirement and currently has no retirement savings plan with your employer, the MyRA is the retirement account for you.

To get started go to MyRA.gov, click the “Sign Up” button, and be on your way to building your
nest egg!

Definitions

  1. MyRA: A specialized type of Roth IRA with features designed for those new to saving for retirement.
  2. Maintenance Fees: Fees charged by an account manager for handling an account.

Further Reading

Retirement: What is a Traditional 401k?

Beach Picture
Like this…but with lots of tourists. Image courtesy of funcrisp.com

Imagine you’re on a nice beach in Florida without a care in the world.  Do you feel the soft breeze on your skin and hear the soft crashing waves on the shore and the tropical birds chirp in the distance? This could be what retirement feels like.  On the other hand imagine having to reach out to your children for help in paying your hospital bills as you didn’t realize health care costs could become so expensive. You have to keep working because you don’t think you can afford to lose your income stream. This could also be retirement feels like. I bring up these opposing visions to illustrate a simple point: retirement is a big deal.

In the next few posts I will be discussing the various retirement plans  available and how to make the most of the dollars you earn today.  It is never too early to think about retirement.  As I mentioned in Lesson 1 there is a benefit in investing today and not fifty years down the line.

Let’s begin with one of the most common terms in the world of retirement plans: the 401k. I will note that most people will be able to use a traditional 401k plan. There are some exceptions including employees of the government or nonprofit plans which I will address in later posts.

Key Points

  • A traditional 401k is an elective retirement plan which grants an employee the ability to defer some of his/her earned income in order to obtain current favorable tax treatment.
  • The benefits of using a traditional 401k plan include favorable tax treatment and employee matching.
  • The limitations of a traditional 401k plan include distribution limits, contribution limits, and later taxation.

What is a 401k plan?

Put simply a 401k plan is a retirement plan an employee enrolls in through his or her employer. There is a tax benefit associated with contributing to a 401k plan and in addition the employer generally will match the employee’s contribution according to some predetermined formula.

In general the company offering the 401k plan does not manage the plan.  It usually serves the role of the sponsor of the plan. To think of it differently, the sponsor of the plan (the company you work for) usually outsources the management of the plan to a financial service company who you contact for the actual management of your plan.  The identity of the financial service company that manages your 401k plan should be detailed in the benefit guide of your employer.  The role of the employer as the sponsor is to pay for the setup of the plan and to make matching employer contributions according to some formula.

A very important term to become familiar with is the term elective deferral. An elective deferral is simply the portion of your paycheck that you are choosing to put into the 401k.

What are the benefits of a 401k Plan?

So why would I want to tell my employer to funnel some of my earnings into my 401k plan instead of putting that money in my pocket? There are two main reasons: tax treatment and contribution matches from your employer.

1. Tax treatment: Taxes suck. Luckily the 401k provides a way to decrease your federal income tax payable.   Your elective deferrals do not show up as taxable income. Said differently the income you choose to defer (put off until retirement) does not count as your taxable income in a given year.   The federal government is rewarding you for investing in your retirement.

IRS Soldier
“Did someone say that taxes suck?” Image courtesy of offthegridnews.com

 

If you think this sounds too good to be true, you’re correct. Though these contributions are allowed to grow untaxed in the fund, when you withdraw the funds (also called a distribution) they are subject to taxes as ordinary income.  An example would be if you have invested in a 401k plan and at age 65 withdraw $50,000 from the plan, this $50,000 would be reflected as ordinary income and subject to taxes.

2. Employer matches: Who likes free money?   By contributing to a 401k plan, this is a possibility.  Most corporations as part as their benefit package offer “401k-matching”. What this means is based on a predetermined formula your employer will contribute to your 401k fund. For example a company may match 25% of your contributions up to $2,500 per year.  Meaning for every $1.00 I set aside in the fund my company will contribute $0.25.  Getting paid for investing in your retirement is a pretty neat thing.

PFT Retirement Plans Traditional 401k Vest Pic
Vesting is surprisingly not related to clothing. Image courtesy of honeybuy.com

There are some caveats to be aware of.  While you always have a claim to the money you contribute to the plan, you may not always be able to have total claim to the employer’s contributions.  Many companies enact a vesting condition in their contributions. Vesting refers to an amount of time that must pass before you have claim to some asset.  This is generally done to ensure you will remain employed by that company for a longer period of time. An example of a vesting schedule would be that you vest 100% in the company’s contributions after five years with vesting beginning at 20% in year one and increasing by 20% each subsequent year.

Let’s use a quick example.  Say John Galt works for Eos Inc.  and Eos has a 25% matching contribution and the vesting schedule is 20% each year for the first five years at the company.  Mr. Galt has been working at the company for three years and contribute $5,000 to the 401k plan each of those years. How much principal does Mr. Galt have claim to (assuming the fund did not earn a return)?

 

John Galt’s contribution to the plan:

3 years * $5,000 = $15,000

Eos Inc.’s contribution:

3 years * 20% of our $5,000 yearly contribution * 60% vesting limit

3 * $1000 * 0.60 = $1,800

Total principal in the fund = $15,000 + $1,800 = $16,800

Limitations of a 401k Plan?

1. Distribution Limitations: Waiting is hard.  At some point that $15,000 may look very tempting to withdraw and go spend on a new boat. Unfortunately the IRS would rather you not blow your 401k and has put in place deterrents to discourage that action.  The deterrent takes the form of a 10% additional tax if you receive the distribution before age 59 ½.  The reasoning is sound. The 401k is to provide you with retirement income, not a boat.

That being said the ways the elective deferrals can be distributed without incurring additional charges include: you die, become disabled, or become unemployed; your employer terminates the 401k plan; you reach age 59 1/2  or incur significant financial hardship.

2. Contribution Limitations: There are two annual limits that every 401k owner should be aware of:

1. The limit on the amount you as an employee contribute to the plan 2. The limit on the total amount that can be contributed to the plan.

The annual contribution limit for the employee in 2015 is $18,000.  This ceiling has increased in increments of $500 for some years and is expected to so as the IRS adjusts it for costs of living and inflation.The annual total of elective deferrals and employer matching contributions cannot be greater than $52,000 or 100% of your compensation, whichever is less.

3. Later Taxation: As I mentioned earlier, the funds in the 401k plan can’t avoid the tax man forever.  When the funds are distributed to you (and hopefully not with the added 10% tax) these distributions will show up on your taxable income.

IRS Soldier
“Did someone say Tax Man?” Image courtesy of offthegridnews.com

An Example

For a comprehensive example let’s return to Mr. Galt who works at Eos Inc.  Mr. Galt has been contributing the $5,000 per year and has been matched by his employer 20% of his contribution.  Assuming that Mr. Galt has been working for Eos for 30 years the principal of his 401k alone is worth $180,000 before taxes. That’s not bad, but the neat thing about that number is it’s grossly underestimating the value of the 401k. Why? The money in the 401k has been invested in stocks, bonds, and other assets depending on the risk Mr. Galt took on.  If we assume that he earned a 5% average return over that time period the value of his 401k is not $180,000…it’s around $400,000 before taxes.

Conclusion

Senior couple
Pictured: Golden Years. Image courtesy of gainesvilletoday.com

Retirement is important to everyone.  Why should someone start early? Growth. What may not be clear is that your 401k will allow you to allocate and invest the funds as you choose. Said differently a 401k is just another type of account for saving and investing, but with an emphasis on retirement.  If done correctly, your fund can grow quite dramatically over the years of employment and you won’t have to worry about money when you reach your golden years.

In the next few posts I will be discussing other retirement plans that exist including the Roth 401k, IRA, and Roth IRA.

Definitions

  1. 401(k): A type of retirement fund which allows employees to defer funds in order to obtain favorable tax treatment and to obtain matching employer contributions.
  2. Sponsor: The employer who contributes funds and facilitates the participation in a 401k plan by its employees.
  3. Elective Deferral: A portion of earned income that an employee chooses to defer by transferring into a 401k and which does not contribute to taxable income in the year earned.
  4. Vesting: The process by which an employee accrues certain rights or privileges from his/her employer.

Further Reading

Lesson 12: ETFs

Mutual funds ETF Headingare great, but they have some drawbacks.  If you want to sell it, you have to wait to the end of the day. In addition mutual funds have some unavoidable costs and some limited functionality. In response to these shortcomings Exchange Traded Funds (ETFs) were created about 20 years ago and are one of the most recent and interesting financial innovations of the present day.

Key Points

  • An ETF is a type of hybrid investment company.
  • Creation is the process by which an ETF is created.
  • Redemption can be thought of as the reversal process of creation.
  • ETFs possess cost and functionality benefits compared to mutual funds.

What is an ETF?

An Exchange Traded Fund is a special type of hybrid investment company that creates marketable shares that trade on an exchange based on the value of the asset base it tracks.  The investor receives profits on the assets owned (interest if bonds are tracked or dividends if stocks) on a pro rata share basis.  The easiest way to describe an ETF is to think of it simply as a mutual fund with some increased functions (if a mutual fund is a knife, an ETF is a Swiss army knife).   One of the most crucial differences between an ETF and a mutual fund relates to the method of trading.

As you may remember a mutual fund is priced once a day at the end of trading. Thus buy and sell orders are processed at the price (Net Asset Value) at the end of the day for mutual funds. This is not the case for ETF shares. You can trade ETF shares at any point during the day on an exchange.  To understand what makes an ETF valuable and why it has key benefits over a mutual fund, we first must see how these funds are constructed.

How is an ETF Constructed?

Two crucial processes in ETF functionality are construction and redemption. Let’s begin by analyzing construction, which as the name suggests is how an ETF is created.

Let’s assume that I want to create an ETF (Colby Duhon Superfund).  Thus the Colby Duhon Superfund is the sponsor of the ETF. My first decision is what asset do I want to track.  Tracking means I will possess this asset whose value can fluctuate.  My choices include indexes like the S&P 500, bonds, gold, etc.  For the sake of this example let’s assume the Superfund will track the S&P 500.  The problem is the Superfund does not have enough capital (money) to purchase all the stocks traded in the S&P 500. This creates the role of the Authorized Participant.

The Authorized Participant (AP) is a large market maker or financial institution with sufficient buying power to provide the ETF with the asset it desires. Basically the Authorized Participant is the rich relative who has the buying power to purchase the assets the sponsor wants to package up as a unit.  It is worth noting that in some cases the sponsor and AP can be the same entity.  For the sake of the Superfund example we will assume this is not the case.

Now that the AP knows that the Superfund wants to track the S&P 500, it will go out into the market and buy the shares that comprise the S&P 500 in the proportion that the shares make up the index.  Once the AP has the shares assembled, it now has a basket of securities.  The AP will then trade this basket of securities to the sponsor (Superfund) and in exchange receive a creation unit which usually represents 50,000 shares of the ETF.  The AP then sells the shares of the creation unit in the open market.  When you buy a share of an ETF, you are buying a piece of this creation unit.

Old Guy in Chair
“Back in my day we didn’t have cool widgets.” Image courtesy of bbc.com

An easy way to think about this is continuing with the rich relative metaphor. You (the sponsor) want to create a cool widget that would sell well but you need some parts to make it. You contact your rich uncle (AP) and ask him to buy all the parts in the market.  The rich uncle buys the parts (stocks) and gives them to you. You assemble the new widgets using the parts and in exchange for the parts give your uncle the widgets (creation unit). Your uncle now has cool widgets to sell while you keep the parts.

As a final note in our example we created an ETF that tracked the S&P 500. We could create an ETF that tracks other assets such as bonds or gold. In any case the process is similar with the AP purchasing the assets (bonds or gold) and the sponsor providing the creation unit to the AP to sell.

ETF Creation Diagram
ETF Creation Process

 

Redemption

Redemption can be thought of as the opposite of creation. In creation the AP gave the basket of assets to the sponsor and received the creation unit of shares. In redemption the AP returns the creation unit to the sponsor and receives the basic of assets back.

As I said before an ETF has many similarities to a mutual fund. So if presented with a mutual fund that tracks a market index and an ETF that does the same why would I choose the ETF? 1. Cost benefits 2. Functionality benefits.

Cost Benefit of ETF vs. Mutual Funds

  1. Cheaper operational fees: Due to the unique structure of the ETF, the ETF fund charges lower operational costs compared to that of a mutual fund. The difference lies in the presence of the AP when investing in an ETF. Due to this “middle man” the investing process is greatly simplified for the ETF fund and investor and this simplification translates into cost savings for the investor. For a direct comparison the average U.S. Equity Fund charges 1.46% in annual expenses where the average ETF Equity Fund charges 0.53%.1
  2. Favorable tax treatment: Most ETFs incur very few capital gains tax due to their unique creation process. ETFs and mutual funds are required to distribute capital gains to their investors, which will be subject to capital gain tax. Ouch. An ETF is able to avoid this problem by having a very low turnover ratio and avoiding the presence of a sale in the redemption process. The avoidance of a sale matters because if the ETF had to sell the shares it had to raise cash, this would be taxed. However a quick review of the redemption process reveals that when the ETF needs to raise more cash it does not “sell” the assets, but trades them to the AP for the equivalent creation unit. This structure enables ETFs to avoid unfavorable taxes.

Functionality Benefits of ETF vs. Mutual Funds

  1. Intraday Trading: As previously mentioned one of the crucial differences between an ETF and mutual fund is the ETF’s ability to trade intraday. Not having to wait till the end of the trading day could make a huge difference on your strategy in addition to being a nice convenience feature.
  2. The presence of options and other features: Though I haven’t discussed them yet, an ETF gets added functionality from the ability to purchase options on them. Options briefly are a form of derivative security that enables you the investor to buy or sell an underlying security for a set price.  What is necessary to understand is based on the presence of these, ETFs obtain a dimension of functionality unmatched by mutual funds.

 

Definitions

  1. Exchange Traded Fund (ETF): A special type of hybrid investment company that creates marketable shares that trade on an exchange based on the value of the asset base it tracks.
  2. Creation: The process of creating an ETF or more specifically creating a creation unit whose shares will be traded on the open market.
  3. Creation unit: A block of shares (usually 50,000 shares) created by the ETF and whose individual shares are sold on the market.
  4. Redemption: The process of trading a creation unit for the underlying assets it represents.
  5. Sponsor: An entity that wishes to create an ETF.
  6. Authorized Participant (AP): A market maker or large financial institution that possesses the capital needed to purchase the underlying assets a sponsor wishes to transform into an ETF.

 

Further Reading

The Growing Problem of Student Debt

Remember how I wrote on all the federal loan programs and college debt? Well that college debt keeps growing and it is getting a bit scary.

Key Points

  • Over the past year alone, the total balance of the direct loan program has grown from $687 billion (with a “B”) to $806 billion.
  • The total size of the student loan debt is now in excess of $1.13 trillion (with a “T”).
  • Since 2007, the federal direct student loan program has increased near seven fold.
  • This increase in leverage on students creates an interesting relationship between the federal government and indebted students.

Woe to the Students

ST The College Debt Bubble
Some readers may be able to relate. Image courtesy of CNNMoney.com

Based on the statistics above you may reach the same conclusion I have. The student debt situation in America is a rapidly growing concern that merits some attention. When considering the sour job market and the ever growing cost of attending college the above statistics really should come as little surprise.  Unlike the housing bubble where banks were the holders of the debt, the federal government now holds 80% of this debt. The future consequences of this system have yet to be seen.

An interesting consequence viewable now is that young adults are lessening consumption according to research by the New York Federal Reserve. Less than 25% of young adults aged 27-30 have any sort of home secured debt (eg. A mortgage).  This pattern is also evident in the auto market. This makes intuitive sense as this age group is already straddled with student debt and is unwilling to take on more debt.

Will universities continue to increase costs of attending? Will the federal government continue to grow the monstrous student debt? What alternatives are available to solve the ubiquitous issue of paying for college?  I wish I knew these answers. What can be said is that it will be interesting to see the relationship that emerges as more and more young Americans become indebted to the federal government.

Further Reading

Student Loans and Paying for College (Part 2)

Student Debt with Ball and Chain
A commentary on today’s student loan situation. Image courtesy of Cognoscenti.

Let’s explore a bit more of the technical details relating to the different grants and loans out there. I won’t touch on scholarships because they vary so widely depending on the offering organization.  Just as a quick refresher grants are need-based gift aid, scholarships are merit-based gift aid, and student loans are loans that must be paid back. We will first discuss the types of federal grants then move on to the different types of federal loans.

Key Points

  • The most common federal grants offered are Federal Pell Grants, FSEOG, and TEACH grants.
  • The most common federal loans offered include Perkins loans, direct unsubsidized loans, direct subsidized loans, and direct PLUS loans.
  • Pay close attention to the Master Promissory Note (MPN), which is essentially the terms and agreements when accepting a federal loan.
  • Federal loans possess many qualities that make them superior to federal loans.

Federal Pell Grants

Federal Pell grants are federal grants granted to undergraduate students who have not earned a bachelor’s or a professional degree who exhibit a degree of financial need.  It also should be noted that you cannot receive a Federal Pell Grant if you are incarcerated or subject to an involuntary civil commitment so before you commit that crime realize it could affect your future education prospects.  The yearly distribution amount differs on a number of factors including the level of your financial need, the cost of attendance, and whether you are a full-time or part-time student. The maximum award for the July 2014-June 2015 academic year was $5,730. This number can be adjusted slightly each year, but do not expect it to jump $1,000 in one year.  You can receive the Pell Grant for 12 semester (or approximately six years). You will receive the full amount you qualify for from your attending college.  As I nagged last lesson and will nag this lesson, you must fill out the Free Application for Federal Student Aid (FASFA) in order to receive a Federal Pell Grant.

Federal Supplemental Educational Opportunity Grant (FSEOG)

The FSEOG is a federal grant granted to undergraduate students who exhibit exceptional financial need such that a Federal Pell Grant is insufficient.  A FSEOG is only available to those student who have received a Pell Grant and exhibit the most financial need.  The FSEOG is not offered at all colleges therefore contact your prospective college’s financial aid office to find out if your college offers the FSEOG. The amount of aid offered through the FSEOG ranges from $100-$4,000 depending on your financial need, the other financial aid you receive, and the availability of funds at your college.

TEACH Grant

The TEACH Grant program is a specific federal grant program that grants up to $4,000 per year to students who are completing coursework related to a career in teaching.  There are some stipulations to accepting this aid such as if you accept you must teach: in a high-need field, at an elementary or secondary school that serves low-income families, and teach at least four academic years of the eight years after you cease schooling. What happens if you do not fulfill these requirements?  The grant is transformed into a direct unsubsidized loan for your breach of contract.  In addition to completing the FASFA if you are interested in the TEACH Grant program, be sure to contact your college’s  financial aid office and ask if they participate in the program. The other stipulations are explained in the TEACH Grant Agreement to Serve which acts as the contract for the grant.

Federal Perkins Loan

The Federal Perkins Loan is a low-interest student loan offered to undergraduate and graduate students who exhibit exceptional financial need.  Once again not all colleges participate in this program so you should contact your college’s financial aid office to see if it participates in this program. The amount you are allowed to borrow depends primarily on your financial need, the amount of aid you have received, and the availability of funds at your college. Unlike the Pell Grants, not everyone who qualifies for a Perkins loan will receive a loan.  As an undergraduate you are allowed to borrow up to $5,500 up to a total of $27,500.  As a graduate you are allowed to borrow up to $8,000 per year up to a total of $60,000.  Repayment begins nine months after you graduate, leave college, or drop below half-time status.  Before the nine months has passed interest does not accrue on the loan.  In addition the interest rate on these loans is fixed at 5% (currently).  To apply for this or any of the following loans you must complete and submit your FASFA (a big surprise I know).

 The Difference between Direct Subsidized and Unsubsidized Loans

Before I describe the direct subsidized and unsubsidized loans, it is worth that the biggest difference between the two is that with a direct subsidized loan the U.S. Department of education pays for (subsidizes) the interest payments that accrue when you are in college. If a student has an unsubsidized loan interest does accrue during your time in college.

Direct Subsidized Loans

Direct subsidized loans are student loans available to undergraduate (not graduate) students who exhibit financial need and are enrolled at least half-time. Once again check with your college’s financial aid office to see if the college participates in the Direct Loan Program.  The annual award is $3,500-$5,500 depending on grade level.  One of the most notable characteristics of the direct subsidized loan  is the interest owed (the rate is now at 4.66%) is paid by the federal government as long as you are in school as at least a half-time student and the grace period during the first six months after leaving school.  Also repayment of principal is not required until this grace period of six months has ended.

Direct Unsubsidized Loans

Direct unsubsidized loans are student loans available to both undergraduate and graduate students who are enrolled at least half-time and there is no requirement for financial need to acquire the loans.  The annual award can range from $5,500-$20,500 depending on grade level and dependency status.  The difference between the unsubsidized and subsidized loan is that that while you are in school you are responsible for paying the interest that accrues on the loan and during all grace periods.  You have the option to not pay the interest at that time but if you choose this option the interest will be capitalized (added to the principal amount of money you owe) thus increasing your interest payment later down the road.  The interest rates for direct unsubsidized loans are fixed and are currently 4.66% for an undergraduate student loan and 6.21%. Similar to the subsidized loans there is a six month grace period following the first six months after leaving school during which no principal payments are required.

Direct PLUS Loans

PLUS loans are federal student loans that graduate students and parents of dependent undergraduate students can use to pay college expenses without the need to show financial need.  Not all colleges participate in the federal loan program so be sure to contact your financial aid office. One of the most notable features of the PLUS loans is that the borrower must have a “good” credit history.  The maximum loan amount is the student’s cost of attendance (which is equal to total costs of attending minus financial aid received). Accrued interest must be paid while in school else it is capitalized to the principal of the loan.  If a parent takes out the loan for his (her) student, there is no grace period and repayment of principal must begin immediately, this is not the case for a graduate student who has a grace period following the first six months of leaving school. The current interest rate on direct PLUS loans is 7.21%. I really should stop beating this dead horse, but in order to apply for the direct PLUS loans you have to complete and submit the FASFA.

Federal vs. Private Loans

I’ve outlined a lot of different options and some may not seem very generous. You may be thinking “Is that the best that is out there?” Sadly I would say yes it is.  Many aspects of federal loans make them superior to loans offered by other institutions (private loans).  These include fixed interest rates instead of variable interest rates (interest rates that could change), the student is not required to repay any principal while in school, and the need for an established credit history or cosigner in order to secure the loan.

Before you agree to any federal loan be sure to read the Master Promissory Note (MPN) that serves as the loan contract and outlines the terms of the loan.

Definitions

  1. Grant: A need based form of gift aid which usually does not require repayment
  2. Student loan: A loan made to a student in college which may either by administered by the federal government or a private financial institution.
  3. Grace period: A period of time during which principal payment of a loan may be suspended.
  4. Interest capitalization: A type of loan stipulation in which unpaid interest is added to the principal balance of a loan.
  5. Private loans: Student loans offered by a private institution.
  6. Master Promissory Note (MPN): The contract outlining the terms and conditions for most federal student loans.

 

Further Reading

Student Loans and Paying for College (Part 1)

I can’t tell if the money is coming out or going into the hat. Image courtesy of saleshq.com

So you got accepted to the school of your dreams?

Congratulations! I’m happy for you! My next question merits a bit of scary thought. How are you going to pay for attending that school? Maybe you have wealthy relatives. If so, count your blessings and the rest of this post is irrelevant for you so you can move on to something else.  For the rest of us…paying for college is no laughing matter. Cost is one of the top determinants of where an individual chooses to attend college (I was one of these individuals). As tuition continues to rise and the job market continues to flounder financial aid for students is becoming a very ubiquitous issue that merits a bit of explanation and study.

Key Points

  • There are some key differences between scholarships, grants, and student loans.
  • The FASFA is arguably the most important financial aid form to complete.
  • Scholarships, grants, and student loans are the most popular methods to pay college costs.
  • Your financial aid office at your school is your friend not your foe.

Grant, Scholarship, or Loan?

Let’s start with the good news. There are entities out there who will give you free money to attend school. These entities can be the school you choose to attend, the company your parent(s) work for, or even the federal government. This “free money” or “gift aid” is usually referred to as grants and scholarships.  Grants are financial aid packages usually given on a financial need basis. Scholarships are financial aid packages usually given on a merit basis.  It is important to note that while scholarships and grants do not usually require repayment they may still have performance conditions attached to them (ex. You cannot fall below a certain G.P.A. while attending school). The largest provider of grants is the U.S. federal government.

Here’s the bad news: this form of aid may not cover all the costs of attending college. When gift aid isn’t enough we must turn to student loans which are loans specifically provided to individuals attending universities that do require repayment. The largest provider of student loans is again the U.S. federal government though there are private student loans offered by banks, credit unions, and universities.

How a Piece of Paper Can Save You $100,000

The Free Application for Federal Student Aid (FASFA) is arguably the most important form to fill out when it comes to financial aid for paying for college.  By filing out the FASFA you are essentially revealing to the government how much of the cost of attendance your family will have to pay (the exact term for this is expected family contribution) and how much of the bill the government will cover.  Needless to say the FASFA is a pretty thorough form that will ask family net worth, family income, number of family dependents, etc.  I do not recommend lying on this form. Why? Because the information you enter is cross referenced with the friendly, neighborhood IRS (Internal Revenue Service) and the last thing someone wants is a call from the IRS regarding the apparent fraud you filled out on the FASFA.

Different states and schools have different deadlines than the federal government (the deadline page can be found here). It is very important to not miss these deadlines as you would be missing out on free money…ouch.  Usually the deadline for the upcoming school year is before the fall of that academic year (Ex. If I were attending LSU from Fall 2015 – Spring 2016 I would have to submit the FASFA before June 30, 2015.)  Another important aspect of the FASFA is that you must reapply each year you want to receive some form of financial aid.  Why? Let’s say that your second year of college your family wins the lottery (or your father loses his job).  This new source (loss) of income will show up on your FASFA and as a result the federal government will expect a larger (smaller) expected family contribution. To capture situations like this the federal government and universities require the FASFA be completed each academic year. Thus write down your log-in information and keep it in a secret, reliable place.

Scholarships

Scholarships are a merit based form of gift aid and are arguably the most sought out form of financial aid. They are offered by universities and many private and non-profit organizations.  The best ways to find these financial gold mines are contacting the university you plan to attend or performing your own private research.

A quick caveat about private research on financial aid: Beware companies that want you to pay for scholarship or grant searches.  Most of these companies want you to pay for results you could get by googling ‘’popular scholarships”.

Once you find a scholarship that you fit the criteria for, apply.  Though sometimes a pain you are sacrificing your time for a chance to lessen that financial burden (I personally applied to a scholarship offered through the finance department at my school and received $3,000 from it. Not bad for spending an hour on the application.)  Scholarships have their own deadlines and criteria so pay close attention so you don’t miss out.

Grants

Grants are a financial need based form of gift aid and take up the greatest percentage of total financial aid offered to students.  They are commonly offered by both colleges and the federal government.  The federal government has quite a few notable grant options which will be discussed in part two.

Apart from being based on financial aid vs. merit, grants function in the same way as scholarships. Based on the results of the completed FASFA different grant options may be available.  Once again grants may have terms attached to them so be sure you understand the terms of agreement when you accept the financial aid.  What do you do if the scholarships and loans are not enough? Other than working three part time jobs, you may want to consider taking on a student loan.

Student Loans

So you have crunched some numbers and discovered that the grants and scholarships just won’t cover all of the expenses. Now what?  You could put the remaining costs on a high interest credit card and bite the bullet, but I would not recommend that.  Seeing the need for a reliable source of student loans the U.S. Department of Education created a loan program to help fill the gap in paying for all of college costs. Some banks and other financial institutions began to offer student loans. The major distinction in the world of student loans is that there are federal student loans (government) and private student loans (non-government).  In many of the cases federal student loans have some key characteristics (fixed low interest rate, possible tax reductions, and post-graduation payment plans) that make them superior to most private student loans.  To apply for a federal student loan you must complete your FASFA (told you it was kind of important) and the results of the FASFA will dictate which types of federal loans you are eligible for.

 

Student with ball and chain attached
You shouldn’t feel like this. Image courtesy of McCarthy’s Weekly.

 

If there is one take away from this lesson let it be this: Your school’s financial aid office is your friend when it comes to paying for college; go to them if you have financial concerns.  For now let’s look a bit more in depth at the different types of federal grants and loans available to students.

Definitions

  1. Grant: A need based form of gift aid which usually does not require repayment.
  2. Scholarship: A merit based form of gift aid which usually does not require repayment.
  3. Student loan: A loan made to a student in college which may either be administered by the federal government or a private financial institution.
  4. Cost of attendance: The total cost of attending a particular university for a certain period of time (usually a year) and includes expected costs such as tuition, room and board, books and supplies, etc. This metric is used in calculating the amount of financial aid offered.
  5. Expected family contribution: The expected dollar amount the family of a student is expected to contribute to college expenses. This metric is used in calculating the amount of financial aid offered.

Further Reading