another other way: islam and finance

As a follow-on to last week’s post, I’d like to talk about yet another alternate view of finance — this time, that held by Islam, as explained to me by a friend and colleague who is a practicing Muslim. This is for two reasons: one, because I personally am fascinated by Islam’s views of God and humanity, at once very similar and somewhat different from Christianity’s, and two, because we of the West know virtually nothing about Islam as it is practiced by the vast majority of its more than 1.5 billion adherents. I mean, have you ever asked a Muslim what jihad actually means? I’ll give you a hint: it’s not what you think.

So I’d like to talk about two areas of finance that work somewhat differently for Muslims than for the rest of us: charitable giving and banking.

Charitable Giving

Islam has a concept similar to Christianity’s “tithing”, which they refer to as zakat. My friend refers to it as “alms giving”. Here, all Muslims are required to give 2.5% (1/40th) of their excess wealth to charity. While that’s the simplified version, there are a few details worth noting.

First and foremost, the tithe is on excess wealth; that is, what is in excess of what is necessary to survive. As a practicing Christian, I’ve often been concerned by the fact that a tithe for someone who makes $30,000 a year is quite different from a tithe for someone who makes $300,000 a year. In my opinion, the zakat is an excellent progression: only those wealthy enough to have a surplus are required to give the tax. Of course, Muslim scholars differ as to what is “surplus”, and the devil is perhaps in the details, but the idea is sound.

Also, Islam stipulates that, rather than being given to the local mosque or spread thinly among various social service organizations, zakat is to be used to raised individuals from poverty. That is, if you are to give $1000 in zakat this year, you are encouraged to give it to a single person in poverty. The idea is that in this way the recipient of this year’s zakat may themselves be able to give zakat next year. Apparently this worked so well in the early days of Islam that poverty was eliminated entirely for a time; as there was no one in their country eligible to receive zakat, they had to go to neighboring countries and distribute it there!

Finally: zakat is not a minor footnote, as it often is in Christian denominations; rather, it is one of the Five Pillars of Islam.

I’m not saying that Christianity should adopt the zakat wholesale; however, those of us concerned with the role of social justice in Christianity should take note.

Banking

Islamic banking centers around the fact that riba — usury, interpreted by most scholars as charging interest on a loan — is forbidden. Islamic scholars see this as an issue of justice, as invariably, if I may paraphrase, someone is going to get screwed. We see this in the West all the time: the spread between what a bank charges for a loan and what a bank pays for a deposit is notorious for making a small percentage of the population ridiculously wealthy.

That isn’t to say that Islam does not believe in banking; rather, it believes that the bank should share the risk equally with those whom it does business with. Consider their equivalent of mortgages, for example. Say you have enough money for a 20% down payment on a house. You go to the Islamic bank, and they agree to pay for 80% of the house. You don’t pay nterest; however, because they own 80% of the house that you live in, you agree to pay them rent for their 80%. Along with that rent, each month you buy a little bit more of the house, and the rent goes down accordingly, so in the end after 30 or 15 or however many years, you own the house entirely.

This may seem like a mortgage, and in practice it works in a similar fashion, but there’s a crucial difference: in a traditional mortgage, the loan itself is not tied to the house. If the house were to evaporate, you would still owe the mortgage. However, in the Islamic bank equivalent, if the house were to evaporate, you would owe the bank nothing! While on the surface, it looks like a mortgage, in reality, it’s more like a joint business venture.

Deposits work in a similar fashion: while current rates of return are advertised as they generally are in Western banks (check out Turkiye Finans‘s website), they are in no way guaranteed. Of course, the bank is still going to invest its deposits in short-term, low-risk vehicles, lest they lose all their customers at the first downturn. Here again, the concept is that of a joint business venture; whatever the profits happen to be, they are split between the bank and the consumer in an equitable fashion.

Fascinating, isn’t it? I wonder what 2008 would have looked like if the financial industry had been more like this?

another way: alternatives to traditional banking and investing

Trust in the financial industry has waned in the past few years, and not without good reason. When an institution is driven entirely by profit, the consumer is generally the one who gets the short end of the stick. I mean, the Frost Bank tower downtown is nice, but…between you and me, I’d prefer higher savings rates, lower loan rates, and better customer service. As it so happens, there’s a way I can get it, thanks to the advent of credit unions.

Credit Unions

The fundamental difference between a bank and a credit union is this: while a bank is owned by shareholders and is operated for a profit, credit unions are owned by its members and are not-for-profit. The board of directors is elected by the members, on a one-vote-per-member basis — how much money you have with the bank is irrelevant.

So does this actually help the consumers? Well, let’s compare Frost Bank rates with its neighbor down Congress, Amplify Credit Union:

Amplify Savings Account: 0.2%. Pretty awful, eh? Well, guess what?
Frost Bank Savings Account: 0.05%. That’s right — five percent of one percent.
Amplify 5-year Share Certificate: 1.49%. Sigh. No good saver goes unpunished.
Frost Bank 5-year CD: They don’t have them. Um, what?
Amplify 2-year Share Certificate:  0.75%.
Frost Bank 2-year CD:  0.6%.

And so on. Well, what about loan rates?

Amplify New-Car 36-month Auto Loan: 1.99%+. Man, I would have liked that back when savings accounts were pulling 5%…
Frost Bank New-Car 36-month Auto Loan:  The same rate as for a 60-month loan. Again…what?
Amplify New-Car 60-month Auto Loan:  3.49%.
Frost Bank New-Car 60-month Auto Loan:  4.74%. Ouch! And remember — if you had taken out a 36-month loan, it would have been the same rate as this one!

I could go on, but I’ve got other things to talk about in this post. Just bear in mind that if you are a member of a bank, credit unions are an appealing alternative. Though banks do tend to have prettier skyscrapers…

Peer to Peer Lending

Speaking of alternatives, if you’re looking to get a loan, especially an unsecured loan (i.e. one that isn’t tied to something you own, like your house or car), there’s an alternative that can work even better than a credit union: peer to peer lending. The big players in this arena are Lending Club and Prosper, and the idea goes something like this: instead of a bank giving you one large loan, you are given many small loans — say, $100 each — by a number of peers. There is still some underwriting and background checking done by the host company, and your loan is “graded” and your rate chosen based on your grade. And check out these rates:

Amplify Unsecured Loan: 9.5%+
Lending Club Loan:  6.78%+ APR (this includes the fee charged for handling your loan)
Prosper Loan: 7.4%+ APR (ditto here)

If you’re running a balance on a rewards checking account — and those suckers tend to average 18+%! — you owe it to yourself to check out peer-to-peer lending.

Is this real? What’s the catch? Yes, it’s real, yes, it works, and yes, there can be a catch. The fact is that P2P lending tends to attract folks who can’t get loans through traditional means. As a borrower, that’s okay, but if you’re considering being a lender, you’ll definitely want to do your research.

Fund-Owned Investment Companies

Finally, if you’re looking at investing for the long term, there’s an alternative to the norm there, as well: fund-owned investment companies. Well, there’s really only one that I’m aware of: Vanguard. The idea behind Vanguard is that instead of being owned by outside shareholders, it is owned by its mutual funds — that is, the people who actually buy its product, its customers. And what are mutual fund customers most interested in, especially ones who are looking for index funds? Why, the lowest expense ratio possible, of course. Even if you’re not buying index funds, expense ratio is still the best predictor of overall fund performance out there. Even Morningstar has to admit it:

“If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds….Expense ratios are strong predictors of performance. In every asset class over every time period, the cheapest quintile produced higher total returns than the most expensive quintile.”

Not surprisingly, Vanguard has the lowest expense ratios anywhere.

Anybody else noticing a theme, here? In all three cases, when financial institutions are owned and operated by the communities they service, the communities are the better for it. Now, I’m not against the capitalist model by any means…but it’s nice to know that there are viable alternatives.

savings, continued: but what about cd laddering?

CD LadderA fellow financial geek asked a very good question about my savings post: what about CD laddering? Fair question!

CD laddering is a technique used to get more of the upside of long-term CD’s (higher interest rates) while mitigating the downside (locking your money up for years at a time). The idea is that instead of putting all your money into one large long-term CD, you build a “ladder”, breaking up your money into small chunks and working your way up from, say, 3-months to 5-years. Once you’ve reached the top of your ladder, the idea is to have a 5-year CD maturing every three months; if you need the cash, you have access to (some) of it every three months, and if interest rates suddenly rise, you can slowly reinvest your maturing CD’s at the new rate.

It’s pretty geeky, so a site called “financial geekery” would be remiss if I didn’t talk about it. I’ll get into the details of how to set one up a little later. For now, though, I want to talk about why I didn’t mention it in my last post.

First off, as I mentioned, if you don’t already have a ladder set up, now is not the best time. 3-, 6-, and sometimes even 12-month CD’s generally are running worse interest rates than an online savings account; even when you get up to 5-year CD’s, the advantage over a savings account is only 1%-2%. If you’re not looking at putting away a large amount of money, it’s really not worth the hassle. Also, while spreading out your money in a ladder is certainly better than plunking it all down in a single 5-year CD in terms of interest rate risk, it’s still pretty much a given that interest rates are going to go up, as there’s no room for them to do otherwise!

Finally, make sure you consider what that money is for. If it’s an emergency fund, think hard about how much of it you’re willing to keep illiquid; if you had a 6-month emergency fund, I might consider putting 3 months in a ladder. If the money is for a long-term goal, like retirement or college savings, you’re better off investing in higher-risk/higher-return vehicles, like stocks and bonds (that’s a post for another time). If you’re saving up for something, rather than having a lump sum you’re putting down, then it’ll be a pain to add that to the ladder while you’re building it.

All that said, if you’re a geek like me, it’s a fun game to play. So if you have at least $10,000 to play with, and you’re almost positive you won’t need to touch more than 5% of it more than once every 3 months, then here’s how it works. It’s pretty straightforward, and the best way to teach is by an example. Let’s say you’ve got that $10,000, and you want to spread it out over 5 years.

Step 1: Start off with the following:

  • $500 in a 3-month CD
  • $500 in a 6-month CD
  • $500 in a 9-month CD
  • $2000 in a 1-year CD
  • $2000 in a 2-year CD
  • $2000 in a 3-year CD
  • $2000 in a 4-year CD
  • $500 in a 5-year CD

Step 2: 3, 6, and 9 months later, take the currently-maturing CD and invest it in a 5-year CD. This is the annoying part — if you don’t do this within a certain period of time after the CD’s maturity (the “grace period”), it will automatically renew. You don’t want the money from the 3-month CD to become another 3-month CD — you want it to be a 5-year CD! Put the dates in your calendar, preferably with automatic reminders (huzzah, Google Calendar).

Step 3: 12 months later, take the 1-year CD and re-invest it as follows:

  • $500 in a 3-month CD
  • $500 in a 6-month CD
  • $500 in a 9-month CD
  • $500 in a 5-year CD

Step 4: For the following 4 years, repeat steps 1 and 2.

Five years after you started, you’ll have 20 5-year CD’s, one maturing every 3 months. At this point, you can let it go on automatic; unless you need the money, when a 5-year CD matures, you can just let it renew — hopefully at a higher interest rate!

working the system

You want a change.

Maybe you want to lose weight. Or get a girlfriend. Or be more productive at work. Or maybe — because this is a financial blog, after all — you want your finances in order: you want to get out of debt, stop getting hit with late fees and overdrafts, and start living for the future, rather than the past. Or all of the above.

So what do you do? Most people fall into a frustratingly predictable cycle: they make Resolutions, say “I’m mad as hell and I’m not gonna take it anymore”, buckle down, grit their teeth, and vow to change by sheer willpower. And it works…for a while. Then they hit a Bad Day, which turns into two, which turns into a week, and pretty soon they find themselves back where they started.

It’s frustrating, but it’s not surprising. As humans, we’re annoyingly irrational. We’re as likely to make decisions from our mood — which, in turn, is influenced by sleep, diet, sunshine, exercise, hormones, marketing, and a thousand other things not necessarily relevant to the matter at hand — as from logic.

So, really, what do you do? You remove your mood from the equation entirely: you create a system.

An example: to avoid late fees, you automate your finances, so that income comes in and bills go out without your interference. To avoid getting hit with overdrafts, you have a monthly “check-in” date on your calendar to make sure that your money is where it needs to be.

Another: so you’re not tempted to go into any more credit card debt, you leave your credit card at home and do your spending with cash. If you don’t have the cash, you can’t buy the dress, the fondue, or the TV.

Another: to help build up your emergency reserve, whenever you get paid, you automatically transfer $100 from your checking account to your emergency savings. Only after that do you budget for the month.

In all of these cases, you make a decision from a point of calm, where you’re not being bombarded by moods or Madison Avenue; once the decision is made, you create a system to help you stick to that decision. As an added bonus, you now have more willpower remaining to spend on making other decisions, like not eating marshmallows.

If the idea of setting up a complete, custom financial system — covering all of the above scenarios and more — sounds interesting to you, drop me a line. I’d be happy to set up a (free!) session with you.

Or if you prefer, next month I’ll be giving a personal finance workshop series at St. David’s Episcopal Church in downtown Austin; in it, we’ll be covering everything from our relationship with money down to the specifics of budgeting tools.

So, how about it? Are you ready for a change?