Archive for the 'Getting out of Debt' Category

Below Your Means Basics: Understanding Savings and Wealth Creation

Our Below Your Means Basics series this week deals has been focused on looking at your finances from a perspective of your Net Worth.  We started the series discussing Income vs. Net Worth, and then took a look at debt.  Today, we’ll be taking about different mechanisms of savings and ways to examine your savings in light of growing your overall net worth.

You may be thinking that day you are dividing up the different kinds of money you have saved into categories is a great day indeed – and one far away from now.  But the truth is that everyone, regardless of their current financial situation, can benefit from looking at their savings, and starting to save.

Types of Saving

Retirement Accounts

There is near-universal agreement that you should start saving for retirement as soon as possible, and this advice is usually accompanied by some sort of chart showing how the $20/month you put away now will turn into a bazillion dollars sometime in the future.  Those charts are right, of course, and you should start saving for retirement as soon as possible, and taking advantage of the various tax benefits of doing so.  Consult a tax adviser for more details, or check out Saving for Retirement at our favorite online legal resource, Nolo.com.

We do have some concerns with the idea of saving for “retirement”.  For one, the whole idea of saving for retirement is really created by the tax code. It came about at a time when people thought they would stay with the same employer for most of their lives.  Really, when you talk about saving for “retirement” you’re talking about saving for “old age.”  Nowadays many people have multiple careers and employers are just as eager to hire contractors as they are hiring employees.

If you focus on building your net worth instead of saving for retirement, then the idea of retirement starts to get a little odd.  It begins to sound like you are going to do something you hate until you hit some magic savings goal (and age) at which point you get to stop doing that hated thing, and start doing things that you love.  But with sufficient net worth, and a focus on using your money as a tool for your happiness, you can come up with ways to have an income doing something that you love, because maximizing your income at any given second to afford a life that doesn’t make you happy… well, you aren’t doing that any more.

So, by all means, keep putting money away for your 60’s and beyond.  We’re not saying you won’t be happy that you did.  But, don’t make that the only thing you are saving for.

The Emergency Fund

In our minds the Emergency Fund is the single best kind of savings you can start working on right away, because it will make a difference in your life very quickly.  There are many different ideas about how large your emergency fund should be, but they tend to fall within 3-6 months of income or expenses.  Since we are looking at our financial life from a perspective of net worth and not just income, we’re going to recommend you start with 3 months of expenses and then work your way up to 1 year of expenses.

You might be saying: One year?!  That’s a lot of money!  And we answer:  Precisely!  It is a lot of money, and having a year of your life in the bank is tremendously liberating.  But even before you have 3 months of expenses in the bank, you’ll see benefits:

  • Most importantly, you won’t have to use your credit card every time the unexpected happens.  This one change will make a profound difference in your financial life.  It will lift your spirits and confidence.  And, there won’t be an interest charge associated with the unexpected.
  • You can self-finance variables in your budget.  By self-finance, we mean you won’t have to use your credit card.  This time, it’s for things that are expected but harder to plan for, like the life insurance bill coming due this quarter and knocking you off your monthly routine.
  • You can afford to carry less insurance.  When you have an emergency fund, the idea of paying a lot of money for a $250 deductible isn’t as appealing.  Again, this is a result of net-worth thinking rather than income thinking.  If you don’t have an emergency fund, then you’ll decide the higher monthly insurance bill is a good buy because you can’t afford a $1,000 deductible if your car gets hit.  But if you have that money in the bank, then saving money on your insurance gets easier.
  • You can start to seize opportunities.  Much like long term debt, you should limit this to opportunities that help you build wealth.  For example, you have the opportunity to interview for a new job that pays 120% of your current salary, but your future employer requires a certification that you don’t have.  You can afford to take 2 weeks of unpaid leave (assuming you can work it out with your current job) to go get the certification.

Once you have one year of expenses in the bank, your life will be very different.  You will start to value and see things differently.  You will be on very secure footing indeed.

Principal Reduction

Every debt you carry has a principal on which you pay interest.  The principal is the money you owe, so in a sense, paying it off is a form of savings.  Once you have debt there is no use beating yourself up about it anymore.  You should, however, focus on getting that principle paid off as soon as possible.  If you have the income, and can cut your spending enough, you should save for retirement, an emergency fund, and pay down the principal on your debt.  Experts generally agree that you should pay down principal first on your credit cards and second on your car loans.  There is disagreement about whether or not you should pay off your home early, but we certainly wouldn’t advocate it unless you have a solid emergency fund and you are on a good plan for retirement.

As far as paying down your credit cards – how much is enough?  The answer here, as with many of your budget decisions, will come from your values and goals.  Having said that, you should also use a credit card repayment calculator (CNN Money has a good one here) to get a clear understanding of how much interest you are paying on the debt.  Some financial advisers recommend you pay down your highest interest rate card first, and then move on to the next highest rate, etc., until they are all paid off.  Others say that you should pay off the one with the lowest balance to give yourself a confidence boost and eliminate a creditor.

We personally recommend that, if possible, you consolidate all of your credit card debt onto a single new card that has as low an interest rate as you can get.  If you can’t get a new card, then consolidate them as much as possible on the lowest card you have.  Cut up the high rate cards.  Check out the Helpful Links at the end of the article for more on paying off your credit cards.  You might also consider refinancing your credit card debt with a lender like Prosper.com or LendingClub.com.  We are affiliates of each and recommend them both.

Personal loan, debt consolidation

Short Term Savings Goals

Short term savings goals are a great way to handle projects (leisure or otherwise) that aren’t part of your monthly budget.  Let’s take two common examples: Gifts (especially around the holidays) and Vacations.

The credit card method of handling gifts or vacations is to have a rough idea of what you are willing to spend, and then to go out and probably spend more.  Afterwards, you finish the vacation (or wrap up December) and cringe when you see the amount of debt you racked up.

Having a savings goal means having a budget.  In this model, in January (or whenever you next review your budget), you decide how much you are going to spend on vacation or gifts.  Then, work it into your monthly budget.  Let’s say a family of four decides they are going to spend a total of $700 on Christmas. $500 will come from the household budget and will be used to buy presents for friends and family.  The spouses decide that they will have a $100 limit on gifts for each other, which will come out of their own personal spending accounts.

Now, the family budget needs to be adjusted to make room for $42 of savings per month, which will yield $500 by the end of the year.  Each spouse also needs to squirrel away a minimum of $8.33 per month from their personal accounts.  (This is the kind of savings that the envelope method is great for).  Now, the spouses get together and split up the $500 pot between the kids, grandparents, other family members and friends.  They revisit the budget on a regular basis to see (1) that they have actually saved enough, (2) that their spending is in line with their plan and (3) to reallocate their budget based on new information (they got Suzie’s present cheaper than they expected so they can afford Grandma’s more expensive gift).

Vacation spending works the same way.  The family vacation budget is set, the savings happens BEFORE the vacation, and away you go.

Once you are saving regularly, and have budget that keeps you from spending more than you earn, you are well on your way to building wealth.  We’ll talk more about that next time…

Below Your Means Basics: Understanding Your Debt

Before we get started, if you are months away from foreclosure or other serious financial consequences, this is not the article for you. We do not cover issues like bankruptcy, credit repair, or debt settlement agencies. Consider consulting the assistance of your financial adviser and/or attorney. Our favorite online legal resource is Nolo.com.  Nolo’s Bankruptcy Center has plenty of good, free information and they also offer a variety of for-fee products to help those with serious credit and debt problems.

The biggest problem with amassing debt is that you are giving up flexibility in your future for flexibility today.  You are agreeing that in the future you will be willing and able to have a certain amount of money.  But none of us can predict the future.  We don’t know what misfortune will befall us, what opportunities will come our way, and what our personal goals will be.  You can read more about our thoughts on debt in our first Back to Basics article.

To get out of debt, and to understand how to use debt in the future, you need to stop thinking about your debt in Income terms and start thinking about it in Net Worth terms.  Meaning, stop thinking about how much debt you can afford to carry (payments), and start thinking about your total net worth, what direction it is heading in and the impact of debt on your net worth.  When you carry debt, you are simply spending money on the privilege of borrowing — you’re paying interest, potentially fees and the money isn’t helping you.  People borrow money all the time without considering the interest payments because the monthly payment seems affordable.  But if I gave you $100 tomorrow, and told you that you had to light a $5 bill on fire every Friday until you paid me back my $100, you’d stop and think about it.

The Debt Payment

Many people when budgeting plan for an $x credit card payment; for argument’s sake let’s use $100/month on a $5,000 debt.  While this approach is practical when you’re dividing up your monthly income, it doesn’t tell you whether or not you’re paying off your debt quickly enough.

Every debt has two key components – the principal (the amount you borrowed — on a credit card this is often the ‘balance’) and the interest (the fee you are paying to the lender to borrow the money).  When you make a debt payment, you typically pay the interest first, and the principal second.  Your payment needs to be high enough to take a good chunk out of the principal of the debt, or else you’ll simply be paying interest month after month.  The Federal Reserve Credit Card Repayment Calculator is a handy resource for approximating the time and money credit card debt will cost you.

Looking at the $100/month payment on a $5,000 debt using an APR (interest rate) of 16%:

  • If you saved up the money ahead of time in $100/month installments, it would take you 4 years and 2 months to come up with the $5,000.
  • If you make the $5,000 purchase and pay $100/month, it will take you 27 years to pay back the debt, and you’ll spend an additional $8,659 in interest.

Why so much interest?  Because your $100/month payment is barely making a dent in the principal of the loan, so the interest keeps piling up and piling up.

If you make larger payments you’ll cut into the principal faster.  Take a look at these two scenarios of paying off the same $5,000 debt at a 16% APR:

  • By paying an extra $42/month, for a total payment of $142, you can cut the time down from 27 years to 4 years and cut the interest from $8,659 to $1,802.  That’s 23 years less, and it reduces the interest by $6,857.
  • By paying an extra $100/month, for a total payment of $200, you can cut the time down from 27 years to about 3 years and the interest will drop to $1,123.

Federal Reserve Credit Calc Site

 

When Debt Helps and When it Hurts

About Credit Cards

Short term debt — debt you carry less than 12 months — is mostly useful to manage cash flow.  For example, you may be paid your salary every 2 weeks but most of your bills come on a monthly schedule.  So, you use your first paycheck to pay off all your monthly bills (and savings goals), and your second paycheck pays off your credit card balance – in full.  Note that if you have saved even 2 weeks of your pay, there really isn’t a need to use your credit card like this.

Another good example of a short term cash flow crunch comes from different types of insurance and fees that are due quarterly or annually.  These bills may push a given month’s expenses over that month’s income.  A credit card will help, but again only if you’ve budgeted for the expense and your income pays off the credit card in a few months, including the interest.  Otherwise, you’re accumulating debt.

Sometimes emergencies exceed the savings we have in our emergency fund, and in that case, carrying some debt while you adjust your budget and quickly pay it off can be a lifesaver.

Outside of these examples, in most cases credit cards are really just a convenience that means you don’t have to carry around cash, and you only have to make one payment out of your bank account per month to cover your purchases.

Long Term Loans on Short Term Assets

Another place people often exceed their means is getting long term loans for a short term asset.  A short-term asset is anything that is not going to retain it’s value for long.

For example, car loans have recently gotten longer and longer, and it is possible to get a car loan that is 5, 6 or even 7 years long.  While this might make the monthly payments low enough to be within reach from an income perspective, it usually adds up to a lot of additional interest on the car.  Worse, the car will lose its value faster than you can pay down the loan.  That means that in two years you will owe, for example, $20,000 on a car that is only worth $15,000.  What do you think happens to you if the unexpected occurs?  Say, you car gets totaled in an accident, and you’re given $15,000 by your insurance company.  You will still owe the bank $5,000.  What happens when the car starts to need serious repairs in years 5, 6 and 7?  Or, say in 3 years you just don’t like the car any more.  It isn’t suited for your life.  If you try to sell the car, you’ll owe more on it than you can make.  You’re stuck.

Credit cards can be even more insidious though, especially when you use them to live beyond your means.  Let’s use a much more common example.  You routinely spend $200 more a month than you make, and you eat out a lot.  In fact, your entire $200 budget overage comes from eating out.  Over the course of just one year you will accumulate $2,200+ in credit card debt even if you’re making the monthly payment.  And it will only take 7 months for credit card interest to consume your entire dining out budget.  The chart below illustrates the example, but of course at month 7 it loses accuracy, since you can no longer afford to eat out OR make your monthly minimum payment.  At this point things start to spiral out of control.

Balance Charge Interest Minimum Payment New Balance
Jan 200.00 200.00
Feb 200.00 200.00 33.52 35.52 398.00
Mar 398.00 200.00 66.70 70.68 594.02
Apr 594.02 200.00 99.56 105.50 788.08
May 788.08 200.00 132.08 139.96 980.20
Jun 980.20 200.00 164.28 174.08 1,170.40
Jul 1,170.40 200.00 196.16 207.86 1,358.69
Aug 1,358.69 200.00 227.72 241.30 1,545.11
Sep 1,545.11 200.00 258.96 274.41 1,729.66
Oct 1,729.66 200.00 289.89 307.19 1,912.36
Nov 1,912.36 200.00 320.51 339.63 2,093.23
Dec 2,093.23 200.00 350.83 371.76 2,272.30

Using Debt Successfully

Before you begin you need figure out if you can trust yourself with debt. In the wrong hands, debt can be like alcohol to an alcoholic. Some people simply cannot control themselves, if you reflect upon it, and you fit into this camp you need to take a strategy of never using debt. Live a cash-only life; people do it all the time. However if you can trust yourself with debt and manage it, it can be a very effective tool to building wealth and happiness.

Also, in general we are going to strongly recommend that you steer clear of interest-only financing, balloon financing and other complicated debt instruments unless you fully understand what you are getting yourself into.  These debts, while designed to provide lower payments, are intended for people with a very good grasp on their finances and are able to predict with certainty and comfort that they will be able to refinance in the future, or make the balloon payment.  If you have to ask the opinion of anyone who isn’t (1) gifted when it comes to finance  (2) impeccably trustworthy and (3) completely unconnected to (will not benefit from) the transaction, then you probably shouldn’t be doing it.

Short Term and Mid Term Debt

First, provided that you budget for it (including the interest), short term debt can be a great way to get over a hurdle that seems insurmountable.  For example, say you have recently graduated from college.  You are working an hourly shift job to pay your bills while looking for work.  But, you don’t have a suit, and while you’ve started saving up for one, you get an opportunity to interview before you’ve saved up enough money to buy the suit you need for the interview.  Assuming you can’t borrow a suit from a similarly-sized friend, you could finance the suit on a credit card.  However, make sure you heed the following guidelines:

  • Figure out how much you are willing to spend before you make the decision to borrow the money.  Don’t let easy borrowing convince you to spend more than you should
  • Figure out how long it will take you to pay back the loan, and make sure that amount is much shorter than the useful life of the asset.  Paying back the suit in 6 months is OK, 3 is even better.
  • Adjust your budget to include the interest payments.  In this example, you are already saving up for a suit so you have a line in your budget for the principal payments.  BUT, this will change to include interest.  Don’t extend the time you are going to pay back if you can avoid it — just cut back on a few areas to include the interest payment.
  • Avoid making rationalizations about future earnings.  You may get the job, you may not.  If you get the job you can pay off the suit much faster than you expected, giving you more freedom in the future. If you don’t you aren’t stuck with a credit card payment you can’t afford.

Mid term debt is debt that you carry for 1 to 5 years.  A great example of this would be a car payment.  Car payments are another great way to get into a vehicle that will make a big change in your quality of life.  But again, beware the rationalization.  You don’t need to have a car payment all the time, and NOT having one is very freeing. There are many examples of millionaires driving modest cars, the big secret here is that the many got to be millionaires by focusing on their net worth and not how fancy their car is.  There are lots of tips out there for getting the best deal on a car, but consider these from a Net Worth perspective:

  • New cars depreciate much faster than slightly used cars.  Reliable used cars depreciate the slowest.  Buying a car that is a few years old can make sure you get the most value from the money you spent.
  • Financing a car for more than three or four years is gambling that you will want the car that long, and that it will run well that long.  Otherwise you are risking that the value of the car will drop below the amount that you owe.
  • A car is, at it’s heart, 4 wheels that get you where you are going.  Don’t fall into the trap of buying a car because ‘you deserve it’ or ‘you have to have it.’  Consider what you value.  A Lexus, Acura, or Infiniti luxury brand is certainly nice to ride in, and may be worth the money to you if you have it.  But going into a large loan to buy the car doesn’t make sense, especially when you consider that they are luxury versions of Toyotas, Hondas and Nissans.

Long Term Debt

Long term debt, debt that you carry for 5 year or more, should be reserved for performing or appreciating assets only.  What do we mean by ‘performing or appreciating assets’?  These are assets that either make money in and of themselves (like businesses) or have significant potential to increase in value.  Recent housing bubble aside, historically housing has been a pretty good performing and appreciating asset.  One, you can live in it while you’re paying off the mortgage, which might be better than paying rent.  Two, there is a good chance that when you go to sell the house you will get a significant amount of your money back. But there are lots of reasons why a house might not make sense.  As either the buyer or seller, you pay a lot of money in taxes, fees, commissions, etc. that aren’t included in the value of the house.  If you move frequently, these charges can add up.  And, if you can’t sell the house for more than you owe, you’re stuck.  Also, houses don’t always hold their value, as just about everybody now knows.

The subject of investing in a business or borrowing to finance other investments is beyond the scope of this article, but we will address it further in the coming months.

Financing vs. Savings

One other special case deals with taking advantage of free or very inexpensive financing.  Assume you have $4,000 in a interest bearing account that is earning 2%.  You have decided to buy new living room furniture that will cost you $4,000.  The furniture manufacturer is partnering with a credit card company offering interest-free financing for 6 months, which jumps to 22.9% if you don’t pay off the furniture by then.  The credit card company is counting on the fact that you’ll buy too much furniture because of the financing and wind up not paying it off.  You’ll owe them thousands of dollars in interest by the time you manage to pay off the furniture.  But, because you follow our ‘short term debt’ guidelines above, you don’t overbuy.  Taking advantage of the financing is a good idea – it means you can leave that $4,000 sitting in the account for 6 more months earning interest.  And if you adjust your budget, you may be able to pay off the furniture over that six months without having to touch your $4,000 at all.  But be careful – don’t use this as a way to rationalize buying $4,000 worth of furniture you can’t afford.  If you don’t have the money in 6 months, the high interest rate will turn your furniture purchase into a long term debt with lots of money disappearing into interest payments.

Emergencies

Of course, debt is also valuable to have at your disposal in case of emergencies.  But we’ll discuss that along side savings next time, as it is closely tied to the subject of emergency funds…

 

Thumbnail Photo: Blocks 1 by Crissy Alright

Below Your Means Basics: Debt and Savings

Before we get started, if you are months away from foreclosure or other serious financial consequences, this is not the article for you. We do not cover issues like bankruptcy, credit repair, or debt settlement agencies. Consider consulting the assistance of your financial adviser and/or attorney. Our favorite online legal resource is Nolo.com.  Nolo’s Bankruptcy Center has plenty of good, free information and they also offer a variety of for-fee products to help those with serious credit and debt problems.

When I was younger I was helping some friends who were newly married with their finances.  I commented that I was impressed with their ability to save.  They quickly added “it’s not that much of an accomplishment when we’re running the credit card up just as fast.”  Fortunately, the statement was an exaggeration, but there was a grain of truth to it – while their savings rate was much higher than the rate they were increasing her consumer debt, the debt was there and the principal was growing.  And because almost all of their savings was tied up in retirement accounts, there wasn’t immediate relief.  I went home and realized I was in a similar situation.  I was saving for the long term but doing nothing to manage my own short and medium term spending.

This kind of problem is very common.  Whether you got in trouble with credit cards (easy to do), were hit by the recession (easy to do), or both, unfortunately it isn’t unusual for people who have respectable incomes and good credit ratings to nevertheless be slowly digging a debt hole that means they will never have financial freedom.

Many people believe (or at least assume) that their spending habits should be directly tied to their incomes.  For this reason, even as people’s incomes increase, their spending increases.  This isn’t necessarily deliberate.  The act of buying a home or moving to larger house, moving into a more expensive neighborhood, having a child, etc. can raise your basic cost of living.  Even without those life changes, it’s easy to see an increase of income as an “improvement” in lifestyle.  This mindset to personal finances often leads to the “payment effect”, where by you become only concerned with what payment plan you can afford.  Unfortunately, this is a vicious cycle that can all too easily end in ruin.

But there’s another way to look at it.  Rather than look at your income, you can focus on your net worth. Your net worth is pretty easy to calculate, and most software programs for tracking your finances can report it very easily.  Your net worth is the sum of all of your assets (the value of your home, your car, your retirement accounts, any investment accounts, your checking and savings accounts) minus your liabilities (your mortgage, car loans, any other loans, and credit card balances).   If the things you own are worth more than what you owe, then you have a positive net worth (sometimes referred to as “in the black”).  If not, then you have a negative net worth (sometimes referred to as “in the red”).

It’s helpful when looking at net worth to pair assets with their related liabilities.  For example, pairing a house with it’s mortgage, or a car with it’s car loan.  Then you can see the effect of a particular purchase on your overall net worth.

Here’s an example of a fictitious family:

Greg and Linda bought a house 2 years ago in preparation to have a child, and Linda is now expecting.  While they put 10% down, the house has lost some value and so their mortgage  is high compared to the value of the house (but they aren’t underwater as they didn’t buy during the peak).  They also just bought a brand new Honda Odyssey minivan.  They are almost done paying off a 2007 Camry that they bought new as well.  They’ve done some saving for retirement and recently opened a 529 account for their baby using a $2,000 gift contributed by the baby’s 4 grandparents.  On the liabilities side, they have 2 credit cards that they use for routine purchases as well as 3 store credit cards they got when furnishing their house.

If you put it into a table you can see the paired assets & liabilities:

Assets Liabilities Impact on Net Worth
Home 200,000 195,000 5,000
2011 Honda Odyssey 32,000 32,000 0
2007 Toyota Camry 11,000 1,500 9,500
His 401(k) 10,000 10,000
Her 401(k) 12,000 12,000
Checking Acct 500 500
Savings Acct 250 250
529 Account 2,000 2,000
VISA Card 5,764 -5,764
MasterCard 8,953 -8,953
Store Credit Card 1 1,572 -1,572
Store Credit Card 2 875 -875
Store Credit Card 3 3,419 -3,419
Student Loans 18,000 -18,000
Totals $267,750 $267,083 $667

Our example couple has a net worth of $667.  The good news is that they are in the black.  The bad news is that they owe about as much on their house as it is worth (they have a high debt to equity ratio), which will make it hard for them to sell their house if they decide to move.  Also, the new minivan will probably depreciate faster than they will pay it off, leaving them underwater on it for a time.  Also, because almost all of their savings is tied up in long term investments (their 401(k) and 529 accounts), they can’t use that money to help reduce the consumer debt they have, which is substantial.  Between their Visa, MasterCard, and store credit cards they owe $20,583, and the interest on that is going to be significant.  Assuming a rate of around 16%, they could be paying upwards of $3,750 in interest each year.

Greg and Linda have the money to make ends meet, although most of their conveniences and luxuries go on the credit card.  So they are making it, and doing just fine from an income perspectiveThe problem is that, from a net worth perspective, they aren’t getting very far. Their credit card debt is rising about as quickly as their savings rate, and while at first they thought it was going to be a temporary increase, they are finding that the maintenance costs of the new home and preparing for their child is changing their spending habits, and not necessarily for the better.  They are looking at their budget and trying to figure out how to cut back, which they’ve done successfully in the past to save up for the down payment on their house.  But for the first time, they are starting to ask themselves net worth questions – do they want to keep two jobs?  Is Greg’s career, which requires some travel, something he wants to keep even as their baby grows?  What about more kids?  Greg and Linda are starting to ask value-based questions about their finances, and realizing the difference between having a high net worth vs. income.

Once you start looking at your financial life through the lens of net worth, you start to see the distinction between what you can afford and what you value. Rather than deciding you should spend X% of your income on a mortgage or car payment, or save only Y% of your income, you can consider how fast you want to grow your net worth and why.  These kinds of decision can help you build a value-based budget and make that budget much easier to stick with.

Next time, we’ll discuss the basics of debt, and how to control it for your own happiness.

Thumbnail Photo: Blocks 1 by Crissy Alright

Story Photo via Wikipedia