Uncommon Cents

Much has been made of the potential pitfalls of using credit cards; the biggest single issue being the interest rate if the balances are not paid in full every month. Credit cards also can bite you with late fees, over limit fees, and annual fees (although it’s quite easy to get cards without annual fees). Many have decided to totally forego the use of credit cards, in large part due to these many pitfalls.

On the other side of the aisle, however, there are some benefits to using credit cards that can make life better for the user. Renting a car without a credit card is close to impossible. Some credit cards offer free or discounted extended warranties on items purchased with them. And of course, there’s the dozens (if not hundreds) of “reward” programs which can give you airline miles, gift certificates to Amazon.com, or actual cash. Responsible use of credit cards, which are often the first type of credit account people have, can help boost your credit score (and yes, irresponsible use of credit cards can harm it).

A disciplined spender can certainly use credit cards largely to their advantage; as long as they pay off the entire balance on time every month, they avoid the interest charges and late fees, and careful choice of cards can eliminate annual fees. I have a Pentagon Federal Credit Union Platinum Visa card that gives me a 1.25% cash discount on all purchases other than gasoline–on gas the discount is 5%, which really helps when gas is $3.50 a gallon. In a pinch, a credit card can–painfully–be an emergency fund.  My Amazon.com Visa card not only gives me a certain percentage of purchases credited toward Amazon Gift Certificates, but also offers extended warranty coverage on almost all purchases, which has saved me a huge amount of money over the years. And sometimes credit cards run “balance transfer” offers where they’ll allow you to pay off the balance of another credit card by transferring the balance onto their card, sometimes with rates as low as zero percent (although often with a fee).

Some will argue that even with balances paid in full every month and no annual fee, credit cards still cost their users money, by encouraging them to buy things they wouldn’t buy if they had to pay cash. This may indeed be true; of course, the discipline of the individual spender is the key in determining what gets bought and what doesn’t.

So are credit cards more likely to hurt you or help you financially? I think that like a sharp knife, a credit card is a tool: used with skill and wisdom, credit cards can reward you in many ways; used carelessly, it can certainly do a lot of damage to your financial situation.

In my previous post on paying off debt, one of the things I suggested was prioritizing what you would pay off by the interest rate and tax deductibility involved with each loan or debt. While this is the method I prefer (and would advise most people to use), there is another method that has gained some notoriety: the debt snowball.

The snowball method has gained fame from financial guru David Ramsey, whose Financial Peace book is in our library. The idea behind the debt snowball is to try and gain momentum on paying off your debt by putting emphasis on your smallest debts first and eliminating them. Instead of prioritizing your debt by interest rate, you prioritize them by dollar amount. Pay the minimum amount to each of your debts except for the smallest one. That debt gets all of the money you can spare. Once that debt is eliminated, put all of that money into the next smallest debt, then the next, until you finally eliminate all of them.

The big advantage of the snowball is psychological; seeing the smaller bills go away completely tends to give an emotional boost to the debtor. It lets the person who has dug themselves in a hole see a bit of a way out, an as those smaller debts disappear, they may see things more and more optimistically.

Critics would argue that this actually does not contribute to paying off debt quicker; attacking the highest interest rate debt first as in my earlier post would be the more mathematically sound method of attacking the debt monster. For the disciplined, that’s unquestionably true, but the facts are that if someone were disciplined, they’d not likely end up in the debt situation and that getting into debt is largely psychological and emotional, so getting out of debt is also psychological and emotional.

The snowball method may not be the most mathematically sound way of paying off debt, but due to its popularity many have tried it, some with great success. It may not be the perfect solution, but it also may be the best one for you.

I teach parenting classes to folks who are involved with child welfare services and one of the things I tell them is that behavior is on a scale, that some behavior is okay and some is not okay, but there are variations on those. Hitting someone is really not okay; leaving your dirty clothes on the floor isn’t okay either, but it’s better than hitting someone.

Similarly, debt is also on a scale. Some debt is better than others; it depends on what the purpose of the debt was (how much whatever it is that the debt was incurred from was needed) and how expensive the debt is (how much interest is charged and if that interest is tax deductible). Going into credit card debt (typically high interest) to get a new 42 inch HDTV is worse on my debt scale than going into mortgage debt (typically low, tax deductible interest) to buy a house.

Even in some “good” debt, there’s variation. If I go into huge mortgage debt to buy a house I really can’t afford, that’s worse on my debt scale than to go into moderate mortgage debt to buy one I can. If I get an automobile loan to buy a $17000 truck, that’s better than going into automobile loan debt to buy a $30000 truck unless the $30000 truck has some feature I really need and can’t otherwise fill with $13000.

When taking a look at your debt and considering where to best put your resources to pay them off, I suggest ranking them in order depending on the factors above. For me, unsecured consumer debt (typically credit card debt) would likely be the first to try to pay off–the higher the interest rate, the higher the priority. An automobile loan may be in the middle (again, depending largely on the interest rate) and the bigger ones with lower rates and tax deductibility–that would be student loans and a mortgage on my primary residence–would be last.

There are other approaches to deciding which bills to pay first and which to wait on, including the snowball method I first learned of in Financial Peace; we’ll look at that approach in a future blog post.

How do you decide which debt to pay off first?

An emergency fund is, well, a fund (a pool of money) that is used in the event of an emergency (such as a loss of a job). Every book I’ve read on personal finance discusses the importance of an emergency fund; what they differ on is how much, where to keep it, and at what point to put money into it.

Dilbert’s one page book on personal finance, which is one of the best pieces ever on the subject, discusses the emergency fund in a single sentence:

Put six months worth of expenses in a money-market account

This is an excellent starting point. Six months is a considerable amount of time; if an emergency of some kind happened, like the loss of a job or a serious illness in the family, it’s likely that six months would be long enough to resolve the situation. A money market account is a safe, easily accessible place to put money that pays better interest than a typical savings account.

Is six months really the correct amount? It’s difficult to say. Those who are currently strapped for cash (those, say, in credit card debt) may not feel they can afford to put six months worth of expenses into an emergency fund paying 5% when they have 20% interest rates breathing down their necks. Even those without debt who are saving for other goals may feel like six months is excessive when they’re trying to save for their kid’s college fund or the down payment on a house. Some people will settle for a smaller amount (say three months), or sometimes a relatively small dollar amount (say, $1000). Others may use “case equivalents”–for example, I try to keep a minimum balance of four weeks of vacation time on the books at my job; I think of that as a month’s worth of salary for emergencies. Others may gamble and say that their credit cards are their emergency fund; it’s a dangerous gamble, but the argument is that if there really is an emergency, they’d have to spend whatever that had saved anyway, so the interest doesn’t mean all that much.

Where to keep the fund? If the emergency fund is really in cash, a check writing money market account is an excellent place to keep it; I keep mine in a Capital One Direct account and I have a checkbook to use if I need to. Others may wish to use a credit or bank local to them so they can go into a branch if they need assistance. Some may opt for certificates of deposit for at least part of their emergency fund to try get slightly higher interest and a locked in interest rate. While this is fine for at least some of your fund, I would suggest against having your entire fund in there, as you’ll either pay a significant penalty to get your money out or you’ll have to wait until the CD matures. Considering the rather slim differences in interest rates between CDs and money markets, I’d stick with the money markets.

When in your overall financial plan do you establish your emergency fund? It’s hard to say; a purist would say this is the first thing you do. Someone who is battling considerable debt and looking at interest rates would likely say that it gets done after paying off that high interest debt. For me, I’d say to split the difference; start by trying to put away at least a minimal amount (say, instead of six months, a single paycheck), then go ahead and attack your debt. If you come into a windfall (say a large gift or inheritance or a bonus at work), use that to build your fund (or at least split the total between the fund and paying off debt). When your unsecured debt is totally gone, consider building your fund to at least three months if not the whole six months.

And remember that an emergency fund is really meant for an emergency! A new model of iPod is not an emergency, and neither is a dress you look great in. On the other hand, an automobile repair or a serious illness is an emergency; in those kinds of cases, don’t feel any guilt about dipping into your emergency fund.

Frugality is one of the common threads of the self-made financially independent. In his book The Millionaire Next Door, Thomas J. Stanley makes the point that it’s critically important to spend less than you earn or you will never increase your net worth, and that of self-made American millionaires (rather than those who came into money due to their family’s wealth), frugality was a common theme.

Frugality isn’t always fun, although it -can- be fun to hunt for great prices on things you need and to try to see how long you can make that $20 you got out of the ATM last. Sometimes it’s not fun when all of your buddies get new iPhones and you don’t, or they all go out to an expensive restaurant for dinner and you decide you can’t afford it.
Frugality, however, is the primary principle of sacrifice and delayed gratification that is needed to practice the kind of financial discipline that leads to financial independence. The exercise of determining your expenses and income helps to determine if you actually are practicing frugality or not and points you in the direction of areas that might need addressing to become more frugal.

When looking at your month to month income and expenses, there are really only two things that can be done to improve your financial situation:

1) Increase your income;

2) Decrease your expenses.

Yes, it’s also possible to do both, but there really aren’t a lot of other options. Of the two, it’s more likely that you can do the latter quickly. Additionally, if you can decrease your expenses, you can also put the money that you no longer spend into some kind of savings plan, whether it’s to increase your retirement savings or build (or start!) an emergency fund or targeted savings for a particular goal.

Now that you have your budget in front of you, can you identify areas where you’re spending more than you think you need to? Where in your budget can you cut? Are you spending more than you want on your electric or gas bill? How about your cellular phone or cable bill? Can you reduce or eliminate some of your expense in these areas? Do you really need both your cellular phone and your landline? Would it be a hardship to use the public library for your music, video, and book supply?

Where do you think you can reduce your expenses to become more frugal?

Liars, damned liars, and statistics; it’s hard to come up with an out and out number that just says, “If you have this much money, put it in this kind of portfolio, and withdraw this percent per year, you can live on it forever and not worry much about draining your principle,” but I’ll try anyway.

Advice and historical numbers that are given out and often pass for facts are really not; as any investor has heard over and over, past results are not an indicator of future success. Still, history seems to be a great teacher in many ways, so some of these could be useful; in some cases, I’ll round off the numbers to make the math easier.

Average yearly stock market return: 10%

Average yearly bond market return: 5%

Average yearly core inflation rate: 2.5%

Percentage of a balanced (50% broad stock market, 50% quality bond) portfolio that can be withdrawn yearly without affecting the principle of the portfolio: 4%

Percent of income while working required to maintain a similar lifestyle after retirement: 85%

Let’s say I’m making $50,000 a year (which is a very decent salary for a social worker, but it’s not my salary); using the 85% guideline, that would make my retirement income need $42,500.

That’s a very simple look at things and it could be glaringly incorrect. For instance, let’s say that yes, my income is $50,000 a year, but I put 10% of that into a 401(k) or 403(b), so it’s pretax dollars that are gone before I can spend it. I certainly wouldn’t be putting that money away for retirement if I was already retired, so instead of my gross being $50,000 a year, it’s really $45,000 a year for purposes of this exercise; that would make my retirement income need actually be $38,250 a year.

So if that’s how much I need to gross a year, I’d like it to be equal to no more than 4% of my total portfolio; that $38,250 would be 4% of a portfolio worth $956,250.
$956,250 is, of course, nothing to sneeze at; it’s also a figure that’s in today’s dollars. Inflation makes calculating this a bit of an issue. Inflation of 2.5% a year doesn’t seem like much, but over time, it can add up. In 20 years, that $956,250 needs to be $1,606,100.15!

So let’s say that I currently have total investments in the stock market and the bond market totaling $75,000–3/4 of that ($56,250) in stocks and 1/4 of that ($18,750) in bonds. Let’s also say that every year I put away another $5,000–3/4 of that ($3,750) in stocks and 1/4 ($1,250) in bonds. Using those figures along with an Excel spreadsheet and the 10% stock market and 5% bond market returns listed above, in twenty years, when I’d like to have $1,606,100.15 socked away, my little portfolio has less than 1/2 of that–$779,392.69–at my disposal. The news gets better with more time, however; in another 12 years–32 years total from the time I started–I finally get to my inflation adjusted goal. That $956,250 number has become $2,107,342.57, but my total portfolio has become $2,205,515.60.

While it’s amazing to see how money grows over time with average returns, it’s also disappointing to see just how long it took my savings to get where we wanted it to be. However, playing with the numbers can help us in a lot of ways. This is something we’ll look at in a coming entry, as well as a discussion on the importance of being frugal.

Now, taking a short break from our journey… just where are we going?

The name of the destination we want to arrive at is Financial Independence. That means different things to different people, but for the purposes of this blog, it’ll mean that we’re able to live off of our investments for the rest of our lives–that work becomes something we want to do–something that gives us pleasure–rather than something that we have to do so we can eat and pay rent. But what does that look like and how much do we need to save to be there and what do we have our dollars invested in? Those are all questions that we’ll look at in this blog.

First off, what does the land of Financial Independence look like?

For me, financial independence would look like working part time for a social service agency that did work I believed in; maybe doing line work or administration or supervision; it might also look like doing therapy a few hours a day four days a week or teaching a couple of classes. For other people it might look like total retirement, as in staying home every day or playing with their grandkids; it might look like traveling the world. It looks different for just about everyone.

In addition, for me, it would look like having enough time to do bike rides and runs and other workouts; to go down to the beach and swim; to be able to spend more waking and sleeping hours with my partner; to work around the house and on my truck; and to volunteer for worthy causes.

And hopefully, it’ll look like that when I’m young enough to still do a 100 mile bike ride and, hopefully, a 26 mile marathon (not on the same day, but at least in the same year).

One of the reasons I’ve stayed at my current job for the last twelve years, almost to the day (I’m 40 now and started this job when I was still in graduate school) is that I’m hoping I can hit early retirement there; this is one of the few private sector jobs that still has a pension, and that’s in addition to its 403(b) [non-profit equivalent of a 401(k)] plan. Whether I can make it the 11 more years I need to I’m not sure, but I’m still hopeful despite my recent struggles there. While it’s difficult to figure out what the pension would look like this far out (it takes into account your final five years of pay), it’s safe to assume that it would be, if taken in a lump sum, about the equivalent of 1.75 years of pay for the earliest possible retirement. That would help a lot with getting to the land of Financial Independence.

What does the land of Financial Independence look like to you? Comment on this post to let us know!

Once you have a grasp on your total net worth, congratulate yourself, if not on the total, the accomplishment of doing it. It’s a huge step in the direction of financial independence.

That said, it’s one step. Even though it’s a major one, there’s need for a second step to get further along this journey, and the second step would be determining your cash flow.

This basically means determining what your income is and what your expenses are. This can be calculated using figures for a day or a week or a month or a year; in practical terms, figuring out your monthly cash flow is probably the most useful.

There are some simple steps in determining your cash flow, but several significant barriers to determining it properly. We’ll look at both.

Determining your income ought to be easy, or at least easier than determining your expenses. Your income is simply the money you get from work, investments, Social Security, or any other forms of cash coming in. Simply checking your pay stubs for the last few weeks is likely to give working people a very accurate picture of their income. For a more accurate picture, looking at your previous year’s tax returns or W2s can be a huge help–to calculate monthly income, divide your net income by 12.

Determining your expenses is a bit more difficult. For one thing, while sources of income tend to be limited to a handful–even if you have two jobs and two income generating investment accounts, that’s just four sources of income–expenses tend to be far more varied. Right off the top of my head, there’s your housing payment, your electricity bill, your water bill, your telephone bill, your gasoline bill–all stuff that gets paid regularly.

Some of those expenses are very easy to figure–namely the fixed monthly ones. Quick, what’s your rent payment? Is it the same as last month, and the month before, and next month? If you can say yes, you probably know what it is without a lot of head scratching. Some of these, however, are much more difficult to figure out, because they’re not quite monthly and they’re not the same all the time. Think gasoline–the price of gas fluctuates pretty often. Since my fill ups tend to be close to weekly–sometimes six days apart, sometimes eight days apart, sometimes an actual seven days apart–and vary from about 11 gallons to 13 gallons with gas prices fluctuating all the time, it’s very hard to give an accurate figure for how much I spend on gas a month.

In addition to that, there’s expenses that come up far less frequently than monthly–things like auto insurance, which I have the option of paying monthly, quarterly, or semi-annually. These are a little easier to determine amounts to budget for monthly–a $450 GEICO bill every six months is $90 a month.

Finally, some expenses are just difficult to estimate. Ever wonder how much you spend eating out every month? It may not be all that tough to guess how much it is typically, but what about that once a year you take your buddy out for his birthday? How about that baby shower you went to at the local Olive Garden?

In trying to determine your monthly cash flow, it’s likely inevitable that you’ll have to make some estimates. If you really want to accurately track your expenses, consider a spending diary–write down every cent you spend. For it to be a really accurate diary, it must be kept for a year. I do this personally and have for several years with a composition book. There’s also a certain psychological benefit given to those who keep spending diaries–you have to be able to live with yourself when you write those expenses down, making someone like me think, “Am I really needing that new pair of shoes?”

Once you’ve determined (or estimated as best you can) your monthly income and monthly expenses, it’s time to subtract your expenses from your income and see what your net cash flow comes out to be. If your cash flow is negative, it’s time to really figure out how to get it positive (we’ll cover some of this in coming entries). If your cash flow is zero, then at least you’re breaking even. If your cash flow is positive, that’s great, but there’s always room for improvement.

Knowing your cash flow–not just that you’re in the positive or negative and by how much, but where you’re spending your money and where your money is coming from. Like knowing your net worth, knowing your cash flow will help you to make a plan for the future.

The place to start with personal finance is where you are; the problem with that is most people don’t really know where they are. It’s very typical for those of us in America to go from paycheck to paycheck and say things like, “If there are checks, there must be money.” The unfortunate part about this is not that we joke; the unfortunate part is that we go around, many for an entire lifetime, not knowing where they stand.

So we start at the beginning.

Before we go anywhere else, we need to figure out where we are. If you go to unfamiliar shopping malls often, think of this as looking for the “You Are Here” point on the map.

Collect all of your current balances from your checking, savings, certificates of deposit, brokerage, 401(k) or equivalent, individual retirement account, and any other places you have money stored away, regardless of whether or not you can easily access the cash or not. Add all of these together and you get your current monetary assets. Add to this the value of things like your vehicle and house and you get your total assets.

After all of that (which in and of itself can be exhausting), it’s time to consider your debt. Add up all of those accounts you owe money on–your mortgage, your car loan, your credit cards, your store credit accounts, and anything else you have–and you have your total debt.

Subtract your total debt from your total assets for your total net worth.

Hope really hard it’s a positive number.

If you’re just out of college, you’re more likely to have negative net worth; after all, you haven’t earned very much yet and are likely to have gone into some debt (or, if you went through extensive schooling like medical school, substantial debt) while finishing your education. However, you’re much better off having negative net worth at this time in your life than you will be if you’re still at the total net worth ten years later, since you have more time to pay the debt off.

One way or another, whether your like the number or not, it’s critical to working on your personal finances to have some idea where you are when you start.