Uncommon Cents

While this is being listed under “Basics”, it may surprise some that the argument between which to do first: save for goals (retirement, a home purchase, college education, or other long term goals) or pay off debt.

The answer I have for this argument is a bit complicated, and includes a little of both, but the short version is: both are important.

When you’re at the point of dealing with this saving vs. debt reduction argument, it’s pretty much a necessity you’ve examined your baseline budget and gotten a handle on your cash flow. If you’ve not done these, do so first! Once you’ve got your cash flow positive from month to month, let’s go ahead and work on what to do with those positive dollars.

First off, start with an emergency fund. Consider a money market or high yield savings account (possibly with ATM card and check writing, like at Capital One Direct) for this money. How large of an emergency fund? We’ve discussed this before, but if you’re considering this choice, I’d suggest having at least $1,000 in there (if, however, you’re at the point that you’ve paid off all of your unsecured debt–basically everything but a mortgage–you’ll want to bump up that emergency fund to something between three and six months of your earnings). So the first part of this answer is, “save–for a $1,000 emergency fund”.

Second, consider your time horizon: if you are less than five years away from retirement, you will want to make saving a priority over debt reduction; however, if you’re on the opposite end of that timeline, debt reduction–and hopefully debt elimination–is certainly a priority.

Third, you are likely to want to do a bit of both at the same time, the question is how much of each you do. If you’ve decided debt reduction is your priority, make a plan and stick to it. Put the majority of your positive cash flow into paying down–and paying off–that debt. Consider the Debt Snowball or some of the other options we’ve written about previously. If you’ve chosen to concentrate on savings, put the majority of your positive cash flow into that (we will discuss some thoughts on how to put your savings dollars to best use at a later date). No matter which you’ve chosen, though, make sure you pay at least the minimums on your debt promptly–late charges and possible hikes in interest fees for paying late or insufficient amounts will make it even harder to overcome these debts.

Finally, keep at it! Persistence and perseverance are the keys to your eventual financial success. There will be many difficult moments along the way, but the sooner you start–and the more diligently you follow your plan–the quicker this will all happen. A journey of 1,000 miles begins with one step–so take the step of figuring out which to work on as your first priority: debt reduction or savings.

I received the following email from a reader:

“Any suggestions on what to do with money that I’d like to have earning at least a little interest but need to be able to access quickly? I’m thinking perhaps a money market, but I’m not sure where to find a good one.”

This kind of money, which commonly is an emergency fund, is what is called “chicken money”, a term I credit to Terry Savage of the Chicago Sun-Times. Chicken money is money that you cannot afford to expose to the risk of the stock market (or any other kind of similar fluctuation).

Chicken money is commonly in either money market (or similar high yield) accounts or certificates of deposit. The issue with using CDs is exactly what our reader cites–the need to be able to access it quickly. While you certainly can get money out of a CD, you pay a penalty if you do it when the certificate hasn’t matured.

That mostly leaves a money market or similar account. Local banks here have been paying pathetic rates; credit unions are a bit better, Internet only banks tend to be even better (to check out current rates as well as any special promotions, consult with Bankrate and Bankdeals). Internet only banks have their advantages, but due to their lack of physical branches that can make access difficult. Having a debit or ATM card associated with the account is beneficial (although there tends to be limits on how much you can withdraw during a day and the network of no charge ATMs might be limited), and check writing would give about as close to “full” access of an Internet bank’s account as possible.

Two options I have personal experience with are ING Direct and Capital One Direct. ING Direct’s Orange and Electric Orange accounts tend to have decent rates (and if you would like, I have bonus referrals available that will give you a few more dollars, contact me for details) and provides a debit/ATM MasterCard; they also have a network of “no fee” ATMs. The good news for me is that there’s such an ATM within two miles of home; the bad news is that there might not be such a situation for you. They do not, however, give you a checkbook (for my Electric Orange account I can have checks issued by them; they mail them out, which takes a few days). Like most online banks, they prefer to deal with money transfers online, which is instantaneous between accounts at ING Direct, but takes a few days to other institutions.

For accessibility, Capital One Direct adds a checkbook to its ATM card (which, unlike ING’s, is not a debit card). This is helpful for me, as I often make deposits from that account into a local bank. However, their ATM network seems very limited compared with ING’s–I cannot find a single no charge one within 75 miles of me, which is basically the entire island, and likely the entire state. The checkbook in many ways makes the money more accessible than the ATM card and does not subject the user to the typical $500 (or so) per day limit on ATM withdrawals. I was offered a special interest rate when I opened my Capital One Direct account as a Costco member but I was not able to find such an offer perusing Costco.com.

So there are two options for chicken money; both are quite safe, pretty liquid, and pay about as high a rate of interest as can currently be found. Capital One Direct has a checkbook which can be quite useful in terms of liquidity; both have ATM cards; ING Direct’s ATM card doubles as a debit card and they appear to have a larger network of no charge ATMs. Take a look at these (and other) options if you have a need to stash away these kinds of dollars.

The last time we looked at “Basics”, I discussed the cash flow equation, which is:

income - expenses = cash flow

Now, once cash flow is positive (and the more positive, the better) the wealth equation is also simple:

(cash flow + sensible safeguards + wise investments) x time = wealth

Simple, but not necessarily easy. Once your cash flow is positive, it’s time to do some smart things with your money and let time do its thing.

What are these smart things?

Sensible safeguards: these are your emergency fund, term life insurance, long term care insurance, and disability insurance. You don’t want to toss money away, but you also don’t want to under insure. Keep a reasonable amount (many say a minimum of $1,000, others say six months of salary–personally, I split the difference and say three months of take home pay) in a money market account with check writing and an ATM card (Capital One Direct is the one I use). If you have dependents, get term life insurance; you may also want to consider disability and long term care insurance.

Wise investments: what we’ve been discussing on this blog forever. Passively managed, no load, low cost, tax efficient index funds and exchange traded funds. High quality bonds and bond funds. Traditional and Roth IRAs, 401(k)s, and their equivalents. Reasonable asset allocations. Investments made at regular intervals. Diversification, diversification, diversification.

Time: you know what this is, and the more you have the better.

Wealth: the dollars you end up with at the very end.

The one other thing that you need will be discipline. We’ll cover that later, but in the meantime, remember that formula. It’s a simple, get-rich-slowly, tried and true over time formula that will help you reach your goals–it’s helped me build a six figure portfolio in less than half a decade!

Many investors worry about stock market risk when dealing with their money, and admittedly, very few investments are without risk. The risk in the stock market tends to be around the market declining and the volatility the market often displays. These factors many times scare investors out of the market and into “safer” investments, like money market accounts, government issued bonds, and FDIC insured certificates of deposit.

While there certainly is a place in any investment account for bonds and cash, these investments only isolate you from certain types of risk. They have their own risks, as well, the biggest one being that your investments will not keep up with inflation.

With the current low interest rate environment, many investors (or just people with an emergency fund) are seeing evidence of just this. If headline inflation is 4% right now and your “high yield” account pays 3.5% (which is a pretty decent rate these days), your money not keeping pace.

This does not mean to pump every dollar you have into stocks; quite frankly, there are good reasons to have other types of investments (see our articles on asset allocation). What it does mean, however, is to be aware that what are considered “safer” investments are not totally safe; there are still risks involved, and in some ways, the risks are more dangerous than those in the stock market. Consider other ways (like diversification, asset allocation, and tax advantaged means of investing) to reduce your risk and help your dollars do better than the rate of inflation–hopefully far better!

For fixed income investors who don’t think much of bonds, finding decent returns has become more and more challenging. Money market and high yield savings accounts have rates that have plunged in recent months, and certificates of deposit have not done much better. It’s become a real challenge to find decent returns, but since this question came up yet again this week, I thought I would go through some possibilities; some of these are similar to what we’ve discussed before, but some are new, or at least a new slant:

Check Credit Unions

Credit unions tend to have better rates than banks; sometimes you qualify to be a member through your employment, membership in an organization, or just where you happen to live, work, or worship. While I wouldn’t expect stunning rates, you certainly won’t harm anything by looking.

Go Online

Online banks (ING Direct, Virtual Bank, Capital One Direct, and others) may offer better rates than you have available locally (and don’t forget I still have bonus referrals for ING and Virtual Bank, contact me for details!). You can also check Bank Deals and Bankrate to see what might be available for you locally and on the Web.

Don’t Tie Your Money Up For a Long Period of Time

Conventional wisdom holds true–if you go with a longer term, you get a higher rate as far as a CD goes. However, given that a “higher rate” isn’t all that high, you’re taking a big risk by tying up your money when rates may increase before the term of the CD is done. Chasing rates in this way doesn’t appear to be wise; you may be better off staying in a high yield or money market account to keep things liquid.

Consider Other Options

If you have debt, consider paying it off or at least paying it down. Remember, if your debt is at 5% and you pay it off, what you’ve done is like earning 5% on that money. This might be one of the best things to do with money that you would otherwise have parked.

Yes, there is a need for even the most aggressive of investors to have at least some cash around, and finding somewhere secure and high yielding to plant it and watch it grow is a smart idea. In these challenging interest rate times, however, you may need to take a harder look around than ever to figure out just where you want to have your money sit.

A Certificate of Deposit, also known as a CD, is a savings certificate which entitles the bearer to receive interest. A CD is time limited in that it is issued with a specific time frame, typically somewhere between one month and five years. When a CD is issued, the interest rate that is paid is locked in until the CD matures; in return, the bearer agrees not to withdraw the principal without paying a penalty. CDs are typically insured by the Federal Deposit Insurance Corporation (FDIC) for American banks or the National Credit Union Administration for American credit unions (hint: if your bank or credit union is offering uninsured CDs, don’t take them up on it!).

CDs are considered among the safest of deposits and subsequently the interest paid on a CD tends to be relatively low. CDs along with money market accounts, government bonds and notes, and commercial bonds are all considered fixed income securities–they are less volatile than the stock market and typically pay a lower rate of return than you may expect with a stock but with less risk. Unfortunately, as they lack liquidity, CDs are not really appropriate for an entire emergency fund, although they could be part of an emergency fund–keep one month’s savings in a money market account and the rest in a one month CD that renews. This approach is a bit more complicated, but may yield a bit more interest.

CDs have a role in the preservation of capital; if you can afford the lack of liquidity and want to make sure you aren’t going to lose your money, get an insured CD at your local bank or credit union. You may not make a lot in interest, but you won’t lose anything either!

Much has been made of the economic stimulus package and the expected $600 per person (with a lot of catches dependent on income) tax rebate coming from the federal government this year. The idea behind this part of the stimulus package is, well, to stimulate the economy. For the most part, that means the government wants you to do one thing with it: spend it.

While spending that money may be the best thing to do for the nation’s economy, it may not be the best thing to do for your personal economy. Here’s a few other things to consider doing with $600.

1) Pay off debt. This good old fashioned personal finance staple is never out of style. If you’ve got debt, particularly high interest revolving unsecured debt (this mostly exists in the form of credit card debt), consider paying it down or outright eliminating it.

2) Save it. Maybe your emergency fund is a little low (or non-existent). Maybe you found a great deal on a CD somewhere (in these tough times, if you have, let all of us know where!) and want to put a bit of money away for a few months or a year. Maybe you’ve paid off all of your debt (congratulations!) and aren’t sure what to do with the stimulus rebate yet, so you’re considering parking it in a money market account. Nothing wrong with any of these either.

3) Invest it. If you’re following a pre-established plan for investing, keep following it with this “extra” $600, or maybe buy a fund, ETF, or stock you’ve had your eye on. If you’re not following a pre-established plan for investing, maybe it’s time to start! If you’re somewhat risk averse, consider going with a high quality bond fund rather than something in the stock market. It’ll be too late for the 2007 IRA contribution, but 2008 is front and center. Keep it socked away for the long term.

4) Diversify. Not in the typical sense; just do a little of each of these, or split the difference between just a couple.

For myself, I’ll be saving my rebate, because my personal savings account tends to take a bit of a hit with tax time for a month or two, so this will help to replenish those.

What are you planning for your tax rebate?

Those of you who have been using high yield savings or money market accounts have found out that the definition of high is getting rather low. I have accounts at ING Direct, Capital One Direct, iGoBanking, and Virtual Bank; they all started the year with greater than 4% interest yields and now are hanging around between 3% and 4%.

Interestingly, many people, spooked by the subprime credit debacle and the volatility of the stock market, are looking for safe havens like money market accounts and certificates of deposit to park some of their money, but come away disappointed by the current yields. What can you do with fixed income money or an emergency fund?

Here’s some ideas:

1) Comparison shop. Bankrate.com makes this relatively easy. I also really like Bank Deals for getting up to the minute news from all over the country on current rates and specials (like promotional rates for a few months or bonus money for new customers).

2) Buy quality. While not appropriate for an emergency fund, high quality bond funds like the Vanguard GNMA Fund or the Vanguard Total Bond Market Index have done exceptionally well for a long period of time, benefiting from the flight to quality that spooked investors have engaged in. If you’re buying CDs, make sure that the financial institution has the requisite FDIC insurance and stay within the limits. Why take more risk than necessary on this kind of money?

3) Learn what your risk tolerance is. If you absolutely can’t deal with net asset value fluctuation, then a bond fund isn’t for you. However, if you can deal with fluctuation between $9.50 and $10.50 per share and like the protection of government backed Aaa securities, consider a GNMA fund for at least some of this money.

4) Consider municipals or tax free money markets. Municipal bonds offer tax advantages and if you are in a high tax bracket, could end up netting more for you than your typical high yield savings or money market account. There are also tax free money market funds like that from Vanguard to consider.

5) If you don’t need the money or the interest right away, there’s always savings bonds and treasuries. While they don’t have fantastic yields, they are as safe as possible (and in the case of TIPS or I series bonds, offer inflation protection) and give some tax advantages.

Money in bonds, CDs, savings accounts, and money market accounts tends to be money that people don’t want to lose, so buying quality is very important. Yes, high yields are nice, but don’t put this money at risk by chasing additional yield when safety is called for. You have many options as seen above; keep that fixed income money safe and working as hard (and earning as much return) as it can!

Netbank got shut down and taken over by ING Direct not long ago. I was a Netbank customer and liked their checking account. ING Direct is not horrible (although their Web site drives me nuts) but they don’t think much of paper checks, which I still use all the time. They recently stopped processing checks from Netbank. I had one check outstanding that I gave at a friend’s wedding, so I told the bride to expedite the deposit. When I told her what happened, she and another coworker had never even conceived of using an Internet bank.

“Ever thought about using Central Pacific Bank or First Hawaiian?”

I do use one local bank, largely because my mother is a retiree. But considering that same bank pays 0.25% interest and even after the recent interest rate drops, online banks still pay over 3.5% in most cases, I just don’t want to put the majority of my money in accounts that pay less than 1/10th the interest. I am not thrilled about the fact that ING Direct isn’t really hot on paper checks (although they do allow you to have them issued by them and sent without charge via U.S. mail–I had to have one issued to myself via mail that took most of a week to show up to balance out some expenses), but I can mostly live with that. In addition to ING, I also have money market accounts with Virtual Bank, iGoBanking, and Capital One Direct; my investment accounts are with Vanguard, Firstrade, Treasury Direct, and Sharebuilder (which was recently taken over by ING Direct as well); while not all of these are actually Internet only, there certainly are no local offices for any of them, and this does not count the credit cards I have which are almost all without local branches and get paid by mail or online.

How many of the rest of you use Internet banks? Does the idea still seem novel to you or your friends and family?

There’s been some talk in the personal finance blogosphere recently about snowflaking, which is a technique used widely to help build up debt snowballs, a debt payoff technique discussed in a previous post. The idea behind snowflaking is to put any amount of “extra” money you come into on top of your snowball to make it bigger and bigger. Sell something on eBay? Work a couple hours of overtime? Put those dollars–your snowflakes—toward your debt payment–your snowball.

Since I don’t have any non-mortgage debt at this point, I don’t have a debt snowball to build up. I do, however, have a savings snowball that I’m trying to build up to purchase a new MacBook. So every little bit of money I pick up in addition to my usual salary goes immediately into that fund. Sunday’s contributions? A $20 Cashback Bonus from Discover Card and $15.94 from recycling (how I end up with $15.94 for five cents per can is beyond me). No, a bit under $36 is not going to get me my MacBook, but it will get me $35.94 closer to it, and every cent closer makes a difference.

I’m not sure what other snowflakes may be coming my way, but they’ll immediately go onto my MacBook savings snowball. Hopefully, it’ll build up the momentum I need to get that computer quickly!