Education is a good thing. I strongly believe that individuals should pursue educational opportunities at all times, and that a population of educated individuals is beneficial to society. So why am I negative on student loan debt? Haven't we already established that it is "good" debt, and an investment in your future?
The problem I have with student loan debt is that it is often entered into blindly. We are encouraged to go to college, and then often post-graduate programs, in order to increase our employment potential and obtain our dream job. If we have to take out loans in order to accomplish those goals, so be it. However, when a student takes out too much in student loan debt, he or she loses freedom and becomes bound by the obligation to pay the debt. It becomes more difficult to take time off work to travel, or visit with loved ones, or move into a career that pays a large personal dividend but a small salary.
I am not against student loans. I have a loan that I pay every month, and when I do it reminds me of the value of my well-rounded education and amazing college experience. Nor do I believe students should only take out loans for majors with "economic value." My Sociology major taught me how to research, write, and most importantly how to look at the world critically, a skill I use in business every day. I know a finance major who is now a veterinarian, an geology major now a Chief Investment Officer, and a philosophy major now a CEO. College should be about learning and exploring, and the more engaged you are in your classes the more you will get out of school.
That being said, education is expensive. And while the benefit side of the cost-benefit analysis is nebulous and not entirely monetary, there is a break-even point. One example is specialized master degree programs. I recently met a student preparing to apply to post-graduate programs in physical therapy. She expects a starting salary of approximately $70,000 a year and does not anticipate much salary growth throughout her career. She talked about the schools to which she is applying, and how the programs rank. Then she told me the cost. She would need a $250,000 student loan to attend her top school. She know it's a lot, but it is for her dream job helping people, and she would complete the program as a doctor of physical therapy. That's a worthy investment, right?
I immediately pulled out my phone and started crunching numbers (yes, I am a nerd and actually have a financial calculator on my phone). At today's rates, she would owe over $2,200 every month for 15 years! At $70,000, she would be paying more than HALF her take home salary every month in student loans, leaving her only $2,000 a month on which to live. She may love her job, but is she willing to take a vow of poverty for it?
I know many others who have found themselves in an indentured servitude situation. One earns $60,000 a year and pays $1,600 each month in student loans. Another is a lawyer with $200,000 in student loans who didn't pass the bar the first time, and took several months afterwards to find a job. Add an additional $30,000 in credit card debt to his loan.
At least those stories are people who enjoy their jobs and love their work. There are others who spend hundreds of thousands of dollars to learn that they do not want to be a lawyer, a doctor, or an investment banker.
Is paying that much for an education worth it? Sometimes it is. No one can value the worth of education and experience, but you can put a price to it. A great resource for estimating the cost of your loan is the calculator at FinAid.org. It will break down your monthly payments, and also calculate the future salary you need to earn to keep those payments to 10% of your gross income. In the physical therapist's case, it is an annual salary of $266,305.20.
Most financial institutions will only loan you money if your debt-to-income ratio is less than 36%. Substantial student loan debt makes it difficult to qualify for a mortgage or even a car loan. And while the amounts I quoted may look like a typical mortgage amount, be forewarned that the interest rates differ significantly. Right now you can get a 15-year fixed mortgage for 3%, while a 15-year student loan will cost you more than twice that at 6.8%! I find it infuriating and unfair that student loan rates are this high at a time when interest rates are effectively zero. Another disadvantage to student loans over other loans is that student loans are extremely difficult to discharge through bankruptcy, especially within the first five years of payments. You can relieve the burden of a mortgage, medical debt, and credit card debt much easier than student loan debt. Like any other loan, make sure you are comfortable with your future payments before you enter into it, even if you lose your job or drop to a one-income family.
Now for the good news. Student loans can allow you to make a significant investment in yourself and put you on the path towards your dream career. Your education is something that no one can ever take away from you, and learning how to think and learn is invaluable. Choose your education and its cost wisely, and no one will be able to indenture you.
Thursday, February 23, 2012
Sunday, January 29, 2012
Savings Vehicles
Congrats! Your budget is under control, you've paid off some debt, and you're now running a surplus. You are now ready to SAVE. So what do you do with that extra money in your bank account?
The first step is to get it out of your checking account. There are several reasons to set up different accounts for different purposes. The first is psychological; it is less likely you will dip into your retirement savings for a new pair of shoes if those funds are kept in separate accounts. The second is logical; some accounts offer more interest and potential for return but less liquidity.
Most people should have at least three accounts- a checking account for paying bills, a savings account for your emergency fund and short-term savings, and a retirement account that you do not plan to touch until you are at least 60 (typically a 401(k) or IRA). Some financial planners recommend that you open a separate account for each short-term and intermediate financial goal, however, that sounds like a lot of paperwork to me. I think it is absolutely fine to save for your wedding, home renovation, and upcoming vacation in the same account as your emergency fund and just track the overall amount you need for each goal. However, it goes back to the psychological- if you are more comfortable with four different accounts, or you want to be able to see how much you have saved for each goal right on your bank statement, then go for it.
Here is a run-down of common accounts that can be used for your savings goals:
CHECKING- Interest rates are at historical lows right now (seriously, 4% mortgages?!). Good for loans, bad for savings. Especially bad for checking accounts, which often charge you fees and pay no interest. However, there are great deals out there. I recently switched from a large bank to a credit union, which has lower costs and actually pays me some interest to hold my money. Compare rates at http://www.bankrate.com/ or http://www.depositaccounts.com/, and make sure you understand all of the fees involved.
How much you keep in your checking account depends heavily on your spending habits, and how many people are accessing the account. If you are the only person on the account and you keep impeccable records, then you probably only need the amount to pay your bills and a buffer of a few hundred dollars. If you are like the rest of us and sometimes spend more than you plan in a pay period, or if both you and a spouse are drawing from the same account, then you should keep at least $500 in the account or keep it linked to another account in case of overdraft. Linking your account to a line of credit or savings account can prevent costly overdraft fees, but if you find yourself making a habit of accessing those funds then you need to reexamine your budget.
Remember that the purpose of a checking account is to keep money you plan to use in the very near future. Therefore, make sure you can access your funds easily and free of charge. Look at ATM, electronic, and check writing fees, and make sure either the bank or the ATM is convenient to your regular schedule.
SAVINGS ACCOUNTS- Even with the best checking account, chances are that you can get better interest rates with a savings account. Less liquid, more interest. Look online at http://www.bankrate.com/ and http://www.depositaccounts.com/ to compare rates, and don't limit yourself to the bank that holds your checking account. Online savings accounts, including Ally, ING Direct, and American Express, offer competitive rates and make it easy to transfer money to and from your checking account.
Great for: Emergency Fund, Home Purchase and Renovations, Weddings, Travel, Cars, Short-term Goals
MONEY MARKETS- Money market accounts (MMA) and money market funds (MMF) typically offer slightly higher interest rates and more restrictions. Money market accounts are offered through banks, are FDIC-insured, have minimum balance requirements, and are limited to six withdrawals per month. Money market funds are mutual funds that are required to hold low-risk securities. They are not FDIC-insured. They usually require you to keep a minimum balance.
Great for: Emergency Fund, Home Purchase and Renovations, Weddings, Travel, Cars, Short-term Goals
CDs- Certificates of Deposit are offered by banks, FDIC-insured, and often offer higher interest rates. In return, you agree to leave your money in this savings tool for a certain time period, and you will be penalized if you take your money out early. The longer the CD term, the higher the interest rate typically. Some people choose to "ladder" CDs, in which case you buy longer-term CDs but space out your purchases every month/quarter/year. For instance, you may buy a 2-year CD every six months. This way you receive a higher interest rate than if you just bought a six month CD, but you still have a portion of your money available every six months. If you really like CDs and choose them as your investment vehicle, then I highly recommend laddering. Be careful to read the terms of a CD to make sure it has low fees and fits your needs. I personally do not like CDs over one year right now because interest rates are so low and you are locking yourself in at that low rate.
Great for: Home Purchase and Renovations, Weddings, Travel, Cars, Short-term Goals (as long as you time the maturity of the CD with when you will need the funds).
IRAs- Individual Retirement Accounts are personal accounts that you can start on your own to save for retirement, outside of a company retirement account. Traditional IRAs are available to anyone without a company retirement plan, or anyone who has a retirement plan but whose adjusted gross income (AGI) is less than $68,000 (if you file for taxes as single) or $112,000 (if you are married filing jointly). Roth IRAs are limited to those with an AGI of less than $125,000 (single) or $183,000 (married filing jointly). The maximum IRA contribution is $5,000 per year (phased out as you get near the maximum income limits). This may not seem like a lot, but if you put away $5,000 from the time you are 30 until you turn 65, and earn 8% a year on your investments, you would have over $850,000 at 65!
IRAs can be confusing because they are an account, not an investment vehicle. You can invest in a number of different vehicles within your IRA account, for instance, you may have one IRA with mutual fund and stock investments, another in a CD, and another with only bonds. You can switch the investments within your IRA at any time and move it to a new IRA account (rollover), but you cannot take the money out of that IRA "bucket" and move it to your checking account without penalties.
Traditional IRAs are tax-deferred, which means you do not pay income tax on your contribution when you earn it, and you don't pay capital gains tax as you earn money off interest and investments. You will pay income tax when you withdraw the funds. Great incentives to save, but the government isn't just giving you these tax breaks for fun. These funds are earmarked for retirement, and you will be penalized 10% of any funds that you withdraw before age 59.5, in addition to paying income tax on the whole amount! That means that if you have a $10,000 IRA and you decide to pull it out to go to the World Cup, you will owe $1,000 in penalties AND owe income tax. If you are in a 25% bracket, you would pay $2,500 in taxes, which means that you only get $6,500 of your $10,000. So make sure that you leave the money in your retirement account for retirement!
Great for: Retirement Savings
Roth IRAs do not offer the immediate tax deduction of a traditional IRA, but allow for the funds to grow tax-free and be withdrawn tax-free. If you are in a low tax bracket or expect to be in a higher bracket in the future (either because of your earnings or higher tax rates), then this is a very powerful tool. You pay the income tax at your current rate and can withdraw it tax-free in the future when your tax rate is much higher. The other amazing feature of a Roth IRA is its flexibility- you can withdraw your contributions at any time without penalty! You are penalized for withdrawing the growth in your Roth IRA, but even then you are given some exclusions, including a first-time home purchase.
Great for: Retirement Savings, First time Home Purchase
COMPANY RETIREMENT PLANS- 401(k)s, Simple IRAs, and SEP IRAs are just a few of the retirement accounts that your company may offer. Companies will often match their employees' contributions, so make sure you are always contributing to the max! A dollar-for-dollar match is a 100% return in the first year, so don't ignore it. As with IRAs, you are penalized for withdrawing your company retirement funds before age 59.5, and you may need a certain amount of service with the company before you are allowed to keep all of the contributions they make on your behalf. When you leave a company, you are able to roll your "vested" funds (your contributions and growth plus the amounts you are entitled to from the company contributions and its growth) to an IRA or your new 401(k) plan. Company retirement plans can have high fees, but new regulations are forcing disclosure of all fees and encouraging companies to offer independent financial advice. This is a huge benefit!
Great for: Retirement Savings
We have just touched on the main points of a few types of accounts that can help you save for your financial goals. In the following months you will see more detail about these accounts, particularly retirement accounts. In the meantime, please comment and tell me how you separate your savings into different accounts.
The first step is to get it out of your checking account. There are several reasons to set up different accounts for different purposes. The first is psychological; it is less likely you will dip into your retirement savings for a new pair of shoes if those funds are kept in separate accounts. The second is logical; some accounts offer more interest and potential for return but less liquidity.
Most people should have at least three accounts- a checking account for paying bills, a savings account for your emergency fund and short-term savings, and a retirement account that you do not plan to touch until you are at least 60 (typically a 401(k) or IRA). Some financial planners recommend that you open a separate account for each short-term and intermediate financial goal, however, that sounds like a lot of paperwork to me. I think it is absolutely fine to save for your wedding, home renovation, and upcoming vacation in the same account as your emergency fund and just track the overall amount you need for each goal. However, it goes back to the psychological- if you are more comfortable with four different accounts, or you want to be able to see how much you have saved for each goal right on your bank statement, then go for it.
Here is a run-down of common accounts that can be used for your savings goals:
CHECKING- Interest rates are at historical lows right now (seriously, 4% mortgages?!). Good for loans, bad for savings. Especially bad for checking accounts, which often charge you fees and pay no interest. However, there are great deals out there. I recently switched from a large bank to a credit union, which has lower costs and actually pays me some interest to hold my money. Compare rates at http://www.bankrate.com/ or http://www.depositaccounts.com/, and make sure you understand all of the fees involved.
How much you keep in your checking account depends heavily on your spending habits, and how many people are accessing the account. If you are the only person on the account and you keep impeccable records, then you probably only need the amount to pay your bills and a buffer of a few hundred dollars. If you are like the rest of us and sometimes spend more than you plan in a pay period, or if both you and a spouse are drawing from the same account, then you should keep at least $500 in the account or keep it linked to another account in case of overdraft. Linking your account to a line of credit or savings account can prevent costly overdraft fees, but if you find yourself making a habit of accessing those funds then you need to reexamine your budget.
Remember that the purpose of a checking account is to keep money you plan to use in the very near future. Therefore, make sure you can access your funds easily and free of charge. Look at ATM, electronic, and check writing fees, and make sure either the bank or the ATM is convenient to your regular schedule.
SAVINGS ACCOUNTS- Even with the best checking account, chances are that you can get better interest rates with a savings account. Less liquid, more interest. Look online at http://www.bankrate.com/ and http://www.depositaccounts.com/ to compare rates, and don't limit yourself to the bank that holds your checking account. Online savings accounts, including Ally, ING Direct, and American Express, offer competitive rates and make it easy to transfer money to and from your checking account.
Great for: Emergency Fund, Home Purchase and Renovations, Weddings, Travel, Cars, Short-term Goals
MONEY MARKETS- Money market accounts (MMA) and money market funds (MMF) typically offer slightly higher interest rates and more restrictions. Money market accounts are offered through banks, are FDIC-insured, have minimum balance requirements, and are limited to six withdrawals per month. Money market funds are mutual funds that are required to hold low-risk securities. They are not FDIC-insured. They usually require you to keep a minimum balance.
Great for: Emergency Fund, Home Purchase and Renovations, Weddings, Travel, Cars, Short-term Goals
CDs- Certificates of Deposit are offered by banks, FDIC-insured, and often offer higher interest rates. In return, you agree to leave your money in this savings tool for a certain time period, and you will be penalized if you take your money out early. The longer the CD term, the higher the interest rate typically. Some people choose to "ladder" CDs, in which case you buy longer-term CDs but space out your purchases every month/quarter/year. For instance, you may buy a 2-year CD every six months. This way you receive a higher interest rate than if you just bought a six month CD, but you still have a portion of your money available every six months. If you really like CDs and choose them as your investment vehicle, then I highly recommend laddering. Be careful to read the terms of a CD to make sure it has low fees and fits your needs. I personally do not like CDs over one year right now because interest rates are so low and you are locking yourself in at that low rate.
Great for: Home Purchase and Renovations, Weddings, Travel, Cars, Short-term Goals (as long as you time the maturity of the CD with when you will need the funds).
IRAs- Individual Retirement Accounts are personal accounts that you can start on your own to save for retirement, outside of a company retirement account. Traditional IRAs are available to anyone without a company retirement plan, or anyone who has a retirement plan but whose adjusted gross income (AGI) is less than $68,000 (if you file for taxes as single) or $112,000 (if you are married filing jointly). Roth IRAs are limited to those with an AGI of less than $125,000 (single) or $183,000 (married filing jointly). The maximum IRA contribution is $5,000 per year (phased out as you get near the maximum income limits). This may not seem like a lot, but if you put away $5,000 from the time you are 30 until you turn 65, and earn 8% a year on your investments, you would have over $850,000 at 65!
IRAs can be confusing because they are an account, not an investment vehicle. You can invest in a number of different vehicles within your IRA account, for instance, you may have one IRA with mutual fund and stock investments, another in a CD, and another with only bonds. You can switch the investments within your IRA at any time and move it to a new IRA account (rollover), but you cannot take the money out of that IRA "bucket" and move it to your checking account without penalties.
Traditional IRAs are tax-deferred, which means you do not pay income tax on your contribution when you earn it, and you don't pay capital gains tax as you earn money off interest and investments. You will pay income tax when you withdraw the funds. Great incentives to save, but the government isn't just giving you these tax breaks for fun. These funds are earmarked for retirement, and you will be penalized 10% of any funds that you withdraw before age 59.5, in addition to paying income tax on the whole amount! That means that if you have a $10,000 IRA and you decide to pull it out to go to the World Cup, you will owe $1,000 in penalties AND owe income tax. If you are in a 25% bracket, you would pay $2,500 in taxes, which means that you only get $6,500 of your $10,000. So make sure that you leave the money in your retirement account for retirement!
Great for: Retirement Savings
Roth IRAs do not offer the immediate tax deduction of a traditional IRA, but allow for the funds to grow tax-free and be withdrawn tax-free. If you are in a low tax bracket or expect to be in a higher bracket in the future (either because of your earnings or higher tax rates), then this is a very powerful tool. You pay the income tax at your current rate and can withdraw it tax-free in the future when your tax rate is much higher. The other amazing feature of a Roth IRA is its flexibility- you can withdraw your contributions at any time without penalty! You are penalized for withdrawing the growth in your Roth IRA, but even then you are given some exclusions, including a first-time home purchase.
Great for: Retirement Savings, First time Home Purchase
COMPANY RETIREMENT PLANS- 401(k)s, Simple IRAs, and SEP IRAs are just a few of the retirement accounts that your company may offer. Companies will often match their employees' contributions, so make sure you are always contributing to the max! A dollar-for-dollar match is a 100% return in the first year, so don't ignore it. As with IRAs, you are penalized for withdrawing your company retirement funds before age 59.5, and you may need a certain amount of service with the company before you are allowed to keep all of the contributions they make on your behalf. When you leave a company, you are able to roll your "vested" funds (your contributions and growth plus the amounts you are entitled to from the company contributions and its growth) to an IRA or your new 401(k) plan. Company retirement plans can have high fees, but new regulations are forcing disclosure of all fees and encouraging companies to offer independent financial advice. This is a huge benefit!
Great for: Retirement Savings
We have just touched on the main points of a few types of accounts that can help you save for your financial goals. In the following months you will see more detail about these accounts, particularly retirement accounts. In the meantime, please comment and tell me how you separate your savings into different accounts.
Wednesday, January 11, 2012
Savings vs Paying Off Debt
We as Americans love to justify debt. Some arguments are more sound than others; for instance, it is easier to justify my student loan debt, which resulted from four years of excellent liberal arts education, than it is to claim that my frequent concert road trips warranted the many, many credit card charges. While I still proudly state that life experiences are priceless, it turns out that mine actually did cost money and I was responsible for paying it back. While trying to build an emergency fund, and save for a down payment, and pay off student loans, and invest for retirement. Sound familiar? So is it best to put the amount set aside for bettering your financial position towards paying off debt or increasing your savings?
Many financial experts reduce the argument to simple math- if you are paying a higher interest percentage on your debt than you are receiving in your investments/savings, then use your cash flow to pay off debt. However, with today's tepid stock market performance and point-nothing returns on savings, a person following this "simple math" might be tempted to pay off his mortgage before saving a penny for retirement! This is not a healthy, sustainable plan, nor is the cookie-cutter "save for emergency fund > pay off debt > save for retirement". Everyone's plan will be slightly different based on goals, personality, and security requirements, however, there are some basic guidelines.
Let's first distinguish between "good debt" and "bad debt". Good debt is an investment in an appreciating asset- a house, an education, or a business. Bad debt is acquired from anything that declines in value- car loans and credit cards (turns out the trips you've taken, the meals you've eaten, and the jeans you've worn are no longer worth the price you charged to American Express). The IRS actually recognizes the difference between the two, as they allow tax deductions for interest paid on home and student loans. Note that this is not a free pass to enter into a mortgage above your means or take out obscene amounts of student loans. Keep the total of ALL your monthly debt repayment amounts to 36% of your current monthly income (not the income you hope to make in 2 years).
DEBT- Start by listing all of your debts with the balance and interest rate. I personally do not worry about paying off debt under 5%, particularly if it is a student loan or mortgage with tax-advantages. I also use 0% interest credit cards for large purchases (think fridge, computer, Home Depot supplies) and pay it over the time period to keep from putting a dent in my savings/ cash flow. I know that most personal finance bloggers are cringing right now, but come on. Free money for 6-12 months? I'll take it. One important caveat- if you cannot make all of the payments and pay it off during the 0% period, don't do it! You will get screwed in the end. Make sure you have the cash on hand to pay it off if you had to.
SAVINGS- Now make a list of your savings (even better, put your accounts in mint.com and have them show you the list). If you say "what savings?", there's a problem. Although I dispute the experts that say you should put six months of living expenses before you touch your interest-accruing debt, I strongly encourage you to have at least the amount of one paycheck set aside in a savings account before you tackle your high-interest debt. If your job is not secure, or you have a variable income, put aside a month or two's worth of living expenses in the bank first. Base it off your own comfort level and employment situation. If you are saving for a down payment, wedding, or another big event, calculate whether it is possible to pause your savings until your "bad" debt is paid off.
RETIREMENT- I know that many people in their 30s do not believe in retirement. Maybe they don't think they will live that long, or perhaps they think that saving enough to actually retire on is impossible. Some think that they will save for it later, when they have more money to put away. Don't be one of them! The one point that all financial advisors agree upon is the power of compounding interest, and that the sooner you start saving the more you will have. Most working Americans save for retirement in either a 401(k) or an IRA, both of which offer tax incentives to save. If you have a 401(k) and your employer offers a match, always contribute up to the match, even if you have credit card debt. To not contribute up to the match is to turn down free money. The only exception is if you plan to leave your job within a year and will not meet your employer's vesting requirements. More about that in future posts.
If your employer does not offer a match, I recommend that you still contribute a small amount to the 401(k). If you do not have a company plan, open an IRA and set up automatic deposits for each pay period. Do this even if you are paying off debt and can only contribute $20 at a time. You will create the habit of contributing to a retirement account, and it will be easier to increase your contributions as you pay off your debt. Also, the small but growing balance will (likely) encourage you to pay off debt so you can start stepping up your contributions.
Once you have established a small safety net and a retirement account, start tackling your "bad" debt. Pay the minimum on all of your debt except that with the highest interest, and contribute all of your extra payment to that one card/loan. Once you pay that one off, apply those payments to the card with the next-highest rate, and continue until you have paid off all of your credit cards and lines of credit. This is called the "snowball method", because as you pay off one debt your payment to the next debt grows. Dave Ramsey coined this term and offers a free calculator on his site, as does mint.com. If you have higher interest student loans (I consider those to be over 6%), apply some extra payments to the principal, but you can also start directing some of your debt repayment money into savings.
After your "bad" debt is paid off, and you are making a dent in your high-interest student loans, you can go back to building a decent emergency fund. Again, the size of your fund will depend on your personal situation. I am currently a salaried employee with a stable job, so my goal is 4 months of "must have" living expenses. If you work on commission, or have a family to support, you may need up to 12 months of "must haves" for protection.
No "bad" debt, emergency fund in place, now it's time to up your retirement contributions! Most experts agree on 10-15% of your gross income. And then you can begin saving for the fun stuff- a house, a wedding, or a fund to live off of while you start your own business, go back to school, or sail around the world. Maybe your idea of fun (or peace of mind) is not owing anyone money. In that case, put your "fun" savings towards extra principal payments on your mortgage or low-interest student loans.
Debt repayment and savings building can be a long road, so it's important not to get discouraged. Celebrate milestones- every card, or every large chunk. Acknowledge when you cut your debt in half, or double your savings. This is not a short-term goal, you are instilling a life-long habit. Put savings aside for your security and your goals, because you're worth it.
All posts on this blog are for informational purposes only and are not intended as recommendations as they may not fit your unique situation. Check with an advisor or financial planner for personalized advice.
Many financial experts reduce the argument to simple math- if you are paying a higher interest percentage on your debt than you are receiving in your investments/savings, then use your cash flow to pay off debt. However, with today's tepid stock market performance and point-nothing returns on savings, a person following this "simple math" might be tempted to pay off his mortgage before saving a penny for retirement! This is not a healthy, sustainable plan, nor is the cookie-cutter "save for emergency fund > pay off debt > save for retirement". Everyone's plan will be slightly different based on goals, personality, and security requirements, however, there are some basic guidelines.
Let's first distinguish between "good debt" and "bad debt". Good debt is an investment in an appreciating asset- a house, an education, or a business. Bad debt is acquired from anything that declines in value- car loans and credit cards (turns out the trips you've taken, the meals you've eaten, and the jeans you've worn are no longer worth the price you charged to American Express). The IRS actually recognizes the difference between the two, as they allow tax deductions for interest paid on home and student loans. Note that this is not a free pass to enter into a mortgage above your means or take out obscene amounts of student loans. Keep the total of ALL your monthly debt repayment amounts to 36% of your current monthly income (not the income you hope to make in 2 years).
DEBT- Start by listing all of your debts with the balance and interest rate. I personally do not worry about paying off debt under 5%, particularly if it is a student loan or mortgage with tax-advantages. I also use 0% interest credit cards for large purchases (think fridge, computer, Home Depot supplies) and pay it over the time period to keep from putting a dent in my savings/ cash flow. I know that most personal finance bloggers are cringing right now, but come on. Free money for 6-12 months? I'll take it. One important caveat- if you cannot make all of the payments and pay it off during the 0% period, don't do it! You will get screwed in the end. Make sure you have the cash on hand to pay it off if you had to.
SAVINGS- Now make a list of your savings (even better, put your accounts in mint.com and have them show you the list). If you say "what savings?", there's a problem. Although I dispute the experts that say you should put six months of living expenses before you touch your interest-accruing debt, I strongly encourage you to have at least the amount of one paycheck set aside in a savings account before you tackle your high-interest debt. If your job is not secure, or you have a variable income, put aside a month or two's worth of living expenses in the bank first. Base it off your own comfort level and employment situation. If you are saving for a down payment, wedding, or another big event, calculate whether it is possible to pause your savings until your "bad" debt is paid off.
RETIREMENT- I know that many people in their 30s do not believe in retirement. Maybe they don't think they will live that long, or perhaps they think that saving enough to actually retire on is impossible. Some think that they will save for it later, when they have more money to put away. Don't be one of them! The one point that all financial advisors agree upon is the power of compounding interest, and that the sooner you start saving the more you will have. Most working Americans save for retirement in either a 401(k) or an IRA, both of which offer tax incentives to save. If you have a 401(k) and your employer offers a match, always contribute up to the match, even if you have credit card debt. To not contribute up to the match is to turn down free money. The only exception is if you plan to leave your job within a year and will not meet your employer's vesting requirements. More about that in future posts.
If your employer does not offer a match, I recommend that you still contribute a small amount to the 401(k). If you do not have a company plan, open an IRA and set up automatic deposits for each pay period. Do this even if you are paying off debt and can only contribute $20 at a time. You will create the habit of contributing to a retirement account, and it will be easier to increase your contributions as you pay off your debt. Also, the small but growing balance will (likely) encourage you to pay off debt so you can start stepping up your contributions.
Once you have established a small safety net and a retirement account, start tackling your "bad" debt. Pay the minimum on all of your debt except that with the highest interest, and contribute all of your extra payment to that one card/loan. Once you pay that one off, apply those payments to the card with the next-highest rate, and continue until you have paid off all of your credit cards and lines of credit. This is called the "snowball method", because as you pay off one debt your payment to the next debt grows. Dave Ramsey coined this term and offers a free calculator on his site, as does mint.com. If you have higher interest student loans (I consider those to be over 6%), apply some extra payments to the principal, but you can also start directing some of your debt repayment money into savings.
After your "bad" debt is paid off, and you are making a dent in your high-interest student loans, you can go back to building a decent emergency fund. Again, the size of your fund will depend on your personal situation. I am currently a salaried employee with a stable job, so my goal is 4 months of "must have" living expenses. If you work on commission, or have a family to support, you may need up to 12 months of "must haves" for protection.
No "bad" debt, emergency fund in place, now it's time to up your retirement contributions! Most experts agree on 10-15% of your gross income. And then you can begin saving for the fun stuff- a house, a wedding, or a fund to live off of while you start your own business, go back to school, or sail around the world. Maybe your idea of fun (or peace of mind) is not owing anyone money. In that case, put your "fun" savings towards extra principal payments on your mortgage or low-interest student loans.
Debt repayment and savings building can be a long road, so it's important not to get discouraged. Celebrate milestones- every card, or every large chunk. Acknowledge when you cut your debt in half, or double your savings. This is not a short-term goal, you are instilling a life-long habit. Put savings aside for your security and your goals, because you're worth it.
All posts on this blog are for informational purposes only and are not intended as recommendations as they may not fit your unique situation. Check with an advisor or financial planner for personalized advice.
Friday, December 30, 2011
The "B" Word
In personal finance, it all starts with cash flow. What comes in versus what goes out. How healthy is your personal cash flow? There are usually two camps- those who are always tight at the end of the month and can't figure out where the money goes, and those who have a surplus but don't necessarily know the best place to hold it.
Let's focus today on the first group, because that is the one with which I identify best. And by identify, I mean exemplify, because I am a spender. So we are going to use the dirty "B" word- budget.
Wait! Don't leave yet. I know you hate budgets. I hate budgets. In financial planning 101, we begin by marking down every expense you have and breaking them down into 100 specific categories. Who has time for that? And what happens when I go over-budget in one category but under in another? And why do I feel so damn guilty every time I write down the amount of the concert tickets line item? (Mom, don't answer that).
Which is why I LOVE the 50/30/20 budget from ELizabeth Warren's fantastic book "All Your Worth", co-authored by her daughter Amelia Warren Tyagi. The premise is simple- structure your budget so that 50% of after-tax pay goes to "must-have" expenses, 30% to "wants", and 20% to "savings". So far, so good.
Your "must-have" expenses are those that must be paid every month regardless of your situation. Housing, utilities, debt repayment minimums, and basic food costs are all considered "must-haves". 50% was not chosen merely because it is a nice, round number. "Must-have" expenses are kept at 50% because if you were to lose your job and collect unemployment, or go from two incomes to one, or collect disability insurance, you would likely receive approximately half of your current take-home income. This means that in tough times, you could shed your "wants", pause your "savings", and still survive without tapping into savings or going into debt. Click here to download a basic "must-haves" calculator from It's Your Money and see where you stand. Even if your expenses are within 50%, experts agree monthly debt obligations (including mortgage payments) should remain within 36% of your gross monthly income.
The "savings" category of 20% includes contributions to your emergency fund, retirement accounts, and debt repayment over and above the minimums. Debt repayments are included because the more debt you pay off, the more wiggle room you have in case of emergency. Note that these are long-term savings, not future "wants" savings.
Finally, my favorite- the "wants" category. Shoes, shows, or sushi, you are free to spend 30% on anything your heart desires. Big wants require saving up your monthly wants allowance until you can afford it. Elizabeth and Amelia understand that in order to enjoy life, you have to have the freedom to spend a little discretionary cash here and there. In fact, they suggest using cash for your "wants" so that you don't overspend. Personally I would rather track my purchases and get some credit card points, but if you are prone to overspending it may be a good idea to leave your cards at home and only take out as much cash as you have to spend.
Some expenses fall in two categories. The most common is food. We all have to eat, but does it HAVE to be wild-caught salmon with truffle mashed potatoes and organic asparagus? While some of you will agree with me that it does, the truth is that a single American can survive on $200 a month. This is more than food stamps provides. So put $200 in the "must-have" category and the remainder in "wants". Another one is basic household needs. Yes, you need shampoo, but it does not have to be Aveda. I find that the majority of my "wants" category is food and music. Yours may be clothes, movies, or cars. Yes, cars. If you want a car that is beyond your budget, you can save your "wants" money until you have a large enough down payment that car loan payments are safely within your "must-have" budget (although even better is saving enough to pay for the car outright).
While I enjoy the simplicity of three categories, I strongly encourage you to reduce your "wants" category to 25% and add a 5% "Giving" category. While most of you unconsciously do so throughout the year, I find that adding donations and gifts as its own category benefits my charitable strategy and allows me to plan ahead which non-profits I will support. 10% giving is my goal, but I am not there yet.
The best online tool I have found for monitoring your budget is mint.com. It is free, easy to use, and they email alerts when you are over your budget in a certain category. You can even track your savings and debt repayment goals.
Let me know how your budgeting goes, or if you have additional tips that work for you.
Let's focus today on the first group, because that is the one with which I identify best. And by identify, I mean exemplify, because I am a spender. So we are going to use the dirty "B" word- budget.
Wait! Don't leave yet. I know you hate budgets. I hate budgets. In financial planning 101, we begin by marking down every expense you have and breaking them down into 100 specific categories. Who has time for that? And what happens when I go over-budget in one category but under in another? And why do I feel so damn guilty every time I write down the amount of the concert tickets line item? (Mom, don't answer that).
Which is why I LOVE the 50/30/20 budget from ELizabeth Warren's fantastic book "All Your Worth", co-authored by her daughter Amelia Warren Tyagi. The premise is simple- structure your budget so that 50% of after-tax pay goes to "must-have" expenses, 30% to "wants", and 20% to "savings". So far, so good.
Your "must-have" expenses are those that must be paid every month regardless of your situation. Housing, utilities, debt repayment minimums, and basic food costs are all considered "must-haves". 50% was not chosen merely because it is a nice, round number. "Must-have" expenses are kept at 50% because if you were to lose your job and collect unemployment, or go from two incomes to one, or collect disability insurance, you would likely receive approximately half of your current take-home income. This means that in tough times, you could shed your "wants", pause your "savings", and still survive without tapping into savings or going into debt. Click here to download a basic "must-haves" calculator from It's Your Money and see where you stand. Even if your expenses are within 50%, experts agree monthly debt obligations (including mortgage payments) should remain within 36% of your gross monthly income.
The "savings" category of 20% includes contributions to your emergency fund, retirement accounts, and debt repayment over and above the minimums. Debt repayments are included because the more debt you pay off, the more wiggle room you have in case of emergency. Note that these are long-term savings, not future "wants" savings.
Finally, my favorite- the "wants" category. Shoes, shows, or sushi, you are free to spend 30% on anything your heart desires. Big wants require saving up your monthly wants allowance until you can afford it. Elizabeth and Amelia understand that in order to enjoy life, you have to have the freedom to spend a little discretionary cash here and there. In fact, they suggest using cash for your "wants" so that you don't overspend. Personally I would rather track my purchases and get some credit card points, but if you are prone to overspending it may be a good idea to leave your cards at home and only take out as much cash as you have to spend.
Some expenses fall in two categories. The most common is food. We all have to eat, but does it HAVE to be wild-caught salmon with truffle mashed potatoes and organic asparagus? While some of you will agree with me that it does, the truth is that a single American can survive on $200 a month. This is more than food stamps provides. So put $200 in the "must-have" category and the remainder in "wants". Another one is basic household needs. Yes, you need shampoo, but it does not have to be Aveda. I find that the majority of my "wants" category is food and music. Yours may be clothes, movies, or cars. Yes, cars. If you want a car that is beyond your budget, you can save your "wants" money until you have a large enough down payment that car loan payments are safely within your "must-have" budget (although even better is saving enough to pay for the car outright).
While I enjoy the simplicity of three categories, I strongly encourage you to reduce your "wants" category to 25% and add a 5% "Giving" category. While most of you unconsciously do so throughout the year, I find that adding donations and gifts as its own category benefits my charitable strategy and allows me to plan ahead which non-profits I will support. 10% giving is my goal, but I am not there yet.
The best online tool I have found for monitoring your budget is mint.com. It is free, easy to use, and they email alerts when you are over your budget in a certain category. You can even track your savings and debt repayment goals.
Let me know how your budgeting goes, or if you have additional tips that work for you.
Monday, December 26, 2011
Welcome to the 30s
It is said that the 30s are the new 20s. Sounds great, right? Credit card debt, student loans, weddings, first home purchases... many of the life experiences (and expenses) attributed to your 20s now occur in your 30s. At the same time, we are told by financial experts that our retirement accounts should be flush by 30. So how to get your financial house in order in your 30s?
My goal is to simplify information on saving, investing, and spending so you can find financial stability while enjoying life. Information that all of us can use. We all have access to information, and thousands of financial experts are willing to share their secrets to financial health. But too often, these sites make us feel guilty. Guilty for going out on an expensive dinner with friends, guilty for not monitoring our credit score monthly and researching investments weekly, and guilty for not thinking about our net worth constantly. I'd like to share the tips and lessons of financial advisors you can use and then move on to more important things, like the people and activity that feed your enjoyment of life.
I began blogging on my co-worker's excellent young professional blog, "Personal Finance for the 20something." As a financial professional, I read a lot of other articles, blogs, and books on personal finance. What I've found is a lot of information for young people just starting out, and massive amounts for those ready to enter retirement. Not a lot for those of us in the middle. Why? Because it's hard. We know what to tell you to do in your 20s, because compounding interest helps those who save early. We know that if you are contemplating retirement, there are certain steps you need to take to prepare. But where are you in your 30s?
For some of us, the 20s were a decade of exploration and experiences. Many studied abroad, moved around the US, ski-bummed it for a few seasons, and then finally decided to settle down, pay off debt, and begin saving. There are others who entered the work force immediately, saved 20% of their income each year, and are in a good place financially. And then there are those who continued their higher education long after college and find themselves finally entering the workforce with multiples letters after their names and multiple digits in their student loan balances. Everyone is at a different place in their 30s. And I realize that even more acutely now that I am here as well.
Two of my close life-long friends who live in our hometown exemplify this dichotomy. As we caught up over brunch, it occurred to us that 30 was not what we expected. As one pointed out to the other, "we are both 30, single, and living with our parents". I laughed because these are two of the most accomplished women I know, with graduate degrees (a PhD in one case and a master's in the other), travelled (one just returned from teaching at a women's university in Bangladesh and the other has lived in Japan, India, and Italy), and full of life. Life is often not what we expect because it becomes more than we ever expected. I hope to help you get your finances under control so you can sit back and enjoy whatever life throws your way.
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