Simple Money: A No-Nonsense Guide to Personal Finance - Tim Maurer (2016)

Part II. PLANNING FOR TODAY

Chapter 7. ESSENTIALS: Straight Talk on Savings and Debt

WHY do I need to read this chapter?

In the previous chapter, we discussed taking stock of your overall financial picture and the important roles that savings and debt play. They are opposite sides of the same coin. After all, why would one willingly go into credit card debt if sufficient savings were available?

In this chapter, we’ll broaden the discussion to consider the topics of savings and debt more practically. How much should you keep in savings, assuming you can get past living paycheck to paycheck? We’ll also discuss the primary forms of debt, including the degree to which they help or hurt us financially, and answer the often-asked question, “Is there good debt, like school loans and mortgages?”

But what’s even more important than addressing the outward signs of financial mismanagement is discerning your fundamental financial disposition. What is your cash flow personality? Are you a Saver or a Spender? Or perhaps you’re one of the more extreme, a Hoarder or a Spendthrift.

Let’s find out.

Savers and Hoarders

Are you naturally inclined to live below your means? If so, you might be a Saver. Savers are predisposed to storing up cash as opposed to spending it. They typically have this proclivity hard-wired early in life as represented in their Money Scripts (chap. 1).

But there is another type of household prone to building up cash, and it’s not always a good thing. Some are Hoarders. Hoarders can’t save enough money. The “I-can-never-have-enough-cash” Money Script can rise to the level of a money disorder. For some, it’s a control issue. But for many, especially from the Great Depression era, it’s more about fear.

Several years ago, I received a phone call from an elderly woman who was audibly concerned. Grace had heard me on the radio and was concerned that a representative of her bank had unnecessarily sold her an annuity in which she invested $100,000. She asked me to review the policy and give her a second opinion. I told her I would be glad to, and gave her the address to my office. Sheepishly, she responded, “But I don’t drive the beltway.”

I wasn’t going to rescind my promise, so I asked Grace for her address and set out, in my mind, on a charitable venture. Based on her address, I thought that $100,000 in Grace’s annuity represented the whole of her life savings. I rapped on her hollow front door, looking left and right a bit apprehensively. She lived in a notoriously bad part of town.

Grace was right. The annuity she’d been sold was entirely inappropriate. It had a seven-year surrender charge, the period in which withdrawals could be penalized. Heck, at her age Grace wasn’t even buying green bananas! Fortunately, we were still within Maryland’s “20-day penalty-free” period, so I accompanied her to the bank to demand her money back.

Thereafter, Grace divulged that the hundred grand in the annuity didn’t represent the totality of her life savings. As it turned out, not even close. She actually had $3.5 million in investments, most of it in the form of US savings bonds hidden behind the curtains of her run-down row home (which had been robbed multiple times).

Grace had been widowed for more than sixty years. She worked as a legal assistant until she was seventy without ever taking a single day of vacation. She saved every penny she possibly could and invested it in the safest vehicles she knew. Her Money Script—that she could never have enough money—was rooted in her intense fear of Depression-era loss.

My office practically adopted Grace. We helped her sell her house and move into a comfortable assisted living facility, but her fear could not be broken. When she died at eighty-seven, she had no heirs and left more than a million dollars to three different charities. Sadly, she never knew what it was like to live with Enough.

How Much Is Too Much?

Too much? Well, that’s a good problem to have, isn’t it? Conventional wisdom says three months of living expenses—the standard we used in the Enough Index (chap. 6)—is how much you should have in emergency savings. But there are four factors that play into this decision:

1. The number of income streams coming into a household.

2. The variability of income streams.

3. The volatility of income sources.

4. The sleep-at-night factor.

If a household has more than one income stream, emergency reserves are a hedge against a job loss or reduction in compensation. Salaried employees have a less variable stream of income than a person who receives a meaningful part of their compensation from discretionary bonuses. Someone who receives a meaningful part of their compensation from discretionary bonuses has a less variable stream of income than a person whose compensation is based solely on eat-what-you-kill commissions.

The volatility of income sources is driven by the stability of the company and the industry it represents. A tenured professor has more stability than a mortgage banker. A mortgage banker has more stability than a self-employed dog walker.

The sleep-at-night factor takes us back, again, to our emotional motivation. If having $50,000 cash in the bank helps you get to sleep five minutes faster, who am I to judge? (If your number is $500,000, however, we might need to talk.) Remember, personal finance is more personal than it is finance. When the Elephant and the Rider (chap. 3) go head-to-head, the Elephant always wins.

How, then, do we translate the above four financial stability factors into an appropriate emergency reserve calculation? There’s no magic, and as is so much of personal finance, it’s as much art as it is science. In the end, though, it should probably range from two to twelve months of living expenses.

If your household has two tenured professors, you’re part of the minority that can slide by with a couple months’ worth of reserves. If your family of five is supported only by a single self-employed income stream, try to have at least a year’s worth of living expenses saved up. Most of us would ideally be between three and six months.

Degrees of Independence

But there’s another way to look at emergency reserves, and it may lead you to consider setting the bar even higher if you’re able. By increasing your emergency savings, you’re actually buying yourself degrees of financial independence, which could totally change your outlook on work.

When most people think about the term “financial independence,” they’re thinking of retirement. They’re thinking about having enough money saved so that they don’t need to work at all. But what if you had enough money saved to buy yourself a three-month sabbatical? Or what if you could take the next six months to retool and change careers? A year to teach snorkeling in Costa Rica?

My friend Tim Donohue began his career about fifteen years ago, self-employed in the mortgage business. He knew he was in a volatile industry. He could easily break six figures in a good year and qualify for food stamps in the next.

He saw his colleagues spending every last penny in the good years, thinking that it would keep raining money indefinitely. But Tim knew better. A couple years into his career, he set his annual spending at the average between a big year and a bust year. That’s what he lived on. Then, he dedicated himself to saving up a full year’s worth of living expenses. In a few years, he was there. Then, he got to two years’ worth of expenses.

Now, fifteen years into his career, thanks to healthy cash reserves, Tim is working because he wants to, not because he has to. His peers are the perpetually busy majority, scraping and clawing to keep up with their mortgage, 2.5 kids, and black Lab. But Tim has a different outlook on life and work. He’s certainly not 100 percent financially independent. Not even close. But he’s reached a meaningful degree of financial independence that has changed the way he views work, money, and life.

Months—Plural??

What if all this talk about having “months” of savings sounds ridiculous because you’re like the majority of American households, who have approximately 0.005 months’ worth of emergency cash reserves saved?

What if you’re living paycheck to paycheck?

Well, you need only one month’s worth of living expenses saved to get out of that certified cycle of stress. Jesse Mecham, founder of YNAB (YouNeedABudget.com), has created a system that is specifically designed to conquer the paycheck-to-paycheck, human-sized hamster wheel by simply getting one month ahead. The goal, and inevitable reality, is to have this month’s income paying next month’s bills. We’ll hear more from Jesse in chapter 8.

Most people aren’t going to go from having zero months of expenses saved to having three or six, but anyone with an income can find a way to get one month ahead, and eventually another. And so on.

How Should It Be Invested?

How should your emergency reserves be invested? Well, emergencies are inherently urgent, requiring you to access the money immediately. Therefore, an FDIC-insured savings account is likely the best option. At today’s interest rates, I realize that using the word “invested” is an embellishment, but the safety of these funds is a priority over the potential for growth.

“Cash has an important place in the plan, and it isn’t about making money directly,” says Joe Pitzl, Managing Partner of Pitzl Financial. “Indirectly, it often leads to more money from less stress, and an ability to take different kinds of risks,” such as a career move.

Consider using an online bank to warehouse your emergency reserves. Since most don’t have brick-and-mortar overhead to support, they often offer higher interest rates than the big banks with endless commercials on television.

But what if you’re fortunate enough to have a significant amount of emergency reserves, enough that it feels like you should be earning more than a savings account rate? First, congratulations. Second, it’s now likely time to open a liquid investment account, if you don’t already have one. To which, most people say, “Huh?”

I’m really just talking about a regular brokerage account, preferably a low-cost brokerage account with a reputable company. It’s “liquid” in that, unlike retirement accounts and education savings plans, the money has no penalties associated with taking early distributions. There may, however, be tax consequences, so consult your tax preparer.

Think about it this way: You have special buckets—like IRAs and 401(k)s, our topic in chapter 11—that are set aside specifically for the future. Your emergency fund is purposefully accessible so that it can be used in the short term if necessary. If your emergency savings start spilling out over the top, your liquid, taxable brokerage account becomes your mid-term savings. You should be able to access your short-term savings in a day, your mid-term savings in three to five days, and ideally you’ll consider your long-term savings off limits.

Financial Peace

“Should I pay my mortgage off?”

A thirtysomething client came to me and asked for advice specific to his home mortgage. He was fortunate enough to have received a significant inheritance, but he’d never imagined having the ability to pay off his mortgage only a few years into buying the home. This was the home where he and his wife intended to raise their children.

Interest rates were low. He fully expected he could make more in a wisely diversified investment portfolio than the interest rate he was paying over the long term. So why even consider paying off the mortgage?

Peace.

I’d worked with enough clients, most of them older, who were privileged to be at a place in life where they too were blessed to consider this dilemma. They had enough money to be financially independent, but still retained a relatively small mortgage. Not all of them accepted this advice, but I recommended that they consider the intangible benefits of paying off their last remaining tangible debt.

Those who did, invariably came back to explain the mere act of paying off the last of their debt was an invigorating experience with ongoing benefits. Now they fully owned all of their assets. No one held anything over them financially.

Debt is clearly an Enough buster, but as it turns out, being debt-free is an Enough booster.

After running the numbers, I concluded that my thirtysomething client was similarly positioned. He could responsibly keep the mortgage and invest the payoff, or he could pay off the mortgage with little fear that it would negatively impact his long-term planning.

He chose to pay it off. A couple months later, he called specifically to say how much of a personal benefit he and his wife had derived from this financial decision.

And fortunately, this was a family of Savers. They were going to warehouse the cash they saved from not having a mortgage and use it to further fortify their family financially.

Spenders and Spendthrifts

If those who are predisposed to storing up cash are Savers and, to the extreme, Hoarders, what do we call those whose tendencies bend more toward evacuating cash? These are Spenders and, in some cases, Spendthrifts.

Spenders suffer to keep cash around. They are prone to considering everyday splurges an “emergency.” Their talk about money is couched in optimism for a successful financial future. Spenders aren’t necessarily addicted to debt, but because they soak up cash so prolifically, there’s none left for emergencies. This can give a Spender license to interpret a dip into debt as an anomalous occurrence—not their fault. And occasionally, it’s not.

A friend of mine, a single teacher known for her ebullient personality and mad karaoke chops, came to me recently. She had $7,000 of RUC debt she acknowledges she incurred for less-than-charitable reasons. She didn’t think that would be a horribly burdensome amount. After all, it was just barely above the national average for her demographic.1 Unfortunately, the interest rate on the loan is so high that she can’t keep up with the minimum payments. “It’s like twenty something,” she told me.

“It was stupid, but c’mon!” she said. “I called them to ask if they would work with me on lowering the payment, but they said they couldn’t while the account was in ‘good standing.’ So let me get this straight. I’ve got to stop paying my credit card bill and destroy my credit just to negotiate a better payment?”

Yep.

Now, by following the credit card company’s mandated default-in-order-to-restructure policy, she’s getting dehumanizing phone calls daily, reminding her of how much she failed financially.

Good Debt, Bad Debt?

“Is there good debt and bad debt?” Such is the debt question du jour, which I’m often asked, but it’s the wrong question. It’s like asking if there are good Yankees fans and bad Yankees fans. No, there are just Yankees fans. Of course, some of them are better than others. Some, we can live with; others—like RUC debt—are so obnoxious that we just need to “get riduvem.”

Instead, think of debt this way. There’s not good debt, just bad debt and better debt. It’s a sliding scale ranging from RUC debt all the way up to a fixed-interest, low-interest, shorter-term home mortgage.

It’s easier to say, “Debt is always bad, always wrong. Pay it off, or else you’re stupid!” But that’s simplistic, not simple. The absolutist’s path certainly saves on word count, but it ignores the nuances and denies real life. Let’s explore the debt continuum in more detail:

· RUC debt, as we’ve discussed, is occasionally necessary, but never preferable. It’s an Enough buster and every effort should be made to pay it off. Yesterday.

· Margin loans are a form of debt secured by market investments (like stocks, bonds, and mutual funds) for the purpose of buying more securities. It is nothing short of dangerous. While history tells us that the market always goes up over long periods of time, there’s no guarantee of that, especially in the short term. And when securities lose big—which they do—margin loans are “called” in and you have to come up with the cash. It’s like betting on the market.

· Auto loans deserve the terrible reputation given to them, especially when used flippantly or habitually. But they’re not inherently unhealthy. The primary reason they’re a bad idea is because they are debt on a depreciating asset—an asset that loses value over time. They soak up cash flow that you could invest in appreciating assets or otherwise enjoy employing.
Auto loans should be used only in a pinch, and paid off early, for two reasons: (1) The devaluation of automobiles happens so quickly that if you have a five-year loan—the norm—you’ll likely be upside down as the depreciation of the vehicle outpaces your ability to repay the loan; and (2) If you need five or six years to pay off your loan, you likely can’t afford the vehicle. Make auto purchase decisions based on the total price paid, not the monthly payment.

· Education loans are one type of debt that has been historically considered “good debt,” allowing students and their parents to believe that any amount of debt in pursuit of education is okay. But it’s not. The “good” label on education loans has played a role in causing the outpaced inflation of the cost of higher education, which has risen at two and a half times the rate of inflation since 1985. Lifelong learning is priceless, but a college education isn’t. Students should examine the value that education will provide relative to the expected salary after graduation. A good rule of thumb is to keep your aggregate school debt no higher than your expected first year’s pay. We’ll discuss this in greater detail in chapter 10 on education.

· Home Equity Lines of Credit, or HELOCs, are an interesting breed and can be used wisely or foolishly. It’s an open line of credit secured by the homestead. This may surprise you: I believe that every homeowner who does not have a debt problem, but does have equity in their home, should have a HELOC. There are a few qualifications, though: (1) Don’t pay closing costs, (2) Don’t pay annual fees, (3) Avoid interest rates above the prime lending rate plus one percent, (4) Ensure that there is no pre-payment or early closing fees, and most importantly, (5) Don’t use it!
Then why go through all the effort? Here’s why: the last time you want to ask a bank for credit is when you need it. The HELOC should be used only in the case of true emergencies, when your emergency savings is exhausted, and for short-term liquidity. What qualifies as short-term liquidity? You’re making an out-of-state move and you find the house of your dreams on a due-diligence trip, but the sale of your house hasn’t yet closed. Use the HELOC to put the required deposit down and then pay it off completely after your house closes.
Please note that buying a car with a HELOC is almost never a good idea. Yes, the interest may be deductible, but if you don’t aggressively pay off the loan, you’ll be paying for your car for 20 years. Home improvements? Consider on a case-by-case basis, but please keep the total debt-to-equity ratio on the house under 90 percent.

· Traditional mortgages have to be “good debt,” right? I’ve even heard of advisors and accountants saying, “You should have a mortgage—even in retirement—for the tax deduction.” Hmm, let’s explore this, shall we? Let’s say you have a 5 percent mortgage rate, and you itemize your tax deductions and therefore are able to write off the interest (and only the interest) on your mortgage. If you’re in a 25 percent tax bracket, this means that your effective mortgage rate is 3.75 percent. Yes, it’s a low rate, but you’re still paying interest. And only a portion of your mortgage payment goes to interest—the rest goes toward paying down your principal. You’re in effect paying the bank a dollar to save a quarter.
Furthermore, the nature of mortgage amortization is that you pay a higher percentage of interest early in the mortgage and very little interest near the end. Therefore, if you have been paying on your mortgage for many years, you’re not really deducting much interest anyway, virtually eliminating the mortgage interest deduction benefit.
All that said, there is no question that mortgage debt is better debt—perhaps even the “betterest.” And for most of us, it’s not an option if we want to own a home. But the only advisable mortgage in most cases is a traditional mortgage, where the home is paid off over 10, 15, 20, or 30 years. Most should stay away from anything exotic, like interest-only loans (which don’t actually pay your house off), sub-prime mortgages (with high interest rates), “no-doc” loans (lovingly referred to as “liar loans”), or “option ARMs”2 (where your debt may actually increase instead of decrease).

· What about reverse mortgages, the increasingly popular tool that allows homeowners with home equity to get money out of their house in retirement? I’d place them on the debt continuum between margin loans and auto loans. They are not to be confused with traditional mortgages.
While their notoriously high fees have come down some, they pose an inherent problem—they increase your debt at a time when you’d prefer to eliminate it. I recommend that they be used only as a last resort, when a retiree intends to spend the remainder of her days (statistically) in her home and requires additional income.

Here’s the bottom line on debt: Debt used wisely can help a household build wealth—today’s modern definition of wealth, that is—when used to buy assets that appreciate in value. However, limiting debt—and eventually being debt free—grants uncommon peace of mind and is a key component of true wealth. Enough.

My advice is that you eliminate debt on the bad end of the spectrum as if it is financial enemy number one. Then, work to accelerate the repayment of better debt and plan to have all debt—including your mortgage—paid off by your expected retirement date.

So, what’s the plan of attack on ridding yourself of the debt you already have?

Your Plan, Not Theirs

First, don’t accept your creditor’s plan for repayment. They make a living by putting you in debt and then stretching out the repayment period as long as possible. Let’s look at a couple examples. First, a traditional mortgage, better debt example:

Let’s say you take out a $350,000 mortgage at 5 percent for 30 years. In this example, the monthly payment (principal and interest only, not including taxes and insurance) would be $1,878.88. If you paid this every month for 30 years, you would pay a grand total of $676,395. That’s $326,395 in interest.

But what if you paid this mortgage off in 20 years? Then, your monthly payment would be $2,309.85 per month, you’d pay $554,363 over the 20 years and $204,363 of that would be interest. By shortening the payback period, you’d save $122,032 in interest. That’s not nothing.

“That sounds great,” you say, “but it also means paying $431 more every month, and I can’t handle that.”

Fair enough, so let’s take a look at simply increasing your monthly mortgage payment by $200—from $1,879 to $2,079. In this example, you’d cut 69 months off your mortgage, or almost six years. You’d spend a total of $254,989 on interest, still $71,406 less than in the case of the 30-year mortgage. And please don’t forget the benefit of ridding yourself of a mortgage payment nearly six years sooner. Imagine the impact of that for a moment.

So, how do you turn your 30-year mortgage into 24 years and some change? Simple. Send your mortgage company two checks every month. You don’t have to do it this way, but it’s safer. Put “Principal Only” in the memo of the $200 check. Better yet, set them both up with online bill pay and watch 69 mortgage payments evaporate into thin air.

You can customize this to your situation. Just making one extra “Principal Only” mortgage payment each year results in a huge difference. Better yet, put those two extra paychecks to work if you get paid every other week instead of twice a month. Analyze your situation with the simple Bankrate Mortgage Loan Payoff Calculator.3

The mortgage pay-down analysis looks especially dramatic because we’re using big numbers and long spans of time, but on a proportionate basis, RUC debt—really bad debt—looks even worse.

Consider for a moment that you have $15,000 in credit card debt, which, by the way, is just shy of the United States household average4 as of December 2014. Let’s imagine that the interest rate on your credit card is 20 percent (not uncommon) and that the default minimum payment required by the credit card company is the interest owed plus 1 percent of the balance (also not uncommon). In this example, your minimum payment would begin at $400 per month, but then the minimum payment goes down each month because of the way it is computed.

In this example, it would take 387 months—longer than a 30-year mortgage—to pay off this $15,000 credit card debt. The $15,000 would cost you a total of $39,392. That’s $24,392 in interest alone. In the case of the 30-year mortgage at 5 percent, you were paying 1.92 times the amount borrowed; in the credit card case, you’re paying a multiple of 2.63.

But what if you took control of this situation and created your own repayment schedule? For the very same card and interest rate, if you paid $500 per month, every month, you’d pay the $15,000 off in only 42 months expending only $5,967 in interest. Or, if you’re able, switch to another card that offers a lower interest rate—say 10 percent instead of 20—and you’d pay the debt off in just under three years, losing a relatively paltry $2,333 to wealth-eating interest.

See how much interest you can kill with the Bankrate Credit Card Calculator.5

But what if there are multiple debts in your sights and you’re trying to decide which to attack first?

Snowball Fight

It depends on who you want to lead the charge—the emotional Elephant or the rational Rider (chap. 3). If this debt issue is emotionally charged for you, and you’ve really struggled to get control of this in the past, Dave Ramsey’s version of the debt snowball may be your best option.

Ramsey recommends you line your credit card debts up in order of balance size, with the smallest first, like this:

· $2,000 at 5 percent interest

· $5,000 at 22 percent interest

· $8,000 at 17.99 percent interest

He suggests paying the minimum on all three cards and then putting the extra money you’ll make available toward the card with the smallest balance each month. The idea here is to get the snowball rolling emotionally—to give yourself an early victory in the battle against plastic. This Elephant-sensitive tactic helps many kick off their debt repayment, but as you may have guessed, this is not the ideal strategy from an economic perspective. You’ll actually pay more in interest.

The problem with this method is that it ignores the Rider. I would prefer to see you engage the Rider as well, and pay as little interest to the banks as possible. Therefore, you would apply whatever extra monetary muscle you can muster each month to the card with the highest interest rate, like so:

· $5,000 at 22 percent interest

· $8,000 at 17.99 percent interest

· $2,000 at 5 percent interest

And, as you get that snowball rolling and improve your creditworthiness, you may even be able to accelerate the repayment by consolidating your balances to the lowest-rate card.

Turning the Tables

There is a way to turn the tables on the credit card companies. If—and only if—you have conquered any money disorders and rewritten your Money Scripts regarding debt dysfunction, then you may consider using a “rewards” credit card for all of your monthly purchases. As long as you pay off your balance every month, you’ll pay no interest and likely thank the credit card company for contributing to your travel, lodging, or whatever other rewards you seek.

I, for one, am more than happy to fly my family home to visit relatives multiple times each year courtesy of my credit card company, and I don’t think you should deprive yourself of the same, as long as you’re not a debt dysfunction candidate.

Know Thyself

The one cash flow personality that we’ve not yet discussed is the Spendthrift, and I don’t use this term casually. Unlike Spenders, whose tendencies are often rooted in the manageable self-deception of over-optimism, a true Spendthrift has a certifiable financial, and quite possibly psychological, disorder. The Spendthrift may be using poor spending habits—and almost certainly debt—to harm someone financially. They may seek to harm their spouse, children, or even themselves, consciously or subconsciously.

Sadly, while the Spendthrift is generally spurned by our culture, the other personality extreme—the Hoarder—is quite often admired for their frugality and material wealth. Sadder still, it is quite often the Hoarder who births the Spendthrift, proactively shaping the Money Scripts of loved ones by communicating in various ways that “Money is more important to me than you are.”

So, let’s be honest with ourselves. Where do you stand?

You’re somewhere on the cash flow personality continuum, and knowing where you stand will help you take the next steps toward having Enough and sharing it with loved ones.

1. Savings and debt are opposite sides of the same coin. Having the former helps avoid the latter.

2. As we increase our cash reserves, we’re able to buy ourselves degrees of financial independence, long before we’re ready to retire.

3. Before you can get three, six, or twelve months of reserves saved, you’ve got to pass your first hurdle—getting one month’s worth of living expenses. It’s crucial to avoid living paycheck to paycheck.

4. The “good debt” and “bad debt” dichotomy is misleading. There is only bad debt and better debt.

5. The bottom line on debt: Debt used wisely can help a household build material wealth when used to purchase appreciating assets. But limiting debt—and eventually being debt free—grants an uncommon peace and is a key component of Enough.