30 June 2011

How much do you know?

Financial knowledge, sometimes known as financial literacy, is cropping up in the news again. The truly good folks over at the FINRA Investor Education Foundation have been doing some excellent survey work on the American public, and one of the things they have found is that we are not very financially knowledgeable. Take this five question quiz for yourself and tune in later for the explanations behind the correct answers.

1.      Suppose you had $100 in a savings account and the interest rate was 2% per year. After 5 years, how much do you think you would have in the account if you left the money to grow?
a.       More than $102
b.      Exactly $102
c.       Less than $102
d.      Do not know

2.      Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After 1 year, how much would you be able to buy with the money in this account?
a.       More than today
b.      Exactly the same as today
c.       Less than today
d.      Do not know

3.      If interest rates rise, what will typically happen to bond prices?
a.       They will rise
b.      They will fall
c.       They will stay the same
d.      There is no relationship between bond prices and interest rates
e.       Do not know

4.      Is this statement true or false: A 15-year mortgage typically requires higher monthly payments than a 30-year mortgage, but the total interest paid over the life of the loan will be less.
a.       True
b.      False
c.       Do not know

5.      Is this statement true or false: Buying a single company’s stock usually provides a safer return than a stock mutual fund.
a.       True
b.      False
c.       Do not know

Correct answers: a,c,b,a,b

25 June 2011

Your Karma $1,000

Having an emergency fund is one of the keys to financial satisfaction. Many pundits will say that you need to have three to six months’ worth of living expenses (debt service, rent or house payment, groceries, insurance, etc.) in a cash savings account to be financially secure. They make a point. It would be nice to have enough cash on hand to see you through a change in jobs, but that might seem like a luxury right now. It is especially luxurious if you are just starting out or among the financially challenged at this point in the economic cycle.

Having a six month cushion would be nice, but do you need that much? If the bulk of your income comes in the form of a steady salary, three months is sufficient for most households. If part of your pay comes from commissions, or if you are uncertain about the security of your job, a larger emergency fund is appropriate. However, your first savings goal should be to put $1,000 into a savings account and keep it separate from your other accounts. I call it the Karma $1,000. 
When your finances are tight, there is nothing worse than finding out that you have to spend $300 at the dentist or $400 to get a belt replaced on your car. These are the kinds of expenses that are not budgeted and could cause you to charge up your credit card, borrow from a family member, or do something else that is financially or personally risky. If you have $1,000 in the bank waiting for just this situation, a trip to the emergency room for a few stitches doesn’t have to ruin your month, or your vacation plans.

Here’s another thing about the Karma $1,000 – when you have a little money in the bank, you are less likely to need it. I don’t have specific research to back this up, just many years of observations. There is a known relationship between financial stress and job performance. I think that extends into our personal lives. Having $1,000 in a savings account has the effect of diminishing stress in our lives, making us less likely to back over a curb, or bite down wrong on a piece of toffee. That’s where the Karma comes in; money in the bank, even that little bit, makes you less accident prone.

Other thoughts: if you have to tap your Karma $1,000, be sure to replenish it right away, even if you can only add $10 or $20 per week. Next, more savings equals more Karma! As this Wall Street Journal article states, $2,000 is the cost of a major auto repair, so make that your next goal. Once you are there, focus on adding a little bit more each pay period until you reach that three month goal.

Also, this is an emergency fund, not an investment account. Savings accounts earn virtually nothing in interest. Most money market funds pay a teensy bit more and are still very accessible. Talk to your bank or credit union and ask what is available. When you’ve got three months worth of emergency savings, we can take the next step and talk about laddering some CDs, but not yet. 

In conclusion, it sure would be nice to have a big fat cash cushion to see you through any potential life transition, and it is an important goal to achieve. However, if you are just getting started on your road to financial independence or experiencing hard times, start with an emergency fund of $1,000 to keep Karma on your side. Keep it funded and build it up to $2,000, then set three months worth of living expenses as your next goal.

Happy Saving!!

18 June 2011

Why you want a 401(k)

You know all of those forms and things that your employer puts in front of you on the first day of work and then about once a year thereafter? Chances are that some of those forms have to do with something called a 401(k) plan.

A common employee benefit is a retirement savings account known as a 401(k) account, named after the section in the Internal Revenue Service codebook that defines said account. 401(k)s provide most working folk a way to save for the time in which they will no longer be working (aka retirement) in a tax-deferred manner (aka something that saves you money now) and, in many cases, with a supplement from your employer (aka free money). 

Most of us plan to retire. Actually, I think we all plan to retire. I mean, who really plans to either drop dead on the job or just keep working through the throes of the final moments? The generally accepted retirement age is 65, although that is gradually being ratcheted up to 67. Life expectancy in these United States is currently just shy of 79 years. You do the math. Will you have enough saved by the time you are 67 years old to sustain you for 12 years? And what if you are a healthy, contrary, stubborn sort who lives longer? How are you going to pay for that? What if, for reasons beyond your control, you have to retire before you reach 67? It happens. All the time. 

Hopefully Social Security, or whatever is left of it, or whatever form it assumes between now and the time you retire, will help. Personally, I’m not counting on this, and I advise you monitor it closely. Depending on whom you listen to, Social Security will run out of money sometime between 2025 and 2060. It seems that the system designed by the folks in charge at the time is heavily dependent on an ever-growing work force and, given birthrates and other such information, we’re not making Americans at the same pace as we used to make us. So, Social Security will suffer. Like I said, I am not counting on this particular program to keep me rosy during my golden years.

Maybe you are counting on getting a pension from your employer. I would check very carefully with my employer if I were you. Without going into excruciating detail, the types of pension plans that many of our grandparents and maybe even our parents were able to depend upon are kind of like dinosaurs. Most employers have decided that the risks of managing other peoples’ retirement funds were too much for them to handle.

Or maybe your last name is Rockefeller or Gates or something like that and you will one day inherit gazillions and you don’t need to worry about this stuff. In that case, thank you for stopping by. Please purchase something from Amazon before you exit the blog; perhaps a house. For the rest of us, do you really expect your parents to provide for you after they’re gone? Do you think it will happen? Do you want to stake your future existence on their ability to provide for you beyond the grave?

So who does that leave? Ummm, that would be you and me. For all practical purposes, you are responsible for funding all of those years between when you quit working and when you quit breathing.

Which brings us back to 401(k) plans. For most of us, this is the most available and accessible way to save for retirement. You want one, you know you do. Stay tuned and learn more.

(P.S. For those of us working in the public sector, the equivalent of a 401(k) is a 403(b) account. There are differences, but the similarities are greater. If you can have one, you want one. Trust me.)

13 June 2011

Book Review - The Wealthy Barber

If you only buy one book about personal finance in your life, I hope it is this one. The idea is basic, there are no pictures, charts, or graphs, and in terms of plot and prose, it is closer to Dan Brown than John Updike (sorry, I was an English major for a while and I’m rather picky). On the plus side, it is a fairly easy read (once you get past all of the Detroit-based sports analogies) and it covers the financial planning basics for just about everyone. And it covers them well, in a conversational style that makes for pleasant reading. Even better, it is available on Amazon.com for pennies, which is something that the wealthy barber himself would think was a pretty good idea.

The premise of the book is that a young teacher, his sister, and a childhood best friend are directed to their childhood home town’s local barber for financial advice. While this at first seems to be an illogical reach, we learn that Roy had to drop out of college to take over a family barber shop and that the experience did not stand in the way of his financial success. He mentors his young charges into learning a few basic steps that, if followed consistently, will lead them to financial success.

A few of Roy’s more important points:
·         Save 10% of everything you earn for long term investments
·         Utilize mutual funds to diversify investments, rather than trying to make big, quick scores with individual stocks.
·         Wills and life insurance are critical responsibilities for people with families.
·         Buying a home is a good thing (in spite of recent activities in some specific areas, this remains good advice).
·         Know when to seek professional help for taxes, investments, insurance, etc.
·         Take advantage of the variety of retirement savings vehicles available to you, especially tax deferral and employer matches (Note: the author is a Canadian, and the book was originally written for a Canadian audience. U.S. versions of the book are widely available, but just in case, it might be helpful to know that Canadian RRSPs are very similar to American IRAs and 401(k)s. The basic advice is still golden.)

If there is one area in which I disagree with Mr. Chilton, it would be that he does not emphasize having a good emergency fund. He does, in one of the wee latter chapters, mention the importance of disability insurance, but that is not the same as an emergency fund. Emerging research indicates that having an emergency fund is a critical element of financial satisfaction, so having one should be a priority.

Another thing: the Wealthy Barber does not harp on debt like many financial authors. Of course, debt is not a good thing in and of itself, but it is not evil either. Leveraging one’s assets is necessary for many things such as buying a home, but it needs to be controlled. The Wealthy Barber’s advice is not for people whose primary financial concern is debt. His advice is aimed at people whose professional education does not naturally encompass basic financial training. 

07 June 2011

Good information about Credit Scores

Five things you should know

The attached article contains some excellent information about protecting or improving your credit score. The negative consequences of using a debit card to rent a car were new to me, but not surprising once you think about it from the perspective of the rental company.

Just to review the differences between hard and soft hits on your credit score: The folks who calculate credit scores have determined that applying for several credit accounts at once increases the likelihood of future difficulties to make one's payments. According to FICO, having six or more hard inquiries on your report may make you look eight times more likely to declare bankruptcy than someone without hard inquiries. Therefore, it is very important to minimize the number of inquiries on your credit report, particularly if you know you will have a need to apply for credit in the near future (to purchase a car or a house, for example). Will one hard inquiry irreparably damage your credit score? No, of course not, but why have more  inquiries than you need? Keep your report as clean as possible.

Soft hits, or soft inquiries, are those that do not directly pertain to your attempts to borrow money. For example, prospective employers have noticed the correlation between good credit and employee retention, so if you apply for a job you can expect to get a soft inquiry on your report. Insurance companies are making soft inquiries into their existing customers' credit and adjusting premiums accordingly. This can be a tremendous boost (up to 25% discount) to those with outstanding credit. But remember that for every action, there is an equal and opposite reaction, so if your credit score is poor, you can expect to pay more for risk management.

The single best thing that you can do to keep your credit score solid is to pay your bills on time every month. Even if you can only pay the minimum, do everything you can to avoid the dreaded 30 days past due label on any of your accounts. Checking your credit three times a year and knowing the sources of all hard and soft inquiries is a good practice, too.