Today it’s time for me to deliver the epic piece I promised to you the other day – here’s my attempt to put the fundamentals of Personal Finance into a single article. Definitely bookmark this one (Control-D on a PC or Command-D on a Mac should do it).
As promised, this piece is going to be wide ranging, with a ton of topics… and a lot of links to more in depth discussions on this site. Also as promised, this information is broad enough to apply to most, but in the interest of time it won’t apply to all. If you find yourself in a place this advice can’t cover… find a financial professional to help before you try to hammer a square peg into a round hole (and I don’t count – I’m just a motivated amateur).
The Personal Finance Outline
Topic 1: Debt
Even though debt isn’t the most popular article topic on this site, it’s easily the most common reason for people to even seek out Personal Finance websites and blogs. Because, let’s face it – for many people the tenets of good debt management were never learned. It takes a negative event – say, not having enough for a minimum payment, or a new milestone of debt (“an even $50,000 in credit card debt!”) for people to get serious.
Most debt blog readers have a significant amount of consumer debt and a newly minted degree which still hasn’t been fully paid off (read: student loans). This lets us make a simple statement, assuming you can’t pay off every balance in a month… the mathematically optimal payoff strategy is to pay the minimum on everything except the highest yield (pay more). Here’s a breakdown/order, with guesses for interest rates as of mid-May, 2013:
- Gambling Debt & Debt from Loan Sharks – APR: Your legs.
- Payday Loans – APR: as high as 50% to 1,000%.
- Credit Card Debt - APR: 8% – 18%
- Car Loan - APR: 4% to 12%
- Student Loans* – APR: 3% to 7%
- Home Loan/Mortgages* - APR: 2.375% to 4.5%
(Again, I can’t cover everyone, and some people might have random interest rates I didn’t cover… think medical debt or 0% interest financing.) You can also do your interest rate ordering within categories – many people have two car loans or 3 or more credit cards, so order those based on interest.
So, quickly pay off things with a higher cost, and as you pay off more and more balances you’ll be able to dedicate more and more resources to each bill. (Oh, and I don’t have enough space for a full accounting of the reasons here, but there is no need for you to have a recent year car if you’re in debt. This is no time for vanity. You might not even need a car.).
*Advanced: You’ll also note that two of the categories have an asterisk. In the United States, it’s possible to receive tax deductions for student loans and mortgage interest, which reduces overall cost by lowering the amount of taxes owed. Student loan interest phases out at a lower income, and mortgage interest usually requires more income before itemizing is worth it. If these apply to you, you can calculate something called Tax-Equivalent Yield.
Topic 2: Savings
Funnily enough, savings is a controversial subject in this little Personal Finance world where we find ourselves. That said, let me set this section up: I’m not an expert, but I’ll share my priorities. Feel free to mess around at the margins.
- Emergency Funds – My feelings have evolved on the so-called ‘emergency fund’. These funds are savings accounts for quick access where you put money in case of emergencies like car repairs. Here’s the problem – when I advocated for EFs, you could find savings accounts which paid 6%, and teaser rates on credit cards for 0%, or limited time 7% rates. Nowadays, the Credit CARD Act has made it harder to find teaser rates if you have a lot of debt, and savings account are a fool’s game. I now lean towards no EF due to that spread – it’s more important to pay down your debt. Like people smarter than me have said, “having a lot of debt IS an emergency”… more-so than putting money in some account somewhere to stagnate.
- Money Management - This will be a positive bullet, since it’s a topic we’ve covered before. I practice something called the ‘Three Account Method“… some trickery where I use direct deposit on my paycheck to hit all my savings targets: First, money goes to a ‘fixed bill’ checking account – here’s where you put your bills that don’t change and you’re in no rush to pay off… like lower rate debt for mortgages and student loans. Some utilities are also fixed – cable and internet bills, for example. (No time now… but cable when you’re in debt? Look hard at that bill…). Second, money goes to a spending checking account. Here are you varied expenses – like for buying food. Last, I put some money in my savings account, which never gets too big (see above).I write a ton about the TAM elsewhere.
- Savings Rates – Whatever your savings rate is now, plus more! I’m not being facetious here – each year you’re alive is a year closer to when work will become difficult for you and you’ll want to retire. That means you should pack away as much as you can, as quickly as you can. Yes, don’t starve or sleep outside – but make a conscious effort to sacrifice. Don’t worry – you can spend it later. My co-writer has talked about the psychology of increasing savings rates, especially when automatic. If you aren’t saving money now, start with 10% and increase it every year.
Advanced: Am I a good guide? That’s for you to decide. Here’s my recent savings rate history, based on a strict definition I made. The most important part of money management is actually net worth increases though, not savings – so your numbers may be more impressive depending on what definition you use.
Topic 3: Investing
Section 1: What To Invest In When You Don’t Know Where to Start!
So you’ve got your debt squared away, and you’ve figured out your money management and savings strategy – it’s time to discuss investing. Most people come into this cold – so this will purposefully be geared towards rank beginners. When you’re talking ‘beginner’, that means an introduction to stock (a highly liquid asset which represents a claim on the future earnings of an underlying company), bonds (debt issued by said companies or governments), and treasuries (similar to bonds, but issued by the United States Department of the Treasury).
The biggest problem people run into when first looking at investing is analysis paralysis. The universe of things you can invest in is so big – some estimates say there are 15,000 companies in the United States alone. How do you decide where to start? REITs? MLPs? Closed End Funds? I’ve heard of Apple before, should I invest in that? No, not at all. The most important thing to remember is investing is a marathon, not a sprint. The best time to start investing is yesterday – so even if you walk the first few miles (or the whole thing) it’s still possible to finish.
Assuming you’re a beginner and don’t have a keen sense of exactly what to invest in, there is a security for you. Here’s what to invest in: something called a Target Date Fund. These TDFs will take your age or approximate number of years until retirement, and automatically invest in a massive basket of stocks, bonds and treasuries – both in the United States and abroad! They are the ultimate hands-off retirement accounts, where you literally will never have to touch them if you never go deeper in investing. Some large providers (all with very good reviews) are:
Those links should bring you directly to information on the right fund from that family for your age.
Section 2: Where to Invest!
The first introduction many folks have to the investment world is in their 401(k). Funnily enough, the 401(k) is actually a reference to a section in the tax code… which is the great irony when folks not-from-America call their main retirement accounts 401(k)s.
I digress. The 401(k) is an account with a huge benefit – traditional 401(k)s allow you to defer taxes! That’s right – money you put into your 401(k) is a deduction on your taxes. There is another huge benefit – many companies incentivize 401(k) contributions, kicking in extra money just because you meet some savings target. Common matching amounts? 50% up to 6% of your income, or 100% up to 4% of your income.
So let’s talk about priorities in investment:
- 401(k) up to the company match. You’re looking at 50% or 100% returns just for playing. You should usually do this even if you’re in debt – don’t leave this free money on the table, as the return is often more than your cost of debt.
- IRA to max. It is usually a safe bet to open a ‘Roth’ IRA – which works in the opposite way as the ‘Traditional’ 401(k), where you pay tax up front and not again when you pull money out. The limit in 2013 is $5,500 per person (you need earnings at least equal to your contribution), so $11,000 for a couple. If you are over 50, $6,500 per person is the limit. Don’t have one yet? We suggest an account with(that’s an affiliate link). We have a TradeKing account; $4.95 trades is a solid deal.
- Continue to invest in your 401(k). That means up to $17,500, total. Over 50? You get an additional $5,500 added to your limit.
- If you hit this point, you’ve advanced past Personal Finance 101 – which means you get to break the rules. We’re biased, but you should start to read the archives of Don’t Quit Your Day Job’s Investment section.
Advanced: Rules are made to be broken, but when you’re new it’s best to stay safe. If you are interested in the next step, you can start with this article on our investment returns, with links to a discussion of beating the market. We’re also well known for our calculators, so try our S&P 500 Return Calculator or Treasury Return Calculator to start a bigger analysis. We’ve also broken down historical returns on the S&P 500 by timeframe.
Topic 4: Insurance
Insurance is an interesting and wide ranging topic, and I am nowhere close to an expert. However, I think my mix of insurance ideas works well if you don’t know where to start. You need insurance wherever you have a downside risk which is too great for you to cover on your own. Let me break it down by some common topics:
- Health Insurance – Your downside risk here is a catastrophic medical crisis OR a chronic disease. They differ mainly in how quickly they hurt your finances, and in the second case your ability to obtain insurance in the individual market (and at what cost). All we can say on this one – get health insurance. Being young and healthy doesn’t extrapolate to always being young and healthy, so at least get high deductible coverage here.
- Car Insurance – It’s a law, first of all. Second, you can easily shoulder some blame for an accident even with the most careful of driving (my perfect driving record was marred when a lady stopped suddenly mid intersection on a left turn at a light… while I was driving into the sun with a pitted windshield and no anti-lock breaks. Yes, it’s still my fault… even with the green arrow… and yes I’m still bitter). When setting limits, remember new cars can cost $50,000 or more. If you total a new luxury car, make sure you can cover it.
- Life Insurance – Once you have the top two covered, you open the can of worms. My philosophy on life insurance is to cover enough major debts that a surviving spouse or child can lead a ‘normal’ life. If I die, my wife would receive enough money to pay off the mortgage… giving her plenty of time to decide her level of work . Read: she won’t have to go back to work the next day. For me, that means Term Life Insurance – through my work, it’s cheap to get enough term to cover my mortgage. Again, I’m not sophisticated on this topic, find someone who is if you have special needs. Here’s some further details.
Home/Renter’s Insurance –
- Many of you will be introduced to these due to a requirement in your lease or from your mortgage. When I rented from private parties, I used to forgo the renter’s insurance – I had way more assets in accounts than I had in my apartments… remember, insurance is there to cover a downfall you can’t cover yourself. On the home side? It’s worth it even without a mortgage. Considering the cost to rebuild if you burn down your house, or the cost hospital bills for someone who slips on your walkway… unless you can afford it, you should keep some level of home insurance. Just keep your deductible high – this isn’t that huge of a risk, and ‘catastrophic’ coverage is the key here.
A note: Other than health insurance and life insurance, NEVER share your limits/accounts with others unless you could trust those others with a password to your financial accounts. If you get in an accident and you say what you’re limits are? You’ll soon see a weird coincidence with the claims that come your way. Home limits? I’m not saying you invite fraud… but I would expect your property to suddenly become slightly more dangerous to those who know your limits. Just keep things to yourselves.
Advanced: Once you’ve got these under control, you need to think asset protection. Your next step is something called ‘Umbrella Insurance’, which covers charges in excess of the coverage limits for car and home insurance. I’m not the de facto expert on Umbrella Insurance, but once you have assets, it’s worth protecting them from legal risks. Oh, not telling people your Umbrella Limit should go without saying, but I’ll say it anyway: Don’t!
Topic 5: Responsible Use of Credit
So you weaned off your debts, you started saving 10% of your income, you’re investing monthly, and you’ve covered your risks. Guess what? It’s time to discuss ‘credit’.
Note that we say ‘credit’ not ‘debt’. In the grand philosophy of this site, credit is never a means to take on more debt, short of some exceptions – student loans for lucrative careers, or mortgages for property. Credit, as in ‘credit cards’ have two features which are useful to us – liquidity (in that you can use them 24/7/365) and rewards. (More discussion on credit cards strategy here.)
So, what am I saying, go wild with your credit cards? No – not at all. Credit cards are the financial equivalents of firearms – dangerous in the wrong hands, but useful used responsibly. Or, perhaps a better example is alcohol – in moderation it’s useful as a social lubricant. However, even a moderate amount of alcohol is dangerous to a past alcoholic. You know how you are with credit – if credit cards are too much of a risk, stay away and pay in cash.
For the rest of you:
- Get a (multiple even, with different bonus category) rewards credit card. It must have no annual fee.
- ONLY buy things you would buy anyway (be honest with yourself here!)
- NEVER run a balance. That means, never have a balance higher than you can pay off that month. Don’t even think about it.
If you obey those rules? You don’t even need to worry about the APR, since you will never pay interest. In fact, you’ll make more money than paying in cash since you’ll have credit card rewards accumulating just by doing shopping you’ll do anyway.
Advanced: As for other types of responsible credit use? Unfortunately, you’ll have to read elsewhere. I refer here to borrowing for education that will pay off (choose your Major wisely; failing that, keep it inexpensive), and borrowing to acquire property (mortgages). Historically, these have been good ideas. That doesn’t mean that they have always been (or will always be) good ideas, but I can’t with a straight face tell you not to buy a house with a mortgage or acquire a Degree with student loans… when I did both.
Topic 6: Taxes
It was Benjamin Franklin that popularized the quote “[I]n this world nothing can be said to be certain, except death and taxes”. We already covered the ‘death’ part with the Life Insurance section… but let’s turn our mind now to taxes.
While all of these other topics (save insurance) are ‘Offensive’, taxation is a topic where you need to play defense in finance. You aggressively pay off debt, you invest with gusto, you responsibly use credit to replace mandatory spending and acquire worthy assets… so it’s tax time. So, just fill out the 1040EZ, right? No! As Judge Learned Hand once said, “Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes.”
What does that mean? It means that you structure your affairs to pay the absolute legal minimum amount of taxes you can. That may mean rate arbitrage – you should put investments which have non-qualified payments (like, say, bonds) in tax advantaged accounts. Stocks can have better rates than earned income when it comes to capital gains or dividends – and real estate can be better still. Some careful management can minimize the payments on your investments simply by carefully considering which account to use.
Tax minimization also means taking advantage of IRAs, 401(k)s , and the like. We also must speak here of tax diversification – since traditional and Roth style accounts act differently (either don’t pay tax now, or don’t pay tax later), it’s nice to have a little of both to hedge the changes in future tax laws! Remember, it’s hard enough to predict elections weeks in the future – do you really know how your rates will look when you retire? Best to have a little of both styles of tax protection.
Taxes can also change your payoff calculations. You may get a discount on your taxes for student loan interest or your mortgage – be sure to factor that discount (again, if it applies) into your debt payoff calculations.
And, again, due to politics ensuring we’ll never have an easy tax system… always keep your ear to the ground on new deductions and tax strategies. It’s the nature of the beast for new things to become lucrative all the time.
Advanced: There are ways to increase the amount of money you shield from the drag of taxes – some basic ways are available to small business owners, such as self directed 401(k)s and IRAs. There are even ways for the majority of folks to shelter more – consider our method to vastly increase your Roth contributions or our experiments with Health Savings Accounts.
Topic 7: Putting it All Together
It may have only taken you a few minutes to read this… but in all honestly it’ll probably take a few years to get it all together, especially if you need to get one aspect of your finances under control (here’s your reminder: bookmark this article!). However, let’s clear up a few things:
Investing is the inverse of paying off debt. Investments which pay more in interest than what debt costs in interest are okay.
Why the rule? Many wonder if it is worth paying off a cheap mortgage before investing. We have a longer answer here. That means that getting everything under control should be done holistically – don’t wait to fund a 401(k) match (100% return, remember!) while paying off a 3% student loan. That means you need to mess around with the order, which is:
- Pay off high interest debt
- Crank up your savings rate
In the meantime, you need to work on protection from taxes and from expensive risk, with insurance. Assuming you’re not a spendaholic*, your common expenses should be paid for with rewards credit cards with no annual fee. (*I hate that portmanteau but it’s so perfect here)
If you do that, you’re well on your way to financial independence (and eventually, retirement)… so you’ll have that going for you, which is nice.
Appendix: The Stuff I Skipped
We sort of put this piece together on a dare from our friend Joe at Timeless Finance. We have said for a while that we could cover all the basics of Personal Finance in a single post. Now, Joe didn’t put a word limit on the dare – but I’ve written more than 3,600 words before so… count it!
If you internalize everything above, you’re definitely in the upper echelons of Personal Finance knowledge, and pretty strong on the breadth front. However, you are just scratching the surface for depth. There are many other things to talk about – your career, investing outside of target date funds, hedging risks (it’s more than insurance), side jobs, alternative investments, valuing opportunities, avoiding scams, well… and enough to write hundreds of blogs about (I’m guessing at the size of the PF sphere here). For a stronger look, [amazon-product text=”our friends at Control Your Cash” type=”text”]1936107880[/amazon-product], and [amazon-product text=”our friend Barb Friedberg” type=”text”]0988855526[/amazon-product] have written entire books. Blogs and web sites we find enlightening can also be found on our right sidebar in the ‘Links’ section… go subscribe to a bunch. Their styles range from snark to tough love!
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