Figuring Your Financial Fitness
In This Chapter
* Common financial problems
* Bad debt, good debt, and too much debt
* Assets, liabilities, and your (financial) net worth
* How much you really saved last year
* Investment and insurance checkups
* Fitting money into your overall life
" I 've made just about every financial mistake there is to make," lamented a student in my personal finance course. The student, who had an anxious yet depressed look, seemed to be asking me for forgiveness.
This is when it first dawned on me that as grown-up children -- referred to as adults -- we're not really allowed to make mistakes. If you mangle your car in an accident because you weren't paying attention or get fired from a job because of poor attendance and performance, you feel awful.
With financial matters, however, the fact that you've made a mistake may not be as obvious as twisted metal or a pink slip and no more paycheck. Some mistakes take months, years, even decades to manifest themselves. Even then, some people don't realize the foolishness of their ways.
Few people like to be made to feel stupid or told that they're doing something wrong. And what you do with your money is a quite personal and confidential matter. I've endeavored not to be paternalistic in this book but to provide guidance and advice that is in your best interest. You don't have to take it all -- pick what works best for you and understand the pros and cons of your options. But from this day forward, please don't make the easily avoidable mistakes nor overlook the sound strategies that I discuss throughout this book.
If you're young, congratulations for being so forward-thinking as to realize the immense value of investing now in your personal financial education. You'll reap the rewards for many decades to come. But even if you're not so young, you surely have many years to make the most of what money you currently have and will earn (and may even inherit!) in the future.
Throughout our journey together, I hope to challenge and even change the way you think about money, about making important personal financial decisions -- sometimes even about the meaning of life. No, I'm not a philosopher, but I do know that money, for better but more often for worse, is connected to many other parts of our lives.
Common Financial Problems
How financially healthy are you? You may already know the bad news. Or perhaps things aren't quite as bad as they seem.
When was the last time you sat down surrounded by all of your personal and financial documents and took stock of your overall financial situation, including reviewing your spending, savings, future goals, and insurance? If you're like most people, you've either never done this exercise or did so a long time ago.
Financial problems, like many medical problems, are best detected early (clean living doesn't hurt, either). Here are some common personal financial problems I've seen in my work as a financial counselor:
* Not planning. Human beings were born to procrastinate. That's why there are deadlines -- and deadline extensions. With your finances, unfortunately, you have no deadlines, and you may think you have unlimited extensions! You can allow your credit card debt to accumulate or leave your savings sitting in lousy investments for years. You can pay higher taxes, leave gaps in your retirement and insurance coverage, and overpay for financial products. Of course, planning your finances isn't as much fun as planning a vacation, but doing the former will help you take more of the latter.
* Overspending. The average American saves less than 5 percent of his after-tax income (in contrast to those in other industrialized countries, where the savings rate is two to three times that in America). Simple arithmetic helps you determine that savings is the difference between what you earn and what you spend (assuming you're not spending more than you're earning!). To increase your savings, you either have to work more (yuck!), know a wealthy family who wants to leave its fortune to you, or spend less. For most of us, the thrifty approach is the key to building savings and wealth.
* Buying with consumer credit. Even with the benefit of today's lower interest rates, carrying a balance month-to-month on your credit card or buying a car on credit means that even more of your future earnings are earmarked for debt repayment. Buying on credit encourages you to spend more than you can really afford.
* Delaying saving for retirement. Most people say they want to retire by their mid-60s or sooner. But in order to accomplish this financially, most people need to save a reasonable chunk (around 10 percent) of their incomes starting sooner rather than later. The longer you wait to start saving for retirement, the harder it will be to reach your goal. And you'll pay much more in taxes to boot if you don't take advantage of the tax benefits of investing through particular retirement accounts.
* Falling prey to financial sales pitches. Great deals that can't wait for a little reflection or a second opinion are often disasters waiting to happen. A sucker may be born every minute, but a slick salesperson is born every second! Steer clear of those who pressure you to make decisions, promise high investment returns, and lack the proper training and experience to help you.
* Not doing your homework. To get the best deal, you need to shop around, read reviews, and get advice from disinterested, objective third parties. You need to check references and track records so you don't hire incompetent, self-serving, or fraudulent financial advisors. But with all the different financial products available, making informed financial decisions has become an overwhelming task. I've done a lot of the homework for you with the recommendations in this book. I also explain what additional research you need to do and how to go about doing it.
* Making decisions based on emotion. You are most vulnerable to making the wrong moves financially after a major life change (a job loss or divorce, for example) or when you feel under pressure. Maybe your investments have plunged in value. Or perhaps a recent divorce has you fearing that you won't be able to afford to retire when you had planned, so you pour thousands of dollars into some newfangled financial product. Take your time and keep your emotions out of the picture. In Chapter 21, I discuss how to approach major life changes with an eye to determining what changes you may need to make to your financial picture.
* Not separating the wheat from the chaff. In any field in which you're not an expert, you run the danger of following the advice of someone who you think is an expert but really isn't. This book teaches you to separate the financial fluff from the financial facts. If you look in the mirror, you'll see the person who is best able to manage your personal finances. Educate and trust yourself!
* Exposing yourself to catastrophic risk. You're vulnerable if you or your family don't have insurance to pay for financially devastating losses. People without a savings reserve and support network can end up homeless. Many people lack sufficient insurance coverage to replace their income. Don't wait for a tragedy to strike to learn whether you have the right insurance coverages.
* Focusing too much on money. Too much emphasis on making and saving money can warp your perspective on what's important in life. Money is not the first or even second priority in happy people's lives. Your health, relationships with family and friends, career satisfaction, and fulfilling interests should be more important.
Most problems can be fixed over time and with changes in your behavior. That's what the rest of the book is all about.
The rest of this chapter puts you through a financial physical to help you detect problems with your current financial health. But don't get depressed and dwell on your "problems." View them for what they are -- opportunities to improve your financial situation. In fact, the more areas for improvement that you can identify, the greater the potential you have to build real wealth and accomplish your financial and personal goals.
Bad Debt versus Good Debt
Why do you borrow money? Usually, it's because you don't have enough money to buy something you want or need -- like a college education. If you want to buy a four-year college education, you could easily spend $50,000 to $100,000, perhaps even more. Not too many people have that kind of spare cash. So borrowing money to finance part of that cost enables you to buy the education.
How about a new car? A trip to your friendly local car dealer shows you that a new set of wheels will set you back around $15,000 or more. Although more people have the money to pay for that than, say, the college education, what if you don't? Should you finance the car the way you'd finance the education?
The auto dealers and bankers eager to make you an auto loan say you deserve to and can afford to drive a nice, new car, so borrow away.
I say, NO! NO! NO!
Why do I disagree with the auto dealers and lenders? For starters, I'm not trying to sell you a car or loan from which I derive a profit! More importantly, there's a big difference between borrowing for something that represents a long-term investment and borrowing for consumption.
If you spend, say, $1,500 on a vacation, the money is gone. Poof! You may have fond memories and even some Kodak moments, but you'll have no financial value to show for it. "But," you say, "vacations replenish my soul and make me more productive when I return. In fact, the vacation more than pays for itself!"
Great. I'm not saying don't take a vacation. By all means, take one, two, three, or as many as you can afford yearly. But that's the point -- what you can afford . In order to take the vacation, if you had to borrow money in the form of an outstanding balance on your credit card for many months, then you could not afford the vacation you took.
I refer to debt incurred for consumption as bad debt . Don't get me wrong -- you're not a bad person for having the debt, but the debt is harmful to your long-term financial health.
You'll be able to take many more vacations during your lifetime if you save the cash in advance to afford them. If you get into the habit of borrowing and paying all that interest for vacations, cars, clothing, and other consumer items, you'll spend more of your future income paying back the debt and interest. So you'll have less money available for vacations and all your other goals.
One of the reasons you'll have less money using bad debt is because of the relatively high interest rates banks and other lenders charge for such debt. Money borrowed through credit cards, auto loans, and other types of consumer loans not only carries a relatively high interest rate but is also not tax-deductible.
I'm not saying never borrow money and that all debt is bad. Good debt, such as that used to buy real estate and small businesses, is generally available at lower interest rates than bad debt and is usually tax-deductible. If properly and smartly managed, these investments should also increase in value. Borrowing to pay for educational expenses can also make sense. Education is generally a good long-term investment. It should increase your earning potential.
How Much Bad Debt Is Too Much?
A useful way to size up your debt load is to calculate how much debt you have relative to your annual income. Ignore, for now, good debt -- the loans you may owe on real estate, a business, an education, and so on. I'm focusing on bad debt, the higher-interest stuff used to buy items that depreciate in value.
For example, suppose that you earn $30,000 per year. Between your credit cards and an auto loan, you have $15,000 of debt. In this case, your bad debt represents 50 percent of your annual income.
bad debt / annual income = debt danger ratio
The financially healthy amount of bad debt is zero. (Not everyone agrees with me. One major U.S. credit card company says in its "educational" materials, which it gives to schools to supposedly teach students about sound financial management, that it's just fine to carry consumer debt amounting to 10 to 20 percent of your annual income.)
When your debt danger ratio starts to push beyond 25 percent, that can spell real trouble. High-interest consumer debt on credit cards and auto loans is like cancer when it gets to those levels. As with cancer, the growth of the debt can snowball and get out of control unless something significant intervenes. If you have this much debt, see Chapter 5 to find out how to get out of debt.
How much good debt is acceptable? The answer varies. The key question is, are you able to save sufficiently to accomplish your goals? Later in this chapter, I help you figure how much you are actually saving, and in Chapter 3, I help you determine what you should be saving to accomplish your goals. Take a look at Chapter 14 to find out how much mortgage debt is appropriate to take on when buying a home.
Avoid borrowing money for consumption (bad debt) -- for spending on things like cars, clothing, vacations, and so on that decrease in value and eventually become financially worthless. Borrow money only for investments (good debt) -- for purchasing things that retain and hopefully increase in value over the long term, such as an education, real estate, or your own business.
Playing the credit card float
Given what I have to say about the vagaries of consumer debt, you might think that I am against using credit cards. Actually, I have credit cards and I use them -- but I pay my balance in full each month. Besides the convenience credit cards offer me in not having to carry around extra cash and checks, I get another benefit. I have free use of the bank's money extended to me through my credit card charges. (Some cards offer other benefits such as frequent flyer miles. Also, purchases made on credit cards may be contested if the seller of the product or service doesn't stand behind what it sells.)
When you charge on a credit card that does not have an outstanding balance carried over from the prior month, you typically have several weeks, known as the grace period , from the date of the charge to when you must pay your bill. Financial types call this playing the float . Had you paid for this purchase by cash or check, you would have had to shell out the money sooner.
If you have difficulty saving money and plastic tends to burn holes through your budget, forget the float game. You'd be better off not using your credit cards. The same applies for those who pay their bills in full but who spend more because it's so easy to do so with a piece of plastic.
Your Financial Net Worth
Your financial net worth is an important barometer of your financial health. It indicates your capacity to accomplish major financial goals such as buying a home, retiring, and withstanding unexpected expenses or loss of income.
Before you crunch any numbers here and before you experience the thrill of bigness or the agony of nothingness or negativity, let's get one thing perfectly clear. Sit down. Take a deep breath. And repeat after me:
"My financial net worth has absolutely, positively, no relationship to my worth as a human being." This is not a test. You don't have to compare your number with your neighbor's. It's not the scorecard of life. So do we have an understanding? Good! I hate to see people get depressed about unimportant things that they have the power and ability to change.
Your net worth is your financial assets minus your financial liabilities.
Financial Assets - Financial Liabilities = Net Worth
A financial asset is worth real money or is something that you plan to convert to hard dollars that you can use to buy things now or in the future.
Financial assets generally include money in bank accounts, stocks, bonds, and mutual fund accounts (see Part III, which deals With investments). Also included is money that you have in retirement accounts, including those with your employer. You should also include the value of any businesses or real estate that you own.
I generally recommend that you exclude your personal residence. Include your home only if you expect to someday sell it or otherwise live off the money you now have tied up in it (perhaps by taking out a reverse mortgage, which I discuss in Chapter 14). If you plan on someday tapping into the equity (the difference between the market value and any debt owed on the property) in your home, add that portion of the equity that you expect to use to your list of assets.
Assets also include your future expected Social Security benefits and pension payments if your employer has such a plan. These are usually quoted in dollars per month rather than in a lump sum value. I show you in a moment how to account for these monthly benefits when tallying your financial assets.
Personal property such as your car, clothing, stereo, wine glasses, and straight teeth do not count as financial assets. I know adding these things to your assets makes your assets look larger (and some financial software packages and publications encourage you to list these items as assets), but you can't live off them unless you hock them at a pawn shop or otherwise sell them to meet your financial goals.
You must subtract your financial liabilities from your assets to arrive at your financial net worth.
Liabilities include loans and debts outstanding, like credit card and auto loan debts. Include money you've borrowed from family and friends (unless you're not gonna pay it back -- I won't tell). Include mortgage debt on your home as a liability only if you include the value of your home in your asset list. Be sure to include debt owed on other real estate, no matter what.
Copyright © 2000 Eric Tyson. All rights reserved.