Kossacks Under 35: Personal Finance
Thu Jan 04, 2007 at 06:05:32 PM PDT
Welcome to the first "Kossacks Under 35" diary of 2007! I've been thinking for a while about writing a diary on personal finance issues, and when Katherine offered me the chance to piggyback on her series, I jumped at it. I'm not exactly in the "under 35" demographic. OK, I'm closer to 45 than 35, but I'd like to pass on stuff that I'm glad I learned before I was 35 and some other stuff that I wish I had known then. I was going to subtitle this diary "Things I'm glad my mother taught me" but some of this I had to learn on my own, so the old lady doesn't get all the credit. (Hi Mom!)
There is virtually no political content in this diary, so if that's your thing, you can bail out now.
Another note before I begin. I'm not any kind of financial professional. I consider myself an interested layman (I'm probably the only person I know who actually enjoys doing my own taxes) but there are lots of people out there who know more than I and please feel free to correct me if I make any errors.
Compound Interest
If there is one single most important concept you need to grasp when it comes to managing your personal finances, it is compound interest. I think it's a crime that we won't let children leave school in this country without knowing that Columbus sailed in 1492, but we release all these young adults into the world without making sure they have a grasp of the power of compound interest. It can be a tremendously powerful tool that you can wield to your benefit, or it can push you into a hole so deep you may never climb out. I run through some detailed examples below, but let me first say that if you are ever tempted to borrow cash from your credit card or, worse yet, get a loan from one of those "payday loan" places, please, please, reconsider.
Budgeting
The first step to gaining control of your finances is to come up with a plan. Figure out what money you have coming in and decide where you want it to go. My mom used to tell me to start with the 70-10-10-10 plan: 70% of your income goes to expenses, 10% to savings, 10% to charity and 10% to education. Over the years, I've tweaked those percentages as my situation has changed, but it's not a bad place to start.
Remember that education doesn't cease when you leave school and sometimes education comes in unexpected ways. I once paid a $900 "tuition" to learn the lesson that one should never sign a contract that says one thing in writing when all the parties agreed orally to something else. The writing is what will be enforced and no one is going to care (or even admit) to what they may or may not have said when you signed it. If you are young, with few responsibilities (e.g., mortgage or children) you probably want to increase the savings percentage while you can. If you are still in school, or still paying off steep student loans, your education percentage may be higher.
Sit down with all your paychecks and your bank statements and your credit card bills for the last 6-12 months and first look at exactly what money you have coming in pre-tax and where it is all going. Divide your expenses into categories like "food", "entertainment", "clothes", "rent", etc. I find it easiest to use software designed for this (Quicken, in my case) but I know people who do this using a simple spreadsheet. If you have a large amount of cash that you spend and can't track, you should try to monitor where that is going by saving all your cash receipts for at least a week (or a month) and then sorting them out at the end of that time. If you are spending cash on things you don't get receipts for, try carrying around a small notebook or a PDA and write it down everytime you spend any cash. You may get weird looks from your friends, but I'm sure they are secretly jealous that you are so organized. (At least that's what I always told myself when I did exactly that for years.)
If you need to decrease your expenses, look for things you can change, not just the biggest expenses. It's quite probable that your tax bill will be the single largest expense you have, and in all likelihood you can't reduce that by much. Pay close attention to exactly how much you are paying for any loan interest, and look to find ways to reduce that by either paying off the loans more aggressively or by consolidating high interest loans into a lower interest vehicle. Always pay off the balance on the highest interest loans (e.g., credit cards) you have before the lower interest rate loans (e.g., car loans). It's a good idea to repeat this exercise at least once or twice a year.
Savings and Retirement Accounts
One of the hardest things for me was to find the motivation to start saving for retirement at an early age. Looking at the younger generation frittering away their opportunities is one of the things that causes old codgers to grumble about "youth being wasted on the young" but mostly we are all mad that we wasted our own youth. My mom used to try to get me to understand that you actually have a pretty limited window of saving opportunity by running through the following analysis. It didn't always work with me, but I'll pass it on anyhow.
Assume you are going to live to 80, you can divide your life roughly into fourths (20 year chunks). In the first fourth, your parents take care of your needs. In the next two you are earning money to take care of yourself and your own kids and in the final fourth, you can hopefully retire and take it easy. So you only have 40 years in which to put away all the money you are going to need for that last fourth of your life. This is where compounding interest can really work for you. If you start saving at the age of 25 and invest $3000 per year at 6% compounded interest (APR 6.18%) at the age of 65, you would have about $500,000 in the account, while the total amount you invested was $123,000. If you wait just 10 years and don't start until you are 35, you would have to save over $5800 per year ($180,000 total) to have the same nest egg at 65. If you wait until you are 45 to start, you would need to save over $12,000 per year ($259,000 total) to achieve the same result. In other words:
| Age Start | Interest Rate | Annual Savings | Total Invested | Total Value at Age 65 |
| 25 | 6% | $3000 | $123,000 | $493,396 |
| 35 | 6% | $5818 | $180,358 | $493,376 |
| 45 | 6% | $12,337 | $259,077 | $493,390 |
It's best to have at least some of your savings be automatic. If you try to save whatever is left over after you pay your expenses, you often find you don't have any left over. Set up automatic deductions from your paycheck for your 401K (if you have one available to you) and/or your IRA. These two types of accounts offer significant tax advantages over regular savings or investment accounts. Individual Retirement Accounts (IRAs) are accounts you set up yourself through your bank or brokerage house. 401K savings accounts (if you are in an education field, there is a similar account called a 403B) are set up through your employer. 401Ks are more attractive than IRAs, since employers often have a matching program where they will match a portion of the contribution you make directly into your account. IRAs are open to anyone who makes above a minimum amount in the year. In both of these accounts, you are limited to a certain maximum contribution per year. If at all possible, you should be maxing out your contributions to each of these. There are two types of IRAs and 401Ks: standard and Roth
Standard 401Ks & IRAs
In the standard version of these accounts, any money you put into the account is tax deductible when invested. When you take it out, after you reach retirement age, you then pay tax on the money as ordinary income. However, it will probably be true that when you retire, your income level will be much less than it was when you were working, and therefore you will be in a lower tax bracket. In addition, if you are buying and selling investments in your IRA account over the years, you pay no capital gains tax for every sale, so that your savings will grow more quickly than they would in a regular taxed account.
Roth 401Ks and IRAs
About ten years ago, the feds changed the tax code and introduced a new type of IRA called a Roth IRA. Just this year, they added a Roth version of the 401K as well. Not all employers offer the Roth 401K, and there are income qualifications you must meet to qualify for the Roth IRA, but if you have access to either, they are very attractive savings instruments, especially for young people. The key is that the money you contribute is no longer tax deductible. You have to pay tax on that income right now. However, you never pay any taxes on the gains in the account as it grows and when you take the proceeds out after retirement, the entire distribution is tax free. (Woohoo! Two of the sweetest words in the English language!)
In addition to retirement savings accounts, you should have a general savings account for things you may want to buy before you retire (like the down payment on a house). However, if you are carrying any high interest consumer debt (credit cards) it doesn't make sense to put your savings into a low interest savings account. Get those high interest debts paid off as soon as possible.
Debt and Credit History
There may be times in your life when you need to purchase something (e.g., a home or car) that you do not have the cash for at the time and you will need to take on debt. Debt in and of itself is not a bad thing, but you do need to understand what you are taking on every time you borrow money. Once again the power of compound interest can bite you in the butt.
There are three main things you need to look at for every loan you take: interest rate, loan duration, and repayment schedule. In addition, there are other things to take into consideration as well (e.g., points, or tax deductibility of interest, etc), but first focus on the big three. I'm just giving some general guidelines here and there are lots of situations that contradict each of these rules, but this is a good place to start. Obviously you want the interest rate to be as low as possible, but you also want the rate to be fixed so that you know that your loan repayment amount will not change in the future. In general, especially for consumer debt (i.e., anything not a home or business loan) you want to keep the loan duration as short as you can manage. For long term loans, you can end up paying many times the value of the original loan in interest payments. Finally, when it comes to repayment schedule, you want to be sure that the loan balance is being reduced by your payments faster than it is growing due to the addition of interest. If you see the words "interest only payments" or "balloon payment" run, do not walk, to the nearest exit.
Here's an example to show the effect of the loan duration and monthly payment. Say you borrow $2000 from your credit card at 12% compounded interest (APR 12.75%) and you make $100 payments per month. In just over 22 months, you will have paid off the entire loan and will have paid $244 in interest. If instead you only pay $50 per month, your repayment will take over 51 months and you will end up paying $571 in interest. If your payments were only $25 per month ("low, low payments!") you would be paying off that loan for over 13 years and your interest payments would total almost $2100. In other words:
| Loan | Interest | Loan | Monthly | Total | Total |
| Amount | Rate | Duration | Payment | Repayment | Interest |
| $2000 | 12% | 23 months | $100 | $2244 | $244 |
| $2000 | 12% | 52 months | $50 | $2571 | $571 |
| $2000 | 12% | 163 months | $25 | $4074 | $2074 |
Incidentally, if instead of borrowing the $2000, you waited to make your purchase and put $100 in a savings account every month that earned 6% interest (APR 6.18%), in only 19 months you would have saved the $2000 you initially needed.
The better your credit history is, the more favorable loan terms you can negotiate, so it is really important to keep your credit history as clean as possible. You need to have activity in your history in order for the lending agencies to be able to judge your ability to repay a loan. Therefore, having credit cards (more than one) is a good thing. However, carrying balances on them is not a good thing, especially if you are trying to qualify for a new loan since the bank may decide that you can't afford more payments each month. In addition, even one single late payment can show up as a detriment on your credit report, so it is very important to always make sure those payments are received and posted before the due date.
A really good rule of thumb with credit cards is to never ever carry a balance from month to month. Pay off your bill in its entirety every month. In that way, you are using the credit card company's money interest free for the period of time between when you purchase the item and when you pay the bill and they are getting absolutely nothing from you. It's always a kick to stick it to the big corporations in your own little way.
If you are really constitutionally unable to resist charging up large balances you can't immediately pay, then don't carry the cards with you. You may, as a last resort have to switch to a debit card. I suggest you set up a separate account for the debit card and only keep a small amount of money in that account. Debit cards offer much less protection when it comes to fraud and theft. If someone steals your debit card and cleans out your bank account, you may eventually get most of it back, but you won't have the use of that money while you are fighting with the bank. Just make sure that your debit card account is not linked to your main account via any "overdraft protection" scheme, or your main account may still get cleaned out by theft.
Further Resources
OK, I guess I am just too long winded to cover all the stuff I wanted to say. I was going to say more on: Investing Basics, Smart Shopping, Money Between Couples, Money for Kids, Taxes and Contracts, but I better stop now. If there is interest, I'll do another diary on those points some day. There are a bunch of books out there on how to manage your personal finances and investments. Here are some that have been recommended to me over the years. I would suggest getting them from the library, since I find most of what they say to fall into the category of "common sense" and may not be stuff you need to read more than once. Note that each of these authors has expanded his/her/their advice to an entire line of books specialized for all sorts of different circumstances (but to be honest, they mostly look like much of the same information repackaged in a different cover).
Smart Women Finish Rich by David Bach
Rich Dad, Poor Dad by Robert T. Kiyosaki and Sharon L. Lechter
The Millionaire Next Door by Thomas J. Stanley and William D. Danko
The Money Book for the Young, Fabulous & Broke by Suze Orman
Also, I saw a Wiki-How page earlier this week on How to Save Money that has some helpful hints too. The above books give general guidelines and advice. For specific answers to legal questions on lots on different topics (real estate, landlord/tenant issues, estate planning, employment issues) I first look to Nolo Press. They have a great line of books on these and other topics. For tax questions, I suggest getting a general tax guide every year. I've used both J.K. Lasser's Your Income Tax and Ernst & Young Tax Guide over the years. I haven't noticed a big difference between the two. If you are really hard core, go for the U. S. Master Tax Guide published by CCH. If you can read and understand that, you could probably write new tax law.
