Interesting Interest Rates

I have been thinking about our current, unusually low interest rate environment and what the future might bring. We know interest rates will have to go up, but we don’t know when or by how much. We know that the U.S. Treasury and the Federal Reserve Bank are trying to fuel a recovery after the slow motion crash of 2006-2009 with borrowed money. The Federal Reserve Bank is buying a lot of new U.S. Treasury debt at an artificially low rate as well as bad debt from private banks. We know that most American families move on average something like once every 5-7 years. Are the banks thinking about that when they write a 30 year mortgage? The important secured rates that directly affect the average consumer mortgage rates, car notes, and student loans all seem to be in the same ballpark.

What does it all mean?

Current Rates of Interest

0.25% Fed Funds Rate-The rate at which banks and other financial institutions lend money to each other on an overnight basis

0.75% Federal Discount Rate-The rate at which the Federal Reserve Bank will lend money to an eligible bank or financial institution; normally this would only be done in the relatively rare case when the bank has insufficient reserves on hand.

2.68% 10 Year Treasury Note Rate-Your rate of return when you buy a ten year treasury note from Uncle Sam.

3.25% WSJ Prime Rate-The rate at which at least 23 of the 30 largest banks in the country are willing to lend money to their most favored trustworthy customers.

3.86% Federal Stafford Student Loans for undergraduate studies

4.09% Typical rate for a 48 month new car loan as quoted by bankrate.com

4.31% 30 Year Fixed Mortgage Rate with no points-We all know about that one.

4.71% Typical rate for a 36 month used car loan as quoted by bankrate.com

5.41% Federal Stafford Student Loans for graduate studies

Note: Fixed interest rate student loans from private sources are currently running between 5.75% and 11.75% depending on the creditworthiness of the student and the cosigner.

2nd Law Investing

Back in the day when I worked in a Government laboratory from time to time we would receive unsolicited proposals. Some of these were from well intentioned people with (shall we say) an excessively active imagination. Some of them were attempted fraud. We received a proposal from a person located in Pakistan who claimed he had developed a machine that would produce a greater output of energy than the amount of energy required to run the machine. Basically, what he proposed was a magic box, called a perpetual motion machine of the second sort. This class of device violates the second law of thermodynamics. No device will ever break even. It will always lose some energy through waste heat. Your automobile might be 30% efficient. That means 70% of the energy generated by burning gasoline is waste heat. A really large marine diesel might raise the ante to 60% efficiency, but sadly the 2nd law of thermodynamics tells us you will never reach 100%, let alone 200%. The man from Pakistan told us he would show us what was in the magic box if we gave him $50,000 in cash. Fortunately the Government declined his generous offer.

If someone promises you get rich quick returns on some investment or method of investing, it is likely that you are looking at a charlatan attempting to separate you from your money. There are no magic boxes that work consistently over long periods of time. Yes, someone will win the lottery, but lottery tickets are not a sensible method of investing for your retirement.

Ask yourself these kinds of questions:

1)If this guy is so smart why isn’t he rich?

2) If this guy has a magic box why doesn’t he just use it rather than offering to share it with me for a fee?

3) If this guy is not telling me a bald face lie, how much time and effort will it require to get the kind of results I want? (Think MLM schemes. Do you really want to alienate your friends, family, and neighbors in an attempt to get rich selling some overpriced product?)

4) What isn’t this guy telling me? Usually you aren’t hearing anything about sales commissions, taxes, or brokerage commissions.

No investment or investment class will work for all time in every environment. Real Estate goes up. Real Estate goes down. The stock markets go up. The stock markets go down. Gold goes up. Gold goes down. There is nothing that will provide consistently high returns with little or no risk in every market situation.

The only way to build wealth with a high probability of success is slowly by investing in a diverse, age appropriate portfolio over a lifetime or in the case of multi-generational wealth over several lifetimes.

Don’t be afraid to pay a professional for advice, but make certain of his credentials and make even more certain he is not a commission salesperson. Commissions are typically structured to benefit the company offering the investment product, not the client’s best interests. Mutual funds with a sales load typically get more or less the same kind of returns offered by similar no-load funds, but if you have lost 5.75% in sales commissions your $94.25 will need to earn 6.1% more than the $100.00 in your neighbor’s no-load fund—just to get even! There are fee for service investment professionals who will design a personal investment plan appropriate for you, your goals, and your particular situation. There are reputable investment newsletters, although most of them are junk. The good ones are a fine place to begin your investigations of individual stocks or investment strategies. You can tell the good ones. They offer no guarantees of high returns with little or no risk. They don’t play on fear and greed. They say things like, diversification in quality assets, plus dividends, plus time offer a high probability of putting the power of compound interest to work for you and your family.

Ultimately, you are responsible for how you choose to invest your hard earned money.

Keep in mind that the purpose of investing is not to get rich. The purpose of investing is financial freedom, a component of a good life that glorifies God, provides for your family’s needs, and leaves you with a little something left over for your personal enjoyment. Money is just a means to an end. It should never be an end in and of itself.

Now, “Let’s be careful out there!”

Exchange Traded Funds

An Exchange Traded Fund (ETF) is basically a mutual fund (usually an index fund) that is bought and sold on a stock exchange rather than through a mutual fund company or by a commission salesperson.

They have only been around for a few years, so as an asset class companies are continuing to develop their offerings. It looks like the ultimate outcome will be ETFs that mimic just about every kind of mutual fund that currently exists.

Like traditional index funds the ETF offers diversification at a very low cost, sometimes lower than the comparable mutual fund. The big difference between ETFs and traditional mutual funds lies in how they are bought and sold. Every day a mutual fund must calculate its net asset value. Everyone who buys or sells shares of a particular mutual fund on that day gets the net asset value. Usually there is a time lag between when customers place a buy or sell order and when that order is actually executed. ETFs are different. If the market is open your buy or sell order is executed in real time. The managers of ETFs do not need to calculate net asset value. You buy or sell at the market price at that moment in time.

Because shares in an ETF are bought and sold like shares of stock, the customer will be hit with a brokerage fee on the way in and on the way out. These days that would run about $9.00 for most people, although depending on the brokerage house I have seen as low as $7.00 or as high as $19.00. If you are buying shares of ETFs in multiples of $1,000 this is a very inexpensive way to buy and sell. If you are buying $100 at a time the fees are killers, even worse than funds sold with a 5.75% sales commission and 12 B-1 fees. If you are a dollar cost averaging kind of investor, go ahead and pony up the $3,000 needed to start buying mutual funds at Vanguard, then let them automatically debit your checking account for $100 a month. Even though you will be paying slightly more in management fees you will be saving an enormous amount of money over the course of many years.

Like index funds, ETFs should be viewed as a long term investment. Ideally you buy and never sell except to rebalance your portfolio. Some argue that because it is more difficult and time consuming to buy and sell index funds sold through a fund provider than it is to trigger a trade through a brokerage house, the small time investor should stick with mutual funds. All too often the small investor is driven by fear and greed. He is afraid when the market is dropping. Then he sells at exactly the wrong time. He gets greedy when the market is at record highs. Then he buys at exactly the wrong time. Putting even a small inconvenience in the way of this predilection helps to control instinctive bad behavior. I am not sure I buy this argument. With the advent of the Internet and cloud computing it isn’t really all that much more difficult to buy or sell mutual funds than it is to buy or sell shares on a stock exchange.

Self discipline is up to you. Your positions in index funds or ETFs are foundational investments. Buy and don’t sell (except to rebalance) then the money will be there for your retirement and if you are diligent and a little lucky for children’s college education.

A couple more things to think about are reinvesting the dividends and capital gain distribution. If you can reinvest the proceeds from your ETF without any brokerage fees that is a good thing. If your brokerage house wants to charge you for that service, you might want to take your money elsewhere. In thinly traded ETF, as in buying or selling shares in small unknown companies, there can be a significant difference between “bid” (the price the market is willing to pay you for your asset) and “ask” (the price you will pay to buy the same asset). For example, on a given day the “bid” price on XYZ Corporation is $50.00 a share. That is what the market is willing to pay you for your shares. Let us assume that if you want to buy shares of XYZ on the open market you would need to pay the “ask” price of $50.50. The difference (called the spread) would be $0.50 a share. Usually the spread is microscopically small and of no concern, but in some cases it can be a consideration.

Mutual Funds (101)

Mutual funds (low cost index funds) should be the foundation of every beginning investor’s portfolio. When the term, mutual fund, is used it generally refers to what is specifically called an open-end mutual fund. A mutual fund buys various sorts of assets. Then it sells shares of this investment pool to the general public. By law an open-ended fund must be willing to buy back their shares from their investors at the end of every business day at a price determined by the net asset value of all the underlying investments. There is no legal limit to how many shares of an open-ended fund can be sold to the public. Therefore, when customers want to buy, the fund managers or their computers must buy more shares with that money. When customers, want their money, the fund must sell some of its underlying assets to pay off their obligation.

Mutual funds are managed in one of two ways, active or passive. In the case of managed funds, people select the size and nature of the investments. In theory a genius fund manger could beat the index with his astute stocking picking skill every time. In practice it is very difficult to beat the index over long periods of time for the same reason it is difficult to beat the Las Vegas line over long periods of time. You may get on a hot streak, but you are competing against the collective wisdom of every sports gambler in the world. Sooner or later you too will revert to the mean. There are genius fund mangers that will enjoy a fabulous run. However, are you smart enough to pick them in advance? The odds say only one in four funds will beat the index in a given year. Over the course of twenty or so years that number drops to something like one in a hundred.

Index funds are simply run by computer programs to mimic the content of an index like the S&P 500. The program buys and sells stock so that the content of the mutual fund exactly replicates the contents of the S&P. This means that the cost of operating these funds is much less than retail managed funds sold by a commission sales force and managed by expensive fund managers. Total cost of ownership is critical component in making sound investment decisions, whether buying automobiles or mutual funds.

Mutual funds cover a number of major investment categories.

Money Market Mutual Funds buy and sell very short term fixed income notes. They are generally used as a substitute for the old fashioned bank account. The Money Market Fund at your bank or credit union is insured. The Money Market Fund at your broker is not insured. Keep that in mind. If you don’t know if your fund is insured, ask.

Bond Mutual Funds buy, sell, or hold bonds to maturity. The name of the fund will tell you what they are doing with your money. There are “investment grade” funds that buy the good stuff. There are “high yield” funds that buy junk bonds. There are funds that buy Treasury Bills, general called Government Funds. There are funds that specialize in tax free municipal bonds, for your taxable accounts. Obviously they don’t belong in a tax favored account like a 401(k). All of these variants are packaged using short, medium, or long term bonds. Again, what they are holding is in the name of the fund. For example, I own shares in an intermediate term tax exempt municipal bond fund.

Most of the action is in equity mutual funds. These are the funds that buy and sell shares of stock. They are categorized by the size of the companies they buy. Typically they are sold as large cap funds, small cap funds, or mid cap funds. If there are no other qualifiers this generally means they are buying U.S. shares. If they are identified as “Global Equity” or “International” stock mutual funds, they are buying shares in overseas markets. They are further defined by geographic region or the state of development of the underlying economies. For example a Developing Markets Mutual Fund might invest in places like Brazil, Russia, India, and China. There are specialty funds that invest in one particular kind of company, like oil and gas. There are even funds that buy, sell, and hold precious metal in a bank vault on your behalf along with shares of mining companies.

Finally there are hybrid funds and life cycle funds that buy all sorts of different investments, both bonds and equities to give you a balanced and diverse portfolio without requiring you to make any further decisions once you put your money down.

There are many reputable mutual fund families. However, before you buy be sure to compare what you are considering with the comparable offerings from Vanguard and Fidelity.

Good luck

And—“Let’s be careful out there.”

Capital Stock, Common Stock

There is really only one place the average American can save for very expensive long term goals like a college education or retirement, stock markets. While it is very important to maintain an age appropriate cushion of bonds, Certificates of Deposit (CD), and cash to protect against market crashes, most of the growth in your investment portfolio will come from shares of stocks. You may choose to hold these equity instruments as shares in individual companies, in mutual funds, or their younger cousins Exchange Traded Funds (ETF).

In this blog, I have never tried to answer the question, “What is a stock?” as I expected that my readers already knew the answer. However, let’s take a minute to define exactly what it is that we are buying and selling.

In Wikipedia, I learned that the Roman Republic had the first stock market, at least in the Western world. Groups of individuals would join together to lease the right to provide different kinds of services controlled by the Government. They were called publicani or societas publicanorum. They issued shares to the owners. Polybius, a Greek historian notes that almost every citizen participated in owning some portion of these government leases. Cicero complains that some of these shares sold at a very high price. Some things never change.

After the fall of the Roman Empire, stock companies did not really take off again until the creation of the Dutch and English East India Companies around 1600. Prior to this only national governments or very rich families could afford to build ships that could participate in the very lucrative trade with the orient. Now both small and large amounts of money could be pooled into potentially profitable ventures. Shares in these enterprises could be bought and sold in open markets, increasing the liquidity of a nation’s wealth and hence the velocity of money as it moved through the underlying economies. These innovations made England and Holland the economic superpowers of the day. Stock companies shifted wealth and ultimately political power away from the feudal nobility into the hands of the rising middle class. I believe that this shift also fueled the Protestant Reformation. The ebb and flow of money generated by profitable corporations continues to fuel the wealth of the world, as well as the growth or decline of the political and military power of nations.

A share of stock (properly called capital stock) is an equity instrument that gives the owner a “piece of the action.” That is they own a portion of the company based on the total number of shares issued by the company. In the case of common stock, the owners possess voting rights to elect the board of directors, as well as certain other rights specific to that particular company.

There are two reasons to buy stock, capital gains and dividends.

When you purchase a share of stock you hope that it will go up in value. Most likely it will go up in value if it becomes more profitable. A little company is more likely to become significantly more profitable in a shorter time period than a very large company. The small company is more likely to go bankrupt than an ancient multinational giant like Exxon. Generally speaking the giants are slow moving but safer. Normally big wins come from small companies. A properly balanced portfolio needs both kinds of shares. Over time, the value of your shares should increase. The term for this growth is capital gains.

Dividends are your share of the profits. Not every company pays a dividend. Small, new companies need to plow their profits back into growing the business. Once established and profitable a company should share its money with its owners. Typically, once every three months, your company will cut you a check for the dividend multiplied by the number of shares that you own. This is your money. You can keep it, spend it, or invest it in something else. You can also choose DRIP (Dividend Reinvestment Program). For no cost, you can reinvest your dividends into more shares of the stock that paid you the dividend. This is a very cool way to make the power of compound interest your servant.

Fortunately for you the shareholder, you do not own shares in a corporation in exactly the same way you own your car. Under law, a company is considered a separate legal entity. In fact it is consider a “person” under the law. This means the company can sue or be sued without the repo man coming in the night for your personal automobile. Private companies that are owned by individuals or small groups of individuals can go public. That is they can issue large numbers of shares that are then sold to the general public. This is the big payday that is the dream of every entrepreneur. A publicly owned company can go private. That is a small group of investors can pony up the money to buy out all the shareholders. This decision is usually made by the board of directors with a lot of input from the major shareholders and sometimes with a lawsuit or two.

In the case of bankruptcy, the bondholders and the other creditors will be made whole before the shareholders get anything. If after this “senior” debt is satisfied, the court will supervise the sale of what is left. Once the lawyers are properly enriched, you the shareholder will get what is ever left. In such an instance expect nothing.

These shares are generally bought and sold through your brokerage house accounts or on your behalf by the managers of your mutual funds. It is important to remember that studies have demonstrated that over the course of a lifetime two concerns will prove most important to the outcome of the average investor’s efforts. First, maintaining a properly balanced diverse portfolio over a long time period is more likely to deliver a good result than picking particular stocks at just the right time. Secondly, the cost of brokerage fees, sales commissions, and management fees are enormously important factors in the ultimate growth of your money. Whatever path you choose to follow be relentless in your efforts to control these expenses.

Remember, that while computers, cell phones, lowered brokerage fees, and the Internet have certainly evened the playing field, the big boys will always have the edge. Don’t ever forget they play by a different set of rules.

In the words of the infamous card shark and conman, Canada Bill Williams, “Yeah, the game is crooked but it is the only game in town.”

Now let’s be careful out there!

The TRUTH

I saw an article on the disintegrating situation in Venezuela subtitled, “International Media Asleep at the Switch.” This is simply not true. The financial press has been following this story for months. If you only get information from one source, whether that source is Fox News or MSNBC, you will not be getting the TRUTH, that is the truth, the whole truth, and nothing but the truth. Every writer, every producer, every media titan has an agenda that causes him or to view the world through a series of lens designed to filter out things he considers unimportant or that conflict with his world view.

There will be hugely different stories told about a particular football game by different sports writers who work for different networks or newspapers. Just about the only thing they can agree on is the final score. Controlling the sports news was important enough to the owner of a NFL franchise that he purchased the city’s only sports talk radio station. Fortunately, a competitor opened a new station and hired a few of the commentators who were fired by the NFL owner because they didn’t like the way he was running his team. If this is true for such trifling issues as how football games are reported, think about how macroeconomic issues that effect the entire world will be censored or “spun” by great corporate or Governmental entities that are ultimately faced with their own survival or death based on the outcome of these events.

In writing this blog, I am attempting to find the TRUTH that will lead the readers (that includes me) to financial freedom within a balanced successful life. I am a Christian, so this is a Christian blog, but in the course of my studies I have discovered that the TRUTH about financial freedom works for non-Christians just as it works for Christians. The TRUTH is the TRUTH and the truth will ultimately set you free. I try to learn about anything that might help me and my readers find their own path to financial freedom. I have other biases besides my faith. I am hopelessly old school when it comes to certain subjects. I try to be honest when I know there are other newer ways of accomplishing a goal that I would not consider for myself. For example, there are smart phone aps that provide the subscriber with budgeting software. I don’t own a smart phone. Unless the cost drops significantly, I probably never will. However, I try to refer my readers to material that examines the question of financial freedom through Gen-Y eyes. I Will Teach You to Be Rich by Ramit Sethi, comes to mind.

Examine everything you read, including this blog article. Ask questions like, “Who is this person? What are his political biases? What is his underlying belief system? Why did he choose to write this article or story rather than some other article or story?”

Always study a question that involves your personal financial future from as many different angles as possible. Never limit yourself to one source or even one point of view, especially if that point of view is your point of view. Investigate what the opposition has to say. If nothing else at least understand the motivations of your antagonists. Let me add, that I almost always find that I can learn something, even from authors who largely disagree with my point of view.

Stay open.

Most importantly ask, “What does the author or his organization stand to gain if I accept this story or article as the TRUTH?” Even very reputable personal finance authors have conflicts of interest that go beyond the sale of their books or CD lecture series. Although I hope to change this in the future, so far this ministry has not generated any income. It has cost me quite a bit in time. Recently I discovered that all the mileage I racked up driving to and from classes I was presenting at our church could have been deducted as a charitable gift.

Oh well, maybe next time.

However, what I have learned through the application of logic, the study of the masters, and in the school of hard knocks have all helped me find my own personal pathway to financial freedom. It is my mission to share what I have learned in order to benefit you, my readers.

The Long Put

Here is the “other” conservative method to use options, the long put. Think of it as buying insurance against a sudden dramatic drop in the price of your current holdings.

A put option, commonly called a put, gives the owner the right but not the obligation to sell a given number of shares (100 shares per contract) to the seller of the put at a specified price on or before the maturity date of the contract. In European option trading the contract can only be executed on one specified date.

John is concerned about his shares of XYZ Company. The CEO of the company just died of a heart attack. No one is certain how this will turn out. Everything may go on as before, or maybe things will get worse. John decides to look into buying a put on his 100 shares of XYZ that are currently trading at $50 a share. As before, he purchased these shares at $30 five years earlier. John discovers that he can purchase a put that will guarantee the current price of $50 a share that expires in six months for $.50. That would be $50 to cover his 100 shares. John executes the trade.

Judy, who sold John the put option, thinks it will never be executed. She believes the directors of the XYZ Corporation will promote Snidely Whiplash, current CFO, to the top spot. Investor confidence should then cause the stock price to jump significantly. She is quite willing to take John’s $50 premium to guarantee a share price of $50.00.

Judy was right. She gets to keep the $50. The share price went to $60 a share. John sells his shares making a $3,000 profit less the $50 cost of the premium.

Judy was wrong. The price of XYZ drops to $30 a share on the news that the top job has been filled with the founder’s grandson, a man the market considers something less than the sharpest quill on the porcupine. Judy must buy John’s shares at the $50 strike price when she could have purchased the same shares for $30 on the open market. She loses $2,000 when John executes the put, although she still gets to keep the $50 premium. As guaranteed by the put, John makes $2,000 when he “puts it” to Judy.

As a conservative investor, I can imagine situations that might lead me to buy a put option at a reasonable price to protect myself in an uncertain environment. However, I can’t imagine selling a put unless I was getting an awfully generous premium.

For heaven’s sake, “Let’s be careful out there!”

Covered Calls

I am learning about writing covered calls. It sounds like a good way to generate a little extra income without too much risk.

A call option (call) is a contract for a specified period of time that allows the buyer of the option the right but not the obligation to buy shares of a given stock from the seller at a given price at anytime before the contract expires. In Europe this option can only be exercised on one specific day.

For example, John owns 100 shares of the infamous XYZ Corporation frequently used in these examples. Today these shares sell for $50.00. Five years ago, John bought these shares at $30.00. Believing that the price of his shares aren’t going to do much of anything in the next six months or so, John decides he would like to juice his returns a bit by selling a covered call option on these shares.

John goes to his broker’s website and notes that a call option for a price of $55 a share that expires three months from now is priced at $0.50. This means that one option contract (always for 100 shares) will put $50 in his pocket today. He decides to execute the trade.

Judy is convinced XYZ is going up significantly in the next six months. Being a bit of a gambler, she decides to gain control of 100 shares of XYZ without plunking down the whole $5,000 today. She goes out to her broker’s website and buys a 3 month $55 a share call option.

After three months shares of XYZ sell at $52 a share. The option expires. Judy loses $50. John sells his shares for $52. His profits are $2,200 plus the $50 premium from the option.

After three months shares of XYZ sell for $60 a share. Judy executes the call option demanding her shares at a price of $55. Judy makes a profit of $500 less the $50 cost of the option. A $450 profit on a $50 investment? Not too shabby. John does OK too. He makes a $2,500 profit plus the $50 premium from the sale of the option.

In this scenario, Judy faces a maximum loss of $50. From what I can gather that is what usually happens. I have read that the majority of options are never executed. However, there is no upper limit to her profits if the price of the underlying shares skyrockets.

The only way John can lose money selling a covered call would occur if shares of XYZ really tanks. If he wanted to sell his shares at any time in the next three months, he couldn’t do it unless he went out and bought a similar call option, since Judy owns “control” of his shares. That is not too much of a risk since if the price of the underlying shares was dropping an option to buy shares at a much higher price wouldn’t be worth too much.

John can use this strategy in two different ways. In this example he is selling covered calls to generate a little income from shares that aren’t paying him a dividend. He could also write a covered call in conjunction with the purchase of additional shares of XYZ Corporation, thereby lowering the cost per share of his purchase by $0.50.

John could also sell an option without actually owning any shares. This is called a naked option. This is very dangerous since there is no upper limit to his loss, if the stock skyrockets in price. In fact, it is unlikely that John’s brokerage house would even allow this to occur. You are not automatically granted permission to buy and sell options when you open a brokerage account. If you specifically desire that ability, you must fill out an application requesting specific permission to execute different kinds of option strategies. Based on your net worth (not including your house or retirement accounts) and your experience as an investor, your brokerage house will grant you limited abilities to execute various options strategies.

Playing with options is more dangerous than buying and selling individual shares of stocks or investing in low cost index funds.

One more thing, “Let’s be careful out there!”

The Value of a College Degree (The times they are a changin')

There are many conflicting currents in our society concerning education. Credentials, while still important in some fields such as medicine are declining in value. Competence, with or without credentials is more important than ever, particularly in the IT field. While the cost of higher education has increased at 5 times the rate of inflation over the last 30 years, the best and the brightest are going to the best school that offers them a full free ride. The competition for these students is enormous.

There is a small cloud on the horizon, no bigger than a man’s hand, Internet learning. Georgia Tech is offering a Master’s degree in Computer Science for $6,000 in conjunction with Udacity, a Silicon Valley company specializing in so-called Massive Open Online Courses.

According to an article in the Wall Street Journal, “The upfront costs to create the online lectures run between $200,000 and $300,000, but once those hard outlays have been made the cost per each additional student is minimal.” It is estimated that it will be necessary, “To hire one full-time teacher for every 100 online students as opposed to one full-time teacher for every 10 or 20 students who study on campus.”

I am currently taking a for real 400 level course in personal finance (self paced and not for credit) offered by the Brigham Young University Marriot School of Management. If you can live with the frequent references to the LDS faith, the material is first rate and it is FREE. All the lectures are on video. All the PowerPoint slides are there in PowerPoint or PDF format. It even comes with a 600 page PDF textbook. All for FREE. This material is more complex and goes deeper into more subjects than any of the popular personal finance courses. This should surprise no one. It is a 400 level class from a highly regarded University. We Christians could learn a thing or two from our Mormon neighbors.

The students taking this class will be prepared for life in the real world.

BYU Personal Finance Course

The number of “good jobs” available to Americans of average ability is in a 40 year decline, due to globalization, automation, and regulation. I firmly believe that the two most important skills to have in our post-industrial world are sales ability and entrepreneurial ability. A competent salesman is never without a job. One good salesman can generate jobs for 100 factory workers. That is not an exaggeration. I have seen it with my own eyes. No matter what the condition of the economy, there are always people who can see a need and then invent their own jobs to fill that need. These are the entrepreneurs. Not only will they be able to support themselves, but they will provide employment for future generations of Americans in fields that we can not even imagine today. Neither of those professions requires a high school diploma, let alone a college degree.

The current model is unsustainable. Consider that a BA in English from Furman University now runs around $216,000 for careers that offer a starting salary of $40,975 according to studentreview.com. I have seen lower numbers in other places. Let us assume that our English major could earn an average of $25,000 a year during her first four years after high school. That makes the opportunity cost of that degree $316,000. Add another $19,664 in interest on a 10 year $50,000 student loan at 7% brings the grand total to around $336,000.

The Real AOL Story, Why Small Changes are Important

About a week ago I happened to view a two minute TV news blab on a change in AOL benefits that the CEO, Tim Armstrong blamed at least in part on the extraordinary expenses associated with two special needs babies. One of the mothers of the babies in question went public starting a typical media firestorm. The news story I saw had no content beyond the cry of a very angry mother.

A better understanding of this story is now appearing in the financial press and the blogosphere. According to a Newsweek article “Tim Armstrong’s Golden Parachute Vs the Cost of Distressed Babies” the author notes that Armstrong was specifically hired to get AOL operating costs under control. He has been successful. Under his watch the value of AOL stock has quadrupled. Tim Armstrong is handsomely rewarded for these accomplishments that naturally include layoffs. In 2012 he received $4.25 Million in salary, $2.76 Million in stock awards, and $5.1 Million in option awards. Given the context I assume option awards means performance bonuses. Including some other relatively minor benefits, his total annual compensation capped out at $12 Million. According to Armstrong’s unfortunate statement, “We had two AOL-ers that had distressed babies that were born the paid $1 Million each to make sure those babies were OK in general.”

Armstrong has apologized to the AOL employees and has backed off the proposed change to the company’s 401(k) plan. What was lost in all the brouhaha was the nature of that change. Armstrong was not cutting the size of AOL’s match to employee 401(k) accounts. He proposed changing the match from a per-paycheck match to an end of the year bonus. In a simple example, “Despite AOL News, 401(k) Matches Are Not Changing” from ABC News notes that in last year’s hot market a $1,000 match would be worth $1,245 by the end of the year. If AOL held on to that money until the end of the year they would get to keep $245 extra. If the employee quits before the end of the year, AOL gets to keep all of it. On the other hand such a plan would have saved 40% one year’s contribution in the crash of 2008.

There is one industry where end of the year bonuses have always been the norm, banks. Needless to say employees in this industry tend to wait until they receive their bonus before shuffling down the road to a better job.

How much would this cost the average AOL employee over their lifetime? According to Vanguard the average employee would lose about $50,000 in today’s dollars at retirement. A New York Times article, “Beware the End-of-Year 401(k) Match,” adds, “That buys a lot of trips to see the grandchildren-or scores of nights in a nursing home.”

This is not the first time a major corporation had this cost cutting idea. IBM did it last year. The New York Times article reports that two senators tried to pressure IBM into reversing this decision. IBM said, “No.” Since IBM offers its employees an unusually generous package of benefits including sizable 401(k) matches and the change wasn’t blamed on two premature babies, there wasn’t a lot of press coverage on this story.

I am including a link to the New York Times story because it includes an interactive retirement calculator that allows you to put in your current salary then play with contribution amounts, time horizons, and expected return numbers. This tool will show you that even small changes in behavior will result in very significant results over long periods of time. You will find the calculator about 2/3 of the way down the page.

Have fun with it.

Beware the End-of-Year 401(k) Match

A Brief Exploration of The Art of Giving

You know the story. Actually there are two versions, one is found in Matthew 25: 13-30 and the other in Luke 19: 11-27. They are very similar but not identical.

Here is the basic story.

A rich noble needs to go on a journey. He gives some money to a number of servants to manage in his absence.

The sum of money he gives to each is a measure of his confidence in their abilities.

When the nobleman returns from his journey, he discovers that two more capable servants have doubled his money. They are praised and rewarded. He also discovers that one of his servants just hid his money out of fear. It is returned without gain. The owner is seriously upset with this lazy worthless servant, who is then severely punished.

That is really all you need to know about giving.

1)Everything ultimately belongs to God. Christian or non-Christian, God has entrusted you with certain abilities and physical resources.

2) They are not yours. You are just a manager.

3) You have been given broad discretionary authority to use the Master’s resources in his absence.

4) You will be held accountable for how you used the Owner’s resources that were under your control.

Now you need to answer a question, “Do I want to hear the Lord say, “Good and faithful servant.” Or do you want to be cast into outer darkness where there is weeping and gnashing of teeth?

How do you become a golfer? You go out to a driving range hit a few buckets of balls. Maybe take a few classes from a local professional. Then you go out to the county course and start playing golf. If you do this most every weekend over the next few years, you are a golfer. If you keep practicing you will get better.

Giving is more important than playing golf, but no different. Start giving today. Maybe spend a little time studying the relevant portions of Scripture that cover this topic, listen to a good sermon on the subject. I am sure your pastor would be glad to help your exploration of this topic. Then, of course, pray.

It doesn’t matter if you are rich or poor. Giving is a measure of what is in your heart, not what is in your bank account.

You are not only accountable for what you give. You are also accountable for where you give. Do you think God will be happy to learn you gave his money to some scam charity? You are responsible for doing due diligence for every penny you give to God’s work.

Christians disagree on how much to give or where to give. I come down on the freedom and grace side of the argument. This is a discussion between you and your God. In my personal experience, the answer to the question, “How much?” has always been, “More,” but then I am a bit of a penny pincher. Ask God about this very important aspect of your personal financial plan.—Today. Listen to his answer.

Although I believe that ideally our giving should be out of a heart of gratitude and love rather than for an expectation of return, I must note that so far I haven’t been able to out give God.

The Roth IRA

During the course of one year Sally and Joe both save the same amount of money towards their retirement, investing identical amounts in identical funds. Sally puts her pre-tax money into a 401(k). Joe puts his after tax money in a Roth IRA. At the end of the year they both retire and withdraw all of the money from their accounts. They have exactly the same amount of money. Why and when should you use a Roth IRA comes down to your perception of your future Vs current tax liabilities. If you think your taxes will be higher today, during your peak earning years, the 401(k) gives you a lower taxable income today, when it will give you the most good. If you plan on becoming an evil rich person in your old age or if you believe that your income tax rates will increase over time then it is better to put your money in a Roth IRA, where the Government will allow you to use that money, tax free, forever.

Always! Always! Always! Take the free money first! If your employer offers any matching money with a 401(k), always take that money and run. You simply can not beat a 100% instantaneous tax preferred return on your investment.

Once you have the free money, think about the Roth IRA. Since you will be investing after tax dollars in the Roth, you won’t be getting any tax deduction today, but income and capital gains generated by this account will never be taxed. You will receive a tax deduction today for anything that you deposit into your 401(k), but when the time comes to withdraw that money in your old age, you will be taxed at whatever your current rate might be at that future time.

There is another advantage to the Roth IRA. You can withdraw your contribution at any time and for any reason without penalty. After a 5 year seasoning period or after age 59 ½ you can withdraw any income or capital gains from this account without penalty. Don’t do it. This money is for your retirement, not a down payment on a larger home. Also, the tax laws may have changed in the 2 hours between the time I write this and the time you read it. Always check any move that might have tax consequences with your accountant before pulling the trigger.

Never withdraw money from you 401(k) prior to retirement. It is just too costly and dangerous. A withdraw from a 401(k) is a loan that must be repaid. If it is not repaid the money will be taxed at your current rate and you will be hit with a 10% penalty. This is true even if you lose your job while repaying a loan from your 401(k). Too many young couples roll the dice on this one. It just isn’t worth the risk.

Contributions to the Roth IRA are limited. When the Roth came on the scene it was too little ($2,000 a year) and too late (age 50) to do me much good. My wife and I do have small Roth IRAs but they aren’t worth much of anything. Current limitations are $5,500 per spouse if age 49 or below and $6,500 if age 50 or above. This number is big enough to be of significant value to younger Americans. Starting with an $11,000 deposit, then continuing to deposit $900 a month throughout a 40 year working life will leave this young couple with an outrageous $2,180,000 tax free dollars when they retire, assuming a very realistic 6.5% return on their investments.

Current income limits are $112,000 for a single filer or $178,000 on a joint return. After that the limit on contributions drops.

The biggest argument against the Roth IRA is the difficulty in saving after tax dollars. If properly done, most families will never miss the pretax dollars that go into a 401(k). Taking real after tax money out of your hand and putting it away for some future day is a lot harder, particularly if you need it for the mortgage payment today. Of course you can automate a contribution to your Roth IRA, but remembering to debit your check register every month is only going to be a little less painful. This is one of those know thyself moments. If you are not the kind of person who is likely to save after tax dollars the Roth IRA is not for you.

You can convert a traditional IRA to a Roth IRA. Generally this is not a good idea, but it can be used to reduce your taxable estate. If you don’t think you will be needing that money in your traditional IRA during your lifetime, you can convert. You will pay income taxes on that money, but the size of your estate will be reduced by the amount you paid, thus avoiding any inheritance taxes on that money. Now your money can grow tax free forever. Your heirs can take money out of this account without paying any taxes. Essentially, you have prepaid your heirs’ taxes. You have given them what would normally be considered a taxable gift, without any tax consequences. Please, don’t try to play these games without the advice and counsel of your CPA, estate planner, or attorney. These rules are Byzantine in their complexity and they change constantly. Unless you are an expert, leave this one to the experts.

Whether you choose to put your money into a Roth IRA, a 401(k), or both make certain that you are paying the lowest possible fees on your money. Avoid retail mutual funds sold by a commission sales person or managed accounts that charge 1% or more per year. Since this is patient, long term money use low cost index funds such as those offered by Vanguard, Fidelity, or Schwab. You don’t need to be sending your financial advisor’s daughter to the private university of her choice with your retirement dollars. When I first discovered Roth IRAs, I invested my money with one of these so called financial advisors. I lost money in what this person described as a conservative value fund, an almost impossible feat given the market performance over the years I held those shares. However, I noted that the broker received her commission and gained even as I lost money. I later learned that this particular fund was one of the worst in America and it came loaded with 12B-1 fees. Anyone who attempts to sell you anything with 12B-1 fees is not your friend.

The rules of the game are constantly changing. What if Congress decides to tax Roth IRAs or convert your 401(k) to a Government mandated annuity to bolster the Social Security system? Just one more thought to make sure you vote in the next election.

Time

I have spent a fair amount of time and effort exploring various methods of living on a budget from just checking your net worth on a monthly basis to the full formal zero balance monthly budget. However, none of these options plan or track how you expend your most precious resource, time.

A child and an old man, a millionaire and the penniless are all given the same number of hours in a day.

Within limits, we all have the freedom to expend our time as we see fit. Life has its seasons, live them to the fullest. In your twenties it is time to conquer the world. It is time to get married and start a family. Live those years with the passion and strength of your youth. You won’t get another chance. As we enter our thirties we become men and women with responsibilities, not just to our children but to our larger communities, workplace, church, city, nation, world. It is time to shoulder those responsibilities that were only implicit in our earlier decisions.

The middle years pass by as a dream. Between the ages of forty and sixty, hopefully we will find mastery in who we are and what we do; even find a way to work less because we know more. Men and women become pillars of their community giving form and order to the world we inhabit. As the middle years wane, we discover we are not only are responsible for the next generation and the larger communities, but we find that we must take responsibility for the care of parents, as that generation declines before departing from the world.

At some point it becomes time to examine our life, not what we have accomplished, but our legacy, what we are leaving to better others and the world we inhabit. What fruit will our lives produce once we are gone? Plant good seed in good soil your harvest will be thirty, sixty, a hundred times what you have planted.

But what have you planted? Your harvest will consist of the same seeds that you planted forty, fifty, or even one hundred years before.

Lao Tse Quote:

“Watch your thoughts; they become words. Watch your words; they become actions. Watch your actions; they become habit. Watch your habits; they become character. Watch your character; it becomes your destiny.”

We are spirit. We have a soul. We live in a body. I am a Christian. I have a particular understand of these words, but my understanding isn’t what is important. What is important is how you choose to nourish the different aspects of your life. If your checkbook and your credit card statement are window to your soul, what would the past years of a completely accurate cosmic day planner say about your life your values? I don’t think I want to look at mine. Personally, I am glad I have a Savior.

Let’s start with the body. You need to sleep, at least eight hours a day, for most of us. I neglected this important need for many years. If a 21st century urban American runs out of time, sleep will be the first sacrifice offered on the altar of something else. How much time do you spend on your diet? For most of my adult life I haven’t invested enough time in food. That sounds funny doesn’t it? But it is the truth. I have eaten too much fast food as well as too many questionable dinners that came out of a microwave. I am doing better but I still have a long way to go. Then there is exercise. Something else I neglected for twenty years or thereabouts. I am doing better in retirement. Finally, consider how much time you spend in a toxic environment. If your job is killing you, it is time to find a new job, really. I am not kidding.

Take some time to examine how you expend time to benefit your body. Are you allowing enough time to meet the needs of your body? If exercise and diet have not been a priority for too many years, it is time to reconsider your lifestyle while you still have a life.

I choose to define soul as mind, will, and emotions. Are you a lifetime learner or are you one of the 33% of Americans who never read a book after they graduate from high school? It doesn’t surprise me that only 15% of America’s prison population is literate. Invest in yourself. Learn a new skill. Take a class at the local community college. Are your habits contributing to your growth; to your value as a human being? It isn’t all about money. Learn how to dance. Learn how to paint a picture or take a photograph. Are you learning how to use your emotions to bless others, or are your emotions a curse? Spend the time necessary to understand yourself.

Sun Tzu Quote:

"It is said that if you know your enemies and know yourself, you will not be imperiled in a hundred battles; if you do not know your enemies but do know yourself, you will win one and lose one; if you do not know your enemies nor yourself, you will be imperiled in every single battle."

Is that all there is to life? I think somewhere in our hearts we know there is more than we can see or feel. Our five senses and our mind are limited often inadequate tools for the study of the cosmos and eternity. Somehow we just know there is something else that is hidden, invisible, just beyond our reach. How did all this stuff get here? What happened before the Big Bang? How do I discern good from evil? Spend some time contemplating the questions that can not be resolved outside of faith. There is a point where scientist, historian, or believer is best served by stating, “It is a mystery,” or “I don’t know.” That is the time to raise your hands and bless God who created heaven and earth and all the mysteries they contain. As you experience the transcendent, the beauty of the heavens; the touch of a lover; the joy of discovery in a child’s eyes, know that there is more to life than can be captured in a net of words. Stop. Become silent before your Creator. Do you invest your time studying and building treasures that we will carry into eternity?

If you have spent your money unwisely, you can always find a way to earn more. If you have spent your time unwisely, it can never be recovered.

Omar Khayyám Quote:

“The Moving Finger writes; and, having writ,
Moves on: nor all thy Piety nor Wit
Shall lure it back to cancel half a Line,
Nor all thy Tears wash out a Word of it.”

Bonds 101

Basically, a bond is a loan. When a company or a government offers a bond to the public, they are asking you to give them money—today. In exchange they are giving you a financial instrument that will pay back the same amount when the bond reaches its maturity date. Along the way the bond will make clearly defined periodic interest payments to the bond holder. This is called the “coupon.” Back in the day, when it was time to collect the quarterly interest payment, the bondholder literally took out a pair of scissors and cut the coupon off the side of the bond. He would then take his coupon to the appropriate financial institution and exchange it for cash.

Maturity is generally categorized as short, medium, or long term. Depending on the type of bond and who is doing the defining short could mean less than three years to less than six years. Medium could mean anything from three to twelve years. Long term could start as low as five years or as high as twelve years. There are even “Perpetuals” that never return the principal. What kind of interest rate would you ask for if I told you I was just going to give you an interest payment every three months, but I was never going to give you your money back? Hmm….

When you buy a bond, you must first consider how much money you wish to place at risk. In this example, let’s assume you want to buy a $10,000 bond with a ten year maturity date. That means ten years from the date of issue, you get $10,000 back (maybe). At this point you need to consider how likely it is that the bond issuer can fulfill his promise. U.S. Treasury Bonds are backed by the “full faith and credit” of the United States of America. As long as our Government owns the printing presses, you will get your money back. How much that $10,000 can buy ten years from now is another question. The last rating I can find for the City of Detroit is CC, deeply in the “junk bond” category. I expect it has dropped further since the city slid into bankruptcy.

There are five rating agencies that can rate your bonds. This power is authorized by the Federal Government. It was grievously misused by the rating agencies in the subprime meltdown of 2008. Hopefully, we have learned our lesson from that fiasco.

With that warning in mind, here is the letter ratings used by Standard and Poors, probably the best know of the rating agencies.

‘AAA’—Extremely strong capacity to meet financial commitments. Highest Rating.

‘AA’—Very strong capacity to meet financial commitments.

‘A’—Strong capacity to meet financial commitments, but somewhat susceptible to adverse economic conditions and changes in circumstances.

‘BBB’—Adequate capacity to meet financial commitments, but more subject to adverse economic conditions.

‘BBB-‘—Considered lowest investment grade by market participants.

‘BB+’—Considered highest speculative grade by market participants.

‘BB’—Less vulnerable in the near-term but faces major ongoing uncertainties to adverse business, financial and economic conditions.

‘B’—More vulnerable to adverse business, financial and economic conditions but currently has the capacity to meet financial commitments.

‘CCC’—Currently vulnerable and dependent on favorable business, financial and economic conditions to meet financial commitments.

‘CC’—Currently highly vulnerable.

‘C’—Currently highly vulnerable obligations and other defined circumstances.

‘D’—Payment default on financial commitments.

Note: Ratings from ‘AA’ to ‘CCC’ may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the major rating categories.

The market price of the bond is driven by maturity date, coupon rate, rating, and the prevailing interest rate. Consider, the current rate on ten year treasuries is 2.68%. In 2013 the “junk bond” index returned 7.4%. During the darkest hours of 2008 the junk bond index went over 21%! At the same time the 10 year Treasury paid 2.3%.

Once a bond has been issued, it can be bought and sold just like stocks. Here is the important rule for pricing bonds that is usually answered wrong on financial literacy quizzes.

When the prevailing interest rate goes up, the value of a bond goes down.

When the prevailing interest rate goes down, the value of the bond goes up.

Think about it. If you can get a return of 5%, are you going to pay full face value for a bond that only pays 3% or are you going to ask for some kind of discount? Maturity date also sneaks back into this calculation. There is less risk if my money is going to be returned in six months than if I won’t get it back for six years. I would expect a larger discount on a ten year bond with six years left to maturity than a ten year bond with six months left until maturity.

When the dust settles, what you are really buying is yield. Current yield is the annual interest payment divided by the current market price of your bond. There are more complicated methods of calculating yield, termed yield to maturity or redemption yield that considers maturity and the actual timing of coupon payments.

Bonds are considered a “senior” security. That means, as a creditor, the bond holder gets paid before anyone else. In good times bondholders are to be paid before shareholders get their dividends. In bad times the bondholder should be given absolute priority in bankruptcy proceedings. As the song says, “It ain’t necessarily so.” During the GM bankruptcy the executives and the unions that wrecked that once great American icon received their golden parachutes, pensions, and healthcare. The bondholders got nothing. That isn’t supposed to happen, but it did.

Be careful. Not all bonds are considered “senior.” There are also subordinated bonds that are considered “junior” securities. That means they get paid off after the senior bondholders are made whole. Needless to say these bonds carry a lower rating and provide a higher yield than the safer, senior bonds.

Bonds are also sold with various options that can affect their market price. Some bonds are “callable” meaning that either the bond issuer or the bond holder has the legal right to call the bond at specific times or under specific conditions. If a bond issuer thinks he will be able to get a better interest rate sometime in the future he might issue a bond today that allows him to repay the principal before the stated maturity date. The market will take that into consideration when pricing the bond. Sometimes bonds are issued that allow the bondholder to convert the bond into shares of stock at some predetermined price at sometime in the future rather than getting his principal back when the bond matures. If you are a billionaire investor discussing the future of a basically sound company that has fallen on hard times, you might find such an option quite appealing.

Generally speaking individual bonds (other than Treasuries) are somewhat illiquid. If the owner of a Fredrick County Water and Sewer Bond needed to sell before the bond’s date of maturity, it might be difficult to locate a buyer unless the bond was sold at a discount. For this reason individual investors are better served by investing their money in low cost bond funds. These funds are highly liquid. They can be sold at posted, well understood share closing price on the day of the transaction. The money will then be available for the investor to spend in no more than a few days depending on the rules of the fund.

The problem with bond funds is interest rate risk. Unlike individual bonds, you are never out of the game with a bond fund. There is no maturity date to a bond fund. When one bond matures the fund managers use the money to buy more bonds. While these funds are frequently categorized by bond type, quality and length of investment term, their price (like individual bonds) moves inversely with changes in interest rates.

Starting to Save

So, when do I start to save? Generally speaking, if you are alive you should be saving for something. In retirement that might take the form of not spending for some greater good, but if you are planning to be alive tomorrow or if you are thinking about those who will be alive tomorrow after you’re gone, think about savings.

As I thought about this question, I concluded the savings habit should begin as soon as a child has the maturity and understanding to connect money to desirable outcomes. For most of us I would guess that happens sometime around 4 years old but certainly before 6 years have passed. I can remember quite distinctly the first time I discovered I could buy what I wanted if I had money in my little plastic cowboy wallet. We were on a family vacation on the Outer Banks of North Carolina. There was a little snack stand near our motel. I discovered that I could exchange nickels and dimes for Cokes and candy bars. That would have been the moment to begin teaching me how to save. My parents did not believe in giving me an allowance. I believe that was a mistake. I think parents should use an age appropriate allowance as a teaching tool. Teach your children to give and save. I expect they will not have any trouble learning how to spend. If you want more of a particular kind of behavior in your children, reward it. As your children learn to save for larger purchases that can not be bought with a week’s allowance, encourage them. I would suggest adding a bonus to any “long term” money, first in a jar or a piggybank, later some time during the grade school years, in a simple savings account at the local bank. How much? Well they’re your children, you decide. I think 10% is too little. Maybe 100% is too much? How about matching 50 cents on the dollar for any long term savings your children manage to put aside for a major goal, like a really cool videogame?

While I do not believe in buying a child a car or paying for their insurance, I do believe in subsidizing and encouraging thrift and part time jobs as they move towards buying a used car, likely their first major purchase.

Generally, when people ask me this question, they are not thinking about their children. They are more likely concerned about some particular issue that is bugging them. While I have discussed these issues individually and at considerable length in previous posts, let’s consider a general order of priority for a typical family as well as a general approach to starting any saving program.

First, consider any exception to the rules that might make sense in your particular case. Some companies offer matching money for the first 3% or so that you contribute to your 401(k) account. For heaven’s sake take the free money. 3% of your before tax income is not going to significantly effect your ability to pay bills. There is simply no way you can beat a 100% guaranteed instantaneous tax preferred return on your investment.

Generally speaking this money is even protected in bankruptcy as long as it remains in your 401(k) account and it has not been pledged as collateral in any kind of a loan. Of course there are exceptions to this general rule. The Internal Revenue Service can go after your 401(k) for back taxes. Certain states have certain rules that might allow creditors to go after your retirement under unusual conditions. If you are in that kind of trouble you need to be talking with an attorney.

Especially, if you are fighting credit cards or some other form of ugly debt, if you don’t have an emergency fund start one today. I can’t say this often enough, “If you don’t have at least $1,000 in an emergency fund, consider that an emergency.” Do whatever it takes to get an emergency fund started. That includes selling your motorcycle or taking a temporary part time job. The final goal is six months take home pay in an insured money market or savings account at a bank or a credit union. It will take a long time to reach this goal, but as long as you are headed in the right direction, you’re OK.

There is another question that is just as important as, “When?”

That would be, “Why?” If you have a really important why in your life that will give you the answer the other question, “When?” A powerful why will also provide you with the motivation that is necessary to lead to a successful outcome.

Of course, pay off your ugly debt before starting any savings program beyond the emergency fund and the free money exception.

Once families are left with only an affordable car payment and some student loans they tend to start thinking about a home of their own. Maybe they should work on those student loans before they think about a mortgage? However, a home of our own is in the genes. It is harder today because young families need 20% down to avoid the dreaded Private Mortgage Insurance (PMI). That is a tall order. As always there is more than one way to skin a cat. Many states offer very generous plans to help first time home buyers. These mortgages can with down payments as low as 3%. They also can offer a break on mortgage rates. Owner financing, typically a five year note with a balloon payment at a higher interest rate, can give the young buyer five years to worry about building a down payment for a conventional loan.

In an ideal world, you should be constantly saving for known but infrequent expenses such as family vacations and new cars. You know you want to go to Disney World in six months. You estimate this trip will cost somewhere in the neighborhood of $3,500. Divide the total cost by six months. You need to save $580 a month to make it to Disney World on time. If you can’t pay cash, you can’t go to Disney World. End of story. Please, pay cash for cars. You won’t regret it. The day you buy a different car, pay yourself a car payment. When you have the money saved for a better car, buy yourself a better car. You may find this hard to believe, but it will not take many iterations of used cars before you are driving a late model low mileage cream puff or paying cash for new cars, if that is what you really want.

Here is something I want you to think about before you buy into the notion that you have to be a debt slave. It takes more sacrifice and discipline to pay off a loan that it takes to pay cash. Consider a $15,000 car. If you make car payments to yourself in 48 months you can pay cash if you $312.50 a month. That assumes no interest. If you can find 2.5% (not an impossible feat) $300 a month for 48 months will give you $15,459.58. If you borrow $15,000 for 48 months at 10% for that car, you will pay $380.44 a month for 48 months. That totals out to $18,261.12. If you don’t submit to this discipline, the repo man will come in the night and haul your car away.

Which path is harder? Do I pay myself $300 a month or do I pay a bank $380 a month? The choice is yours.

Let me share three secrets to successfully start and continue any savings program.

1) Start small. Whenever you begin a new savings program, start with a small amount that you are certain you can continue even if something goes wrong. While 15% of your pretax income into tax preferred retirement plans is your ultimate goal that is not a good starting point. It is almost certain that if a young married couple starts at that level something will happen that cause them to fail. If they start at 3% to capture what is offered by the company’s matching program, it is unlikely they will ever miss any of that money.

2) Make slow incremental increases. The next time you get a raise, bump that contribution to the 401(k) by 1%. After 10 more raises that you might get over the next ten years, you will be at 14% of your pretax income into tax preferred retirement plans.

3) Automate. Make your savings automatic. This is particularly important for retirement, the longest goal of all. If you never see that money, you aren’t going to miss it. This extends to any savings program. If you only need to make the decision to save one time you are more likely to succeed than if you have to decide to save every single month. Also the less you have to remember on a monthly basis the more likely it is that you will succeed.

Living on a Formal Budget (Part II)

OK: Here we go! Our hypothetical young person from the section on the Lazy Man’s Budget has decided to hear my advice. He is going to try to live on a budget, so he can save for some desirables, like vacation with his girl friend who lives in another city.

This example is intentionally simple. If you have a husband or a wife, children, and a home it will get more complicated. The object is to keep it as simple as possible as long as it captures every penny in categories that make sense to you. For example, you may want to include makeup, deodorant, shampoo, and such things along with prescriptions in the drug store category rather than breaking down your receipt into two or three categories. However, if you buy your cigarettes at the grocery store, by all means separate that expense out of your food budget into a separate line. The purpose here is mindfulness. A budget, properly organized, will allow you to quickly determine where you are spending your money. If you are happy with the results, good! If you are unhappy, you will know what you need to change.

Here is where we left the young person. His take home pay was $2,000 a month. His quick and dirty budget told him he was too close to the edge.

$500 Rent
$150 Electricity: If your bill in December was $130 it is a safe bet that it will be higher in January.
Water: Included in the rent.
$300 Car Payment:
$130 Gasoline:
$25 Minimum Credit Card Payment
$35 Cable TV
$125 Cell Phone: Unlimited Data Plan
$300 Grocery Store Food:
$100 Restaurant Food and Beverages:
$100 Clothing Allowance

Total: $1,765
Allowance: $1,400
Difference: -$365

Since last time our example; let’s give him a name; Jim has received a raise. His take home pay is now $2,080 a month. In addition, he is looking for overtime. His willingness to work odd hours to cover for absent or tardy coworkers is adding an extra $100 a month, but this is money that is not guaranteed.

In addition Jim wants to start three envelopes, give something to the homeless shelter located a couple of blocks down the street from his apartment, and build his savings.

How does his first attempt at a budget appear?

$2,080 Take Home Pay

$208 Emergency Fund
$20 Charity (Hey, it’s a start.)
$208 Contingency Fund

That leaves him $1,644. He knows that isn’t going to be enough, so we back up and try again.

$108 Emergency Fund
$20 Charity (Hey, it’s a start.)
$108 Contingency Fund

Now he has $1,844.

$500 Rent
$150 Electricity:
$0 Water: Included in the rent.
$300 Car Payment:
$130 Gasoline:
$25 Minimum Credit Card Payment
$35 Cable TV
$125 Cell Phone: Unlimited Data Plan
$300 Grocery Store Food:
$100 Restaurant Food and Beverages:
$0 Clothing Allowance

That leaves him with $179 after covering the basics.

Jim has a credit card balance of $800. He also has $600 in savings. He wants to start envelopes for car repair, insurance ($1,200 auto and renters), and vacation.

He knows he needs to start an envelope for insurance that is going to take $100 a month. That leaves him with only $79. He wants to put $30 a month into the car repair envelope, so he is left with $49 for vacation.

Jim knows there is a good chance he will take home an extra $100 in overtime. He can plan for that money in his basic budget, but he can plan on how to use it if he gets it. His decision is to split any overtime between vacation and paying down that credit card. Of course, I would go after the credit card balance before planning a vacation, but this isn't my budget. It is Jim’s budget.

After carefully accounting for every single penny expended, here is how the month worked out for Jim.

$2,080 base pay + $80 in overtime

$108 Emergency Fund (New Emergency Fund Balance $708)
$20 Charity (Hey, it’s a start.) Spent as planned
$108 Contingency Fund

$500 Rent: Spent as planned.
$150 Electricity: Actual bill $140. Difference $10 Jim put on some more clothes so he could turn down the thermostat.
$0 Water: Included in the rent.
$300 Car Payment: Spent as planned.
$130 Gasoline: $150 actual. Difference -$20. A refinery in Texas burned down causing a spike in fuel prices.
$25 Minimum Credit Card Payment Spent as planned.
$35 Cable TV Spent as planned.
$125 Cell Phone: Unlimited Data Plan Spent as planned.
$300 Grocery Store Food: $290 actual Difference: $10
$100 Restaurant Food and Beverages: $150 Actual--Difference: -$50 Whoops!
$0 Clothing Allowance $0 Spent

$100 Insurance Envelope New Balance $100
$ 30 Car Repair Envelope New Balance $30
$ 49 Vacation Envelope New Balance $49

In this example Jim had to take a total of $50 out of the Contingency Fund to cover the Super Bowl party at the local sports bar, leaving a balance of $58 at the end of the month.

Question: Where does this money go?

Answer: Anywhere Jim wants it to go. It is his budget. He is a little worried about only having $100 in the Car Insurance Envelope so he decided to raise that to $158 with the leftover money.

Leftover money? What a concept!

$80 in overtime was split as planned.

$40 went along with the $25 minimum payment lowering the credit card balance to $735. $40 went to the vacation envelope raising that total to $89.

Conclusion and Proof

When you start out try to keep this process as simple as possible. The less effort required in the beginning the more likely it will be that you will continue to live on a budget. Be honest, remembering the proof is in the pudding. If your net worth increases at a regular and acceptable rate your budget is working. If you net worth is decreasing, what you are doing is not working.

Living on a Formal Budget (Part I)

I don’t really enjoy writing about the formal budget. No one wants to hear about it. I am fortunate. For most of my life I haven’t lived on a written formal budget. I got away with it because of the way I was raised and because I was blessed with a mind that could juggle a lot of numbers without writing anything down. Over the course of my life, I have spent a lot of time worrying about money, checking my bank balance, projecting what would be required to pay an infrequent bill (like biannual car insurance premiums) as well as attempting to control power bills with a thermostat. When all was said and done I am not sure that I spent any less time tracking my income and outflow than I would have if I had used a formal budget.

Before we get into the nitty-gritty details, ask yourself the question, “Why would I want to live on a budget?” The answer is your goals, the life you want to lead. The answer is freedom. Any good thing requires the sacrifice of something that you perceive as less valuable. I read an article written by Peggy After, a 47 year old mother and cancer survivor entitled A Black Belt is a White Belt who Never Quit. What did it take for a 47 year old woman to earn a black belt in Muay Thai Kickboxing? They don’t give those things away in cereal boxes. What are you willing to sacrifice to achieve your life’s ambition, whatever that might mean to you?

Money In = Money Stored + Money Out

Once again consider the money equation. This equation integrated over a lifetime is all the mathematics there are to the story of your money. The “Zero Based Budget” more properly called the Zero Sum Budget looks at two components of the money equation on a reoccurring monthly basis, Money In and Money Out.

At the end of the month, Money Stored will absorb Money Out that was allocated but not expended, building special purpose funds for infrequent events from vacations to car repairs.

For most of us Money In is a predictable number that reoccurs on a weekly, biweekly, or monthly basis. We call it our paycheck. For those of you on straight commission or if you live on tips, estimate that number. Then adjust it to match reality as the month progresses.

Write this number down on the left hand side of a piece of paper, or in the appropriate blank in a monthly budgeting form or enter it into the appropriate box on a spreadsheet or your budgeting software.

On the right hand side of the piece of paper write a list of everything you can imagine that will require some of your money over the course of the month. Be sure to include lines for savings, giving, and a line for contingencies. At the end of the planning process, as well as the end of the month the sum of the numbers on the left hand side of the paper will exactly match the sum of the numbers on the right hand side of the paper. These two sums, when added together will equal zero. Hence, the name Zero Sum Budgeting.

Always start with savings.

Every personal finance author I know anything about tells their readers, Pay yourself first.” Most recommend 10% of your take home pay goes into savings before the first penny. It may be difficult to start with that number but give it a try. Until you reach a full six months take home pay in an emergency fund your savings will be building a safety net for you and your family.

There is an evolution how budgets might work as a student of money management progresses through life. Consider a typical emergency, a $1,000 car repair. They happen.

Before living on a monthly budget, this kind of event could constitute a serious emergency resulting in a visit to a credit card, or something worse like a payday loan company. A loan from an 18% credit card paid back at the rate of $200 a month would result in six months of payments, $1,200. At such a time in a person’s life this could constitute a very serious problem.

After building even a $1,000 emergency fund, a thousand dollar emergency while quite unpleasant and painful only costs $1,000.

After living on a budget for a time, our student simply goes to the auto repair envelope, a real envelope or a virtual envelope in a large single bank account. When the time comes, the money is there. The emergency has no effect on the monthly budget whatsoever.

Finally, after years of consistent effort, the mortgage payment is gone. Faced with a $1,000 repair bill, the unfortunate car owner shrugs their shoulders and thinks, “Well, a little less is going into savings this month.”

You can get there. Step by step. Year after year. You can improve your financial condition and your life.

Giving

It doesn’t matter if you are a Christian, a Buddhist, a neo-pagan, or an atheist. If you are a human being living on this planet, you need to be a giver. Take a moment as you plan your finances at the beginning of each month to thankfully reflect on all you have received from the Lord, the universe, or whatever you believe is the source that has given you life. Then offer a portion of these blessings to benefit the other beings with whom you share the earth. Do this before you spend the first penny on yourself.

I will not tell you how much to share or where to give. I am a Christian. I believe in a religion of freedom and grace. I have learned that the ability to give is a gift from God as well as a spiritual discipline. As you learn to exercise this muscle, I believe that you will discover that you can not out give God. I am not going to discuss conmen who would cheat a widow out of her Social Security check. I am asking you to look deeply into the needs of others both in your city and the world. When you are convinced that the money entrusted to you is going to be used wisely, be a blessing in this unhappy world. You will not regret it.

No Matter Who You Are, No Matter What You Believe, Giving is Important.

Jesus Quote: (Luke 12:33)
Sell your possessions and give to the poor. Provide purses for yourselves that will not wear out, a treasure in heaven that will not be exhausted, where no thief comes near and no moth destroys.

Siddhartha Gautama quote:
"If you knew what I know about the power of giving, you would not let a single meal pass without sharing it in some way."

Al-Tirmidhi, Hadith Quote:
The Prophet also said: "Give charity without delay, for it stands in the way of calamity."

Confucius Quote:
"He who wished to secure the good of others, has already secured his own."

Winston Churchill Quote:
“We make a living by what we get. We make a life by what we give.”

Chief Seattle Quote:
“The earth does not belong to us. We belong to the earth.”

The Contingency Fund

There is a third component to fund before actually beginning to plan your expenses, contingencies. As you learn to prepare and live on a budget, you will make mistakes, big ones and little ones. The contingency fund is your first line of defense. If you estimate your power bill at $130 and it comes in at $150, where are you going to get that extra $20.00? Just lower the number in the Contingency Fund by $20.00. Move it to the line for the power bill. Pay the power bill. End of story. Say you spend all this month’s allowance for restaurants when an old friend unexpectedly shows up in town on a business trip. If there is still money in the contingency fund, you can still meet him for lunch at your favorite restaurant. By the way, lunch with your buddy does not rise to the level of an emergency. If the contingency fund is empty, meet him for lunch in the park with a brown bag and a thermos bottle in your hand.

How much to put in the Contingency Fund? Try starting with 10%. I expect you will need to whittle that number down the first time you try to prepare a budget.

The Envelope System Revisited

Back in the day, before rural electrification was an accomplished fact; before every home had a crank telephone hanging on the wall; there was a simple foolproof family budgeting method, the envelope system. Not everybody had a checking account. No one had a credit card or a debit card. They hadn’t even been invented at that point in time. Electronic debiting on the Internet didn’t even exist in science fiction. Most people paid for just about everything with cash. Vestigial remains of this simpler time can still be found in American churches. The numbered offering envelope made perfect sense when everyone used cash. The church treasurer could tell the difference between the Homer Smith’s five dollar bill and the Barney White’s five dollar bill. It isn’t all that many years ago that Henry Ford shocked the world with his generosity by offering his employees $5.00 for a days work. A five dollar bill would have probably been a special one time offering.

With so many expenses, credit cards, utilities, car payments, mortgage payments, taxes, stores, and service stations an old fashioned cash envelope system doesn’t make a lot of sense any more; at least most of the time. However, it still makes a lot of sense in a spread sheet or subaccounts offered by banks like ING. Every time a paycheck is electronically deposited (How many years has it been since your boss came around on Friday afternoon with your paycheck in his hand?) husband and wife sit down at the family computer to divide that money up into electronic envelopes before the first penny is spent. Metaphorically speaking, in this electronic system there is an envelope for credit cards, an envelope for utilities, an envelope for food, the mortgage payment, and something for that silly little numbered envelope, if your church still has such a thing. Really the formal family budget is nothing more than an elaborate envelope system on pieces of paper or contained in electronic spread sheets.

This system is a nearly idiot-proof method to avoid debt. When cash money comes into a household it is placed in an envelope. Money for food always and only comes from the envelope marked food. When that envelope is empty, no more money is spent on food until the next paycheck arrives. American used to live like that, really.

There are categories of spending that I believe still merit an envelope, problematic discretionary expenditures. While cigarettes, beer at the local tavern, and women’s shoes are obvious candidates for an envelope, there is one overwhelmingly pervasive problem area for the modern American family that might well require an actual factual envelope containing actual factual cash. Restaurants! Almost everyone I know (including me) admits that they spend too much money in restaurants. Young single folks alone in a new city find community and entertainment in bars and restaurants with their friends. Married couples with two jobs, two kids, and no free time live on fast food. Many of us, see sharing a well prepared meal with friends at a nice restaurant as a reward we deserve for all our hard work. For most of my career the cafeteria offered better food than a brown bag at prices I was willing to pay. Sometimes I felt guilty about this practice, but it was just too easy to walk over to the cafeteria for a hot meal.

Go ahead, the next time some money comes into your house, count out some real paper money. Put it into an envelope marked restaurants and fast food. If you buy a burger at a fast food joint, a doughnut and a cup of coffee at a convenience store, or sit down to nice breakfast with an old friend, pay for it with money taken from that envelope. When the envelope is empty, that’s it. No more meals or even a cup coffee brewed outside the home until the next infusion of cash.

One more “envelope,” this time an electronic envelope. Back in the day, banks offered something called a Christmas Club Account. The customer authorized the bank to move a predetermined weekly amount from their regular account to a special account for Christmas. The customers didn’t like them because they paid little or no interest. Also once the money was in the Christmas Club Account it could not be used for any other purpose. If any money was withdrawn before the specified date, the customer was charged a fee. The banks didn’t like them because in those days before the computer, the cost of accounting for these small deposits simply was not worth the effort. This common sense approach to a common problem was replaced with the credit card. Not a good solution. In our marriage, Christmas generated our ugliest money arguments. A lot of nasty words and hurt feelings could have been avoided if we opened a little bank account, agreeing to deposit some weekly or monthly amount that was to be spent on Christmas.

The point of this exercise is not to deprive you of a good thing. The key is mindfulness. It is your money. Spend it as you wish. If you want to live in a cold water flat, but want to complement meals from the finest restaurants in your city with $100 bottles of wine, that is your business. If that is what makes you happy, go for it. If you are autopilot, spending your money without thought, you are going to run up debt without ever really, consciously, enjoying the fruits of your labors.

The Quick and Dirty Lazy Man's Budget

There is no doubt about it. The full formal written budget is the gold standard, but not too many students of personal finance stick with it, once the class is over or the emergency has passed. Here is an inferior option for the lazy. It is better than nothing and it might just tell you that you need to contemplate living on a formal budget.

Start with your take home pay. Don’t tell me that you are a commission salesperson or a server who lives on tips. Therefore, you don’t know your salary. If you couldn’t make a reasonable estimate about how much you were likely to take home, I doubt you would have taken the job in the first place. If you have been on the job a couple of months, you know.

OK, let’s say your take home pay is $500 a week. That would be $2,000 a month, except for the “happy” months with an extra paycheck. Back in the day, I loved those “happy” months. Since the budget in my head was based on 4 week months, that extra paycheck seemed just like winning the lottery.

Base your budget on $2,000. First subtract $200 (10%) for savings. Then subtract $400 (20%) for unknowns. Your goal is to try to create a quick and dirty estimate of your monthly expenses that is equal to or less than $1,400. For the sake of this example, let us assume that you will not make it work on the first try.

$500 Rent
$150 Electricity: If your bill in December was $130 it is a safe bet that it will be higher in January.
Water: Included in the rent.
$300 Car Payment:
$130 Gasoline:
$25 Minimum Credit Card Payment
$135 Cable TV, Landline, and High Speed Internet
$100 Cell Phone:
$300 Grocery Store Food:
$300 Restaurant Food and Beverages:
$100 Clothing Allowance

Total: $2,040
Allowance: $1,400
Difference: -$640

Note: This total did not include “known” infrequent expenses like car insurance or “known unknowns” like medical bills or car repairs. You have a problem, but not a really bad problem.

Let’s try again.

You could ditch the package deal from the cable company and live with $35 a month basic cable service and go to the unlimited data plan on your smart phone at $125 a month, saving $75.00 a month.

I am assuming this example is for a single young person. It seems like $600 a month for food is a little high. Let’s look into that number. Perhaps the grocery store bill includes a lot of microwave convenience food, very expensive. Perhaps the Restaurant estimate is lower than reality. One night out with friends could blow $50 right quick. 20 workdays in a month multiplied by $10 for fast food and coffee is $200. It is on controllable items like this where mindfulness and discipline will make or break a budget.

Let’s hold the Grocery bill at $300 but make a serious effort to stretch those dollars. Let’s put $100 actual factual dollars in an actual factual envelope for restaurants; when they are gone, no more restaurants for the rest of the month. That might mean sweet tea instead of beer or wine on those nights out and brown bagging it instead of the company cafeteria. That saves $200 a month.

Now how does it look?

$500 Rent
$150 Electricity: If your bill in December was $130 it is a safe bet that it will be higher in January.
Water: Included in the rent.
$300 Car Payment:
$130 Gasoline:
$25 Minimum Credit Card Payment
$35 Cable TV
$125 Cell Phone: Unlimited Data Plan
$300 Grocery Store Food:
$100 Restaurant Food and Beverages:
$100 Clothing Allowance

Total: $1,765
Allowance: $1,400
Difference: -$365

What are the numbers in this example telling you? I would propose a quick and dirty scale to go with this quick and dirty budget.

Green Light: If you are living on 70% or less of your take home pay
Amber Light: If you are living on 90% or less of your take home pay
Red Light: If you are spending more than 90% of your take home pay

It this example this person is spending 88.25% of their take home pay. Way too close to the line for comfort. I would recommend ditching the clothing allowance. Most adult Americans have enough clothing to last them several years. If there were children in this example this would not be true. That would drop the number to 83.25%, still not good but better.

I would suggest that this person consider living on a formal budget. I would also recommend that this person look for opportunities to work a little overtime. When I was working on the factory floor back in the day an extra four or five hours a week at time and a half made a big difference in what was left over at the end of the month.

It might take you 15 or 20 minutes to run through a couple of iterations of this process. If you are honest, it will tell you a lot with only a little effort.

Stock Market Math

January was not a good month for the stock market. It happens. That is why it is important to hold an age appropriate balance between stocks and bonds.

Consider a 50% drop in the market (that almost happened in 2008-2009).

If you had 100% of your holdings in stocks you would lose ½ your money. In order to get back to even you would then need to double your money. That is very hard to do. Even with a 12% return, the rule of 72 tells us it would take six years to break even after such a loss.

Starting Balance: $100
After Crash: $50

72/12= six years to double your money at 12%

Final balance after six years: $100

If you had 50% in stocks and 50% in bonds you would only lose ¼ of your money. Now what happens?

First you rebalance

Starting balance: $50 in stocks + $50 in bonds = $100
After Crash: $25 in stocks + $50 in bonds = $75

After Rebalancing: $37.50 in stocks + $37.50 in bonds = $75

In six years at 12% return on your stocks and 4% return on your bonds you now have

Final balance after six years: $75 in stocks + $46.50 in bonds = $121.50

That is why even young folks who have all the time in the world to save for retirement need to keep a little of their powder dry. Even in you are in your twenties you need to hold 15% or 20% of your 401K in bonds. Then a crash in the market still hurts but it also becomes a once in a decade opportunity to pick up some quality shares at bargain prices.

One more thing; Let’s be careful out there.

The Emergency Fund -- Again

A new report from the Corporation for Enterprise Development finds that 44% of American households have less $5,887 in savings for a family of four. The same report notes that 56% of Americans have subprime credit ratings. In case of an emergency these families will be forced to rely upon high interest credit cards or payday loans that will keep them in debt, sometimes for months at a time.

Nearly ½ of American families are living paycheck to paycheck. It is not only the improvised who are considered “liquid asset poor.” Approximately ¼ of middle class households fall into the same category.

It isn’t just the poor and the middle class who are playing with fire. Let me take a minute and introduce you to a power couple who live, as I once did, in the suburbs of Washington D.C. We will call them Jack and Jane. Jack just turned 40. Jane is still in her thirties, just barely. They live fairly near my church in a house valued in excess of $650,000, although they still owe a little over $700,000 on that property. Together they earn a little more than $175,000 a year. She is a biotech researcher, works at NIH. He is a middle manager at a major investment banking house. With two mortgage payments, a leased Lexus SUV, payments on a new Chrysler mini-van, and credit card debt if one of them looses their job, the family would be in trouble within six months. They have essentially no savings. If they were to both loose their jobs, the family would be in bankruptcy court within three months.

Living in the Washington D.C. area during the real estate bust of 2006 followed by the crash of 2008, I saw quite a few McMansions go into foreclosure auctions. I also expect more than a few of those leased SUVs parked in their driveways were hauled off by the repo-man.

Every six months or so, I see the results of a new report (like this one) that indicates the lack of an emergency fund is a pervasive and persistent problem.

So—One More Time:

Rule seven of my basics for young couples states, “Start a “rainy day” fund in a bank or a money market fund. The goal here is six months cash reserve (six months take home, both salaries). It will take some time to reach this goal. Don’t beat yourselves up about this but keep putting a little something aside every month.”

This emergency fund is the critical beginning to financial freedom. Start by living on less than your take home pay. Put the difference in a savings or money market account at an insured bank or credit union. These dollars are not for the purpose of investment. They are a life raft that will keep you afloat if something happens to sink your ship. The goal is that every month you place 10% of take home pay into savings before any of that money is spent. It won’t be easy but even the first $1,000 will protect you from flat tires, dead washing machines, and similar everyday real world problems. If you can pay cash, you will not be victimized by the credit card companies or worse, payday loan companies.

If you have less than $1,000 in a designated emergency fund, consider that an emergency. Cut your expenses to bare necessities. Hold a yard sale. Take a part time second job for a few months. Do something. Start today. It is that important for your family’s survival.

Use the emergency fund for emergencies, never for anything else. If there is any other way to pay for something other than debt, don’t tap the emergency fund. As you build up savings for special purposes, such as automobile repair, vacation, Christmas, and medical expenses you will be less likely to need money from the emergency fund.

Consider the emergency fund one of your top priorities until you reach that six month mark. Even if you don’t have a completed emergency fund, continue to make any 401(k) contributions that will be matched by your company. You simply can not beat a guaranteed tax-favored instantaneous 100% return on your investment.

When is the emergency fund sufficiently large to begin a fanatical effort to pay down your credit card debt? This is a matter of debate among personal finance authors. The low number is $1,000 in the emergency fund—then a full bore attack on your credit cards. The high number is eight months of living expenses before attacking high interest debt. It is your life. You need to make a reasoned decision based on your job security, controllable versus uncontrollable expenses, and the size of and interest rates on your unsecured debt. Personally, I think $1,000 is too low and eight months is way too high. If you have a good secure job, perhaps 2 months take home might be a good point to switch gears from defense to offense. If you are worried about the future of your job, you might want to exercise more caution, perhaps 4 months in the bank before a full frontal assault on your debts. Of course you can choose to strike a balance between building an emergency fund and paying down debt at the same time, but only after you have a balance in the emergency fund that is high enough you can go to sleep at night.

Even when you are working on your credit card debt, pay yourself first. Continue to put as close to 10% of your take home pay into savings as is humanly possible before you spend the first penny on anything else.