For the first post of 2018, I thought we could switch things up a bit. Chances are, if you read this blog on a regular basis, you are already financially oriented and likely have a solid hold on your personal finances. This post is not for you. Instead, I will be sharing some helpful tips for getting your financial house in order, as well as what I personally do to make sure I’m not underwater.
Let’s start with some facts. Financial literacy is unfortunately not taught in public grade school, and as a result, few Americans come out knowing a whole lot about money. This shows in some data.
- The nationwide average savings rate as of 12/22/2017 is only 2.9% (taken from FRED) meaning on average, people are only saving 2.9% of their income.
- Fourth Quarter 2017 total outstanding Consumer Credit (credit card debt) is $3.802 Trillion! Divide this by the total US population (323.1 million) and you get $11,767, of this type of debt alone, for each American citizen.
- Average deferral rate to an employer-sponsored 401(k) retirement plan for 2015 was only 6.8%, meaning employees on average only contributed 6.8% of their paycheck to this type of plan. Source: https://www.fool.com/retirement/2017/01/15/average-americans-401k-contributions-by-age-and-in.aspx
We’ll stop with the data there, but this paints a stark picture. Income inequality aside, Americans on average are saving very little, have an enormous amount of debt, and are not planning for their financial future (retirement).
I’ll stop to clarify something here. In economics and finance, Credit is the same thing as Debt. Both are simply the lending of money at interest, and by itself, it is not a bad thing. A moderate amount of student debt ($40,000), at a reasonable interest rate (4%), in exchange for potentially doubling your earning power ($8.50/hour working retail or $20/hour working a professional service job) is well worth the manageable loan payment ($296 monthly at 15 years). Another example is the US Government. The government maintains a deficit of around $600 billion every year, meaning there is not enough tax revenue coming in to support its operations. However, if it borrows money to fund those operations, and those operations boost economic output, then the interest payments would be more manageable and the government could continue to function as normal (this is basic Keynesianism). I’ll explain this in more detail further down the post.
In short, Americans on average do not have a hold over their finances. There is too much money going out, not enough coming in, and we all pay the price in the form of low inflation and a weakening middle class. So, I have some advice on how to make sure your 2018 goes the right way.
- Understand Different Types of Credit – For most Americans, this is the biggest one, so it goes first on the list. Though we all borrow money for various things (mortgages, auto loans, financing appliances, credit cards), the rate of interest we pay on these varies a lot. For example, Student Loans are 95% backed by the Federal Government, so there is not much risk to a bank in lending them. As a result, the interest rate is mostly around 4-5%.
There are two main types of credit. The first is Revolving Credit, which includes the credit I referenced above (credit card debt) as well as Home Equity Loans and Home Equity Lines of Credit (HELOC). This credit type is generally classified as a certain amount of credit every period (monthly credit limit on a credit card) that should be paid in full every month, and any outstanding credit carried over to the next month will begin to accrue interest. For example, say I have a $500 credit limit and spend $400 of it, but can only pay $300 of that $400 back to the bank at the end of the month. The remaining $100 sits on my statement and I will have to pay interest on it until I can repay the original amount (the principal)
The second type of credit is Installment Payment based, which means any amount you borrow at a certain interest rate for only a certain amount of time. Common examples of these are mortgages, car loans, and payday loans. Unlike revolving credit, this structure is intended to be a one-time loan and fully paid back at the end of the term period. For example, if I take out a $400,000 mortgage for 30 years at 3.5% interest, my monthly payment will be $1,796. Note that for this type of credit, interest is calculated at origination, so total interest on my mortgage example would be $246,624, and this is built into my monthly payment.
What determines the interest rate on credit? The benchmark for determining an interest rate is the corresponding Treasury Rate. A mortgage typically runs for 30 years, so the rate would correspond to the 30-year US Treasury Bond, plus a little extra for the bank to make money. 4-5 year car loans also run closely with the 5-year Treasury. Revolving credit, carrying no term limit, is most affected by the Federal Funds Rate. But another big factor in determining this rate is your individual Credit Score. This is a number calculated based on your history with credit (past cards owned, payments made, etc.). The credit score range is from 200 to 900, with higher credit scores showing a higher ability to repay borrowed money based on previous history. The more able you are to repay debt, the less risk a bank would have to take by lending you money, so your interest rate would be lower to compensate. Try to get this number as high as possible.
Let’s come back to the US Government, from above in the post. How are they able to borrow such outrageous amounts year after year? Credit rating agencies give Governments scores based on their economic strength and their ability to levy taxes to pay their debts. Even though the US Government has not ran a surplus in over a decade, the size of the economy, coupled with the ability of the government to raise taxes if it needs to, means that creditors to the US have reasonable assurance of its ability to repay. This is, in essence, all a credit score is.
- Pay Down Outstanding Debts – I mentioned earlier that debt by itself is not necessarily a bad thing, but if you let it sit for too long, it can turn into a real problem. This is especially true for revolving credit. Since the bank doesn’t make money on credit cards if people pay their statement on time, the interest charged on outstanding balances is high to compensate. Credit card interest is typically as high as 25% on this money! To put this into a scenario, my $100 missed credit card payment above would be charged $25 in interest the next month. If I was unable to pay any of that back, interest would be charged on the $125, making me owe an additional $31.25 the month after. Because interest compounds, this has the potential to get out of control very quickly.
As for the other type of credit, loans are usually backed by some collateral that the bank can reclaim if you are unable to make the payments. This means the bank comes and repossesses your house. In the case of student loans, you are the collateral, so there is no way to default. Make sure you make those payments!
- Start an Emergency Fund – After you’ve paid down your high interest debts, it’s time to start putting money away. The best place to start is an emergency fund. Literally, this is an account for emergencies, if you suddenly get laid off at work, if you get into a car accident, money in this account should be able to cover these sudden expenses. It can even be used to save up for a down payment on a house, or tuition expenses. The typical rule of thumb is to put 3 to 6 months’ worth of pay in this account, but the amount varies with your personal situation.
An emergency fund should absolutely NOT be mingled with a checking account. This is reserved for money you will eventually need, but will not frivolously spend. My favorite place to have my emergency fund is an online savings account from a non-brick & mortar bank. There are several options one quick google search away, but I personally use a Goldman Sachs account that pays 1.4% interest. To contrast, the average big commercial bank savings interest rate is 0.05%, that’s quite a difference.
- Contribute to a Retirement Plan – Once you’ve erased your debt and secured a big enough cushion, you’ll want to start letting your money grow for you. The easiest way to do this is through a designated retirement plan. The two main types are Employer-Sponsored and Individual.
Employer Sponsored plans come in a few shapes and sizes, either 401(k), 403(b), or 457 (corresponding to the IRS code). If you work for an employer who offers these plans, you can elect to defer a percentage of your income to the plan. Each plan offers a set of mutual funds, selected by the employer, that you can choose to invest in. Your employer may also match your contributions up to a certain amount, as an incentive for contributing. The contribution limit to this plan for 2018 is $18,000.
Individual Retirement Accounts (IRA) are the second type of retirement plan. These do not require an employer to use, but they do require earned income to contribute (meaning wage or salary). I prefer this type of account because the individual has full control over which investments he/she can buy and sell. The contribution limit to this account for 2018 is $5,500.
Why pick these types of accounts over a normal brokerage account? These two accounts are Tax Advantaged. Under a Traditional 401(k) and IRA, you can exclude the full amount of your contributions from that year’s income taxes, meaning up to $23,500 of your income would not be taxable if it goes into these accounts. However, tax would have to be paid on any gains made on your money, and when you distribute on retirement. There is a second option, called a Roth, that lets you contribute post-tax dollars now, and lets the gains and distributions from these accounts be tax free later. Whether or not you should pick either one depends on your current tax rate and financial situation.
- Start Investing – If you’ve made it this far, congratulations! Your financial house is in order and you’re saving the right way for your future. The last thing to do is to start saving up in a taxable brokerage account. You can open one of these the same way you opened your IRA, and you can invest in whatever financial instruments your broker allows (stocks, bonds, mutual funds, currencies, derivatives, etc.). This is the most personal step on this list because at this point, how you continue to save and invest your money is entirely up to you.
If you are reading this for the first time, I can understand that it’s a lot of information to take in at once. So how do you keep track of it all? It helps to keep track of your income and your expenses all in one place, so you can look at your spending and see how you can be impacted by various changes. Microsoft Excel and Google Sheets are my personal favorite places. To track all of this. I have attached links to two types of Google Sheets I have used for tracking my financial situation. The first is a small summary that tracks expected income and has a simple expense budget. The second is far more detailed, and has separate sheets for every month as well as sheets for tracking your net worth.
Short: https://docs.google.com/spreadsheets/d/1pl589lihxJSqUjEPSsp6nhPuwMhg_u_Ugo_RjDj-mRA/edit?usp=sharing. Edit only the cells shaded in green, and the rest will populate.
Long: https://docs.google.com/spreadsheets/d/1XbEtKkZD2RDpmn_6yM-LsdJI9RaGk4UXQJdTk0Q6Axc/edit?usp=sharing. Instructions are on the first sheet, follow them closely.
I currently use the second sheet, because it breaks out each month separately. The most important number to see is the Savings Rate, on the top of each month’s sheet. This is your revenue minus your expenses. Get this number as high as possible and you will be in sound financial position in no time.
I hope this helped you get your financial house in order. If you follow these instructions, you’ll be building wealth and starting off 2018 right! As always, if you have any questions or comments, please feel free to send me a message.