personal finance secrets: have a plan

Earlier today, I was talking with a colleague of mine about saving for college. Our children are still very young — my older child is five, and his is two — but we both know that college will be here in the blink of an eye, and if costs continue rising as they are, we have no time to lose.

Of course, that’s the catch, isn’t it? “If costs continue rising as they are.” Does anyone really think that college education’s current 7-8% rate of inflation is sustainable? Surely, something has to give soon, right? (Edit: Check out this article — written the same week as the one you’re currently reading! — for more on the subject.)

Well, maybe. Probably. But maybe not. What, then, do we do? Sit back and hope that things have changed by the time our children are college-bound? Hardly. I’ve seen what happens when a cavalier attitude is taken towards college finances — bright kids go to a prestigious, expensive university, only to discover that the work they’re passionate about can’t support the student loans they’ve had to take. And so begins the debt spiral.

So we can’t do nothing. But we can’t create a plan that relies on things staying as they are, either; setting up an auto-withdrawal into a 529 plan and then ignoring it for the next couple decades is, while marginally better than doing nothing, still sub-optimal. The middle ground is this: make a plan that has some assumptions and some flexibility, and make course corrections as time goes by. It’s fairly certain that you’re going to have a wide margin of error at the beginning, but that’s OK — at least you’re travelling in the right direction. As your target date approaches, and as your information becomes more accurate, you can adjust your plan accordingly.

I know what you’re thinking, being the smart person you are: “Hmm…this probably applies to more than just college, doesn’t it?” That’s very insightful of you!

This concept applies to just about any long-term financial goal; retirement is another great example. You can create a super-complex formula for determining how much you need to save, but change just one or two variables — how much social security you get, how the tax code changes between now and then, how much you average returns are — heck, even whether the bulk of your high-return years are now or close to retirement — and you’ll get completely different answers. All you can do is make some assumptions, use those assumptions to make a plan, execute on that plan, and revisit and re-evaluate periodically. Again, your initial plan will almost certainly be very, very wrong, but that doesn’t make it worthless! Rather, it gives you a decent starting point, which will gradually become closer and closer to reality as time goes by and you make the necessary course corrections.

Sure, it takes some work — but it beats waiting until the last minute.

this just in: sky not falling

Seriously?

OK, I get that the US and Europe are having a rough time of it. Yes, we have a ton of debt. Yes, our politicians are being, well, politicians. Yes, something needs be done about it. And yes, American’s debt rating just got downgraded by S&P. But…seriously, what is up with investors? From the way the market tanked today, this is the scene that’s playing out in my head:

Panicked Rich Guy: “Did you hear that S&P downgraded the US debt rating?”

Patient Financial Advisor: “Yes, sir, it was kind of hard to miss.”

Rich: “This is terrible! Pull all of my money out of stocks!”

Advisor: “Actually, now that stock prices have already dropped, it’s a bit too–”

Rich: “I’m just thankful they haven’t dropped any further yet! Quick, sell it!”

Advisor: “Sir, I am compelled to remind you that the basic objective of investing is to ‘buy low, sell high’. This is precisely the opposite –”

Rich: “Sell, or I’ll find someone who will!”

Advisor: *sigh* “Very well. And will we be putting that money into your FDIC-insured bank account or into Treasuries?”

Rich: “Oh, either one. As long as it’s safe!”

See what I mean? I keep expecting US bonds — you know, those loans that are supposedly more likely to default now — to tank, or at least decline in price a little bit, but they haven’t; in fact, they’ve gone up! Apparently no one actually thinks the US will default, so everyone’s still holding on to their bonds. Moreover, S&P’s reputation isn’t exactly stellar; yes, the White House has a few choice words for them, but other intelligent folk like Nate Silver also think that the initials should stand for Substandard and Porous.

So given all this…Mr. Stock Market, could you please take a deep breath and relax? You haven’t heard anything you didn’t already know, so please stop panicking as if you had.

(Edit: seems that Morningstar feels the same way.)

tricks of the trade: “fake” (levellized) salary

Last night I talked a lot about the key to managing your bills: automation. We had some fun going step-by-step through the process of turning your bills from a headache into very nearly a treat, and in the process, went through several tips and tricks I’ve picked up over the years, including one I call the Fake Salary. If you have a variable income, are a freelancer, or even are just paid biweekly (and thus get an extra paycheck once every six months), check it out:

Unless you are making so much money that you literally cannot figure out how to spend it all, variable income is a problem. Some months you’re flush with cash, and so you treat yourself, spending without a care in the world. Then some months find you on the low part of the cycle, paying for the groceries with credit card debt (which you then resolve to pay off the next time you’re rolling in dough). How do you even things out, so that you’re making steady forward progress rather than two steps forward and one step back (or two or three!)?

Well, you’re smart, so you’ve guessed my solution: the Fake Salary.

It works like this. Currently, you’re probably depositing your income into your checking account, which is all well and good. With the Fake Salary, however, you’ll deposit your income into a different account — another checking account, or even a savings account (which you can only pull from up to six times per month by federal law, but that’s okay, as we’ll only be doing it once per month). Nothing comes out of this account, except for one thing: your Fake Salary, which you’ll deposit into your normal checking account once per month, like a normal salary. This is the money you use for budgeting, paying bills, and other financial planning. The money in your deposit account — your buffer, I’ll call it — may as well not exist, except insofar as it determines what your Fake Salary is.

How do you calculate your Fake Salary? Well, it will be different for each person, but the idea is to take the average of your income, so as to smooth out the rough spots. So for example, if you’re paid biweekly, your Fake Salary would be (paycheck*26/12), suspiciously like what your real salary would be if you were paid monthly. If you get a quarterly bonus, add (most recent bonus/3) to your salary. And so on, and so forth.

With this in hand, you should have a better idea of how much money you really have to spend, and can plan accordingly. However, it’s not for everyone; some people are quite happy to live off of the money they make in poorer months, and put any extra money they get in richer months into savings. If you’re this kind of person, and think you would spend money on less valuable but more attractive things if you went to a Fake Salary, then by all means: keep on your path.

To others folks with variable income, however, I suggest you give the Fake Salary a whirl. Questions or thoughts? Let me have ’em in the comments section below!

another other way: islam and finance

As a follow-on to last week’s post, I’d like to talk about yet another alternate view of finance — this time, that held by Islam, as explained to me by a friend and colleague who is a practicing Muslim. This is for two reasons: one, because I personally am fascinated by Islam’s views of God and humanity, at once very similar and somewhat different from Christianity’s, and two, because we of the West know virtually nothing about Islam as it is practiced by the vast majority of its more than 1.5 billion adherents. I mean, have you ever asked a Muslim what jihad actually means? I’ll give you a hint: it’s not what you think.

So I’d like to talk about two areas of finance that work somewhat differently for Muslims than for the rest of us: charitable giving and banking.

Charitable Giving

Islam has a concept similar to Christianity’s “tithing”, which they refer to as zakat. My friend refers to it as “alms giving”. Here, all Muslims are required to give 2.5% (1/40th) of their excess wealth to charity. While that’s the simplified version, there are a few details worth noting.

First and foremost, the tithe is on excess wealth; that is, what is in excess of what is necessary to survive. As a practicing Christian, I’ve often been concerned by the fact that a tithe for someone who makes $30,000 a year is quite different from a tithe for someone who makes $300,000 a year. In my opinion, the zakat is an excellent progression: only those wealthy enough to have a surplus are required to give the tax. Of course, Muslim scholars differ as to what is “surplus”, and the devil is perhaps in the details, but the idea is sound.

Also, Islam stipulates that, rather than being given to the local mosque or spread thinly among various social service organizations, zakat is to be used to raised individuals from poverty. That is, if you are to give $1000 in zakat this year, you are encouraged to give it to a single person in poverty. The idea is that in this way the recipient of this year’s zakat may themselves be able to give zakat next year. Apparently this worked so well in the early days of Islam that poverty was eliminated entirely for a time; as there was no one in their country eligible to receive zakat, they had to go to neighboring countries and distribute it there!

Finally: zakat is not a minor footnote, as it often is in Christian denominations; rather, it is one of the Five Pillars of Islam.

I’m not saying that Christianity should adopt the zakat wholesale; however, those of us concerned with the role of social justice in Christianity should take note.

Banking

Islamic banking centers around the fact that riba — usury, interpreted by most scholars as charging interest on a loan — is forbidden. Islamic scholars see this as an issue of justice, as invariably, if I may paraphrase, someone is going to get screwed. We see this in the West all the time: the spread between what a bank charges for a loan and what a bank pays for a deposit is notorious for making a small percentage of the population ridiculously wealthy.

That isn’t to say that Islam does not believe in banking; rather, it believes that the bank should share the risk equally with those whom it does business with. Consider their equivalent of mortgages, for example. Say you have enough money for a 20% down payment on a house. You go to the Islamic bank, and they agree to pay for 80% of the house. You don’t pay nterest; however, because they own 80% of the house that you live in, you agree to pay them rent for their 80%. Along with that rent, each month you buy a little bit more of the house, and the rent goes down accordingly, so in the end after 30 or 15 or however many years, you own the house entirely.

This may seem like a mortgage, and in practice it works in a similar fashion, but there’s a crucial difference: in a traditional mortgage, the loan itself is not tied to the house. If the house were to evaporate, you would still owe the mortgage. However, in the Islamic bank equivalent, if the house were to evaporate, you would owe the bank nothing! While on the surface, it looks like a mortgage, in reality, it’s more like a joint business venture.

Deposits work in a similar fashion: while current rates of return are advertised as they generally are in Western banks (check out Turkiye Finans‘s website), they are in no way guaranteed. Of course, the bank is still going to invest its deposits in short-term, low-risk vehicles, lest they lose all their customers at the first downturn. Here again, the concept is that of a joint business venture; whatever the profits happen to be, they are split between the bank and the consumer in an equitable fashion.

Fascinating, isn’t it? I wonder what 2008 would have looked like if the financial industry had been more like this?

another way: alternatives to traditional banking and investing

Trust in the financial industry has waned in the past few years, and not without good reason. When an institution is driven entirely by profit, the consumer is generally the one who gets the short end of the stick. I mean, the Frost Bank tower downtown is nice, but…between you and me, I’d prefer higher savings rates, lower loan rates, and better customer service. As it so happens, there’s a way I can get it, thanks to the advent of credit unions.

Credit Unions

The fundamental difference between a bank and a credit union is this: while a bank is owned by shareholders and is operated for a profit, credit unions are owned by its members and are not-for-profit. The board of directors is elected by the members, on a one-vote-per-member basis — how much money you have with the bank is irrelevant.

So does this actually help the consumers? Well, let’s compare Frost Bank rates with its neighbor down Congress, Amplify Credit Union:

Amplify Savings Account: 0.2%. Pretty awful, eh? Well, guess what?
Frost Bank Savings Account: 0.05%. That’s right — five percent of one percent.
Amplify 5-year Share Certificate: 1.49%. Sigh. No good saver goes unpunished.
Frost Bank 5-year CD: They don’t have them. Um, what?
Amplify 2-year Share Certificate:  0.75%.
Frost Bank 2-year CD:  0.6%.

And so on. Well, what about loan rates?

Amplify New-Car 36-month Auto Loan: 1.99%+. Man, I would have liked that back when savings accounts were pulling 5%…
Frost Bank New-Car 36-month Auto Loan:  The same rate as for a 60-month loan. Again…what?
Amplify New-Car 60-month Auto Loan:  3.49%.
Frost Bank New-Car 60-month Auto Loan:  4.74%. Ouch! And remember — if you had taken out a 36-month loan, it would have been the same rate as this one!

I could go on, but I’ve got other things to talk about in this post. Just bear in mind that if you are a member of a bank, credit unions are an appealing alternative. Though banks do tend to have prettier skyscrapers…

Peer to Peer Lending

Speaking of alternatives, if you’re looking to get a loan, especially an unsecured loan (i.e. one that isn’t tied to something you own, like your house or car), there’s an alternative that can work even better than a credit union: peer to peer lending. The big players in this arena are Lending Club and Prosper, and the idea goes something like this: instead of a bank giving you one large loan, you are given many small loans — say, $100 each — by a number of peers. There is still some underwriting and background checking done by the host company, and your loan is “graded” and your rate chosen based on your grade. And check out these rates:

Amplify Unsecured Loan: 9.5%+
Lending Club Loan:  6.78%+ APR (this includes the fee charged for handling your loan)
Prosper Loan: 7.4%+ APR (ditto here)

If you’re running a balance on a rewards checking account — and those suckers tend to average 18+%! — you owe it to yourself to check out peer-to-peer lending.

Is this real? What’s the catch? Yes, it’s real, yes, it works, and yes, there can be a catch. The fact is that P2P lending tends to attract folks who can’t get loans through traditional means. As a borrower, that’s okay, but if you’re considering being a lender, you’ll definitely want to do your research.

Fund-Owned Investment Companies

Finally, if you’re looking at investing for the long term, there’s an alternative to the norm there, as well: fund-owned investment companies. Well, there’s really only one that I’m aware of: Vanguard. The idea behind Vanguard is that instead of being owned by outside shareholders, it is owned by its mutual funds — that is, the people who actually buy its product, its customers. And what are mutual fund customers most interested in, especially ones who are looking for index funds? Why, the lowest expense ratio possible, of course. Even if you’re not buying index funds, expense ratio is still the best predictor of overall fund performance out there. Even Morningstar has to admit it:

“If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds….Expense ratios are strong predictors of performance. In every asset class over every time period, the cheapest quintile produced higher total returns than the most expensive quintile.”

Not surprisingly, Vanguard has the lowest expense ratios anywhere.

Anybody else noticing a theme, here? In all three cases, when financial institutions are owned and operated by the communities they service, the communities are the better for it. Now, I’m not against the capitalist model by any means…but it’s nice to know that there are viable alternatives.

working the system

You want a change.

Maybe you want to lose weight. Or get a girlfriend. Or be more productive at work. Or maybe — because this is a financial blog, after all — you want your finances in order: you want to get out of debt, stop getting hit with late fees and overdrafts, and start living for the future, rather than the past. Or all of the above.

So what do you do? Most people fall into a frustratingly predictable cycle: they make Resolutions, say “I’m mad as hell and I’m not gonna take it anymore”, buckle down, grit their teeth, and vow to change by sheer willpower. And it works…for a while. Then they hit a Bad Day, which turns into two, which turns into a week, and pretty soon they find themselves back where they started.

It’s frustrating, but it’s not surprising. As humans, we’re annoyingly irrational. We’re as likely to make decisions from our mood — which, in turn, is influenced by sleep, diet, sunshine, exercise, hormones, marketing, and a thousand other things not necessarily relevant to the matter at hand — as from logic.

So, really, what do you do? You remove your mood from the equation entirely: you create a system.

An example: to avoid late fees, you automate your finances, so that income comes in and bills go out without your interference. To avoid getting hit with overdrafts, you have a monthly “check-in” date on your calendar to make sure that your money is where it needs to be.

Another: so you’re not tempted to go into any more credit card debt, you leave your credit card at home and do your spending with cash. If you don’t have the cash, you can’t buy the dress, the fondue, or the TV.

Another: to help build up your emergency reserve, whenever you get paid, you automatically transfer $100 from your checking account to your emergency savings. Only after that do you budget for the month.

In all of these cases, you make a decision from a point of calm, where you’re not being bombarded by moods or Madison Avenue; once the decision is made, you create a system to help you stick to that decision. As an added bonus, you now have more willpower remaining to spend on making other decisions, like not eating marshmallows.

If the idea of setting up a complete, custom financial system — covering all of the above scenarios and more — sounds interesting to you, drop me a line. I’d be happy to set up a (free!) session with you.

Or if you prefer, next month I’ll be giving a personal finance workshop series at St. David’s Episcopal Church in downtown Austin; in it, we’ll be covering everything from our relationship with money down to the specifics of budgeting tools.

So, how about it? Are you ready for a change?

the financial geek

Money is awesome, isn’t it?

It’s like raw energy. You can use it to get a car, get stuff to make the car go, get a place to park it, fix it when it’s broken, or paint it when you decide you don’t like the color. You could even pay someone to drive it, if you wanted to. It can do almost anything. Handy stuff!

But it can also be a huge headache, and in so many ways…

-Maybe you’re trying to make finances work with your significant other, and you’re finding out that you just don’t see eye-to-eye when it comes to spending.

-Maybe you’re trying to get out of debt, but every time you manage to kill the balance on your card, some unexpected expense comes up and puts you right back where you started.

-Maybe you keep getting slammed with late payment fees — or maybe you just hate sitting down to pay the bills — and you wish there were a way to organize things so that your bills would handle themselves, with just minimal oversight from you.

-Maybe you want to start saving up for something big, like a vacation or a house or even retirement, but somehow there’s not any money left at the end of the month. (Maybe you’re not even sure where it all goes.)

-Maybe your personal finances are just a huge mess, and you don’t even know where to start.

This is when you want a financial geek.

You’ve heard of the Geek Squad, right? They’re the guys from Best Buy that you can hire to set up your PC or entertainment center or what-have-you. You tell them your situation, tell them how you want things set up, and they’ll take care of all the geekery. They’ll get the system set up, teach you enough so that you can maintain it yourself, and leave their card so that you can call if something goes awry.

What if you could have a financial geek to do the same thing with your finances? Someone who could come in, take a look at your situation, and help you set up a system to get things the way you want. Of course, unlike entertainment centers, you can’t fix your personal finances in a single afternoon, and money requires a bit more maintenance than most electronics; that’s why you would probably want to set up ongoing meetings, maybe once every few weeks for six months or so, until you felt comfortable taking care of things on your own.

The good news is: such geeks exist, and would like nothing better than to help out with your financial headaches. Sound interesting? Click here for more info on how Financial Geekery coaching works.