The Amateur Financier

If you’ve been reading my blog all this week, you know I’ve been going through a list of ten steps to get your financial life in shape.  If you don’t feel like going through five posts to review my suggested steps, here is the whole list, collected and put in the proper order:

0) Help Those Who Are Less Fortunate – Even before you have your own finances under control, give what you can to charities and others who need help.

1) Earn More Than You Spend – Cut your expenses or increase your income so you have a surplus.

2) Have Adequate Insurance to Protect Yourself and Your Family- Make sure that you have homeowner’s/renter’s insurance, car insurance, health insurance, and life insurance to cover you in emergencies.

3) Fund Your 401(k) or Equivalent Plan Up to the Match Provided by Your Company – Not doing so is essentially giving up free money from your bosses.

4) Create a Small Emergency Fund – Put aside at least enough money to cover one month worth of expenses, more if your job situation is shaky or you generally need more protection.

5) Pay Down Your High Interest Debt – Pay off any debt that charges more than six percent interest.

6) Bulk Up Your Emergency Fund – Save at least enough money to cover six months of your expenses.

7) Increase Your Retirement Savings if Needed – Increase your retirement savings (if necessary) in IRAs, your 401(k) and taxable accounts so that you are on track to meet your retirement goals.

8 ) Buy A House (If You Want to Own a Home) – By this point, you should be ready to save up for a house down payment and start on the path to home ownership.

9) Start Donating to Charity (If You Aren’t Already) – If you haven’t already started to give back to others who are less fortunate (preferably as early as you are able without jeopardizing your own financial situation), do it now!

10) Save and Invest for Other Long-Term Goals- Now’s the time to consider where you want to go in life, and meet whatever goals you desire:

-Pay down low interest debt

-Invest for your childrens’ education

-Invest more to retire early

Once you complete these ten steps, you will be in great shape financially.  And that’s a wonderful thing.

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Last time, we looked into maxing out our retirement funds and buying a house   Now, we’ve reached the end of financial journey together, and it’s time to cover a few last steps.  I hope you’re in a charitable mood, cause that’s our next step.

Step 9: Donate To Charity (If You Aren’t Already)

I’ve been debating about when to bring this issue up.  I’m hoping that, even as you work to pay down your debts or save up for your house down payment, you find some money to donate to those who are less fortunate.  I haven’t mentioned it as a specific step up to this point because I thought that it might be better for you to focus on getting your own finances in order.

Now, though, there’s really no more excuses.  If you’ve been following my steps to this point, you’ve eliminated your high interest debt, are investing enough for a solid retirement, and have an emergency fund that can last for six months or more.  There’s not much that should rattle your plans now, so what reason could there be not to give money to those who are less fortunate?

If you need somewhere to start, JustGive.org is great one stop shop; you can search for charities, find out pertinent information, and even make your donation directly through the site.

Step 10: Save and Invest for Other Long-Term Goals

Well, we’ve reached the end of our journey together.  At this point, you know enough that you should be able to monitor and control your finances.  The question now is, where do you go from here?  There are many possibilities, depending on your goals,  values and hopes.  Here are some possible avenues to pursue:

-Pay down low interest debt: We put aside paying down debt with interest rates below six percent earlier in order to focus on other financial goals.  Now, of course, all those other financial goals have been achieved.  If you want to be debt-free, now is the perfect time to pay down any remaining debt and live debt-free from this point on.  Just follow the same procedure for the high interest debt, and you’ll be out of debt in no time.

-Invest for your childrens’ education: If you want to help your children (assuming you have any) with college, the best time to do so is when you’ve managed your finances properly and don’t need to worry about saving anything more for yourself.  There are several different different accounts designed for college savings, including 529 accounts and Coverdell Accounts.

-Invest more to retire early: One of the great working person fantasies: put more money into your investments and with some luck and planning, you could cut years off the time you need to work and save in order to retire in the manner you desire.  The more you save, the sooner you can retire, and the longer you’ll have to enjoy your retirement.  (That is, as long as your retirement plans don’t include lots of sky diving or other wild activities.)

There you have it; ten steps that should lead you to a better financial situation.  They won’t be easy or quick (this week of posts could easily take years to properly enact), but the end result, financial freedom, is well worth the effort.

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Last time, we got through two of the toughest steps in our personal finance plan, eliminating our most expensive debt and building up an ample emergency fund, should the need arise.  Now that you’ve ensured that your financial situation is secure, it’s time to look at some of the other goals you may want to accomplish.

Step 7: Ensure Your Retirement Saving is on Track

Reality check time: for better or worse, funding your retirement is largely up to you.  As a result, you need to be sure you are providing enough funding to cover your expenses.  The standard set of assumptions is that you’re going to need 70-80% of your final income during retirement, and that if you take 4% of your nest egg each year (adjusting for inflation), you should be able to make your nest egg last throughout your retirement, no matter how long it lasts.  Crunching the numbers, holding 20 times your final income in your starting nest egg will allow you to withdraw the proper amount.

However, getting to 20 times your final income is quite an achievement.  The earlier your start saving, the easier it will be to reach your goals.  Here’s roughly how much of your gross salary you will need to save to meet your goal at age 65, starting with no invested money at each of the following ages:

Start Investing at 20: Save 12% of your income
Start Investing at 30: Save 20% of your income
Start Investing at 40: Save 37% of your income
Start Investing at 50: Save 75% of your income

As you can see, the earlier you begin, the less money you will have to save to reach your goal by the age of sixty-five.  Of course, the assumptions I made when running the calculations are fairly conservative; no pension payments (pretty reasonable, nowadays), no Social Security payments (a bit more of a stretch; you should be getting at least some portion of the promised Social Security payments, if not the full, expected amounts), and an 8% growth rate (a little below what the markets have returned historically, but reasonable for our calculations).  So, if you are fifty and can’t imagine saving 75% of your salary, don’t panic; chances are, you will have some help from the government.  Still, the further you are from retirement, the less you should count on things like Social Security or a pension, and the more you should try to save, at or above the levels listed above, if necessary.

Here’s a short list for the priority of your retirement savings:

-In a 401(k) up to the match: We covered this already, back in step 3, but it should be your top priority.  If you’re fairly young and your company gives a good match, this might be all you need to get to your desired contribution level.

-Open up an IRA: Opening an Individual Retirement Account (IRA) with a mutual fund company allows you to have much more choice and control over your retirement investments.  They come in two flavors, traditional and Roth, which vary in how they are taxed.  Which one to choose?  My suggestion: go with the opposite of your 401(k); if you have a traditional 401(k), go with a Roth IRA, if you have a Roth 401(k), choose a traditional IRA.  That way, you will come ahead, no matter what happens with tax rates by the time you retire.

-Max out your 401(k): Unless your 401(k) has truly horrible investment offerings, you’re probably best off by taking advantage of the tax deferment by investing more in your 401(k).

-Invest in a nonretirement account: If you need to invest a fairly substantial portion of your income or you have a very large income, you might need to invest more money than you can put into a 401(k) and IRA.  In that case, even though you won’t get any tax advantages, putting money into a nonretirement account is pretty much the only remaining option.

Step 8: Buy a House (If You Want to Own Your Home)

An often overlooked financial goal, but one that’s especially relevant to my fellow young whippersnappers, buying a house is worthy of consideration.  It’s not an easy or quick process to buy a house, but it can provide a solid base from which to continue your financial growth.  Given the upheaval in the real estate market recently, there are a few things you need to keep in mind:

-You’ll need a sizable down payment: The days of zero percent down, liar’s loans are gone.  Expect to pay at least 10% down on your mortgage, and better yet 20%.  Save up the money, using either very safe methods like money market funds, or if you have lots of time before you intend to buy your home, a higher-yielding short-term bond fund.

-Go for a fixed rate mortgage: Again, with the current environment, this might be your only option.  In any event, having a fixed rate mortgage will save you from worrying about sudden rate hikes and allow you to more easily plan for your future.  Plus, over time inflation will lowered the real cost of a fixed payment, making it easier to handle.

-Buy only as much house as you can afford: If you can’t afford to make the payments on the house using a thirty-year fixed mortgage, you can’t afford it.  Period.  No using option-only loans or reverse amortization loans to buy a huge house.

Given the current mortgage rates, chances are getting a mortgage in the next year will let you have a mortgage that falls below our six percent threshold for our debt, so we won’t worry too much about paying down the mortgage.  Instead, you can add the mortgage to your low-interest debt, and just be sure that you can make the payments on all that debt without overextending ourselves financially.

We’re almost at the end of our journey to control your finances. There’s only two steps left, and at this point, you’ve paid off all your high interest debt, built up an emergency fund, created adequate investments to fund your retirement and possibly bought a house.  Congratulations to you; that’s quite the list of accomplishments.  The last few items should be a piece of cake for you by now.

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Last time, we funded our 401(k)s up to the maximum match our employer will give us (yay for free money!) and built a small emergency fund covering about one month of expenses.  Now that all of that is done, it’s time to begin the real fun: paying down debt and ensuring a good retirement!

Step 5: Pay Down High Interest Debt

Here’s the biggie; most people who are having money trouble get stuck on this step, cutting down their high interest debt.  You might be wondering, what exactly constitutes high interest debt?  Personally, I would consider any debt with an interest rate above six percent to be high interest.  That’s about the amount you can earn from a good bond mutual fund, a fairly conservative investment.  Thus, if given the choice between paying off debt at five percent or investing the money, I would opt for the investment option.  (You could raise the limit to eight percent if you are willing to pay a little more interest on the higher interest rate debt; just be sure not to hold debt at rates any higher than that.)

Once we know what high-interest debt is, the question becomes, how do we best pay if off?  The simple version is, you pay the minimums on all your debt (which you should already be doing as part of your regular expenses, anyway) and put all the money you can spare toward paying down the highest interest rate debt.  When that debt is gone, you start putting all the money that wnet toward paying down that debt into paying off the second highest rate debt, then the third, and so on until all the high interest debt is gone.  (I ran some numbers a few weeks ago to prove that this is the most efficient method.)

That’s it; no special formulas, no secret codes, no cheats or ways to skip ahead.  You just need discipline to stick to your repayment plan, control to avoid building up more debt, and patience to see it through to all the high interest debt is gone.

As for the low interest debt, the debt below six percent, the best plan is just to keep paying the minimums and enjoy having relatively low interest debt.  Consider your interest payments as rent on money you can put toward investments that will return more than six percent.  If you invest properly, as in our next step, you’ll end up better off financially by investing than focusing purely on debt repayment.

Step 6: Bulk Up Your Emergency Fund

Once the high interest debt is out of the way, you can go back to our emergency fund and work on bulking it up some more.  One month of expenses is decent start, but it won’t cover you in a serious emergency.  Before you start to pump up your retirement savings, you need to make sure that your won’t have to tap your 401(k) or IRA if there is something major and long-term, like losing your job.

A good goal for our expanded emergency fund should be six to eight months.  There are plenty of options for where you can hold your money in order to keep it safe but available.  Our standard suggestions of money market funds and high interest online savings accounts both work quite well.  You could also consider a CD ladder in order to get a little more interest from your emergency savings.  The important thing is to just build up your savings; now that you aren’t making the minimum payments on your debts, it should be easier to find money to put towards your emergency fund.

Alright, these steps took some pretty serious effort.  If you completed them, enjoy your accomplishment; it gets easier from here.  No, really, it does.

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