Saturday, September 12, 2009

A reader asks for financial planning suggestions

In a comment on my post yesterday about the state of the economy, reader STxRynn said:

I like your clear warnings. I really like the way you take this information and explain it.

What would you suggest to a neophyte in financial planning?

Your call to "look at your financial situation, right now, and deciding what you're going to do to ride out the storm that's bearing down on us" rings true with me, but there is so much conflicting "advice".

I'm not sure where to go to protect my family.

Any advice on where to look for the good answers is appreciated!!!!

Well, I'm hardly the world's greatest financial expert, and I've made more than my fair share of dumb decisions, economically speaking, but here goes.

In days past, financial advice was conservative, oriented towards accumulating a minimum of debt and suspicious of 'buy now, pay later'. Given the state of many consumers' debt load today, they might wish they'd had such advice in recent years! Bankers used to use (many still use) a formula known as '28/36'. This stated that one's total monthly debt load (i.e. the total amount spent on all debt except one's home mortgage or rental payment) should not exceed 28% of one's gross monthly income; and, furthermore, one's total regular monthly payments, including one's home mortgage or rental payment and utilities, insurance, etc., should not exceed 36% of one's gross monthly income.

This formula is sometimes difficult to apply, because it refers to gross (i.e. pre-tax) income, before deductions. Some prefer to work on a formula of '35/45': 35% and 45% of net income (after all deductions at source), which is an increase of 25% over the '28/36' formula in each category (i.e. multiply 28 and 36 by 1.25 and you get 35 and 45 respectively). I use the 35/45 formula myself. Also, if your income varies per pay period (according to the number of hours you work, or the commissions you earn) that can make the consistent application of such formulas difficult. In such cases, it's best to decide on a figure for the average minimum income you can expect per pay period, and budget for that. If you happen to earn more than that in any pay period, put the excess into a savings account and let it build up. It'll make a nice nest-egg, or allow you to clear a debt with a single payment, or indulge in something like a nice holiday, or pay for an unexpected expense such as vehicle repairs.

Many people find it extremely difficult to stay within the 28/36 or 35/45 debt ratios. That's hardly surprising, given the numerous financial demands on the average person today. Medical insurance, property insurance, insurance on personal and household possessions, life insurance, utilities such as electricity, gas, sewage and garbage removal, municipal rates and taxes, vehicle licensing and insurance, cable and telephone and Internet service payments . . . by the time you add all these to your rent or mortgage repayment, you might find yourself already crowding the 'top end' of your chosen ratio (i.e. 36% of gross or 45% of net income), even without taking into account a credit card or vehicle loan repayment!

On the subject of credit cards, let's highlight the difference between credit card debt and credit card payments. If you pay off your credit card balance in full every month, carrying nothing over to the following month, that's the same as paying cash for things. Such payments are not included in your 36% or 45% ratio - they're not debt. On the other hand, if you have an ongoing balance on the credit card, and you're paying it down bit by bit each month, that's debt. Those payments do fall under the 36% or 45% ratio.

What if you're already over those limits? My strong advice is to reduce your debt load as fast as possible so that you can get down to (and preferably well below) those limits. There are many ways to do this, and a quick Internet search on topics such as 'debt consolidation', 'financial planning', 'budgeting' and the like will yield plenty of helpful sites. A few standard recommendations:

  • Consolidate several smaller debts into one larger one, with a lower monthly repayment (and, if possible, a lower interest rate). This can often be done by using a balance transfer offer, at preferential interest rates, from a credit card issuer (although you should check out their up-front fees for such transfers - they can be prohibitively expensive).
  • Pay the minimum monthly payment on several accounts, and increase your payments on another account (usually the one on which you're paying the highest rate of interest) to pay it off in full as quickly as possible. As soon as you've cleared it, do the same for another account, and so on.
  • Don't take on any more debt! If you can't pay cash for something, don't buy it. The only exceptions are critical issues such as medical emergencies, an unavoidable vehicle repair, etc.
  • Consider selling some of your assets. If you have expensive 'toys' such as electronics, firearms, etc. that are valuable to others, you could sell some of them on eBay, or through your local classified advertisements (in print or online), at local events such as gun shows, etc. Even smaller items such as books, CD's, DVD's, etc. can be sold for a dollar or two each, or 'bundled' with similar items to sell as a 'package deal' on eBay. The money raised by such sales should be either used for debt reduction, or saved - not spent on non-essentials!
  • Develop a budget and stick to it. More than anything else, routine financial discipline will get you out of debt in due course, and help you to plan your financial future.

In today's economic climate, where the short- to medium-term future looks bleak indeed, I have a few specific suggestions.

  1. If you've built up equity in your property, consider selling it to 'cash out' that equity and use it to reduce debt in other areas. In many parts of the country, houses or apartments are available for rent at very competitive rates right now, and that's likely going to be the case for some time to come. In addition, as house prices continue to fall (they're likely to drop a further 25% to 30% in many markets over the next year or so, as repossessions increase and new construction goes unsold), it'll be easier for those in sound financial health to buy another house at a bargain price. I've just done this myself. I'll be renting for at least the next six months to a year.
  2. If you're already renting, consider cheaper accommodation. There's a glut of rental property in many markets right now. See how much you could save by moving. When you've checked the numbers, you could always talk to your present landlord and ask for a reduction in rent. If you've been a good tenant, and he knows that you have lower-cost options elsewhere, he might be willing to make you a better offer.
  3. Stop buying fripperies and luxuries. Buy 'no-name-brand' or 'house brand' groceries and household goods instead of more expensive brand names; shop for basic items of clothing at low-price outlets such as Wal-Mart or Target, instead of up-market boutiques and department store chains; make do with fewer pairs of shoes, or suits, or ties, or whatever. If a man has more than a dozen ties, ask him, "Why?" The same goes for anyone with more than eight to ten pairs of shoes. You'll be surprised how much less you'll spend by following such steps.
  4. Consolidate vehicle usage. Instead of driving your vehicle on eight or ten shopping trips per week, most of which are for one or two items you need in a hurry, try to consolidate everything into no more than one or two trips per week. Using a shopping list and keeping a reserve of regularly-used items will help you achieve this. Given average vehicle running costs of at least 50c per mile, the savings will add up in a surprisingly short time. For the same reason, consider car-pooling to and from work, or for your children to and from school and other engagements. If your kids are running their own cars, make them pay for their own gas out of their allowance! You'll be surprised how quickly that'll make them decide to leave their car parked, and travel with you - to the benefit of your wallet.
  5. Don't buy lunch at work, and don't eat out so often. If you take sandwiches to work, and cook supper at home, you'll save a surprisingly large amount of money each month. Think about it. A relatively cheap lunch at work, even at the office canteen, plus a fruit-juice or soda or bottle of water from a vending machine, can cost at least $5 each day - frequently more. Over 22 working days in the average month, that comes to over $100. If you make sandwiches at less than half that cost, and drink 'regular' water from the cooler, that's more than $50 you've saved right there, every month - over $600 per year.
  6. Cut out unnecessary luxuries. What are you paying for your monthly gym membership? Why? Can't you get as much exercise by walking or running at home? If money's tight, that expense is a luxury, not a necessity. Does your cable TV package include premium channels? Do you watch them enough to justify the additional cost? If you can cut your cable subscription in half, that's an extra $30 to $50 each month you can spend on something more important. Why not do without cable TV altogether, and spend more time as a family, without its distraction? I gave mine up years ago, and I've never regretted it.

Those are only a few practical steps you can take. There are many more. As I said, do a couple of Internet searches and see what you can learn.

Finally, as a high priority, I recommend that every family should build up at least six months' expenditure in reserve, in a savings account, ready for any emergency. If you get laid off, you won't have to worry about a roof over your head or meals on the table for that long at least. If you have a sudden medical emergency, and have to find $5,000 or $10,000 that 's not covered by your medical insurance for some reason, you'll have it, and won't have to chew your nails worrying about where to find it. If your car's engine blows up, you can afford the $3,000 that a new engine will cost you, and be back on the road in a matter of a week or two, instead of worrying about affording a replacement vehicle. A six-month reserve is an invaluable foundation for your overall financial position. I'd suggest starting to save towards it even while you're reducing debt load and cutting other expenditure. You'll sleep much easier at night when it's there, believe me!

I hope these ideas help.



Anonymous said...

Why should anyone avoid debt? Won't the government continue to bail everyone out?
Sounds sarcastic, but perhaps not: many are convinced inflation is coming in a big way, such that today's debt will be repayable with tomorrow's less-valuable dollars - and thus 'repaid' by those of us who saved and invested.

Stranger said...

Buy now on tick and pay later in toilet paper? It sounds well enough, but it has not worked in practice.

The real problem is that when hyperinflation starts financial institutions no longer have sound money to lend. So business collapses, no one has cash income, and everyone is back to trading what they have for what they need, in a barter economy.

Since barter may be inevitable, it would be best to trade soon-to-be-worthless fiat money for stuff you can trade for food, fuel, and things you cannot make yourself. As well as tools to make or grow what you need, and weapons to protect what you have.

And it would be a really good idea to get together with the neighbors for mutual self defense at the first sign of things going south.


Anonymous said...

Ammo has been the best investment over the last 12 months.

STxRynn said...

Way back in 1999, we got on a no debt bandwagon. Sold some investments to clean up massive credit card debt. Just before the tech bubble popped. Not my crystal ball, just good timing. We are out of debt, have been for a year or more. Only owe on the house.

Taking your advice on eating out/work meals. Wife already had decided we were eating out too much.

I guess what I am really interested in is where to put the money.... Stranger is kinda hinting around what I have been considering. An article on Argentina, post 2001 collapse, mentioned having some small gold jewelry as barter items. Sort of along that vein.

I'm working on the six month cushion. And I'm finding myself wondering if cash money is better off in tangibles, gold, silver, tools, "hardware", etc....

I have read your blog quite a bit, and I really like the thought process you have. It really resonates with me. Thanks for pointedly hitting the importance of shedding debt, and watching spending.

Whats your take on an economic crisis, where our money is devalued/worthless? Like Germany, post WW1... That seems to me, to be where Uncle Sugar is driving us.

Thank you very much for your well thought out response to my first question...

Take care....