Assess Your Financial Situation
Every financial plan needs to start with goals: what you really want and are trying to achieve. You may have very specific notions: a trip to Europe in two years, college education for your kids in 10, retirement in 25. Or you may be looking for a state of mind, such as feeling in control, content, and not anxious about money.
The real work of financial planning comes when you try to figure out which goals are most important, how to prioritize them, and how to save for them while paying the expenses of your day-to-day life.
Setting you up with a full-fledged financial plan is well beyond the scope of this book. But you must address two goals before you construct any debt repayment plan—retirement savings and financial flexibility.
Retirement Savings
This needs to be a high priority for almost everybody. It should take precedence over just about every other goal—including your child's college fund.
This is really tough for many parents to hear, since they're so focused on providing a better life for their kids. One of my personal finance professors put it this way: If worse comes to worst, your kid can always borrow money for school. No one will lend you money for retirement.
In the past couple of decades, the burden of ensuring an adequate retirement has shifted from the employer to the worker. Instead of traditional defined benefit pensions, which promise a set paycheck in retirement to loyal employees, companies increasingly offer defined contribution plans like 401(k)s. How much money workers will have to spend in retirement depends on how much they contribute and how well they invest the money. The company makes no promises.
Another change is in the works. Most retirees today get half or more of their incomes from Social Security. But Social Security has already promised far more benefits than it can deliver to future generations. Higher taxes or cuts in benefits may be needed. If the system is privatized, more risk will be shifted to workers.
Finally, we're living longer than ever before—and that means living longer in retirement. Many Americans plan to cope with the high costs of retirement by working longer. More than half of the workers (54%) surveyed by the Employee Benefit Research Institute in 2004 expected to work to 65 or older, while 68% expected to work at least part-time in retirement.
But, as the EBRI noted, the typical worker retires at age 62, and four out of 10 retirees it surveyed said they left work earlier than they'd planned—often due to ill health, disability, or layoffs.
All these issues underscore the need for most of us to stockpile a decent amount of money—and the earlier we start, the better.
The value of time in helping our savings grow really can't be overstated. Even relatively small delays in getting started, or brief interruptions along the way, can have an outsized impact on how much we can put away.
The Value of Starting Early—and Not Stopping
To illustrate this point, many financial planners use the example of the twins. One twin puts $3,000 aside in a Roth IRA starting at age 22. She continues contributing $3,000 annually until age 32, and then she stops—never to contribute another dime.
Her sibling, in contrast, doesn't start contributing until age 32 but continues until they both retire at 62.
Who has more money? The answer may surprise you: the first twin. She accumulates $437,320, compared to her sister's $339,850 (assuming that both siblings earn an average 8% annual return). The first twin's early contributions gave her a head start that her sibling couldn't match.
This illustration shows why it's important to get an early start; now here's one to show why it's important to keep going.
Let's say our siblings each put $10,000 into a 401(k) annually starting at age 22. Ten years later, the second sibling stops contributions for five years to pay off some debt; the first sibling continues funding her 401(k).
Once she restarted her contributions, how much would Sibling Two have to shell out annually to catch up with her sister by retirement age? The answer: $15,496 a year, or 55% more each year than she would have had to contribute if she hadn't stopped. She'll need to make those extra payments for 25 years to match her sister's kitty at 62.
There's another reason not to stop. Many people who suspend retirement contributions have a tough time resuming their savings later, just as those who put off getting started often let inertia keep them on the investing sidelines. We can always find other ways to spend our money once we've got our hands on it; that's why most of us are far better off simply putting our retirement contributions on automatic and not stopping, whatever the short-term temptations.
That doesn't mean we should tolerate high-rate debt in our lives or delay paying it off indefinitely. The better solution is typically to find money for debt repayment by cutting other spending, not by shortchanging our retirement savings.
You'll notice that I use the words “typically,” “normally,” “usually,” and “generally” quite a bit. That's on purpose because most rules have exceptions, and the rules of debt repayment are no exception.
If any of the following are true, you may be able to suspend your retirement savings for a while so that you can pay off your most troublesome debt faster:
You work in a job that offers a traditional defined-benefit pension plan that will give you 50% or more of your salary in retirement. This is likely to be true if you're a public-school teacher, police officer, firefighter, or federal government worker—and you plan to retire in the job rather than switch to the private sector. State and local governments often have such generous pension plans as well. These plans are far rarer among private companies; if you're not sure what you've got, ask your human resources department.
You know how much you need to save for retirement and are on track to exceed that goal. If this is true, you're a rare bird indeed, since most people have never done the calculations needed to determine how big their retirement fund should be—and many fewer are actually saving more than necessary. If this describes you, though, you have some flexibility to redirect part of your retirement contributions to another goal.
Your employer doesn't offer a 401(k) or similar plan or doesn't offer a match. People who fail to contribute when there is a match are passing up an instant 50% return (if the company matches 50 cents of each dollar you contribute). Unless you've fallen into the clutches of a payday lender, the interest rates you're paying on your borrowing are much, much less. You can see how it's foolish to give up a 50% return to pay off a debt that's costing you 10%.
If you don't have a tax-deferred retirement plan at work, however, or the one you have has no match, you're not giving up the “free money” match if you don't contribute. That doesn't mean you shouldn't start saving at some point—and the earlier the better—but you're not costing yourself as much by not contributing as someone who has a decent plan.
Financial Flexibility
Retirement isn't the only factor you'll want to consider as you construct your debt repayment plan. You'll also want to make sure your household can survive the financial catastrophes that can wait around almost any bend.
As mentioned in the previous chapter, we Americans are pretty lousy at saving for a rainy day. Fewer than one out of three households have the cash on hand to survive even a short stretch of unemployment, and more than 40% live paycheck to paycheck. This helps explain the soaring bankruptcy rate and the state of financial stress in which many people live.
Unfortunately, traditional debt repayment plans ignore how close to the edge most people live. They typically advise paying off the highest-rate debt first, even if doing so could make you more vulnerable to financial setbacks.
A few fortunate folks don't have to worry about their financial flexibility quotient—they've got plenty of cash to tap in an emergency. If you can answer “true” to any of the following three statements, you're one of the lucky few who don't need to make financial flexibility an immediate goal:
You have six months' worth of expenses saved in a safe, liquid, and easily-accessible place like a money market or savings account.
You have less than six months' worth of expenses saved in cash, but you have ready access to a similar amount of cash on credit cards or a home equity line of credit.
You have friends or family who are well-off and who would gladly lend you enough money to pay the bills for six months.
(Personally, I wouldn't advise anyone to rely on the kindness of others to survive a job loss or other financial setback—especially if your borrowing would cause your lender financial hardship. But if you have the proverbial rich aunt or doting parent who would step in if necessary, you already have more financial flexibility than most people.)
As I noted in the previous chapter, most people can't answer yes to any of these questions. But you still may not need to make emergency savings a high priority if you can answer “true” to all three of the following statements:
Your household has more than one income earner.
You work in a growing industry where the possibility of layoffs is remote.
You have adequate life, health, and long-term disability insurance and enough cash to continue your coverage for at least six months if one or both income earners lose their jobs.
If all three are true, you should still boost your emergency savings eventually, but it needn't be one of your highest priorities.