Paying off high-cost consumer debt

Paying down debts isn’t nearly as exciting as investing, but it can make your investment decisions less difficult. Rather than spending your time investigating specific investments, paying off your debts with money you’ve saved may indeed be your best investment.

Consumer debt includes borrowing on credit cards, auto loans, and the like, which are often costly ways to borrow. Banks and other lenders charge higher interest rates for consumer debt than for debt for investments, such as real estate and business, because consumer loans are the riskiest type of loans for a lender. Risk means the chance of the borrower’s defaulting and being unable to pay back all that he or she borrowed.

Many folks have credit card debt that costs 18 percent or more per year in interest. Some credit cards levy interest rates well above 20 percent if you make a late payment or two. Reducing and eventually eliminating this debt with your savings is like putting your money in an investment with a guaranteed tax-free return equal to the rate that you pay on your debt.

For example, if you have outstanding credit card debt at 18 percent interest, paying off that debt is the same as putting your money to work in an investment with a guaranteed 18 percent tax-free annual return. Because the interest on consumer debt isn’t tax-deductible, you would need to earn more than 18 percent by investing your money elsewhere to net 18 percent after paying taxes. Earning such high investing returns is highly unlikely, and to earn those returns, you’d be forced to take great risk.

Consumer debt is hazardous to your long-term financial health (not to mention damaging to your credit score and future ability to borrow for a home or other wise investments) because it encourages you to borrow against your future earnings. I often hear people say such things as “I can’t afford to buy a new car for cash, given how expensive cars are.” Well, okay. New cars are expensive, so you need to set your sights lower and buy a good used car that you can afford. You can then invest the money that you’d otherwise spend on your auto loan.

Now, I do “recommend” one exception to my guideline of not borrowing through a credit card: Tapping credit card debt may make sense if you’re financing a business. If you don’t have home equity, personal loans (through a credit card or auto loan) may actually be your lowest-cost source of small-business financing (see Chapter 14 for more information).

Establishing an emergency reserve

You never know what life will bring, so having an accessible reserve of cash to meet unexpected expenses makes good financial sense. If you have generous parents or dear relatives, you can certainly consider using them as your emergency reserve. Just be sure you ask them in advance how they feel about that before you count on receiving funding from them. If you don’t have a financially flush family member, the onus is on you to establish a reserve.

I generally recommend that you have at least three months’ worth of living expenses to as much as six months’ worth of living expenses as an emergency reserve. Invest this personal-safety-net money in a money market fund (see Chapter 7). You may also be able to borrow against your employer-based retirement account or against your home equity, should you find yourself in a bind, but these options are much less desirable.

If you don’t have a financial safety net, you may be forced, under duress, to sell an investment (at a relatively low price) that you’ve worked hard for. And selling some investments, such as real estate, can take time and cost significant money (transaction costs, taxes, and so on).

Riskier investments like stocks aren’t a suitable place to keep your emergency money invested. While stocks historically have returned about 9 percent per year (see Chapter 3), about one-third of the time, stocks decline in value in a given year, sometimes substantially. Stocks can drop and have dropped 20, 30, or 50 percent or more over relatively short periods of time. Suppose that such a decline coincides with an emergency, such as the loss of your job or a health problem that creates major medical bills. Your situation may force you to sell at a loss, perhaps a substantial one. As I discuss in Chapter 8, stocks are intended to be a longer-term investment, not an investment that you expect (or need) to sell in the near future.

Assessing student loans

If you’re one of many young adults with lingering student loan debt, you’re probably wondering whether you should focus your efforts on paying down that debt or instead invest the extra cash you have.

The best choice hinges on the interest rate on this debt (after factoring in any tax breaks) and how that compares with the expected return from investing. Of course, you must be reasonable and not pie-in-the-sky about the rate of return you expect from your investments.

Under current tax laws, with student loans, you can deduct up to $2,500 in student loan interest annually on your federal 1040 income tax return. So this deduction can lower the effective interest rate you’re paying on your student loans. This deduction is available to single taxpayers with adjusted gross incomes (before subtracting the student loan interest) of $65,000 or less and married couples filing jointly with such incomes of $135,000 or less. Partial deductions are allowed for incomes up to $80,000 for singles and $165,000 for married couples filing jointly. Another requirement for taking this deduction is that you and your spouse, if filing jointly, cannot be claimed as dependents on someone else’s income tax return.

If you can deduct student loan interest on your tax return, to determine the value of that deduction, please see Chapter 4 to understand what tax bracket you’re in (what your marginal tax rate is). For most moderate income earners, 25 percent is a reasonable number to work with.

Suppose you have student loans outstanding at the attractive interest rate of just 3.5 percent. Assume that you’re able to deduct all this interest and that your income tax bracket is 25 percent. So after taxes, the effective interest rate on your student loan is .

Now, the question to consider is this: Can you reasonably expect to earn an average annual rate of return from your investments of more than this 2.63 percent? If you invest your money in a sleepy bank account, the answer will probably be no. If you instead invest in things like stocks and bonds, over the long term, you should come out with a higher return.

If you have student loans at a higher interest rate — say, 6 percent — it may make more sense to pay those loans down faster with your extra cash than to invest that money elsewhere. To get a higher return than that from investments, you need to take a fair amount of risk, and of course there’s no guarantee that you’ll actually make a high enough return to make it worth your while.

When deciding whether you should pay down student loans faster, there are some factors to consider besides the cost of your student loans and comparing this cost to the expected return on your investments. Other good reasons not to pay off your student loans any quicker than necessary include the following:

• Paying off your student loan faster has no tax benefit. Instead, you could contribute to your retirement (also known as tax reduction) accounts, such as a 401(k), an IRA, or a SEP-IRA plan (especially if your employer offers matching money). Putting additional money in a retirement plan can immediately reduce your federal and state income tax bills. The more years you have until retirement, the greater the benefit you receive if you invest in your retirement accounts. Thanks to the compounding of your retirement account investments without the drain of taxes, you can actually earn a lower rate of return on your investments than you pay on your student loans and still come out ahead.

• You’re willing to invest in growth-oriented, volatile investments, such as stocks and real estate. To have a reasonable chance of earning more on your investments than it costs you to borrow on your student loans, you must be aggressive with your investments. As I discuss in Chapter 3, stocks and real estate have produced annual average rates of return of about 9 percent. You may be able to earn even more by creating your own small business or by investing in others’ businesses.

  Keep in mind that you have no guarantee of earning high returns from growth-type investments, which can easily drop 20 percent or more in value over a year or two.

• Paying down your student loans depletes your emergency reserves. Psychologically, some people feel uncomfortable paying off debt more quickly if it diminishes their savings and investments. You probably don’t want to pay down your debt if doing so depletes your financial safety cushion. Make sure you have access — through a money market fund or other sources (a family member, for example) — to at least three months’ worth of living expenses (as I explain in “Establishing an emergency reserve” earlier in this chapter).

Considering paying down mortgage debt

Paying off your mortgage more quickly is an “investment” for your spare cash that may make sense for your financial situation. However, the wisdom of making this financial move isn’t as clear as is paying off high-interest consumer debt; mortgage interest rates are generally lower, and the interest is typically tax-deductible.

As with the decision to pay off a student loan faster (look to the previous section), when evaluating whether to pay down your mortgage quicker than necessary, compare your mortgage interest rate with your investments’ rates of return. Suppose you have a fixed-rate mortgage with an interest rate of 5 percent. If you decide to make investments instead of paying down your mortgage more quickly, your investments need to produce an average annual rate of return, before taxes, of more than 5 percent for you to come out ahead financially.

Don’t get hung up on mortgage tax deductions. Although it’s true that mortgage interest is usually tax-deductible, you must also pay taxes on investment profits generated outside retirement accounts. You can purchase tax-free investments like municipal bonds, but over the long haul, such bonds and other types of lending investments (bank savings accounts, CDs, and other bonds) are unlikely to earn a rate of return that’s higher than the cost of your mortgage.

Considering your investment options and desires

Many good investing choices exist: You can invest in real estate, the stock market, mutual funds, exchange-traded funds, or your own business or someone else’s. Or you can pay down debts such as on your student loans, credit cards, auto loan, or mortgage debt more quickly.

What makes sense for you depends on your goals as well as your personal preferences. If you detest risk-taking and volatile investments, paying down some debts, as recommended earlier in this chapter, may make better sense than investing in the stock market.

To determine your general investment desires, think about how you would deal with an investment that plunges 20 percent, 40 percent, or more in a few years or less. Some aggressive investments can fall fast. You shouldn’t go into the stock market, real estate, or small-business investment arena if such a drop is likely to cause you to sell or make you a miserable wreck. If you haven’t tried riskier investments yet, you may want to experiment a bit to see how you feel with your money invested in them.

A simple way to mask the risk of volatile investments is to diversify your portfolio — that is, put your money into different investments. Not watching prices too closely helps, too; that’s one of the reasons why real estate investors are less likely to bail out when the market declines. Unfortunately (from my perspective), stock market investors can get daily and even minute-by-minute price updates. Add that fact to the quick phone call, click of your computer mouse, or tap on your smartphone that it takes to dump a stock or fund in a flash, and you have all the ingredients for shortsighted investing — and potential financial disaster.

Making investing decisions and determining your likes and dislikes is challenging when you consider just your own concerns. When you have to consider someone else, dealing with these issues becomes doubly hard, given the typically different money personalities and emotions that come into play. In most couples with whom I’ve worked as a financial counselor, usually one person takes primary responsibility for managing the household finances, including investments. In my observation, the couples that do the best job with their investments are those who communicate well, plan ahead, and compromise.

In my work as a financial counselor, one of the most valuable and difficult things I did for couples stuck in unproductive patterns of behavior was help them get the issue out on the table. For these couples, the biggest step was making the time to discuss their financial management, whether as a couple or working with an advisor or counselor. The key to success is taking the time for each person to explain his or her different point of view and then offer compromises. So be sure to make time to discuss your points of view or hire a financial advisor or psychologist/marriage counselor to help you deal with these issues and differences.

Assessing your savings rate

To accomplish your financial goals, you need to save money, and you also need to know your savings rate. Your savings rate is the percentage of your past year’s income that you saved and didn’t spend.

Part of being a smart investor involves figuring out how much you need to save to reach your goals. Not knowing what you want to do a decade or more from now is perfectly normal; after all, your goals, wants, and needs evolve over the years. But that doesn’t mean you should just throw your hands in the air and not make an effort to see where you stand today and think about where you want to be in the future.

An important benefit of knowing your savings rate is that you can better assess how much risk you need to take to accomplish your goals. Seeing the amount that you need to save to achieve your dreams may encourage you to take more risk with your investments.

During your working years, if you consistently save about 10 percent of your annual income, you’re probably saving enough to meet your goals (unless you want to retire at a relatively young age). On average, most people need about 75 percent of their preretirement income throughout retirement to maintain their standards of living.

If you’re one of the many people who don’t save enough, do some homework. To save more, you need to reduce your spending, increase your income, or both. For most people, reducing spending is the more feasible way to save.

To reduce your spending, first figure out where your money goes. You may have some general idea, but to make changes, you need to have facts. Examine your bill-paying records and review your credit card bills and any other documentation that shows your spending history. Tally up how much you spend on dining out, operating your car(s), paying your taxes, and everything else. After you have this information, you can begin to prioritize and make the necessary trade-offs to reduce your spending and increase your savings rate. Earning more income may help boost your savings rate as well. Perhaps you can get a higher-paying job or increase the number of hours you work. But if you already work a lot, reining in your spending is usually better for your emotional and economic well-being.

If you don’t know how to evaluate and reduce your spending or haven’t thought about your retirement goals, looked into what you can expect from Social Security, or calculated how much you should save for retirement, now’s the time to do so. Pick up my book Personal Finance in Your 20s & 30s For Dummies (Wiley) to find out all the necessary details for retirement planning and much more.

Investing regularly with dollar cost averaging

Regularly investing money at set time intervals, such as monthly or quarterly, in volatile investments such as stocks, stock mutual funds, or exchange-traded funds is called dollar cost averaging (DCA). If you’ve ever had money regularly deducted from your paycheck and contributed to a retirement savings plan investment account, you’ve done DCA.

Most folks invest a portion of their employment compensation as they earn it, but if you have extra cash sitting around, you can choose to invest that money in one fell swoop or to invest it gradually via DCA. The biggest appeal of gradually feeding money into the market via DCA is that you don’t dump all your money into a potentially overheated investment just before a major drop. No one has a crystal ball and can predict which direction investments will move next in the short term. DCA helps shy investors psychologically ease into riskier investments.

DCA is made to order for skittish investors with larger lump sums of money sitting in safe investments like CDs or savings accounts. It also makes sense for investors with a large chunk of their net worth in cash who want to minimize the risk of transferring that cash to riskier investments, such as stocks.

As with any risk-reducing investment strategy, DCA has its drawbacks. If growth investments appreciate (as they’re supposed to over time), a DCA investor misses out on earning higher returns on his money awaiting investment. Studying U.S. stock market data over seven decades, finance professors Richard E. Williams and Peter W. Bacon found that approximately two-thirds of the time, a lump-sum stock market investor earned higher first-year returns than an investor who fed the money in monthly over the first year.

However, knowing that you’ll probably be ahead most of the time if you dump a lump sum into the stock market is little solace if you happen to invest just before a major drop in prices. For example, from late 2007 to early 2009, global stocks shed about half of their value.

If you use DCA too quickly, you may not give the market sufficient time for a correction to unfold, during and after which some of the DCA purchases may take place. If you practice DCA over too long a period of time, you may miss a major upswing in stock prices. I suggest using DCA over one to two years to strike a balance.

When you use DCA, establish an automatic investment plan so you’re less likely to wimp out of your strategy. Your money that awaits investment in DCA should have a suitable parking place. I recommend a money market fund that’s appropriate for your tax situation.

Paying for college

If the way in which the financial aid system works effectively encourages you to save in your own retirement accounts, how will you pay for your kid’s education expenses? Here are some ideas and resources:

• Home equity: You can borrow against your home at a relatively low interest rate, and the interest is generally tax-deductible.
• Company retirement plans: Some 401(k)s allow borrowing for educational costs.
• Student loans: Several financial aid programs allow you to borrow at reasonable interest rates. The Unsubsidized Stafford Loans and Parent Loans for Undergraduate Students (PLUS), for example, are available, even when your family isn’t deemed financially needy.
• Grants and scholarships: Grant programs are available through schools and the government, as well as through independent sources. Complete the Free Application for Federal Student Aid (FAFSA) application to apply for the federal government programs. Grants available through state government programs may require a separate application. Specific colleges and other private organizations — including employers, banks, credit unions, and community groups — also offer grants and scholarships.
• Work and save: Your child can work and save money during high school and college. In fact, if your child qualifies for financial aid, she’s generally expected to contribute a certain amount to education costs from employment (both during the school year and summer breaks) and from savings. Besides giving your gangly teen a stake in her own future, this training encourages sound personal financial management down the road.

Considering educational savings account options

You’ll hear about various accounts you can use to invest money for your kid’s future college costs. Tread carefully with these, especially because they can affect future financial aid.

The most popular of these accounts are qualified state tuition plans, also known as Section 529 plans. These plans offer a tax-advantaged way to save and invest more than $100,000 per child toward college costs. (Some states allow upward of $300,000 per student.) After you contribute to one of these state-based accounts, the invested funds grow without taxation. Withdrawals are also tax-free provided the funds are used to pay for qualifying higher-education costs (which include college, graduate school, and certain additional expenses of special-needs students). The schools need not be in the same state as the state administering the Section 529 plan.

Section 529 plan balances can harm your child’s financial aid chances. Thus, such accounts make the most sense for affluent families who are sure they won’t qualify for any type of financial aid. If you do opt for a 529 plan and intend to apply for financial aid, you should be the owner of the accounts (not your child) to maximize qualifying for financial aid.

Investing money earmarked for college

Diversified mutual funds and exchange-traded funds, which invest in stocks in the United States and internationally, as well as bonds, are ideal vehicles to use when you invest money earmarked for college. Be sure to choose funds that fit your tax situation if you invest your funds in nonretirement accounts. (See Chapter 10 for more information.)

When your child is young (preschool age), consider investing up to 80 percent of your investment money in stocks (diversified worldwide) with the remainder in bonds. Doing so can maximize the money’s growth potential without taking extraordinary risk. As your child makes his way through the later years of elementary school, you need to begin to make the mix more conservative. Scale back the stock percentage to 50 or 60 percent. Finally, in the years just before the child enters college, reduce the stock portion to no more than 20 percent or so.

Some 529s offer target-date-type funds that reduce the stock exposure as target college dates approach so you don’t have to make the adjustments yourself.