Kicking Financial Ass
Page 7
•Number of transactions permitted: While you are unlikely to make a lot of transactions with an emergency fund, ensure that the number on the account is enough for your needs.
•Accessing the funds: What options are available to withdraw funds? Can you write checks? Transfer funds electronically? Use an ATM? The easier you can access the funds, the better. In an emergency, you will need the money quickly.
Step 2: Build an Emergency Fund Using an Automatic Savings Plan
Start with a $1,000 emergency fund. This initial $1,000 will build a buffer between unexpected life events that will most likely pop up. The last thing you want is something like getting a flat tire and going further into debt. Moreover, $1,000 is an achievable target and will build your confidence to save money.
The easiest way to start is to have money automatically withdrawn from each paycheck and funneled into a separate savings account. Before you know it, you will have enough money saved up for an emergency.
Step 3: Pay Off Your Debts
Once you have a $1,000 emergency fund, focus your attention on your debt, starting with the highest interest debt first, known as the “Debt Avalanche” method.
Step 4: Build Up Your Emergency Fund to Two Months and Use Springy Debt Instead of a Large Cash Cushion
Many personal finance experts suggest having three to six months of living expenses (or more) in an emergency fund. I do not necessarily agree with this strategy as long as you have a small cash cushion to keep your life running smoothly in the event of losing a job or encountering a big unexpected expense. I recommend saving a minimum of two months’ worth of salary after first starting with $1,000 and then paying off your debt. I consider anything more a waste of potential earnings. I loathe keeping excess money in a savings account when it could be working for me in some investment.
The solution is to use springy debt. As previously mentioned, springy debt is debt you can easily draw on like a line of credit. The most important thing is to keep this at a zero balance and use it only in an emergency.
The critique to this view is that lines of credit and credit cards can be turned off by the bank. Critics argue that it is better to have a larger stash of cash in an emergency fund versus using springy debt. However, the way I see it is there is little chance of the bank closing your credit card and line of credit if you are making payments. The only caveat is if you lose your job, then your two months of salary savings will get you by. If you have been following my advice in this book, your spending rate should only be 60% of your monthly income, meaning your two-month salary savings will last you 2.8 months. Not to mention that you would probably cut back on non-critical expenses under these circumstances, meaning your two-month salary emergency fund could last you three to four months, around the average time it takes to find another job.25
SUMMARY
Prioritize having a $1,000 emergency fund over anything else, including paying down your debt. The buffer will build your confidence and allow you to handle any financial hiccup that may come, without derailing your debt repayment progress later.
•Open a high-interest savings account for your emergency fund. It is important to get as much interest as you can from your accounts, while simultaneously keeping your emergency fund liquid in case you need to use it. Do not invest this money in the stock market.
•Use an automatic savings plan to achieve your emergency fund goal effortlessly.
•Once you have $1,000 saved up, focus on debt repayment. Make this your number one priority.
•After your debt is paid off, build up your emergency fund to two months’ worth of salary.
•Use springy debt instead of a large cash cushion for any unexpected expenses that go beyond what you saved in your emergency fund.
•Focus on putting the rest of your savings into index fund ETFs and watch your retirement nest egg grow.
CHAPTER FIVE
TAKE BACK CONTROL OF YOUR DEBT
FOCUS ON YOUR CREDIT CARD DEBT FIRST
During my undergrad, I was hesitant to use my credit card. Not making much money and facing a large student loan debt, I was scared to fall further into debt. I used my debit card almost exclusively, saving my credit card for the odd purchase that was above my debit card limit and immediately transferred funds to pay it off. I am not exactly sure where I developed this mentality, but I have a feeling my tough upbringing had something to do with it.
The truth is many of us spend our lives in debt. More specifically, credit card debt. Average credit card debt per household is now more than $7,000. Total debt is worse. As I mentioned in the introduction, the average American has about $12,000 in debt, not including mortgage debt. And, the average student has $20,000 of debt at graduation. It is no one’s fault. Stores offer promotions to receive a discount if you apply for a card right then. Banks give away pre-qualified credit cards through the mail. It should be no surprise that the average American has four credit cards.
It is in the lender’s best interest if you keep a balance on that credit card and are charged obscenely high interest rates. High-interest debt can and will grow so fast that it can overwhelm you and your other investments. This often means it makes sense to prioritize paying down your credit card debt. The average credit card has about a 15% interest rate, whereas store credit cards often charge above 20%. Paying off high-interest debt first is probably the best return you will ever see. When you start paying down your credit cards, you produce an immediate 15% to 25% return in your pocket. Remember: The stock market averages just under 10% per year.
To pay back your debt, start by paying more than the minimum payment each month. About a third of Americans pay only the minimum payment each month. Another third vacillate between paying part of the balance off one month, and then the minimum the next month. Why do so many of us only pay the minimum? For one, the credit card company says it is okay. And, we know just paying the minimum should not affect our credit score. As for what the minimum payment is, each credit card is different, but often it is $25, or 1% to 2% of the balance, plus interest and fees, whichever is greater.26 In Canada, minimum payments are typically $10 plus the interest and fees.27
The reality is the minimum payment is set in such a way that if you had a $3,000 credit card balance and were making the $80 minimum payment each month (1% balance + interest), it would take you 226 months to pay off the entire debt, which is about 19 years!
Let’s look at what paying the minimum payment and double the minimum payment saves in interest.
Credit Card Balance: $3,000 Carl Joe
Monthly Payment $80 (minimum) $160 (minimum x 2)
Pay-Off Time 18 years, 10 months 1 year, 11 months
Interest Paid $4,390.04 $627.24
*assuming 19.99% APR
You would save $3,762.80 by doubling the monthly minimum payment.
The above example also assumes that you spend no more on the card, even if your credit limit increases, which is something credit card companies often do. It is easy to become trapped in an endless debt cycle if you only make the minimum payments.
Know When Your Credit Card Payment Is Due
With credit cards, you have at least 21 days from the day the billing cycle closes to pay your bill without incurring the interest charge. If you pay your credit card entirely, it is like receiving an interest-free loan and collecting rewards, if your credit card offers those. If you miss a full payment, you are paying the interest rate on the outstanding balance. If you skip a payment, make a late payment, or pay part of the minimum payment, you incur extra charges.
Credit Cards Can Be Good
If you pay off your balance every month, credit cards allow you to earn rewards and save you from needing to either carry cash at all times or using your debit card, which offers no rewards and can include its own fees. Furthermore, having a credit card makes it easier to track your spending habits online and offers additional benefits, such as extended warranties and travel insurance. Two or three credit cards
, say a Visa and a MasterCard, with manageable credit limits are the most you should have. Make sure no more than one has an annual fee.
Why have two or three cards? If a store does not accept Visa or MasterCard, then you will have a backup. Also, if one is stolen or compromised, you still have access to a card. Avoid those credit card offers you receive in the mail. Only apply for a credit card if you need it, however.
Be aware that 60% of people do not pay off their credit cards every month. If you have a credit card, pay off the balance every month. Did you know that people typically spend 47% more when using credit instead of cash? This also includes debit cards. Why? Paper is real, and we feel a tangible sense of loss using it to pay. Psychologically, when you pay with cash, you tend to spend less. If you find you spend more because you use a card instead of cash, either lower your credit limit or cancel your cards and pay with cash.
What if you do not have enough savings or emergency fund and have to carry a balance for something you absolutely need? In these circumstances, see if you can get a line of credit with a lower interest rate. Or, put it on your card and pay off your balance within three months or sooner. If you think it will take longer than three months to pay off your credit card or line of credit, then you cannot afford it.
Important: Three months of interest on a credit card is equivalent to about 7% depending on the card, almost equal to a full year of gains in the stock market. Seriously question if the purchase is worth it and if you need to carry a balance at all.
Credit Cards Can Be Bad
Stay within your credit limit. Banks often charge a hefty fee if you go over your limit, assuming your credit card transaction was not denied.
Do not use your credit card for cash advances. Most credit cards can be used to take cash out from the ATM. But when you do this, the issuers charge even higher interest rates on this amount and/or fees. Moreover, most cash advances do not have a grace period, so interest starts accruing the second you take out the cash.
Again, carrying a balance is very detrimental to your personal finances. Aim for a zero balance each month.
A basic, cash-back or travel rewards card offers 1% to 2% back. Chances are you will only spend enough during the year earning rewards to make it worth having only one card. If the rewards are less than what you are paying in annual fees, switch all your cards to no annual fee cards.
Other cards offer more on groceries, gas, travel, and dining out. Matching your spending to the highest reward category maximizes the cash back you earn on every dollar spent. Use this strategy only if you are experienced with credit cards and pay off the balance monthly. Paying interest nullifies the benefits of earning rewards.
Be Aware of the No Monthly Payments Promotions
You might be tempted by the following:
“Don’t pay for 12 months. No monthly payments. 0% interest!”
“12-month financing. Pay no interest for 12 months with equal payments on all purchases.”
“Employee pricing on all vehicles!”
You have probably seen ads like these. In the fine print, the interest rates are equal to or greater than most credit cards, especially if you do not pay the balance within the time frame they advertise. Be careful about store credit cards. Even with those “10% off now” promotions, they often have higher interest rates than standard credit cards. Over time, this can cost you more than the savings you receive with your purchase.
KNOW YOUR CREDIT SCORE
You may think that only credit card companies, mortgage lenders, and car dealerships care about your credit score. Unfortunately, this is not the case. Potential landlords may run a credit check to look for red flags, like a history of missed payments or a heavy debt load relative to your income. Employers may pull credit reports, which are not the same as a credit score, to see if you manage your finances well and verify your identity.
Between credit scores and credit reports, credit scores garner more attention. Your credit score is a number that lenders use to judge your ability to pay them back and as a crucial factor in determining interest rates on your debts. A good score allows you to receive the best deals on everything from credit cards to mortgages. A bad one can potentially cost you tens of thousands of dollars in additional interest. The difference in interest rates can be huge, especially on mortgages. Check myFico.com’s loan savings calculator to determine how much a good score can save you on interest. It can be well over a 1.5% difference on a 30-year mortgage, which translates to $100,000 in interest savings with a top score versus the lowest score on a $300,000 mortgage.
To understand credit scores, you first must understand credit reports. These are created by credit bureaus that gather information from a range of credit card companies, lenders, and merchants with whom you have done business. Included in each report is the date you opened each account, how much you owe, your credit limits, and your payment history. Your report also indicates whether you have had major financial problems, like defaulting on a loan or declaring personal bankruptcy. It shows any requests for your credit history by third parties like landlords, employers, and lenders. All this information from your credit report is plugged into a mathematical formula to create your credit score. Every time you apply for a new loan or credit card, credit bureaus supply your credit report or credit score, sometimes both.
How Your Credit Score Is Calculated
The most common type of credit score is called the FICO score, named for the Fair Isaac Corporation, which created it. It is also referred to as a Beacon score. There are 5 important factors when determining your credit score:
1.Payment history – 35% of your score
2.How much you owe – 30%
3.Length of your credit history – 15%
4.Mix of credit – 10%
5.Number of credit applications you have – 10%
Most FICO scores range from 300 to 850. The higher the number, the better. The average score is 700, and your goal should be in the 700+ club. This is the breakdown of the scores:
•800+: Exceptional credit
•750 to 799: Excellent credit
•700 to 749: Good credit
•640 to 699: Fair credit
•580 to 639: Poor credit
•Below 580: Bad credit
Three major credit bureaus maintain your credit reports in the U.S.: Equifax, Experian, and TransUnion. You are legally entitled to one free credit report per year from each. Everyone should know what their credit score is. To find out, go to AnnualCreditReport.com or CreditKarma.com. If you are in Canada, CreditKarma.ca is a useful resource, and some Canadian banks offer free credit score services.
Improving Your Credit Score
Surprisingly, your net worth and salary have no impact on your credit score. If you have a below-average credit score, or just want to improve it, follow these tips:
•Automate your payments. Payment history makes up the largest portion of the credit score at a 35% weighting, so making payments on time will have the biggest effect.
•Owe less than what you can potentially borrow. In other words, avoid having your credit cards and lines of credit maxed out. This is another 30% of your score, so it will have a big effect as well.
•Once you pay your debt, do not close the account. Credit history is another 15%.
•Have different kinds of debt. Having a mix of credit is another 10% of your score. For example, people with top scores have a mix of debt, like student loans, credit cards, and car loans.
•Do not apply for multiple credit applications within a short time. Every time you apply for a loan or credit card, it is noted on your credit report as an inquiry. If an employer or landlord checks your score, this is deemed a “soft” inquiry, which will not hurt your score. If a lender or credit card issuer checks your report, however, this qualifies as a “hard” inquiry. Having too many of those can negatively impact your score temporarily.
•Maintain a low utilization ratio, which is your actual debt versus the potent
ial debt you could borrow. Let’s say you have two credit cards, each with a $4,000 limit. You have a potential debt of $8,000. You owe $3,000 on one card and $1,000 on the other, for an actual debt of $4,000. You have a utilization ratio of 50%. If you pay off the credit card with the $1,000 balance and close it, your utilization ratio will increase to 75% since you now have a $3,000 balance with a $4,000 limit.
What if I Missed a Bill and It Is in Collections?
Having a bill in collections is the fastest way to destroy your credit rating. According to a 2014 Consumer Financial Protection Bureau (CFPB) report, an estimated 43 million Americans have medical debt in collections. This does not include delinquent car payments, cell phone bills, missed utility bills, or unpaid student loans.
Unfortunately, the credit bureau has a zero-tolerance policy on bills in collections, so your score will take an immediate 70 to 100-point hit. You are essentially saying, “I do not care about paying my bills on time.” They do not listen to excuses. Once a bill is in collections, your first priority should be to pay it back.
Fortunately, your delinquent bill may eventually roll off your credit report, but it will take 7 or 10 years.
•Foreclosures: Removed from your credit report after 7 years
•Chapter 13 bankruptcy: Removed after 7 years
•Chapter 7 bankruptcy: Removed after 10 years from the filing date
•Civil judgments: Removed after 7 years
•Unpaid tax liens: May be removed after 10 years from the filing date but could stay on indefinitely
•Paid tax liens: Removed after 7 years from the paid date
4 STEPS TO MANAGING YOUR DEBTS
Now that you know what your credit score is and how important it is, the next thing is to devise a plan on conquering your debt. Follow these 4 steps:
Step 1: Calculate Your Debt
List all your debts except your mortgage from highest interest rate to lowest, including those with zero percent interest rates. Typically, credit cards will be at the top of the list. I recommend listing the following: