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Financial Literacy Building Block: Compound Interest

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financial literacy building blocksAlbert Einstein said compound interest is the 8th wonder of the world.

Those who understand it, earn it.  He who doesn’t, pays it.

In other word, it’s a double edged sword.

Terrific if you’re earning it.  Debilitating if you’re paying it.

And compound interest is a fundamental building block of personal financial literacy.

Why compound interest matters

Understand compound interest, and you’re motivated to contribute to your IRA faithfully.  The interest your account earns this year itself earns interest next year.  And next year, and the next,

Borrow money at compound interest and the interest bearing balance can grow to be larger than the original loan.

Compound interest is at the heart of many of the student loan horror stories.  Student borrows $10,000, uses some deferments,  and, after paying for years, owes $18,000.

How does that work?

Deferred student loan payments compound

The interest portion of a deferred payment is added to the loan balance, and that unpaid interest accrues more interest.

Student loan servicer Navient explains it this way.

Unpaid accrued interest is added to the principal amount of your loan after you leave school and finish any applicable grace period. Simply put, there will be interest to be paid on both the principal of the loan and on the interest that has already accumulated.

Sallie Mae uses slightly different language.  They talk about “capitalization”.  Different words, same idea.

“Capitalized” means added to the Current Principal of the loan.  Your billing statement might show a Current Principal that’s more than the original amount that you borrowed. That’s because the interest has been accruing since the loan was originally disbursed. The more frequently interest is added to the Current Principal, the more interest you will pay. Capitalization may occur when the separation or grace period ends, or at the end of a period of forbearance or deferment.

So, that comforting deferment of your payment obligation has you suffering the downside of compound interest.

Reverse mortgage sucks equity

At the other end of the age spectrum, homeowners taking out a reverse mortgage suffer compound interest on their loan.

The money you draw out incurs interest, which you don’t pay under the terms of the mortgage.  However, that unpaid interest is added to the loan balance of the reverse mortgage.

Next accounting period, you’re incurring interest on the interest you didn’t pay before.

Equity shrinks fast at that rate.

Einstein got it:  Fail to pay according to terms and the debt grows even faster than at simple interest.

Compound interest fuels savings

If you are the saver, rather than the borrower, compound interest works great.

The interest your savings earn this year earns more interest next year.

Suppose you save $100 a month and it earns 3% interest.  At the end of 10 years, you have $15,782.

That’s $3782 in interest, even at today’s paltry interest rates.

Same rate of savings over 30 years gets you $25,716 in interest, swelling your nest egg.

Personally, I’d rather be earning compound interest than paying it.  You?

 

The Most Powerful Debt Management Tool

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black box croppedThe most powerful debt management tool isn’t a software program.

It isn’t a website, nor a consulting firm.

It isn’t even a calculator.

The most powerful debt management tool is a letter opener.

  • letteropener_tobyotter_FlickrIf you don’t open the mail, you don’t really know where you stand with your creditors.
  • If you don’t open the mail, you don’t know that your lender has instituted foreclosure proceedings.
  • If you don’t open the mail, you don’t know that you’re overdrawn at the bank or over limit on your credit card.

Or, less threateningly, the lender has transferred the servicing of your loan.

You don’t know anything about your situation except that you are in trouble, if you don’t open the mail.

Now, there is another step:  you need to read what’s in the envelope.

The envelope, please

I know confronting what you owe and your sense that there’s little you can do about it increases your stress.

But, the dunning letter or the lawsuit isn’t itself dangerous.

Creditors don’t lace their missives with ricin or anthrax.  They need you alive to pay them!  They hope, anyway.

What you’re trying to avoid by not opening the mail, or worse, tossing it out, is confronting your situation.

What you don’t know can hurt

Ignoring what’s in the mail can make the situation worse.

The only situation in which we throw people in jail for not paying their ordinary bills is when they’ve gotten a court order requiring their appearance and they ignore it.

My friend Jay Fleischman tells a marvelous story of a doctor and the doctor’s lawyers who didn’t open the mail nor read what was inside.  Instead of collecting money from Jay’s client, they ended up paying Jay’s client $20,000 for ignoring the court-ordered bankruptcy stay.

Fight or flee

Whether the solution to your debt problems is a payment plan or a bankruptcy filing, you need to know who you owe money to and where they get their mail.

All that’s contained in your mail.

So, open the mail, know whether there’s a situation that requires your attention.  Then if you want to put the opened mail in a shopping bag to bring to your bankruptcy attorney, that works.

Just don’t show up in my office, deep in debt, and not be able to tell me who to notify about your bankruptcy case.

More

How to weigh whether to file bankruptcy

How to interview a bankruptcy lawyer

The life-threatening cost of stress

Image of black box courtesy of Thierry Ehrmann and Flickr.

Image of letter opener courtesy of tobyotter and Flickr.

Smoke, Mirrors, And Budgets: Are You Missing Where Your Money Goes

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smoke and mirrors theilr cc

 

In honor of Financial Literacy month, we’re pulling out some vintage posts on financial basics.

I can’t save anything because it takes every dollar I make just to get by.

Sound like a description of your budget?

For some folks, that is absolutely true.

But for another slice of working folks, there’s some black magic budgeting going on that hides what’s really afoot.

These voodoo budgets look rational, but only on the surface.  If there were two budget line items:  1) food, and 2) groceries,  you’d see the duplication.

But what often happens is more subtle.  Meet the twins of budget self deceptions.

Budget Blunder #1:  Electronic entertainment

Got cable?  More than basic cable?  Do you also budget for entertainment, eating out, vacations?

Whoa!

What is premium cable if not entertainment?  You can probably say the same thing about data on smart phones.

These services make our days brighter.  But the cost has to be counted against the same budget category as other non essential pleasures.

Somehow, smart phones and HBO have become, in our minds, utilities or basics, rather than embellishments.  Once you count them as a given expense, then it’s easy to say, I have nothing left to save for the unexpected emergency or the absolutely expected old age.

Put digital diversion in the entertainment category when you lay out your budget.  Putting like with like, you can assess whether the allocation of income makes sense.

Then you can ask whether you can get what you’d like for less, or,  whether you’re paying for more than you use.

Budget Blunder #2:  Credit card payments

Credit card debt service is the second twin in the world of smoke-and-mirrors budgeting.

Monthly payments on credit cards now rate their own line in most budgets.  If you’re carrying a balance, some part of this month’s income is going to pay for last month’s spending.

But what did you buy with your credit card?  It’s not as though those purchases are distinguishable from the rest of the categories in your budget.

You probably bought gas, clothes, movie tickets, meals out.

By creating a separate cubby in your mental budget for payments on your credit card, you’ve hidden some part of  what you spend on transportation, clothes, and entertainment.

Cut through the smoke and mirrors

So, banish voodoo budgeting from your life.

Pull out your cable and wireless bills.  Read through where you used your credit cards last month.  Push those purchases into the right categories.

See if your spending is skewed in a way you didn’t see before.

Image courtesy of Theilr

Bankruptcy and “Ruining your credit score”

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No matter how precarious their financial situation, almost every client I meet thinks bankruptcy will ruin their credit score.

Not only ruin it, but damage it for all time, precluding normal life after bankruptcy.

Some resolve to stagger along, burdened with their debt and the fear of escaping debt.

So, my encounter with a financial columnist was on point.

Liz Weston, L.A. Times financial writer, lead a room full of bankruptcy attorneys through the impact of various life events on  one’s credit score.

She recounted how, after meeting some debtors as she worked on stories, she no longer saw debtors as deadbeats.

She saw the challenges in their lives and the soundness of electing bankruptcy. Her candor about the change in her world view was refreshing.

Having written a book on credit scoring, she naturally was caught up in the interface with bankruptcy.

But as one who is frustrated by the fixation of those drowning in debt on their credit score, I wanted to stand up and shout:

 Ruin your credit score, not your life!

The financial media sounds a drum beat that one’s life and worth is wrapped up in that credit score.  All the while,  that score is something  we don’t fully understand and  is based on credit reports which are notoriously inaccurate.

Life will end, we’re told, if our credit score declines.

Poppycock!

That fear keeps American consumers struggling to pay debt that they can never repay, in this life or the next.  In order  to preserve their credit score, they appear resigned to a lifetime of minimum payments rather than a fresh start in bankruptcy

As Liz pointed out, the credit score is dynamic: it is constantly changing, and heals over time.

My call is to fix your balance sheet.

  • Get rid of dischargeable debts.
  • Save for retirement.
  • Live beneath your means.
  • Have some reserves.

Don’t walk the financial tightrope.

Image courtesy of terwilliger911,? pursuant to a Creative Commons license.

How Does Your Household Budget Measure Up?

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stretching money

The expenses your paycheck has to cover go on and on.

Each dollar is stretched;  each expense clamors for attention.

Too often, the expenses go on long after the available money is gone.

What seem like immediate needs squeeze out those necessities that only come round occasionally but in big numbers:  car repair, medical incidents, college.

And when the “occasionals”  do come round, you’re caught short.

I generally see families to talk about bankruptcy when things have gotten so out of balance that better budgeting won’t fix the problem.

So, let’s take a tour of the cost of living so you can stay in balance, and we’ll never meet face to face in my law office.

What daily living costs

Consumer Credit Counselors  proposes a model allocation of your income among all of those categories on your household expense list.

The headings in blue are the big wedges of the pie;  below are all of the expenses to be paid from that percentage of your income.

 

MONTHLY EXPENSES

MONTHLY AMOUNT

HOUSING

 35%
Rent
First Mortgage
Second Mortgage
Association Dues
Property Taxes
Renters/Homeowners
Lot Rent
Home Maintenance
Electric/Gas/Oil/Propane
Water/Sewer/Garbage

TRANSPORTATION

 15%
Gasoline
Auto insurance
Maintenance – Oil/Lube/Tires
Auto Tags/Inspection
Bus Fares/Ride Shares/Parking

INSTALLMENT DEBT

 15%
Car Payment #1
Car Payment #2
 Student Loans
Tax installments

EVERYTHING ELSE

 25%

FOOD
Groceries
Meals Out
School Lunches
Food/Snacks at Work
Telephone/Cell Phone/Beeper
Cable TV/Internet

CLOTHING

INSURANCE
Medical
Life

HEALTHCARE
Drugs/Medication
Office Visits/Deductible
Dental
Optical

CHILDCARE
Daycare/Babysitter
Allowances/Kid’s Stuff
Diapers/Formula/Baby Supplies
Child Support
School – Tuition/Supplies
Church/Charities
Lawn/Pool Maintenance/Home Security
Personal Care – Shampoo/Toothpaste/Haircuts
Bank Service Charges/Postage
Work Tools/Clothes/Occupational Dues
Dry Cleaning/Laundry
Home Cleaning Supplies
Cigarettes/Tobacco
Hobbies/Clubs
Lottery/Casinos/Bingo
Gifts/Parties/Holidays/Cards
Vacations/Travel
Alcohol
Books/Newspapers/Magazines
Lawn/Pool Maintenance/Home Security
Movies/Sporting Events/Entertainment
Pet Care/Vet/Food/Medications

Savings/Reserve

 10%
Emergency reserves
Retirement
College

TOTAL

 

So, how do your monthly expenditures line up against this model allocation?

I was struck by how many of my standard expenditures are slated to come out of just 25% of my income.  That’s a long list.

Reshuffle the cards

Another way to look at your allocation of money comes from now-senator Elizabeth Warren’s book, All Your Worth:

  • 20% to savings;
  • 50% to must-haves; and
  • 30% allocated among your “wants”.

How does it work in your household?

 

 

Will You Have Money For A Lifetime?

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financial literacy building blocksThe financially literate manage their money for the long haul.

In a world of biweekly paychecks and monthly billing cycles, it’s easy to let your perspective shrink to 30 day increments.

  • Mortgages are paid monthly
  • Utilities bill every 30 days
  • Credit cards come due 12 times a year
  • The monthly bank statement tells you how you did that month.

But that view is incredibly short-sighted.

Your working life isn’t everything

Most of us don’t work for our entire lifetimes. Your financially productive years  may be only half of your lifespan.

There’s growing up and getting an education;  there’s a working life; then there’s old age.

And the money we manage in that middle slice of life usually determines how well we live at the end of our lives.

If you expect to inherit a fortune from short-lived relatives, you can stop reading here.

For the rest of us, let’s keep thinking.

We usually grow up and go to school on someone else’s nickel, though it may take student loans to get a post secondary education.

But unlike funding school, you can’t borrow to fund your old age.

No one lends a 70 year old money to live on.

  • You’ve either saved for retirement, or
  • You sorta  get along on Social Security,  or
  • You are supported by your family.

Your house won’t support you

Lots of equity in a home, even if paid for, doesn’t put food on the table and prescriptions on the counter at the end of a working life.

Home equity isn’t a retirement plan

Those things require cash.

Out of pocket medical costs for a couple in retirement reach $240,000

The house will need repairs.  Property taxes come due.  Appliances wear out.

It simply takes cash to maintain a comfortable life in retirement.

Sell the house, and you are paying rent or moving away from the community you live in.

It would be nifty if today’s housing payments could double as retirement savings, but that seldom really works.

Manage your money for the long haul

With life expectancy increasing, more and more people are finding that retirement is as long as their working lives.

Assuming you hope to enjoy a long life, change the measure of your financial thinking from months to decades.

What you save now funds those decades after the end of your working life.

The easiest way to do that is to pay yourself first from every new dollar in the door.  Whether you draw a salary or live in the creative or gigster economy, some part of what you earn today has to support you in retirement.

I like to think of setting aside something this week for a nice night out when I’m 75.

If you don’t pay yourself first, and think you will save what’s left over at the end of the month, you set yourself up for failure.  It’s too easy to have nothing left at the end of the month.

Save first, and your challenge is to make what’s left work to cover your expenses, the necessary and the indulgent.

When that gets tough, hum a few chords of “When I’m 64“, and imagine what you want your life to be at 64.  At 74.  At 84.

The rest of your life is a long time.

More

The real threat to your retirement savings

Update your  money management thinking

Where is your money really going

Which comes first: debts or saving

 

 

 

 

Get Annual Credit Report For Free

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free credit report bandWhen is FREE not FREE?

In a world seemingly driven in all matters by credit reports, getting that report for nothing ought to be a good thing,

But the commercial entities beat the federal government to the web address freecreditreport.com.

And they also got a better ad agency that wrote catchy tunes promoting their product, under the guise of free credit report.

But freecreditreport.com provides you a free credit report only if you surrender personal information, wait for it to come by snail-mail  and sign up for a monthly service billed to your credit card.

They bank on you not cancelling that subscription.

Cha ching!

It’s not really free.

Free credit report

The three big credit reporting agencies do provide a no-strings attached credit report  free to everyone, once a year.

Unfortunately, the URL doesn’t mention free, and doesn’t come with a catchy, banjo driven jingle;

Annualcreditreport.com

But it does provide simple, and free, access to your credit file.

The right to know

Federal law enacted in 2003 gives everyone the right to request a free credit report each year from each of the three national credit reporting agencies:  Experian, Equifax, and Transunion.

For nothing (that is: free) you can examine your credit report once every four months, if you request your free report sequentially from the CRA’s.

Repeat after me:  annualcreditreport.com.

What to do if you find errors

The Federal Trade Commission website walks you through how to challenge inaccurate information on your credit report.  They’ve even included a sample dispute letter.

ConsumerHelpCentral.com  sorts out your remedies if the CRA doesn’t correct the information.

Sing the chorus

Here’s the game plan:

  • Click on www.annualcreditreport.com
  • Order a copy of your report from one agency
  • Look for errors and inaccuracies
  • Challenge bad information
  • Mark your calendar for 4 months to order a report from one of the other national CRA’s

Then, how about I offer a free subscription to BankruptcySoapbox to the best jingle submitted for ANNUALCREDITREPORT.COM. 

I talk about credit after bankruptcy at Bankruptcy in Brief and what your credit report should show after bankruptcy discharge.

Financial Lessons From Furloughed Federal Workers

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out of work

The plight of workers going without pay because of the government shut down looms over our news.

If our incomes haven’t been affected, it’s easy to see this as someone else’s problem.

But are the rest of us really immune to the same financial straight?

Over and over again, we hear that most U.S. families couldn’t pay an unexpected $400 bill without borrowing money.

The current problem is a lot bigger than $400.

Effectively out of work, federal workers face weeks with nothing coming in, and too little set aside.  It’s notable now because there are so many families affected.

But ending up with no income isn’t unique to the governmental workforce.

To paraphrase the credit card ad, what’s in your savings account?

Image courtesy of DavityDave and Flickr under a CC license.

 

Stop Making Quarterly Tax Deposits

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tax+forms+and+billsWe never make tax deposits for our small business because we don’t know what we’ll owe.

We just wait til the return is prepared and try to pay then, he explained.

But, again this year, he couldn’t write a tax check for a year’s worth of income.

So the client sitting across the table from me had an $8,000 tax bill for last year, and in mid October, had made no deposits toward this year’s taxes.

Waiting for certainty about what he’d owe, he racked up penalties for not making advance deposits, penalties for not paying when the return was filed, and interest on the unpaid tax.

And he was positioned to do it again this year.

Ouch!

Quarterly tax deposit trap

I’m sure the provision that the self employed make quarterly deposits, rather than more frequently, was thought to be a convenience for small business.

Instead, in my opinion, it is a trap.

It calls on entrepreneurs to estimate what they’ll owe, set money aside as it comes in, and, every three months, have enough money on hand to cover the check for the taxes.

That’s often a tall order for the self employed, who wear lots of hats and juggle lots of responsibilities in their business.

And it’s costly and uncomfortable when you don’t manage to do it.

Replace the quarterly tax deposit

Discard the quarterly tax deposit.  Instead, make a monthly tax deposit.

Treat income taxes as one more regular, monthly expense of being in business.

Deal with current year taxes each month so you don’t have to save up the money to cover the tax bill.

How much to pay

Start with your tax liability for last year.  Deposit 1/12 of that amount each month toward your current year taxes.

Write on the check your tax ID number, and a notation that the check represents estimated [current year] tax liability.

As the year goes on, you can estimate how this year’s income compares to last year and adjust that monthly check up or down as the facts suggest.

Breaking the tax delinquency cycle

For the man in my office, I had this suggestion:  rather than  paying $1000 for last year, when you’ve paid in nothing for this year, split up the money available for taxes.

Make a smaller payment toward the already delinquent taxes, say $250;  pay $750 toward the current years taxes.

It’s already October, so he probably can’t pay in enough to avoid all penalties for being underwithheld for this year, but it’s a start on changing his ways and paying less in tax penalties in the future.

More on taxes

When taxes are dischargeable in bankruptcy

Tax question round up

If you haven’t filed returns

Image courtesy of Flickr and 401(k) 2013  

Pay Down Debt Or Save? Which Should Come First

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debate

Pay off debt first or start saving now?

It’s a debate almost as convoluted as which came first, the chicken or the egg?

Experts heatedly take opposite sides.

You get rid of debt faster if you put all available cash into paying off balances.

BUT

You have no reserves for the unexpected if you spend everything that comes in.

After much thought, and triggered by new research, I’ve got my answer.

Start saving now.

I am convinced habits are more powerful than arithmetic.

Pay debts first is cheaper

In a world where your savings earn 1 or 2% annual interest, while credit cards cost 15-25%, it’s clear your net worth benefits from paying debt first.

The biggest bang for your buck, dollars and sense wise, comes from paying off debt.

Unless, of course, you have an unexpected expense and find yourself without funds to pay.  Then, short term borrowing is usually on even worse terms than credit cards.

But, hang arithmetic, I say.

Your balance sheet isn’t everything.

Habits drive the bus

Get the savings habit.  Even when you’re in debt.

Put a bit of your income aside every paycheck.

Dictionary.com says a habit is an acquired behavior pattern regularly followed until it has become almost involuntary:

Habits control as much as 40% of our daily activities.

Most of us have a bad habit on the subject of savings:  we label saving as something we can put off til later.

Later

  • When there are fewer demands on our money.
  • When our income has increased.
  • When the kids are grown
  • When the house paid off.

Whatever it it, we’ve created a habit of thinking that savings can wait til later.  That saving will be easy at some future time, whereas it’s hard now.

Only for most of us, no matter what life benchmark we’ve passed, savings never looks easy.  Or immediately rewarding.

So, it’s not easy.  It’s just essential.

Essential for a stable financial life.

Start small building savings habit

You don’t have to jump head first into the gold standard “set-aside of 10-20% of your income.”

If you’ve got debts from your past, it’s probably not really feasible.

Start small.  Save $30 bucks a month this month.

Save $35 next month. And so on.

Pay down your debts, but cultivate that saving habit.

Don’t allow yourself to think that saving is discretionary.  That’s a nasty habit.

Yes, saving while you’re paying interest on old debts slows your climb out of debt.

But the savings habit gets stronger.

As your debt shrinks, your rate of savings can increase.

Along with your peace of mind.

That’s where I come down on which comes first: paying off debt or savings.

It’s not one or the other.

More

Smoke, mirrors, and budgets

Update your money software

The most powerful debt management tool: not what you think

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Suite 403
Redwood City, CA 94063
Phone: (650) 694-4700

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