The 1-2-3 Money Plan Part 19

Your mortgage, especially if it's at a favorable fixed rate, is the one debt you can relax about. It comes far down the priority list. You don't need to pay it off early until you have your other financial goals achieved, especially retirement savings.

The reason is you're probably paying a relatively low interest rate. If you can take a mortgage-interest deduction on your income taxes, your interest rate is effectively even lower.

I'm not saying never pay your mortgage off early. Just have retirement planning, kids' college savings, and other essential financial goals well under way first.

Should I Use a Home Equity Loan to "Pay Off" My Credit Card Debt?.

The good news is you can get a lower interest rate by using the stored value in your house to pay debt. But this debt swap can be dangerous for a couple of reasons.

First, you must realize you're not "paying off" anything. You're just moving your debt. If moving your debt makes you feel better, that might be a bad thing. That's because you haven't addressed the fundamental problem: spending more money than you could afford. To solve a debt problem long-term, you'll have to dig into that question. Either your income is too low or your spending is too high.

Second, you're moving unsecured debt to secured debt. In English, that means if you don't pay your credit card bill, the bank can't do much to you, except to bug you with phone calls and damage your credit score. If you don't pay a home-equity loan, on the other hand, the bank can take your house. I think losing your house is a bigger deal.

So, if there's any chance you won't be able to pay, keep the debt on credit cards. If you discovered the reason you're in debt and have permanently addressed the problem, shifting to a lower interest rate with a home equity loan will probably save money.

Is Credit Counseling Worthwhile?

Credit counseling can be a good idea or a bad one. But it's a more complicated decision than you might think.

Often, you will pay money for the service, and your creditworthiness might be trashed in the process. Though these agencies might be technically nonprofits, it doesn't mean they are charities offering free or even legitimate a.s.sistance. You could end up paying high fees and getting bad advice. In fact, one thing to look for is the free education and advice an agency is willing to provide. It might hint at a good counselor.

These warnings don't mean you shouldn't seek credit counseling-and if you're filing for bankruptcy, you're required to get it. But you should know that hiring a credit counselor is an important spending decision, so you should treat it like you're hiring a contractor to renovate your kitchen. That means interviewing multiple credit counselors.

First, determine whether you're a good candidate. Often a credit-counseling agency doesn't do anything you couldn't do for yourself. Evaluate all of your options before entering credit counseling, including developing a better spending and savings plan, and negotiating with creditors by yourself.

Enlisting a credit counselor will be noted on your credit report. It will damage your ability to borrow money at good interest rates because future creditors will see a notation that you are in credit counseling. However, credit counseling doesn't directly affect your three-digit credit score. Of course, many distressed people seeking counseling have already badly dinged up their creditworthiness, so an additional bad mark is only incremental.

If you feel overwhelmed, you're using credit cards for daily living expenses, and you've considered tapping your home equity or retirement plan to pay debts because you don't know what else to do, you might be a good candidate for counseling.

If you decide to go through with credit counseling, beware of an agency that says it can eliminate your debt quickly and erase your bad credit history. The agency is not reputable. The same goes for debt-settlement companies, which are not really credit counselors. Many advise you to stop paying your bills and become a true deadbeat, in hopes you can settle your debts for less than the amount owed. This tactic can work for some desperate people who have the right types of creditors, but it can be expensive, and results are not guaranteed. You could end up owing more than before you started. Even if successful, you'll have a ruined credit score and probably owe taxes on the amount forgiven.

When you sign up with a credit counseling agency, find out how it makes money. Be dogged when asking about how the fee-structure works. Reasonable onetime fees and monthly fees are in the $25 to $75 range. If total fees are measured in hundreds or even thousands of dollars, you're in the wrong ballpark.

Many agencies will try to get you on a debt management plan, or DMP. It allows the counseling agency to work with creditors on your behalf. It often can get lower interest rates on some of your debts, get more flexible repayment schedules, and potentially get extra fees waived. You pay the agency regular lump sums, and it distributes the money to your creditors, according to the repayment plan, which often lasts three to five years. DMPs are generally for unsecured debts, such as credit card debt, not auto loans and mortgages.

But know that DMPs are how counseling agencies make most of their money. They get paid by creditors, such as banks that issue credit cards. That establishes a dicey relationship about whom the counselor works for-you or the banks. If counselors are paid on commission for setting you up with a DMP, look elsewhere for help. If a counselor is pushing a debt management plan within the first 20 minutes of learning your financial picture, you might not be dealing with a reputable agency.

A counselor's affiliation with industry groups, such as the National Foundation for Credit Counseling, found at www.nfcc.org, raises your chances of dealing with a good counselor. Many NFCC members go by the name Consumer Credit Counseling Service, or CCCS. Another certifying group is the a.s.sociation for Independent Consumer Credit Counseling Agencies, found at www.aiccca.org.

PART III Spending Smart Tomorrow.

Chapter 7.

How to Save Money.

As I talked about in Chapter 2, "First Things First," goals give you direction and can provide peace of mind. They even have application in daily life. With all the marketing bombarding us every day and fueling our wants, a set of goals helps us to say no. They remind us there's something we want more than the tempting purchase right in front of us.

Even when you have written savings goals, it takes a lot of willpower to consciously stash away money each month. We humans are hardwired to consume immediately. So, saving for future needs and wants goes against our nature.

That's why saving toward goals must be automatic.

It could be an automatic 401(k) deduction from your paycheck to fund retirement or an automatic draft from your checking account that adds to your "snorkeling in Bahamas fund."

You put money toward priorities first, and then you're free to spend what's left on daily living. In that way, having goals is freeing. You don't have to be constantly wondering if you're doing all the right savings things and feeling guilty about indulging in small daily purchases.

You might have heard this called "Pay yourself first" because you stash away money for your goals before paying everybody else. It's also an alternative to a full-fledged household budget. By saving first, you create an artificial environment of money scarcity in the household. It erects boundaries to our spending. Specifically, it cuts down on the cash we have around, so we don't spend as much. It's based on the idea that we'll spend all that's available to us unless there's a darned good reason not to. This is why increasing your retirement contribution is relatively painless. It's true, you'll have less money to spend each week, but you unconsciously adjust your spending accordingly. Unless it's a huge jump in savings, you won't even notice the difference.

Automatic savings leads automatically to lower spending.

Erecting these artificial boundaries for money is useful. In America, we get very used to abundance and "unlimited." Do you remember when we used to pay for a certain number of hours each month for Internet access? Now, most Internet access is unlimited. We used to pay by the minute for long-distance phone calls. Today, many calling plans include unlimited long distance.

For decades, gasoline seemed unlimited because no matter how much we used, the price was always about $1.25 per gallon. Of course, it only seemed unlimited, as we found out in recent years, as demand grew and prices fluctuated wildly.

Diamonds aren't rare, and aren't intrinsically valuable. They only cost a lot because diamond companies restrict the supply and constantly advertise that diamonds are special. And somehow they became a mandatory element of marriage proposals. Producers of diamonds create an artificial environment of scarcity.

You can do the same thing with your household finances.

Of course, the big problem with the artificial scarcity plan is the availability of credit. Whether credit cards or a home-equity line of credit, that ability to borrow money easily removes the scarcity boundaries you artificially set up. It makes no sense to pay yourself first and save money earning 3 percent interest but exceed your boundaries by spending on credit cards and pay 18 or 29 percent interest. So, to use the artificial scarcity plan, you must not borrow money for consumer purchases.

It's like being on a diet and throwing away all the cookies and potato chips, creating a scarcity of junk food in the kitchen. The only thing to eat is healthful stuff, so you do. But such a diet plan is doomed if you regularly stop by the convenience store for donuts and Doritos, in effect sidestepping the scarcity boundaries you artificially set up. (In case you got lost with that a.n.a.logy, credit cards are the convenience-store Doritos.) In the end, paying yourself first is voluntary self-deception, like setting your clock ahead 10 minutes so you won't be late. If you are committed to the deception, it works great.

Short-Term Savings.

Don't be shy about opening separate bank accounts for each of your short-term goals. Of course, you want accounts that won't charge you any fees. It's true that opening more accounts slightly complicates things because you have more accounts to keep track of. But it's well worth it because you'll be very clear about what your short-term spending goals are and how you're funding them. It's similar to the simple envelope system for daily spending, with one envelope containing money for food, another for clothing, and so on.

Short-Term Savings, 1-2-3.

1. Emergency fund.

2. Car fund.

3. Seasonal fund.

If you're going to be stashing cash in separate accounts, it would be nice to earn a little interest on the money. That's why an online savings account is a great choice. For years, among the best choices for online savings accounts have been: * EmigrantDirect.com * INGDirect.com * HSBCdirect.com Frankly, it doesn't matter much which one you choose. Go with whichever account happens to be paying a higher interest rate than the others at the time you look at them. Rates change often, but historically, they have been in the same narrow range. You'll drive yourself crazy always trying to get the absolute highest interest rate. Remember the concept of "good enough?" Deposits at all three banks are insured by the Federal Deposit Insurance Corp. (FDIC), up to $100,0001 per depositor. And they are all good enough.

Opening an online account is fairly easy. Follow instructions on the Web sites, and fill out forms. You will have to electronically link a personal checking account to the savings account to make automatic deposits. You will also have to provide your Social Security number.

1. Emergency Fund.

Whether you call it a rainy-day fund, an emergency fund, or a cash cushion, having cash available for when bad things happen is fundamental to financial planning.

What exactly const.i.tutes an emergency fund? The typical advice is also the most conservative definition: cash equal to three to six months of living expenses. I would modify that to be three to six months of "bare-bones" expenses, meaning enough money to pay rent or mortgage, food, utilities, transportation, insurance, and so on.

Why? Because in a financial crisis-think, losing your job-you should immediately cut back on nonessential spending-no going out to eat, no clothing purchases, and no golfing. You could even start canceling your gym membership, your cable TV service, and your fancy hairdresser appointment. The point is you need a cushion to pay for necessary expenses, a total far less than expenses during flush times.

How do you decide on whether to save three months of expenses or six? It depends on your circ.u.mstances. For example, two-income families have less of a need for a large emergency fund, especially if both earners make about the same amount of money. That's because a job loss, among the most serious of emergencies, doesn't wipe out the entire household income. A one-income family needs a larger contingency fund. The size of the emergency fund can also depend on your financial commitments. People with a paid-off house and no car payments might get by with a smaller cushion. This, by the way, is yet another reason to keep debt at a minimum.

Why have an emergency fund? We talked about the most serious scenario, having cash to live on if you lose your job. Other reasons include life's expected-but-unexpected cash drains. We don't know when they're coming but cash outlays for such expenses as car repairs, medical bills, and plumbing leaks are coming sooner or later. Without the cash to pay for these, you're likely to put them on a credit card and rack up finance charges. That just makes those "emergencies" more expensive.

Other reasons to have an emergency fund are less obvious. It can actually save you money. Think about it: With a cash cushion, you can feel comfortable saying no when a salesperson offers you an extended warranty. Why? Because you have the money to pay for the repairs if the item breaks. You can call your insurance agent and raise deductibles on your home and auto insurance, which will save you money on premiums. Why? Because you have the cash to pay a higher deductible if you file a claim.

Maybe an emergency fund's greatest value is providing peace of mind, which any financially stressed-out person will tell you has a real dollar value.

Creating a rainy-day fund can be a two-step process. Although the long-term goal is a fund equal to three to six months' worth of bare-bones living expenses, a shorter-term goal might be to stash away $2,500. At that point, you haven't protected against job loss, but you have given yourself financial breathing room when the car and the clothes washer break down at the same time. Make the $2,500 emergency fund a high-priority goal. Fully funding the cash cushion can be balanced among your other financial priorities. For example, it would take a backseat to paying off high-interest debt.

That's especially true if you take a few steps to grow your emergency fund through noncash means. A cash horde is ideal, but in a crisis you simply need quick access to money, whether it's your own or someone else's.

Here are a few temporary moves to make in lieu of a fully funded emergency fund. These are in addition to your $2,500 in cash: * Establish a home-equity line of credit. Homeowners could count home equity as part of their temporary emergency fund. A home-equity line is an open credit line against the equity you have built up in your house. It's cheap or free to open a line of credit, and you pay no interest unless you use it. If you use it, the interest you pay is likely to be tax deductible. With most HELOC accounts, you tap the line of credit by writing checks on the account or using a debit card to access the credit line. Apply for an equity line before a crisis occurs. Once disaster hits-you lose your job, for example-you might not qualify to open a HELOC. All that said, however, a home-equity line is not a good choice for compulsive spenders who will use the credit line for nonemergencies. And lenders have tightened requirements for getting a HELOC since the 2008 financial crisis. Improving your credit score will increase the chances of being approved for an equity line.

* Raise your credit card limits. Using high-interest credit cards is a very common but lousy way to address a financial emergency. If you're responsible with credit cards and rarely carry a balance, however, it couldn't hurt to ask your card company to raise your limits if you do it the right way. You must ask them to raise your maximum charge limit "without pulling my credit report." That way, the request will not damage your credit rating, as I said in Chapter 6, "Credit When Credit's Due." In fact, it could help your credit rating if you're successful because part of the credit score is based on the amount of used credit compared with the amount of available credit. A second advantage is the higher limit gives you a source of cash during a temporary cash-flow jam. There are more details about your credit cards in Chapter 6.

Once you're already in a money crisis with no emergency fund to tap, more desperate measures might be necessary. None of these options is an ideal solution: * Consider nonretirement investments. Your regular investments outside of retirement plans might be mostly held in volatile stocks or in accounts that might charge an early withdrawal penalty, but these can be sources of emergency cash. True, using these funds in an emergency might force you to take an investment loss, but addressing a true crisis is usually more important.

* Evaluate the bank of mom and dad. Borrowing from relatives or friends is dicey at best, and should probably be among the last resorts in a crisis because it has ruined many relationships. But it could be a source of emergency money. One idea is to formalize such a loan by writing down the terms. Consider using loan doc.u.ments from a place such as LawDepot.com or using a company such as CircleLending.com to formalize the paperwork.

* Borrow or withdraw from a 401(k). I hesitate to mention this option because unless you're desperate, it's a really bad idea. But you can borrow and withdraw from a 401(k) retirement account. There can be huge tax penalties and you'll lose growth on the money, which was supposed to go toward retirement. In the case of borrowing, you'll withdraw pretax money and pay yourself back with interest by using after-tax money. Then in retirement, you're taxed on withdrawals. So, you're being double-taxed on that money. Review with your plan administrator all the disadvantages of loans and withdrawals before going ahead. All that said, it is a source of cash if you're desperate. But consider this my attempt to nudge you away from this option.

In short, you need a rainy-day fund and a plan to access cash in a financial storm. It will, indeed, rain. It's just a matter of when.

2. Car Fund.

Just like you will have financial emergencies, you will replace your vehicle. It's just a matter of when. Maybe no purchase gets consumers in more trouble than buying a car or truck. It's a two-headed problem.

First, people l.u.s.t after cars they can't afford, which leads to five-year loans or longer and ridiculous leases (which is redundant because almost all leases are a ridiculous choice for people concerned with spending money smarter). People concentrate too much on the monthly payment, instead of how the purchase fits into their financial life. For the record, I'm obligated by all that's good and true in personal finance to urge you once again to buy a slightly used vehicle. That way, you avoid much of the new-car depreciation.

The second big mistake many people make is not putting down much money when buying a vehicle-or worse, rolling the payment of a previous vehicle into the loan on a new one. This leads to the brutal situation of actually owing more on a car than it's worth, or being "upside down." You can't sell the vehicle-or, if you get in a bad accident, you can't total the car-without losing thousands of dollars.

I don't want to get all ridiculous on you, but what if you paid cash for your next vehicle? In fact, I would argue that if you can't pay cash for a vehicle, you can't afford it.

Here's how to pay cash for your next vehicle: After you pay off your current vehicle, continue making the same monthly payment to yourself. Do that by making an automatic payment to a separate car-fund account. Then when you go to replace your vehicle, you'll have the trade-in value, plus cash saved in this account. That total becomes the purchase price of your new car, which you can now buy for cash. At the very least, you'll have a sizable down payment.

Here's just one example of how it would work: Keep your vehicle for four years after paying it off. If you were paying $400 a month, you would acc.u.mulate $19,200, plus interest, in your car fund. For simplicity, let's call it 20 grand. This, by the way, requires no additional sacrifice on your part. You've already been paying this $400 a month for several years.

If you get $5,000 by selling or trading in your old car, you can now pay $25,000 for a lightly used luxury car of your choosing.

How cool is that?

3. Seasonal Fund.

This is an intentionally vague account. Customize it to fit short-term savings goals in your life. For example, you could use it for three major seasonal expenses, which happen to be s.p.a.ced apart on the calendar. That means you can fund and deplete the account continually throughout the year. These seasonal expenses are as follows: * Holiday spending. Gifts, travel, decorations, parties * Spring vacation. Airfare, hotel, car rental * Back-to-school. Clothing, school supplies, tuition, computers, textbooks Another good idea is to have a separate account when you're saving for a house down payment. If you already own a house, you might create an account for home improvements, whether that's new siding, new furniture, or a kitchen remodel.

The running theme with any of these short-term savings accounts is to fund them regularly and automatically. That way, you'll have no trouble achieving those goals.