Investing 101 – Dividend Investing

It was brought to my attention the other day that I may have jumped into things before explaining to my readers what everything actually was, especially with dividend investing.  I tend to do that.  I just go off on tangents or talk about things that seem normal to me and are just way off the beaten path for everyone else.  Sorry about that.

So what is a dividend?  According to the all knowing Investopedia, a dividend is a “distribution of a portion of a company’s earnings.”  So when we talk about dividends, we’re talking about the money that we receive on a monthly, quarterly, or annual basis just for owning a share of the company.  For example, may issue a dividend of $0.25 a share a year.  If the stock has a value of $10.00 a share, that means the dividend is a 2.50% return on your money. Better than your savings account!  However, if the stock rises to $50.00 a share, the dividend is now a return of 0.50%.  Better than most savings accounts but not as good as before.

However, this huge capital appreciation doesn’t often happen with dividend producing companies.  You see, companies with dividends tend to be more mature companies with established revenue streams and earnings.  In fact, Standard and Poor’s produces a list of the “Dividend Aristocrats,” a list of companies that have increased their dividend every year for at least 25 years.  These are companies we all know, like AFLAC, Chevron, Target and many others.  These companies are ideal investments for the everyman (or woman) because they have easy to understand products and businesses.  You look at them and you just know what they do!  Even better, their stock prices do not fluctuate as much as others.  Because they are big, blue chip stocks with dividends to their shareholders, they tend to be more stable.  They go up less in the good times and they go down less in the bad times.  They’re an ideal investment for someone who wants better returns than a CD or savings account but is still too risk averse for a tech stock or an early IPO.

So how do we use this knowledge of dividends and what they are to start a dividend investing program?  Well, with dividend stocks, you have two possibilities: you can take the dividends as income or you can reinvest them back into the company tax free.  In dividend investing, you’ll typically do the latter.  Why is this?  Well, it helps your portfolio in two ways.  The first way, and I think the most important, is that you’re taking that 2.50% from our first example and you’re using it to buy more stock in the company, which will produce more dividends which will buy more stock which will produce more dividends etc etc.  Add in the capital appreciation and you can have some serious growth on your hands.  In fact, using the handy dandy dividend reinvestment calculator we are able to see just HOW much this can help.  If we were to invest $10,000 in Aflac in January of 1980 and you chose to not reinvest the dividends, you would have just over $1.4 Million today.  However, if you reinvested the dividends, you would have $1.65 Million.  An extra $250K is nothing to sneeze about when you only put in $10K (if adjusted for inflation, it would be the equivalent of $28K invested today).

The point here is that dividend investing can help build a strong portfolio if you start when you’re young and use your iron nerves to avoid selling the moment you have a miniscule profit.  If you do this, your dividend invest can eventually turn into dividend income for retirement, something everyone wants!

Let me know if there are other topics or subjects which you need explained.  Passing on my knowledge is what this is all about!

Retirement planning in your twenties and thirties

I was roaming Investopedia today and I came across a great series of articles related to retirement planning in your thirties.  Not wanting to be left out of the party, I decided to take a look and read it.  As with most of the articles and series on the site, it was well written, well structured, and had a lot of great ideas in it.    In general, a lot of the ideas can be taken to someone in their twenties and applied with ease.  Or even if you’re, you know, actually near retirement.  I mean, the important thing is that you’re trying, right?

Needless to say, the key points were awesome.  I’d really like to highlight three of them off the bat:

1. Increasing your Savings Rate

We’ve talked about this before and the methods you can employ.  You can save more of each raise or you can cut out things in your life that are too expensive or have inexpensive substitutes.  The biggest thing is to Save More.  Whether this is through reducing your taxable income by contributing to a 401k and a regular IRA or but putting 50% of every raise into your Roth IRA and your Taxable investment account, savings is key.  If you keep saving at a low rate from when you’re young, you’ll never get there.  Granted, you’ll have a huge leg up on the guy that doesn’t start saving until he’s 40 but if the savings aren’t growing, you’re not going to have an easy retirement.  Rule of thumb: save 10% of your income.  Once you do that, start increasing it until you can eventually save 25% or even 30%.  Some people (Financial Samurai, I’m looking at you!) have been able to save 50% or more of their taxable income.  While that’s amazing, it is also not for everyone.  Remember, this is a process.  Baby steps folks, baby steps.

2.  Managing your Investments

If you’re going to read any bit of the series on Investopedia, read this.  This is fantastic.  It breaks down many of the financial instruments you can invest in for your retirement, the different risks involved, and gets a bit into asset allocation by age.  Basically, you shouldn’t have the same asset allocation at 25 as you do at 40.  You also shouldn’t have the same asset allocation at 40 as you do at 65.  It’s a constantly changing and balancing thing and what it all comes down to is one thing: you.  Are you able to accept risk?  Can you tolerate short run losses or will you get fidgeting watching 40% of your portfolio disappear?  If you want to have a strong retirement or even an early one, you have to active in managing your investments and choosing the best items to give you a good future.

3.  Minimize withdrawals

One of the worst things you can do is take money out of your retirement accounts years or decades before you retire.  The time value of money and compounding interest is hugely powerful device and taking out a portion of your nest egg to buy that jet ski will set you back.  If it’s to buy your first home, something you’ll live in for twenty years, I can understand that.  That makes sense!  But for a car or a vacation, it’s just not worth the loss.  The less you take your money out of the retirement accounts, the more money you’ll have once retirement actually arrives.

Investopedia consistently has great series on investing and retirement and this was no different.  I strongly suggest that you all go check this out and make sure you’re following at least some of the advice given in the article.  You won’t regret it, I promise!

I used to do Crossfit

I used to do Crossfit.  Past tense.  I recently had to quit, not because I didn’t like it (I loved it) but because my wallet couldn’t handle the pressure.  At $150 a month, it was arguably one of the most expensive gyms (or boxes, as the crossfit community calls their gyms) in the area.  That’s saying something for Los Angeles.  The truth was that although my waistline and my mind were getting a great workout, my wallet was struggling to keep up.  For someone as cost conscious as me, the knowledge that I was spending $1800 a year on working out was troublesome.  I knew I could get a gym membership nearby for only $40 a month, a huge savings, but I was reluctant.  I enjoyed the community and the camaraderie too much to leave.

Eventually, though, I did leave and my wallet and bank account thanked me for it.  I’m still working out, albeit not quite as crazily as before, and in general living a good quality life.  So this got me thinking: what are items in our lives that we pay a premium for that aren’t entirely necessary OR have substitutes that are cost efficient? Crossfit was an expensive, albeit effective, version of going to the gym.  What else could I cut out of my budget in order to save money?

I’ll be honest, I don’t have internet.  I don’t steal it, no no no.  I have free wifi in the lobby of my building and publish from there.  And I don’t have cable either.  I get movies or shows from netflix and go to town on those.  So where on earth could I cut back on?

Eventually it fell to two areas: food (alcohol included) and my car.  Food and drink I’ve been working on cutting back on anyway so now I’m looking into maybe refinancing my car or switching it for a lease (shudder).  Right now my car costs me a HUGE amount of money each month, almost $500.  Ridiculous.  However, I was desperate at the time.  My Jetta had a failing transmission (the second time in the year I owned it) and I needed something reliable.  Rather than playing the game I swung for the fences and bought a 2007 Acura RDX.  It’s by far my favorite car that I’ve ever owned but it is WAY too expensive.  I get serious buyers remorse over it.  Even worse, watching the value sink every month kills me just a little bit.

So, even though I love the car, I’m constantly on the lookout for a good lease or a cheap option, something I could just put some cash down for.  The way I look at it, I’m wasting thousands of dollars a year on this car. Granted I’d love to have it for 10 years but something tells me that I need to be more realistic about my money now.  I mean, time value of money IS important.  I don’t want to give up thousands of dollars in future side income from investments (or a house) just because I bought a car that was too expensive.  That would be ridiculous.

Have you ever had buyers remorse?  Have you ever taken a look at your finances and found good substitutes for your major (or minor) monthly expenses?  Let me know!

Starting your own business | Start ups

As some of youmay or may not know, I work at a sort of startup.  Not like a google, free food with all crazy stuff start up.  My company is in finance, as I’ve mentioned, and we have a foreign parent providing all the capital.  Instead, we’re run with the intent of being as nimble and innovative as possible while having the immense financial backing of a foreign parent with a whole lot of cash and an incredible long term view of how to make money (not going to lie, I love it).  The result is that I’ve seen a lot of things that start ups have gone through: the scaling of a product, the building of the workforce, the decision between hiring an extra person or just letting things ride for a year.  And because we weren’t created with the concept of building an idea to sell for a profit inside of three years, we’re focusing on sustainability.

This kind of thought has been on my mind a lot lately and I feel like working it out.  It’s not quite personal finance and is more entrepreneurship but still, hear me out.  I’m sure there is a finance lesson in here.  I promise, as with most of my inane ramblings, there will be a point.  That point: investing.

Facebook seemed like a great investment to a lot of people.  A billion users, everyone is addicted, how could it not make money.  And then the IPO happened, the stock rose, it fell. Then it fell some more.  NASDAQ got sued, Morgan Stanley got sued, everyone got sued.  In general, everyone was pretty pissed.  Well, except Facebook.  You see, they did everything right.  They raised the most money possible, according to demand, for their company.  Of course now it sucks for everyone that bought the stock (with a short term viewpoint) but that’s life.

IPO’s, especially start type companies that haven’t been around for a while, are tough.  If you had purchased stock in the company that makes Annie’s Mac and Cheese (my favorite, if you ever want to get my some food) instead of Facebook, you would have brought home over a 30% return by now.  Why is this?  Annie’s was private too, how come their stock went up.  And this is what drives us deep into the concept of the start up as an investment.

You see, Annie’s wasn’t a start up.  Not all IPO’s are actually.  In fact, several IPO’s each year are mature companies with solid business plans and proven track records of profits.  While there is risk, as with any equity investment, there is a history you can use to discern whether or not the IPO gives you good value for your dollar.  With a start you don’t have that chance.  Instead, you have to figure out if the deal is worth while.  Even then, you’re still stuck.  Start ups have the unique problem in business of growing even when nothing else is.  A start up in a mature industry will grow, like crazy, simple because the market dictates that they have to have a bit of the pie (if they are run correctly).  So you’ll look at their numbers and think that they can continue the torrid pace and become the biggest open source software company working on a linux platform in the industry.  Then the plateau, see no more organic growth and that’s the end.  Or maybe their picture filtering software can’t match instagram.  Or their fake gold on their fake mafia facebook game just isn’t popular enough anymore.

The point is that not every idea is profitable.  Start ups are fun.  They create cool things, they have great people working for them and when things work out, they turn into Microsoft or VMware.  But most of them end up like…well I can’t remember the name but they were not a good start up.  Should this fact deter you from investing in a start up or working for one?  No!  Working for one, although in the enterprise space, is one of the best decisions I’ve ever made.  Learning how to run a business from the ground up will benefit me for years.  It’s a masters in entrepreneurship except they pay me for it.  On the same hand, investing in a start up (at the IPO or through a website like sharespost) is also worth it.  However, the company needs to make sense.  For example, Warren Buffett didn’t invest in Facebook.  Also, sorry, I talk about Mr. Buffett a lot.  Whatever, he’s awesome.

Anyway, the general idea here is that if you can understand what a start up is doing (oh, you’re offering networking gear that has open source, linux based software that can be configured for any business? Right on!) they aren’t necessarily a bad investment.  Even more, they might not be a bad place to work.  As I mentioned earlier, I’m learning more from working at a start up that I would at a regular firm.  And working for one of these firms is just as much of an investment as buying into them.

When all my rambling is said and done, what I’m really trying to say is that if you evaluate a start up, either as a job or a capital investment, you will find that if you don’t understand it, the risk isn’t worth it. However, if you understand it, whether it is a new oil pump company or an electric motor or a networking software firm, you’ll realize that this can be something.  What it comes down to is you.  And in investing, that’s almost always the case.

 

Money as you grow | Personal finance 101 for your kids

Today I discovered a pretty cool personal finance site called Money as You Grow. This is a website set up by the President’s Advisory Council on Financial Capability and they’re setting out to try to help us educate our kids on personal finance and improve financial literacy (okay not my kids.  I don’t have any kids.  But J Money does!).  This website is striving to offer 20 essential lessons for us to teach children so they grow up understanding money, debt, and working hard for your money.  They also highlight compound interest, so I guess you’re also teaching the kids how to make their money work hard for them.

In general I’m all for personal finance education and teaching the kids.  In particular, I love that they actually are starting the age brackets at 3 years old.  I mean, have you ever tried to teach a three year old about money?  Or even a five year old?  I have a 7 year old sister and a 11 year old brother and it hasn’t always been easy to impart these lessons upon them.  They definitely understand that you have to WORK for money.  Obviously they like to just ask but they get the concept behind it, that it’s a reward for something you’ve done well (or just done, in the case of cleaning the garage).

Personal Finance 101 for kids

She runs the toughest candy shop on the block

The toughest lesson of personal finance I’ve had to teach either of them has been saving their money.  The Money as You Grow site includes the 10% rule (save 10 cents of every dollar) for kids but you know?  Kids don’t get it!  I swear, it’s because to them a year is such a long time that they just can’t fathom saving for twenty or fifty years.  If the kid is ten then a year is literally 10% of their entire life!  Trying to build perspective on savings for that length of time, let alone decades, is incredibly hard.  I suppose if you’re going to do it, you’ve got to either start young OR build a sense of need for it.  Like for college or for a car.  I know that’s one thing my brother does well; he figures out what he wants, how much it is and then how much he has to save and for how long.  This isn’t exactly a case of him wanting to save  though, he just has expensive tastes.

In general, I love this site and I applaud the effort the government is giving here.  In general, kids don’t learn enough about personal finance early enough and it can definitely hurt them later on in life.  Besides, if you talk to your kids about this then maybe you won’t have to have a more awkward discussion later.

So I’m thinking about buying a house Part 2 | Real Estate Madness

Real Estate

Condo photo by Ed Bierman

One of my first posts on this site was about how I was starting to lose my mind and considering buying a house without putting 20% down.  After meeting with a real estate agent and discussing buying a first home and building my real estate empire (evil laugh), I have to admit that I have no idea what I’m doing.  This is completely foreign territory to me.  In general, the thought of buying a place and not throwing money down the drain is pretty attractive to me right about now.  I’ve spent almost $33K in rent since I moved to LA in 2009 and that money is just gone. No equity, no return, nothing!

Digging more deeply into the numbers have made it pretty clear that buying a place, even if it’s just a one bedroom condo, makes a lot more sense.  Right now I’m paying $1000 a month.  The breakdown for the one bedroom condo would look something like this (not including real estate broker fees, loan fees, etc):

Purchase Price       $150,000
Down Payment      $  10,000
Loan amount         $140,000
Interest Rate                   3.6%
Mortgage Payment  $634.60
HOA                            $268.00
Insurance and PMI  $195.83
Property Tax              $152.55
Monthly Cost           $1250.98

Using the mortgage amortization calculator from Bankrate.com, I’m able to see that after 5 years, my equity position in the property (if the value sees neither appreciation nor depreciation) would have grown from $10,000 to $24,000.  Not bad!  But wait, let’s play around with the calculator a little bit.  If I pay an extra $100 a month into the mortgage, then my equity position will grow to just under $31,000 in five years.  Not only that, the value of the mortgage will have dropped below 80% of the property value (once again, if values neither appreciate or depreciate).  Although that is a big if, let’s assume that does happen.  I would then be able to refinance (if rates were good) in order to reduce my PMI.  If rates were not good, I could always just leave it be.

Either way, let’s look at the rental value for the one bedroom condo’s in this complex.  After checking craigslist, as well as some other comparable items, a fair price seems to range from $1500 to $1600.  I’m guessing that the $1500 range is more likely, even in 5 years and with inflation.  So, I put my property on the market to rent and am able to find a good tenant at $1500 a month.  At this point I am able to make an additional $250 dollars a month from my initial $10,000 investment.  If you wanted to even skip the part where I lived there myself, I could buy it and immediately put it on the market to rent and collect the extra $250 a month.  However, there is no way I want to be caught holding any property without a tenant.  I definitely do not have the savings to manage that sort of mishap right now.

So where does that leave me now?  Well, in theory this really seems like a good idea.  But in practice I’m just not so sure.  I run the numbers over and over again and while they work, they leave me feeling not so hot about the whole thing.  The risk management side of me is terrified (or maybe that’s just the young adult side of me, who knows?) while another part of me is screaming for me to pull the trigger. Although the thought of finally owning some real estate and getting some (sort of) passive income is tempting, I really am not sure I’m ready to commit to that.  I’m not terribly concerned about a property tying me down at all but still, who knows.

What do you think I should do?  Is it a wise investment or a poor decision?  Not going to lie, I could use some real estate advice right about now!

Index Funds | Investing for the rest of us

Yesterday I wrote about actively investing your money, something that many people are not comfortable with. Realizing this, I decided to write about investing with Index Funds, something I’ve mentioned before but haven’t gone too in depth with.  Yeah, I kind of just went a bit crazy the past few weeks and jumped into some more advanced topics on investing and saving than I probably should have.  My bad!  Investing with index funds is not an advanced topic though.  In fact, it’s one of the greatest ways to build your wealth over time.  I use it for most of my money and tend to speak my opinion about Vanguard and their amazing collection of index funds to pretty much everyone I meet.

But why, you ask?  I know what you’re thinking, you want to BEAT the market, not just match it.  Well here’s the thing about that: in the long run, very few mutual funds can beat the market.  It’s a fact.  Many of them can match or slightly under perform the market, which you might think isn’t that bad.  But then you realize that the returns you’re looking at don’t take into account the fees of the manager.  Typically the annual fee will be between 1.10% and 1.50% for an actively managed fund.  So if you were able to match the return of the market, well, you just lost to the Vanguard S&P 500 fund, which only costs 0.17% on an annual basis, keeping your returns in your pockets.  Just taking into account the costs of the index fund makes it a significantly better idea!  Who wants to pay for below average returns anyway?  If your 401k plan has an indexed mutual fund, take it!  The lower expense ratio will save you boatloads of money down the road!

Another aspect we want to take into account is obviously the return.  I mentioned above that it’s rare for a mutual fund to outperform the market and your index funds in the long run and of course, being long term focused on retirement and financial freedom, we’re all about the long run.  So what has Vanguards S&P 500 fund averaged for an annual return since its creation in 1976?  10.55% a year, not including dividends paid out and reinvested.  At that rate, your money will double every 7 years!  Granted this rate is smoothed out but still, it’s a better return than you’ll see on any savings account or CD account.  If you take $20k today and split it into two separate accounts: $10k in an ING savings account with 0.80% interest and $10k in Vanguards S&P 500 Index fund and just leave it for ten years, what do you think the difference would be?  The savings account would have grown to a whopping $10,832 in those ten years.  The S&P index fund, maintaining its historical growth, will be $28,587, more than double your original amount without dividends reinvested.  Granted, the stock market could fall again but any student of the market knows that you can’t be too concerned with the ups and downs of the market if you’re investing passively.

By passively investing your money into index funds you can achieve good returns and you can balance your portfolio easily, without having to constantly buy and sell stocks and incur huge broker fees.  Save yourself some time, set up a Roth IRA and start saving your money.  The earlier you save, the better!

 

If you have thoughts or questions about investing or index funds, leave a comment or send me an email!

 

The Three Rules of Dividend Investing

A lot of people are scared to invest in equities (stocks) because they’re afraid of losing all their money. Strategic dividend investing can help alleviate this fear. This is a method I tend to follow myself that has been fairly successful in keeping my from losing my shirt in the stock market.  You see, in my day to day job I focus a great deal on risk management.  Every day I spend a decent amount of time doing in depth financial analysis of customers and prospective customers, risk rating them and making sure that they have the ability to pay their obligations to us and others.  While this may give me a big advantage when it comes to pouring over the balance sheet and the cash flows, it is not insurmountable to the average investor if they follow several simple rules.  These rules are items I have taken from Benjamin Graham, Warren Buffett and other wise investors on how to invest smart and minimize losses.

First I should probably explain why I tend to use dividend investing as my investment vehicle.  In general, stocks that have dividends tend to be a bit stronger than the small cap or IPO type stocks.  Yes, there isn’t as much possibility for massive growth with them but they are established companies that you know, ie Johnson and Johnson.  My big obsession is the  Standard and Poors list of Dividend Aristocrats.  These are stocks that have increased their dividend every year for 25 years.  These are the blue chip stocks you know and love.  In fact, if you had invested in these stocks 25 years ago, well, you’d be very wealthy right now through both capital appreciation and dividend reinvestment.  Granted hindsight is 20/20 but there is still money to be made in the blue chip, dividend segment.  In general, if you follow these three rules, you can do well in investing.

1.  Never, ever invest more than 10% of your investable funds in one stock.

This should seem simple but to many people, it’s not.  If you’re only investing $10K dollars total for your stock portfolio (not including your bonds and cash), then the most you can put into one stick is going to be $1000.  While this may seem like you’re keeping yourself from realizing some big returns on that stock your cousin Vinnie told you about, dividend investing isn’t about that.  Here we are trying to reduce risk and provide steady returns.  If you have too much of your available cash invested in one area, then you’re at the whim of the market.  If that company goes bankrupt and you had 25% of your cash in there, you just lost a lot of money.

2. Never buy a stock that has had a positive return in the trailing 52 weeks.

I get a lot of flack for this one but it makes a lot of sense.  The stock market is about buying low and selling high.  Warren Buffett one said “[be] fearful when others are greedy and [be] greedy when others are fearful.”  The idea here is that you look for the bargain stocks, the ones whose value is good.  By finding these stocks, with good fundamentals and a healthy dividend, you set yourself up for positive long term growth.  You might hold onto the stock for a year or two years before you see an profit but the point is that you eventually see a profit.  I’d rather buy a good company with consistent sales and earnings and hold onto it for two years for a 20% above market gain than take a flier on an IPO that I could be burned on in one month.  And that leads us to number 3.

3. Buy what you know and understand.

A big part of investing is understanding the company and the product.  A big part of the financial meltdown was that the financial instruments were complex and not easily understood by an average person.  This makes investing in companies and funds that use these instruments dangerous because you don’t know what they are using your money for.  Remember, you’re buying ownership in this company.  If you started a business yourself, you’d want to know what you and your employees are doing.  If you don’t understand it, you can’t make money!  This is one of the reasons Warren Buffett and dividend investors tend to buy companies with easy to understand products, like Johnson and Johnson or AFLAC.  By understanding what they do, it makes it a lot easier for you to review the company and know if they’re halfway to bankruptcy or just a great deal because the stock market says so.

Another rule that isn’t exactly a rule but something I like to follow is that you never buy a stock without looking at the past five years financial statements.  As they’re a public company all of their financial information is available on Edgar, the SEC and Federal Government’s repository of financial and securities information for all public companies.  By looking at this and using basic arithmetic skills (as well as a whole lot of referencing to investopedia.com) you can figure out whether a company is going down the drain or is just undervalued.

In general, I like to use google finance to find all the stocks with a dividend between 3% and 7% that have lost more than 15% of their market value in the trailing 52 months.  I then narrow this down even further with their price to earnings ratios and then, even further with their operating income and net income.  This typically yields only a few (under 40) stocks that are worth looking at and eventually I invest in only about 4 or 5.  I try to stay away from looking at it segment from segment simply because my method will focus on the segments that are performing the worst, market wise.  By doing this once every quarter or so, I allow myself to find the best possible dividend investing deals to invest in.  This will hopefully one day yield even more positive results than it has already.

If you’ve already worked with dividend invest or have comments regarding this, please let me know!  I’m always trying to grow my method and my portfolio so any thoughts pro or con are welcome.  Until next time!

 

The Dave Ramsey Folly | Why you should keep those credit cards

Dave Ramsey is one of the most popular and influential personal finance writers and radio show hosts of our time as well as the biggest anti-credit card advocate. The man has boiled the personal finance lessons of The Richest Man in Bablyon and other famous personal finance guru’s into seven easy to follow steps.  While the steps are fantastic advice and starting points, I vehemently disagree with one essential point: cutting up your credit cards.  Yes credit card debt is huge in this country.  The average U.S. household has almost $16K dollars in credit card debt!  That’s absurd.  But the fact that Ramsey wants you to cut up your credit card ignores some pretty central issues about how our credit scores, those little things we need to purchase homes and get apartments.

Before we get too far into debunking the credit card myth here, go and check your credit score.  The easier way to do this, in my opinion, is with Credit Karma.  Primarily because it is free! Now I’m not paid by them or affiliated with them in any way other than the fact that I use them to track my credit score.  What they do is break your score down for you and show you what areas are important and need to be worked on.  In building our road map to financial health, this can prove to be invaluable.

Once you’ve filled in your information you’ll notice some sections regarding you credit score: Credit Utilization Rate, Debt to Income ratio, Length of time you’ve had accounts, etc etc.  This is where the Ramsey method begins to fall apart.  If you cancel your cards your score will go down!  That’s right, down.  The reason is that if you cancel you’ll be negatively affected in the areas I just mentioned.  The length of time you’ve had your accounts will change when you cancel; if you cancel your older credit cards it will get shorter and thus, worse.  If you cancel your credit cards you’ll lose the availability of debt, which means your credit utilization rate will skyrocket.  These two items alone can knock your score down 100 to 200 points.  When trying to buy a home that can mean the difference between being a prime buyer and a sub-prime buyer.  AKA the difference between spending more on interest for your home or less.

The other area I disagree with Ramsey on is having a credit card in general.  He says we should never use credit cards.  I say we should always credit cards, so long as you pay the balance off every month.  I learned this from my mother years ago; if you pay off your balance in full every month then you’ll increase you credit score, which means the credit card companies will increase your limit, which improves your credit utilization ratio, which increases your credit score and so on and so on.  Even better are the rewards programs out there now.  I’m not talking about airline miles because that is always a rip off.  I’m talking about cash back rewards cards, specifically the higher (5% or more) rate cards for gas and groceries.  If you’re going to be able to pay your credit card off in full every month and you have to buy those groceries or fill up that gas tank anyway then why don’t you use the card and get cash back.  Sure, there are limits to how much you can get but let’s look at this with a little bit of math here.  Let’s say you have a credit card that gives 5% cash back and you and your family spend $550 a month between gas and groceries.  That is $6,600 a year in expenses.  5% cash back on that is an extra $330 dollars, which is less than the capped limit but still a substantial dollar amount.  That could be one or two car payments or it could go towards the kids college fund.  The point is it is money, that if you maintain good financial discipline with your credit cards, will be handed over to you free from the banks and credit card companies.  So why not game the system a little bit, just this time?

 

Promotions, Inheritance, and other windfalls

Before I really get started on this post, I want to congratulate my college friend Frenchie on her new promotion and raise!  Congrats!  Well deserved.  Of course, this post is inspired by my friend and her promotion because it eventually lead to a discussion about what she was going to do with the raise.  This lead to the inevitable answer of “well, I’m going to go shopping.”  With my finance brain turned on, I saw this as an opportunity to build a bit of a concept here.  In general, if we’re living within our means and are focusing on saving and investing all extra earnings, then a promotion, inheritance, settlement, etc is going to present an awfully tempting situation to increase our consumption.  I myself am an example of not following this premise.

I received a big promotion and raise in December of 2011.  It was enough money to radically change my standard of living.  If I had been on top of my game then I would have taken most (we’ll say 75%) of my after tax income from the promotion and socked it away to save up for a house or something along those lines.  Instead I financed a new car which, although incredibly necessary due to the failing transmission on my Volkswagen, ate up 50% of the promotion.  Completely not ideal!  I mean come on now Brian, you’re basically being given free money for doing a good job.  You’ve got to save it!

Let’s say that right now, you’re living off $36K  a year after taxes.  It’s not an easy life by any means but you’re doing well with your budget and you’re saving 10% of your after tax income.  You’re good at your job and get a promotion and a raise each year.  It’s not much but it adds up: 5% after tax raise each year for five years.  There are two paths you can go with this: you can increase your spending and keep saving only $300 a month OR you can look at the raise and promotion as extra money and save the whole thing.  The differences are drastic: after the one year at $36K and the five consecutive years of raises you will have either roughly $54K if you put your raise towards savings or $24K if you spend the entire promotion (if invested at an annual rate of return of 5%).  That’s a HUGE difference over a short time period and can make all the difference over the course of an entire career.

Of course you can’t be expected to save every penny of every raise you’ll ever get.  And you won’t always get a 5% raise and you won’t always get a 5% return.  The point here is that if you’re diligent and live within your means (and work hard enough to actually get that promotion you deserve instead of letting it go to Ted, the guy from down the hall who totally doesn’t deserve it) that you can save a good deal of money within a short time frame.

If you have feedback, whether you agree or disagree, let me know!  Comment on the post or send me an email.  I’m always looking for new ideas and for items to discuss.