What is an Emergency?

Save an emergency fund!  This is one of the most important first steps to getting control of your finances and stopping the cycle of reaching for the credit card when things get tough.  I even made saving an emergency fund Millionaire Rule #5.  I've scraped together almost $2 grand for my emergency fund over the last year, and that is great progress. Right?  

My problem today is that my car needs work, but I don't want to raid my emergency fund.  The $400 repair bill seems small enough for me to pay out of my regular living money, but history has shown that I won't tighten the belt enough.  I know that if I pay this bill out of normal income I will run out of money by the end of the month.  When the money runs out the immediate response will be to reach for the credit card for groceries and gasoline that I've got to have.  Spending more on credit is exactly what I shouldn't do.

However, I would almost rather seem my credit card balance go up than see my emergency fund balance go down...   I know it is crazy talk, but it took so much to build it up I don't want to use it!  I like knowing if a real emergency happens I have the money to cover it.  I also like looking at the nice balance and watch it continue to grow each month.

So here is the real question, how do you decide what constitutes an "emergency" and justifies raiding savings?  For example, I needed to buy two pairs of shoes (one for the gym and one for work) for which I hadn't planned.  Is that $100 expense for shoes enough to raid the emergency fund?  What about redoing the brakes on the car? What about text books for my wife?  It seems there is a possible emergency that doesn't fit into the budget every month.  Ugh.

In the last two months I've spent significant sums on these unplanned expenses.  Fortunately I've also had a significant inflow of cash from selling unused items on eBay that has covered these expenses.  That extra money was originally earmarked for paying off debt.  Instead of paying down my debt I chose to pay the bills and let my balances tread water.  This seems like a decent trade off, but in reality is is the same as if I had paid down the debt and later (when money got tight again) run the credit card right back up.  That scenario may have actually saved me some interest now that I think about it.

I'm a little confused about how I should be using my emergency fund, and a little frustrated with all of the unbudgeted expenses that have popped up.  Please leave some comments to let me know what you think.  Thanks for reading.

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Millionaire Rule #6

Pay Off Debt (except a mortgage or federal student loan):
"Compound interest is the most powerful force in the universe." This quote is often attributed to Einstein. Whether the famous physicist ever said this or not, the fact remains that the avalanche effect of compound interest produces remarkable financial sums. When a person uses credit to make purchases they are on the loosing end of compound interest; they are trying to swim against a powerful current.

One of the best ways to stay poor (or middle class) is to get onto the debt treadmill. Johnny Carson while hosting the Tonight Show once said, "Scientists have developed a powerful new weapon that destroys people but leaves buildings standing - it's called the 17% interest rate." While he was referring to the staggeringly high rates of the early 1980's on mortgages and other bank loans, rates even higher are found on most credit cards. With a credit card balance of $3,500 and a minimum payment of $50 per month it would take over 28 years to pay off the balance. The total interest paid would amount to approximately $13,500. It nearly quadruples the sticker price of a purchase if a person buys on a credit card and opts to only pay the minimum payment. Would you still buy something if you knew it would ultimately cost 4x as much on credit? Too often credit is used to buy short lived pleasures like clothes, food, or gadgets that will be long gone before you finish paying off the debt.

Obviously, getting into the habit of buying on credit it can be nearly impossible to build wealth. The same $50 per month could be saved for 5 years and you could pay cash for the $3,500 purchase. Then if the $50 per month savings were invested with an 8% return it would amount to more than $40,000 in the same time it would have taken to pay off the purchase on credit. Which would you rather do, save for 5 years, pay cash, and create $40,000 in wealth by keeping the debt payments, OR make payments for 28 years and have nothing left to show for it at the end. As you can see, credit card debt is a sucker's game.

I make two important exceptions to my rule to avoid debt. In many cases it is beneficial to take out student loans for education spending. Education has an intangible value which comes from learning and personal growth. It is an investment in yourself that will provide rewards through out your life. Education also provides a tangible value by increasing a persons employability and career prospects. Education loans also benefit from special tax treatment and generally lower interest rates that make this type of loan even more financially palatable.

I still have some caveats that need to be taken into account. First, only borrow what MUST be borrowed. Do not take out "education loans" to pay for a Spring Break vacation, bar tabs, or frequent restaurant meals. Also, do not rush off to a pricey private school to be piled up with loans when a local or state institution can serve you equally for a fraction of the cost. Second, do not borrow for a degree that you do not feel passionate about. If you do not know what you want to learn or what career you are studying for, do not take potentially useless classes. Wait until you have more life experience and are sure how education will advance your goals before borrowing to pay for it. Finally, do not borrow more than you can realistically expect to pay back. I see too many people with a passion for art or music borrow tens of thousands of dollars, while their career path will never allow them to pay back. Take out loans that are in-line with the realistic salary you can expect once you graduate. On a $30k per year salary it is a massive handicap to have $100,000 in loans. The same $100,000 is not nearly the same burden if it pays for a professional degree like law school, medical school, or masters degree in business or engineering.

My next exception to the no-debt rule is to take out a mortgage. Buying a home is often a very good wealth building method. A home will still be around long after the debt is retired. A home also goes up in value and will be worth more in the future. Everyone must have a place to live, and owning a home can sometimes greatly outweigh renting. However, it is important to recognize that this is not always the case. In many locations renting is cheaper than buying. Make sure to look at both options and choose the one that is right for you and the current market situation.

Many of the same caveats listed with student loans also apply to paying a mortgage: only borrow what MUST be borrowed, wait until you are sure you will stay in one place and are ready to buy, and do not borrow more than you can realistically expect to pay back. Other rules of thumb which apply only to home buying are: buy a house which is 2-3 times you gross income and no more, if you can't afford to have a down payment you should not buy a house, never let your house be your largest investment, and get a fixed rate mortgage. Do not allow your home purchase to control your life by eating up all of your time and money.

If a person can live their life in a way the lets the power of compound interest work for them rather than against them, they will be well on their way to wealth. Check out the rest of the Millionaire Rules to learn about other basic tenants which can guide you on your path to wealth. Be sure to subscribe to my RSS and check back regularly to follow my progress as I Aspire 2 Wealth.

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Blog Roundup - Adfecto's Sick Edition

I've been sick all week. It started with some sniffles on Sunday and by Tuesday morning I couldn't get myself out of bed. I spent two days of sick leave from work (Tuesday and Wednesday) but today I had to drag myself into the office. I don't really feel up to writing anything new and original but I have spent a good deal of time reading my long list of favorite blogs (while drinking gallons of hot tea).

Here are some of the posts that caught my interest the most:

J.D. at Get Rich Slowly wrote about The Value of a College Education. I completely agree with his thoughts. When I sat down to write a post about my money decisions, I immediately knew that my educational choices were far and away my best. I got a BA in Computer Engineering and then took a job with an employer that paid for me to get a MS in Software Engineering. To get here it is/was a lot of hard work, long nights, and Red Bull but it has paid off. This path is really only for those who enjoyed taking apart electronics when they were kids, begged for Legos and erector sets for Christmas, and would rather learn C++ than Spanish. My total bill for education was near $100k but 2.5 years out of school I’ve made back every penny.

Free Money Finance added a helpful post about How I Paid Off My Mortgage. I can only imagine what it would be like to be totally debt free. The debate of paying off a mortgage early versus investing is explicitly left out of the discussion, but reading the post made me question my current plan to hold a mortgage up until right before I retire. Right now it seems like it would be nearly impossible to have the type of house I want, with enough room for a family, in the right neighborhood, and so on for an amount I could pay in cash.

Lastly, Plonkee Monkey wrote a great set of posts about Planning for Retirement: Buy-to-Let vs Pensions. This analysis (for those in the American market) compares the overall retirement income produced from rental property compared with investing in stocks and bonds. While the numbers and assumptions differ from what I estimate for my local market, the conclusion ends up being the same. Rental real estate is a valid way to invest your money and CAN beat the stock market. However, it is not for me! Renting out homes and apartments requires a high initial investment, high risk, poor diversification, and worst of all... a LOT of work. I've mulled over the decision to become a landlord dozens of times and every time I decide that the payoff just isn't worth it. You should still check out the articles yourself and see if it could work for you.

Now I am going to drink one last mug of tea and get to bed. Hopefully I will shake this germ and be back to my old self soon.

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Two-Prong Attack: Pay Debt and Invest

I came across an article on CNN Money today that directly speaks directly to my personal finance situation.  Walter Updegrave answers the question of a reader who has $11,000 in credit card debt and $650 per month left in the budget to allocate between debt payment and investing in a Roth IRA. My situation is almost identical, as I too have about $11,000 of "bad debt" that I need to eliminate and $800 per month to allocate.  Walter's answer was, from a strictly numerical perspective, it is generally better to pay the credit cards first.  This is because payment of the debt is the same as an automatic return on investment equal to the interest rate.  To put this in simple terms, if your credit card charges 14% interest your investment must be able to beat that rate (which is not a realistic expectation) for investing to be the better option. 

My situation is slightly different because I have been able to use low rate balance transfers to lower my overall interest rate.  I am paying a little less than 6% on average to carry my debt.  In that case it is fairly reasonable to expect that investing can meet or exceed the return I would gain from paying my debt first.  My current spending plan however is to do both in a two-prong solution. 

I pay $600 per month toward my debt (roughly double the minimum payments) and $200 per month toward my Roth IRA.   This will allow me to start working toward my retirement goals and pay my debt on at accelerated pace.  When I get my next raise in mid-to-late 2008 I will further increase my Roth contributions up to the $5,500 per year maximum.  A Roth IRA provides a potential source of cash (contributions can be withdrawn at any time for any reason without penalty) and future tax advantages as I'm nearly certain my tax bracket will increase in the future.  Having a Roth to tap may also keep me from running up debt at a higher interest rate in the event of an absolute emergency further down the road. 

The article also begins to discuss the psychological issues of debt spending.  It is all too common for a person to take a few steps in the right direction only to take two steps back as the run up new debt.  By attacking both goals you can move forward even if your debt balance stays maxed out.  I hope that this blog and the publication of my financial results will keep me from falling into this trap, but it is an important point to make.

Today I was included in the Carnival of Personal Finance #134.   MrsMicah did a great job hosting, and provided some nice commentary with her Editor's Picks.  It is one of my goals for 2008 to have one of my posts selected as an Editor's Pick.  The article that got me most fired up was by Lily at The Honest Dollar called In Defense of Personal Finance Bloggers.  I like to think of myself as a blogger who is not obsessed with retirement (which is what the article is all about), hopefully I don't come across as that type.  I don't care for possessions or having "things" but I do value experiences like traveling, hosting parties, and eating at nice restaurants.  These are things best enjoyed while I am young so I can enjoy the memories for an entire lifetime. 

However, I AM actually obsessed with making the most of the money I have; which means getting rid of debt, investing for growth, and spending money wisely.  I also recognize that the lifestyle I truly desire is well beyond my current means, so instead I will live below my means (which is even farther below my desired lifestyle) in order to build wealth so I can life that lifestyle "one day."   I want to live in a house with a dedicated home theater, drive a luxury car, and take month long vacations to the Mediterranean.   This is not possible with a household income of $80k but it WILL be possible when I am 50 and have an income of $200k with a couple million in the bank.  So for now I will forgo the $4k beautiful 60" 1080p plasma television I drool over in the store and instead buy the 37" 720p LCD television that I got on sale for $620.  For vacations, my wife and I do things like rent a cabin with friends for a long weekend or meet my family at a rented condo at the beach instead of a fancy cruise or European jaunt.  That is by no stretch of the imagination frugal like how some other personal finance bloggers live their lives, but it will still enable me to save 16% of my gross income in a Roth and 401(k) and have some fun too. 

I guess I see spending and saving, paying debt and investing, hard work and playing hard, etc as parts of our lives that need to be balanced in order to get the most out of the years we've got.  Readers, please call me on this if you see me spouting non-sense or acting hypocritically. 

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It's The Big Things Stupid!

One of the biggest misconceptions that I read all the time related to personal finance is that the little choices we make about money are the key to fixing our financial ills. Every time I turn around someone tells me the reason I am broke is that I buy my coffee every morning and have a couple cans of soda every day; that the little things sink our financial boat. I don't buy it. I think the reason most people are broke is that they don't do the BIG things right. Think about it, what has more effect on your overall financial health, your car buying habits or your coffee habits?

Buying a car is a Big Thing in our financial lives. When a person finances a $40k car for 60 months at 8% (or even higher) interest the monthly payments are over $800 a month not even including the insurance, maintenance, or taxes. Sadly I have a neighbor that lives up the street who has $200k worth of cars parked in front of his $180k house for himself, his wife, and his 3 driving age children. You could drink 6 designer coffees every day to catch up with what is wasted for each of his 5 cars. You could buy a house 5 miles closer to the city center and install a full roof of solar panels. Or you could continue to throw you money away for the speeding tickets that a V-8 turbo charged engine brings you. The same consequences are true for buying a house or leasing an apartment which exceeds the needs of its occupants. The picture gets even worse when you consider boats, ATVs, jet skis, or other pricey toys bought to keep up with the Joneses.

Another Big Thing that will ultimately sink your financial ship that so few people consider the free money that comes from a 401(k), IRA, or Roth IRA plan. According to this paper by the Social Security Administration the 401(k) participation rate was 67% and the Traditional IRA participation rate was only 8% (Roth IRAs were not included in the analysis). The choice to skip using these vehicles to contribute to your quest for instant gratification is the loosing end of a million dollar choice. That choice has consequences which far outweigh whether or not you uses coupons when buying your OJ at the local grocery store. It has even been shown that the amount contributed and the particular investments selected within these retirement accounts is not nearly as important as simply contributing NOW.

The final Big Thing that I think too many people get wrong is they miss the opportunities that education presents. A good paying middle class job for the high school graduate is a thing of the past. According to this Census Bureau paper investing in a college degree is another million dollar decision that people fail to make. Public and private assistance for college is available for nearly everyone in some form or fashion. Federal Tax incentives such as the Lifetime Learning Credit and Hope Credit apply to everyone who has earned income and wants to attend higher education.

I don't abdicate completely forgetting the little things, but I think if you make good choices about the Big Things you will end up doing better than most. So far I feel like I've gotten most of the big things right, but screwed up plenty of smaller things. Despite these mistakes which might amount to a few hundred dollars here and a couple thousands dollars there, I know that buying a house I can afford, striving to pay cash for my reliable (not luxurious) transportation, investing as much as I can stand (and then a little more till it feels tight), and taking lifetime learning to heart I build my wealth and bring prosperity.

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Back to the Grind

I am back from my Holiday travels. The entire trip consisted of three things: 1) Driving, 2) Eating, and 3) Football. My wife and I had a good time visiting her family, and I'd say the trip was a success.

During the trip I was asked several times what my plans are for the future. That got me thinking that I don't really have a cohesive plan for the next phase of my life. I've reached a point where most of my short term goals like completing my masters degree and buying a house have been achieved. What do I do next?

I might get a Ph.D. It can almost never hurt to get more education (especially when my work contributes to these endeavors) and it would be really neat to be Dr. Adfecto! I have also thought about becoming a Certified Financial Planner. Why not make my favorite hobby into my day job? I might actually enjoy my work that way. I have also looked into becoming an entrepreneur by starting businesses in a few different fields; 1) real estate investing, 2) real estate property management, 3) franchise (Subway, Papa Johns, etc), 4) home theater/networking/automation/AV installer, and 5) financial services firm. I can already see the glass ceiling above me at my current job (though I have a few years before I hit it) so I want to be prepared to maximize my earning potential.

Another thing I thought about a lot over the last few days is my near term financial goals. I'd like to put them down here to document my thoughts and outline the specifics. First, I want to pay off all of my debt except my mortgage. That is my most immediate goal and I think is a great goal that everyone should achieve. I currently have about a 12k car loan and about 12k in consumer debt that I want to pay off. I also want to reach a savings level that maxes my Roth IRA ($5500/year) and puts me on course to max my 401k (15% of gross pay). Next I want to purchase (preferably with cash) a replacement for my 1999 Chevy sedan that is sadly already struggling. Third, I want to establish an emergency fund with > 3 months of expenses in an online savings account. I have set a very ambitious completion date of July 1, 2010.

This is the basic advice that the columnists like Walter Updegrave (CNNMoney), Michelle Singletary (Washington Post), and Liz Pulliam Weston (MSN Money) or the gurus like Dave Ramsey (The Total Money Makeover), Robert Kiyosake (Rich Dad, Poor Dad), and David Bach (The Automatic Millionaire) or the scores of personal finance bloggers (Money Blog Network) write about every day. I agree with them and will put these goals into practice in my life. Reading these articles and books is a great start however, is not enough to bring out the type of wealth I want in my life. I want to be able to travel to exotic places, to own a beautiful spacious home (or two) with upgrades like a home theater and billiards room, own a pair of late model mid-luxury cars (for example Infinity G35 for me and an FX35 for my wife). I want be able to work with flexibility and generate as much of my money as possible from completely passive sources (bonds, stocks, 3rd party managed real estate or businesses, etc). In other words, I want to be truly wealthy with a net worth of 10-15 million. That my friends is not the 'Millionaire Next Door' or the 'Comfortable Retiree' that will result from the advice of those I mention before. What then should I do to achieve this kind of wealth that such a small percent of Americans achieve? That is a whole different set of ambitious goals I need to figure out.

Aspire 2 Wealth is a center piece of this thinking. It will provide me a place to put my thoughts into concrete form so my ideas don't go to waste. It will also (hopefully, one day soon) give me an audience (or even better, a community) to give me feedback, encouragement, and tough love to push me further toward my goals. I think I need someone to call me on my pie-in-the-sky dreams and make me take action on the dozens of "million dollar ideas" I think I have on a regular basis. Thoughts and suggestions appreciated.

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