August 2008
Advice to live by? Maybe not
We analyze oft-repeated recommendations in light of today’s economic realities
Advice is cheap, often even free, in the Internet age. Financial tips and recommendations are repeatedly dispensed online,
on radio and TV, in print, and from the lips of friends and colleagues. After awhile we start believing them to be true, whether
the advice is good or not.
But some bits of long-standing wisdom have been blindsided by events such as the mortgage and credit meltdown. Also, what seems to be good general advice might not be right for some people. And then there's the advice that seems as if it were thought up by someone trying to make a sale.
Below we look at several pieces of advice you might have heard and analyze their credibility in light of changing times.
Pay yourself first
We've said it ourselves, and we mean it: Build your savings automatically by direct-depositing part of your income first into a tax-deferred retirement plan, such as a 401(k), 403(b), or IRA, and then, if you have more to invest, into after-tax investments such as a savings account or no-load index fund. Ideally you should put the maximum allowable amount into your tax-deferred investments before moving on to the taxable ones.
But does that suggestion hold if you carry large balances on your credit cards or have other high-interest loans? No. Unless you are making fabulous returns on your savings and investments—higher after taxes than the double-digit costs of your credit-card debt—deal with your debt first.
Focus first on paying off your highest-interest debt. Pay down, say, an extra $500 a month until that account is paid, then move on to the next-highest account until it's all paid off. Then use that same $500 a month to build savings, starting with an emergency fund of three to six months of expenses, suggests Stacy Francis, founder and president of Francis Financial, a planning firm in New York City.
During this repayment period, continue to divert some savings to a tax-deferred retirement account up to the limit of an employer match. "Employees who do not contribute to their available retirement-savings vehicles, especially if employers match those contributions, are throwing money away," says Ethan Ewing, president of Bills.com, a personal-finance Web site with numerous links to online resources.
Borrow from your home for nearly everything
You don't hear this one as much as you did before the housing market plunged. But the siren call of home-equity lenders isn't entirely silent, even as they tighten up their criteria for loans and lines of credit. If your credit is good and your home equity is still a significant part of your home's estimated value, you remain a good candidate for a home-equity loan or HELOC. Many lenders are hawking those products for their tax advantages and their ability to help you maintain your lifestyle during difficult times.
But even if you qualify to borrow against your home, proceed with caution. If you have an open HELOC, don't close it, but view it as an emergency backup. Because rates are relatively low, it might make sense to use it for long-term expenses such as a home-improvement project or even educational costs.
True, you can deduct interest on up to $1 million borrowed to buy, build, or improve your home, and on $100,000 more in home-equity debt used for anything else. But using your HELOC or loan to maintain or enhance your lifestyle—paying for a flat-screen TV or a dream vacation—means your cash flow is out of whack. Those kinds of purchases should be built into an annual budget, financed by income and savings. If home values fall and your lender limits what you can borrow from an existing HELOC—a recent trend—you'll have less available for emergencies.
Sellers of reverse mortgages use the same come-on to entice folks as young as 62 to tap their home equity. These loans, available to some older homeowners, convert home equity into an income stream, credit line, or lump-sum payment that does not have to be repaid as long as the owner lives in the home. With their interest costs and high fees, reverse mortgages should also be a last resort for people who can't find the money to stay in their homes, not consumers who want to use their equity to maintain a high style of living. Similarly, just say no if a financial salesman recommends that you take a reverse mortgage to free up funds to buy an annuity or other financial product.
Borrow from your 401(k) and pay yourself interest
On the surface, this move seems terribly savvy. If you turn to your retirement account to borrow needed funds, the interest you'll pay goes to yourself, not a bank. And typically the fee to initiate a loan is less than $100—similar to what you'll pay for a HELOC but far lower than the origination fees for a home-equity loan.
But unless you have a significant balance in your account, this strategy could backfire. For one, with less in the pot you could stunt the growth of your long-term savings and fall short of what you'll need in retirement. Your employer will probably require you to pay back the loan entirely if you leave the job—a double whammy if you get fired or laid off. In most cases, if you don't repay the loan within five years it is considered a withdrawal, so you'll owe federal and state income taxes on the outstanding amount. And if you're younger than 59½, you'll be slapped with an additional 10 percent penalty.
Keep a big mortgage for the tax benefits
Financial advisers often tell clients in high tax brackets to hold on to mortgage debt because they can deduct the interest. Next to charitable contributions, mortgage interest is one of the few itemized deductions left for people subject to the Alternative Minimum Tax.
To judge the merits of this strategy, you need to see how much you could earn from alternative investments. "What's the reasonable rate of return you can expect investing the money vs. the cost of the mortgage?" asks Eric Tyson, author of "Let's Get Real About Money" (Financial Times Press, 2007) and other personal finance books. "If you're close to retirement, you are better off getting rid of a mortgage. But a younger person might not want to. This is a case where one size doesn't fit all."
Tyson notes that paying down a mortgage has more emotional weight than a typical investment decision. "If you're not going to pay down the mortgage, you have the stress of investing the money you didn't use to pay down the mortgage," he says. And for many, there's the stress of still having the debt.
Close credit-card accounts you don't use anymore
Putting the scissors to unused plastic seems like an easy way to simplify your life. But closing a credit-card or store charge account can work against you down the road, especially if you expect to need credit from other sources.
When you close an account, you lower your credit-utilization ratio, the ratio of debt to available credit that lenders and credit-scoring bureaus use, with other indicators, to gauge your creditworthiness. If you have $4,000 in credit-card debt and $20,000 in available credit, for instance, your utilization ratio is 20 percent. Eliminating a $5,000 line of credit at Sears would reduce the denominator to $15,000, making your ratio higher—almost 27 percent. That may seem insignificant, but in a period when lenders are becoming super picky about doling out preferred interest rates, you might as well hang on to any edge you've got.
If you've held the card for a long time, closing the account can further affect your credit score. That's because 15 percent of the score relates to the length of your credit history. Your action can also affect your "types of credit" category, notes Gail Cunningham, a spokeswoman for the National Foundation for Credit Counseling. "The lender likes to see how you handle a variety of lines of credit—secured and revolving, for instance," she says. "If you close out a credit card, you could unknowingly be affecting your types of credit lines in use," she says. That carries a 10 percent weight in your credit score.
Focus on the payment, not the total cost
You won't hear this from us, but you might the next time you're car shopping. The auto-financing business thrives because so many consumers look at monthly payments rather than the vehicle's total cost. How else to explain the seven-year car loan, which can add $6,000 in interest to the cost of a $22,000 Toyota Camry?
Keep your eye on the total cost. And when you're buying a big-ticket item, remember that what seem like small additions compared with the overall price can add up to significant, and often unnecessary, outlays. "Some people figure that as long as you're spending $30,000 on a car, you might as well get the special rims for an extra $500," says Ron Wilcox, a professor at the University of Virginia's business school and author of "Whatever Happened to Thrift: Why Americans Don't Save and What To Do About It" (Yale University Press, 2008). "What people don't take into account is that $500 is $500."
But some bits of long-standing wisdom have been blindsided by events such as the mortgage and credit meltdown. Also, what seems to be good general advice might not be right for some people. And then there's the advice that seems as if it were thought up by someone trying to make a sale.
Below we look at several pieces of advice you might have heard and analyze their credibility in light of changing times.
Pay yourself first
We've said it ourselves, and we mean it: Build your savings automatically by direct-depositing part of your income first into a tax-deferred retirement plan, such as a 401(k), 403(b), or IRA, and then, if you have more to invest, into after-tax investments such as a savings account or no-load index fund. Ideally you should put the maximum allowable amount into your tax-deferred investments before moving on to the taxable ones.
But does that suggestion hold if you carry large balances on your credit cards or have other high-interest loans? No. Unless you are making fabulous returns on your savings and investments—higher after taxes than the double-digit costs of your credit-card debt—deal with your debt first.
Focus first on paying off your highest-interest debt. Pay down, say, an extra $500 a month until that account is paid, then move on to the next-highest account until it's all paid off. Then use that same $500 a month to build savings, starting with an emergency fund of three to six months of expenses, suggests Stacy Francis, founder and president of Francis Financial, a planning firm in New York City.
During this repayment period, continue to divert some savings to a tax-deferred retirement account up to the limit of an employer match. "Employees who do not contribute to their available retirement-savings vehicles, especially if employers match those contributions, are throwing money away," says Ethan Ewing, president of Bills.com, a personal-finance Web site with numerous links to online resources.
Borrow from your home for nearly everything
You don't hear this one as much as you did before the housing market plunged. But the siren call of home-equity lenders isn't entirely silent, even as they tighten up their criteria for loans and lines of credit. If your credit is good and your home equity is still a significant part of your home's estimated value, you remain a good candidate for a home-equity loan or HELOC. Many lenders are hawking those products for their tax advantages and their ability to help you maintain your lifestyle during difficult times.
But even if you qualify to borrow against your home, proceed with caution. If you have an open HELOC, don't close it, but view it as an emergency backup. Because rates are relatively low, it might make sense to use it for long-term expenses such as a home-improvement project or even educational costs.
True, you can deduct interest on up to $1 million borrowed to buy, build, or improve your home, and on $100,000 more in home-equity debt used for anything else. But using your HELOC or loan to maintain or enhance your lifestyle—paying for a flat-screen TV or a dream vacation—means your cash flow is out of whack. Those kinds of purchases should be built into an annual budget, financed by income and savings. If home values fall and your lender limits what you can borrow from an existing HELOC—a recent trend—you'll have less available for emergencies.
Sellers of reverse mortgages use the same come-on to entice folks as young as 62 to tap their home equity. These loans, available to some older homeowners, convert home equity into an income stream, credit line, or lump-sum payment that does not have to be repaid as long as the owner lives in the home. With their interest costs and high fees, reverse mortgages should also be a last resort for people who can't find the money to stay in their homes, not consumers who want to use their equity to maintain a high style of living. Similarly, just say no if a financial salesman recommends that you take a reverse mortgage to free up funds to buy an annuity or other financial product.
Borrow from your 401(k) and pay yourself interest
On the surface, this move seems terribly savvy. If you turn to your retirement account to borrow needed funds, the interest you'll pay goes to yourself, not a bank. And typically the fee to initiate a loan is less than $100—similar to what you'll pay for a HELOC but far lower than the origination fees for a home-equity loan.
But unless you have a significant balance in your account, this strategy could backfire. For one, with less in the pot you could stunt the growth of your long-term savings and fall short of what you'll need in retirement. Your employer will probably require you to pay back the loan entirely if you leave the job—a double whammy if you get fired or laid off. In most cases, if you don't repay the loan within five years it is considered a withdrawal, so you'll owe federal and state income taxes on the outstanding amount. And if you're younger than 59½, you'll be slapped with an additional 10 percent penalty.
Keep a big mortgage for the tax benefits
Financial advisers often tell clients in high tax brackets to hold on to mortgage debt because they can deduct the interest. Next to charitable contributions, mortgage interest is one of the few itemized deductions left for people subject to the Alternative Minimum Tax.
To judge the merits of this strategy, you need to see how much you could earn from alternative investments. "What's the reasonable rate of return you can expect investing the money vs. the cost of the mortgage?" asks Eric Tyson, author of "Let's Get Real About Money" (Financial Times Press, 2007) and other personal finance books. "If you're close to retirement, you are better off getting rid of a mortgage. But a younger person might not want to. This is a case where one size doesn't fit all."
Tyson notes that paying down a mortgage has more emotional weight than a typical investment decision. "If you're not going to pay down the mortgage, you have the stress of investing the money you didn't use to pay down the mortgage," he says. And for many, there's the stress of still having the debt.
Close credit-card accounts you don't use anymore
Putting the scissors to unused plastic seems like an easy way to simplify your life. But closing a credit-card or store charge account can work against you down the road, especially if you expect to need credit from other sources.
When you close an account, you lower your credit-utilization ratio, the ratio of debt to available credit that lenders and credit-scoring bureaus use, with other indicators, to gauge your creditworthiness. If you have $4,000 in credit-card debt and $20,000 in available credit, for instance, your utilization ratio is 20 percent. Eliminating a $5,000 line of credit at Sears would reduce the denominator to $15,000, making your ratio higher—almost 27 percent. That may seem insignificant, but in a period when lenders are becoming super picky about doling out preferred interest rates, you might as well hang on to any edge you've got.
If you've held the card for a long time, closing the account can further affect your credit score. That's because 15 percent of the score relates to the length of your credit history. Your action can also affect your "types of credit" category, notes Gail Cunningham, a spokeswoman for the National Foundation for Credit Counseling. "The lender likes to see how you handle a variety of lines of credit—secured and revolving, for instance," she says. "If you close out a credit card, you could unknowingly be affecting your types of credit lines in use," she says. That carries a 10 percent weight in your credit score.
Focus on the payment, not the total cost
You won't hear this from us, but you might the next time you're car shopping. The auto-financing business thrives because so many consumers look at monthly payments rather than the vehicle's total cost. How else to explain the seven-year car loan, which can add $6,000 in interest to the cost of a $22,000 Toyota Camry?
Keep your eye on the total cost. And when you're buying a big-ticket item, remember that what seem like small additions compared with the overall price can add up to significant, and often unnecessary, outlays. "Some people figure that as long as you're spending $30,000 on a car, you might as well get the special rims for an extra $500," says Ron Wilcox, a professor at the University of Virginia's business school and author of "Whatever Happened to Thrift: Why Americans Don't Save and What To Do About It" (Yale University Press, 2008). "What people don't take into account is that $500 is $500."
