Do terms like "money market fund" and "401(k)" leave you scratching your head? The new edition of "Get a Financial Life" by Beth Kobliner helps you learn the basic language of the financially savvy. This excerpt offers a cheat sheet on some of the fundamentals you should know about saving money.
Crib notes: A "cheat sheet" for time-pressed readers
If you prefer CNN Headline News to the newspaper and opt for the Cliffs Notes over actual books, this chapter is made for you. It cuts to the chase and offers you the most important steps toward a good financial start. So if you don't have the patience to read the entire book right now, adopting one or two of these strategies will put you ahead of the game.
Of course, as someone's mother once said, cheaters only cheat themselves. And while this chapter is a good launching point, ignoring the remaining eight chapters is a little like relying on a friend's ten-minute summary of Moby Dick — you'll get the basic plot line but never understand it in any real depth. Still, the following crib notes should give you a quick-and-dirty rundown on the basics, I've tried to list them in rough order of importance, but your priorities may depend on your own situation.
1. Insure yourself against financial ruin.
It's not surprising that people don't like to talk about insurance. It's expensive, confusing, and mostly about sickness and death. But if you're interested in getting adequate medical care in case of a serious accident or illness, and would prefer not to bankrupt yourself and your family in the process, there really is no higher financial priority than health insurance.
If you work for a company that offers employees health insurance, you're lucky; participating in your employer's group plan will probably cost you much less than buying a policy on your own, and the coverage you get is likely to be more comprehensive than any individual policy you could afford. You may even have more than one type of health insurance plan to choose from through your employer. When deciding among offerings, make sure you consider not only price but also the type of coverage you will receive. If, for example, you're thinking about joining a type of plan called a health maintenance organization (HMO), inquire about exactly what is covered, ask about the procedure for seeing specialists, and find out what happens if you want to visit a doctor outside the HMO. Although HMOs are generally less expensive, if you come down with a serious illness and want to see a specialist outside your HMO network, you may have to foot the entire bill yourself. Before you sign up for any health insurance plan, talk to coworkers about their experiences with the various options.
If the company you work for does not offer insurance, you'll have to pay for it yourself. If you recently graduated from college, see if you can extend coverage from your parents' plan for a few years. If you're job hunting, at the very least get temporary coverage. If you're employed but your company doesn't offer you insurance, see if there are any organizations you can join (a trade association, for example) that will allow you to purchase health insurance at a group rate. This can be much less expensive than purchasing individual coverage. Since plans vary dramatically from state to state, your best bet if you're on your own is simply to call the major insurers and HMOs in your area and see what they have to offer. Also call Quotesmith (800-556-9393), USAA (800-531-8000), and your local Blue Cross/Blue Shield company for quotes. And if you're having trouble getting coverage because of a medical condition, your state insurance department may be able to provide you with the names of companies that will cover you. (See page 182 for the phone number of your state's office.)
Another type of protection you may want to consider is life insurance, but only if you have children or if someone else is financially dependent on you. If you don't have dependents, you don't need life insurance. If you do, the type you should buy is called term insurance, which is relatively inexpensive. There are several services that will scan their multicompany databases free of charge and mail you a list of some of the least expensive policies. Try the Wholesale Insurance Network (WIN) (800-808-5810), Quotesmith (800-556-9393), SelectQuote (800-343-1985), and Termquote (800-444-8376). One warning: If you deal with a life insurance agent, be prepared to hear a big pitch for a type of policy known as cash value life insurance. Ignore it. While it's more profitable for the agent, it's probably not a good deal for you.
Depending on your current financial situation, you may also want to consider protecting your earning power with disability insurance. A disability policy will pay you an income (typically 60% to 70% of your current salary) if you're injured or very sick, and are unable to work for an extended period of time. Depending on the state in which you're employed, you may already be covered by a mandatory disability insurance program and/or by insurance provided voluntarily by your employer as part of your standard employee benefits package. Even if you are, it's a good idea to find out how much coverage you currently have, whether it's possible to buy more, and what it would cost you. As with health insurance, the least expensive way to buy disability insurance is generally through an employee benefits plan. If it's not available to you through your employer's plan, look into purchasing some on your own, though you'll probably find that it's pretty expensive. Some companies that specialize in disability insurance are Unum Life Insurance (800-227-8138), Paul Revere (800-843-3426), and Provident Life and Accident (615-755-1011). Also try USAA (800-5318000), the Wholesale Insurance Network (800-808-5810), and Termquote (800-444-8376).
2. Pay off your debt the smart way.
Whether you're drowning in debt or just have a few manageable loans, more often than not the smartest financial move you can make is to take any savings you have (above and beyond money you need for essentials such as rent, food, and health insurance) and pay off your high-rate loans. The reason is simple: You can "earn" more by paying off a loan than you can by saving and investing. Paying off a credit card that has a 17% interest rate is equivalent to earning 17% on an investment — an extremely attractive rate of return. (Actually, it's even better than that; it's the equivalent of earning 17% after taxes.) If you want a full explanation of this concept, turn to page 48. Otherwise, take my word for it.
If you can't pay off your high-rate debt immediately, take steps to reduce the interest rate you pay. One of the simplest ways is to apply for a low-interest-rate credit card. For a list of low-rate credit card issuers, send a request and $4 (check or money order) to Bankcard Holders of America, 524 Branch Drive, Salem, VA 24153, or call 703-389-5445. Another good source is RAM Research's CardTrak, P. O. Box 1700, Frederick, MD 21702; the charge is $5.
If you have several different types of debt — say, a credit card balance on a card with a 17% interest rate, a car loan with a 12% rate, and a student loan at 9% — pay off the loan with the highest interest rate first. One strategy you may want to consider is stretching out your student loan payments over 15 years instead of 10 years by signing up for the Federal Direct Consolidation Loan program. (To see if you're eligible, call the Department of Education at 800-4FED-AID.) This will reduce your monthly student loan payment and leave you with extra cash. Use this money to pay off your credit card balance faster. Once you've gotten rid of your credit card debt, start paying off your auto loan faster. After you wipe out that loan, too, increase your student loan payments to at least their initial levels.
The only time it doesn't make sense to kill your debt is when the interest rate you're being charged is lower than the rate you can receive on an investment. If, for example, you have a special student loan with a 3% rate, you'd be better off maintaining your usual payment schedule on the loan and putting your cash into an investment that pays you an after-tax rate greater than 3%.
3. Start contributing to a tax-favored retirement savings plan.
Okay, okay — the last thing on your mind is retirement. But if you're lucky enough to work for a company that offers a retirement savings plan like a 401(k), you should take advantage of it.
There are several reasons to participate in a 401(k). For starters, many employers will match a portion of the amount you put into such a plan. That means the company will contribute a set amount — say, 50 cents — for every dollar you contribute, up to a specified dollar amount. That's an immediate 50% return on your money! (In fact, if your company offers such a fabulous matching deal, you should probably contribute to the plan even before paying off your credit card debt.) In addition, the federal government allows you to delay paying taxes on the money you contribute to a retirement savings plan. That translates into an immediate tax break of hundreds of dollars each year. If, for example, you contribute $1,000 to a retirement savings plan, you're entitled to deduct the full amount at tax time, reducing your taxable income by $1,000. If you're in the 25% tax bracket, that's a savings of $250.
Be forewarned that you're likely to come across people who'll tell you you're too young to lock up your money in a retirement savings plan. Ignore them. While it's true that you won't be able to withdraw your money until you reach age 59 1/2 without paying a 10% penalty, many plans allow employees to borrow against their retirement savings at favorable rates. What's more, your money will grow tax-free in a retirement plan for years. The benefits of tax-free growth could easily outweigh the penalty you'd have to pay for making an early withdrawal. And if you switch jobs, you may be able to move your 401(k) money into your new employer's plan.
The easiest way to start contributing is to contact your employee benefits office and ask to have a set percentage of each paycheck automatically transferred to your company plan. Try to contribute the maximum allowed by law. If you can't afford to stash away this much, at least contribute the maximum amount for which you're eligible to receive matching funds.
If you aren't lucky enough to work for an employer who offers a 401(k) or a similar company retirement plan (and possibly even if you are), you should start investing in an individual retirement account (IRA). The most you can contribute to an IRA is $2,000 annually; if at all possible, contribute this amount every year. The tax advantages of an IRA are very similar to those of a 401(k). But IRAs don't have all the advantages of 401(k)s, so putting money in an IRA is somewhat less pressing than enrolling in your company-sponsored plan. For starters, with an IRA you don't have the benefit of an employee matching program. Also, you can't borrow money from an IRA before you reach age 591/2 the way you can with most 401(k)s; if you need to get at your money, you'll have to pay the 10% penalty. As of this writing, however, Congress is considering modifying the IRA rules so that savers can borrow from their accounts for medical emergencies and down payments on first homes. If this happens, investing in an IRA will be a no-brainer for anyone who isn't eligible for a 401(k). But even if these rules don't change, the advantage of tax-free growth for many years is extremely beneficial; if you have to make an early withdrawal from your IRA, you'll often still come out ahead, even after factoring in the penalty.
If your employer does offer a 401(k) or a similar tax-favored retirement savings plan, you should contribute to that plan before thinking about an IRA. Once you've hit the maximum on your company retirement plan, you can decide whether or not to contribute to an IRA as well. If you do, you'll get the benefit of tax-deferred growth. However, the fact that you're eligible to contribute to a company-sponsored plan may make your IRA contributions nondeductible, depending on your income level.
4. Reduce your monthly banking fees. If you're like most people, you don't pay much attention to your bank, despite the fact that it's the center of your financial universe. But by becoming aware of bank charges, you may be able to save hundreds of dollars a year.
Two of the most burdensome bank fees are checking charges and automated teller machine (ATM) fees. To reduce these charges and possibly eliminate them entirely, shop around for a bank that waives them for customers who maintain a specified minimum balance. Some banks require you to maintain the minimum in a checking account only; others will waive monthly checking charges as long as the combined balances in your checking and savings accounts meet the minimum requirement. Either way, look for a bank with a low minimum. While some banks require you to keep as much as $3,000 in the bank to get free checking and ATM use, others require you to keep just $100. Even if you have enough money to meet the higher minimum balance requirements, it still makes sense to find a bank with low balance requirements. That way you won't have to tie up large sums of cash in a bank account that pays a pitifully low interest rate.
Before you switch banks, ask whether yours will waive its minimum balance requirement if you sign up for direct deposit (which would mean that your entire paycheck would be deposited automatically into your checking or savings account each pay period); some banks will. You should also find out if you're eligible to join any credit unions, which are special not-for-profit banks that tend to have lower minimum balance requirements and lower fees all around. For help in finding a credit union, call the Credit Union National Association at 800-358-5710.
5. Build an emergency cushion with an automatic savings plan.
If you find it impossible to save any money, you're not alone. But once you've gotten rid of your high-rate debt and taken care of Crib Notes 2, 3, and 4, it's time to start. A relatively painless way to do it is to enroll in an automatic savings plan. These plans allow you to have money withdrawn automatically from each paycheck and funneled into a bank account or mutual fund. (See Crib Note 6 for a brief discussion of mutual funds.)
If you're trying to accumulate a balance in a savings account large enough to qualify for free checking, see if your bank offers an automatic savings program. If it does, contact your company's payroll office and ask if you can have a portion of each paycheck — say, $50 — deposited into your savings account and the rest put in your checking account. If your employer doesn't offer this option, your bank can probably offer you an alternative way to save automatically. If, for example, you deposit your entire paycheck into your checking account on the first and fifteenth of every month, you might ask your bank to withdraw a fixed amount from your checking account on the sixth and the twentieth and transfer it to your savings account. Use the money in your checking account to pay your living expenses, and consider the money in your savings account off-limits.
Once you've met the minimum balance requirement for free checking at your bank, you're ready to invest in a special type of mutual fund called a money market fund. Money market funds are considered nearly as safe as bank savings accounts and tend to pay higher interest rates. Although they are also sold by brokerage firms and certain banks, you're probably better off with one that's offered by a low-cost mutual fund company. (For my suggestions on specific low-cost mutual fund companies that offer money market funds, see Crib Note 6.) Find out if the fund company and your employer will allow you to have the amount you want to invest automatically deducted from your paycheck and deposited into the fund. If not, the next best option is to have the fund company automatically siphon the cash out of your bank checking account once or twice a month.
No matter what type of automatic savings plan you choose, your goal should be to save at least three months' worth of living expenses in a money market fund before you even think about the more aggressive investments discussed in Crib Note 6. To figure out what three months' worth of living expenses amounts to, use the work-sheet in Chapter 2.
6. Begin investing in stock and bond mutual funds.
Once you have your three-month savings cushion in place in a money market fund, it's time to get a bit more aggressive with your investments. The advantage of stocks and bonds over money market funds is that they've historically tended to earn higher rates of return for investors over long periods of time, and many experts predict that they will continue to do so in the future. You may need these higher returns to stay ahead of inflation. (For a discussion of inflation and why you need to worry about it, see Chapter 5.)
The downside of stocks and bonds is that they're riskier than money market funds. Translation: You can lose money by investing in them. Only you can decide how much risk you're willing to take for the chance to earn higher returns over rime, but one reasonable approach might be to put about hall of your holdings into stocks, one-third into bonds, and the rest in money market funds.
If you do decide to put some of your money in stocks and bonds, I recommend that you do so by investing in stock mutual funds and bond mutual funds. A mutual fund is a type of investment that pools together the money of thousands of people. It's headed by a fund manager, who invests the entire sum in a variety of stocks, bonds, and/or money market instruments. (Sorry, but to find out exactly what these are, you'll need to read Chapter 5.) I recommend that you consider only no-load mutual funds. A load is a fee that some mutual fund companies charge each time you put money in or take money out of a fund. Avoid investing in load funds -- they don't perform any better on average than no-load funds, so there's no point in paying the extra fees.
Although stock funds are considered somewhat riskier than bond funds, they have also performed somewhat better over the years. If you decide to invest in a stock fund, I recommend that you limit yourself to a type known as a stock index fund. Three companies that offer stock index funds with relatively low management fees are Vanguard (800-662-7447), Charles Schwab (800-2NO-LOAD), and T. Rowe Price (800-638-5660). Vanguard has the lowest fees and the largest selection of index funds, but you'll need at least $3,000 to open an account there. Schwab requires a minimum initial investment of $1,000, while T. Rowe Price allows investors to get started by putting in just $50 a month.
Bonds are generally less risky than stocks but riskier than money market funds. Holding bonds as well as stocks will help to diversify your investments, thus reducing your overall risk. Two companies that offer no-load bond funds with low expenses are Vanguard (800-662-7447) and USAA (800-531-8181). While there are several different types of bond funds, a reasonable approach would be to choose an intermediate term bond fund that invests in government securities or highly rated corporations.
7. Think about buying a house or apartment.
At a certain point in life you may start to feel that you should buy a home. But deciding that it makes sense to purchase a place of your own involves more than simply comparing your monthly rent with the monthly mortgage payments you'd make as an owner. A range of financial factors — including the tax break you'll get from buying, the fees you'll pay when you buy, and how long you plan to lire in the new home — should enter into your decision. For a discussion of some of these factors and information on where you can get software to help analyze your situation, turn to Chapter 7.
Many people who are ready to buy a home have difficulty coming up with a down payment. If you're in this position, don't despair. Several options are available to you. Start by calling your state housing office to see if it offers any low down payment mortgage programs for which you're eligible. The advantage of these state programs is that they typically charge lower interest rates than you can get on a bank mortgage. (For the phone number of your state housing office, see pages 158-59.)
Your next step is to get information on Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac) loans. Fannie Mae and Freddie Mac are "quasi-governmental" agencies that were organized to help banks and mortgage companies expand their mortgage offerings to all types of borrowers. Fannie and Freddie offer several low down payment loan programs. When you shop around, ask lenders if they participate in Fannie's "Community Home Buyer's Program" and "FannieNeighbors," and in Freddie's "Affordable Gold." They'll know what you mean. For several free booklets from Fannie Mae on purchasing a home, call 800-688-HOME.
If you don't qualify for one of these programs, a third alternative is the Federal Housing Administration (FHA) loan program. FHA loans require only a very small down payment — between 2% and 4% of the price of the home, depending on the amount you borrow — and they're usually easier to qualify for, but the deal you get may not be quite as good. Contact a lender or your local Housing and Urban Development (HUD) office for more information on FHA loans.
If you don't qualify for any of these programs, don't give up. There are many lenders out there that offer creative options. Some allow down payments of as little as 3%, and some require no down payment at all as long as a friend or relative is willing to pledge assets as collateral.
8. Get smart about taxes.
Nobody likes paying taxes. One way to reduce the portion of your paycheck that goes to Uncle Sam is to take as many tax deductions as you are eligible for. Deductions are specific expenses that the government allows you to subtract from your income before calculating the amount of tax you're required to pay.
The government allows you to take advantage of deductions in either of two distinct ways. The easiest approach is to take the standard deduction, which is simply a fixed dollar amount ($4,000 for singles and $6,700 for couples in 1996) that you subtract from your income. Although all taxpayers are permitted to take the standard deduction, depending on your circumstances you may wind up paying less if you itemize your deductions instead. Itemizing means listing separately the specific items that are deductible under the current tax laws and then subtracting their total cost from your income.
If you choose to itemize your deductions, you'll have to fill out a tax form called a 1040 (also known as the long form) rather than the simpler 1040A or 1040EZ. You'll then have to list your deductions on an attachment to Form 1040 called Schedule A. Among the types of expenses you may be allowed to deduct are state and local taxes you've paid, donations you've made to a charity, and certain moving, job-hunting, business travel, and education expenses.
The only way to find out if you can save money on your taxes by itemizing instead of taking the standard deduction is to fill out a copy of Schedule A and see if the amount you're allowed to deduct is greater than the standard deduction. Even if you find that you won't save money by itemizing this year, this exercise will help you get better acquainted with some common types of deductions and may help you plan things in a way that could reduce your tax bite next year.
To get tax forms and a general instruction book from the IRS, call 800-TAX-FORM and ask for Tax Publication 17, called Your Federal Income Tax. Also consider using your computer to help you prepare your taxes. For about $35 you can purchase software that provides you with the forms and instructions you'll need, performs all the necessary calculations, and prints out completed forms you can send to the IRS. Two programs worth considering are TurboTax (or MacInTax for Macs) and TaxCut.
Excerpted from “Get a Financial Life: Personal Finance in Your Twenties and Thirties,” by Beth Kobliner. Copyright (c) 2009, reprinted with permission from Simon and Schuster.