My dad told me that the best way to pay off a credit card is to pay it all off at once so I have been saving up the money to do that. My boyfriend argues with that saying that the best way to do it is to make the biggest possible payment each month. Who is right?

Your boyfriend’s plan is better in a very straightforward sense. I think your dad is also bringing a good concept to the table, too.

If you look at nothing but the debt, the best way to pay off that debt with the minimum total interest payments for you is to pay it off with the largest payments you can throw at it each month.

Let me give you an example. Let’s say you owe $1,000 and that it’s compounding at a rate of 2% per month (which would be roughly a 25% annual interest rate). Let’s also say that the minimum payment is $25 and that each month, you’re capable of putting $200 toward that debt each month.

Now, let’s follow your father’s plan.

After the first month, you’ve paid the $25 minimum payment and put $175 in the bank. The starting balance was $1,000 and 2% interest was charged – $20. Your $25 covers the $20 in interest and knocks $5 off of the balance, bringing the ending balance down to $995. Your bank account has $175 in it.

After the second month, you’ve paid the $25 minimum payment and put $175 more in the bank, raising your account balance to $350. The starting balance was $995 and 2% interest was charged – $19.90. Your $25 covers the $19.90 in interest and knocks $5.10 off of the balance, bringing the ending balance down to $989.90. Your bank account has $350 in it.

After the third month, you’ve paid the $25 minimum payment and put $175 more in the bank, raising your account balance to $525. The starting balance was $989.90 and 2% interest was charged – $19.80. Your $25 covers the $19.80 in interest and knocks $5.20 off of the balance, bringing the ending balance down to $984.70. Your bank account has $525 in it.

After the fourth month, you’ve paid the $25 minimum payment and put $175 more in the bank, raising your account balance to $700. The starting balance was $984.70 and 2% interest was charged – $19.69. Your $25 covers the $19.69 in interest and knocks $5.31 off of the balance, bringing the ending balance down to $979.39. Your bank account has $700 in it.

After the fifth month, you’ve paid the $25 minimum payment and put $175 more in the bank, raising your account balance to $875. The starting balance was $979.39 and 2% interest was charged – $19.59. Your $25 covers the $19.59 in interest and knocks $5.41 off of the balance, bringing the ending balance down to $973.98. Your bank account has $875 in it.

After the sixth month, your starting balance of $973.98 is charged 2% interest, equaling $19.48 and bringing your balance to $993.46. You apply that $875 saved to that balance along with an extra $118.54 to pay it off.

All told, under your father’s plan, you will have paid $1,118.54 to pay off the loan. Now, what about your boyfriend’s plan?

After the first month, you’ve paid $200 directly to the credit card company. The starting balance was $1,000 and 2% interest was charged – $20. Your $20 covers the $20 in interest and knocks $180 off of the balance, bringing the ending balance down to $820.

After the second month, you’ve paid $200 directly to the credit card company. The starting balance was $820 and 2% interest was charged – $16.40. Your $200 covers the $16.40 in interest and knocks $183.60 off of the balance, bringing the ending balance down to $636.40.

After the third month, you’ve paid $200 directly to the credit card company. The starting balance was $636.40 and 2% interest was charged – $12.73. Your $25 covers the $12.73 in interest and knocks $187.27 off of the balance, bringing the ending balance down to $449.13.

After the fourth month, you’ve paid $200 directly to the credit card company. The starting balance was $449.13 and 2% interest was charged – $8.98. Your $25 covers the $8.98 in interest and knocks $191.02 off of the balance, bringing the ending balance down to $258.11.

After the fifth month, you’ve paid $200 directly to the credit card company. The starting balance was $258.11 and 2% interest was charged – $5.16. Your $25 covers the $5.16 in interest and knocks $194.84 off of the balance, bringing the ending balance down to $63.27.

After the sixth month, your starting balance of $63.27 is charged 2% interest, equaling $1.27 and bringing your balance to $64.54. You pay it off in full.

All told, under your boyfriend’s plan, you will have paid $1,064.54 to pay off the loan. This is $54 less expensive than your father’s plan.

The principle is very clear: in terms of maximizing every dime in a perfect environment, you’re better off making big payments on the debt than holding cash back for a big payment at the end.

So, what benefit is there to your father’s plan, then? The benefit appears when you recognize that your life is not a perfect environment.

If you do not have any cash in the bank and something unexpected happens in your life, like the transmission in your car failing or your grandmother passing away, you’ll find yourself in a situation needing more cash than what you have and your response to that will be to add to your credit card balance.

Of course, you might just think that having a credit card with some of the balance paid off will serve your needs, as you can just use that credit card. The problem with that scenario is you’re trusting that the bank won’t lower your credit limit. That’s a tactic many banks use if they see someone who is a potential risk at their current credit limit. If they lower that limit, then you’re really in a bind.

Cash is the most secure emergency fund. You’re not relying on a bank extending credit to you for your emergency protection purposes.

Given that, is your father’s plan better than your boyfriend’s plan? It really depends on what the rest of your life looks like. Do you already have an emergency fund? If so, then your boyfriend’s plan is a better one. Do you have lots of avenues of risk in your life, such as a car that you need for a daily commute? If so, then your father’s plan is better because of the security it provides.

This is one of those situations where personal finance really is personal. If you assume a perfect life, your boyfriend’s repayment plan is best. The question is how perfect will your life be during the period of repaying that debt.

The post Examining Two Credit Card Repayment Strategies appeared first on The Simple Dollar.

I was at the store recently with my seven year old son. When it’s just the two of us, he’s very quiet and observant of what’s going on around him (he can be quite a bit less so when he’s with a friend or with younger siblings).

Anyway, he watched very carefully as I paid for the groceries with a credit card. I swiped the card, signed the signature pad, and got my receipt from the cashier, and he watched this all with interest.

As we were walking out together, I asked him whether he realized that I had just spent a decent amount of money on groceries. He shook his head yes. I then asked him where the money came from. He said, rather astutely, that the money was stored on my credit card. “So,” I said, “do you think that Mom and I sometimes go to the bank and have money put on the card?” He thought about that for a moment and then said, “Sure.”

I smiled and told him that, actually, the bank was lending us money every time I used the card. “Whenever I swipe the card, bud, our bank is telling the store that they’re covering whatever we spend. Then, later on, I have to pay the bank back for whatever I spent. Now… why do you think the bank would do that? Remember… every business is out there trying to make money.”

He thought about this for a little bit, then said he didn’t know.

“If I don’t pay the bank back very quickly, they start charging me more money. So, if I borrow $100 for groceries using that credit card and I don’t pay it back in a week or so, I’m going to owe the bank $110 or so. If I don’t pay it back after that, it’ll keep going up and up and up. I only spent $100, but if I don’t pay it back quick, I’m going to be paying the bank a lot more than $100.”

His eyes got big. “So you want to pay it back fast!”

I smiled at him. “Absolutely.”

For most of the ride home, he didn’t say anything at all. I glanced at him in the rear view mirror and he seemed to just be looking out the window.

As soon as I pulled into the driveway, he asked me another question. “Are you going to go inside and pay off that credit card right now?”

I told him that I could do that, but that I usually just pay off the whole balance every few weeks, before I get charged any interest. I just make sure that I pay off my full balance before any interest is charged.

A cute story, right? Well, here’s where it gets interesting.

This morning, I turned the calendar page in our kitchen to the next month. The first thing out of my son’s mouth? “Is it time for you to pay that credit card now?”

I have a few thoughts on this.

One, the credit card industry would collapse if every American understood credit cards as well as my seven year old. He doesn’t see any point in paying the banks a dime of credit card interest – and I don’t, either. He understands that using a credit card directly means that you’re borrowing money from a bank and that the sooner you pay that all back, the better off you are.

Two, you can teach good personal finance practices to young children. They want to understand how the adult world works and they absorb information and ideas at a very fast rate. If you just explain things piece by piece, they’ll understand it. If you explain good personal finance habits bit by bit, they’ll understand it.

Three, when they do understand the ideas, they watch how you behave. You need to live up to the standards you explain to your children or else those standards won’t mean much to them. You can teach a child all of the ideas you want, but if you don’t actually follow through on those things in how you live your life, those lessons won’t hold much weight. After all, why should a child be smart about their money if their parent obviously doesn’t care?

The post A Seven Year Old Learns About Credit Cards appeared first on The Simple Dollar.

I’ve read stories from readers about the many small things that have caused them to start reassessing their lives. They had a credit card rejected at an inopportune moment. They didn’t have enough cash to pay for the groceries in their cart. For me, it was facing a stack of bills that I didn’t have the money to pay.

For some, that figurative back-breaking straw can come with the first real sign of financial distress. For others, it takes something much more severe, and sometimes nothing will make them change their routines.

When people reach that back-breaking point, though, whatever it may be, their first instinct is usually to get their short-term finances in good shape. In other words, they want to do things so that they know they’re going to make the rent this month and that their bills are paid. Once that’s under control, medium and long-term planning can begin to take priority – how can we get out of this mess, in other words.

Today, let’s focus on that first step. What do you do when you finally reach a breaking point, realize that your finances are a disaster, and need a plan to help you get rid of some late bills and still make the rent?

The first step to take is to get those credit cards out of your wallet. If you are carrying a monthly balance on any of these cards, you need to stop using them for a bit until you get things under control.

Open up your wallet, take the cards out, and put them in a safe place so that you don’t have access to them when you’re out and about. Don’t give yourself the opportunity to add more debt load to your situation.

The second step is to assess how close you are to paying off your bills for the next month. Are you going to be able to make the minimum payment on any and all bills as they come in? Can you take care of any late bills that aren’t yet in collections?

Quite often, you’ll find that you’re not able to do that with the cash you have on hand plus the cash you’re bringing in for the month.

If that’s the case, you need to sell off some stuff. Clean out your closets and find any and all items that you don’t use that might have value.

Once you have a stack of items, hit Craigslist and offer them for sale. If you don’t find any luck there, try eBay, particularly if the items are collectibles.

The purpose of this is to turn things you’re not regularly using into enough cash so that you’re not struggling to keep your head barely above water every week. Before you can take the next steps forward, you need to be sure that you’re not late on any of your bills and that you can easily take care of your bills over the next month. Often, it takes a small boost of cash to get a person up to that point, and the easiest resources for that is found in a person’s closet.

The next step you should take is to engage in cost-cutting, but don’t do it to the point of misery. Look for obvious ways in your life to spend less, but stick to the ones that feel good when you spend less.

Many people reach this situation and then respond by diving deep into hardcore frugality. They try to avoid spending anything.

Doing that is no different than going on an all-lettuce diet. Eventually, you’re going to resent it and you’re going to “snap back,” undoing all of the progress you made.

Instead, stick to cost-cutting measures you feel good about. Every time you have to make a spending decision or consider buying something, consider the path of spending less, but only choose it if it feels like the right choice. If you always choose the cheap path, particularly if it’s not something that comes naturally to you, you will eventually have a big resentment-filled backlash against it.

In other words, choose to spend less on the things that are less important to you, and don’t cut back on the things that are important.

How do you know which is which? Try cutting back on something and decide for yourself if it’s having a real negative impact on you. If it is, go back to the way things were before the next time you have to make a similar purchase. If you feel you “have” to always do something you don’t like, frugality becomes misery – and, trust me, frugality done well is the opposite of misery. When frugality becomes misery, it becomes very easy to walk away from it – and then it becomes very easy to find yourself right back where you started.

Remember, always, that you can do this. I’ve done it. Many of the readers of this site have done it. We’ve been in financial situations that seemed overwhelmingly bad. We’ve been depressed about it and we’ve often felt completely hopeless.

It doesn’t have to be that way. You can do this. You can dig out of your financial hole. It just requires you to make some changes regarding how you use your money.

The post Making the Rent appeared first on The Simple Dollar.

The honeymoon, however, was a different story. We went to the United Kingdom for our honeymoon, flying into Heathrow and traveling up and down the country from south London to Inverness.

While we had some savings, most of that trip went on a credit card.

In 2004, we spent almost two weeks in Washington state. We rented a car, camped in a few national parks, and saw a bunch of the sights of Seattle.

While we had some savings, most of that trip went on a credit card.

In early 2005, we attended the wedding of a friend at a faraway vista. We stayed at a hotel, enjoyed the local flavor, and enjoyed a few other events while we were there.

While we had some savings, most of that trip went on a credit card.

In 2005, we went to Las Vegas. We saw a couple of shows, played some blackjack, drove out of the city to Hoover Dam, and even did an overnight stop at the Grand Canyon.

While we had some savings, most of that trip went on a credit card.

I bet you’re noticing a theme here. Whenever we had a special event, like a wedding to attend or a vacation, we allowed the credit card to finance a trip we would not have otherwise been able to afford.

Our logic at the time was that we would easily be able to pay this off in the future. With any sort of deep examination, it would have been pretty clear that this logic was flawed. If we were spending more than our income now with only a tiny apartment and no children, why would we be able to magically pay off debts in the future without drastically changing our habits? Would we magically get rich?

Here’s the truth. You should never, ever go into debt for a “special event.” If you can’t afford to save up for a special event, then don’t enjoy that event. It’s that simple.

Since our financial turnaround in 2006, Sarah and I haven’t done a single special event that wasn’t paid for entirely out of pocket. We’ve gone on a few trips, sure, but every one has been paid for entirely with cash. No credit cards were harmed in the making of our vacations.

In a few years, we plan to do some international travel with our children. Do you know what the cost of five international plane tickets is? Thousands. Do you know what the cost of living is in many European nations (our first trip or two will be to Europe)? In many cases, double the costs of the United States and you have Europe’s costs.

These trips will be expensive. We will not go on any trip until we have adequate cash in hand for that trip. If we can’t afford the trip we want to go on, we wait another year and go camping in a national park that summer.

What about a wedding? You have to go to a wedding, right? The second you hear about a wedding that you have to attend, start saving. Remember, you never have to attend. Your attendance at a wedding won’t affect the roof over your head or the food on your table. If you want to make room for this desire, then cut back as much as you can and put aside that cash for the wedding travel expenses. Weddings don’t just appear out of nowhere; usually, you do have several months of notice.

If you want financial success in your life, you have to separate the genuine needs from the wants. Modern life tries very hard to blur that line, but the truth is that the list of needs is pretty small. A roof over your head. Clean clothing. Basic hygiene. Basic food and water. That’s about it. Everything else is a “want,” and the more “wants” that you fill your life with, the harder the path to financial success becomes because of your choices.

The high cost of a trip or a concert or of cable television isn’t holding you back from financial success. Your choices are.

The post The Debts of Special Events appeared first on The Simple Dollar.

“I have an offer from a credit card company in which they pledge 0% interest for 15 months on a balance transfer. The way they seem to do that balance transfer is that I give them an amount and they send me a check which I then use to pay off a credit card. I don’t carry any other credit card balances so I am thinking about just asking for a check for say $2,000 and then investing it and then paying it back at the end of the fifteen months and just pocket the return. What do you think of that plan?”

I simply wouldn’t do this as you describe it. I would not take out debt to put the money into anything with risk.

For starters, let’s look at the “best” outcome. The next fifteen months continue a stock market juggernaut while nothing bad happens in your life. That $2,000 earns you a $400 return, on which you pay taxes, letting you keep about $300.

Now, let’s look at another outcome: the next fifteen months act like 2008 and you lose 40% of your investment. At the end of those fifteen months, you’re paying back the $1,500, but your investment is only worth $900. You have to come up with the $600 out of pocket.

Several years ago, there were people who were doing this kind of thing but stashing the money in a high interest savings account, back when savings accounts were returning 6%. In that event, it’s not a terrible idea. Under those conditions, the $2,000 over the course of fifteen months would return $150 or so to you before taxes, leaving you with around $100 after taxes. That’s probably worth it.

Today, with interest rates at 1%, you’re looking at a $25 return over that period before taxes, or $20 after taxes. That’s not worth locking down $2,000 over that period.

These assumptions aren’t even including other problems with this situation. One, you’re likely going to have to be making payments on that debt during the interest-free period. Two, organization is a must because you often get hit with some form of penalty for not paying all of it back by the end of the fifteen months. Three, the entire plan rests on nothing bad happening in your life in the interim. Four, it doesn’t include brokerage fees.

In terms of my personal finances, this just doesn’t add up to a worthwhile trade for me. If bank account interest rates were back in the 6% range, we might be looking at a different story, but when you have to take on a lot of risk to have a chance at a return that makes this worthwhile, then it’s not worth it.

Now, if you’re looking at a separate business that you’re trying to run, it might be worth it. As I’ve said before, if I’m running a business, I’m willing to take on some risk as long as there’s a positive balance sheet (with some sizeable breathing room) and a positive cash flow (meaning the business is consistently bringing in more than it’s paying out).

Why is a business different than personal finance? If the business were to fail, I could sell off all of the assets in that business with no impact on the lives of my family in any way. The same is not true when it’s your personal credit or personal property that’s on the line.

(My advice to anyone who wants to start taking more risks with their money is that, if they have their personal finances in a very secure place (no personal debt, a significant emergency fund, retirement savings well in hand) and they have some extra money to play with, starting a company and seeding it with some of that money is a reasonable step. What you do within that company is up to you, but my general advice is what I stated above: keep a positive balance sheet (asset value if you had to sell it right away is higher than the total of the business debt) and make sure the business has a positive cash flow month over month and doesn’t require you to infuse it with more. If you can do that, feel free to take some risks. It’s how many people transition to investing in real estate. If you’re investing in stocks, of course, there’s no need to do this, though you may want to consider it.)

So, when you see a zero percent credit card offer issued to you personally, be careful about it. There’s risk involved and, for most people, the reward doesn’t add up to enough to balance out that risk.

The post Some Thoughts on Interest-Free Debt appeared first on The Simple Dollar.

It’s true – collateralized debt for people with good credit histories has a very low interest rate right now. You can get car loans and home loans for stupendously low rates, and it’s easy to understand why it’s attractive to people.

Right now, you can get a fifteen year mortgage for $200,000 at a 3.5% interest rate, giving you a monthly payment of $1,429.77. Just a few years ago, that same loan would have come with a 5.5% interest rate, giving you a monthly payment of $1,634.17. That’s $200 a month less than it was just a few years ago, and many, many thousands less in interest over the course of the loan.

Monthly payments on a big loan like that look a lot easier than they did a few years ago, so people who have stable credit are looking at those options and thinking about the housing and automobile upgrades they could make right now while the “iron is hot,” so to speak.

There’s one problem: it doesn’t matter how low the interest goes, it doesn’t take care of my number one concern when it comes to debt.

Let’s look at it this way. Let’s say you take out a $20,000 car loan to buy a new car. The interest rate is 3% over five years, so the monthly payments are $360. You can handle that, right? You’ve got a steady job that pays well and so on, and you’ve got to strike while the iron is hot, right?

You drive off the lot and your car immediately depreciates by about 40% or so. It’s now worth about $12,000 because it’s inherently a used car now.

A week later, you lose your job. You can’t afford that $360 car payment, but you’re stuck with it. (You’re also facing a higher auto insurance rate.) Even if you sell the car, you can’t recoup all of the money you’d need to pay off the loan.

Let’s look at another angle. You decide to go ahead and get that mortgage, but you know money is going to be tight for a while. Your monthly bills are adding up to a very large part of your income.

A month later, your car fails and you have a $1,500 repair bill. You know that the car needs replaced before something else goes wrong, but if you stack a car payment in with the other payments, you simply don’t have enough to make ends meet.

The real problem is cash flow.

Do you have enough cash on hand to pay all of your monthly bills and still save a bit of money? Are you in complete crisis mode if you lose your job – or your spouse does?

If either of those are true, you’re in a position of insufficient cash flow and taking on debt becomes a much, much riskier proposition. It becomes a bet that nothing will go wrong in your life, and that’s just not a safe bet to take.

My suggestion is to avoid debt, always. The only type of debt that’s worth taking on is student loan debt. Mortgage debt is tolerable if you’re buying a low-end first house. Other than that, if you don’t have the cash, you shouldn’t be buying it. You’re piling on personal risk. You’re ensuring that you don’t have the freedom to make lateral career moves. You’re praying that nothing goes wrong in your life.

If you get lucky, it might all work out, but you had to walk a stressful tight rope to get there. If you don’t get lucky, you lose everything and are back where you started, except with creditors after you and a poor credit rating.

Neither a “nicer house” nor a “nicer car” is worth it. Get what you can afford and save for the next purchase, when you perhaps can afford something nicer with more reliability.

The post The High Cost of Low-Interest Debt appeared first on The Simple Dollar.

If I can refinance my house at 3.5% why would I ever want to pay it off early if I can earn 7% over the long term in the stock market? Debt freedom seems like a bad goal when credit is so cheap.

Even if credit is available at 0%, I argue that debt freedom is never a bad idea.

In order to explain that idea, let’s roll back the clock to 2005. In 2005, Sarah and I were swimming in consumer debt.

We had one car loan at 7% on which we had to pay $200 a month.
We had another car loan at 6% on which we had to pay $250 a month.
We had a credit card at 20% on which we had to pay $100 a month.
We had two other credit cards (around 20% each) on which we had to pay about $80 a month each.
We had two lines of consumer debt (around 20% each) on which we had to pay about $30 a month each.

These payments added up to about $770 a month. Add on our rent of about $600 per month, our auto insurance, our commuting costs, our food, and our utilities, and our budget was on the verge of exploding.

The problem in this situation wasn’t the interest rates on those debts. The problem was the sheer amount of debt and our monthly commitment to repayment. Almost $800 per month went toward debt repayment.

If you add a house payment on top of that, it’s easy to see that amount getting into the thousands of dollars a month.

The thing is, even $1,000 a month in take-home pay has a drastic impact on one’s life situation. $1,000 in take-home pay adds up to $12,000 a year in take-home pay. Add federal income tax and state income tax on top of that and you’re easily looking at a salary impact of $20,000 a year.

A person making $40,000 a year with that debt load has the same lifestyle as someone making $20,000 a year that’s debt free.

A person that has the freedom to take a $20,000 a year job without financial suicide has a lot more peace of mind and personal security than a person who has to make $40,000 minimum to keep their head above water.

A person who can live on $20,000 a year can take enormous career risks. They can leap into a new career path without worry. They can shrug if they’re downsized and go apply for a job at Home Depot the next day.

A person who needs $40,000 to pay the bills can’t take such risks. They’re often locked into their job, and if they’re downsized, it’s a desperate situation.

Debt freedom isn’t just freedom from debt. It’s freedom from worry.

But what about the situation where you can take on debt at a low rate and invest it to theoretically earn a better rate, such as in the stock market example above?

First of all, there’s no investment that has a guaranteed return that beats the current interest rates on debt. In order to shoot for a better return, you have to take on some risk, particularly in the short term. If you buy stocks now, you could easily see a 20% loss over the next year, even if you would get that nice 7% annual return over a long period of time.

Let’s say you lose your job as a result of that downturn. Suddenly, you have debt around your neck and an investment that has purged money. That’s the risk you take if you decide to take on personal debt for investment purposes.

Second, even if you do invest that money, you’re still locking yourself into a monthly debt payment. You’re signing up to be tied even more tightly to your job than before and to having a narrower range of jobs and career paths you can take on while you hold that debt.

Debt freedom eliminates all of these concerns. It minimizes your monthly expenditures, giving you maximum freedom in your life. You can stick with the high-paying job and start investing a truckload (or enjoying some of the perks of a large gap between income and expenses), or you can take the lower-paying and lower-stress job for other life benefits.

Debt freedom gives you life freedom. It maximizes your personal gap between income and expenses, which goes a long way toward maximizing the variety of life choices and options available to you. That’s why I’m always in favor of freedom from debt.

The post The Case for Debt Freedom appeared first on The Simple Dollar.

Some might argue that you’re only $200,000 in debt. However, when you look at the payments you’ve committed yourself to making over the years, you’re actually promising to make payments totaling $364,813.20.

Thus, I’d argue that your actual debt is $364,813.20, even though you actually only received $200,000 in cash out of it.

It’s kind of a scary way to think about it, isn’t it? You get similar scary pictures when you look at the federal budget and examine the pledges we’ve made for future Social Security payments. If we’ve promised to pay it, it’s reasonable to include it as part of our indebtedness.

In fact, I’ve actually moved to calculating my net worth in this way. This number reflects the payments I’m obligated to make in the future. Yes, if I were to liquidate all of my possessions, I could reduce that number, but it’s not realistic to think that I’m going to liquidate my possessions to pay off a mortgage. If you think liquidation is a reasonable assumption, then by all means calculate things with just your debt total.

So, now you’re $364,813.20 in debt. You’re going to have to repay that much money over the next thirty years. You’re going to make 360 payments, one per month, of $1,013.37 each (do the math – if you multiply $1,013.37 by 360, you get $364,813.20).

Here’s the interesting part. Let’s say you add just $1 to just the first payment. This single extra dollar paid drops the entire debt by $2.83. You turned $1 into $2.83 in terms of your net worth. Not only that, you’ll also have your final payment reduced by $1 beyond the $2.83 in interest savings.

Essentially, you invest $1 now and you get it back in 30 years. Along the way it reduces your debt for you by $2.83.

Let’s say you add $100 to just the first payment. You reduce the entire debt by $283.33. You get the $100 back in 30 years and, along the way, it reduces your debt by $283.33.

Let’s say you just add $1 to each payment. You reduce the entire debt you’re going to pay by $399.16. You get your $360 back at the end of the 30 years, plus it reduces your debt by $399.16.

Every time you add a little extra to the payment, the total payment amount you’ve agreed to play goes down. Your obligations are reduced for the future. Not only that, you get the extra money you added back at the end of the debt in the form of a smaller final payment.

For me, the easiest way to keep track of this and of the impact of an extra payment is to use a sophisticated mortgage calculator like this one at Bankrate or, better yet, this Microsoft Excel template. I keep my mortgage data stored in this calculator so that I can see the impact of any extra payments I might make and so that I can see how much I really owe going forward assuming I just make the minimum payments from here on out.

Why think of things this way? For me, there are really three reasons that stand out for looking at debts this way.

One, this method makes it clear how much you’re actually obligated to pay. A $200,000 debt doesn’t mean that you’re obligated to make $200,000 in payments. It means you’re obligated to make quite a lot more.

Two, it’s very clear how much of a positive impact early debt payments can make on your future obligations. The impact is large. Thanks to calculating things in this way, one can really see the big impact extra debt payments make to one’s future obligations.

Three, it lets you see how powerfully debt repayment compares to investing. Without using this method, early debt repayment doesn’t have a powerful impact on your financial bottom line. In fact, it has no impact for the time being – it only shows up very gradually as future payments begin to take advantage of the lowered principal and less of your payments go toward interest. An investment, on the other hand, can quickly begin showing returns that directly show up on your balance sheet.

If you do use this method, though, you can quickly see the long-term impact of an extra debt repayment on your bottom line. Your obligations are immediately lowered by that extra payment, which lets you breathe easier.

To me, knowing my total obligation instead of my total debt feels like a more financially honest approach. It’s the same approach many of us are demanding from our government, so why not apply it to ourselves?

The post A Different Way of Thinking about Your Debts appeared first on The Simple Dollar.

On Facebook, Tyler wanted to know, “Should I stop my retirement contributions while i pay back my college loans? I am 23 and my employer will match up to 5% of my contribution. Should i continue? or hold off until my loans are paid?”

The challenge with any question like this is that it relies so much on future events. What will the stock market do over the next thirty or forty years? That’s unknown. What path will Tyler’s life take over the next ten years or so? That’s unknown as well. Both of these factor enormously into answering the question above.

The best thing we can do is follow some reasonable approximations and rules of thumb for future investment growth while also striving to give Tyler as much freedom as possible in the coming years.

The Ghost of Investing Future
In order to get an estimate of how much someone should be investing for retirement, you have to come up with a few basic assumptions.

When will the person retire? This lets us know how many years of investing we’ll be able to account for. I’ll asume that Tyler will retire at 75, giving us 52 (!) years to work with.

How much of an annual raise can we assume? I usually just match this at the same rate as inflation. Speaking of inflation…

How much inflation should we assume? I usually peg this at 3%, which is pretty sound based on the economy of the last twenty five years.

How much of an annual return on stocks can we assume? Warren Buffett projects a 7% annual return over the long haul in the American stock market, so I’ll use that number.

Do you see how tenuous all of these calculations are? When you estimate retirement savings, you’re making a lot of guesses for the future.

What you’re going to shoot for is an amount high enough so that the person’s annual expenses equal 4% of the total savings at the time of retirement.

I ran the numbers, assuming that Tyler is able to live on about 75% of his salary each year. My calculations showed that Tyler should be saving somewhere between 9% and 10% of his annual income for retirement, so we’ll use 10%.

10% is an excellent thumbnail to use. In this case, Tyler has the advantage of a long period until retirement, but I’m also using some pretty conservative returns on his investments for my calculations.

Tyler’s Choice Today
In order to make it to a healthy retirement, Tyler needs to be saving 10% of his annual income starting today. He can choose to delay it a few years, but then he’ll be locking down 11% or 12% or more to make it to his goals. He’s a lot better off locking things down at 10% starting today.

Tyler’s employer will match up to 5% of his contribution, so if Tyler contributes just 5% of his salary today, he’ll be on pace for what he needs for retirement. This is exactly what I would recommend that Tyler does.

Once that’s taken care of, he should throw every dime that he can at his debts. It is far easier to live a little lean now when you’re single and aren’t weighted down with responsibilities than to live lean later on when you’re burdened with career and personal requirements.

Should Debts Ever Delay Retirement Contributions?
This is a tricky one to answer. Quite often, people eschew retirement savings in order to pay off debts because they don’t want to make lifestyle changes. This is a giant mistake. If you find that you’re in a situation where you can’t make your minimum debt payments, a small retirement contribution, and live your current lifestyle all at once, changes need to be made with regards to your lifestyle first and foremost.

If you are in a situation where further lifestyle changes genuinely are not possible – meaning you have no cable or satellite bill, no cell phone, no new or nearly-new car, no living quarters larger than you need, etc. – then you should take care of your high-interest debts before renewing your retirement savings. Of course, this does need to be coupled with an emergency fund and a commitment to avoid debt in the future, because without that, this is all a moot point.

Personal finance almost always comes back to impulse control, and this is no different. If you can’t control your impulses and desires when it comes to spending money, financial success will almost always be elusive in your life. You won’t get ahead if you can’t control yourself.

The post Retirement Contributions: When Should They Delay Debt Repayment? appeared first on The Simple Dollar.

The reason is simple. It’s all about the cash flow.

Let’s start off with the basics and explain what cash flow is. Cash flow refers to the amount of income you take in minus the required bills you have to pay. Ideally, you have money left over at the end of this process, and the more cash you have left over, the better. That cash can be saved for the future, invested, or applied to extra debt payments.

Let’s say, for example, that you’re bringing home $3,500 a month. You have a $1,000 mortgage at 6.75%, a $500 student loan payment at 3%, and another $1,000 in required bills (electricity, food, fuel, etc.). At this point, you must have $2,500 in monthly income to pay for your minimum required bills. At the end of the month, with a $3,500 income, you’re left with $1,000 to do with what you please.

Now, let’s look at your situation if the mortgage is paid off. You still has a $500 student loan payment and another $1,000 in required bills. You must have $1,500 in monthly income to pay for your minimum required bills. At the end of the month, with a $3,500 income, you’re left with $2,000 to do with what you please.

Because your mortgage is paid off, your monthly cash flow is far better than before. This helps you in countless ways.

Let’s say you lose your job and can only find one that gives you a 40% pay cut. At this point, you’re bringing home only $2,300 a month. In the first scenario, you have $2,500 in required bills. You’re going to have to make some major scary cuts in your life in order to make ends meet. In the second scenario, you have only $1,500 in required bills. You’ll be just fine and still have a surplus.

There are countless other examples of life changes, planned or otherwise, that can significantly alter your income. The greater the amount of required bills each month, the more difficult it is to swallow those life changes.

This is why it’s nearly always useful to improve your cash flow. Improving your cash flow improves your life options. It makes job transitions far less painful, for one. When you’re fired or “downsized,” you can take a lower paying job without pain. On the other hand, you also have a lot more flexibility with your career choices as you’re able to take a lower-paying but more career-building job. In fact, this is exactly what I did: I paid off a lot of debts, which reduced my monthly required payments and made it easier for me to live on less income, which enabled me to switch to writing The Simple Dollar full time because my cash flow was in much better shape.

The worse your cash flow situation is, the more you’re tied to your current job. It gives your boss more power and you less power because the threat of losing your job is devastating. Your job becomes more stressful by default because the always-present threat of losing that job – and the pain it would cause – is always hanging over your head. Your career options are limited, too, because you can’t deal with a reduction in pay.

In short, pinching your cash flow pinches your options.

Debt pinches your cash flow, of course. For example, getting a car loan pinches your cash flow because you’re now responsible for those payments. On the other hand, living without a car loan for a while and saving up for your next car is a much better cash flow option, as it allows you to simply pay cash for the next car, keeping your cash flow as wide as possible.

Overspending pinches your cash flow, too. If you needlessly spend a lot of money, you’ve pinched your cash flow for that month. You take money away from your savings. Thus, at a later point when you need that cash for a purchase, you’re forced to rely on debt, which forcibly pinches your cash flow.

It’s because of these things that I usually encourage people to just get rid of all of their debt. Eliminating all of your debt opens that cash flow up, making it easy to save for the future, change to a different job, or make other significant life changes that would be nearly impossible with a constant debt payment hanging around your neck.

The post Why Should I Hurry to Pay Off Low Interest Debts? appeared first on The Simple Dollar.

For the longest time, I’ve been making larger than minimum payments on all of my debts. I got the idea from Suze Orman because she said that if you just make minimum payments, you’ll never get rid of debt. I have two credit cards and a student loan. Here are their interest rates and outstanding balances and minimum payments:

Credit card 1 – 19.99% interest – $3,400 balance – $57 minimum payment
Credit card 2 – 15.99% interest – $4,000 balance – $55 minimum payment
Student loan – 6.75% interest – $41,000 balance – $470 minimum payment

What I’ve been doing is putting $700 in payments towards these debts each month, but I have been spreading out the extra among the loans. This means adding $39 to each payment, giving me a payment of $96 on the first card, $94 on the second card, and $509 on the student loan.

Is this the right way to go?

Suze is both right and wrong here. She’s absolutely correct in making the point that if you make just minimum payments on a debt, you’ll find it takes decades to fully pay it off. Even worse, the longer you take to pay off a debt, the more money you pay in just interest on your debt – it’s just money lost.

However, she’s not quite right on the idea that you should make larger-than-minimum payments on all debts.

According to my back-of-the-envelope math on the three debts you named, it will take about thirty years to pay off each credit card with just minimum payments, and just under ten years to wipe out that student loan with just minimum payments. If you use your alternate plans with a bit larger payments on each debt, you save about $6,000 in total interest, pay off each credit card in about five years, and pay off the student loan one year earlier. In other words, you’ll go another five years without eliminating any of the debts.

I agree with making overpayments, but I think you should channel all extra payments to the highest interest debt. In this case, that’s the credit card with the 19.99% rate. If you make a $117 extra payment on that debt each month, you’ll pay off that debt in a year and a half. At that point, you can apply a $174 extra payment (the $117 extra payment you were making, plus the $57 you were making on that first debt that’s now eliminated) on the second credit card, paying it off in about a year and a half. You can then apply a $229 extra payment each month to that student loan (the two minimum payments, plus the $117 in extra payments) and eliminate that student loan in about seven and a half years (total).

That simple shift will get you to debt freedom one and a half years earlier than before.

This is called a debt repayment plan, and the basic idea behind it works no matter how many debts you have or what type they are. You just order the debts by interest rate, make minimum payments on all of the debts, and make the biggest extra payment you can to the debt with the highest interest rate.

You may also want to do things like negotiate with your credit card companies for a lower rate. The worst thing they can do is lock your account, which doesn’t matter a bit if you’re not using it, and you might just see a nice interest rate reduction, saving you even more money.

Just stick with contributing $700 toward your debt every month and you’ll be fine.

The post A Little More Than the Minimum appeared first on The Simple Dollar.

Now what?

Quite often today, people are bringing significant debt into relationships with them. Credit card debt. Student loan debt. Auto loan debt.

I often get emails from readers asking me how to deal with them. Should they keep these loans separate from each other? How much debt should they really share?

This was also an issue that Sarah and I struggled with when we got married. After some struggles, we eventually came to a conclusion that really makes the reality of these debts quite clear.

First of all, regardless of who actually owns the debts, they are now shared debts. When you’re married, your money effectively becomes a shared pool, whether or not you directly share that money or not. If one of you has a debt, the money to pay for that debt comes out of the shared pool. What’s left in that shared pool is smaller, reducing your opportunities as a couple to build towards other financial goals.

When we were married, for example, I had an auto loan and my wife had an auto loan. I had student loan debt, as did my wife. I had credit card debt, as did my wife.

At first, we each tried to handle our own debts. What we discovered, though, is that after covering these debts, we each had much less left over to contribute to the things we shared – rent, energy bills, food, and so forth.

Even though we were keeping our debts separate, the reality was that the consequences of those debts were shared. If the consequences are shared, then it follows that the responsibility for paying off the debts ought to be shared as well.

Which brings me to my next point: once you acknowledge the debts as essentially shared, the optimal way to get rid of those debts is to consider them all together. It should no longer matter who has the worst debt. What matters is that the worst debt is the one that you both focus on first.

When my wife and I reached this conclusion in 2006, we began to really work together to focus on all of the debts either one of us had. It didn’t matter whose name was on the credit card or on the car title. The consequences of those debts were shared, so we both benefit when any of those debts go away.

Doing all of this successfully requires complete openness. You can’t hide debts from each other. You can’t hide money from each other. You can’t hide spending splurges from each other.

Whenever you do these things, you are taking money out of that shared pool that helps you both get what you want from the future. You’re also being dishonest with your partner and, likely, you’re undermining your debt repayment plan and other financial plans for the future.

This type of dishonesty is acid to any relationship. It opens the door to other forms of dishonesty that can completey destroy a relationship.

Any relationship where things are not completely in the sunshine is a relationship that’s eventually asking for problems.

If you’re not comfortable with that openness, then your relationship needs work. This goes beyond mere finances. It’s an indication that there are trust issues in your relationship and as long as those trust issues exist, you’ve got a gigantic fault line in your relationship that can easily erupt into a earthquake.

Simply put, share your debts. Regardless of who brings them to the table, you share the consequences, so you should also share the effort of eliminating them. This can also help you to pay them off in a more optimal fashion.

The post His Debts, Her Debts, or Our Debts? appeared first on The Simple Dollar.

What do you do?

Getting to Zero
The most vital thing that you must do in this situation is “get to zero.” What do I mean by that? Getting to zero means that you’re trimming your spending enough that your income matches your spending. If you bring home $2,000 a month, you can spend only $2,000 a month.

In order to make this number, I usually encourage people to look for big changes – single moves that can save them a bunch of money each month. Some options include eliminating cable, eliminating a telephone landline, moving into a smaller apartment, downgrading to a less-expensive car, bundling your insurance, refinancing your mortgage, or renegotiating your credit card interest rates. Almost everyone is capable of making at least one of these changes, and such a change can make a huge difference in your month-to-month spending.

Sometimes, though, making one or two big changes isn’t enough. The next step is to focus on what I call “one-off changes.”

One-Off Changes
These changes revolve around activities you can do once to either bring in a quick money spike (which you would then apply to paying off a debt) or to lower a bill for the foreseeable future.

Some options here include cleaning out your closet and selling off unwanted items, having a yard sale, selling off the contents of a collection on eBay, installing a programmable thermostat, replacing light bulbs with more energy-efficient ones, air sealing your home, and/or putting your home electronics on a more energy-efficient plug setup (with the devices set to a switch or to a “master” outlet that cuts power to the other devices when the master one isn’t in use).

The one-off options that produce a money spike can be applied toward your debts, preferably the smallest debt. Ideally, you’ll be able to pay off at least one debt very quickly, which naturally reduces your monthly bills.

The next step is the part that people think of as being “painful” when it comes to making more frugal choices.

Behavioral Changes
These changes revolve around making better choices every day. We’re constantly inundated with choices that have some financial consequence, from the moment we get up until the moment we go to bed.

Should I grab a bite at home or grab something on the road for breakfast? Should we go out with coworkers for lunch? Should I stop at a store on the way home? Should I hit Starbucks? Should I order take-out tonight? Should I go out with my friends or stay home? Should I buy this neat item from Amazon or hold onto my cash? Should I prep some stuff for tomorrow or should I just turn on the whole home entertainment system and veg out?

Each one of those situations is a choice, and each one has a financially good and a financially bad option. Quite often, it seems as though the expensive option is easier or more fun, and it seems utterly painful to give them up. It is choices like this – where you’re made to give up something you enjoy – that gives frugality a bad name for some people.

If you’re in that boat, I encourage you to not give up big swaths of stuff. That approach will leave you feeling miserable and will inevitably lead to a big backlash against making changes. If your heart is not into a big change in your life, you’ll never make that big change.

Instead, I suggest a different route. Simply focus on the choice you have at hand. Don’t make big plans about giving up Starbucks only to find yourself resenting it later. Instead, whenever you have the option to stop at Starbucks, ask yourself whether you’d rather stop or you’d rather put yourself in better financial shape. If you choose to stop today because you could really use that giant cup of sweet coffee, then go for it and don’t think twice about it. On the other hand, view it as a personal success if you decide not to stop today.

Retaining What You Save
What I usually encourage people to do is, once they’ve reached zero and are spending only what they bring in, they start directly setting aside every dollar they save to get rid of their debts.

Let’s say you’ve decided not to stop at Starbucks. At that point, literally take a $5 bill out of your pocket and put it up, or log onto your online banking service and move $5 to another account. You can also just track this with a pocket notebook with a note that says “$5 – saved by no Starbucks.”

Over time, with every good choice you make, it’ll add up. “$10 – didn’t buy that book and hit library instead.” “$12 – made dinner at home and ate leftovers for lunch.” “$8 – used coupons at the store.” “$30 – stayed home with friends instead of going to a club.”

Remember, you’re looking at individual choices here. If a choice seems too hard, don’t make it. Do not let yourself get miserable because of frugality. What I found at this stage is that most of the time, making the financially sensible choice felt really good – better than what I was giving up. I was proud of it. However, there were certainly times when I didn’t want to make that good choice, and I found that if I forced myself to do it, I ended up resenting the whole thing. Don’t fall into that trap.

The perfect is always the enemy of the good. You’re far better off making three good financial choices and two ordinary ones and feeling really good about it than making five good financial choices and resenting your life so much that you eventually backslide out of everything.

As these numbers add up, make sure you’re putting that amount to good use. It is a bad idea to make these good moves, then look at your checking account balance, think that you’re rich, then spend it all on something silly. Instead, pour that money into improving your financial situation by paying off debts, building an emergency fund, saving for a down payment, and so on. Use a debt repayment plan and make sure your dollars are going toward something powerful.

The post You Need To Cut Your Spending. It Sounds Painful. Now What? appeared first on The Simple Dollar.

I’m visiting a lawyer next week to get started on filing for bankruptcy. I have no way to pay my debts or even make the minimum payments each month. My problem is that I simply can’t find a place online that actually explains what the different kinds of bankruptcy are and how they work in any terms I can understand. What’s Chapter 7 and Chapter 11 and Chapter 13?

I’ll attempt to explain these concepts in the clearest terms I can. Of course, when you do that, you tend to lose some details in the process, so if you want to know more about your specific situation, I suggest contacting a lawyer.

What Is Bankruptcy?
Bankruptcy simply means that you can’t pay off your debts and you’re asking the legal system for help. This event appears on your credit report and can have a negative impact on your credit score for seven years, though being diligent about following through with the plan developed in bankruptcy court means you can minimize that impact. It also means that the court system will come up with some sort of plan that works for both you and your creditors for you to pay back some portion of your debts. The exact way you do that differs depending on the type of bankruptcy.

Typically, bankruptcy is an option of last resort. It has legal costs which can add up to the thousands and a very negative long-term impact on your credit. You should only turn to this if you cannot come up with a successful debt repayment plan on your own. I suggest creating your own debt repayment plan and making a serious effort to execute it on your own before considering bankruptcy. Credit counseling can also help; in fact, it is legally mandated before you file for bankruptcy.

Chapter 11 Bankruptcy
Chapter 11 bankruptcy is usually the best option if you own a business. This form of bankruptcy typically allows a business owner to remain in control of their business while going through bankruptcy proceedings. This typically occurs if you own a business that isn’t able to pay its bills at the moment. If you do not own a business, Chapter 11 is not right for you.

Chapter 7 Bankruptcy
Chapter 7 bankruptcy is a “liquidation” bankruptcy. You can typically only use this type of bankruptcy if you have sufficient income – usually more than the median income in your state. If you qualify, what happens is that some portion of your possessions are sold and the money from selling those possessions are used to pay off your creditors.

You’re allowed to keep some of your possessions during this process depending on the specifics in your state. This usually includes your home, your clothing, minimal transportation, a few hundred dollars’ worth of personal possessions, your pensions, and a few other odds and ends. The rest of your assets are liquidated and used to pay off the creditors. At the end of this process, your creditors go away, but your credit report has a big black mark on it and you’ve lost many of your assets.

If you hear stories of people repeatedly filing for bankruptcy, that usually means they’ve adopted some form of lifestyle where they repeatedly file for Chapter 7 bankruptcy. They usually don’t accumulate assets and spend the debt money they accumulate on experiences. Then, when they file for Chapter 7, there aren’t many assets for the creditors to take.

Chapter 13 Bankruptcy
Chapter 13 bankruptcy is the most common type of bankruptcy. In this form of bankruptcy, you and your legal counsel come up with a debt repayment plan. During the process, the plan is usually adjusted a bit to match the creditor’s demands and your own ability to repay such debts. Often, these plans lower your monthly payments to the point that you can actually handle them within your income. Often, that also means that your total debt amount is lowered.

What’s the drawback? For starters, the cost usually is in the thousands – this is tacked onto the court-ordered debt repayment plan. The plan itself usually ties up almost all of your spending money for a few years as you’re paying off debts. It also damages your credit severely, as does any bankruptcy, but your successful repayments will help mitigate that damage.

Which Is Right for Me?
For most people, Chapter 13 is the best route. Chapter 7 is better if you’re a high wage earner with few assets. Chapter 11 is the one to consider if there’s a business involved.

Of course, the specifics of bankruptcy vary somewhat from state to state. If you’re considering any of these avenues, contact legal representation before you move forward and make sure you understand the specifics in your state.

Your best choice, of course, is to avoid being in a situation where you’re concerned about this in the first place. Hopefully, this advice helps those who need it – and encourages people heading in that direction to reconsider their path.

The post Some Notes on Filing for Bankruptcy appeared first on The Simple Dollar.

I rarely do. Taking out a loan for a car is only a good move if (a) you’re buying your first or your second car and absolutely need one today to commute to work – and even then, you should be buying a used one or (b) you have enough cash to buy the car you want but you’re offered 0% or extremely low financing, making it cost-effective to take out the loan and then sit on your investment (a pretty rare case, but one we found ourselves in recently).

We fully own both of our automobiles and don’t intend to replace either one of them for years. Of course, we’re slowly saving up for their replacements at a reasonable rate, but we’re not paying interest – interest is working in our favor.

Let’s run the math so that you can see, in real dollars, how much is saved by paying cash. You have no cash at all, but you need wheels. What do you do?

Option 1 – Buying New Now
You go to the dealership and take out a $25,000 loan on a new car. That loan is offered to you at 6% for five years, meaning you have a monthly payment of $483.32.

You drive this car for seven years. Each month, you pay $483.32 as a car payment. After five years, you own the car, but you’ve paid out $28,999.20 for the loan – $3,999.20 of that being pure interest. You then start saving $483.32 a month for your next purchase – after two years, your savings account totals $11,715.68 ($11,599.68 in savings, plus $16 in interest).

At the seven year mark, you trade in your used car for $6,000 in trade in and also make an $11,700 down payment on your next $25,000 car. You’re still borrowing $7,300 to buy the car, which means monthly payments of $141.13 over the next five years, totaling $8,467.80 – $1,167.80 of that being pure interest.

At this point, you also need to save $285 a month so that you have $25,000 in cash ready for your next car purchase at the fourteen year mark – seven years after this one. $23,940 of the savings will be cash and the rest will be interest – $1,104.64.

So, after all of this, you wind up paying out $73,006.68 over the course of these fourteen years and find yourself with a new car at the end of it.

Now, let’s look at fourteen years starting in a different fashion.

Option 2 – Buying Used Now
You go to the dealership and take out a $5,000 loan to buy a used car that will work for five years. You make monthly payments of $483.33 each month. For the first year, $430.33 of it goes towards the loan payment, while the other $53 goes into savings. For the remaining four years, the whole $483.33 goes into savings.

At the five year mark, you have just shy of $25,000 saved and the trade-in on your junker puts you over the top. New car time, paid for in cash. You then start saving for your next new car in seven years, saving $285 a month.

At the twelve year mark, you replace that car and keep saving the $285 a month. At the fifteen year mark, you have a three year old car and $10,414.67 in savings.

Over the course of all of this, you’ve actually only shelled out $63,199.80 out of your pocket for these cars.

Comparing These Two Scenarios
Here’s the real take-home message here: simply by buying a low-end used car at first in the second scenario and driving it until the owner could pay cash on a new car (at the five year mark), that owner saves $10,000. In other words, choosing to take out a loan for a new $25,000 car means that $10,000 is simply evaporating out of your wallet.

Remember that from here on out, both scenarios are going to be saving the same amount of money in their savings account to keep up with future car replacements, which essentially means that the money is a car payment.

I like to look at it this way: the owner of the second option is essentially paying himself $2,000 a year to drive a used car instead of a brand new one.

There are a few additional things to point out as well.

First, the insurance costs in the second scenario are lower as well. For those first five years, the person owns a used car which will have lower insurance costs than a new automobile.

Second, considering used cars in your buying decision can save you money. When you run the numbers on your car purchase, always include used cars, particularly ones from model years with a good reputation. Sometimes, those cars can save you significant money over the long haul through insurance savings, plus they allow you to retain some of your cash savings for your next car purchase.

Finally, having the money in the bank puts you in control. If you can buy the car in cash, you’re no longer worrying about your credit history or about whether a bank will offer you a good rate. You have your cash, you find the best deal, and you buy. Simple as that.

I’ll say this much: every time I run the long term numbers with regards to paying cash or taking out a loan for a car, I further reinforce my own plan to never again borrow a dime for a car (unless, as I mention above, I have the money in an investment that offers a better guaranteed return than the interest rate of the car loan).

The post Doing the Math on Paying Cash for Cars appeared first on The Simple Dollar.

I just heard an ad on the radio offering a 3.99% mortgage. That makes sense to me. Where I’m confused is when the ad then mentions a 4.22% APY immediately after that. What does it mean? What interest rate will I actually be charged?

First, let’s break down the terms.

APR, or Annual Percentage Rate, defines the interest rate that is charged to the principal of the loan. You will be charged a total of 3.99% interest on that loan over the course of a year.

APY, or Annual Percentage Yield, describes the percentage of the principal of the loan that you’ll have to pay over the course of the year.

The trick here is to understand that we’re talking about two separate and somewhat different things. An example will illustrate this difference clearly.

An Example: Quarterly Interest
Let’s say you have a loan from a bank that has 3.99% with interest that is compounded quarterly. That means that every three months, your loan is charged 1/4 of the interest for the year, which would be 3.99% divided by 4, or 0.9975% interest.

Let’s say your loan has a balance of $100,000 at the start of the year, to make the math more clear.

At the first quarter, your $100,000 loan will be charged 0.9975% interest, or $997.50. This gives your loan a new balance of $100,997.50.

At the second quarter, your loan has a balance of $100,997.50 and that balance will be charged 0.9975% interest, or $1,007.45. This gives your loan a new balance of $102,004.95.

At the third quarter, your loan has a balance of $102,004.95 and that balance will be charged 0.9975% interest, or $1,017.50. This gives your loan a new balance of $103,022.45.

At the fourth quarter, your loan has a balance of $103,022.45 and that balance will be charged 0.9975% interest, or $1,027.65. This gives your loan a new balance of $104,050.10.

Over the course of a year, your $100,000 loan turned into $104,050.10, earning $4,050.10 in interest. That’s 4.05% of the balance of the loan, which is your APY.

Thus, this loan has a 3.99% interest rate, but a 4.05% APY.

In the United States, APY is legally defined as being the rate achieved when using daily compounding. In this case, that would give you an APY of 4.07%. So, where does the rest of that 4.22% come from?

The Other Parts of a Mortgage
What the radio ad isn’t telling you is that in order to get that 3.99% interest rate, you’ll have to pay some fees and possibly a discount point or two. These are up-front costs that add to the balance of the loan.

In this specific case, the fees and points will add enough to the balance of the loan to raise the APY from 4.07% to 4.22%. In other words, the total of the fees and points will be somewhere around $165 on a $100,000 loan, or about $817 on a $500,000 loan.

These fees will be rolled into the true APR that the lender has to give you (not that nominal rate given on the radio that doesn’t include these fees), and it’s that APR that you should be paying attention to if you’re intending to live in the house for a long time.

Another point worth considering is the fact that banks are allowed to advertise interest rates as much as 0.125% lower than what they’ll actually give you. In theory, this is done to allow for market fluctuation between the time you hear the ad and the time you sign on the dotted line, but lenders often push this so that they can advertise with seemingly incredible low rates.

What’s the moral of the story? Two things.

First, shop around. Getting a mortgage is a major financial decision, one that will have an impact on you for a long time. You owe it to your finances to shop around.

Second, get the APR on paper. Remember that APR takes into account most loan costs (points, most loan fees, mortgage insurance), but doesn’t account for some other charges, like application fees, title insurance, title examination, appraisals, document prep, and so on. You’ll likely have to come up with some additional cash for those when you move forward with the loan.

No matter what, never take out a mortgage based on an advertisement. This is far too important of a decision to do it based on a radio ad. Spend the time doing your homework and shopping around first, even if your favorite radio host is recommending a particular product.

The post APR, APY, and Mortgage Math: A Real World Example appeared first on The Simple Dollar.

What do I do?

You can really make a compelling case for either just buying the car with cash or keeping the money in checking and using the low-interest loan. In fact, I often go back and forth on that very question, and you’ll see differing opinions on this from different personal finance folks, including answers that vary depending on the interest rate of the loan.

The issue comes down to one of personal finance philosophy: cash flow versus liquidity.

Cash flow simply means the amount of cash you have going in and coming out each month. Your income versus your expenses. The fewer expenses you have, the greater your cash flow and the easier it is to save for other goals or survive economic twists and turns.

Liquidity means that you have easy access to cash or the cash value of something. Your baseball card collection has really low liquidity. The home you’re living in has pretty low liquidity. On the other hand, the cash in your pocket is very liquid. Liquidity means you have flexibility because you have cash in hand.

The usual argument against improving your cash flow is that you have to sacrifice liquidity to get it. In other words, to buy that car, you have to sink $20,000 in cash into that car. Suddenly, you have a lot less liquidity. You have a smaller cash reserve to deal with emergencies that come your way.

The argument against liquidity is that it requires discipline to maintain it. If you had $50,000 in the bank, would you not be tempted to buy something that you wanted? If you did, you’ve lost that liquidity for something you don’t really need.

My belief is that liquidity is better if you assume that your future is full of positive opportunities. If tomorrow is going to bring opportunities to get ahead, investment opportunities, business opportunities, and the like, liquidity will open those doors for you.

On the other hand, cash flow is better if you see a future with significant risk. A future with significant risk translates into a future with reduced income or with increased expenses – in other words, a crunch on your monthly cash flow. A long illness. A job loss. A new child. An ill or dependent parent. Having collateralized debt – like a car loan or a mortgage – means that the item can be repossessed, leaving you not only with reduced cash flow, but without transportation or a roof over your head.

The problem? We can’t see the future. We do not know what’s coming in the future. Is it a future loaded with opportunity? Or is it a future with significant risk?

In the excellent book The Black Swan, the author, Nasim Nicholas Taleb, argues that we often use mental tricks to disguise the randomness of the past from ourselves, turning our very random lives into a coherent and understandable story. We often do the same thing with the future, imagining not the chaotic future we’ll likely have, but a smooth road leading to some destination.

Lately, I’ve found myself hedging my bets more and more. What if I become ill? What if my income level drops? The better my cash flow is right now, the more room I have in my cash flow to deal with these challenges.

My conclusion is this: once you have a certain size of emergency fund (I usually use two months’ of living expenses per dependent), your focus shouldn’t be on further liquidity. Your focus should be on improving your cash flow. Not only does this protect against longer-term problems, it also creates a future where you’re more able to tolerate the unexpected in your life.

In simpler terms, get an emergency fund, then shoot as hard as you can for debt freedom. That might sometimes involve additional savings (like saving up to pay cash for a replacement car), but the goal is to keep your cash flow as healthy as possible.

Coincidentally, just an hour before this article went live, I got into a Twitter discussion about this very topic.

The post Pay Cash or Not? Cash Flow Versus Liquidity appeared first on The Simple Dollar.

I was at a local car dealership looking for a replacement for my truck. I only have about $8000 in savings so I knew I would have to take on some debt to buy. The dealer offered to sell me a new F150 for a good price and a 0% loan for 36 months for $589 a month car payments. This seems awesome and I am looking for any problems with it.

Over the last few months, I’ve received a few emails like Brian’s, where individuals were strongly enticed by 0% or other extreme low interest loans. Are they a good deal? Should they sign up for these loans before making a purchase?

The problem with such loans is that they don’t eliminate what I consider to be the chief problem with all debt. Yes, they have spectacular interest rates and, yes, they’re often sold as being “free money.”

However, all debt – including 0% debt – has a strong negative impact on your future cash flow. By signing up for this debt, Brian, you’re agreeing to pay $589 a month for the next thirty six months.

That means, for each of the next thirty six months, you’re going to have to come up with $589. It doesn’t matter whether money is tight that month. It doesn’t matter whether you have a job or not. None of that matters. Come up with the $589 per month or they’ll repossess your truck. Add on top of that the vehicle registration costs, the insurance costs, and the maintenance costs and you’re marking off at least $700 a month for this new vehicle each month.

That’s a pretty big responsibility to throw onto your future self. For the next three years, you’re making a commitment to $700 a month without knowing what the future may hold.

Does your future hold steady employment – or is a pink slip around the corner? Will your health be perfect in three years? In three years, will you find yourself in a situation where an F-150 doesn’t meet your needs?

Even if everything goes perfectly, there will still be months when $700 from your monthly budget will really hurt in the form of missed opportunities. Some will simply jump on board those opportunities anyway in the form of credit card debt, further mortgaging their future self.

If I’ve learned anything over the years, it’s that relying on your “future self” to do things you want right now is a quick route to failure. Our future selves are unreliable for the reasons I listed above: job loss, change of heart, illness, life changes, and so on.

Debt is always a challenging choice because it relies on that inherently unreliable “future self” to pay it off. The fewer commitments you put on your future self – and the more commitments you just take care of today – the easier you’ll find your life getting as time goes on. That means more freedom in the future, not less. That means a greater ability to go in whatever direction life leads you, not less.

I won’t say explicitly that a debt-free lifestyle is the best choice. There are times where debt is the preferred option or the only option. For example, if you’re living in a situation where the cost of renting housing is comparable to that of taking out a mortgage to purchase a home, the purchase may be the better choice.

In most situations, though, debt merely allows you to put big burdens on your future self in exchange for something you don’t need today. Brian, do you really need the shiny new 2011 F-150? Or would a used model work for now, putting less of a burden on your future self, while you save up the cash for the vehicle you really want down the road?

The post Why a 0% Loan Isn’t Always the Best Choice appeared first on The Simple Dollar.