5 Financial Rules That You May Need To Break

November 30, 2017

There are certain guidelines that we financial planners tell people to help keep them out of trouble. Most of the time, they’re right on. But there’s almost always an exception to the general rule. Here are some of those rules, why they usually make sense, and when they might not.

RULE: Pay your credit card balances off in full

Why it usually makes sense:

Not paying off your credit cards in full each month means that you’ll have to start paying interest to the credit companies at an average rate of 14%. That’s high, but you could be charged a lot more than that, especially if your credit isn’t too great.

Have you seen those calculations that show how the magic of compound interest can grow your savings over time? Well, when you have credit card debt, that same magic of compound interest is actually working against you. Pretty soon, you could find yourself paying more in interest than you spent on the original purchases. Some will even have to file for bankruptcy…and it all started with carrying that first balance.

Exceptions to the rule:

There are two opposite situations that I can think of in which carrying a balance can make sense.

If you have a very low rate and would be better off investing the money than paying down the balance. In this rare instance, your credit card debt actually becomes “good debt” like a mortgage or student loan. In fact, I wrote a whole post about how you can make money off zero rate credit card offers. However, that post actually came with a warning from our CEO because you have to be very disciplined to make sure that you save that money and that you keep track of when the low interest rate offer expires so you can pay it off beforehand.
When you’re in such financial difficulty that you’re having trouble paying your mortgage or your car payment. In that case, make sure those bills are paid first because as much as you don’t want to pay interest or fall behind on credit card payments, you don’t want to lose your home or your car even more.

RULE: Aim to have 80% of your income in retirement

Why it usually makes sense:

First, any target is better than none. In fact, our research shows that most employees aren’t confident they they’re on track to retire comfortably and have never even run a calculator to see how much they need to save. 80% is a good starting place because people tend to need less income when they retire since they won’t be saving for retirement or paying into Social Security and may have their have kids out of the home and their mortgage and other debts paid off.

Exceptions to the rule:

The key word there was “tend.” Your situation may be different depending on the lifestyle you want to have in retirement and how your various expenses may change. For example, you may want to spend a lot more on travel while someone else may prefer to stay close to home and spend more time with the grand kids. Look at what debts will be paid off but don’t forget to add in the costs of retiree medical insurance and possibly long term care insurance. In short, some people will need a lot less than 80% and some will need a lot more.

RULE: Start contributing to your 401(k) as soon as possible

Why it usually makes sense:

The earlier you start saving for retirement, the better off you’ll be. The longer you delay, the more you’ll have to save or the later you’ll have to retire. In other words, your future self won’t be very happy that you had other “priorities” with your money. Plus, if your employer offers you a match, you don’t want to leave that free money on the table.

Exceptions to the rule:

There are three reasons why you might want to delay contributing to your 401(k).

To focus on paying down high-interest debt. This is because high-interest debt can cost you more than you’re likely to earn in your 401(k). Just make sure that you make up those lost contributions once the debt is paid off.
To build up an emergency fund. Your future emergency may not qualify you for a hardship withdrawal and even if you are eligible, you could be subject to a 10% tax penalty, so it’s best to have funds available outside your 401(k) to pay for things that come up. You might be able to borrow from your plan but only up to half of your balance, which may not be enough.
To save for a home purchase. After all, owning a home could be part of your retirement plan too. Once again, just be sure to make up for those lost contributions after you throw that house warming party.

One final note is that you can save for emergencies or a home with a Roth IRA since the contributions can be withdrawn tax and penalty-free at any time for any reason and the earnings can also be withdrawn tax-free for a first-time home purchase as long as the account has been open at least 5 years. The advantage is that anything you don’t use can grow tax-free after age 59 ½ so you’re still saving for retirement too.

RULE: Don’t borrow from your 401(k)

Why it usually makes sense:

Speaking of 401(k) plans, too often people use them like an ATM. Since the interest you pay just goes back into your account, it can seem like a cost-free loan. However, you’re missing all the earnings that your money would have earned if you hadn’t borrowed it. Meanwhile, the loan payments you’re making could have been additional contributions. If you leave your job for any reason, you may also have to pay the outstanding loan balance back within 60 days or it would be considered a taxable distribution and subject to a 10% penalty if you’re under age 59 ½.

Exceptions to the rule:

I’ve seen situations where people have used their 401(k) to pay off high-interest debt and get themselves out of severe financial distress. That’s because there’s no credit check and low interest rates mean that the 401(k) loan payments could be a lot lower than the credit card bills.

The key is that this needs to be part of a long-term strategy to get and stay out of debt. The worst thing you can do is find yourself back in debt but with a much lower retirement account balance. Also, don’t raid your retirement account if you’re thinking of declaring bankruptcy since it’s a protected asset.

RULE: Don’t borrow from your home either

Why it usually makes sense:

In short, you’re putting your home on the line. Lots of people did this during the housing boom, expecting to pay off their loans with rising property values, only to find themselves underwater and struggling to make the payments.

Exception to the rule:

If you have a comfortable amount of home equity and you’re confident that you can afford the payments, a home equity loan can be a tax-deductible and low-interest alternative to more expensive sources of credit. Just be careful of variable rates and balloon payments that can make that loan not so affordable in the future.

As they say, rules were made to broken. But that doesn’t mean they should be broken lightly. If you’re unsure, talk to a qualified financial professional first. After all, you don’t want to learn the hard way why the rule was created in the first place.

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How Much Do You Really Need In Your Emergency Fund?

August 02, 2017

In this age when people are measuring everything from the number of steps they take, to how many hours they sleep, and even how many calories they burn while they are sleeping, it’s no wonder that people regularly ask me if what they are doing is considered “normal” when discussing their personal financial questions with me — we like knowing not only where we stand, but how we measure up compared to our peers.

But really, who am I to say what’s normal — is there even such a thing? This is why we have rules of thumb in the financial world. And while there are exceptions to all of the rules, they are generally good guidelines to help make decisions. One of the more common rules of thumb I discuss with people is the importance of establishing an emergency fund (often called a nest egg or rainy day fund).

How much should you have in your emergency fund?

Rule of thumb = three to six months of your expenses

While you may need more if you own a home that could potentially be hard to sell, work in a field that is highly volatile or specialized or have a large family dependent on one income, this is a pretty good gauge of things to make sure you’re protected. When real estate prices plunged along with a lot of people’s job prospects during the last recession, twelve months would have been more appropriate because that’s how long it took many people to find new jobs when selling their home wasn’t an option because suddenly their houses were worth less than the mortgage.

What’s the emergency fund for?

Get you through an unexpected loss of income

The emergency fund’s primary purpose is to ensure you have the money you need to cover all your core financial expenses in the case that you or your spouse loses your job. Being unemployed is stressful enough, so it’s nice to know that you have that money aside, so that you don’t have to accumulate a mountain of credit card debt or miss payments that can impact your credit score. These savings will ensure this unfortunate event doesn’t cause too much long-term financial damage.

In the event that the loss of income is more permanent, it’ll also give you time to adjust to a new reality, allowing you to keep paying your bills until you’re able to reduce them through cancellation or adjustment of service, sale of your home or termination of your lease, etc.

Large unexpected one-time expenses

While this is more of a last resort, as you should be budgeting for most non-recurring expenses like home maintenance, pet illness, healthcare bills, etc., there are always things that come up that just can’t be planned for beyond just having the right insurance to minimize the impact. That said, it’s better to tap into these savings than it is to get into credit card debt that’ll amass large interest charges.

What it’s not there for

It’s NOT your piggy bank to tap into when you are feeling that spending itch or paying for expenses that should be planned for through your normal budgeting process like vacations, holidays, etc. This is your safety net and can leave you in pretty bad financial shape if you don’t have it when you need it (and you’ll need it, I promise). That’s why the best emergency funds are those that are held in a separate account that’s a bit harder to access and remains untouched except in times of true emergencies. And once the emergency has passed, they are brought back up to their necessary amounts to protect against the next thing!

So what do you do if you don’t have an emergency fund yet?

Figure out your monthly fixed expenses: First, you need to know how much you should be aiming for. If you don’t know what your monthly fixed expenses are, that’s a great place start. Our Expense Tracker tool is one way to figure that out, or you can use a free online tool such as Mint.com, which will link directly to your accounts and download your spending. That exercise can also help you figure out how much you can afford to save each month.
Open a separate savings account: Trust me. You’ll want to keep it separate to make it harder to tap into. You’ll thank me later.
Automate your savings: Set up a direct deposit or automatic monthly transfer to your separate savings account. Your payroll department may be able to even take money directly out of your check and deposit it for you. Otherwise, set the transfer for pay day so you never even have the temptation to spend the money. That’s what I do. (And yes, I’m still working to get my emergency fund fully set up, so don’t beat yourself up if this takes some time.)

Now don’t let the math freak you out. Six months of expenses is a big chunk of change! Start first by trying to get $1,000 in your account. I started mine with just $25 per paycheck. After that, aim for three months worth of your mortgage or rent payment. Then tack on three months of car payments, then utilities, etc. and if you have any little windfalls like a tax refund or you won on that scratch ticket your friends got you for your birthday, use that to get you there sooner.

Finally, it’s important to reassess the amount needed in your emergency fund when you have big life changes such as the birth of a child, new home purchase or even an empty nest when the amount needed may actually decrease.

The bottom line is, an emergency fund is your first line of financial defense against life’s little twists and turns. Even if you’re working to pay off credit card debt, it’s important to start your emergency fund to help you avoid derailing your debt pay-off plan should an unexpected expense arise. Don’t delay. Start saving today.