Perspective Matters
Happy new year! January is Financial Wellness month so it's a good time to think about some basics to help improve your net worth.
Notice I said improve your net worth, not “save more” or “pay down debt.” Net Worth is calculated by adding up the value of everything you own and then subtracting everything you owe. Financial Wellness means considering both your assets and your liabilities and making choices about when it makes sense to have debt and when it doesn't. By thinking of both sides of your balance sheet when you think about your financial situation you have a better chance of avoiding the pitfalls of one-size-fits-all types of advice. Let me give you an example.
Let’s say two years ago, you were a great shopper when it came to your car loan, and you are paying an interest rate of 2.9%. Last year you continued your efforts as a good shopper and put some money in an online savings account paying you more than 4%. One-size-fits-all advice might lead you to think that you should take money out of your savings account to pay off your car because “we all know” that a car is a depreciating asset, and you should “never” borrow money to buy a depreciating asset. But would that really be the best thing to do today? The short answer is not necessarily. If the interest you're earning on the savings account is more than you’re paying on the car loan your net worth goes up every month by the difference between what you are earning on the savings account and the interest you are paying on the car loan.
You'll note that I do not take into consideration here the depreciation of the car. That's because if you are deciding between keeping the car loan vs. paying it down or paying it off using money in your savings account, the depreciation is the same no matter what, so we can just take it out of the equation for now. In this case I would suggest that you check the interest rate every month that you are earning on that savings account and if it falls below the interest rate you're paying on the car loan then you would consider taking money out of the savings account to pay off the car loan. In the meantime, just keep accumulating more money in that savings account. The smart thing to do here is to accumulate enough money in that savings account so that you can pay off as much of that car loan as possible if and when the interest rate on the savings account drops below the interest rate you're paying on the car loan.
Next let’s talk about debt. Many of us end up spending more than we should over the holidays and have January credit card bills that are higher than average. Generally speaking, when we think about debt, we should try to avoid borrowing for things we consume, like vacations and gifts, or for buying things that will not go up in value (like cars, clothes, furniture etc.) If we update our Net Worth statement every month, the value of the items purchased goes down every month, and we are using up another asset, cash, so it’s a double hit to our net worth.
When we borrow to buy an asset that is likely to increase in value, like real estate, it’s important to consider the appreciation potential as well as the cost of the loan. Usually, over a long period of time, the value of the real estate will go up more than what we spend on interest (especially if we itemize deductions on our tax returns) so we think of mortgage debt as being better than credit card debt.
What if you find yourself with balances on your credit cards you can’t pay off immediately? What’s the best strategy for getting them paid off? First, see if you are eligible to transfer any balances to a low or zero rate card. There are often transaction costs of up to 5% of what you transfer, so do the math to make sure you truly reduce your cost with the transfer. With what is left, there are two different approaches, commonly known as the Avalanche and Snowball methods. Both start with you making a list of debts, including how much you owe, the interest rate you are paying and the required minimum payment.
In the Avalanche method, you make the minimum payments on all debt except the one with the highest interest rate. You pay as much as possible on that one until it is paid off. Then you do the same thing with the next highest interest rate debt. In deciding how much “as much as possible” is, plan on making sure that current expenses are paid in cash, not added to the credit card balance. For example, if you spend $500 on groceries, either use a debit card, or put the groceries on your lowest rate card, and pay the minimum PLUS whatever the current charges are for groceries. If cash is tight, put new charges on the lowest rate card, pay only the minimum, and make sure the payment you make on the highest rate card is more than the minimum plus what you have charged that month on the lower rate card. Track the change in your total debt each month. As you reduce the balance on the higher rate card you’ll see an acceleration in the drop in your total debt – hence the name Avalanche.
In the Snowball method, you start by paying the minimum on all the cards except the one with the lowest balance. All of your extra available cash goes to paying off the card with the lowest balance first, then the next highest balance and so forth. The rule about using cash for new spending still applies; if you need to put current expenses on a credit card, use the one with the lowest interest rate and make sure that whatever you are paying on the lowest balance card is more than the minimum plus new spending. The Snowball method allows you to get to zero balances on some cards faster, so the snowball effect is in reducing the accounts on which you owe.
Now many of us use credit cards with cash back and/or points features which may seem to contradict either of these strategies. There is definitely value to be considered when using these cards but look closely at the value of the perks. If you get 1% back in cash but are paying 5% more in interest than on another card, it doesn’t take long for the interest you pay to be more than the cash back benefit. Everyone’s situation is different, so consider your priorities as well as what will keep you motivated to stick with whichever method you choose. The Avalanche method can be a bit more effective if you have a lot of debt that will take you more than a year to pay down, while the Snowball method can give you some immediate gratification from getting balances to zero more quickly.
Another action of Financial Wellness is something we call paying yourself first, which means building your planned savings into your budget just like your rent or mortgage payment. Treat it like a fixed expense in your budget; like a bill that must be paid every month. Delaying gratification is one of the hardest things for all people to do. We are hardwired to focus on getting our most immediate needs met first because no one knows what's going to happen in the future.
If you are going to set savings goals for the future, you're much more likely to be successful if you have something very specific in mind that you want to accomplish. We can all understand rationally that “saving for a rainy day” or “saving for the future” or even “saving for retirement” are smart things to do. When we're faced with something that we want to do today - such as go on vacation with our friends or even just go out to dinner, it can be easy to choose to head out to that restaurant even if we didn’t plan for that expense this month. The future can seem very vague and far in the future and we tell ourselves we will make up the savings next month. Instead of a vague savings goal be as specific as you can. If you’re saving to buy a house, think about as many specifics about the house as you can. What neighborhood do you want to live in? What style house do you want? How many bedrooms? Is there a yard? Have you seen any pictures of houses you’d love to buy today if you could afford it? Cut them out and look at them every day. That will help you delay the gratification of going out today in favor of saving towards the house you want to buy.
This idea can work for almost any goal, even a short term one like planning a vacation. Decide where you want to go and find pictures to look at. When you are tempted to spend money on something to satisfy today’s needs, look at the picture of the vacation spot you’ve picked out and ask yourself if buying the shirt is worth delaying your vacation for.
Paying yourself first can also include your employer provided retirement plan. Most will offer some sort of matching contribution, which means your employer adds to your retirement account based on how much you put in from your salary. The formula might be something like 50% match up to 6% salary deferral – which means if you save 6% of your salary, they’ll throw in another 3%. That’s like getting a 50% return on your money right away. The employer match generally goes in pre-tax, even if you are contributing to a Roth 401(k) or 403(b) so you’ll pay taxes eventually but you’ll still be way ahead so this should be your first place for long term savings.
Start off the new year by seeing where your money goes, and making sure that in 2024, more of it goes to places that are better for you! As always, working with a Certified Financial Planner® professional can help you assess where you are and develop a plan to take charge of your financial future!
Neither Prism Planning and Solutions Group nor Insight Advisors provide tax advice, and nothing in this communication should be treated as such. This communication should not be interpreted as a recommendation for a specific investment or tax-planning strategy. We are providing this material for informational purposes only. We have made every attempt to verify that information contained in this communication is accurate as of the date published but make no warranties. Before making any decisions related to your own tax and/or investment situation you should consult the appropriate professionals.
Certified Financial Planner Board of Standards, Inc. (CFP Board) owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, and CFP® (with plaque design) in the United States, which it authorizes use of by individuals who successfully complete CFP Board’s initial and ongoing certification requirements.