Upon graduation from Cornell long ago, my net worth consisted of a $1,000 loan from my parents, juxtaposed against college loans and credit card debt. I was failing one of the first tests we have as independent adults: a financial stress test. Not only was I living beyond my economic means, but I also had no way of surviving an economic shock: getting sick, losing a job, or even repairing a car. And the "stress" part was no picnic either.
Can you pass a stress test? Are you able to keep your standard of living after a layoff, a large medical bill, or a losing investment? Does financial worry keep you up at night?
The best ways to pass a stress test are to reduce debt, and to increase available assets. In this post, I will give you specific ideas on which kinds of debt to reduce, and how. Next week, I will teach you ways to shore up your assets in case of emergency.
Debt is appropriate when you're borrowing against an appreciating asset, one that increases in value over time. Homes grow in value over the long term, and therefore mortgages are an appropriate debt. Business ventures (assuming you've done your homework, you're competent, you work hard, and you're lucky) are appropriate. Even college and graduate education is appropriate, as an education historically more than pays for itself over time via higher income and professional growth potential.
What's inappropriate debt? The classic example is credit cards: these almost always indicate that you're living above your means, and should only be used as loans in cases of emergency.
So, one element of passing your financial stress test is eliminating your inappropriate debt. Focus on this debt first, and you strengthen your ability to pass other parts of the test.
So, how to pay off this debt? If you have credit card debt, remove all your cards but one from your purse or wallet, and stick them in the freezer ... ideally in the back. Take your one remaining card (Mastercard or Visa only), call the bank of issuance, and request that your credit limit be lowered to $500 above your current balance. Take this card, and bury it somewhere out of sight in your car. (I suggest taping it to the underside of the passenger seat.) This gives you enough credit for an emergency in case you're stranded somewhere, but not enough for a shopping spree.
Next, write down the amount you owe, and the interest rate charged, on each card. Tape this list to your bed, fridge, or wherever you'll see it most often. Every month, pay the minimum for each card, except for the one with the highest interest. For that card, pay off the most you can possibly afford. Then, update your list of card debt to reflect your payment. This should help motivate you to repeat this process every month.
For most people, the hardest part of this exercise is cutting back on fun stuff: restaurant meals, shopping excursions, even gourmet coffee. So, when you pay off a credit card, give yourself a small reward: go out for a nice dinner, or give yourself some other treat. Just don't use a credit card to do it!
By paying off this inappropriate debt, your net worth goes up, you have hundreds of extra dollars a month to save, and most importantly, you're that much closer to passing your financial stress test. Stay tuned for tips to increase savings, coming next week.
Lou Dagen is a Certified Financial Planner in the San Francisco Bay Area. For 23 years, he has helped clients around the world retire in comfort, educate their children, and increase their net worth. If you have questions, please post them in the comments below or call Lou directly at 925-997-8507.
Some people have a spending compulsion, and others will have an unrealistic view of their lifetime earning potential. But for others, I think life will be happier if they smooth their consumption rather than fitting it realtime to "spot" income. If you're going to deficit spend, you obviously should try to minimize your cost of capital (not 24% credit cards), but I don't mind reasonable debt loads for young people with high potential. As Econ majors will recognize, these aren't my ideas. Milton Friedman won a nobel prize (in part) for his work on this topic (permanent income / consumption smoothing)
According to CreditCards.com, the average household credit card debt is almost $16,000, with an average interest rate of 12.78%. Of course, many credit card holders, like yourself, don't carry revolving debt. However, Americans have over $800 billion in revolving debt, most of which belongs to credit cards. Clearly, there are many less responsible than you. Glad you enjoyed the article, and keep posting! --- Lou
Respectfully, I have to caution regarding "their likely salary trajectory." I'm biased here, but I've lived through some bad economic times. I remember the dot-commers in the late 90s exercising their stock options, and immediately heading to the Porsche dealer with their down payments. And I bet most of us recall people leveraging themselves to the hilt a few years ago to buy real estate. "Likely" does not guarantee certainty. Also, that $5 latte at age 24? Invested at 10% annually (the historical return of the stock market), that cup of coffee cost you $401, which you could have used for retirement. I'm not asking you to live like a monk. But I am suggesting that you live within your means, and only borrow money for investments that increase your net worth. This is a good discussion, please keep your comments coming! --- Lou
My only point is that "your means" is a lifetime concept-- not measures for one particular week/month/year. Given the diminishing marginal utility of consumption and the rational "discount factor" in computing the NPV of deferred gratification, the happiness maximizing decision is often to NOT match current income with current spending. I think we agree with each other here in the middle years (when everyone should be actively saving). I am just pointing out that a natural corollary to this is that you SHOULD deficit spend when you are young (initially (as a child/student) via parental subsidies....). I understand that this is dangerously-tempting theoretical advice to give in the real world.
In contrast, picking up on Lou's Porsche example, I think big ticket luxury items should be paid for with cash (like a Porsche). Again, it all comes down to the marginal utility of consumption--- a little extra can go a LONG way when a balanced budget implies Top Ramen and solitude. I think people get dogmatic about the virtues of frugality/savings and lose sight of what must be the true underlying objective: increasing lifetime happiness. Nothing magic about being "debt free," IMHO.
However, as you also mentioned, people don't think theoretically. Rather, they act emotionally. (Not intellectually, much of the time.) To continue with the Porsche example, I guarantee that people don't go to a car show thinking about, "the diminishing marginal utility of consumption and the rational 'discount factor' in computing the NPV of deferred gratification." :-) Now, if you could guarantee that a person would always have a job, and that their pay would rise faster than inflation, and they wouldn't have any significant, unanticipated expenses in the future, then I'd agree that credit card debt wouldn't be a huge deal. However, since none of these premises can be guaranteed, I encourage clients to pay off all non-deductible debt. (With very few exceptions, I won't even take on clients with non-deductible debt.) Thanks for the great discussion! --- Lou
Say someone in her 20s or early 30s is saving 10% of her pre-tax income in her 401(k). Because of this contribution, her paycheck is lower than those of her friends. But, she likes participating in the same activities as them. So, she ends each year with a few extra thousand dollars in credit card debt. However, due to her education and work ethic, she's very employable, and if she stays at her current firm, she should be promoted in the next couple of years. In this case, I'd agree with Chris that a little deficit spending is fine. That said, I'm biased. As a financial planner, I try to err on the side of caution. I'd encourage this woman to make a budget, and see if there's any expense she can cut, without greatly negatively affecting her quality of life. Thanks to you both for a great discussion! --- Lou