How to Pass a Financial Stress Test

Can you pass a financial stress test? Are you able to keep your standard of living after a layoff, a large medical bill, or a losing investment? Learn how to pass your own financial stress test here.

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.

This post is contributed by a community member. The views expressed in this blog are those of the author and do not necessarily reflect those of Patch Media Corporation. Everyone is welcome to submit a post to Patch. If you'd like to post a blog, go here to get started.

Fred Eiger January 17, 2013 at 03:15 AM
Excellent post. Far too many people do not understand that a credit card is there to be used when large amounts of cash are not readily available nor useful to carry around but instead view it as an opportunity to spend to the maximum allowed with no concept that the money has to be paid back...with interest.
Lou Dagen, CFP, ChFC January 17, 2013 at 02:13 PM
Hi Fred, you're absolutely right. To avoid this temptation, my wife and I use debit cards exclusively to stay out of trouble. --- Lou
c5 January 17, 2013 at 02:28 PM
rational commentary lou, always good to have logical and rational financial behaviors outlined. the discipline on credit card behavior is difficult for most people. we are fortunate in using credit cards mostly to generate points and for convenience, always paying off the balances on time...but i think we are the exception, not the rule.
Chris Nicholson January 17, 2013 at 04:43 PM
I disagree that austerity and balanced budgets (or surpluses) is always right answer-- I think you need to consider the age of the person in question and their likely salary trajectory. I actually think it is OK to "deficit spend" until mid to late 20s, then save a bunch for the next 30 years, then deficit spend again. Denying yourself that dinner or or double soy latte at age 24 seems silly since you will enjoy it a bunch more then versus getting two double soy lattes at age 55. Deferring gratification is fine, but the NPV of future pleasure should be viewed with a steep discount rate. 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)
Lou Dagen, CFP, ChFC January 21, 2013 at 03:20 AM
Hello C5, you are indeed fortunately to use your credit cards wisely. And yes, I believe you are the exception, not the rule. 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
Lou Dagen, CFP, ChFC January 21, 2013 at 03:28 AM
Hi Chris, you're absolutely correct that "austerity and balanced budgets ... [are] always right answer." That's why I differentiated between appropriate debt (home mortgages, business loans, college loans) and inappropriate debt (credit cards). 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
Chris Nicholson January 21, 2013 at 04:57 PM
Your penultimate sentence was the key one "...I am suggesting that you live within your means..." 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.
Jennifer January 22, 2013 at 12:04 AM
I disagree, Chris. Deficit spend on small items like lattes? How about saving first and then buying the things you want, rather than buying first and then always owing for it plus interest. Doesn't make sense for small ticket items. It really doesn't take much effort to save up front and then enjoy the rest of your life debt free (except for mortgages and maybe an automobile).
Chris Nicholson January 22, 2013 at 12:35 AM
Funny how people see things differently. I recommend kids in good colleges getting good grades and young people with entry level jobs in promising (economically) sectors should absolutely deficit spend a little bit on life's little pleasures. 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.
David January 22, 2013 at 12:52 AM
American Express has a no fee pre-paid card. Load up your monthly bar tab with your part of your paycheck (or whatever you want to call it--latte money or whatever). When it's done, it's done. Or you can get an envelope of cash for your walking around money for the month. Spend it in one place, spend it every day, but that's it for the budget. Done and done. Rest goes to bills, investing, etc.
Lou Dagen, CFP, ChFC January 22, 2013 at 03:59 AM
Hi Chris, I appreciate your approach. I agree that in your teens, twenties, and early thirties, when you are purchasing household necessities and toys, it's almost a given that you'll outspend your income. 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
Lou Dagen, CFP, ChFC January 22, 2013 at 04:05 AM
Hi Jennifer (and Chris again), maybe there's a happy medium here. Could we perhaps agree on a case like the following? 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


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