Advanced Personal Finance

In early September Congress passed a bill called the College Cost Reduction and Access Act that is great news for anyone with student loans. The President still hasn’t signed the bill yet signed the bill just yesterday.

The law has some good provisions and some downright awesome ones. Here’s a quick run-down.

Interest rate cut. The law immediately reduces the interest rates on new federally subsidized Stafford loans (also called Direct Loans). Note: this does not apply to loans in repayment right now, only newly issued loans. Right now the rate is 6.8%. The rate drops to 6% right away and continues to decrease until it hits 3.4% is 2011. However, if Congress doesn’t act before 2012, the rate goes right back to 6.8%, so load up on that debt now.

Low payment option. The law establishes a ceiling on how much your student loan repayment can be each month. Using a formula, the most you will pay per month is 15% of your discretionary income.

Loan forgiveness for public service. Currently, some teachers qualify to have student loans forgiven. With the new law, many more professions will get similar treatment. Police, librarians, firemen, military members, and government employees in general all get added to the list. Significantly, so do prosecutors and public defenders with their fancy pants law degrees and huge student loan balances.

Loan balance forgiveness for all. For everybody else, there’s still hope. After making student loan payments for 25 years (yeah, I know, that’s a helluva long time), any remaining balance is forgiven. This provision applies to anyone with federal loans.

Higher Pell grants. This is probably the least-significant provision. Pell grants will increase yearly from their current pathetic level of $4,310 to a whopping high of $5,400 in 2012. Never mind the fact that you can’t even think about a Pell grant if you’re in the middle class.

Naturally, private lenders say this law will make it harder to go to college, since they claims some of them will get out of the business. I find that extremely hard to believe; don’t believe stories to that effect.

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Most of the time when you read about 401(k)s, it’s something like, “contribute at least up to the company match,” or, “don’t put too much in company stock.” But what do you do when your company’s 401(k) sucks?

Problem: Your company doesn’t offer a match.

Solution: Contribute as much as you can to a Roth IRA, then contribute to your 401(k).

I recommend maxing out a Roth IRA before contributing to a Traditional 401(k). The reason is that Roths are funded on an after-tax basis, but you withdraw the money at retirement tax free. I believe most people will be paying more taxes in the future, so a Roth is usually the best solution.

I also recommend contributing to a Roth IRA even if your plan offers a Roth 401(k). The reason is because you can always withdraw your contribution to a Roth IRA without penalty before retirement if disaster strikes and you need the money.

After you max out the Roth IRA, go back to your 401(k) plan. A 401(k) has great tax benefits. It reduces your current taxable income. Your contributions compound tax-deferred or tax-free, depending on with type you use (Traditional or Roth). It’s also an easy, automatic way to save for retirement. A company match is nice, but it’s not the best reason to use a 401(k) to save for retirement.

Problem: Most or all of the funds offered in your plan suck.

Solution: Figure out just how bad the funds are and decide if saving outside a 401(k) makes more sense.

Great, so how do you do that?

I’d consider a fund ‘bad’ if it has higher-than-average fees for its type and middling or below returns compared to its peers over many different time periods. If just some of the funds in your plan fit that description, invest instead in the ones that are good, even if it means overweighting your asset allocation. That is, if you’re offered a good stock fund in your plan, but no good bond funds, go ahead and invest in the stock fund. Outside your 401(k), say in an IRA, you can overweight bonds to compensate.

If truly all of the funds are bad, you have to consider not contributing to the 401(k) at all. Before you do, though, consider any employer match. If you’re offered a match, you’re almost certainly better off contributing to the match maximum and investing in bad funds. That’s because the immediate 50% or 25% return a company match gives you counteracts the general suckiness of the fund you invest in. For example, if you’re offered a 50% match on contributions up to 6%, go ahead and contribute the 6%. Even if your fund returns -20%, you’re still netting a positive 30% return - great by any standard.

So what if you have the worst situation of all - the funds suck and there’s no company match? In that case, there’s a very good chance you’d be better off not contributing to the 401(k) at all. Instead, invest in an IRA. I recommend a Roth IRA, but Traditional is good, too. That way, you can choose any fund you want.

Problem: Your match is in company stock and the stock is going nowhere.

Solution: Sell your company stock as soon as you can.

In 2006, Congress passed the Pension Reform Act that allows 401(k) participants to sell company matching stock. For stock given before the law was passed, you can sell 1/3 of the total each year over three years. For future matches, you can sell immediately. I advocate selling matching stock as soon as you can anyway, but this is especially true if the stock is declining or flat.

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People’s buying behavior can be extremely bizarre. When it comes to buying versus saving, it gets even more weird. The Finance Buff left a comment on my post about the ‘latte factor’ to that effect. Here’s the comment:

I also think the latte factor got it backwards. True, saving some small expenses helps, but it requires discipline day after day after day. The removal of small joys makes people resentful. Instead, it’s the large money decisions that matter — job advancement, purchase of a house, car, etc. Latte factor trivializes the savings efforts. Cutting down coffee is not enough. Serious savings requires real sacrifice. It means smaller houses, older, less expensive cars, less fancy furniture, less fancy vacations…

Saving and Dieting

FB had a couple of excellent points I’d like to expand on. First, I think it is very true that “the removal of small joys makes people resentful.” I suspect this is a big reason some people fail when they resolve to save more money.

Like a dieter trying to avoid their favorite foods, a new budgeter feels obliged to give up things that make him or her happy. It could be that daily coffee or lunch out, whatever. If missing those things is too difficult…to hell with it. There goes the budget.

Buy Big - Save Big

The second point TFB makes is that large purchases matter the most. This might seem obvious, but it’s worth keeping in mind. Why is it that people will cut coupons to save $0.35 on Hamburger Helper but don’t bat an eye when told they’re being charged a $100 ‘administrative fee’ when buying a car? The car, the house, the college - all those things are major money events. They have great potential to either save a lot of money or cost more than necessary.

I’m guilty of this myself. We’ve only bought one house in our lives. When you buy a house, you’re presented with a whole list of fees you’re paying at closing. I’m sure we paid something like a ‘processing fee.’ I’d have to dig out the paperwork to know how much it cost, which I’m not going to do because I’m lazy. But let’s keep to the low side and say it was $100. I could have saved $100 by asking them to strike the charge. But I didn’t. It cost me $100 real dollars.

That $100 is a trivial amount of money when signing to owe hundreds of thousands of dollars. Most people don’t give it a thought because they’re paying more attention to the much bigger numbers. But a $100 charge in a $500 transaction will most certainly raise eyebrows. Why? One hundred dollars is one hundred dollars.

The difference is the charge in comparison to the transaction size. I think economists call it ‘framing.’

My point is that the major money events in your life are the best opportunities to truly save money. Not buying a four dollar cup of coffee.

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I’m happy to report my wife gave birth to a healthy boy this morning.  Mom, baby, and big sister are all doing great.

I’d like to add some smart-ass comment, but frankly, I’m beat.

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Today I’m attending to some very important business, so I’m proud to present this guest post from I’ve Paid For This Twice Already. Paidtwice blogs about her family’s journey to finally pay for all that stuff they bought and become debt-free. Check out her site or subscribe to her RSS feed. Thanks for covering for me!

–oOo–

You might be in too much debt.

I love Jeff Foxworthy’s “You Might be a Redneck” jokes. Lately I’ve been thinking up my own version where the punchline is “You might be in too much debt”. But they’re all about me. All about who I used to be back when I was playing this credit-juggling game with myself and trying to keep all the balls in the air and holding my breath for that inevitable crash.

If the cable goes out and your first thought is if you paid the bill yet….

If you get excited when your credit card sends convenience checks and your first thought is paying the other credit card with them….

If you postdate a check “accidentally” and hope that means they can’t cash it until next week…

You might be in too much debt.

I used to play the 3 am game with myself a lot. I’d wake up in the middle of the night and I couldn’t go back to sleep until I had thought out in my head every bill due and which ones had to be paid on time and which ones didn’t seem to care if it was a few days late and what order I could pay them in so nothing would bounce and I could pay the least amount of fees possible. Utility companies don’t seem to care if they get their money late, as long as it isn’t too late, the cable company doesn’t seem to notice if their due date is the 6th but you call them on the 9th, but pay a credit card 15 seconds late and you could end up with a mountain of fees and a jacked up interest rate. I spent a lot of time and energy keeping my credit card companies happy at all costs.

But one day I finally realized - this was no way to live. There had to be a better way than waking up in a panic in the middle of the night over and over wondering which bill you could put off until after payday and if you were going to have to find a convenience check from one credit card to pay the other and how close the first credit card was to its limit.

Luckily I didn’t have to crash to realize that there had to be a better way to live than this. It took a major mental meltdown on my part at the all the energy and stress it took to keep juggling those balls, but no huge catastrophe initiated me putting away the credit cards, holding my breath and focusing on paying my way out of trouble, whatever it took. I’m one of the lucky ones. I’m not completely there yet, we’re still living paycheck to paycheck, and we’re still in debt. But I’m not juggling which bills get paid on time this month (although I still have to sort them by due date), and when I wake up in the middle of the night it is because my 3 year old has decided to invade my bedroom instead of staying in his own. And the credit card debt is slowly but surely disappearing.

But I still might be in too much debt. I just have to take things day by day and keep hoping I didn’t start too late. But the juggling act becomes simpler by the day as the balls move slower and weigh less.

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