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The
Financial Professional's Guide to Before
beginning, please read the following instructions:
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New Tax Legislation |
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The Economic Growth and Tax Relief Reconciliation Act of 2001 brought significant tax reductions for most taxpayers. However, many of those reductions are phased in over a number of years. In addition, the new law is subject to a “sunset” provision that, without further Congressional action by December 31, 2010, would cause any changes to expire after 2010. Note the following changes that are integrated in this course to the extent they are currently applicable.
Federal Estate and Generation Skipping Transfer (GST) Tax In 2010, the federal estate tax and GST tax will be repealed. In the meantime, both will have phased-in reductions. The maximum tax rate will be reduced to 50% in 2002 and phased down to 45% in 2009, the last year before the tax is repealed. The estate tax exclusion amount (aka unified credit) will increase to $1 million in 2002, $1.5 million in 2004, $2 million in 2006 and $3.5 million in 2009. Beginning in 2002, the credit for state death taxes will be phased out. In 2005 the credit will be completely phased out and replaced with a deduction for the amount of state death taxes actually paid. Effective in 2004, the exclusion for qualified family owned business interests will be repealed. Federal
Gift Tax Beginning in 2002, the gift tax exclusion (aka unified credit) will increase to $1 million and remain until 2010, and then it will be annually adjusted for inflation. Beginning in 2002, the maximum gift tax rate will be reduced to 50% and phased down to 35% in 2010, where it will remain the same and not be repealed.
Cost Basis of Inherited Assets Beginning with the repeal of the estate tax in 2010, inherited assets will no longer receive an automatic stepped-up basis. Instead, the basis will be the lower of (1) the decedent’s adjusted basis or (2) the asset’s fair market value on the date of death. In addition, up to $1.3 million in additional basis can be allocated to certain assets going to non-spouses and $3 million to spouses.
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This study on Personal Finance delves into the very heart of financial problems that exist in homes today and addresses everyday issues, questions, application of simple finance and principles. Even though the emphasis of this study is focused on the individual and family, the financial advisor can certainly apply the content of this study in a business setting. Of the many reasons that one can enumerate as a cause in disrupting the delicate functioning of the home or business, financial problems are at the very core. Because
of expanding areas of expertise and public perception, financial
advisors are becoming more available in areas not considered before. The
typical financial advisor of ten years ago is not so typical today.
Attorneys have experienced growing demands to address issues
historically outside their realm of knowledge. Today, many attorneys are
Certified Public Accountants (CPAs) and Certified Financial Planner®s
(CFP®s)
for the sole purpose of meeting their clients' expanding needs. CPAs are
no longer just number crunchers and tax preparers. The scope of a CPAs
practice has broadened such that the public views them as financial
advisors as well. Many in need of a financial advisor seek out the CPA,
CFP® or Attorney advisor because he is more trained, experienced and
educated to handle one’s financial affairs. In any text, issues of reference to gender must be appropriately dealt with. In this study, all references to gender will use the masculine, however, the meaning will be generic. Financial problems, difficulties and any associated inferences will be referred to as financial bondage. It only stands to reason that an individual is either free from a thing or slave to a thing. Financial freedom and financial bondage seem to define these extremes the most accurately. The
context of this study begins with a financial overview and addresses the
basics of financial management. Initially, the financial advisor must be
able to understand and empathize with the client’s situation and
decision-making processes. Also, as an integral part of the basics,
one’s expectations and living standards must be contrasted with
financial reality. Financial
bondage does not “just” appear. It is usually the result of years of
wrong decision-making and choices. Red flags and sirens are indicators,
sometimes insignificant, that point out potential problem areas. One
must be proactive in looking for and heeding these warnings. If not, one
may plunge headlong into financial bondage. By reflecting upon past experiences and using common sense, one can come up with many do’s and don’ts for financial management. Even though experience is one of life’s best teachers, one may find many resources (e.g., bookstores, publications, CPAs, CFP®s, attorneys, Internet, etc.) that can help enumerate and establish some do’s and don’ts in one’s personal planning. Unfortunately, many individuals and businesses continually overlook these principles either because of their own ignorance or stubbornness. Either way, the ending results are still the same – financial bondage. This study highlights many techniques that should become a normal function of one’s daily financial management and decision-making. The financial advisor should incorporate these simple principles as a normal function of his ongoing professional and advisory services. Budgeting
is the basis for: correcting any financial difficulty, heading off
potential problems, or strategizing a plan for financial freedom.
Unfortunately, many individuals and businesses underutilize this
valuable technique, but yet all successful corporations include
budgeting as a normal part of any planning. Since they do, shouldn’t
your clients? Even
though The Terminator was a
futuristic film and full of hoopla, you can assist your clients in being
the Terminator of their financial bondage by using the Ways and Means to Terminate Financial Bondage mentioned in this
study. Instead of “I’ll be back,” they’ll be able to say,
“I’ll never be back...down that road again!” A
debt-free individual or business is a modern rarity, not because of
inability or impossibility, but because of choice. Making the right
financial choices separates those in financial bondage from those
experiencing financial freedom. Debt-freedom is not only attainable but
also liberating and rewarding. This study will reveal some principles
and guidelines on the best perspective on debt and how to keep your
clients from becoming a slave to the lender. Up to this point, a foundation of understanding personal finance and everyday application has been given. Next, one may proceed with the more dynamic processes of personal finance such as investing, retirement and estate planning. Financial goal setting is the last critical step that is frequently overlooked. Goal setting is done within the context of one’s financial capacity. It addresses time constraints, realistic vs. unrealistic goals and steps to financial freedom. Many believe that goal setting is a useless endeavor. It’s not! Its purpose is to make one cognizant of and plan the disposal of acquired and to be acquired assets. Every individual has been appointed the task of steward, to use acquired assets in a wise, philanthropic, or profitable manner, a responsibility not to be taken lightly.
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I heard a story awhile back about one of football’s great coaches. After his team had lost an assured win, this coach called the whole team back to the playing field and instructed the players to sit down. “Boys, we’ve got to get back to the basics!” With an outstretched arm, football in hand, “This is a football,” he declared. “This is the instrument of our glorious victories and crushing defeats. Many a cow has gone on to greener pastures to provide us the opportunity to bust heads and feel good about it. The aerodynamics of this ball is such that....” After a long oration on football basics, the team became entrenched in the fundamentals of what wins games. Now I don’t know if this story is true or not, but it sure sounds good. As a matter of fact it has some solid applications, not only with the topic of finance, but with most things that one may get involved in. It especially reminds me of children. You know how children are - information sponges - asking questions about every conceivable thing on the face of the earth. To parents, the questions are so ridiculous it takes some serious thought to give an explanation in such a way that the child can understand. When children see something for the first time, they may not understand it but they accept it. In order for children to understand a simple concept, a simple answer is crucial - the basics. In order for one to overcome financial bondage and secure financial freedom, he may have to get back to the basics. I often hear a comment such as, “You just don't get it do you?” Well, I think this may be what many financial advisors want to relate to those clients who can never seem to overcome their difficulties. As
financial advisors service the needs of those in the private and public
sector, it becomes apparent that the client may have inherited a short
memory span. When things are going good, clients have a tendency to grow
independent of prior constraints and forget the diligence they went
through to secure their success. It is the task of the financial advisor
to keep his client on track, to provide that financial roadmap that has
since faded into a distant memory, and to help the client secure those
goals in which he is striving toward. Many
individuals attempt to get ahead by circumventing traditional methods of
making money – hard work and making the right decisions. One of the
most popular ways is the state lottery. It’s a statistical fact that
the majority of those who play the lottery are those who can’t afford
to - the poor. In case you are a statistics guru, or you just want to
satisfy your curiosity, what are the odds of winning a lottery, say six
out of fifty? How about 1 out of 15,890,700. Statistical Combination formula: What
about those who live in a state where the chance of winning is much
better, say, six out of forty-two. The odds of winning are still 1 out
of 5,245,786. Why in the world would someone in financial bondage throw
money away? The reasons are numerous but not so “earth shattering”
that time and proper financial advice could not overcome. Nonetheless,
adherence to sound financial principles does not guarantee that there
will be no financial problems. It does guarantee, however, that one will
have the proper tools and techniques to deal with the problem in an
appropriate and efficient manner! This study takes financial principles and applies them to the basics of money management. The topics will be presented in such a simplified manner that the financial advisor can relate them in a way that can be understood by the novice. It’s been said that ninety-five percent of financial advisors in the U.S. seek out the top five percent of income earners. Well, if that statement is correct, that leaves ninety-five percent of the population available for those who are not so picky. Of that remainder, most fall within the unsophisticated arena as defined by NASD guidelines. Many of these potential clients feel as though they cannot afford a financial advisor, don’t need a financial advisor, and certainly can’t understand the lingo enough to carry on an intelligent conversation. As a financial advisor, you know all of these perceptions are false. One of the tasks of the financial advisor is to relate financial planning concepts, ideas and strategies in such a way that the client will not only understand but will be able to intelligently participate in his own planning process. Prior to consulting a financial advisor, the client has probably been relying upon past experiences, other non-professionals, personal training and education or even neighbors. The client’s historical financial track record will give the financial advisor some insight into his thinking and reasoning. Relying upon one’s own understanding can lead to financial problems or compound the ones that already exist. The financial advisor, in addition to giving proper financial advice, may have to first deal with a client’s misconceptions, incorrect reasoning and thought processes. In
helping the client to recognize, deal with and overcome his past
financial mistakes, the financial advisor should recommend the client
take a hard look at his financial track record and enumerate the
decisions that has brought him to his current financial status, good or
bad. This is not to get the client to relive his mistakes, but to allow
the advisor to place himself in the client’s shoes thus enabling him
to redirect and properly counsel the client. Spending habits are
developed over many years and can only be properly dealt with when the
advisor understands the client. Sometimes the financial advisor has to be the bearer of bad news. Many people are pursuing goals and attempting financial feats that are impossible with the resources they have available. Some clients live beyond their means and the day of reckoning is knocking at their door. It is the task of the financial advisor to bring reality to the table. “You can’t have your cake and eat it too,” may have to be the first words out of the advisor’s mouth. Financial constraints limit one’s abilities and the tradeoffs have to be enumerated and choices have to be made. It’s a tough job, but somebody has to do it!
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Chapter 2: Red Flags and Sirens When
my family and I lived in Wichita Falls, Texas, better known as Tornado
Alley, we became accustomed to the city’s early warning system. At
noontime the first Monday of every month, sirens throughout the area
would blast your socks off and make your hair stand straight up. As with
anything mechanical or electronic, the only way to keep such a warning
system effective and in good working order is to test it periodically. At
other times when the sirens blasted, a cold chill would run down my
spine because I knew a potential disaster was lurking somewhere.
Although we took immediate precautions, we were also fortunate enough to
never be in a tornado’s path. One’s survival depended upon heeding
the warnings and taking immediate, appropriate action. In
the same way, there are many warnings of pending financial bondage.
These warnings, or red flags
and sirens, are often overlooked until one is in the middle of the path
of destruction, coming in like a freight train. The aftereffects are:
dodging creditors, ruined credit, repossession, bankruptcy and stress
that can squeeze the financial lifeblood out of a family. It’s not a
pretty picture and it’s happening to more people than one may think. Following
is a sampling of some of the most common red flags. When a red flag
occurs, one may not realize the severity of the problem and not perceive
any danger. This apathetic perception, in and of itself, is a red flag.
Most people get into financial bondage not because of big, dramatic
occurrences, but because of minute occurrences happening over a period
of years. ¨
One of the first indicators of creeping financial bondage is the inability
to payoff a new credit charge when the bill hits the mailbox or the inability
to maintain a zero balance. Exactly what does “inability” refer to?
It refers to the lack of financial resources needed to immediately pay
the debt. If one lacks the financial resources to pay off a debt, then
the debt should not be incurred. For example, if one has a savings
account greater than or equal to the debt, then there would be
sufficient financial resources to pay off the new debt. However, the
savings may be earmarked for something else. Does this matter?
Definitely! Since part or all of the savings may already be earmarked,
one may have to make a downward adjustment in available resources;
therefore, the savings may be insufficient. What about other financial
resources such as IRAs or retirement plans? Well, these can have a high
cost to liquidate and the trade-offs are usually not worth it.
Typically, one should only consider easily accessible resources, such as
savings, certificates of deposit and insurance cash values. Remember,
the issue is ability versus inability (or) available
financial resources versus the lack of financial resources.
Chances are that none of the available financial resources would
be used to pay off the debt, but rather could be used in a worse
case scenario or if one decided to be debt-free. In addition to lacking the financial resources to pay off a debt, one may be carried away by an inability to control spending. Nevertheless, this red flag first begins with a need, supposedly, and no readily available cash to satisfy the need; therefore, credit is used. After awhile the small credit payment causes little financial pain and it becomes a normal part of the budget. A few months down the road, one has become completely accustomed to the payment and now it’s time to repeat the process again, and again, and again. The payment gets a little bigger every time. This process is called “credit creep” and it is now out of control. One becomes more accustomed to using a credit card than writing a check. The paycheck is ultimately stretched like a balloon just before it pops. Ultimately, if one loses total control, all subsequent “need” purchases (clothing, gas, utilities, food, etc.) may have to be on credit, thereby perpetuating the cycle. A growing mountain of debt becomes a financial black hole with all roads leading to the aftereffects previously mentioned. ¨ Another red flag is the lack of prompt payment of bills. Some people pay bills at specific times (e.g., once a week) just for the sake of time efficiency. Others pay bills to coordinate with a paycheck or other income. What is considered prompt? I believe there are two “acids tests” one could perform. The first acid test is paying a bill by the due date. If one cannot do this, then financial bondage is probably the reason. The second acid test, and most important, is the ability to write a check for the bill when the mailman drops it off. Anything other than this falls into the “juggling” category, which is reserved for those in financial bondage. Living
from paycheck to paycheck and juggling bills is no fun. One soon becomes
weary and lacks the motivation to break out of bondage. This course
discusses many simple solutions to overcome common financial problems. ¨
If one has many outstanding
sources of credit, financial bondage is probably the problem or is just
around the corner. A consolidation in these instances is usually not a
solution; it only postpones the inevitable and treats the effect, not the cause. The usual reason for having many outstanding credit sources is that one lacks financial capacity (FC) - the ability to carry debt. Creditors base the amount of a loan on one’s financial capacity to pay back. Millionaires have tremendous FC. They can borrow lots of money because they have the financial resources to pay back. The poor do not have any FC. If one is poor, there are no financial resources to pay back a debt. Those
that have sufficient FC don’t have many outstanding credit sources
because each source has adequate limits to satisfy credit needs. Many
times, those that have “minimal” FC lack sufficient income to
support their standard of living; therefore, credit is used to make up
the difference. Since FC is minimal, each credit source has minimal
limits as well. Have you ever known of someone who fills out every
credit application that comes in the mail? I have known and counseled
many. Many years ago I met a young lady who had acquired over forty
credit cards and her debt was over $20,000, which was considered a lot
back then. She was living on the local military base, had very little
living expenses and the minimum credit card payments were infringing
upon her food budget. For many, there is a compulsion to have more
credit. It serves as a mental safety net and becomes the basis for one's
financial security. ¨
When one has a reversal in financial priorities, then financial
bondage may be the reason. Financial bondage causes one to reevaluate
priorities. “What bills do we pay and which ones do we skip?”
Payments go to the bills that are a must and the optional ones get
bypassed. This red flag to financial
bondage never leads the way; it is always preceded by another red flag. ¨ Without adequate cash reserves,
financial bondage is inevitable. It is foolish for one to think that
there will never be an expense greater than the paycheck can handle.
These so-called budget-busting expenses are unpredictable and happen when one least expects it.
In addition, most people always think in terms of the paycheck. What if,
all of a sudden, there was not a paycheck? Developing a cash reserve is one of the first steps in getting out of debt and defeating financial bondage. Without cash reserves, all budget busting expenses must be financed (debt), causing credit creep. ¨ A systematic savings plan goes hand in hand with the need for an adequate cash reserve. Without a systematic way of saving, cash reserves will always be depleted and forever insufficient. To many, saving is a paradox: there is insufficient money to pay bills, much less save. Allow me to put this misconception to rest. Let’s say the refrigerator bites the dust, there are no cash reserves and the budget already squeaks. What does one do? Most will go to Sears, or another appliance center, and buy another refrigerator on credit. Thirty dollars per month gets added to the budget and the family adjusts. The wise individual realizes these things are inevitable and makes the commitment/sacrifice to start saving now. This reality has hit home numerous times for many families. They have become graduates of the School of Hard Knocks. Apparently, many had failing grades because history has shown that they have gone through the school numerous times. All the while, they knowingly disregarded setting aside dollars for the financial unpredictables that they would one day face, and paid the price every time. There are some financial advisors who recommend taking all surplus, if any, and pay toward debt. This technique will get one out of debt the quickest; it will also get one back into debt the quickest. It is more important to establish a systematic savings plan first, then use surplus to pay off debt. The reason - one must establish the right habits first before past mistakes can be properly dealt with. ¨ Certain insurances are just as
important as cash reserves. Without either, one is setting up himself
and his family for financial bondage. There are only two legitimate
reasons why needed insurance coverage would be insufficient:
uninsurability or unaffordability. Because of certain medical
conditions, many people are uninsurable. In
financial planning, money is spent for two basic categories: dollars
for the present (DP) and dollars
for the future (DF). DP is for the basic necessities of life (e.g.,
housing, food, clothing, etc.), cash reserves and insurance. When any of
these is insufficient, there is always the possibility of financial
bondage. DF are those monies spent for some future purpose (e.g.,
education fund, pension and retirement plans, vacation home, etc.). DF
should always play second fiddle to DP. In other words, items under the
DP category should be sufficiently provided for before spending
significant monies toward DF. Another way of looking at it is, “Don't
put the cart before the horse.” Sometime ago, a couple in their early
60s went to visit a financial advisor for some pre-retirement
counseling. Through many years of diligence, they had accumulated a
sizable retirement nest egg (DF). Unfortunately, they had been without
health insurance (DP) for the past several years because they thought it
was too expensive. Even though they could afford health insurance,
planning for retirement received top priority. The husband had a heart
attack a few months prior to the visit and the resulting medical bill
was around $80,000. Now, he is uninsurable and the anticipated golden
years won’t be so golden. It
is unlikely that everyone can afford every financial planning necessity.
There have been times in every family’s past when they may have lacked
cash reserves, life insurance, health insurance, car insurance and
others. It was probably during those times when they were going through
some major financial transitions and the money just wasn’t there. Many
are fortunate and eventually rise above their financial woes and suffer
no consequences while others do not. ¨ There are many families where both
spouses must work. The key
word is “must.” Dual income families don’t happen overnight and
have become the norm and not the exception. They are the result of many
years of poor planning, financial incompetence or lifestyle choices.
Because of this trend, traditional households are slowly becoming a
thing of the past. More and more women have to work outside the home,
not because they want to, but to help pay bills. On the other side of
the coin, many families have both spouses working because they want to
and circumstances allow them to. This trend has had the most impact on
families with dependent children. Statistics continue to reflect the
importance of parental presence at home. Recently, a radio program was
discussing issues such as teenage sex, drug and alcohol abuse, etc.
According to the commentator, the majority of instances occurred within
the confines of the home. There
is also a less noticeable causal factor of this red flag. As technology
moves forward at a breakneck pace, many are finding their skills and/or
education obsolete. The academic world calls this process the churn. If not heeded, a result of the churn is that one’s income
slowly becomes insufficient with the ultimate result being unemployment.
Many disregard the warning and keep on doing the “same ole stuff.”
Then, at a time when one should be thinking about retirement, he finds
himself back in school or training for another career. In addition, the
breadwinner and/or the spouse may have to obtain additional employment.
Either way, it does not lessen the impact of pending financial bondage
and the need for counseling and dramatic financial changes. ¨ Some individuals suffer from compulsive buying. True compulsive buyers may need counseling for an addiction as well as financial counseling. Nevertheless, openness and honesty about the problem can lead to treatment and recovery. In
summary, this listing of red flags and sirens is certainly not an
all-inclusive list. Since this course only covers basic financial
issues, the previous situations relate to the simple, common and daily
issues financial advisors deal with. Obviously, as the planning scenario
becomes more sophisticated and complex, so do the problems. Red flags and sirens are the primary warnings of pending financial bondage. One must be aware of them and heed the warnings. They are also the less painful to deal with and the easiest to overcome. If not, the secondary warnings come into play whereby control is lost and financial bondage becomes a reality. Secondary warnings are: IRS notices, creditor calls, collection letters, etc. At this point, if one is unable to resolve the crisis, then the third warning takes place which is really not a warning but rather, “Three strikes, you’re out!” The results are lawsuits, garnishments and bankruptcy.
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Chapter 3: Do's and Don'ts of Financial Management This section is for those wanting to get out of and stay out of debt and/or retake control of their finances. It also includes various pitfalls on the road to financial freedom. Some of the topics are extreme in comparison to the norm of typical financial planning. However, for one wanting to be financially free, extreme measures may be just what are needed! There are an abundance of financial mistakes that people make because of ignorance and pay the price for it. The learning curve for proper financial management can be long and painful. Libraries are full of books that offer direct and indirect precepts for managing money, and financial professionals are just a phone call away. Nonetheless, the public seems to be oblivious to taking advantage of these resources in their effort to achieve financial success and freedom. The following discussion does not cover every contingency, but it does address many of those situations that individuals are oftentimes faced with. ¨ Do not co-sign for anyone, unless you are willing and financially able to pay the note. In the Bible, there are many passages in the book of Proverbs that warn about the pitfalls of becoming a surety. You may know someone who can personally attest to the dangers of being a surety. Problems can exist in all surety relationships. For example, in the business world, certain people can unknowingly become a surety for business debts because of their positions; therefore, they must be aware of contractual and assumptive obligations. Intra-family relationships, for purposes of this discussion, are between parents and children. Another accepted “job” of parenting is to help get the kids financially established. The old cliché “it takes credit to get credit” is just as true today as when you first became an adult. In order to help children get established, many parents do co-sign, all the while knowing the potential consequences. Sometimes the debt does revert back to the parent. Initially, there is disappointment along with a few other unmentionable emotions, but the relationship usually survives. Other than intra-family relationships, all co-signing arrangements should be taboo or at least looked at long and hard before one makes the commitment. If the borrower defaults, then creditors will always pursue the one with the best ability to pay - the co-signer. Many friendships, personal and business, have been destroyed because of co-signing arrangements. Here’s a thought for one to ponder if someone asks you to be a cosigner, “If the professional lenders are not willing to lend the money without a cosigner, maybe that’s a good sign for me not to.” ¨ Do not over-finance a depreciating asset; that is, fair market value must always equal or exceed outstanding debt. A depreciating asset is one that loses value over time; e.g., vehicles, boats, etc. It is not that unusual for the fair market value of an asset to decline faster than the outstanding debt. In the area of financing, a general rule of thumb is that if adverse financial conditions forced one to dispose of an asset, would the fair market value received pay off the debt owed? If not, one would be subjecting himself to financial bondage. This scenario would leave an outstanding debt and no asset! To overcome this predicament, one should always be in a position to pay down the balance to ensure that the fair market value is equal to or greater than the outstanding debt. Those who typically find themselves in this predicament are those families with two incomes and spending every penny. The family may have a new car for both spouses, a home, a boat and outstanding balances on one or more credit cards. Somewhere along the way, one of the spouses either loses a job, has a transfer, has a job relocation uprooting the whole family, or something else takes place that disrupts the delicate financial structure of the home. Things become tight and financed assets must go or get repossessed. Just because an asset (car, boat, etc.) costs lots of money doesn’t mean one automatically goes to the bank and gets a loan. If one does, fair market value must always equal or exceed debt or undesignated cash reserves must be sufficient to makeup the difference. This goes against the norm for most financial planning techniques and may be considered extreme, but an ounce of prevention can go a long way. ¨ Do not purchase anything on credit unless funds are available to pay off the bill. Otherwise, uncontrollable “credit creep” may take place. Remember, “credit creep” is the systematic process of increasing debt service. In other words, every time a credit card is used, monthly payments get bigger, each time bringing financial bondage closer to reality. ¨ Do not use credit until one first establishes a regular systematic savings program. In order to be successfully weaned from credit and financial bondage, this is a must. ¨ Do not pay current living expenses on credit. If this ever happens, financial bondage already exists. The only solution is for one to seek professional counsel and NOT to try and handle it himself. Obviously, the problem has gotten bigger than the individual and is out of control. ¨ Do not retire with debt. Retirement and debt make bad companions. Retirees do not have the luxury of earning additional income to make up for wrong financial decisions. Also, health and life expectancy are at the peak of unpredictability; therefore, retirees should not be financially obligated to anyone. If one is in the pre-retirement stage, make “zero debt at retirement” a top priority. If one is already retired and has debt, close all accounts to new purchases and cut up any credit cards. At this point, something needs to be clarified. If a person has debt, it means there is an outstanding balance that carries over from one month to the next. If one pays off a credit card balance every billing cycle, this is not carrying debt. The issue at hand is one’s financial ability to stay out of debt. If it can’t be done, one should not use debt/credit! ¨ Do not borrow to pay taxes. Borrowing to overcome any financial difficulty usually treats the cause and not the effect. If one is caught in arrears with any taxing authority, the only solution is to seek professional help. To elaborate any more would go beyond the scope of this course. ¨ Do not subject one’s self to any sales presentation (e.g., time share) without a prior discussion with the spouse and a preliminary decision made beforehand - and stick with it. How many times have individuals gone to a sales presentation to receive that special gift, and they got ‘em hook, line and sinker? We all know the pitch, “If you don’t buy today, the offer terminates,” or “If you don’t buy today, the price will be higher tomorrow.” One should never, never, never buy anything on impulse or under pressure. ¨ Do attempt to maximize take-home pay. All financial planning, budgeting and cash flow management evolves around the paycheck and income. Since the primary source of one’s income is the paycheck it only makes sense, in order to get the most benefit, one must maximize take-home pay. Those who are in or about to be in financial bondage should heed the following suggestions. First, one must temporarily stop all nonessential deductions; e.g., retirement, United Way, health club, etc. Second, ask for a pay raise and additional hours. Hey, it doesn’t hurt to ask. There is a fifty percent probability one will get the right answer. Third, work with the payroll clerk to minimize federal income tax (FIT) withholding. Minimizing FIT withholding attempts to equal, or surpass as little as possible, the amount of tax owed after filing each year’s tax return. For example, if one gets paid twice a month (24 paychecks per year), and has a tax refund of $2400, then $100 in FIT is overpaid every paycheck. $100 each pay period can make or break many budgets. Remember, all planning evolves around the paycheck. The only exceptions are the wealthy, those with large inheritances or those who win a lottery. The rest of us must take a little from each paycheck to pay for bills, vacations, retirement and other future events. In order to minimize FIT withholding, one needs to do a little homework and have a working knowledge of taxes and tax returns. Also, if one doesn’t have the patience, understanding or inclination to do this, then it may be an effort in futility. A projected tax liability can be prorated to a per paycheck basis. One can pass this information along to the payroll clerk to help submit the proper form w-4 and/or specific FIT withholding. An obstinate payroll clerk can make this a miserable task so be very nice. In January, Mr. Taxwise called his CPA to get this year’s tax schedule and other tax information. He did a preliminary tax return and found that he should owe approximately $5,760 for the current year. Since he receives two paychecks every month, the FIT withholding per paycheck should be around $240. He completed another w-4 to adjust the FIT withholding for each paycheck. According to the employer’s withholding schedule, the closest amounts were $225 and $250. Mr. Taxwise picked the higher amount to secure a buffer and not underpay. ¨ Do operate from a checking account or use the envelope method, especially if finances are tight. Without either, control is lost and spending cannot be traced. In order for one to keep track of finances, there has to be some sort of tracking system - operating on cash is not it. A checking account provides not only a record of expenses and deposits, but it should also be used for cash withdrawals. Cash is perceived as mad/play money and serves no specific budgeting purpose. Many times it is the spending of mad/play money that leads to financial crisis. During times of financial crisis, all cash may have to go for necessities only and the checkbook register serves as the control mechanism. If a spouse is in the habit of taking out cash before a deposit is made, control is partially lost. The
envelope method is second best and, of course, more burdensome. Every
monthly bill is identified by its separate envelope and placed in order
of priority. Each bill is paid when the cash in each envelope matches
the amount needed. Some people do not have checking accounts and must
use cash. The reasons vary, but the most common is because they don’t
want anyone to supposedly have access to their money, or there is a
history of bounced checks. Banks participate with other information
reporting agencies and will not issue checking privileges for bad check
writers. Unless the last situation exists, a checking account should
always be used. It is the safest, most prudent and easiest to use. ¨ Do debt swaps to mitigate interest charges. Let’s say one has an outstanding credit card balance of $1,000 and the rate is 18.9% per year. Another bank offers 14% for balance transfers. Should you or should you not make a transfer? First, call the old company and tell them what you are doing and give them the opportunity to match the deal. If they are unwilling to renegotiate, make the transfer - this is called a debt swap. DEBT #1 Balance:................ $1,000 It takes 158 months to pay off and costs $680.93 in interest. DEBT #2
Balance:................ $1,000 It takes 108 months to pay off and costs $460.60 in interest. If one pays only the minimum, it will take thirteen years and two months to pay off Debt #1 versus nine years for Debt #2 along with a savings of $220.33. Remember, the purpose is to lower credit charges, not obtain additional credit. In reference to the new account, beware of the introductory rate. It may be low at first, but onerous once the introductory period has expired. In addition, the new company may figure minimum payments differently. For instance, ABC Credit Company (old account) may require a payment of 2% of the outstanding balance while XYZ Credit Company (new account) requires 3%, a fifty percent increase. The budget may be unable to handle a fifty percent increase in payments. This will not be a problem for small balances, but could be a real struggle for large balances. ¨ Do shop around for interest rates, moving interest bearing assets to higher yielding options. This is really a given but some don’t carry it far enough. Investors are well versed in this area but savers typically are not, mainly due to the various types of short-term vehicles that fall under the savings category; e.g., certificates of deposit, NOW accounts, savings accounts, life insurance, treasury bills (t-bills) and tax-deferred annuities (TDAs). Even though most financial advisors consider TDAs long-term investments, many consumers perceive them as a type of savings. When shopping for interest rates, banks are not the only source. Many other financial institutions (savings banks, savings & loan, credit unions and brokerage firms) offer many of the same products and services that commercial banks do. They also have differences, for example, credit unions are not-for-profit but commercial banks are for-profit. If a credit union does not have a profit motive, it only makes sense that interest rates should be higher. Stockbrokers can sell certificates of deposit and treasury bills while insurance agents sell TDAs. Some professional advisors are licensed to do both. Since there are several choices from which to choose, one would need to have a good idea of the pros and cons of each type of savings vehicle as well as the objective being sought. A real asset is for one to be aware of the current trend in interest rates. Short-term rates (maturities of one year or less) move up and down frequently and are determined by the actions of the Federal Reserve Board (Fed). A quick look at the financial section of the Wall Street Journal or listening to CNN would give one some insight. Savings vehicles with the shortest maturities (e.g., 90 days) would probably be advisable if short-term rates are moving upward. If interest rates are moving downward, then the longest short-term maturities would fare better; e.g., one year. On the other side of the coin are long-term rates (maturities longer than one year). These would include term CDs, TDAs, treasury notes and bonds. (There are other interest sensitive investments, but a discussion of them would go beyond the scope of this course.) The previous rule for investing in short-term applies to long-term as well. For example, if long-term interest rates are moving upward, then a two year treasury note may be preferred; if rates were moving downward, a ten year treasury bond would fare better. The key issue on shopping for interest rates is to take advantage of not only what’s the best rate today, but also the best rate in the near future. If interest rates are moving upward, one does not want to be locked into a rate that will soon be considered low. Maturities should be kept at a minimum until such time it appears that interest rates have peaked - then lock into longer-term maturities. This will allow one to lock into a high rate while riding out the downward trend. There is no way one will be able to determine when an interest rate trend has peaked or bottomed out. But, what can be done is to get the impressions of the professionals. They won’t be able to hit it right either, but they have a much better feel for things. Listen to what they say, add that to your own impressions and you will have some insight as to a proper decision. ¨ Do coordinate insurance deductibles and coinsurance with cash reserves. If one had an insurance claim, the deductible and coinsurance would be the amount the insured (you) would be liable for. Deductibles are listed as a dollar value and coinsurance as a percentage. A low deductible means high premiums; a high deductible means low premiums. A low coinsurance percentage means high premiums; a high coinsurance percentage means low premiums. Most people have low deductibles and coinsurance because they can’t afford to pay a substantial amount for a claim. Here’s an example of a typical health insurance policy: $500 deductible with 80/20 coinsurance up to $5,000. Interpreted in English, this means there is a $500 deductible. The insured pays this before the insurance company gets involved. Afterwards, the insurance company will pay 80% of the next $5,000 and the insured will pay 20%. For a medical bill of $5,500, the insurance company will pay a total of $4,000 and the insured will pay $1,500. The insurance company will pay all covered expenses over $5,500. In any insurance arrangement, there is a cost-sharing relationship. The cost (insurance claim) that an insurance company assumes is considered a financial risk. In order for the company to assume that risk, they charge a fee - the insurance premium. As one’s cash reserves grow, deductibles and coinsurance should be increased, thereby reducing premiums. Afterwards, one should automatically increase the systematic savings, penny for penny, by the amount of premium reduction. This cycle continues to minimize premiums and maximize cash reserves. ¨ Do shop around for insurance rates and compare various types of coverage. No one company has the best rates for all types of insurance. Typically, a company specializes in one area of insurance and will offer other products for the one stop shopper. The more familiar one is with insurance, the more educated questions one can ask to secure the right coverage at the lowest cost. Many insurance products have additional bells and whistles attached. These usually serve more as additional commission and premium than meeting a viable and probable need.
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Budgeting is a control mechanism, nothing more, nothing less, to: turn financial chaos into financial order, track cash flows, help bring about financial adjustments, find one’s Ps and Qs, make sure cash inflows exceed cash outflows, etc. Since budgeting is such a large part of financial management, many of the things discussed in this chapter will be repeated throughout the course. There are basically two types of budgets that one may deal with. The first, a formal budget, will be discussed in this chapter and is created for those whose finances have gotten out of control. It is not, however, used as a means to restrict spending or surrender the checkbook. Many times when financial counseling had been sought, the persons involved went to the advisor’s office with a preconceived idea that a major loss was about to occur. Since they waited until the last minute to seek professional help, there was a sense of anticipation and anxiety that they would have to give up something. It’s almost the same scenario as when people prepare themselves for surgery or go to the dentist. Nonetheless, budgeting is not a bad thing! To restate a prior premise, formal budgets are created for the purpose of control; they exist as a documented regimen for helping one control certain out-of-control expenses. The
second, an informal budget, is a familiar item. Everyone has an
informal budget. There is no regimented routine; nothing is
documented; bills are paid when received; it’s the day-to-day
activity of managing one’s money. Any further usage of the word
“budget” will be referring to the “formal budget.” Following
is a list of actions that formulate the budgeting process, the end
result being the budget. Needs
Determination. Since budgeting is only a control mechanism, its
purpose may be comprehensive to include all expenses or it may be
limited to include only one or more expenses that are getting out of
control. For example, one may have a credit card with a large, growing
balance. This is certainly a red
flag and must be dealt with. The purpose of the budget, in this
instance, is narrow in scope and consists of a plan of action to get
uncontrollable credit card use under control. Typically, one’s
financial problems are more extensive and will require a comprehensive
budget. For instance, there’s just not enough money to go around and
the topic of discussion between spouses is how to juggle the bills to
meet the most pressing needs without attracting the attention of
creditors. It
is at this beginning point of the budgeting process where a
determination must be made as to whether or not to seek
professional help and/or legal assistance. Men may have to discard
that macho image, arrogance and pride and admit the problem has gotten
bigger than they can handle. Wives may have to insist on getting
outside help, and by default are usually the ones with the appointed
task of doing the initial legwork. The majority of calls that
financial advisors receive from those families in financial bondage
are from wives. Over the years, it has been the wife who has made the
office visit to seek help. She goes home armed with tools and
techniques to overcome their financial bondage only to be overruled by
her uninformed husband. Financial advisors should make it a practice
to discourage “one” spouse appointments. It should either be both
or none. It’s especially comical to meet with husbands (only) who
say they make all the financial decisions in the home. Those of us
providing professional consulting services know better.
Notwithstanding a spouse’s stubbornness to deal with the problem,
both husband and wife must work together and evaluate the extent of
their financial difficulties. Singles, on the other hand, don’t have
spouses to deal with and therefore are blessed in that respect. Some
professionals will do initial consultations for free to help one
determine the extent of his problem and point him in the right
direction.
Data Requirements. Once the problem has been identified, financial data
will need to be accumulated. The kind of data that one needs is
historical payment information. Fixed expenses such as house or car
payment are easily accounted for because they are always the same.
Variable expenses, on the other hand, differ from month to month.
These need to be averaged, preferably over a twelve-month period. An
average less than twelve months would not be representative of
seasonal expenses. For example, let’s say one heats with gas and
cools with electricity. If the time frame used in determining an
average gas bill was for a six-month period beginning in April and
ending in September, then it would not be truly representative of the
gas bill since primary usage occurs between October and March. The
electric bill would have the same misrepresentation. There are other expenses, such as credit card debt, that have a declining payment every month, assuming no new charges. The most recent payment in this instance is the best representative figure to use. In averaging variable expenses, one needs to be sensible, accurate, perform no shortcuts and only use rounding at the last. There are occasions when one prepares a budget whereby some of the resulting entries end with two zeros (e.g. annual gasoline expense - $1,200). Immediately, one would know that the person did not use historical data, but took a wild guess. Remember, anything worth doing is worth doing right.
Budget OhNozs. Picture the following scenario and see if it rings a bell.
The budget is tight, but the family is making it. Out of the blue,
there is an accident, sickness, or something major breaks or falls
apart; cash reserves are insufficient to handle the problem and one
has to borrow; the additional payment busts the family budget. Typically,
most families are one to two paychecks from financial bondage and any
expense out of the norm hinders any attempt in getting ahead. If it
has happened before, one knows it will happen again. If one has been
fortunate thus far, it doesn’t take a genius to figure out that it
will happen sooner or later. One knows that he is financially
unprepared but can’t do anything about it. It’s inevitable. When
it happens, all one can say is, “OH NO!” To
battle these unpredictable expenses (OhNozs), one must acknowledge
their existence and budget them. To keep track of a family’s
expenses, one should keep and maintain a twelve-month rolling budget.
Additionally, one may have to add new entries for “one time”
expenses that occurred out of nowhere. Once that particular month
rolls around again, an adjusting entry can be made to delete that
“one time” expense. In the meantime, however, that single expense
became a real part of the budgeting process. The fun part is trying to
categorize OhNozs in a way that makes sense. It’s assumed that not every OhNoz can be budgeted, but the vast majority can. There will always be some expenses that could have never been anticipated. For example, one may have to take a hurried plane trip to another state because of a family member’s unforeseen, life-threatening medical condition. On the other hand, most OhNoz occurrences are not so surprising. For example, what if the tires on one’s car are beginning to look like racing slicks. It’s common knowledge that 100,000-mile tires are out of the question. Tire expense is inevitable. Also, the clothes dryer has been making weird sounds for a long time. It finally bites the dust; therefore, it gets a new motor installed. The screeching sound was a good sign that something was about to happen, so one is not hit with an abrupt expense. Here’s one that parents can attest to - when the kiddos get teeth, get prepared for retainers and braces. OhNozs usually give off warnings and significant signs before they raise their ugly little heads. Watch for them and budget accordingly. First,
to budget OhNozs, they need to be categorized. One may choose a one
size fits all category, e.g. Miscellaneous; or one may choose broad
categories, e.g. Medical Miscellaneous, Vehicle Miscellaneous, Home
Miscellaneous, etc. Simplicity may initially dictate only one
Miscellaneous category. This may work best for budgeting beginners. As
one becomes more proficient and wants more detail then broad
categories may suffice. Second,
after one determines which OhNoz accounts need to be created, each
account needs to be funded. This is why these accounts are sometimes
called “allocation accounts.” In order to properly fund an OhNoz
account, one needs to know how much money to fund it with. One may
choose past expense experience along with an “educated guesstimation”
in estimating the amount. Third, once an amount is determined, there are a couple of ways to get the money “into” the account. The easiest way is for those who already have a savings account that is not really earmarked for anything. Just divide the savings into pie pieces and earmark each pie piece toward each OhNoz account. The most common way, however, is through the paycheck. If one allows a complete year to fund an OhNoz account, then a “per paycheck” contribution must be made into each account. When describing this funding technique, clients may quickly remind the financial advisor that the account may never be fully funded because of the probability of an expense occurring. That’s ok! Sometimes the account may be zero. There may be other times when one account is robbed to help another. All of these situations will probably occur. Time will allow one to modify and “tweak” each account in such a way as to get maximum use. Last, using the “envelope” method, checking or savings account can set up each OhNoz account. For example, after careful consideration of past experience, Mr. Wisdom determines that the total of all potential OhNoz occurrences should be $1,040 annually. He takes twenty dollars from each weekly paycheck and deposits it into a 9”x11” manila envelope labeled “Miscellaneous.” When an OhNoz occurs, he simply withdraws the needed funds to pay for it. Mr. Wisdom’s sister, Ms. Wiser, had the same estimation and decided to do the same thing, except through a savings account at her bank. When an OhNoz occurs, she simply transfers the money to her checking account and writes a check for it. She felt that she could earn some interest on the unused portion of the account plus the monthly reports serve as an excellent record keeper.
Budget the Infrequent. Any known, infrequent expense must be budgeted for
in the same way as OhNozs. Many people pay their homeowner’s
insurance and property taxes annually. Others pay car insurance on a
quarterly, semi-annual or annual basis. For example, Tex owns his home
and pays $2,400 every January for taxes and insurance. The first year,
Tex waited until after Christmas to start saving the $2,400. Needless
to say, he almost lost his home by the time he rounded up the money.
Now he sets aside $100 from each of his bimonthly paychecks into a
savings account. When January rolls around, he takes $2,400 out of his
account and pays the taxes and insurance. The account is now zeroed
out and the process starts over again with his first paycheck of the
year. On a side note, let’s expand on this. What if the account had accumulated $120 in interest earnings? Since $120 translates into $5 bimonthly, Tex only needs to contribute $95 per paycheck instead of $100. What
if Mr. Efficient has an infrequent expense, car insurance, which is
paid quarterly? He is usually not financially prepared to write a
substantial check every three months, nor is he willing to put out the
effort to create a separate account designated for car insurance.
Instead, he makes a monthly deduction (allocation) from his checking
account that amounts to one-third of the quarterly expense. When the
bill arrives, he makes one adjusting entry to “add back” those
deductions and writes a check for the bill. The point? There are many
ways to handle OhNozs and Infrequents. Find the ones that are simple
and work for you and your clients.
Savings. Savings is the vehicle by which one becomes weaned from and stays out
of debt. Without savings, debt is inevitable. Savings is also the best
vehicle to place money allocated for Ohnozs and Infrequents. There
are, however, going to be exceptions as mentioned in the prior
discussion. Some expenses may occur with such frequency that one way
could be more burdensome than another. Experience will help determine
the one that works best. Although this money can serve its purpose in
a checking account, envelope or coffee can, one would be better served
by earning interest on the money until it was spent. A
savings account should also be the recipient of the “Buffer.” The
changing employment climate increases the probability of a job change,
layoff, transfer or loss of job, or relocation. Also, there could be a
loss of income due to accident or illness. All of these possibilities
warrant a savings buffer ranging from three months (lower limit) to
six months (upper limit) of expenses.
This does not mean income, optional items or savings – it means
expenses only - the bare necessities. The
Buffer is to take up the financial slack during times of transition.
There are many people who want to exchange employment for
self-employment but can’t afford to. Cash flow is lean during the
start-up period and a strong buffer or financial backing is a must.
There have been others who wanted to relocate and get a new start with
a new company but lacked the financial backing. There are those who
live in gang and drug infested neighborhoods and desperately want to
move but can't afford to; they have become victims of their
environment. The best-laid plans are distant thoughts unless
companioned with sufficient funding. If
the Buffer ever exceeds the upper limit, one should periodically take
the surplus and reinvest in a longer term or higher yielding
investment. The Smith family has been building up their savings buffer
for a long time. Currently, if Mr. Smith lost his job, the family
would need $2,000 a month just to make ends meet. Their buffer is
greater than the lower limit ($6,000) and is approaching the upper
limit ($12,000). The Smith’s financial advisor recommended that they
not alter their systematic savings commitment when and if the savings
surpassed the upper limit. His reason: good financial habits are hard
to start up again once they have stopped plus circumstances could
deplete the savings overnight. Since savings accounts don’t earn as
much as other investments, Mr. Smith was concerned about having too
much money in a low paying savings account. To overcome his dilemma,
he decided to take any surplus and reinvest elsewhere. Periodically,
when the upper limit is exceeded by $1,000, Mr. Smith will withdraw
the excess ($1,000) and reinvest in his retirement fund. Currently,
their children’s education fund and vacation fund are fully funded
but his retirement plan needs a financial boost. However, next year
may be a different story and he will have the flexibility to do
something else.
For purposes of budgeting, the total amount of savings should
represent the sum of Ohnozs, Infrequents and Buffer. To coordinate
with the “hypothetical
budget,” the following items will be the focus of the savings register. Ohnozs
are represented by Medical Misc. ($50/month), Vehicle Misc.
($25/month), Clothing Misc. ($50/month) and Home Misc. ($50/month).
Infrequents are represented by car insurance ($85/month) and health
insurance ($265/month), which in this example are paid semi-annually.
The total of all six accounts is $525. Ohnozs and Infrequents should
take priority over the Buffer and be saved for from every paycheck.
Surplus, when and if it happens, should be earmarked for the Buffer.
If one is blessed financially, then he may be able to make the Buffer
a regular budgetable item.
Savings
Register shows
periodic and varying buffer
entries for example’s sake. “P” represents payments and “D”
represents deposits. “D” entries should be made every pay period
and “P” entries when an actual payment has been made. In this
illustration, payday is on the first of the month. In the Hypothetical
Budget, the Buffer is placed
last and has a question mark for the amount in order to represent its
unpredictability. Since the Buffer is the largest “savings register item,”
it will take a much longer time to fund. Carefully examine the savings register below so that you will be able to understand how it works. I think you get the picture! One must be prepared to be flexible with the savings account and not be disappointed if it goes up and down or even spent on things not planned for. That’s ok. Remember, it’s the catchall - to keep one out of debt and financial bondage. Use the above format in creating a personalized version and select the OhNoz and Infrequent accounts that apply. Feel free to make the categories as broad or as specific as clients want. Cash Account. The cash account is for items in the budget that need to be held in liquid cash. Similarly, savings is for items in the budget that need to be held in savings. For example, the hypothetical budget shows that monthly gasoline expense is $85. Suppose one lives in an area where gasoline stations do not accept personal checks or it’s too much hassle to use a credit card or write a check every time the tank gets filled up. The only alternative is to pay with cash. One should get a legal size envelope, or choose one to your liking, and write “Gasoline Expense” on it. If one gets paid four times a month, put $21.25 (85/4) into the envelope and take out money to pay for gas. Periodically, one may want to keep the receipts in the same envelope and compare actual average gasoline expense with the budgeted amount. This is just another form of “check and balance.” Use this method for any budget item that fits the cash account criteria. Budget Preparation. This is the process of placing everything on paper, listing all expenses and monthly amounts. By now, every possible expense should have been assigned a monthly budgetable amount and one should have created the savings register and cash accounts. One is now ready to prioritize and allocate. Prioritize and Allocate. In the process to financial freedom, one needs to have a beginning point - the budget. A hypothetical budget, properly prepared, is shown at the end of the chapter. Whether income is sufficient to pay all bills or not, every expense should be prioritized. The budget should have bills categorized into three groups. The highest priority group is Basic necessities and collateralized debt (BN). The second group on the priority list is Other necessities and non-collateralized debt (ON). Non-necessities (NN) is last. Every Item within each group is prioritized as well. The minimum payment (Min Pmt) should be listed, for reference, as well as a running balance of cash flow needs (CF Needs). The CF Needs column indicates the amount of money needed to pay every Item up to that point. For example, it will require a take-home pay of $1,810 to pay the BN, $2,185 to also pay ON, and $2,452 to also pay NN. If money is limited and since the CF Needs column dictates what gets paid first, it only stands to reason that one or more expenses may go unpaid. The budget, if properly prepared, should eliminate “surprises” and allow one to know exactly what to expect. If a financial shortfall is inevitable, then other income producing alternatives can be sought after. Next, there are five sources of debt that need to be dealt with: house payment, car payment, Norwest Financial, Master Card and Visa. Since the house and car are collateralized, they must be paid before other debt. Also, there are other expenses that take priority over non-collateralized debt. The real dilemma comes when one is attempting to become debt-free and has a surplus every month or periodically. If you will notice, there are four OhNoz accounts in the budget: Medical Misc., Vehicle Misc., Clothing Misc. and Home Misc. These must be considered and budgeted before allocating any surplus. When there is a surplus, which debt gets it - the one with the highest interest rate, biggest payment, biggest balance, or what? It is always recommended to “load up” on the debt with the smallest balance. This method is not quite the most cost-effective, but it is the most successful. When asked about motivation in attempting to get out of debt, people are usually results oriented. Of the people who succeeded in getting out of debt, the ones that experienced quick results were in the majority. The “flow” of money works as follows. Take the surplus, for example, of fifty dollars a month and add to the payment of the smallest debt. In looking at the hypothetical budget, it is Visa. Add the fifty dollars to Visa’s minimum payment of thirty-five dollars and you have eighty-five dollars a month going to Visa until it is paid off. Next, take the eighty-five dollars and add it to the next smallest debt (Master Card) for a total of one hundred twenty dollars. Continue this process until all debts are history. By using the previous technique,
observe the rapid pace to debt freedom. Both numbers indicate the
time frame in which a debt is paid off; the first number considers
the minimum payment only and the second column reflects the
“loading up” technique: Visa (3.83 yrs
v. 1.33 yrs), Master Card
(8.67 yrs v. 2.67 yrs),
Norwest (5 yrs
v. 3.58 yrs), Car (5 yrs
v. 4.33 yrs) and House (6.08 yrs
v. 5.42 yrs). Even though there are many different ways to get out of debt,
the one that fits best is the one that should be done. If there is no
“sticktuity” (Greek for
sticking with it), all efforts are in vain.
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Chapter 5: Ways & Means to Terminate Financial Bondage There are many things one can do to get out of financial bondage, but since it did not happen overnight, it will not disappear overnight. Over the years, one develops certain “habits” and “mindset” which are both hard to reverse and change. Many go through the School of Hard Knocks and a few learn from it while others can never seem to get it right. The good news is that everyone can be free of financial bondage. Some of the topics mentioned in this chapter have been discussed
in previous chapters, therefore; only a reference to the chapter in
question will be made. Topics are listed in no particular order and
certain ones have been left out because of their common usage; e.g.,
second job, liquidations, garage sales, craft fairs, requesting an early
inheritance from rich relatives, coupon clipping, bargain sales, etc. ·
Creditor Communication.
Sometimes creditors are empathetic to one’s financial woes. This may
be because they are trying to create a new, kinder image or they know
bankruptcies can be costly. On the other hand, creditors can be
determined, creative and/or vicious. Nonetheless, it is one’s
responsibility to communicate with creditors no matter their response.
If creditors call or send letters, respond to them immediately. Debtors
must be honest with creditors about their situation and what they can
and cannot do. Most often this will be in direct conflict with the
creditor’s demands, but there will be no deception on the debtor’s
part. Whatever one commits to, follow through with it. There are several avenues one may pursue to find financial relief. If payment history has been good, request a lower rate. Some creditors have this available for their better paying customers, but they usually don’t advertise it. In some instances, a creditor may discharge interest. In other instances, a creditor may apply past due interest to the end of the note. In this instance, the latter will not give any relief, but rather bring the bill into “current” status. If the creditor is unwilling to work with a debtor, then he will have to do his best and consider some of the other alternatives in this chapter or go to one of the few websites, such as www.cfs-gc.com/bfhome.htm, that offer relatively unknown but very effective remedies. Remember, what the creditor does is beyond one’s control or realm of influence. However, the law does limit a creditor’s collection activities. If one has a creditor that is using unscrupulous techniques, it is up to the debtor to know his/her rights. One may go to any public library or law library and read the Fair Debt Collections Practices Act. It is found in the United States Code under title 15, section 1692a, et seq. Every state has complementary statutes as well. ·
Consolidation. The
purpose and selling point of a consolidation is to combine all debts
into one, thus lowering the applicable interest rate and payment. There
are, however, some inherent dangers with this technique. A consolidation treats the effect,
not the cause. The cause, or
reason(s), one gets into financial trouble is what needs to be treated
first. The cause can range from insufficient income to financial
incompetence. Nevertheless, one may need some serious self-evaluation
and financial counseling to find the real cause. After successfully
treating the cause, then one will succeed in treating the effect. Without a complementary savings plan, it is pointless to do a consolidation. Savings is the tool by which one is weaned from and stays out of debt. For example, let’s say the Taylor family consolidates all their debts, but have no savings. Three months down the road, the transmission fails on the family car. Where do they get the money to have it fixed? You guessed right - they use one of the credit cards that were recently paid off with the consolidation note. Moneylenders are not concerned if one’s credit cards are cut up
and accounts closed. They just want to make loans – that’s their
business. They will get complete information about all the creditors
involved, pay them off, and now they become the creditor. What happened
to the credit cards or other sources of debt? Unless the debtor took the
initiative to cut them up (credit cards) and called the bank to close
the account, they still exist, except they now have a zero balance. Is
this a financial accident waiting to happen or what? Undoubtedly, a consolidation extends the time period before one
has any financial freedom. There is a psychological impact that needs to
be taken into consideration before making a consolidation. When one is
in financial bondage, there is no better reward and motivator in getting
out of debt than to see results. A consolidation takes the little debts
with short payment periods and combines them with the big debts with
long payment periods. There is no financial relief or pat on the back
until the whole debt is paid off. Any attempt toward financial freedom
must be rewarded with some visual progress, and soon, otherwise, one may
get disillusioned and give up. Nevertheless, if one does consolidate,
and the total payment is less, he must take the difference and apply to
savings and/or debt reduction. If one does not apply the difference (aka
discretionary income) to either savings or debt reduction, it will
disappear - poof. Discretionary income is hard to come by for some
families. If a consolidation is the event that creates discretionary
income, it is critical to designate those dollars to either savings or
additional debt reduction before the family unknowingly consumes it. ·
Home Equity Loans. Of the
various ways to consolidate, this is one of the most cost effective. In
essence, one is borrowing against his home’s equity. One must take
into consideration other associated costs, which make the effective
interest rate higher. Unlike non-collateralized loans, one’s home is
at stake. Also, the dangers that are inherent in consolidations exist
here as well. ·
Retirement Plan Loans.
Some corporate retirement plans, namely 401(k) plans, have provisions to
make loans. These plans allow for loans up to a certain percentage of
the employee’s account balance and repayment goes back into the
account. In essence, the employee is borrowing from and paying back
himself. However, if one is considering changing jobs or if his present
job is at risk, borrowing would not be wise. These types of loans
require the loan to be paid off when employment terminates otherwise one
will be subject to the tax consequences of a premature distribution on
the unpaid balance. ·
Expense Conversion.
Variable expenses may be monthly or in the form of OhNozs. It is always
the variable expenses that cause the most problems in budgeting. Income
and fixed expenses are determinable, variable expenses are not. For
example, utilities are always in the budget but vary from month to
month. Some utility companies take the guesswork out of the payment process and offer average billing. This is a great idea because it turns a variable expense into a determinable fixed expense. For all other variable expenses, one needs to take, preferably, a twelve month average and make this the budgetable amount. Once this is accomplished for all variable expenses, one now knows the exact amount to set aside each pay period. For example, Mr. Smarts used a twelve-month average for each variable expense. Added with fixed expenses, his total monthly expenditures are $2,000. Since Mr. Smarts gets four paychecks each month, he deposits $500 from each paycheck into his checking account. By doing this expense conversion for all variable expenses, one gets a handle on and a better mental picture of expected monthly expenses. Initially, it will take a little work, but it will be well worth the effort. ·
Checking Buffer. Every
checking account should have a buffer. This is not to be confused with
the savings buffer mentioned in the Budgeting
chapter. Monthly expenses are never as anticipated and it is foolish to
think otherwise. A buffer gives one the flexibility to adhere to a
budget and bring some consistency in the bills-paying process. In determining the amount of buffer, one should use the most sophisticated technique known today - guesstimation. Every person has a different comfort level, so trial and error is recommended to find what fits best. Always make sure the buffer is adequately funded. When balancing the checkbook, the excess balance will equal the buffer. Mr. Cash knows that when he pays a bill (variable expense) the
actual payment will differ from the averaged budgeted amount so he added
another $250 to his checking account as a buffer. After receiving each
monthly statement, he balances the checkbook and the resulting excess
balance is the value of the buffer. If the buffer gets too big, he takes
the extra (the amount over $250) and puts it in his savings account; if
the buffer starts to dwindle, he adds to it to equal $250. This is
technique #1. If Mr. Cash wanted a “play by play” instead of a month ending valuation, he could get another checking register and label it “Checking Buffer Register.” The beginning balance would be $250. After each variable payment is made, he would make an adjusting entry to the buffer register. For instance, let’s say the budgeted amount for electricity is $50 and the actual bill was $57.98. Since the actual exceeded the budgeted by $7.98, he would make an adjusting entry to the buffer register by reducing it by $7.98. Afterwards, the resulting balance would be $242.02. He would do just the opposite when an actual variable expense was less than the budgeted amount. This technique #2 would allow him to keep a close tab on his buffer and take quick action if needed. Technique #1 is very convenient for most people while technique
#2 is much more burdensome. If one prefers to crunch numbers, technique
#2 would certainly fill the gaps in a boring day. A checking buffer
works well for those households with sufficient income to pay bills but
is pointless for those households that juggle from paycheck to paycheck. ·
Collateralized vs.
Non-collateralized. This technique would only be a viable option if
one was seeking to protect assets from creditor repossession; e.g., work
car. If this is the case, one should convert collateralized debt to
non-collateralized. A perfect example of this is someone who recently
had some financial difficulty and was about to lose his only vehicle to
repossession. Having another credit source in good standing, he took a
cash advance and paid off the vehicle note. Even though this will shift
creditors, prevent a needed asset from repossession and relieve a
burden, it will not, however, change the financial obligation. Even
though a debt is still owed, the character of the debt has changed. A
trade-off is that the interest rate may be higher. ·
Reduce standard of living.
Recent tax legislation makes this a very viable option for many people
without being unfairly penalized. Those who choose this route do so for
various reasons: to reduce or pay off current debt, to lower current
living expenses, and even to prepare for retirement. Society says that
bigger is better and the home represents one’s prosperity. Kudos and
thumbs up to all those who have taken this bold step and reject the
stigma attached to “moving down.” ·
Market skills/expertise,
aka personal assets. This is probably one of the most untapped
resources of potential income ever. People from all walks of life
possess skills and expertise that are more valuable than they will ever
know. Most people have jobs by hiring out at an hourly rate and think
nothing else about it. However, a little creativity and entrepreneurial
spirit can turn personal assets into additional income. For example,
many policemen work part-time during holidays to meet the extra security
needs of businesses. Some even do security consulting on the side and
sometimes that leads to a better paying, less hazardous full-time job.
Others have taken the network-marketing route, which has historically
proven to be one of the best avenues for making wealth. A little research can sometimes reveal a niche that is not being
supplied in the marketplace or is inadequately being supplied, and you
have the personal assets to fill the gap. One can spend a little time to
go through the learning curve to properly market himself, and whammo, he
has additional income. One should take some time for self-evaluation and consider the
marketability of his personal assets. Talk to others in the same field
or profession and learn as much as possible. There is always the
learning curve to deal with so one must take his time and ask the right
questions and get as much information as possible. One might read about
how others got started: Sam Walton (Wal-Mart), Leslie Wexner (The
Limited), Harland Sanders (Kentucky Fried Chicken), James Cash Penney
(J.C. Penney), Luciano Benetton (Benetton’s), William Dillard
(Dillard’s), Gordon Segal (Crate & Barrel), Anita Roddick (The
Body Shop) and many others. All of these took their personal assets to
the marketplace and look at the results. It’s not reasonable to assume that everyone will be as successful as the prior list, but it is reasonable to assume that if one markets his personal assets the extra income may be exactly what is needed. ·
Bankruptcy. As a form of legal protection from creditors, bankruptcy
has become a means of legitimate as well as unscrupulous avenues for
those in financial bondage. There are businesses that have failed
because of indebtedness and the business owners sought bankruptcy
protection from creditors by having the slate wiped clean. After a few
months, the business reorganizes under a new name, with zero debt, and
they’re back in business. On the opposite end of the scale, there have
been situations where the same thing occurred, except the business
owners involved vowed to pay back every cent and over a period of years
they did. The first situation is unscrupulous and the second is
honorable. Both situations, however, came about as a result of
indebtedness. Even though bankruptcy has become a popular method, it is
not as effective as the remedies mentioned under creditor
communication. There are also occurrences that are neither self-induced nor the
result of borrowing. One that comes to mind is a medical bill that
resulted from a disease or accident. In this instance, the patient is
not a debtor, but a victim of circumstance. From the hospital’s
perspective, this does not relieve the patient (or responsible person)
from any financial obligation. Services were performed, expenses were
incurred in performing the services, the hospital must be paid to keep
the doors open, and the caregivers
need to be paid because they have families to support. Even though
massive medical bills can accumulate beyond the patient’s ability to
pay, one must attempt to resolve the financial dilemma. One of several things may occur to provide financial relief. First, the hospital may recognize the uncollectability of the debt and charge it off. This, of course, may or may not have a bearing on one’s credit record depending upon the credit reporting procedures of the hospital. Second, the hospital may sue and get either a judgment or garnishment order, depending on the state of residence. This will have a negative effect on the credit report, but, if one is in financial bondage, it’s a moot point. For some, a garnishment’s bark may be much more threatening than its bite because of income exception rules. One must educate himself on his state’s statutes to know his rights and protect his family, or consult legal counsel. Third, one may qualify for one of the many charities that make funds available for such instances. Last, one may seek court intervention through bankruptcy procedures. Of course, bankruptcy has its own associated costs, and most individuals attempt to make this the avenue of last resort because of the stigma attached as well as the issue of ruined credit. Table 5-1 tells the real story of the magnitude of bankruptcy in our society. If one will notice that business filings reached a high in 1986 and have been on a downward trend until the beginning in 1996. Personal filings, on the other hand, have been on the rise without fail. On a percentage basis, personal filings continue to rise and make up the bulk of filings. ·
Create a Budget.
Discussed in the chapter, Budgeting. ·
Debt Swaps. Discussed
in the chapter, Do’s and
Don’ts of Financial Management. ·
Maximize Take-Home Pay. Discussed in the chapter, Do’s
and Don’ts of Financial Management.
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Chapter 6: Debt and Debt-Free Living For all practical purposes, debt, or the concept of usury, has been around since written history. However, the extent of debt in our modern society is unprecedented. Everyone living today has grown up with the co |