Concerning personal finance, here is what I tell my grown or mostly grown kids:
: I have four tiers of money.
1) A checking account where I keep enough money to pay monthly bills including a little extra to handle normal fluctuations.
2) A savings account where I keep zero money. When I was right out of college, advisors would tell you to keep six months worth of salary in an emergency savings account. The reality these days is that that savings account doesn't pay any interest. I keep an emergency credit card with enough of a balance that I can handle almost any emergency. If I have to float a month or two of interest while I move money around, I can do that if I have to.
3) A intermediate term investment account where I save money towards the next car, major family purchase. When I was younger I would pay myself a car payment every month so that when it came time to buy the car I would be ready. Not everyone can do that but it should be the goal. I invest this money in investment grade preferred stocks or REIT's that pay 6-7% return and have very little market sensitivity. If I have to sell one, I might have a small loss or gain but the dividends are what I'm after here.
4) A diversified retirement fund consisting of low cost index funds for all the rest that is rebalanced quarterly.
If you can't afford to take a loss, you have to have insurance. If you can, you probably shouldn't (unless required by law). To understand this statement, you have to realize that insurance companies make money - from you.
- If you buy a TV and they sell you an "extended warranty", what you have just done is buy an insurance policy. That policy costs more than what your expected repair costs are because the company is going to make money. If you can afford to repair your TV in the rare case it has a problem outside the manufacturer's warranty, you shouldn't buy additional insurance. I have never seen an extended warranty for any product I think is worthwhile.
- Car and House Insurance is another matter. You likely cannot afford an extra $20K to replace a car so paying some every month to cover an accident makes sense. It makes more sense to pay for liability coverage since if you hurt someone it could ruin you. Not likely but you can't afford the risk. A house is even more expensive so the same rules apply to a greater extent. Even if you rent you should have renter's insurance to get you liability coverage.
- Life insurance is the most tricky. It costs your survivors a lot when you die. Your income stops, your bills do not, you have to get buried and your survivors need time to recover. People make mistakes on both sides of this equation. Some people have too little or none leaving their families at significant risk, others feel like they need a million dollar policy and end up paying monster premiums that limit their ability to save. The insurance industry will tell you 5-7x your salary. If you are a two income couple with no kids, $50k is plenty. If you have a stay at home spouse, then 3x your salary makes sense. If you have a bunch of kids who are counting on you to get to college, you need more. If you have a lot in the bank, you need less because that money will work. My approach is to have a small life policy to cover basic death expenses and use term insurance to cover me when the kids are younger. A good insurance agent can help you here, but anyone trying to sell you a high six figure or seven figure policy is just padding commissions.
The cost of credit often ends up costing as much as the purchase, but the reality is that people starting out will probably need some credit to get started.
- Everyone should have a credit card since they are pretty much required to today's world. No one should keep a balance on one unless you have to due to an emergency. Credit cards are the worst form of credit not counting pay day lenders. (If you are on the hook to a pay day lender, so everything in your power to pay that off and never get back on.)
- Unless you are taking advantage of an employer matching fund, in just about every situation, you should pay off credit debt before investing in either tier three or four money areas
. I sure there are people who disagree but remember that interest you pay is paid after tax. If you are paying 6% on your car loan and you are in a 15% tax bracket you need to earn over seven percent on your investment to cover the payment. A guaranteed six percent after tax return will usually beat just about every investment option you have. If you are looking at 18% on a credit card, this is a no brainer. Pay down your debt today, invest harder tomorrow. But what about your 0% car loan? Well, the car dealership included the interest in the price of the car and you've already paid it, so just keep making the minimum payment and put your money on other debts or into investments. Note that this requires some discipline. If you have a $300 car payment at 6% interest and $100 extra to invest, put $400 on your car until it is paid off then start putting all four hundred into tier three or four
. Just because you paid off the car early doesn't mean that you can have some extra mad money.
If you are trying to lose weight, you can exercise more, but to really make a difference you have to eat less calories. Wealth growth is the exact same. What you invest in is not nearly as important for the first twenty years or so as how much you spend. Everyone is trying to nickel and dime you. That eats up what is available to pad your nest egg. Drink soda vs water? $20/month. Like the best cell company vs the cheapest? $30/month. Feel like eating out twice a week instead of once? $50/month. Like that fancy cable plan with the 100 channels of which you watch two for one hour a week? Another $50/month. To put that in perspective, to earn $100 a month from your investments, you need $20,000 in investments yielding 6% interest, more if you talk about taxes. Make that car last an extra year, grill out instead of eating out, get the 42" TV instead of the 55", drink water instead of tea at restaurants and it adds up to a lot, leaving you more money to grow your nest egg. In your forties, your nest egg will be big enough that it starts to take on a life of its own and you can start splurging on yourself. Remember that $50 per month invested at 6% interest will grow to $23k in twenty years.