Author: Nicholas

Identifying financial goals

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Financial objectives

Most people, on being asked the question ‘what are your top three financial objectives? ‘ Reply mentioning general goals such as achieving financial security.  Not enough of us pay much attention to considering which financial objectives matter the most.  We tend to muddle through our financial lives spending to cover our ongoing day-to-day commitments unless our circumstances adversely change.

Following this approach your most important objectives risk being left unfulfilled.  Our object is to avoid this by helping you identify the financial goals that matter most to you and making sure they happen.
Ii is not as easy as it sounds, as financial goals continuously clash with each other.  Ideas of equal merit arise but only one is affordable or the time available means that only one has a chance of success. Choices such as how much provision should you make for your children’s higher education as against your retirement requirements.

In order to achieve what you want most, first decide which goals take priority.  Secondly work towards the lesser goals only after the important ones, while not letting the secondary goals drift.

An early start is desirable

You can enjoy the good fortune of time if applied early, even if only a small amount of money is set aside at compound interest.  Interest can show extremely good results over long time periods. A small snack costing about £0.50 a day invested in a tax-deferred account paying 5% a year compounded on a monthly basis will accumulate to £2,362 in just ten years and to £12,657 in 30 years.

Making an early start to a saving plan is the key to getting the best results.  Based on the results of a typical Individual Retirement Account scheme.  A woman starting at 20 years old contributed £1,750 per year to a plan for ten years and then let the amount accumulate until retirement at 65 years amassing £374,500 without any extra contributions after ten years.
Her husband started the same scheme ten years later at 30 years old and contributed £1,750 a year until the age of 65 and amassed a sum of £338,625 about 20 percent less.

Use time, start early and keep the payments up.  If the couple had started at 20 years old and kept the £1,750 a year contribution, they would both be worth £700,000 on retirement at 65 years.

Getting underway

Try to set out all the money related things that fire your imagination and involve your spouse or significant other, this is an exercise that should be done together because it’s defining your lifestyle.   From the very start of earning money try to consume only 85 to 90 percent of your earnings diverting the 10 to 15 percent into long term savings.and let time do its work. The following is a typical list drawn from my survey of students.

An emergency fund to cover 3 to 6 months earnings

Getting debt under control and getting out of short-term debt

Buying and furnishing a house

Providing for child minding of very young children

Providing assistance to your parents in their old age

Having adequate life assurance to meet each phase of family life

Assisting your children through university or apprenticeship

Making adequate provision for a comfortable retirement

Providing adequate transport for family and employment needs

Have a found for the pleasures of life, clubs, theater, entertainment, charities and presents, etc.

Make provision for funeral expenses

Each person’s list will be different reflecting culture and lifestyle the first listing can be quite random and should allow for the emotional as well as pragmatic content; basically this is about lifestyle.

Investing, Money Basics.

Posted on by Nicholas

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Investing, Money Basics.

  1. Over the long term, stocks have historically outperformed all other investments.

Stocks have historically provided the highest returns of any asset class — close to 10% over the long term. The next best performing asset class is bonds. Long-term U.S. Treasurys have returned an average of more than 5%.

  1. Over the short term, stocks can be hazardous to your financial health.

On Dec. 12, 1914, stocks experienced the worst one-day drop in stock market history — 24.4% . Oct. 19, 1987, the stock market lost 22.6%. More recently, the shocks have been prolonged and painful: If you had invested in a Nasdaq index fund around the time of the market’s peak in March 2000 you would have lost three-fourths of your money over the next three years. And in 2009, stocks overall lost a whopping 37%.

  1. Risky investments generally pay more than safe ones (except when they fail).

Investors demand a higher rate of return for taking greater risks. That’s one reason that stocks, which are perceived as riskier than bonds, tend to return more. It also explains why long-term bonds pay more than short-term bonds. The longer investors have to wait for their final payoff on the bond, the greater the chance that something will intervene to erode the investment’s value.

  1. The biggest single determiner of stock prices is earnings.

Over the short term, stock prices fluctuate based on everything from interest rates to investor sentiment to the weather. But over the long term, what matters are earnings.

  1. A bad year for bonds looks like a day at the beach for stocks.

In 1994, intermediate-term Treasury securities fell just 1.8%, and the following year they bounced back 14.4%. By comparison, in the 1973-74 crash, the Dow Jones industrial average fell 44%. It didn’t return to its old highs for more than three years or push significantly above the old highs for more than 10 years.

  1. Rising interest rates are bad for bonds.

When interest rates go up, bond prices fall. Why? Because bond buyers won’t pay as much for an existing bond with a fixed interest rate of, say, 5% because they know that the fixed interest on a new bond will pay more because rates in general have gone up.

Conversely, when interest rates fall, bond prices go up in lockstep fashion. And the effect is strongest on bonds with the longest term, or time, to maturity. That is, long-term bonds get hit harder than short-term bonds when rates climb, and gain the most when rates fall.

  1. Inflation may be the biggest threat to your long-term investments.

While a stock market crash can knock the stuffing out of your stock investments, so far — knock wood — the market has always bounced back and eventually gone on to new heights. However, inflation, which has historically stripped 3.2% a year off the value of your money, rarely gives back what it takes away. That’s why it’s important to put your retirement investments where they’ll earn the highest long-term returns.

  1. U.S. Treasury bonds are as close to a sure thing as an investor can get.

The conventional wisdom is that the U.S. government is unlikely ever to default on its bonds – partly because the American economy has historically been fairly strong and partly because the government can always print more money to pay them off if need be. As a result, the interest rate of Treasurys is considered a risk-free rate, and the yield of every other kind of fixed-income investment is higher in proportion to how much riskier that investment is perceived to be. Of course, your return on Treasurys will suffer if interest rates rise, just like all other kinds of bonds.

  1. A diversified portfolio is less risky than a portfolio that is concentrated in one or a few investments.

Diversifying — that is, spreading your money among a number of different types of investments — lessens your risk because even if some of your holdings go down, others may go up (or at least not go down as much). On the flip side, a diversified portfolio is unlikely to outperform the market by a big margin.

  1. Index mutual funds often outperform actively managed funds.

In an index fund, the manager sets up his portfolio to mirror a market index — such as Standard & Poor’s 500-stock index — rather than actively picking which stocks to purchase. It is surprising, but true, that index funds often beat the majority of competitors among actively managed funds. One reason: Few actively managed funds can consistently outperform the market by enough to cover the cost of their generally higher expenses.

 

 

Pros and cons of different investments

The 1990s enjoyed the biggest bull market in U.S. history. During the decade the Dow more than quadrupled.

While stocks, as represented by the S&P 500, have not always performed so extraordinarily — compounding at a dazzling 15.3% annual rate for that time period — they have usually been the best performing asset class over time.

Since 1926, stocks have returned nearly 10% — and that included the most recent horrendous bear market. Over the same period, government bonds returned 5.4%. (This according to the folks at Ibbotson Associates in Chicago.) In other words, if you’re investing for the long-term, stocks are the place to be.

But if you’re looking to invest money you may need in a year or two, the stock market can be downright dangerous. Look no further than the Dow’s 777-point drop on Sept. 29, 2008. Or the 554-point drop on Oct. 27, 1997, and the 508-point drop on Oct. 19, 1987 — a harrowing 22.6% loss — to see what a difference a day can make.

Then there are those bloody bear markets, like 1973-74, when the Dow fell 45%. In 2008, the total stock market lost 37%.

To cite a severe example, if you had bought the stocks in the Dow Jones industrial average at their peak in early 1966, you wouldn’t have made any significant profit until mid-1983 — more than 17 years later. Even that was better than if you’d bought in the pre-crash peak of 1929. After that, it took until 1954 for the market to regain all it lost in the Depression. As for the market woes of the early 2000s, it would take more than five years using an historical average rate of return, for the Dow to return to its glory-day levels from its October 2002 low.

Bonds, of course, are another story. While they won’t give your portfolio the kind of kick that stocks will, nor are they likely to give it the same kind of thrashing. In 2009, the worst single year for bonds in recent history, intermediate-term government bonds (that is, Treasury securities with maturities of 7 to 10 years) fell 9%.

 

Stock values and why they change

From 2000 through 2002, bonds outperformed stocks every year — a historic “three-peat” that hadn’t been seen in the modern investment era that began in 1929.

While the stock market often seems to behave like a manic-depressive who’s been off his medication, in fact it’s quite rational most of the time.

Information about the economy and the prospects of specific companies comes in, and the market reacts. Sometimes those reactions are extreme, but they usually sift down to a handful of causes.

So why does the market seem so erratic? Because life in general is unpredictable. A war here, a hurricane there. These things can occur without much warning, having effects on the economy that no one could anticipate.

What’s harder to explain is why the market can ignore obvious problems for a long time and then suddenly overreact. Here’s one explanation: Investors have a hard time gauging the magnitude of problems.

But if you ignore the occasional surprises that roil the market and focus instead on its long-term behavior, you’ll find corporate earnings and interest rates are key.

Earnings growth

Over periods of five years or more, stock prices closely track corporate profit growth. The longer the stretch of time, the more important earnings trends are. Indeed, since World War II, an estimated 90% of the stock market’s gain has come from profit growth. As profits add up over time, the scale tips and prices rise, regardless of how investors have voted in any given day, month or year.

Interest rates

In the short run, changes in interest rates can be more important than earnings. When rates go up, all other things being equal, investors tend to pull money out of stocks and put it into bonds and other fixed-income investments because the returns there are so attractive.

That brings stock prices down, and sends bond prices higher. On the other hand, when interest rates come down again, once more with other things equal, then investors tend to shift money into stocks, reversing the previous trend.

Note, however, that the operative phrase above is “other things equal.” In real life, other things are rarely equal, and so this relationship — while true in general terms — is hardly perfect.

 

The value of investing in bonds

Bonds at their best are basically boring, which is probably a virtue.

You loan money to a corporation or government agency, like the Treasury Department, and the borrower agrees to pay it back at a fixed rate of interest (sometimes known as the coupon) over a fixed period of time (the term or maturity).

Typically, the longer the maturity of a bond, the higher the coupon. For example, the spread between 5-year Treasury notes and 30-year bonds is often a full percentage point or two. Why? Because the longer the term of the bond, the longer its owner will be left earning a low rate if interest rates in general rise. The greater the risk, the greater the reward.

Similarly, the interest rate a bond pays is directly related to the riskiness of the bond. Treasury bonds, for example, are as close to a sure thing as you can get in the world of bonds, since Uncle Sam can always print more money to pay them off. (Even the feds aren’t immune to the laws of economics, though. If the government ever did print lots of extra cash to pay off its bonds, that would cause inflation to soar and make the bonds worth less.)

At the other end of the spectrum, however, are low-grade corporate bonds, known as high-yield or junk bonds, which have coupons that are several percentage points higher because of the risk that the corporations that issue them might stumble. In between are investment-grade corporate bonds from large, blue-chip companies. The job of grading bonds comes from outfits like Standard & Poor’s and Moody’s, which rate the riskiness of most non-Treasury bonds.

One additional quirk to bonds: If they are issued by a state, county or city agency, their interest earnings are usually free from federal taxes. These municipal — or muni — bonds pay less than taxable bonds in nominal terms. But for investors in a high federal tax bracket, they often return more after taxes than comparable taxable bonds. If you happen to live in the municipality or state that issues the bond, it may also be exempt from state and/or local tax — an added benefit. Similarly, bonds issued by the federal government are exempt from state and local taxes, but the tax rates are lower and the benefit is too.

Although bond prices tend to fluctuate less than stock prices, they aren’t risk-free. If interest rates rise, bond prices will fall. Why? As new bonds paying higher rates become available on the market, the price of older bonds falls proportionately so that the interest they pay is the same as that of a comparable new bond. That’s worth remembering in the current environment, in which interest rates in the United States have hovered around their lowest levels in decades.

Here’s a simplified example of how it works: Let’s say that you paid $1,000 for a 30-year bond that yielded 7% interest, or $70 a year. A year later, the rate for a comparable new bond falls to 5%, which means it yields just $50 a year. Your old bond is now going to be worth more, because investors are willing to pay more to get a $70-a-year income stream than they will to get $50 a year.

Since the interest rate of your bond is now 40% higher than normal, its new price will be about $1,400, or 40% more than you paid for it. And its yield? Exactly 5%, since $70 a year is 5% of $1,400. (Note: the equation is not quite that simple, since your bond now has only 29 years left to maturity and will be matched to other 29-year bonds, not new 30-year issues.)

Conversely, if rates jump from 7% to 9%, meaning new bonds are paying $90 a year interest, the value of your bond will fall to about $778 — because your bond’s $70 annual interest is 9% of $778.

Eventually, of course, when the bond matures, it will be worth $1,000 again. However, its value will move up and down in the meantime, depending on what interest rates do. The longer the time to maturity of a bond, the more dramatically its price moves in response to rate changes. That is, long-term bonds get hit harder than short-term bonds when rates climb, and gain the most in value when rates fall.

As a result, bond buyers tend to divide into two classes: investors (or speculators), who hope to make money thanks to a decline in interest rates that sends bond prices higher; and savers, who buy bonds and hold them to maturity as a way to earn a guaranteed rate of return.

 

Mutual fund fundamentals

The theory behind mutual funds is simple: you need the advantage of being able to pool your money together with that of a lot of other investors. Then, a professional manager can invest that money across enough investments to reduce the risk of being wiped out by any single bad bet.

That’s how a mutual fund operates. The fund is essentially a corporation whose sole business is to collect and invest money. You join the pool by buying shares in the fund. Your money is then invested by a team of professionals, who research stocks, bonds or other assets and then place the money as wisely as they can.

The managers charge an annual fee — generally 0.5% to 2.5% of assets — plus other expenses. That puts a drag on your total return, of course. But in exchange, you get professional direction and instant diversification, factors that have helped propel the number of funds to 7,600 in 2010, according to the Investment Company Institute.

There are several flavors of mutual funds. Funds that impose a sales charge — taking a cut of any new money that comes into the fund, or a cut of withdrawals — are called load funds; those that do not have sales charges are called no-load funds.

Funds can also be divided into open- and closed-end funds. Open-end funds will sell shares to anyone who cares to buy; essentially, they are willing to invest any new money that the public wishes to pump into the fund. Their share price is determined by the value of the underlying investments and is calculated anew each evening after the close of the U.S. markets. Closed-end funds, on the other hand, issue a limited number of shares that then trade on the stock exchange like stocks. The price of such shares can fluctuate above or below the actual value of the underlying shares held within the portfolio.

Funds also can be broken down by their investment strategy. Here’s a quick overview of some of the principal types; we’ll have more to say in later Money Essentials lessons:

Index funds

When people talk about the long-term performance of stocks, they’re usually talking about the Dow Jones industrial average, the Standard and Poor’s 500-stock index, or some other broad market index. Funds based on the S&P 500, by definition, will never outperform the market. But because they are so cheap to run — you’ll typically pay just $2 a year in expenses for every $1,000 invested compared to $14 a year for the average stock fund — they outperform the vast majority of actively managed funds over time.

Growth funds

These invest in the stock of companies whose profits are growing at a rapid pace. Such stocks typically rise more quickly than the overall market — and fall faster if they don’t live up to investors’ expectations.

Value funds

Value-oriented fund managers buy companies that appear to be cheap, relative to their earnings. In many cases, these are mature companies that send some of their earnings back to their shareholders in the form of dividends. Funds that specifically target such income-producing investments are often called equity-income or growth-and-income funds.

Sector funds

Sector and specialty funds concentrate their assets in a particular sector, such as technology or financials. There’s nothing wrong with that approach, as long as you remember that a hot performing sector one year could crash the following year.

Others

Since there is a lot of overlap in the stocks held in each of these fund types, you’ll need to branch out to get any kind of meaningful diversification. That’s where the more aggressive funds, like aggressive growth funds, capital appreciation funds, small-cap funds, midcap funds, and emerging growth funds, fit in. Typically, these funds, which tend to be more volatile than large-cap funds, pursue one or more of the following strategies:

– Invest in smaller companies, where earnings aren’t as reliable as at bigger firms but where the potential for gains (and losses) is higher.

– Invest in pricey, high-growth stocks.

– Invest in stocks that are in “hot” industries, such as technology or health care.

– Invest in just a handful of companies.

International

Funds that invest outside the U.S. come in three basic flavors. The first, international funds, typically buy stocks in larger companies from relatively stable regions like Europe and the Pacific Rim. Global funds do likewise, but they can also invest heavily in the United States. Emerging market funds invest in riskier regions, like Latin America, Eastern Europe and Asia.

Bond funds

These tend to be segmented across the risk spectrum, with those that specialize in Treasury securities being the safest (and the lowest yielding) and those that specialize in junk bonds being the riskiest but offering the highest yield. They also divide according to whether the bonds they hold are taxable or tax-free.

One thing to remember: When the market is headed down, funds that invest in Treasurys tend to rise in value and investors flock to the safest investments around. Likewise, when the market is going up, junk-bond funds tend to do the best, as the better things are for business, the more likely that even the riskiest bond bets will pay off.

Understanding how inflation works

Let’s say the market takes a 30% dive over the next year. Every time you check your stocks or stock mutual funds, you’re going to feel the pain. Likewise, if interest rates rise, your bonds won’t let you forget it.

Nowhere on your bank or brokerage statement, however, are you likely to get a report on what inflation is doing to the real value of your holdings. If your money is stowed in a “safe” investment, like a low-yielding savings or money market account, you’ll never see how inflation is gobbling up virtually all of your return.

Here are some points to bear in mind:

– At an average annual growth rate of 9.8% a year, stocks will double your money in a little over seven years. Factor in inflation, which has historically run at about 3% annually, and it will take more than 10 years to double your actual buying power.

– Likewise, bonds, which have historically grown at roughly 5.4% annually, will double your money every 12 years. After inflation, however, it will take 26 years.

– If your money is in cash, you’ll have to wait 23 years for the nominal value of your account to double, assuming the cash earns the historical 3% annual return. But even your grandchildren won’t see the real value of your money double.

That’s why, whenever you add up your gains or losses for a given period of time, you have to add in the effects of inflation to understand how much further ahead or behind you really are.

Controlling Personal debt

Posted on by Nicholas

Controlling Personal debt

Credit-card debt
The household with a credit card has nearly £2,293 on average in credit-card debt (in 2014), according to themoneycharity.com. The average interest rate falls between the mid-to-high teens at any given time.

There is good debt
Borrowing for a house or university usually makes good sense. Just make sure you don’t borrow more than you can afford to pay back, and shop around for the best rates.

There is bad debt
Resist using a credit card to pay for quick consumption items, such as meals and holidays, if you are unable to pay your card bill in full at the end of the month. To do so is equivalent to giving an extra tip on each item, there’s no faster way to fall into debt. Pay the bills in full for these items using a small cash float set aside for such things.

If there’s an expensive item something you want, save for it over a period of weeks or months. Make most of the purchase in cash, you can pay the balance by card, avoiding interest charges by paying the balance when it’s due.

Get a grip on your spending
Most people spend large sums of money on individual low-cost items without much attention to what they’re buying. Start a budget, make a note of everything you spend for a month. Cut back on things you don’t need, and start saving the money left over or use it to reduce your debt more quickly.

Pay off your highest-rate debts
First reduce highest interest card balances as fast as possible. Once the high-interest debt is paid down, tackle the next highest, and so on. Meanwhile pay at least the minimum due on all your other debt.

Avoid paying just the minimum
It is a very poor decision to pay only the minimum required by the credit-card bills, the card company will love you. It will take you years to clear the principal meanwhile paying interest and potentially spending thousands of pounds more than the original purchase.

Watch how you borrow
Using your house to as collateral to borrow to pay off debt has its risks; you could lose your home if you default.

Expect the unexpected
Have a cash reserve of say three to six months of living expenses to cover an emergency.

Don’t rush to pay off your mortgage
Don’t commit all your cash paying off a mortgage if you have other debts. Mortgages usually have lower interest rates than most debt. If you have a high rate mortgage, consider refinancing with the view to adjusting your monthly payments.

Seek help as soon as you need it
If you are overwhelmed with debt, more than you can manage, get help before your debt destroys you. Find a reputable debt counseling agency that may be able to consolidate your debt and assist you to manage your finances better. There are a lot of disreputable agencies in the market, so take care.

Good debt vs. bad debt

Living debt-free is almost impossible for most of us. Especially when starting out as young people, we can’t pay cash for our house and setting up home. Letting debt get out of hand is all too prevalent.

Expert opinion reckons your mortgage and credit cards total monthly long-term debt payments should not exceed 36% of your gross monthly income. That’s one-factor mortgage lenders consider when assessing the creditworthiness of an applicant.

Credit cards make it far too easy to spend more than you can afford, especially when you are shopping as a leisure activity or at an auction sale. Personal bankruptcies in recent years have hit record highs.

It is not a wise option to avoid debt at any cost if it means encroaching on your emergency cash reserves. The art is how to judge which is a sensible debt and which is not, and then managing the money you do borrow with prudence.

Good debt includes anything you need but can’t afford to pay for up front without wiping out cash reserves or liquidating all your investments.

In cases where debt makes sense, only take loans for which you can afford the monthly payments.

Bad debt includes debt you’ve taken on for things you don’t need and can’t afford. Credit card debt is the worst form of debt as it is an unsecured loan on demand; hence it carries the highest interest rates unless you clear the full amount each month.

 

Sometimes the decision to borrow doesn’t hinge on how much cash you have but on whether there are ways to make your money work harder for you. If interest rates are low, compare what you’ll spend in interest on a loan versus what your money could earn if it were invested. If you think you can get a higher return from investing your cash than what you’ll pay in interest on a loan, borrowing a small amount at a low rate may make sense. 

Examples of good personal debt

Debt is not always a bad thing. In fact, there are instances where the leveraging power of a loan actually helps put you in a better overall financial position.

Buying a home

The chance that you can pay for a new home in cash is slim. Carefully consider how much you can afford to put down and how much loan you can carry. The more you put down, the less you’ll owe and the less you’ll pay in interest over time.

Although it may seem logical to plunk down every available dime to cut your interest payments, it’s not always the best move. You need to consider other issues, such as your need for cash reserves and what your investments are earning.

Also, don’t pour all your cash into a home if you have other debt. Mortgages tend to have lower interest rates than other debt, and you may deduct the interest you pay on the first $1 million of a mortgage loan. (If your mortgage has a high rate, you can always refinance later if rates fall. Use our mortgage calculator to determine how much you might save.)

A 20% down payment is traditional and may help buyers get the best mortgage deals. Many homebuyers do put down less – as little as 3% in some cases. But if you do, you’ll end up paying higher monthly mortgage bills because you’re borrowing more money, and you will have to pay for primary mortgage insurance (PMI), which protects the lender in the event you default.

For more on financing a home, read Money Essentials: Buying a home.

Paying for college

When it comes to paying for your children’s education, allowing your kids to take loans makes far more sense than liquidating or borrowing against your retirement fund. That’s because your kids have plenty of financial sources to draw on for college, but no one is going to give you a scholarship for your retirement. What’s more, a big 401(k) balance won’t count against you if you apply for financial aid since retirement savings are not counted as available assets.

It’s also unwise to borrow against your home to cover tuition. If you run into financial difficulties down the road, you risk losing the house.

Your best bet is to save what you can for your kids’ educations without compromising your own financial health. Then let your kids borrow what you can’t provide, especially if they are eligible for a government-backed Perkins or Stafford loans, which are based on need. Such loans have guaranteed low rates; no interest payments are due until after graduation; and interest paid is tax-deductible under certain circumstances.

For more on educational financing, read Money Essentials: Saving for College and “Beating the Financial Aid Trap.”

Financing a car

Figuring out the best way to finance a car depends on how long you plan to keep it, since a car’s value plummets as soon as you drive it off the lot. It also depends on how much cash you have on hand.

If you can pay for the car outright, it makes sense to do so if you plan to keep the car until it dies or for longer than the term of a high-interest car loan or pricey lease. It’s also smart to use cash if that money is unlikely to earn more invested than what you would pay in loan interest.

Most people, however, can’t afford to put down 100%. So the goal is to put down as much as possible without jeopardizing your other financial goals and emergency fund. Typically, you won’t be able to get a car loan without putting down at least 10%. A loan makes most sense if you want to buy a new car and plan to keep driving it long after your loan payments have stopped.

You may be tempted to use a home equity loan when buying a car because you’re likely to get a lower interest rate than you would on an auto loan, and the interest is tax-deductible. But before going this route make sure you can afford the payments. If you default, you could lose your home. And be sure you can pay it off while you still have the car since it’s painful to pay for something that has been consigned to the junkyard.

Leasing a car might be your best bet if the following applies: you want a new car every three or four years; you want to avoid a down payment of 10% to 20%; you don’t drive more than the 15,000 miles a year allowed in most leases; and you keep your vehicle in good condition so that you avoid end-of-lease penalties.

Whatever route you choose, shop for the best deals. Remember, it’s in the car dealer’s best interest to finance at the highest rate possible, so look at what you’ll pay overall, not just the monthly amount. If you tell your car dealer you can spend $400 a month, you could end up with a new car for $400 a month based on an uncompetitive interest rate.

For more on auto financing, read Money Essentials: Buying a car. And read “The right vehicle” to get a sense of how much car you really can afford.

 

How to avoid borrowing to pay debts

Besides life’s big-ticket items – home, car and college – you may be tempted to borrow money to pay for an assortment of other expenses such as furniture, appliances and home remodeling.

Generally speaking, it’s best to pay up front for furniture and appliances since they don’t add value to your home and are depreciating assets. If you do finance such purchases, however, read the fine print.

Retail stores often charge high interest rates. And even if they offer a low-interest or no-payment period for several months on a purchase, you may be required to pay for the item in full at the end of that period or risk being charged a high interest rate dating back to the day of sale.

Taking a home equity loan or home equity line of credit makes sense if you’re making home improvements that increase the value of your house, such as adding a family room or renovating your kitchen. The interest you pay in many cases is deductible, and you increase your equity.

If, however, a home project doesn’t boost your house value, consider paying cash or taking out a short-term, low-interest loan that will be paid off in five years or less.

If you’re saddled with a lot of high-interest credit-card debt, you might be tempted to pay it off quickly by borrowing from your 401(k) or taking out a home equity loan.

There are two primary advantages to home equity loans: They typically charge interest rates that are less than half what most credit cards charge. Plus, the interest you pay may be deductible. (Note, however, that when you use a home equity loan for nonhousing expenses, you may only deduct the interest paid on the first $100,000 of the loan, according to the National Association of Tax Practitioners.)

But there is one potential and very significant drawback when you borrow against your house to pay off credit cards: If you default on your home equity loan payments, you may lose your home.

Borrowing from your 401(k) is even less advisable. That’s because you lose out on two of the biggest advantages to workplace retirement plans: tax-deferred compounding of your money and tax-deductible contributions. Sure, you pay yourself back with interest, but that interest is paid with after-tax dollars, and it will be harder for you to make new contributions while you’re repaying your old loan.

Also, if you quit or lose your job, you’ll probably have to repay the entire borrowed amount within three months. If you aren’t able to do that, you’ll owe income taxes on the money, plus a 10% penalty if you’re under 59-1/2.

One other word of caution if you take any kind of loan to pay off your credit cards: Once your credit-card debt is paid off, you have to be vigilant about not running up your balance again because you still will have big loan payments to make.

If you’re having chronic trouble paying off your credit-card debt, it may be time to consult a debt counseling service for help managing your finances in the future.

 

Personal debt management strategies

Outside of fixed monthly bills such as your housing or car payment, you probably don’t have a precise idea of how you spend most of your money.

If you want to get your debt under control, start by figuring out your spending patterns and identifying unnecessary expenses.

For one month, write down every cent you spend. “Every” means “every,” including that $2 cup of coffee that starts your workday or that $4 magazine you buy on a whim. That will clarify in black and white how much of your spending is fixed and how much is variable (and hence easier to curb).

Tally the expenses on the list and compare the sum to your monthly income.

How much do you bring in after taxes? How much do you have left at the end of the month after paying fixed expenses? How much do you spend on variable items like that $2 cup of coffee every morning?

Consider, too, whether there’s any way to boost your take-home pay. If you get a big tax refund every year, that means you’re having too much withheld from your paycheck. If that’s the case, you can reduce your withholding by changing your W-4 at work.

Next, make a list of all your debt obligations and the interest you’re charged for each.

Once you’ve done all that, you’re ready to start lightening your debt load.

The basics of debt reduction are simple: Cut down on your variable spending and put the extra money toward your debt payments. Once you determine the maximum amount you can pay off each month, pay down the debt with the highest interest rate first – that usually means your credit-card balance – while paying at least the minimum monthly amount due on all other revolving bills.

Once the debt with the highest rate is wiped out, put your money toward paying the debt with the next-highest rate. One exception: If you have a credit card with a low teaser rate that will go up after a fixed amount of time, strive to eliminate that balance before the low rate expires.

You might also consider moving some of your high-interest credit-card balances to a card with a lower interest rate. But read the fine print on any invitation to transfer balances. Sometimes such low-interest-rate offers are only in effect for short periods of time, after which the rate skyrockets. What’s more, consolidating your debt on one card may lower your credit score if your debt-to-available-credit ratio worsens.

For many people, reining in discretionary spending for a few months goes a long way toward tackling debt. But if that’s not enough, try to reduce your fixed expenses. Take steps to lower your household bills; refinance your mortgage to get a lower interest rate; or, if you have a good payment history, ask your credit- card company to lower the interest rate you’re charged.

For budget tips, read Money Essentials: Making a budget.

Check your credit reports and scores

While you’re cleaning up your debt, order copies of your credit reports, which are free, and your credit scores, which cost about $15, since the information contained in them will directly affect the interest rates you’re offered on credit cards, mortgages and other loans.

There are three major credit bureaus: Experian, Equifax and TransUnion. Each collects information on your credit history which is culled into a credit report. From that report, a credit score is derived. That score is a quick way for lenders to assess how risky you are as a potential borrower. The higher your score, the less risk you pose to lenders and the more likely it is that you’ll get their best available rates.

The score most commonly used by lenders is the FICO score, developed by Fair Isaac.

When lenders review your credit reports and resultant FICO scores, they take into account not only how much you owe but also how much credit you have available to you. Too much of either, and they may not loan you any more money.

So when you get your reports, check for inaccuracies; the bureaus are required to investigate and correct them once you report them. Look, too, for things that may lower your credit rating, including open lines of credit you never use or accounts you thought had been closed long ago.

The bureaus may have different information about your credit history, which means your credit score can vary somewhat from bureau to bureau. So it’s important to view reports from all three.

You can get any of the bureaus’ credit reports free at www.annualcreditreport.com and your FICO score from MyFICO.com. Then check if this is true: If you’ve been turned down for credit, employment or housing in the past 60 days, you may receive a free credit report from all of the three credit bureaus.