Saving without the sacrifice

I'm sick of stores trying to convince me that the only way to save money is to spend money. Buy-one-get-one-free sales and false discounts sucker consumers into buying crap that they don't need by creating a false impression of savings.

Have you ever been to Kohls? Next time you're in there, take a look at their on-sale items. You'll notice that every item, every day, is on sale.

...let me say that again.

EVERY SINGLE STUPID THING, ON EVERY SINGLE STUPID DAY IS ON SALE.

It's funny to see my family and friends talk about their shopping experiences at Kohls. "Look at what I bought today at Kohls!" they'll say as I am shown the ridiculous impulse purchase. "And I got it on sale!"

If you really want to save money, put your wallet away. You can justify buying just about anything if you think you're getting it cheaper than everyone else. I think that people feel fulfilled and intelligent when they paid a perceived low price for something. Retail stores, by displaying items as "on sale," they're trying to eliminate your desire to shop around. They're trying to convince you that you don't need to shop around because the best deal you're going to find is right in front of you, begging to be placed in your cart.

Geico auto insurance does the same thing in their commercials. Ask anyone on the street " how can you save 15% or more in 15 minutes or less?" They'll answer "by calling Geico."

The gecko is full of crap.

With a ten-minute phone call yesterday, I saved about 50% on my auto insurance by switching from Geico. With my next premium coming due in a month or so, I decided to do some shopping around. With Geico, I was paying $72o twice a year. With my new company, I'll be paying $450 for the same exact coverage. And I'll be able to receive monthly bills without a penalty, too. Geico used to charge $3 per month to do that.

Another reason we pay too much for things is our tendancy to form habits and never question our service providers that we take for granted. I was frustrated when I received yet another trash bill this week that had increased from the previous month. In the past, I had just paid the extra few dollars without question. But this month I decided to shop around. When I closed my account, I was paying $20 per month for weekly trash service. Within a half hour I found a place with the same size can and the same weekly service for $154 per year. By prepaying, I ensured that my rates would never increase (as they often had with my old company) while saving $7 per month.

If you want to start saving more money, you'll probably need to make some sacrifices. But before you do, look to save money in areas where you won't have to sacrifice anything. I saved $540 per year by switching car insurers. I saved $7 per month by switching trash companies. I save $25 per month by having my wife cut my hair at home (easy because I have a buzz cut).

No one likes sacrificing, so try your hardest to save money on the things that don't matter.

Paying down that mound of student loans

A reader of my site sent me a private message describing an intimidating financial situation that she found herself in. After attending an expensive out-of-state college and starting grad school, she has found herself with $140,000 in student loans. Let me just say this: if your parents paid for your education, call them today and thank them.

I called her while driving back home from a business trip to talk it over. In this post I'll describe to you some of the specifics of her situation, some options that she was considering, the advice that I gave her, and the numbers that I crunched when I got back home, and my final conclusion.

Specifics:
Current sum of balances: $140,000
Current interest rate: varies; different loans have different rates ranging from 4.5% to 7.5%
Current salary: $60,000
Current credit: So-so, but her father has good credit and is willing to co-sign
Current living expenses: limited, as she is living with her grandmother

Options she was considering:
#1 - Buying a house and consolidating the student loan debt into the mortgage:
Her father suggested doing this, but she wasn't sure about her options. I can't say that this is not necessarily bad advice, but it really isn't an option. Here's why:

Depending on your situation, down payment, and credit score, mortgage lenders may be willing to give you some extra cash to help with certain expenses, like necessary repairs or closing costs. However, they're very careful about not giving you too much money, as they don't want the balance of the mortgage to exceed the value of the home because the home is used as collateral.

Mortgages tend to have lower interest rates than personal loans, credit cards, and student loan consolidations. That's because they present less risk to the lender because the loan is secured with an actual house. If you don't pay your loan back, the bank can seize and sell your home. The same goes for car loans. On the other hand, if you fail to repay your student loan or a personal loan, sure, the bank can destroy your credit, but they're S-O-L when it comes to getting their money back.

If my reader were to roll her student loans in with her mortgage, the balance on the mortgage would be $140,000 more than the cost of the home, less the down payment. So unless she was putting at least $140,000 down on the house, the bank would be "upside down" on her loan -- meaning they were owed a lot more than the collateral was worth. Banks don't like to be upside down, so her request would likely be denied.

On a side note, this type of lending and borrowing was a root cause of the recent economic downturn. People bought homes and assumed that, because of the housing bubble, the value of their homes would skyrocket and they would have incredible amounts of equity. Let's say I bought a house for $200,000 with no down payment. At first glance, I would have zero equity. But if after a couple of months the house was assessed at $300,000, my equity would be $100,000 and my bank would potentially loan me up to that amount in a home equity loan. This happened often and sounded great to everybody. But as home values eventually declined, all of that false equity diminished. All of the sudden, people that exercised these types of loans owed $300,000 on a home that was now only worth $175,000...but I digress.

#2 - Consolidating her private loans
My friend has a combination of federal and private student loans. Her federal loans are already consolidated at 4.5% -- a rate I wouldn't part with for the world. Her private loans (which I assume are the majority, given the high sum of her balances) have interest rates which vary from 6.5 to 7.5 percent.

This morning I looked into the cost of consolidating private loans. Turns out, it's more expensive than I had imagined. According to studentloanconsolidator.com, consolidating your private student loans will give you a variable interest rate from 7.9 to 11.93 percent and smack you with a one-time consolidation fee of 1-5%. I've got to say, that's pretty expensive! Of course, there are other options out there, but the consolidation of private student loans are very very expensive, especially considering my reader's current 6.5 to 7.5 percent interest rate.

The advice that I gave her on the phone:
When we spoke, I was in the car and didn't have time to research the total cost of paying back her loans or her consolidation options. I told her that consolidating her loans with a mortgage were simply not an option because she wouldn't have enough equity in the home. I told her to continue living with her grandmother as long as she could stand it and keep sending extra money to her lenders. I told her to start keeping track of her money -- how much she has, where it goes, etc, by using my favorite site on earth, mint.com. Finally, I told her to save a couple of months' pay in an emergency fund.

The numbers I crunched this morning:
Assuming a $140,000 principal balance, a 20-year payback period (common when it comes to loans), and an average rate of 7%, her regular monthly payments are probably somewhere around $1,085 per month. If I knew what her actual monthly payments were, I could be more certain about her average interest rate.

By paying that minimum payment each month, her student loans will be paid off in 20 years. However, if she sends and extra $500 per month toward the principal, her loans will be paid off in just over 10 years. If she can scrape together an extra $700 per month, the loan will be paid off in less than 9 years.

If some of her loans carried a higher interest rate, she could consider asking her father to take out a home equity loan for her. Because he's willing to co-sign on a loan, he's already shown that he's willing to put his credit and cash on the line to help out his daughter. Assuming that he owns his home and has considerable home equity, he could take out a home equity loan with a potentially low interest rate and pay off her student loans. The thing to consider is that home equity loans typically last for 30 years, so this would only be a valuable option for her if she were to 1) pay off the loan early and 2) obtain a lower interest rate than the highest of her student loan rates.

Final conclusion:
My friend is really in no position to purchase a home at this point. Her current student loans really resemble a mortgage. At her current income level, I would expect that she could afford a home worth approximately $140,000 to $180,000 dollars. But because her $140,000 in debt doesn't come with a house, she doesn't have the option to "live in her investment" or rent out a room. I would recommend that she refrain from buying a home until the balances on her student loans are cut down to at least $50,000.

If her student loans each carry different interest rates, she should start by paying down the one with the highest interest rate. Once that's paid off, she should start paying off the next one and the next one and so on. I recommend that she do this methodically and automatically by setting up regular payments with her bank. But she should make sure that the extra payments are going toward principal and not toward next month's payment.

An education is a valuable thing -- and an expensive one, too. Student loans are a part of life for many people, including myself, my wife, and many of our friends. By being smart about paying them down and using all of the resources available to you, you can bring your balance to a big fat zero in no time. Then, you'll be able to start saving that money for your own child's education!

To my reader that called asking for help: feel free to send me an email with the specifics of your loans. I've built some calculators that will help optimize their payoff, ensuring that in the end you're paying as little as possible.

How to survive the recent Wall St fallout

Count your money. Save your money. If you have more than $100,000, split it between banks.

Be careful, sit tight, and prepare yourself for a wild ride.

It'll be alright :-)

Prosper.com: Convincing My Wife, Part 3

Side note: If you're browsing Prosper.com, check out their ad for "PayDayMax.com" where you can get a 7-day loan for only 970.9% interest! It's a super deal if you're strapped for cash!

Now back to convincing my wife that we should invest on Prosper.com...

Today I'm going to discuss some of the things that give me confidence in a borrower and some of the things that raise flags. I'll also highlight some general rules of thumb that will increase your chances of establishing a pattern of profitability on Prosper.com.

Loan characteristics that give me confidence:

1. Specificity -- especially by low-credit borrowers. I am more encouraged to loan to a a high-risk borrower when it's clear that they're completely tuned in to their financial situation and are willing to be completely transparent. A specific description like this is nice:
   

   "I am paid bi-weekly and my take home pay is 1067.39 (2134.78 monthly)."

2. Homeownership -- looking at the statistics, homeowners are 25% less likely to make a late payment. If you're torn between lending to two borrowers with similar credit profiles, choose the homeowner or demand a higher interest rate from the non homeowner.
   
3. Asking only for the minimum that they need -- if a borrower is asking for a specific amount for a specific reason, it indicates to me that they're being genuine with their request. If their request states that they're consolidating credit cards and the sum of their balances is $8,200, the closer their request is to $8,200 the better. Asking for "buffer cash" indicates financial irresponsibility in that they're willing to borrow money at a high interest rate just to have cash in the bank...kind of like AIG, just not $85 billion.

Loan characteristics that raise flags:

1. Large loans to people with low income -- Even if you're only investing $50 in someone, consider the amount of the loan that they're requesting. Look at the size of their monthly payment. If someone is unable to pay that amount for three years, your 50 bucks is SOL.
2. Loans to pay for something unexpected that shouldn't have been unexpected -- If someone needs to borrow a relatively small amount for car repairs, it indicates to me that they're completely strapped for cash and are unable to handle the everyday surprises that come about. What's going to happen when the next emergency happens? My wife and I have unexpected costs every month. Last month the car battery needed to be replaced. The month before that, we needed an exterminator. These things happen. If they're stretching themselves to make payments on a three-year loan that covered this month's emergency, what's going to happen when they need to cover next month's?
   
3. Instant funding -- When filling out loan requests, borrowers can select an option that will allow the loan to be "instantly funded" once their requested amount is funded. By selecting this, they forfeit their chances of lenders bidding down their interest rate until the listing's scheduled end date. Borrowers will lock in a higher rate just to have the money a few days sooner. This implies that the borrower is very desperate -- to the point where they are willing to pay a higher interest rate for three years just to have the money faster. According to ericscc.com, a borrow that selects this option will default 32% of the time and is more than twice as likely to default than a borrower that does not choose this option.
4. Current delinquencies -- I don't care very much as much about delinquencies in the past seven years. Current delinquencies are the real kicker. A borrower without any current delinquencies has a 10% chance on being late. As soon as they have one current delinquency, that rate almost doubles to 19%. Do they have eight current delinquencies? Well then that rate will double again to 41%. Many borrowers with lots of delinquencies will say that this loan will bring them into favorable status with those creditors. Be careful. With multiple current delinquencies, you've got up to a 50/50 chance of that person being delinquent with your money.
5. Multiple credit inquiries -- It's normal for people to have a few credit inquiries in the past few months. But you should know that if they're shopping around for a loan for a car or house, credit bureaus will only report one inquiry as long as their shopping doesn't last more than 30 days. If a person says that they have multiple inquiries because they've been shopping for a car or house loan, they're lying...and lying is the biggest flag of all. Once a borrower's recent inquiries hits three, their chances of becoming delinquent on their Prosper.com loan have doubled.

General rules of thumb for lending:

1. Don't invest more money than you can live without for a few years. It isn't like putting money into a savings account where you can take it out in case of an emergency. You don't get your money until the borrower makes their monthly payments.
2. Until you're comfortable with your strategy, don't invest more than the minimum $50 in any loan. There is absolutely no cost for you to diversify, so it doesn't make financial or statistical sense to give anyone more than that.
3. Remember, people can lie in their requests, so make your decision mostly off their credit history. Don't be fooled by people with kids (irrelevant), a high income (unverifiable), or a story about a soon-to-be-successful business (it probably won't be). You never know if they've got gambling debts or a drinking problem. Everyone's going to look their prettiest and say whatever they can to get a loan.
4. Know the lending limits -- loans can be no more than $25,000 and at an interest rate no higher than 35%. Those who are requesting loans at one or both maximums may be extra desperate.
5. Make sure that the distribution of your loans follows a somewhat normal, bell-shaped curve. Settle on a target (or average) credit score that you're comfortable with and center your curve on it. My post from yesterday has some good info on that. Look at my analysis of the average lender and the excellent lender.

I think she's starting to come along...

I'll be out of town for a couple of days starting tonight. I will most likely refrain from posting until Monday. Have a good weekend!

Prosper.com: Convincing My Wife, Part 2

...she ain't convinced yet.

In my continued efforts to convince my wife that Prosper.com is a good investment, I'll analyze another aspect of the website today. Today I'll study what makes the successful lenders successful, what makes the average lenders average, and what makes the biggest losers, well, the biggest losers. I'll be moving my analysis platform to a fabulous website that focuses solely on Prosper.com lender and loan data, EricsCC.com.

To get things moving along quickly, consider the following graph that shows all lenders' rates of return on a seemingly normal distribution curve (please click any graphic to enlarge it):
As you can see, the majority of lenders are making money, and a significant majority are also earning a higher rate of return than they would earn in a traditional savings account. However, of all the non-average lenders, there are more that are doing exceptionally poor than doing exceptionally well. This indicates that if you do not follow a reasonable, disciplined investment strategy, you are more likely to lose at a high rate vs gain at a high rate. I guess the same could be said about the stock market. Essentially, it's easier to make mistakes than it is to get lucky.

Do you ever watch that show called The Biggest Loser on NBC? Well meet the biggest loser on Prosper.com: scoobydoo. Here is a graphical representation of his investments:
As Antonio from the Merchant of Venice would say, His "ventures are in one bottom trusted." This guy has invested a lot of money into Prosper.com and has given several large loans to people with C-grade credit. If one or two of those loans defaults, his ship will have sunk.

Let's look at another big loser's profile. How about jasonpeery:
Here's another guy that has a poor, lazy investment strategy. He has invested over $50,000 in Prosper.com listings and has scores of late payments and defaults. This guy has made several individual loans over $1,000, including one that is in default for $11,000! Why in the hell would you EVER loan $11,000 to a person with high-risk credit? And without even asking them a question! I sure hope that jasonpeery is better at personal finance than he is at determining to whom he should lend his money. As Neil Boortz would say, I bet that this guy has a lot of rent-to-own furniture in his house. My guess is that this guy's grandmother died recently and left him a bunch of money. No one that worked for $11,000 and saved it would ever be that careless in giving it to a single high-risk stranger.

One thing to remember about Prosper.com's fee structure is that all individual loan fees are passed along to the borrower except for a 1% loan servicing fee which is paid by the lender. This means that, statistically speaking, there is no reason to invest more than $50 in ANY candidate. Period. If I lend $500 to one person or $50 to ten people, I will pay the same loan servicing fee. And though I may save a little time by investing more money in lower-risk candidates, it's just plain silly to not diversify to the max with sub-prime borrowers.

OK, so let's look at someone with an average return. Consider the portfolio of helpishere777:
Ahh, this is refreshing. This user is right in the middle. He is earning about 11% interest, which takes into account the probability of his late payments going into default. He has invested the same $50,000 that our last big loser had invested, but in a completely different way. Look at the nice even relationship between all of the blue and green lines. Do you know why they're all equal? Because he invested the same $50 into every single loan. He understands that in order to mitigate his risk, he needs to diversify -- especially if he can do it at no additional cost!

Now let's look at the best lender. I'm not going to evaluate the person earning the highest return on his money. Currently that person is DrakeCO, who is earning about 33.6% interest. However, the average length of his loans is less than one month and most of his loans have been large amounts (max of $1,500) to high risk borrowers. Because of the youth of his loans and the nature of his strategy, he is bound to fail. Instead, I'm going to look at someone earning about 20% return with a reasonably large average loan period (if it's not old, the borrowers don't have time to be late!) and a significant amount of money. It looks to me like the golden child of Prosper.com is brother_tam. Here is his portfolio:

brother_tam is obviously smart and probably a little lucky. He has invested a little more than $10,000 in Prosper.com, mostly in $50 increments. Of his 224 loans, he has given more than $50 only 13 times, probably just to spice up his account. As a lender that understands the need to diversify. He is aware that he can invest in lower-credit borrowers because of his discipline. But he doesn't invest in only low-credit borrowers. He has a nice normal distribution of his loans that has a mean slightly on the low-credit side.

To be a successful lender on Prosper.com, you need to stick with a disciplined strategy that is formulated around the values of diversification and a normally distributed loan strategy. When choosing which loans to bid on, consider your current portfolio and establish a quota. "Right now, 75% of my loans are to high-risk borrowers. I should invest in some low-risk borrowers."

Remember: there is no penalty for investing the minimum amount in a person. And with more than 2,300 active listings, you shouldn't run out of people to lend to.

If she's still not convinced, I'll have to write more tomorrow.

Prosper.com: Convincing My Wife, Part 1

My friend and frequent tepom.com commentator Steve Butcher has an active account with Prosper.com and is doing quite well with it. His current rate of return is about 16.9%. I'm interested in joining him and trying my hand at peer-to-peer lending, however, my wife takes a very conservative approach to lending and will definitely need some "talking-into" if I ever want to open an account.

I will write a small series of posts that will attempt to justify peer-to-peer investing and convince my wife at the end that it's a good idea. The end goal of my analysis will be to prove my hypothesis that Prosper.com provides an excellent lending opportunity by using their empirical loan data. If my hypothesis is proven, I will convince my wife to start investing and share with you all my plan of attack.

Day one analysis: The correlation between debt-to-income ratio and loan delinquency
Prosper.com evaluates borrowers' credit reports and assigns them an alphabetical risk rating, from AA (the best) to HR (high risk -- the worst), with A, B, C, D, and E in the middle. In today's analysis, I decided to evaluate the correlation between a borrower's debt-to-income ratio (DTI) and the delinquency rate for each credit classification. My analysis assumes that any amount that is not current (>15 days late) is considered delinquent. It should be noted that these numbers do not suggest a loan default, just the probability of delinquency. Here I evaluate both the number of default dollars and the number of default loans. In my opinion, the number of delinquent dollars are more important than the number of delinquent loans because we intend to diversify our money as much as possible. The more you diversify your money, the more important the number of deliquent dollars become. The less you diversify, the more important the number of delinquent loans become.

Though my analysis evaluates delinquencies as a whole, it should be noted that those with poorer credit that go into delinquency are much more likely to have their loans written off than those with better credit. Essentially, those that have better credit are better at getting themselves out of trouble.

Click a chart to enlarge:
Looking at all loans regardless of the borrower's DTI (the blue line), it comes as no surprise that as the borrower's credit rating declines, there is a higher probability of the loan becoming delinquent.

However, when three bands of DTI are considered, the equation changes. With a DTI of anywhere from zero to 50%, the curve doesn't shift or change significantly for any classification of borrower. However, with a DTI above 50%, the curve is flipped nearly upside down. This suggests that a dollar loaned to a person with great credit but a high DTI ratio is more likely to be late than a dollar loaned to a person with poor credit and a similarly high DTI.

Similarly, when looking at the number of delinquent loans, the curves are closely aligned for borrowers with DTI less than 50%. But once the DTI rises above 50%, the difference in likelihood of the loan's delinquency rises substantially, especially for borrowers with great credit.

To summarize, the number of loans that will become delinquent do not vary significantly as the borrower's DTI changes except when the borrower has great credit. A borrower with great credit and a high DTI is much more likely to become delinquent than a borrower with great credit and low DTI. A borrower with poor credit and a high DTI is just as likely as a borrower with poor credit and a low DTI to become delinquent on his or her loan. When you consider a dollar loaned, a dollar loaned to a person with great credit and high DTI is much, much more likely to be late as opposed to a dollar loaned to a person with great credit and a low DTI. The reverse is true for poor credit borrowers. A dollar loaned to a person with poor credit and a low DTI is more likely to be late than a dollar loaned to a poor credit borrower with a high DTI.

So what do we learn from this? When lending to people with great credit, be wary of those with a high DTI requesting a lot of money. Don't lend to them unless you can obtain a premium rate. When considering lending to a borrower with poor credit, be sure to diversify your money across different loans. If you're torn between two poor credit borrowers, if the only difference between their profiles is their DTI, consider lending your money to the one with the higher DTI, especially if their rate is higher!

More to come on other Prosper.com lending strategies.

Why Social Networking is Killing the Traditional Survey

TechCrunch announced today that LinkedIn is going to begin its own ad network. Non-personally-identifiable information about users' age, income, education, etc will be placed into cookies that will be shared with partnering sites to help target certain ads based on a user's profile.

This is quite similar to the idea that I discussed last month about advertising based on financial profiles. The premise of my idea is to develop an exceptionally "sticky" personal finance website that would make assumptions about its users based on their financial transactions and then advertise appropriately.

Networking sites are starting to understand that their users are spending an incredible amount of time online, entering terabytes of their personal information in hopes of developing a new life-changing business or social relationship. The more useful features that these sites develop, the more information they'll be able to obtain about their users. For instance, if Facebook were to place a mapping feature on their users' photos albums (like Picasa has), they could see where their users travel and sell that information to local advertisers.

Back in the 90s, companies would try to obtain this kind of information by sending its customers index cards that asked questions about income, address, etc. Retail stored would ask for a zip code or area code to find where its customers were coming from.

Today, social networking sites are becoming Survey Central, and their users may not even realize it. By sites developing new features that are perceived as useful/fun/cool for users, they're opening a door into yet another dimension of personal information. By providing users with a useful or fun product, sites can collect the honest, accurate information that traditional survey adminstrators couldn't dream of. Take LinkedIn for example. As many join the site in hopes of being discovered by the Donald or at least scoring a lucrative business deal, their descriptions of their work experience are likely to be pretty accurate. Just as most people place reasonably accurate and verifiable information on their resumes, the professionals on LinkedIn will enter similarly accurate information into their profiles.

Social Networking sites should work with their key advertisers to figure out what information would be the most valuable to them and develop "back-door" applications and features to try and extract that information. Bars in New York City may be interested in advertising to Facebook users that are between 21 and 28, live in NYC, and have listed their interests to be "partyin" "drinkin" "gonig out" or "chillin." A government contractor looking to fill a handful of positions might ask LinkedIn to advertise the positions to users that log in frequently, are interested in job offers (a metric tracked on LinkedIn), and have at least five years of experience working for the federal government.

Because of user-created content on social networking sites, the way that companies collect data is doing a complete 180. Instead of asking 20 specific questions in a survey and deducing a conclusion about the participant, companies can inductively analyze a collection of user-provided data and target groups and demographics based on a predetermined strategy. Because of the nature of social networking sites, potential customers are already answering unasked questions. Now all advertisers need to do are figure out how to ask the questions and fill in the answers accordingly.

The Colors of Budgeting: The Red, The Green, The Gray

As I've said many times before, personal financial management begins with budgeting. It would be nice if we lived in a simple as black and white universe, where every month we would spend exactly what we had planned and never a penny more. But in the universe of expense planning, simple black and white do not exist. While tracking the reds and greens of our personal ledgers, we will rarely be "right on the money" with our monthly financial predictions and allowances in many categories. So as we follow our reds and greens, it is important to manage the gray.

So what does managing the gray mean? It means understanding that a budget is an inherently flawed two-dimensional plan tracking the lifestyle of a multi-dimensional household. It means understanding that life will change and spending will fluctuate for a number of different reasons. Debits and credits will hardly ever equal each other exactly; if you keep a running total of how well you're adhering to your monthly budget, you're either ahead or behind.

Budgets are a guideline to help you ensure you're making healthy choices about your finances. They'll tell you where your problem areas are and help you determine your capacity for savings. But don't let your budget control your every move. I would rather see you follow the spirit of your budget and use it for long term planning -- not short-term dictation of your daily purchases. Our daily activities aren't black and white -- they're full of shades of gray which are often out of our control.

Be sure to plan for the unpredictable by ensuring that the sum of your monthly budget is less than your monthly income. Save regularly and automatically (like into a 401(k)). By leaving yourself some wiggle room at the end of the month and stashing your cash behind the scenes, you'll ensure that your gray areas of spending don't break the bank.

Debunking Dave Ramsey's Snowball Plan for Debt Reduction

A reader recently commented on my site,  suggesting that I check out Dave Ramsey's website and learn about some of his suggestions for getting out of debt.  This morning, I performed a detailed analysis of his debt reduction plan which he calls the "Snowball Plan."

First accumulate $1,000 cash as an emergency fund. Then begin intensely getting rid of all debt (except the house) using my debt snowball plan. List your debts in order with the smallest payoff or balance first. Do not be concerned with interest rates or terms unless two debts have similar payoffs, then list the higher interest rate debt first. Paying the little debts off first gives you quick feedback, and you are more likely to stay with the plan.

I should mention that Mr. Ramsey is a faith-based financial advisor and regularly takes into account more than just the numbers.  When speaking on personal finace, he focuses on the "personal" just as much as the "finance."  Though his system has proven to be effective for some, it is not my style.

He urges his readers and listeners to build momentum when reducing their debt and try to feel a sense of accomplishment.  But let me warn you: those senses of momentum and accomplishment may not come cheaply.  Essentially, by "feeling good" about paying down debt, you risk taking more time to do it and thus wasting more of your money on interest payments.

Consider this analysis:

Let's say you have two loans: A student loan for $25,000 and an auto loan for $10,000.  The student loan has an interest rate of 8% and regular payments of $227 for 200 months.  The auto loan has an interest rate of 6% and regular monthly payments of $304 for 36 months.  In addition to your regular payments, let's say you have $100/month extra that you can apply to whichever loan you're currently paying and that once it is paid off, you will take the normal payments of it and apply them toward the other loan until it is paid off.  In this scenario, with minimum payments of $227 and $304 and extra cash of $100, you will be paying $631 per month until both loans are paid off.

Because the length of the student loan is much longer than the auto loan, even if you decide to apply the extra money to the student loan first, by the time it's paid off the auto loan will have been long-since paid off.  The total you will have spent on interest over the life of the two loans will be $10,603.  If you had decided to pay off the smaller auto loan first and then send all of your debt-reducing cash to the student loan, you would have saved $2,262 in interest.  In this case, Dave Ramsey's strategy works.

But let's look at another scenario.

Let's say you marry your college sweetheart.  After the wedding, you decide to merge your individual finances and adapt a joint financial strategy that works for both of you.  Let's say that you have a student loan of $30,000 at 9% for ten years.  Your spouse has less: only $15,000 at 6% for the same 10 years.  Like the previous example, you can pay an extra $100 each month toward the principal on whichever loan you're paying down first.

The terms (length) of the two loans are the same, one is twice the size of the other, and the smaller loan carries a smaller interest rate.  Dave Ramsey would tell you to pay off the smaller $15,000 loan first.  By doing that, you're costing yourself $1,534 in unnecessary interest.  If the difference in the interest rates was greater, this wasted amount would be even larger.  Let's say your loan carried 10% interest and your spouse's carried 5%.  You would then waste $2,058 in additional interest by paying the smaller loan first.

Let's tweak the numbers one more time: Assuming the same rates and balances,  a change in terms so that the smaller loan lasted for 15 years instead of ten would result in a waste of $2,656 in unnecessary interest payments; just because you listened to Mr. Ramsey.

As you can see, there is not a definitive high-level strategy that can accurately determine the order in which you should pay off your loans.  Mr. Ramsey tries to justify his financially flawed plan by adding emotion and human perception to the equation.  Here is my solution:  When considering the order in which you pay off your loans, crunch the numbers.  Once you prove which will save you the most money, set up a regular payment with your bank and forget about it.  You should find satisfaction in the fact that you're paying off your loans in the smartest, cheapest way possible.  Maybe it means paying off the smaller loan and maybe it doesn't. 

What to do if you're upside down on your mortgage

Also see my related post: What if You're Upside Down on Your Mortgage and Need to Move?

A lot of blame for the housing crisis is placed on "sub-prime" borrowers and the banks that loaned to them. It is true that at one point earlier in the decade it was probably too easy for someone with bad credit to obtain a loan. But declining house values and the subsequent emergence of negative equity also affected many intelligent, well-educated homeowners with decent credit. Many of them Gen Xers and Gen Yers that were buying their home because they were entering the home-owning phases of their lives -- not because low-payment mortgages were falling from the sky like raindrops.
Many of these homeowners that are in trouble had simply overestimated their luck in hopes of making a good investment. I'm sure that many of them, before buying a home, analyzed the cost of renting vs the cost and appreciation associated with owning. Given the numbers at the time, buying made sense. Additionally, many of the homeowners in trouble believed their lenders were looking out for their best interests; a belief that was unfortunately discredited for thousands. And TV shows like HGTV's "My House is Worth WHAT?" gave intelligent homeowners false hope about the financial returns they could receive by spending thousands on home upgrades (and financing them with home equity lines of credit).
So if you find yourself in an upside-down situation, what do you do? Should you pay down your balance until your equity is positive? Not necesarily. You should treat your loan -- upside-down or right-side-up -- just like any other loan that you're considering to pay off early. The higher the interest rate on your loan and the lower the interest rate at which you can save, the more sense it makes to pay extra. But if you have a reasonable rate, let's say below 6.5%, I'd rather see you hold on to your money. Throwing more money at your morgage isn't going to increase the value of your home. Only time and inflation will.

If you're upside down on your mortgage, don't expect to be able to move anytime soon. Save as much money as you can in an interest-bearing savings account that is easy to access until the time comes to sell your house. If you're able to wait long enough, your upside-down issue will eventually correct itself. If you need to sell before then, your savings will enable you to send a heap of cash to your lender a week before the sale, bringing your equity back into the green in one fell swoop.
In the future, never forget the old addage "if it seems too good to be true, it probably is." I'm not saying that good investment opportunities don't exist. They certainly do. But truly exceptional opportunities rarely exist in the stubborn, slow, and steady real estate market. If you ever see your equity in your home growing faster and faster faster to a level that you can't believe, be cautious. It's like watching a racecar driving 300 miles per hour (they usually don't go much faster than 200). Sooner or later, it's going to crash.

The Cost of Credit Card Debt

You've probably heard by now that credit card debt is as good for your finances as cigarettes and syphilis are for your health. In my opinion, if you're in credit card debt but refuse to assess its damage to your finances because you're afraid of what the numbers will look like, you're behaving no differently than someone who knows they're unhealthy, yet refuses to visit the doctor because they're afraid of the diagnosis. I've crunched a few what-if scenarios for those of you that may have credit card debt and are paying the minimum balances. Yes, this is meant to scare you.

First, let me explain assumptions I used to calculate my numbers:

• Credit card minimum payments vary over time; the higher your balance, the higher your minimum payment. They're equal to the current month's interest plus 1% of the principal. Usually, there is a minimum minimum payment, typically $20. This means that if your balance plus month's interest is less than $20, your minimum payment will be $20.
• Your first minimum payment will be the highest. Minimum payments will get smaller as time goes on because your balance will go down.
• If you can afford the first (and highest) minimum payment, you should be able to afford it every month if you choose to accelerate the credit card's payoff.
  
• You would be able to afford to put the amount of your first (and highest) minimum payment into a savings account if you did not have credit card debt.
• I assume 5% earnings in a savings account if money was saved versus paid to credit card
• I assume a 28% tax bracket
• I assume a $20 minimum minimum payment

Definition of savings terms:

• Savings account balance: variable contribution: This is what the savings account balance would be if the credit card's minimum payment each month was saved for the length it would take to pay off the credit card with a minimum monthly payment. Because of the shrinking credit balance, this assumes a decreasing monthly savings amount.
• Savings account balance: variable contribution: This is what the savings account balance would be if the first (and highest) credit card minimum payment was saved each month for the amount of time it would take to pay off the credit card with minimum monthly payments. This draws upon the assumption that if you could afford to pay the first minimum payment once, you could afford it every month.
  

Here are my scenarios:

• Credit card debt: $8,000
  Interest rate on debt: 15%
  Initial minimum payment: $180
  Months to pay off debt with minimum monthly payment (decreases over time): 283 (23.5 years)
  Total amount paid to credit card company: $17,300
  Total interest paid on balance: $9,300
  Potential savings account balance: variable contribution: $41,000 ($34,375 post-tax)
  Potential savings account balance: fixed contribution: $96,900 ($84,000 post-tax)
  
  Note the difference in slopes from the CC payoff (pink line) and the two potential savings growths (black and blue lines)
  
  
  
  
• Credit card debt: $3,000
  Interest rate on debt: 30%
  Months to pay off debt with minimum monthly payment (decreases over time): 215 (17.9 years)
  Total amount paid to credit card company: $9,520
  Total interest paid on balance: $6,520
  Savings account balance: variable contribution: $17,564 ($15,312 post-tax)
  Savings account balance: fixed contribution: $36,400 ($32,530 post-tax)
  
  
  Note that even with a smaller balance, with a high interest rate on a credit card, it still takes years and years and thousands of dollars of interest to pay it off with the minimum monthly payment
  

Now let's see what would happen with these same balances after making some sacrifices and putting more than the minimum payment to the card every month:

• Current credit card debt: $8,000
  Current interest rate on debt: 15%
  Original minimum monthly payment: $180
  New monthly payment: $500
  Months to pay off debt with new monthly payment: 18 (1.5 years)
  Total amount paid to credit card company: $8,981
  Total interest paid on balance: $981
  Total interest payment savings vs. minimum monthly payment: $8,319
  
  
  Note that by scraping together an extra $320 for a year and a half, you save yourself $8,319! If you were only able to scrape together an extra $100 per month and pay $280 per month, you would still save about $7,350 in interest.
  
  
  
• Current credit card debt: $3,000
  Current interest rate on debt: 30%
  Original minimum monthly payment: $105
  New monthly payment: $255
  Months to pay off debt with new monthly payment: 14 (1.2 years)
  Total amount paid to credit card company: $3,825
  Total interest paid on balance: $825
  Total interest payment savings vs. minimum monthly payment: $5,690
  
  
  Note that by scraping together an extra $150 for 14 months, you save yourself $5,690! If you were only able to scrape together an extra $75 and pay $180 per month, you would still save about $5,585 in interest. And again, if you could only scrape together an extra $20 per month, you would still save yourself $4,877 in interest!
  

As you can see, even putting a little bit extra toward your credit card balance goes a long way. A way to look at credit card debt is this: If you have a credit card on which you carry a balance and pay 15% interest, you're paying 15% on everything that you buy, even if you're not putting it on a credit card. That's because that every penny that you spend while you're carrying a balance could have gone toward paying off the balance.

If you have credit card debt and are paying the minimum payment each month, sending any extra that you can afford -- even if it's only $20 -- will result in incredible long-term savings.

Writing the news by knowing the buzz

Writing every day is tougher than I thought it would be. I'm always consulting my friends for help finding topics that people care about. And I owe lots of story ideas to my good friend Steve Webb. Steve (son of the recently infamous MLB scorer Bob Webb) is much better than me at keeping up-to-date with current trends and ideas in just about any subject: business, technology, music, sports, politics, science, pop culture, etc. If I ever hear anything and want more information, I hop on Gmail chat, ping Steve, and ask, "so what's the buzz?"

If I want to know what the buzz is with a new musician's album, he fills me in. How about the buzz on the new VP pick? Or on Pandora for the iPhone? What about the controversial party-boy writer Tucker Max? Spotting things that buzz around the globe is his sixth sense. In fact, I'd challenge anyone to write a thoughtful, professional paragraph on a larger number of topics than Steve. He's a hybrid of the RSS news feed in my web browser and the website howstuffworks.com.

I'm thankful to have a friend as resourceful as Steve. But many other writers are not so lucky. My wife is a news reporter. Chasing stories, she spends hours of her day driving throughout southeastern North Carolina, sometimes resembling Clark Griswold following Christy Brinkley's red convertible to Wally World. News informants are few and far between, and their leads sometimes send her down a rabbit hole.

But recently, I noticed that many local reporters are finding new ways to "catch the buzz" and elicit leads from a number of once-untapped local informants. They're using Twitter. When you think about it, by "following"people in their communities, reporters are mining a rapidly growing resource that only recently came to exist. Professional writers are able to "catch the buzz" without ever needing a friend like Steve or sneaking up on a whispering circle of conversation and slyly pointing their ear toward the gossip.

In my recent post about strangers following me on Twitter, I didn't realize that some of the unsolicited members of the Scott Fan Club were actually local news reporters. It wasn't until I read the author's name on an article in my local paper that I put two and two together: Jim Ware, one of my mysterious followers, was a night editor at the Star News -- not some creepy stranger that wanted to know when I was mowing the lawn or watching The Office. He was merely a local journalist that wanted to improve the efficiency of his story procurement and save himself a little legwork when determining, "what's the buzz?" And I applaud it!

I would encourage more local reporters of follow their neighbors on Twitter to get story ideas. However, after choosing to follow them, send a direct introductory message to inform them of your intent. It's a nice gesture and puts the ball in their court.

On another note, if for some reason Google is down and you ever need the buzz on something, give me a call and I'll forward your question to Steve...we'll put my paragraph theory to the test.

Why do I care about personal finance?

I keep a careful watch over my website's visitor statistics. I can draw a pretty reasonable correlation in the number of visitors each day to that particular day's topic. What I find is that I get the most hits on days where I talk about something somewhat controversial, like my opinions on drunk driving. Second in popularity are writings about technology or photography (my most popular post by far has been the one where I described the relationship between ISO, shutter speed, and aperture). Bringing up the rear, unfortunately, are my writings on my favorite topic: personal finance.

So why do I keep it up? Why is it my favorite thing to write about? In college, I didn't major in finance nor have I ever worked as a financial adviser. My family is not wealthy, nor am I. I live a relatively normal financial life and have relatively normal debts and assets that are made up of mortgage, auto, and student loans as well as savings, checking, retirement, and college accounts. And I'm certainly no Jim Cramer when it comes to picking stocks.

So again, why do I write about personal finance five days a week? Because I think that it's an enormous problem in our country. I think that mismanaged personal finances, preventable financial irresponsibility, and a sense of consumer entitlement have knocked the legs out from under our dollar. Americans have blindly wasted their money for years -- and I used to do it, too. Money falls from our pockets like snow from the sky, leading to the highest levels of revolving debt in history. Americans' inability -- or refusal -- to regularly assess the health of their personal finances has, in my opinion, become the largest cause of our current economic instability.

I know people with absolutely no savings that will put a new hi-def TV on a credit card. I know people with remarkably low income that eat out every single day just for mere convenience. I know people that are so far in credit card debt that they're literally afraid to sum up their balances, yet continue to shop, shop, shop to their hearts' delight. And I have people close to me with no savings, excessive debt, and an award-winning ability to self-justify frivolous spending.

I'm very lucky and thankful to have escaped from this type of behavior. As I have mentioned before on this site, upon graduating from college I had nearly $10,000 in credit card debt, most of which came from a distorted sense of entitlement and my ridiculous perception of a credit limit being analogous to a checking account balance. When I was 19, my cell phone was shut off for non-payment. By the second half of my junior year, I had even racked up a heap of debt with my fraternity.

It wasn't until my early to mid-twenties that I understood I was killing my future. Refusing to assess my financial damage was no different than refusing to go to the doctor in fear of hearing bad news. But after forcing myself to diagnose the disease, I vowed to cure it. I created a plan to get out of debt, save my money, and -- most importantly -- get some sleep at night.

It's tough to deny that the nation's economy is in trouble, and it's easy to blame it on George Bush, ExxonMobil, or the credit card companies. It's even easier to say that everything will be fixed once John McCain or Barack Obama takes office. But I hate to deliver the bad news to the country that fixing our problems won't be that simple. To solve our nation's economic crisis, we'll need to take it upon ourselves to make more responsible financial decisions. We need to go back to the basics; like Clark Howard once said about college, "If you don't have the green, you don't get the pizza."

In my opinion, the remedy for our economic downturn is difficult, yet not complicated: a grassroots movement of financial responsibility that is based on the principles of planning, monitoring, and measuring. So on those days that I "sacrifice" my web traffic, all I'm trying to do is do my part and get the word out.

Picasa face recognition and name tagging

Google's Picasa took a giant step forward yesterday with the implementation of face recognition software. After playing with it for a while, I must say that it is one of the neatest, most revolutionary pieces of desktop computing technology that I've seen in quite a while. It's been a long time since I have been genuinely wowed by an application (especially a free one); I literally burst out laughing with excitement when I saw it in action.

Here's how it works:
When you log in to Picasa, you'll see a little widget on the side of the screen with a button to activate the face recognition software. After clicking the button, the site will work behind the scenes for a few minutes (depending on how many pictures you have in your web albums) with a progress bar moving across the widget. When it is finished, you access a page that has extracted every face in every picture; in my albums, it found about 1,000 faces.

After finding the faces, it will group together the ones that it is "certain" are the same person into what I'll call a person category. For example, it found about 30 very clear instances of my face, which it placed into a single category, displaying a little icon for each instance. Each icon has a check box below it that is selected by default and may be deselected to indicate an incorrect person in the category. Below the icons, there is a simple text box that is used to tag all of the checked face instances in the category as a person. Conveniently, this name tagging section integrates with your Gmail contacts.

Going through my pictures, it found different instances of faces that it was less "certain" about, which it then placed into different face categories. Then it recommended name tags for the faces based on the tags that I had already used in other categories. In the 30 or so examples of my face that it placed in the first category, I standing straight up, smiling, and looking right into the camera. Photos where I was wearing sunglasses or looking to the side were grouped together in a different category and Picasa suggested that the person in the photos was me.

It will be interesting to see how social networks use this software in the future. Facebook already allows users to simply (though, manually) tag their friends in their pictures. I can just picture Facebook using face recognition software to identify people in the background of users' uploaded photos and tag them automatically. Imagine being automatically tagged in albums that you don't even know about. I'll bet college students would find it funny to get an email on Sunday mornings after their face appeared in a photo from the night before that was uploaded by a stranger!

And keep on eye on law enforcement's usage of this tool. From what I understand, they're already using facial recognition software. But if that usage was partnered with a major social networking platform, imagine the possibilities! The FBI or a police department could look at any publicly published photo on Facebook and run it through a face recognition application like Picasa. Who knows how many fugitives it would catch? I'll bet that a few wanted scofflaws and outlaws show up every now and then in nightclubs or other Facebook photo hotspots.

Setting long-term financial goals

I've been a long-time proponent of creating a budget and setting short-term financial goals. As a recent escapee of credit card debt, short-term goals have been the best tools to dig myself out of that hole. But during dinner last night, my wife and I were talking a little bit about our retirement and I realized that I had no idea when we could retire. All I knew was that we make decent money, don't waste too much on frivolous things, and try to pay cash for as many big-ticket purchases as we are able. Given our current situation, can we retire at 65? 60? 50?!?!

Because I'm no expert, I won't try and tell you how specifically to plan for your retirement. But I will share some results of exercises that I've been going through this morning. Ideally, I'd like to retire at age 50. And according to some initial calculations, I'll need to save a significant percentage of my income to retire at that age, assuming that I do not receive any social security. Of course, my lifestyle during retirement will affect the amount of money that I need to save. Assuming the following lifestyles (% of my current annual income, adjusted for inflation, that I would like to withdraw during each year of retirement), I will need to save the following percent before tax (assuming 8% growth before and during retirement):

• 70% of income: 32% savings
• 80% of income: 37% savings
• 90% of income: 42% savings
• 100% of income: 46.5% savings

Of course, those numbers assume that I will retire at age 50 and will receive no social security (mainly because the system is in the toilet and I don't want to rely on it). If I assume that I will receive social security benefits, my income/savings percentages change significantly:

• 70% of income: 23.5% savings
• 80% of income: 28% savings
• 90% of income: 32.5% savings
• 100% of income: 37.5% savings

One important thing to consider about these numbers is that they all reflect the minimum percent savings required to ensure that the money won't run out by age 90. Each percentage will result in a near-zero balance by age 90. However, by saving approximately 4% more than the minimum savings percentage required for my desired income, I will be able to draw from the account annually without decreasing the principal balance. Essentially, by saving for an 80%-income lifestyle and actually living a 70%-income lifestyle, my account balance will continue to grow indefinitely. Assuming that I save enough to live off of what is today $42,000 per year (70% of 60,000), saving an extra 4% annually will give me an account balance at age 90 of about $1.5 million. Not saving the extra 4% annually will leave me with a balance by age 90 of about zero dollars.

What I have learned from my research is this: I should figure out what kind of annual income I would like to have in retirement. Next, I'll save enough to make that goal, plus at least an additional 4%. It is that relatively small extra savings that will determine if I die rich or poor.