Why a Black-Coffee Management Style Would Have Saved Starbucks

In a waiting room magazine I once read that Howard Schultz, the founder and CEO of Starbucks, ironically prefers black coffee to any of the outrageous hot or cold drinks offered by the morning/afternoon/evening "fix" giant. The pied piper of java himself sticks to the core of coffee, and I think that says a lot about him as a person. Black coffee is strong and bold; it is foundational and pure; it's as American as Lewis and Clark; and though it is so incredibly simple, it's almost against-the-grain. Now I understand that not everyone likes black coffee. Some think it's bitter and rather plain, which is why Starbucks' overhead menu is bigger than that of McDonalds. And just as their menu appears to be slightly cocky and over-the-top (a 13-shot venti soy hazelnut vanilla cinnamon white mocha with extra white mocha and caramel? You've got to be kidding me!), in recent years their business plan started to follow suit by adding dozens of stores to every corner of the globe. Today, with profits down an astounding 97%, the executives at Starbucks are starting to feel an awful lot like mortgage lenders, cleaning the gum off their faces from a freshly-popped bubble.

Now that the economy is looking like a typical season for the Pittsburgh Pirates (they suck, BTW), consumers are cutting back on spending like never before. And luxuries -- like Starbucks -- are hurting the most. We're through with our smoke-'em-if-you-got-'em (and-borrow-'em-if-you-don't-got-'em) spending habits and have moved to a more conservative way of living, as if we just discovered that we can actually brew coffee at home. We're starting to treat fru-fru coffee as a luxury now as opposed to an everyday entitlement. And guess what -- if Starbucks had stuck to a simple, black-coffee management style, they would've seen it coming.

Am I saying that we should never drink Starbucks because it's a luxury? Absolutely not. Actually, I almost always drink Starbucks when I'm at the mall watching my wife spend money on clothes that cost a hell of a lot more than my cup of coffee. I can probably count on two hands the amount of times that I visit a Starbucks each year. But when I think of coffee spending getting out of hand, a story comes to mind. While enjoying a hot drink with my in-laws at their local 'bux, I spotted a woman waiting in the 15-person line. She carried her own purple mug (going green -- nice), but it had a homemade sticker on it; I investigated. On the sticker was printed the exact specifications of her favorite [complicated] drink, the details of which I will not bore you with. I couldn't believe it! This seemingly frivolous experience (which we recognize with every $4 coffee joke we make) had become an obvious daily habit of this woman. After I watched her pass her mug across the counter, I noticed many of the other patrons in line ordering their drinks without even glancing at the menu. They were hooked, too.

A big reason that the economy is where it is today is that people spent outside of their means for several years. Today, the average amount of household credit card debt is over $8,000. And though the woman with the purple mug may have very well been wealthy and within her means while indulging in her $100/month habit, I've got to imagine that at least half of those people in line were part of the startling outside-of-our-means American spending statistic.

Did Starbucks know that consumer debt was spreading like a California wildfire? They must have. Did they know that their coffee was expensive? Umm, does a bear shit in the woods? Despite evidence that Americans were becoming poorer and the clear and present fact that their product was expensive and easily replaced by a much less expensive homemade substitute, Starbucks continued to build store after store after store. Now, with profits down for the count, they're closing hundreds of their locations to make up for their grossly overestimated forecasts that, frankly, were as ridiculous and pretentious as their holiday coffee selection.

I'm sorry to pick on Starbucks. What's happening to them is happening to a lot of businesses, which is why so many Americans are losing their jobs and, subsequently, their mortgages. When Americans as a whole strayed from a reasonable and symmetrical expense/income ratio, businesses like Starbucks saw the desert mirage of infinite exponential growth that, in reality, was merely dust. This is why I preach, day after day, the covenants of responsible spending.

Responsible spending helps individuals by allowing them to save for the future. It allows them to keep more of their own money and to live a sustainable and healthy financial life. Responsible spending helps the entire nation by eliminating these false forecasts of eternal growth and profits for businesses. It keeps the economy in check, managing inflation and stabilizing cash flow. Keep in mind that I am an absolute proponent of spending money. Spending is the be-all-end-all of a capitalist society. And if we as a people bought only the bare essentials, we'd eat nothing but rice and all live in caves. But by buying the things that we don't need day after day for years and years, we become a gluttonous society that cannot sustain itself, much like a balloon. Now, because of America's overspending -- much like overeating -- we must reduce our consumption to below normal levels to get back to the point of a healthy equilibrium.

So while irresponsible customer spending helps companies like Starbucks in the short term by giving astounding inflated profits for a few years, it can destroy them in the long term. If Howard Schultz had stuck to a black-coffee, back-to-the-basics management style, he would have recognized the looming bubble and directed the company proportionately. Like black coffee, it would have been simple, yet against the grain, to slow expansion -- but it would have saved his ass. Instead, for years he and his stockholders were swooning over the streams of cash and credit pouring through the doors and laughing all the way to the bank. But who's laughing now?

Managing the Finances of a Two-Income Household

Before I got married, I had been warned that money was the root cause of many marital disagreements. My wife and I hoped that we would be exempt from this trend, noting our comfortable individual salaries and modest tastes. Each of us is good with money and we had no problem agreeing to share it 100% from day one. But we didn't realize that merely sharing money with your spouse, even without financial difficulties, can sometimes prove to be a challenge.

So what's so hard about sharing money with another person? If you can each afford the things you want on your own, how does bringing in another person with his or her own income affect this? I can tell you from experience that joint checking accounts will sometimes test you. In a couple that carefully manages their finances, one may feel controlled by the other, like he or she can't spend a dollar without first asking the other. Or a person risks being sneaky by making a large purchase without a spousal consultation.

Sentiments of control or sneakiness can also be amplified by factors outside of spending, like differences in salary, the number of hours worked each week, or even the amount of chores that one does around the house. If a wife makes more money than her husband, she might feel entitled to spend more than him. Or if she feels like she does more around the house than her husband, she should be able to splurge without first consulting him because, hey -- she earned it. On the other side, the husband, though he makes less money than his wife, might work more hours than she does in a given week. Therefore, he justifies spending money on an expensive leisure item -- maybe a boat or a case of expensive beer.

When we are single, we choose to reward ourselves for varying reasons. We might reward ourselves for something big, like getting a high-paying job, or for something smaller, like finishing a long 60-hour week at the office. These are habits that we probably developed as bachelors and bachelorettes and it's easy for them to be part of the package when we promise to have and to hold and till death-do-us-part. But once you're married and have checks with both of your names on them, it's easy to disagree with the other's spending habits. The good news is that there are a couple of simple things you can do to help ease the transition.

#1 - Talk about money regularly, but only at established intervals
If your wife comes home from the mall with an armload of shopping bags or your husband walks in the door with leftovers from Outback, it's easy to call him or her out on it. "Hey, didn't you just buy new clothes?" or "Hey, isn't steak a little out of our budget?" The opportunities to micro-manage your partner's spending are limitless, but they should be avoided because they can give the impression that you're being controlling.

What I suggest is this: Only review your budget and spending at established periods -- be they weekly, bi-weekly, or monthly -- and not in-between. As you know, I am a huge proponent of using free online personal finance tools, such as Mint.com. Mint has a feature that will email you every Friday with your account balances and month-to-date adherence to your budget. And it gives you the option to send the message to two email addresses. So each period, you and your spouse should look at those items together and note any flags. "Hey, we're way over budget on restaurants this month -- we should start eating in more," or "I've already spent $300 on clothing this month. Maybe I should hold off on another shopping spree for a while." These regular reviews will help prevent micro-management of each others' spending while allowing the two of you to stay on top of your finances as a whole.

#2 - Establish a $100 rule
Call it whatever you want to call it -- the $50 rule, the $100 rule, or the $500 rule. Establish a spending threshold that will constitute a required consultation with your partner. If you have a $100 rule, any time one person is going to spend more than $100 on anything, the other needs to be consulted. You can bypass this by setting up spending limits for trips. For example: "When you're in Pittsburgh, don't spend more than $200." Again, this is a rule to help alleviate sentiments of one controlling the other's spending while ensuring that the couple's financial goals are on track.

It's easy to have be critical of your partner's spending -- especially if you do more around the house, work longer hours, make more money, etc. But if you two have decided to pool your green, forgive the expression, but you'll have to put your money with your mouth is. Check your grievances at the door and manage your finances as an individual with two jobs. Play nice, don't micro-manage, and consult one another on large purchases. Active or passive aggressiveness won't cut it.

How do you and your significant other share finances?

The Inability to Say No and Having Ritz-y Taste on a Econo Lodge Budget

I usually hate to give generic, common-sense financial advice that you can find anywhere on the internet. The most common is "instead of buying a cup of coffee at Starbucks, put that money into a savings account." No shit. My readers are not stupid and I'm not going to insult you by giving that kind of cookie-cutter advice.

Today's post will consist of something like observational humor, except not funny...at all (that was kind of funny, right? No? OK, I'll move on). I'll highlight some of my specific observations related to people's spending habits that drive me nuts -- especially when I see those in question complain about their finances or at least imply their struggles.

#1 - The inability to say "no" to your friends
Many people are aware that they've got financial difficulties, yet accept any invitation to spend money, as if it is OK to do it because it wasn't their idea. If you know that you're going to be short on rent for next month but your friend invites you on a weekend road trip, what should you should say? "Hell no!" Making excuses for spending money is easy. Just because it was someone else's idea doesn't mean it's any less of a poor decision.

If you're invited to spend money and cannot afford it, it's OK to say no. In fact, some of your friends and family might respect you for it. Whether the invite is direct, like "Want to go to Cancun this winter?" or indirect, like "Hey Bob -- all of us bought new Macbook laptops -- where's yours?" you need to learn to say no. There is simply no point in taking the time to come up with spending and financial goals if they can be so easily changed by some peer influence.

#2 - Ritz-y taste, Econo Lodge income
Regardless of the weakness, I see that many people have at least one. Whether it's designer clothing, organic groceries, a certain brand of electronics, or the refusal to cook for oneself, every day I see people that cannot afford their personal luxuries try to justify them. Here are some real, specific examples with fake names:

- Joe is unemployed, has a young child, no savings, and a wife working a low-paying full-time job, recently refused a truck full of free furniture from his grandmother for his new apartment because he's "looking for matching stuff."
- Devin struggles to pay his mortgage and other bills, yet goes out to lunch every day because he hates to cook and thinks it's a good way to socialize.
- Fred has thousands of dollars in credit card debt yet buys expensive designer clothes every month.
- James uses his first paycheck from his first job out of college to buy a Hi-Def TV and a Wii.
- Tom has many tens of thousands of dollars in student loans but goes to the bars with his friends every Friday and Saturday night.
- Tracy has a very low income and is unsure how she'll pay her rent for the month. Yet she refuses to do her grocery shopping at any place other than the specialized organic food store.

Am I trying to say that you can't have matching furniture, a Hi Def TV, or designer clothes? Abosolutely not. Am I saying that you can't eat organic food, go out to lunch, or drink beer at a bar? No. What I'm saying that that you cannot classify these items as affordable simply because they're mainstream and everyone else is consuming them or because you feel entitled to them. If you've got an Econo Lodge income, you can't stay at the Ritz.

Insisting on expensive habits when you cannot afford them is, in my opinion, the biggest reason that people get themselves into financial trouble. Consuming based on our personal preferences gives us a feeling of independence. It makes us feel like we're doing things our way on our terms. But in the end, the choices that we made that once made us feel so independent actually enslave us and forfeit our control to our creditors.

By saying "I'm going to go out to lunch if I want to," or "I'm going to eat organic food if I want to" or "I'm going to go drinking with my friends if they invite me," if you can't afford it, all you're doing is signing over control of your life every time you sign a credit card receipt.

It is often said that the troubles with today's economy stemmed from "securitizing" mortgages, which means taking big bunch of mortgages, putting them all in a box, taping it shut, writing "security #1" on it, and then selling it. Those who buy it don't have the details of what's inside -- just that it's got a bunch of mortgages. To me, not being aware of your individual transactions is the same thing. By refusing to analyze where and how you're specifically spending your money, all you're doing is looking at the credit card bill at the end of the month and seeing one big number that reflects the sum of your monthly spending. Without looking at the individual transactions and evaluating their impact on your big picture, you're simply asking for trouble -- just like the mortgage industry.

So before you start spending on one of your vices, create a budget to see what you can really afford. You may be quite surprised!

Three Parts of a Practical, Effective Budget

Many times I've recommended creating a personal budget to help you meet your financial needs. It doesn't sound too difficult, does it? Believe it or not, the hardest part is finding the discipline to stick with it and give it the care and feeding it needs to be effective. It's easy to add up your income and divide it across all of your expenses/savings goals. But budgeting is more than that. In this post, I'll tell you the three important items that you'll need to have an effective budget: a Budget "Thermometer," Running Total Tracker, and Cash Planner.

1. Budget Thermometer








Here is a sample of my budget thermometer for September. It is simply a screenshot from my favorite free personal finance software, mint.com.

Coming up with categories and their monthly allowances is an important first step and the part of your budget that you will pay the most attention to on a daily basis. Mint.com not only allows you to create your budget, but it will show you a daily thermometer to display how well you're adhering to your plans. Because it's integrated with your bank and credit cards, each day it will classify your spending transactions and tell you whether or not you're on track to meet your monthly goals. If you spend half of your grocery budget by the 5th of the month, Mint will alert you so you can rein in on your shopping until you're back on track. As you spend money in a category, your little "thermometer" will fill in. Its color will change if you're on pace (green) , not on pace (yellow), or over your monthly budget.

I can't tell you how to split up your income each month, but here are some tips:

- Before creating your categories and their associated monthly allowances ($500 on groceries, $200 on restaurants, etc), take a look at where you currently spend your money and don't just pull the numbers out of thin air. If you're using personal finance tool like Mint, Quicken, or Money, you should be able to see a pie chart that shows you how you've spent your money in the past. But make sure your past transactions are classified correctly!

- Next, establish new goals for each of your categories. It's OK (and encouraged!) to spend less each month in certain categories than you have in the past. If you spent $400 last month at restaurants and want to bring that down, this is the perfect time to set those goals. Make sure you're using reasonable and achievable estimates for everything, but don't be afraid of a challenge.

- Don't forget about your savings goals! If you're saving up for something specific like a vacation or an engagement ring, start implementing those goals into your budget as categories after you've figured out what you'll have left over. Whether it's $10 per month or $500 per month, it's important to put money away for the things you'll need in the future.

- Don't budget down to your last penny. We're dealing with your personal finances; you're not an accountant. I like to leave out 2.5% of my monthly net income (after-tax pay) unaccounted for. There's no doubt that at least one of my expense categories will go over one month (as you can see above), so it's nice to have a little buffer for such an occasion without throwing off my other goals.

- If there are expenses that aren't incurred monthly, like car insurance or, in my case, my dog's annual vet visit, split them up in terms of months. Divide your six-month premium by six and use that as your monthly budget. This, of course, means that you'll be under budget some months, and over budget the months that the expense is paid. This point illustrates the need for the other two pieces of an effective budget: a Running Total Tracker and a Cash Planner.

2. Running Total Tracker
Unless you're an incredibly disciplined, you're not going to spend exactly the same amount of money each month on all of your categories. Certain things like your car payment, mortgage, etc are fixed, but other expenditures like groceries, clothing, and utilities will vary a bit. This is why it's important to track running totals.

Mint does not have running total tracking functionality, so I do it myself once a month in a spreadsheet. Two of my columns are identical to my categorical budget columns that are tracked by my personal finance software. One column has the identical category and the next has the monthly budget. Each month, I evaluate my monthly adherence to my budget and note the amount that I was over or under for each category in a new column; I have columns for each month that I have been using the spreadsheet. If my restaurant budget is $140 and I only spend $90 in September, my September column would have a green "$50" because I spent $50 less than budgeted. If I had spent $150, my September column would have a red "$10" because I spent $10 more than budgeted.

Next to the first two columns that display spending categories and their monthly allowances, I have a third column with a number that is either red or green. This number represents the sum of all of the monthly over/under amounts, which I call the "running total."


The running total is important for me to know how well I'm adhering to my budget over time. Also, it keeps track of the balances of certain non-monthly expenses and can help when you create next year's budget. If you see that you're constantly spending more than your budget on gas or groceries, you might need to rethink your amount.

Additionally, the running total column can indicate whether or not my wife or I can afford greater than normal spending in a certain category. Recently she said she wanted to go clothes shopping. We hadn't spent any money on clothes in a few months, so when I checked our running total for clothing, I saw that we were about $123 in the green. Because we hadn't spent our $50 clothing budget in a few months, she was able to go and spend more money on clothes this month. When I update my spreadsheet next month, the running total will be back to zero.

3. Cash Planner
Our incomes and expenses aren't always regular and incremental. There are times of the year when we receive bonuses or incur extra costs. The third piece of budgeting is important to help you determine how much cash you'll have after receiving irregular income (possibly after getting your tax refund) and after paying your abnormal expenses (like the January post-holiday credit card bill).

This budgeting tool is also something that I track manually in Excel. Across the top are columns indicating two periods per month -- one ending on the 15th and the other on last day of the month. It's up to you to determine how small your time increments will be. Depending on how often you're paid, you can have columns represent every Friday from this day forward, or simply the end of the month.

For each column, I have a series of rows for my expenses and incomes. My income is a row and my wife's is another. My expense rows resemble my budget categories, but unlike my running total spreadsheet, they don't follow them explicitly. This is because not all of my expenses are paid on the same day of the month. Many of them, like groceries and my XM bill, are put on my credit card. Since my credit card bill is due only once per month, I have a single row for "credit card" that includes many of my regular expenses. Other expense rows include one for my mortgage, my car loan, and my student loan payment.

Two other important rows include "Additional Income" and "Additional Expenses." These will be places where you can input anticipated fluctuations in your income or expenses. If you know you're planning on spending $350 next month on your quarterly student loan interest, you can plan for that. If you're getting a big tax refund in the spring, put that in your April column. Add as many columns as you're comfortable with. If you want to plan out six months ahead, you may. If you only want to plan two months ahead, that's fine, too.

Next, for each period column, I enter the expected amounts for each row (if any) that will be applied during the period. For example, my mortgage and car payment are paid on the 10th of each month. For the column labeled 10/15 (representing the period from October 1st - 15th), I will enter the amount of my monthly mortgage and car payments as well as any income I expect to receive. Since my credit card and student loan payments aren't due until later in the month, those expenses will show up in the second column for the month, 10/31. Similarly, because my wife is paid only at the end of each month, I'll enter her income only for the second period.

At the bottom of each column, I do a little math to estimate my cash balance. I take the cash balance from the bottom of the previous column, add the incomes from the current column, and then subtract the expenses from the current column. This will result in my new expected cash balance for the period. For example if I had $5,000 at the end of the last period, received $1,000 of total income, and incurred $800 of total expenses, my new cash balance would be $5,200.

While the Budget Thermometer and the Running Total tracker are useful for tactical budgeting, the Cash Planner is great for strategic cash management. If you're trying to develop an emergency fund of a few months' salary, the cash planner will give you a good idea of how long it will take to reach your goal.

As you can see, there's more to budgeting than just coming up with monthly allowances for spending categories. To budget effectively, you must have reasonable monthly goals (derived from your past spending), the ability to monitor your adherence to those goals, a willingness to log your monthly adherence (running totals), and a view into the future to know what your financial situation will be and how soon you can achieve your goals.

What are your own personal budgeting strategies?

How to Spot Your Family and Friends' Financial Troubles

I'm proud of my audience. I really am. Since becoming a regular reader of my posts, I'm sure you've long-since retired and are enjoying the fruits of your pre-retirement frugality on a secluded beach in the Caribbean or on your 40-ft yacht (for which you paid cash, of course). I'm thrilled that you've achieved financial independence, so today I'm going to reward you with a day off and a break from lending advice on your finances.

Now don't get me wrong -- I'm not going to stop talking about finances. But today, instead of talking about yours, I am going to talk about those of your friends and family and how to spot a problem. I'm going to talk about clues: those that indicate current trouble and those that indicate a future fiasco. The way I see it, family and friends are supposed to help each other through hard times and support each other during painful periods. For many, personal finance is a private subject that offers very little transparency for outsiders. Many times you can't detect problems with your eyes, your ears, and your nose, as you can easily do when it comes to identifying substance abuse. Instead, you will rely on your gut -- playing detective and piecing together the clues to support your argument that a problem -- or even crisis -- really exists.

Before you consider whether or not a friend of yours is having financial problems, you'll need to have an original suspicion; we can't investigate and confront everyone (like the nosy neighbor Martha Huber on Desperate Housewives). Many reasonable suspicions will come from a passing statement about credit card debt, the infrequency of pay days, the inability to pay a bill, the inability to save, or something else. Let's look at a few potential flag statements:

• "I have no idea how much credit card debt we have."
  Your friend's lack of knowledge of the amount of his credit card debt indicates a detachment from his own finances. Though his personal finances are private and he is unlikely to share his net worth with others, his own accurate view into them is absolutely critical to his financial wellbeing.
  
  
• "I'm just paying the minimums."
  This statement indicates an inability to sacrifice when repaying debt and/or a fundamental misunderstanding of the nature of revolving debt. As I proved in a previous post (the Cost of Credit Card Debt), paying the minimum on a credit card is about the worst financial decision one can make, second only to taking out a payday loan or using cash as kindling. If your friends are paying only the minimums on their credit cards -- especially if they continue to eat out and spend on non-essentials -- it shows that they are in denial of their situation and are likely in need of a friendly nudge to get the ball of debt reduction rolling.
  
  
• "Thank god that my spouse and I are paid on alternating weeks."
  Living paycheck to paycheck is part of being young. When I first graduated from college, it was important for me to analyze my paydays and sync them with my bills' due dates. But as I got older and was able to save a little more, I eventually got to the point where I had an amount equal to one paycheck sitting in my checking account. Once I hit this milestone, life became easier because I didn't need to strategize the days on which I paid my bills. But when you see friends and family in their 40s or 50s worrying about which day of the month they're getting paid, it can indicate a paycheck-to-paycheck lifestyle and therefore, a lack of savings (or at least liquid savings). Assuming he has a moderate salary, that lack of savings might come from excessive minimum payments on loans and credit cards or from current overspending. Additionally, this indicates that your friend struggles with budgeting and planning for expenses that fall far away from payday.
  
  

If your family and friends are quiet and don't give these kinds of clues, you can infer financial troubles in different ways. If you're good at doing math in your head, you may be suspicious of their spending habits if they just don't seem to add up. If you know that your friend has a salary of $30,000 per year, yet you see him going out for lunch every day, driving a new car, living without roommates, wearing expensive clothes, and watching a high-def TV, you can assume that he is living outside of his means. It's not easy to look at someone's lavish lifestyle and automatically assume that they're spending more than they make. But it can certainly be grounds for suspicion and, combined with other clues (like some of the statements above) be a strong indicator of financial trouble. If a friend or family member tries to keep up with the Joneses without having the means of the Jonses, they're setting themselves up for trouble.

So why do people get into financial trouble? Clearly, some are presented with circumstances which are out of their control, like a sudden illness or a layoff in a poor economy. But some get into trouble for other reasons. Here's my theory:

Have you ever heard the principle that a liar will begin to believe his own lies if he tells them enough? Eventually, his lies can be spouted off without guilt or remorse. I think the same concept can be applied to those with preventable financial troubles. The snowball will start to roll when the person initially buys something which he cannot afford. He'll lie to himself about the item's affordability, being well aware that he should walk away and abandon the need for instant gratification. "Oh, it's just a lousy TV. I can afford it," knowing deep down that it's not a good idea. Later, when presented with another opportunity to spend unwisely, the same person will more easily convince himself of the affordability of said unwise purchase, despite contrasting evidence. Eventually, when it's told enough, the lie of affordability becomes second nature and is no longer is perceived as a lie; and that's when it becomes dangerous.

Do you remember the first cigarette you ever smoked and how horrifying that first puff was? It was awful and bitter and burning and easily sworn off. But the second one was a bit more tolerable. And the third became somewhat enjoyable. Over time, you developed a habit and never looked back at how terrible that first drag was. On day one, your body was trying to tell you something. You knew it was bad for your health, but you found a reason to do it anyway, probably related to high school popularity (keeping up with the Jonses) or the relief of stress (instant gratification). Whatever cookie-cutter excuse you came up with on that first day, you used it again and again until you didn't need to excuse yourself any longer. Non-smokers, please forgive this example, but I hope you get my point.

I certainly don't condone sniffing into the business of others. Personal finance is often a taboo subject among friends and family and a confrontation can affect a person's sense of independence and pride. However, depending on the situation, financial troubles on their part may result in a bailout on your part. Depending on the size and nature of the debt, what was once their problem may eventually become your problem. The way I see it, family money is family money. The benefits and the detriments to one member most certainly have the ability to benefit or detriment another. In other words, though it may not be your business today, it may become your business tomorrow.

I welcome anonymous comments about the financial stuggles of your friends and family.

When Do We Eat? The Value of Financial Individuality

Do you remember when you were growing up and your mother told you that you were special? Or maybe it was a teacher or your grandmother or a family friend. Chances are, a caring adult in your life encouraged your individuality and, more importantly, your independence. The lesson may have been taught in different ways, but was nonetheless important. Maybe you were encouraged to think twice before jumping off a bridge if all of your friends decided to do it. Maybe you were taught to "just say no" when presented with an opportunity to engage in an activity that threatened your moral fiber. However it was taught to you, I'd like to discuss the lesson's importance and relevance to your financial wellbeing.

Individuality and independence are important traits for people to possess in many respects. The right kind of individuality will set you apart from other candidates when applying for a job or admission into college. The wrong kind of individuality might earn you inquisitive glances from strangers and fearful looks from small children clutching their mothers' legs.

The ability to think critically and independently will also fuel your ability to responsibly manage money and increase your wealth. Lots of Americans have been frightened of the downward trending stock market and have been selling their stocks like nobody's business. The band wagon is speeding away from Wall Street just as fast as its little wheels can carry it, and the value of our investments are falling as a result. But just because so many people are jumping on, should you do it as well?

I guess it depends.

When I was in college, the most popular dining hall was called West End Market. It had a fun atmosphere and the food was diverse and delicious. But in my opinion, it was an absolutely miserable place to be at 6pm. Every evening, West End looked like Times Square on New Years Eve. Hokies arriving at dinnertime lined up like motorists at the DMV, often waiting more than 30 minutes for a sandwich or a plate of the ever-famous Chop House london broil.

I like eating at a normal time like everyone else, but being the impatient person that I am, one experience at West End during dinnertime was enough for me. I avoided it altogether for months, eating at the non-award-winning dining halls, until one day when I decided to pop in an hour early. You'd be amazed at the difference that hour made. At five, though I had worked up less of an appetite, I could hear crickets chirp as I leisurely approached every food station that I desired. Free tables were bountiful and I was able to feast in peace like Kevin McCallister on Christmas Eve. At six o'clock, patrons would be reminded of an overcrowded high school cafeteria on a day where all but one of the lunch ladies called in sick. Sure, it was easy to socialize, but those that came with the crowd wished they had brought a snack for the line.

So what does a dining hall have to do with investing? Well, when everyone is selling -- to the point the Dow falls to its lowest value in five years -- you have to ask yourself what your strategy is. You might not be starving until six, but at six, everyone will be starving. So chances are, you might not eat until seven. So you have to ask yourself, are you a six o'clock person? Or are you a five o'clock person?

The six o'clock person will sell, sell, sell and wait until the market is trending upward before they buy again -- just like everyone else. The five o'clock person will start buying when no one else is. He will understand that stocks are on sale and remind himself of the history of the market, which has always stood the test of time, despite its sometimes significant peaks and valleys. He's not famished yet, but he knows that hunger will come soon and he had better get in line before everyone else does.

Warren Buffet once said "Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can't buy what is popular and do well."

Of course, investing in the stock market during a troublesome time is much more complicated than determining what time to go to dinner. But at a high level you have to ask yourself why you're there. Are you there to socialize? Or are you there to eat?

Guidelines for accelerated loan payoffs

If you've been frustrated with the faltering markets lately, as have most Americans, you've probably been discouraged from investing your disposable income into the stock market. That could very well be the correct choice for you and your family, depending on your financial plans and tolerance for risk. But if you're not investing in the stock market, what are you doing with all that money? Are you putting it in a savings account? Or a CD? Or are you paying down debt?

My personal financial plan calls on paying down my debt during the economic downturn. The markets have been unpredictable (and by unpredictable, I mean they're going straight down) and the amount of debt that my wife and I have will take a relatively short amount of time to pay off. We're hoping that when we're out of debt in a couple of years (excepting our mortgage), the market will be trending upward and we'll have a larger portion of our income to regularly invest, given the fact that we'll have no regular payments for our auto or student loans.

If you're going to start paying down debt in lieu of investing, consider the following three guidelines to help you prioritize where your money is being sent:

1. Pay off the loans with the highest interest rate first (as long as they're not tax advantaged)
Dave Ramsey will tell you to pay off your loan with the smallest amount first instead of the one with the highest interest rate. This adds a layer of subjectivity to your personal finance that, while making you "feel good" about paying down your debt, will cost you money. In a recent post, I discuss the financial disadvantages his plan.

Non-tax-advantaged loans that fall into this category include credit card debt, personal loans, and auto loans. Look for your highest interest rate, and start sending whatever extra money that you can to pay it off.

2. Pay off loans incrementally -- don't save your money and pay it off in one fell swoop
I'll give a personal example here. Though I still have a couple of years' worth of payments remaining on my auto loan, I'm hoping to have it paid off by January. While maintaining my "emergency fund" in my checking account, and have been placing my monthly disposable income into an "auto loan payoff fund" that lives in a savings account. Last I checked, I had a few thousand dollars in there.

I had originally planned to keep making my regular monthly payments and continue saving money in the payoff account until I had enough money to pay off the car. But then I crunched a few numbers and found the flaw in my plan. Here's how it goes:

Whenever you make a regular monthly payment on a loan, a portion of that payment goes toward the principal balance and another portion goes toward interest. Those percentages are determined by a couple of different factors:
1) the time left on the loan (the less time left, the higher the percent that goes toward principal) and
2) the amount of remaining principal balance (the lower the balance, the higher the percent that goes toward principal).

So if my monthly payment is $500, maybe $400 of that goes toward principal and the other $100 goes toward interest. Next month, after the principal balance has been slightly reduced, the payment distribution may be $405/95, and so on. But if I have a few thousand dollars in a savings account that's just waiting to be used to pay off the loan, I am better off sending that money as a principal-only payment immediately. If I reduce my principal by, let's say, $5,000, a much higher percentage of my regular monthly payment will go toward principal. If you're paying off a loan on an accelerated schedule, sending the extra money as soon as you have it instead of saving it and sending one big fat check at the end may save you several hundred dollars over the life of the loan.

3) After non-tax-advantaged loans are repaid, evaluate the tax benefits of other loans before repaying them.
Once your credit cards, personal loans, and auto loans are paid off, hopefully all you'll have left is a mortgage and maybe a student loan. At this time, before deciding to accelerate the payoff on these loans, you should reevaluate the stock market. Has it picked up yet? If you're still not feeling warm and fuzzy, do some math and figure out how much your tax-advantaged debt is really costing you.

If your mortgage has a 5% interest rate, remember that depending on your tax bracket, you'll get maybe 25 or 28 percent of that interest back in your tax refund. So think of the effective cost of the debt to be 3.75% (5%, minus 25% of the 5). Your mortgage is a very long-term loan, and you won't see the benefits of paying it down early for a very long time. Paying it off early won't reduce your monthly payments. Sure, it will be paid off sooner, but even if you double your monthly mortgage payment every month until it is paid off, it will take almost 10 years to pay off a 30-year mortgage. If the effective interest rate on your mortgage (the interest rate less the tax benefit) is only slightly higher than the amount you could earn in a CD or a savings account, I would rather see you hold onto that money just in case you need it.

With all loans, especially those that are tax-advantaged, the lower the interest rate, the less sense it makes to accelerate your payoff. My friend Quang's student loan has a 3% interest rate. I wouldn't pay that off early for the world. But the rate on one of my wife's student loans is 7.9%. I can promise you that as soon as my car is paid off, the next thing to go will be that sucker.

Non-tax advantaged debt is nobody's friend. If you're not satisfied with the performance of your investment portfolio, it could be a wise decision to pay it off early in lieu of investing. But if your only debts are mortgages or student loans, think twice before you start sending extra cash toward the principal. True, you're saving yourself money in the long run, but remember that you're also reducing your tax writeoff and parting with that money for a long, long time. And keep in mind: even if you're using the standard deduction (not itemizing), your student loan interest is still tax deductible!

Pork Barrel Spending in Corporations is Equally Appalling

To understand the significance of the downturn in the market, check out Sequoia Capital's Powerpoint presentation on Tech Crunch, which contains a quote near the end that reads "spend every dollar like it's your last one." Though this exaggerates the advice that I offer on this site, it's an interesting principle to consider before you open your wallet.

When you, personally, are fronting the bill for an expense, it's easy to say "no" if you feel like you're overpaying or being frivilous. But when your company is going to pay the bill, you're probably less likely to stop yourself, knowing that you can just "expense it."

Employees in come companies legitimately think, because they're traveling for business, that expensive dinners and hotels and plane tickets and car services and luxury retreats are consumables to which they are entitled. Somehow the fact that the company is going to pay the bill excuses them from making financially sound decisions that are in the best interest of the shareholders. The same goes for over-the-top construction, decorating, and other unnecessary eyes-closed, blank-check spending.

Not all companies are guilty; I actually believe that the company I work for does an excellent job of exercising thrift. However, I find it sad that employees in other organizations that expense extravagant happy hours and meals and hotel rooms are doing a horrible disservice to the actual owners of their companies. All employees of a corporation have an indirect fiduciary responsibility to their stockholders, even if that relationship is separated by many degrees.

It's easy for John McCain and Barack Obama to criticise the government for its pork-barrel spending. Americans hate to see their tax dollars wasted. But the truth is that much of our retirement money lives in corporations. Why do we not hold them accountable for their inefficiencies and outrageous spending (does the AIG $400,000 retreat ring a bell?)?

Every time a client is taken to Morton's instead of Panera; every time a consultant stays at the Marriott Marquis instead of the Comfort Inn; every time a quarterly meeting is held in Las Vegas instead of corporate headquarters, the bottom line is knocked down another notch. And the more corporations whose bottom lines are affected, the more affected are those whose retirement accounts are in mutual funds.

My grandmother has her life savings in her IRA, which is losing money like it has holes in its pockets. I understand that frivilous business expenditures aren't the main culprit that got us into the crisis we're in today, but they're his first cousin. I believe that outrageous senses of entitlement and a complete lack reasonable, responsible financial behavior, on behalf of both individuals and corporations, are to blame.

I welcome and encourage your anonymous comments about outrageous corporate spending that you've seen in your career.

Reevaluating my Rewards Card

I've sworn by my rewards card since the day I had it. But a friend of mine and reader of my site named Steve emailed me the other day to talk up and recommend his own strategy. On this site, I try to be a big proponent of reevaluating our spending and habits, so I knew I'd be a hypocrite of I didn't at least check out his plan and contrast it against my own. Here's what he said:

I've got a schwab account for everyday checking that has the same benefits as the e*trade. Then i automatically send rent/utilities/insurance to a wachovia account and a percentage to a ing direct account for savings.

I use a chase freedom for gas/groceries/utilities for 3% cash back, and I have an Amex that's linked with my corporate amex for everyday expenses that gets points i can turn into airline miles or hotel points.

I've got to say that Steve has a great setup. A benchmark for rewards is about 2% -- anything more than that is tough to come by. And if those rewards are CASH then it's an even better deal.

Before I go any farther, let me reiterate a point I made a couple of months ago and say that unless you pay off your balance in full every month, you shouldn't use a rewards card. They tend to have higher interest rates than non-rewards cards, so in the long run, those rewards might actually cost you a lot of money.

When you're picking out a rewards card, try and figure out what the actual value is of your reward. Cash is easy; points, not so much. If your card offers points instead of cash, figure out how much each of those points is worth in terms of cash and then make your decision. I use my Choice Privileges rewards card, which earns me free stays at Choice hotels. Here's how my points work out:

I earn two points per dollar on everyday purchases that I put on the card. So how much is that worth? I just looked at their online booking system and found a hotel room that would cost $150 per night plus tax if I paid for it, or 6000 points if I used my rewards. To earn 6000 points, I would need to spend $3,000 on everyday purchases (two points per dollar). So if $3,000 in everyday spending gets me $150 worth of hotel rooms, that means that my points are "worth" about five percent of my everyday spending. That's a bit nicer than a one, two, or even three percent cash back card.

I'd say that I travel slightly more than the average American, so I never have trouble using my points whenever I do. Yes, cash back is usually better than points because it has more utility (you're not limited in where you can spend it), but if you can earn twice as many dollars' worth of free hotels than you could dollars' worth of cash, it pays to have the points as long as you would have otherwise paid for those rooms at some point.

Steve also mentioned that he uses his American Express card so he can pool his points with his business expenditures. That's another great idea. Because points are essentially useless until you reach a threshold at which they can be redeemed, it's best to earn them in a place that has more than one "input." A second business card earning you points is a great example of this.

With my rewards card, I don't just earn points from everyday spending. I also get three bonus points per dollar spent at Choice hotels. I travel a lot for business -- sometimes for months at a time -- so these really add up with weekly (reimbursable) bills that often exceed $500. Additionally, these same hotel points can be earned by anyone that signs up, regardless of their method of payment. So Joe Schmo can sign up for an account online, make a reservation, and earn about 10 points per dollar spent, even if he pays cash. This is similar to frequent flyer miles -- anyone can sign up and earn them when they fly, but frequent flyer cardholders earn extra.

So how quickly do my points add up? Let's say that I spend $500 on a room for a weeklong business trip. I'll earn a) the 10 points per dollar that I automatically get for being part of the program, b) the two points per dollar that I earn for everyday purchases on my card, and c) the three bonus points per dollar that I get for spending money at a Choice hotel with my card. That comes out to be 15 points per dollar. Multiply that by the $500 that I spent, and I just earned 7,500 points -- more than enough for a free $150 night.

Choice also runs seasonal promotions that you see advertised on TV pretty often (does the Johnny Cash song ring a bell?). They just finished doing their "triple points" promotion, that will triple the normal 10 points per dollar. Also, because I have spent more than 40 nights at Choice hotels this year, I personally earn four extra points per dollar. So If I spent that same $500 during a promotional period with my preferred status, I would have earned 39 points per dollar, earning me 19,500 points, enough for more than three free nights at a $150/night hotel (assuming 10% tax, that's worth $495). That comes out to be virtually "buy one night, get one free!"

So my rewards card gives me 5% worth of free hotel rooms for everyday purchases. And because those points are going into an account that has multiple inputs, I can use them much faster. Other examples of these types of multiple-input accounts are Airline rewards, which deposit miles into your already existing frequent flyer account, or grocery rewards at specific chains that deposit points into an account that was opened with your little keychain grocery card.

So I'm generally a fan of getting a rewards card that gives non-cash rewards as long as two criteria are met: 1) the value of the non-cash rewards is significantly more than the amount of cash you could get back on a cashback card and 2) the non-cash rewards will be spent on something that you would have otherwise paid for in the future, like hotel rooms, plane tickets, groceries, etc (NOT random crap in an all-points Sharper-Image-like catalog).

As far as my friend's banking choice goes, I have to say that it's a wise one. The 3% interest is high and it has no minimum balance. Today my E*Trade pays me 2.8% on my checking and 3.3% on my savings, with a $5,000 minimum balance on the checking account. Technically, the Schwab account is better than my E*Trade account because it doesn't require a minimum balance. However, I like the fast transfers to my brokerage and IRA accounts that I hold with E*Trade. Though there would technically be value in switching my account, it would be too small to justify the effort of switching.

If you're choosing a rewards card of your own, look for the best offers and try and figure out where you spend most of your money. Use Mint.com to determine this, as they'll tell you how many times you've visited a particular business and how much you've spent there. That'll be a good place to start when determining which rewards card is best for you.

Thanks for your comments, Steve.

Liquidity: The Apples and Oranges of Your Financial Health

It's important to periodically assess your personal financial health. I enjoy using a free tool, NetWorthIQ, to determine my overall net worth. Essentially, the tool works by applying generally accepted accounting principles to your accounts, summing all of your assets and subtracting all of your debts to produce your net worth. It's just like high school accounting where Assets minus Liabilities equals Owner's Equity. Though this tool is useful for numerically and graphically tracking progress from month to month, it can't be interpreted as a realistic assessment of your financial health. Here's why:

All of your assets and liabilities aren't quite as simple as apples and oranges. Some liabilities have tax advantages and disadvantages, and some assets have costs associated with turning them into cash. For example, a student loan and an auto loan may look similar on paper if they have a similar balance and interest rate, but the interest paid on a student loan is tax deductible. $10,000 in a 401(k) and $10,000 in a RothIRA may seem equal, but the Roth money will never be taxed while the 401(k) will be once it's withdrawn.

So when you're determining your financial health, it's important to figure out not just your net worth, but also your liquidity. Liquidity is essentially your ability to turn your assets into cash. I'm sorry to say that these dorky financial terms don't just apply to corporations and accountants -- they apply to you. Think I'm full of it? Consider this:

Some friends of mine bought a house a few years ago for $190,000 and got a zero-down loan. Today, they owe about $187,500 on the place. After a recent life change, they need to move to a different state. Though their house is listed for several thousand dollars more than they paid and now owe, they're still worried about being able to afford to move. According to Zillow, their home's value exceeds what they owe by about $20,000. But when calculating their liquidity, they need to take into account the likely sale amount and their real estate agent's commission, which happens to be an exceptionally low four and a half percent.

Yesterday, a potential buyer offered $195,000 -- $6,500 more than what they owe. But in order to not lose any money, they'll need to sell the house for at least $196,355. The current offer leaves them bringing $1,300 cash to the table at the time of sale. Sure, they could counter offer, but who's to say that they'd ever get a higher offer?

I'm a big proponent of bean counting. It's an important step in the road to wealth. But when you decide to count your money, be sure to do a second analysis that considers only the liquid value of your assets. Obviously, cash is completely liquid. But when considering at your home's value, use a pessimistic market value (depending on how quickly you need to sell) and subtract whatever you would expect to pay a real estate agent. When considering the value of your retirement savings, subtract any taxes and penalties you would need to pay as well as any non-vested employer contributions. When calculating the value of your vehicles and personal property, think about how much cash you would realistically receive for them from a sale.

You'll probably find that your liquid assets are much smaller than your total assets. Though it might not be fun to look at, it's an important truth factor that speaks wonders about your genuine financial wellbeing.

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.

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. 

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.

Healthy spending series: Part 2 - Make a plan and stick to it

Continued from yesterday's post...

2. Make a plan and stick to it

This includes financial planning at all levels, from creating a budget for both spending and saving, always making a shopping list (hence, avoiding impulse buys), and establishing some long-term goals. Let's break it down one-by-one.

• Creating a budget will probably be your first step toward achieving your financial goals. When I was getting out of debt, I had to figure out what I needed to pay no matter what (like rent, utilities, groceries, etc), what I expected to pay for other miscellaneous things (including some fun stuff -- no one wants to live in the stone ages), and how much I'd have left over to contribute to debt. Once I realized how much I should be able to contribute, I sent that same extra $500 a month every month like clockwork, treating it the same as I treated my rent. It was only with planned discipline that I was able to eliminate $9,000 debt in less than a year.
  
  Creating a budget and getting to know it will guide your spending every day. Start with the essentials, and then with the non-essentials, and find out what's left to save. If you're not happy with the amount, adjust your non-essentials. Mint.com provides a nice interface to enter your monthly budget goals and has a reporting feature to show you if you're on pace to meet those goals.
  
  See also my post on the benefits of creating a simple budget.
  
  
• Making a shopping list before you go grocery shopping is important. Or if you're shopping for something else, make sure you know what you're out to get. If you're on a random, just-for-fun shopping trip, establish a spending cap ahead of time.
  
  Avoiding impulse buys is an important part of adhering to your spending goals -- even if you've spotted a good deal. Just because the DVD player is 50% off doesn't mean you need to buy it. After all, do you really need another DVD player around the house? If you hadn't been planning to buy a DVD player, you didn't save 50%, you wasted 50%.
  
  Of course nobody's perfect, so plan ahead and give yourself some leeway. When creating your monthly budget, budget some fluff money that you can use for whatever you want. That way, you can make a few of those irresistible impulse buys without as much guilt -- or at least with more predictability.
  
  
• Establishing long-term goals can be tricky. And I'm certainly not a licensed professional qualified to give you advice on how to save for retirement. If you feel like you need help, seek professional advice, preferably from a fee-only financial planner.
  
  Still, it's important to know the basics: The younger you start saving, the better. And the more you save when you're young, the better. If you're older and haven't started saving, you've got some catching up to do.
  
  Save for things other than retirement, like college and the purchase of a big-ticket item. If you own your car and don't plan on buying one for a few years, start making monthly 'car payments' now into a savings account so you can pay cash when it comes time to buy.
  
  Always keep an eye toward the future; understand the basics; don't invest in anything that you don't understand; know that unexpected things will come whether you like it or not.

Tomorrow on tepom.com, the Healthy Spending Series continues with Part 3: Finding leisure activities with income potential or the ability to further your career.

Healthy spending series: Part 1 - Replace costly activities with free ones

Everyone has their ups and downs when it comes to spending money. Hell, I sure had mine! When I graduated from college in 2006, I had about $9,000 in credit card debt that had been a parasite on my bank account for years. On a card with a $5,000 balance, I remember making the $175 minimum payment each month, of which only $25 or so went toward the principal. I had a spending hangover that I'll never forget; one that I hope I never have to experience again.

Like an oversized person commits to lose weight, I committed to drop my debt once I got my first 'real' job. It took a few months of monitoring my finances, but in the end it was less painful than I imaged it would be-- and what a weight it was off my shoulders! Since dropping the debt, I've watched my net worth start to climb, bit by bit, as I gladly pay myself each month rather than Chase. Now that I'm a better place financially, I follow these guidelines as best as I can to make sure that the parasite of debt doesn't return.

1. Replace costly activities with some that are free
Let me first say that it's OK to go out and spend a little money; just like it's OK to eat a cheeseburger for dinner every once in a while -- I mean, we need to eat! But too much of a 'good thing' isn't a good thing for anyone. And overeating is just like overspending. Regardless of your financial situation, it's OK to overindulge now and then. But day-to-day, you should fill your life with healthy spending.

Consider why you shop. Do you do it because you're bored? I know I used to. Going to the mall or to a movie or to a coffee shop are all fine things to spend your time doing, but they could easily be replaced by things that are less expensive or even free. Set a goal for yourself to replace one of your regular costly activities with something that doesn't cost anything. The next time you're considering going to the movies, stay in and watch one you already own (I bet you own quite a few). The next time you're thinking of going shopping for a new cell phone, stay in and call your mother.

The big difference between overeating and overspending is that it's much easier to spot when you've been overeating...Imagine a planet where the more money you wasted, the fatter you'd get. I bet that with such obvious, negative symptoms, the citizens of that place would be much more financially responsible.

[ to be continued tomorrow..."2. Make a shopping list and stick to it ]

Easy, free, accurate online personal finance tools.

This week, I started researching alternatives to Bank of America's MyPortfolio program -- the main reason that I'm keeping an account with BOA. After doing a little research and with the help of some friends, I found a few websites that provide a comparable service for free. Now, I'll need to think long and hard about whether I want to keep my BOA account or not.

There are few sites that I found that will synchronize your finances from all of your financial institutions and give you a compiled list of transactions that populate a spending profile. This repository of transactions will drive a graphical breakdown of your spending, showing where all of your money is going.

My favorite site so far is Mint.com. They boast that users are able to set up an account in five minutes and instantly be given suggestions on ways to save money (usually in the form of an opportunity for a lower APR credit card or a higher APR bank account). The interface is simple, and the extra features are helpful and relevant.

I particularly like the budgeting feature. After manually entering your monthly spending goals for all expense categories (some initial goals are set to values that represent your last three months of spending), Mint will tell show you how well you're adhering to your budget so far. If you're on track to spend more than your monthly budget (let's say you spent $100 of your monthly $150 gasoline budget in the first week of the month), you will be alerted by a simple change in color of your budget 'thermometer.'

Another tool compared your spending in a given category to the spending of other Mint users in other parts of the country. It will even compare your spending at a specific store to any other part of the country. I'm amused that I spent slightly more at Waffle House last month ($19) than that average American ($17). I would love to see a feature that shows you where people in your area that spend less in a certain category do their shopping. For example, if you spend 25% more than most people in your area on groceries or internet service, wouldn't it be neat to see where everyone else does their shopping or from whom they buy their internet service?

My main criticism of Mint is its inability to show my equity in my real assets. Some of Mint's competitors, like BOA's MyPortfolio, integrate with zillow.com to estimate your home's approximate value. Just because I owe tens of thousands of dollars on my home doesn't mean that I have a negative net worth. Because my house is worth more than I owe, it should improve my net worth. The same story goes for our two cars. I'd like to see an integration with a car valuing website like Kelly Blue Book. I own two cars; one is paid off and one is not. If Mint is going to take my auto loan into account when calculating my net worth, they might as well recognize that my car is worth something.

If you'd like to get a grip on your finances and have a single place to check in on them from time to time, I'd suggest visiting Mint.com. It's free and easy for those with already established online access to their bank, mortgage, auto loan, and credit card accounts.