The Ramsey Plan vs. The Nerd-ey Plan

A reader commented on a previous post (thanks!) about my general financial strategy and how similar it is to Dave Ramsey’s Baby Steps. This post is a result of that comment. Also, before reading the details of my family’s strategy, please understand that I am not a financial planner. I don't have a degree in finance or even economics. I don't work in finance for a living (directly, anyway). I’m just a regular Joe that’s lucky enough to have a decent finance understanding and is willing to share my family’s long-term strategy!

I’m big fan of goal-setting, both short-term and long-term. I write them down, check on them regularly, revise them if necessary, and celebrate my successes when I reach them. I truly believe that once you set a clearly defined goal for yourself and write it down, you’re well on your way to achieving that goal. Just merely having a plan to follow makes decisions easier and keeps you focused on what’s really important to you.

So it shouldn’t surprise you that I’ve got financial goals...lots of them. I keep monthly, yearly and lifetime financial goals and they’re all meticulously documented, revisited, and revised regularly. They all help me make day-to-day decisions, and keep me moving the direction I want to go. One of the most important is my overall financial strategy.

Dave Ramsey's plan is a great starting point for the majority of Joe Q. Public. It's simple, easy to understand, and effective. But, I certainly don't think it's optimum, at least for us. The plan my wife and I follow to manage our finances and investments is more sophisticated than Dave Ramsey's plan, but I think it's a better fit for us. Yours may be totally different!

For comparison's sake, here's Dave's plan:

1) $1000 for a starter emergency fund.
2) Pay off all consumer debt using the debt snowball.
3) Accumulate 3 to 6 months worth of living expenses for an emergency fund.
4) Invest 15% of gross income into Roth IRAs and pre-tax retirement.
5) Fund college.
6) Pay off home early.
7) Build wealth with mutual funds and real estate.

My family's strategy varies in the steps themselves and in the amounts dictated by each step. Hopefully, I'm able to fully explain my reasoning for the changes I've made. Here are my steps:

1) Save $1000 per member of your family for a starter emergency fund. Personally, I don't think $1000 is quite enough, especially if you have children. It's a great goal for a single person, but if you've got a family, you've got more folks to cover and emergencies have the potential to hit a little harder. I realize for people with large families, this goal becomes significantly more difficult, so good judgment needs to be used when determining your personal amount.

2) If your company offers a match on your 401(k), take it. Invest only up to the amount required to get the entire match. If you don't do this step, you have the potential to leave a HUGE amount of free money on the table. Think of it this way: If on every payday, a man at the exit of your office's building would hand you a stack of 20-dollar bills ($100, $200, or $500) just for investing 5% of your income, wouldn't you take it? That's what your company match is: free money. Even better, it's free money that'll compound as your 401(k) balance grows over the years.

3) Pay off all consumer debt, starting with the smallest amount, using a debt snowball. In this instance I agree with Dave. Even though starting with the balance with the highest interest rate would result in a mathematically better result (minimally in most cases); I think the smallest balance should be tackled first, for a couple of reasons. First, if you go after the smallest balance first, you knock a minimum payment off your books quickly. This could be a big help if your family does get hit with some sort of financial hardship; it's one less minimum payment to make, which means your overall minimum monthly outlay is smaller. Second, there is a significant psychological boost over dropping a debt entirely, which does help to motivate you to keep moving.

4) Accumulate 4-6 months of living expenses for an emergency fund in a high-interest savings or money-market account. . I've written about the virtues of a solid emergency fund in the past, so this shouldn't be a surprise. Once you've got your debt paid off, accumulating this money shouldn't be too difficult. If you've only got one bread-winner, I think a six-month cash cushion is pretty darned important.

5) Invest 15-20% of gross income in Roth IRAs and tax-advantaged retirement accounts, up to federal maximums. I think that you can never have too much retirement income. Dave suggests 15%, but for us, 20% works up to the federal maximums. If you're fully funding two people's Roth IRAs (currently $5000 each), it doesn't take very much additional investment to reach that 20%! If you can make it automatic, so much the better. Fully funding a Roth IRA for one person is only $96 a week!

6) Fund 80-95% of college costs for your children. While you can certainly do 100% funding if you so choose, I like the 80-95% number a bit better. I firmly believe that when someone has a monetary stake in something, they take it more seriously, and in my mind, college is no exception. I fully expect my future son to contribute something to his college education (which is a long way off!).

7) Put 10% of your net paychecks into a mutual fund as a "freedom account". This is your "retire early" account, or your "travel around the world" account, or whatever-big-dream-you-may-have account. For us, it's retire early!

8) Pay off your home mortgage. Obviously, we'd all love to own our homes outright. Since a home mortgage is typically lower interest and tax-advantaged, I think this is the proper step to do it.

9) Build wealth with mutual funds, real estate, and businesses. When you get to this last step, you're living the good life. You'll have plenty of cash on hand, solid retirement accounts, a paid-for house, and fantastic cash flow. It's time to build it up even more through investing. If you choose real estate (rentals) or a business, that’s great. Mutual funds are great, too.

As I said before, this likely isn't the path that's right for you. Each individual needs something just a little different. Right now, this path is perfect for us. As things change in the future, our goals and needs may change, too. So, we're going to keep our strategy flexible.

So, what does your financial strategy look like?

YFNN

Today's 401(k) Conversation

I had a conversation this afternoon with a former co-worker about his 401(k), the current economy, and his future. He's a bright guy, but not exactly money-savvy, and is pretty darned impulsive. Here's how it went:

~~~~~~~~~~~~~~~~~~

Him: My 401(k) has plummetted recently. I've lost about $35,000 just in the last several weeks.

YFNN: I'm sure. Everybody's getting hit hard.

Him: It's ridiculous. I can't stand losing that much. I'm thinking about pulling it all out and buying a rental property.

YFNN: WHAT?!? Are you crazy?

Him: At this rate, I won't have anything left in a couple months. Why not? I can try to find a foreclosure or something.

YFNN: First of all, you buying a foreclosure is a disaster. Second, pulling out of the market now is crazy. The rule about making money in the stock market is simple: Buy low, sell high. If you sell out now, you're doing the exact OPPOSITE.

Him: I just don't like it.

YFNN: So don't look at your account for a while, like six months or so. In the meantime, keep on making contributions.

Him: That's stupid. I've already stopped adding more. Why would I put money in it just to lose it?

YFNN: Because the market is LOW. Stocks, mutual funds, ETFs, they're all basically on sale for 30% off! If you continue to contribute, you're lowering your cost basis. You're buying things low, to sell them high. You've got decades to recover from this. Do you honestly think that the market won't recover by 2040 when you retire? Please.

Him: I guess. The news just drive me nuts though.

YFNN: If we were close to retirement it'd be different, but we've both got plenty of time to see some real gains. I've even stepped my contributions up in the last couple of weeks. You've just got to hang in there, regardless of what that airhead Katie Couric says to try to scare you.

~~~~~~~~~~~~~~~~~~

This has got to be the overall attitude from most folks around me, and I can certainly understand why since the "sky-is-falling" media is playing the market woes up for all their worth. But, if you're 50 or younger, you've got to remember to be a long-term investor. That money you're pumping into your IRAs and 401(k)s and such is meant to be for retirement, not for next year. Continue to invest now, while prices are low, and be well-positioned for the recovery!

YFNN

APRs and APYs...What's the Difference?

If you've got a credit card, a savings account, or any kind of loan, there's no doubt you've been exposed to APYs and APRs. They're both methods of stating interest rates, but what's the difference? When and why is each used?

First, a few definitions:

APR - Annual Percentage Rate
APY - Annual Percentage Yield
Compounding - Earning interest on previous interest

The difference between the two is all about compounding. The APR is the annual rate of interest, without taking into account the compounding of interest within that particular year. The APY does take into account all that extra compounding within the year. It seems like a pretty small difference, but it can actually add up to some major bucks. This is really better shown with some formulas, illustrating their inter-relationship.

APR = Periodic Rate X Number of Periods in a Year

APY = (1 + Periodic Rate)^(# of Periods) - 1

"Holy crap, FNN! I haven't had algebra since high school. What the heck does that mean?"

Okay, a more real-world example: Say you've got a credit card that has an APR of 18%. That means that each month, you're charged 1.5% of the balance (1.5% X 12 months = 18%). Pretty simple, right? Well, look at it from an APY perspective: plug the numbers into the formula:

[(1+1.5%)^(12 months) - 1] = 19.56%

That's a difference of over 1.5%!

So what does this actually mean? Well, if you only carry a balance for one month's period, you'll be charged 1.5%, or the equivalent yearly rate of 18%. But, if you carry that balance for a year, your effective interest rate becomes 19.56%. That higher effective rate is all due to the effect of compounding each month.

"That's all well and good, but I'm still not getting it. How does this affect me in a broader sense?"

Well, it depends on your perspective.

As a borrower, you should always be searching for the lowest rate. The lenders know this, and will usually specify their rate in the lower of the two methods, the APR. This is because it doesn't account for compounding, and is a lower number than the APY.

The reverse is true if you're the lender, like when you're shopping for a savings account. The banks will usually specify the larger number, the APY because it accounts for the additional compounding.

So, when you're comparing rates of banks, credit cards, mortgages, savings accounts and everything else in the financial world, you've got to make sure that you're comparing the same thing, either APRs or APYs. It can make a big difference in your wallet.

YFNN

02/27/07 Market and Me

Disclaimer: I'm not a stock analyst. I'm just an average guy that pays attention to this stuff and knows just enough to be a danger to himself and others.

If you follow the stock market at all, or you listen to the bobble-headed chicken littles on CNN, you probably noticed that the U.S. stock markets took a tumble yesterday. In fact, the drop was the largest single-day drop in five years, wiping out the gains for the calendar year so far and making for fabulous sound bites for the "The economy sucks! Alarm! Recession! The sky is falling!" pundits of the cable news shows.

But, what does this stock market correction mean to me, FNN, the average investor?

In the grand scheme of things, it means next to nothing. Almost zero. I'm a firm believer that the slow, sure path to investment success is to buy and hold quality stocks and especially quality index funds. If you follow this mantra, then the daily market rollercoaster, even the large swing that happened yesterday, is almost completely irrelevant. I'm in it for the long haul, so short term gains and losses mean little to me.

If anything, I look at yesterday's sell off as an opportunity. Fundamentally, I don't think anything has changed about the market, so I see this next week as a golden buying opportunity, not as an indication of a long-term slide.

Really, what YFNN thinks it comes down to is this: Nobody really knows what yesterday’s sharp drop really means. Nobody ever knows what’s going to happen with the stock market. Not even Jim Cramer. I still believe the best bet for me and 99% of the folks out there is to just relax, take a deep breath, and remember that investing in the stock market is a long-term journey.

Keep on keepin' on.

YFNN