Cash

This is the problem with debt consolidation

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It’s not a math problem. The numbers on debt consolidation actually sometimes make sense. Credit cards (for instance) offer high interest rates because they’re unsecured, personal lines of credit. The most popular consolidation loans are home equity loans which offer much lower interest rates because they’re secured against your home. If you stop paying a credit card, the debt goes to collections and the credit card company receives pennies on the dollars that you owe them, their risk is high and you pay for it. If you stop paying a home equity loan, the bank has a stake in your house and they can sell it to get their money back (foreclosure), their risk is much lower and you pay less for it. So that all makes sense, isn’t it an obviously beneficial move to slide the debt from unsecured credit cards with high interest rates into a secured home equity line with a low interest rate?

Like I said, the math may sometimes make sense on paper (may, although there are some serious issues with home equity loans which offset the juicy interest rates), but the math was never the issue. We need to consider the root of the problem. If the root of the problem is that you’ve got high interest rates on credit card debt then a consolidation loan solves the problem; done, easy. Unfortunately, that’s not the root problem. The root of the problem is that you’ve got a broken relationship with money and things. You buy things because you want them and you worry about where the money will come from later. You use credit cards because, points (obviously), and they make you feel like lots of little purchases are no big deal. Your financial life lacks intention, there’s a disconnect between your purpose/values, and your money/spending. A consolidation loan is appealing for the momentary relief it could provide, your monthly debt payments might be cut in half, but it’s only a bandaid. Without a more fundamental change to your relationship with money and your spending habits, the consolidation loan will actually only end up causing more debt and more pain in the future.

Home equity loans (again, the most common type of consolidation loan) are usually interest-only loans, which means if you make the minimum (interest-only) payment each month, the debt could continue on into eternity. The lower interest rate is not helpful if the debt isn’t going down. People often end up paying far more interest on a low-rate equity loan than they would have by aggressively paying off a credit card.

A debt consolidation loan will wipe out your credit card balances leaving lots more room to spend. Without a change in the deeper issue (your relationship to money), you’ll just end up with the old credit card debt in the consolidation loan and new credit card debt on the credit cards. It’s a wicked spiral.

So don’t play the debt games. Credit cards aren’t necessarily the enemy, but using them without having the cash to back your purchases, that’s a problem, a problem that the best consolidation program in the world can’t solve.

Finances by age

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We’ve all heard of general financial guidelines which wisdom would suggest we follow. Dave Ramsey talks about them, financial planners use them, we all interact with them on some level. As you move through life the guidelines also move a little bit, some things you didn’t have to deal with in your 20’s become pressing in your 40’s, and vice versa. This is a breakdown of these financial guidelines by age, things that you should be thinking about based on your stage of life. This does not mean that you’ve failed if you’re working on some 20’s things in your 30’s or 40’s, or even 50’s. But these guidelines are a helpful measuring stick to see how you’re doing currently, and they provide a good pathway for lifetime financial success. Let’s dig in.

Teen years:

  • The number one thing you can do in your teens is to start developing good financial habits.
  • Stay away from consumer debt. These debts are often subject to high interest rates (credit cards), tied to depreciating assets (cars), and often end up funding things that are unnecessary. They encourage bad spending habits and can cost years to catch up from.
  • Learn to save money. Instead of unnecessary spending, practice going the other way, save up money for things you want. 
  • Learn to work hard. Financial guidelines will certainly help you succeed, but you won’t get far if you can’t earn money. 
  • Get through college with minimal student loans.


20’s:

  • Now you’re out of college and real life is set in. The number one thing you can do is create a zero-sum budget and stick to it as if your life depends on it. Give yourself some spending money, make sure to budget your savings, and again, avoid consumer debt. The budget is not a forecast of your future spending, and it’s not just for tracking your spending either, it’s for planning your spending. You intentionally decide what you’re going to spend money on and how much, and you don’t spend beyond that. 
  • Start a financial plan. Meet with an advisor, learn about how the market works, and start putting together a loose plan for retirement. Things will obviously change, but the plan will ensure that you’re pointed in the right direction.
  • Create an emergency fund. Dave Ramsey says save $1,000, that’s a good place to start. Eventually, you might work up to a month or two worth of expenses. This is how you will pay for life’s curveballs instead of using your credit card.
  • If your company offers a 401k plan, start putting some money away. The money you invest in your 20’s will work the hardest for you over the long haul. If your company’s 401k plan offers some sort of match, try to contribute whatever is required to take full advantage of the match. The free money is hard to pass up.
  • Be aggressive about paying off student loans (and any other consumer debts).
  • Start saving for a house.


30’s & 40’s:

  • Now that you’ve set the stage in your 20’s, you’re ready to start executing in your 30’s and 40’s. Keep meeting with your advisor and updating the plan, keep learning, and keep on the straight and narrow.
  • Become debt free (aside from a potential mortgage loan). If you have any consumer debt or student loans, be aggressive about paying them off.
  • Think about buying a house. Your financial plan will show you that buying a house is the most cost-effective way to provide housing, a home is a good asset. Save up a large down payment and ensure the payment fits nicely in the budget, there are few things more financially stressful than being ‘house-poor.’
  • Make a plan to pay off the house, ideally in 15 years or less. Owning a home free and clear is one of the most impactful things you can do for your retirement. It’s also a great way to help kids through college if that’s a goal of yours.
  • Increase retirement savings. You’ve been contributing enough to take advantage of the match, but there’s no need to stop there. Bump up your 401k percentage or put some extra money away in an IRA. 15% of your income is a good goal.
  • Buy some term life insurance, especially if you have children. A 20-year policy is often sufficient, the goal is to ensure that your family will be well-off in the event of a tragedy.
  • Put together a will, again, especially if you have children. It’s another way to ensure the family will be well-off in the event of a tragedy.
  • Increase the emergency fund to cover 3-6 months (or whatever number feels most comfortable) worth of expenses. Think about this money as insurance. It’s not going to earn much if anything, but that’s not what it’s for. The investments will earn money for retirement, the insurance is to shield you from unforeseen events.

50’s:

  • Talk to your advisor about your investment allocations. As you move closer to retirement, you’ll want to ensure the retirement funds will be available for you, which means you’ll probably scale back the risk factor in your portfolio, or at least have a plan in place to do so. This means owning a higher percentage of bonds and fixed income type assets and fewer equities (stocks). A good advisor will engage with you on this subject pro-actively.
  • Adjust investment contributions. It could be a good time to increase savings again to maximize what will be available in retirement. It’s the home stretch!
  • Pay off your home. I mentioned this earlier, but paying off your home is one of the most significant things you can do for your retirement. From a cash-flow perspective, it makes a ton of sense. If you owe $100,000 on your mortgage, and your payment is $750 per month, you’ll gain $9,000 in spendable cash-flow per year for spending by paying the $100,000. If you instead saved that $100,000, you would be able to pull about 5-6% per year ($5,000-$6,000) and you’d still be making the mortgage payment. A mortgage-free budget will also be much more flexible. Many people end up working in retirement mainly because they still have to cover the mortgage.
  • Look at your social security estimate. This is available online (https://www.ssa.gov/benefits/retirement/estimator.html) and will be helpful as you get more detailed in your retirement plan.


60’s+:

  • Finalize your retirement plan. Determine when you’ll retire, what your new income sources will look like, how your advisor will manage the retirement funds, when to take social security, all the exciting stuff. These are important details to nail down as you move into retirement.
  • Revisit your budget. Income, expenses, taxes, and cash-flow all change significantly in retirement. A good comparative cash-flow analysis from your advisor could prove very helpful. Usually, retirees can achieve a similar or better cash-flow with significantly less income because of how the taxes and expenses shape up (especially if that mortgage is gone!).
  • Decide what you’d like to accomplish in retirement, maybe even set some goals. The great benefit of retirement is not the ability to stop doing anything, it’s the opportunity to focus on the things you want to do. A part-time job or some sort of enjoyable work, more family time, travel with loved ones, important hobbies, these all can be part of a richly fulfilling retirement; but don’t let them simply happen to you, do them on purpose.

Pay attention to asset classes, not returns

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When people think about deciding between investment advisors, or mutual funds, or even stocks, the temptation is to look at past performance. That’s the default. And it seems basic, you’re looking for returns, what else would you look at? What else could you even look at?

The problem is the past performance we see is short term. You’ll see three to five year histories on your account statements, Morningstar defaults at a ten year history (if the fund has been around that long), and the news rarely talks about anything further back than the last year. Those are relatively short periods of time, especially when we’re talking about market returns. Instead of comparing past performance in advisors and mutual funds over the past ten years, we should be looking at long-term historical returns of asset classes.

An asset class is a group of similar securities that tend to move together. The main general asset classes are equities (stocks), fixed income (bonds), and cash. Each of these, but especially the equities group, can be broken down further. In equities, we see large vs small, value vs growth, U.S. vs international. For an example, a very popular asset class is U.S. Large Growth, which is basically the S&P 500. We have returns data on these asset classes all the way back to the early 20th century. That information can tell us much more than the past ten years. We can see which asset classes tend to outperform others, we can see how the different asset classes correlate to each other, and we can know what returns and risk a fund or portfolio can expect over long periods of time. A ten-year history of returns is almost irrelevant. Over ten years any asset class could outperform any other, but we don’t know when or which. So to look backward at the performance of a fund is not only unhelpful, it’s more often hurtful. A good ten-year history on a fund, or even an asset class, deceives us into thinking the performance will continue in the future. The short-term history the only information we know to use, and besides that, it seems to make sense. But that’s the opposite of a good investing strategy. Instead, let’s analyze the asset class data going back as far as it goes, understand where returns come from, and diversify our portfolio’s in a way that’s consistent with the data. Then we let the market perform and deliver results. Our balanced diversified portfolio won’t always be the big winner year by year, but over the long haul, it will outperform anyone trying to predict market movements based on ten-year histories, or any other material information.