Figure 2-1: Lenders use credit scores to estimate how likely people are to default on a loan.
Chapter 2
Measuring Your Financial Health
In This Chapter
Tallying your assets, liabilities, and your (financial) net worth
Requesting (and fixing) your credit reports
Making sense of your credit score
Understanding bad debt, good debt, and too much debt
Calculating your rate of savings
Assessing your investment and insurance know-how
How financially healthy are you? When was the last time you took stock of your overall financial situation, including reviewing your spending, savings, future goals, and insurance? If you’re like most people, you’ve either never done this exercise or you did so too long ago.
This chapter guides you through a financial physical to help you detect problems with your current financial health. But don’t dwell on your “problems.” View them for what they are — opportunities to improve your financial situation. In fact, the more areas you can identify that stand to benefit from improvement, the greater the potential you may have to build real wealth and accomplish your financial and personal goals.
Avoiding Common Money Mistakes
Financial problems, like many medical problems, are best detected early (clean living doesn’t hurt, either). Here are the common personal financial problems I’ve seen in my work as a financial counselor:
Not planning: Most of us procrastinate. That’s why we have deadlines (like April 15) — and deadline extensions (need another six months to get that tax return done?). Unfortunately, you may have no explicit deadlines with your personal finances. You can allow your credit-card debt to accumulate, or you can leave your savings sitting in lousy investments for years. You can pay higher taxes, leave gaps in your retirement and insurance coverage, and overpay for financial products. Of course, planning your finances isn’t as much fun as planning a vacation, but doing the former can help you take more of the latter. See Chapter 4 for details on setting financial goals.
Overspending: Simple arithmetic helps you determine that savings is the difference between what you earn and what you spend (assuming that you’re not spending more than you’re earning!). To increase your savings, you either have to work more, increase your earning power through education or job advancement, get to know a wealthy family who wants to leave its fortune to you, or spend less. For most people, especially over the short-term, the thrifty approach is the key to building savings and wealth. (Check out Chapter 3 for a primer on figuring out where your money goes; Chapter 6 gives advice for reducing your spending.)
Buying with consumer credit: Even with the benefit of today’s low interest rates, carrying a balance month-to-month on your credit card or buying a car on credit means that even more of your future earnings are going to be earmarked for debt repayment. Buying on credit encourages you to spend more than you can really afford. Chapter 5 discusses debt and credit problems.
Delaying saving for retirement: Most folks say that they want to retire by their mid-60s or sooner. But in order to accomplish this goal, they need to save a reasonable chunk (around 10 percent) of their incomes starting sooner rather than later. The longer you wait to start saving for retirement, the harder reaching your goal will be. And you’ll pay much more in taxes to boot if you don’t take advantage of the tax benefits of investing through particular retirement accounts. For information on planning for retirement, see Chapters 4 and 11.
Falling prey to financial sales pitches: Steer clear of people who pressure you to make decisions, promise you high investment returns, and lack the proper training and experience to help you. Great deals that can’t wait for a little reflection or a second opinion are often disasters waiting to happen. A sucker may be born every minute, but a slick salesperson is pitching something every second! For important investment concepts and what kinds of investments to avoid, turn to Chapter 8.
Not doing your homework: To get the best deal, shop around, read reviews, and get advice from objective third parties. You also need to check references and track records so that you don’t hire incompetent, self-serving, or fraudulent financial advisors. (For more on hiring financial planners, see Chapter 18.) But with all the different financial products available, making informed financial decisions has become an overwhelming task. I do a lot of the homework for you with the recommendations in this book. I also explain what additional research you need to do and how to do it.
Making decisions based on emotion: You’re most vulnerable to making the wrong moves financially after a major life change (a job loss or divorce, for example) or when you feel pressure. Maybe your investments plunged in value. Or perhaps a recent divorce has you fearing that you won’t be able to afford to retire when you planned, so you pour thousands of dollars into some newfangled financial product. Take your time and keep your emotions out of the picture. In Chapter 21, I discuss how to approach major life changes and determine what changes you may need to make to your financial picture.
Not separating the wheat from the chaff: In any field in which you’re not an expert, you run the danger of following the advice of someone you think is an expert but really isn’t. This book shows you how to separate the financial fluff from the financial facts. (Flip to Chapter 19 for information on how to evaluate financial advice online and Chapter 20 for how to evaluate financial coverage in the mass media.) You are the person who is best able to manage your personal finances. Educate and trust yourself!
Exposing yourself to catastrophic risk: You’re vulnerable if you and your family don’t have insurance to pay for financially devastating losses. People without a savings reserve and support network can end up homeless. Many people lack sufficient insurance coverage to replace their income. Don’t wait for a tragedy to strike to find out whether you have the right insurance coverage. Check out Part IV for more on insurance.
Focusing too much on money: Placing too much emphasis on making and saving money can warp your perspective on what’s important in life. Money is not the first — or even second — priority in happy people’s lives. Your health, relationships with family and friends, career satisfaction, and fulfilling interests are more significant.
Money problems can be fixed over time with changes in your behavior. That’s what the rest of this book is all about.
Determining Your Financial Net Worth
Your financial net worth is an important barometer of your monetary health. Your net worth indicates your capacity to accomplish major financial goals, such as buying a home, retiring, and withstanding unexpected expenses or loss of income.
Your net worth is your financial assets minus your financial liabilities:
Financial Assets – Financial Liabilities = Net Worth
The following sections explain how to determine those numbers.
Adding up your financial assets
A financial asset is real money or an investment you can convert into your favorite currency that you can use to buy things now or in the future. Financial assets generally include the money you have in bank accounts, stocks, bonds, and mutual-fund accounts (see Part III, which deals with investments). Money that you have in retirement accounts (including those with your employer) and the value of any businesses or real estate that you own are also counted.
I generally recommend that you exclude your personal residence when figuring your financial assets. Include your home only if you expect to sell it someday or otherwise live off the money you now have tied up in it (perhaps by taking out a reverse mortgage, which I discuss in Chapter 14). If you plan on eventually tapping into the equity (the difference between the market value and any debt owed on the property), add that portion of the equity that you expect to use to your list of assets.
Assets can also include your future expected Social Security benefits and pension payments (if your employer has such a plan). These assets are usually quoted in dollars per month rather than as a lump sum value. In Table 2-1, I explain how to account for these monthly benefits when tallying your financial assets.
Consumer items — such as your car, clothing, stereo, and so forth — do not count as financial assets. I know that adding these things to your assets makes your assets look larger (and some financial software and publications encourage you to list these items as assets), but you can’t live off them unless you sell them.
Subtracting your financial liabilities
To arrive at your financial net worth, you must subtract your financial liabilities from your assets. Liabilities include loans and debts outstanding, such as credit-card and auto-loan debts. When figuring your liabilities, include money you borrowed from family and friends — unless you’re not expected to pay it back!
Include mortgage debt on your home as a liability only if you include the value of your home in your asset list. Be sure to also include debt owed on other real estate — no matter what (because you count the value of investment real estate as an asset).
Crunching your numbers
Table 2-1 provides a place for you to figure your financial assets. Go ahead and write in the spaces provided, unless you plan to lend this book to someone and don’t want to put your money situation on display. Note: See Table 4-1 in Chapter 4 to estimate your Social Security benefits.
Now comes the potentially depressing part — figuring out your debts and loans in Table 2-2.
Now you can subtract your liabilities from your assets to figure your net worth in Table 2-3.
Interpreting your net worth results
Your net worth is important and useful only to you and your unique situation and goals. What seems like a lot of money to a person with a simple lifestyle may seem like a pittance to a person with high expectations and a desire for an opulent lifestyle.
In Chapter 4, you can crunch numbers to determine your financial status more precisely for goals such as retirement planning. I also discuss saving toward other important goals in that chapter. In the meantime, if your net worth (excluding expected monthly retirement benefits such as those from Social Security and pensions) is negative or less than half your annual income, take notice. If you’re in your 20s and you’re just starting to work, a low net worth is less concerning and not unusual. Focus on turning this number positive over the next several years. However, if you’re in your 30s or older, consider this a wake-up call to aggressively address your financial situation.
Getting rid of your debts — the highest-interest rate ones first — is the most important thing. Then you want to build a safety reserve equal to three to six months of living expenses. Your overall plan should involve getting out of debt (Chapter 5), reducing your spending (Chapter 6), and developing tax-wise ways to save and invest your future earnings (Part III).
Examining Your Credit Score and Reports
You may not know it (or care), but you probably have a personal credit report and a credit score. Lenders examine your credit report and score before granting you a loan or credit line. This section highlights what you need to know about your credit score and reports, including how to obtain them and how to improve them.
Understanding what your credit data includes and means
A credit report contains information such as
Personal identifying information: Includes your name, address, Social Security number, and so on
Record of credit accounts: Details when each account was opened, the latest balance, your payment history, and so on
Bankruptcy filings: Indicates whether you’ve filed bankruptcy in recent years
Inquiries: Lists who has pulled your credit report because you applied for credit
Your credit score, which is not the same as your credit report, is a three-digit score based on the report. Lenders use your credit score as a predictor of your likelihood of defaulting on repaying your borrowings. As such, your credit score has a major impact on whether a lender is willing to extend you a particular loan and at what interest rate.
FICO, developed by Fair Isaac and Company, is the leading credit score in the industry. FICO scores range from a low of 300 to a high of 850. Most scores fall in the 600s and 700s. As with college entrance examinations, higher scores are better. (In recent years, the major credit bureaus — Equifax, Experian, and TransUnion — have developed their own credit scoring systems, but many lenders still use FICO the most.)
The higher your credit score, the lower your predicted likelihood of defaulting on a loan (see Figure 2-1). The “rate of credit delinquency” refers to the percentage of consumers who will become 90 days late or later in repaying a creditor within the next two years. As you can see in the chart, consumers with low credit scores have dramatically higher rates of falling behind on their loans. Thus, low credit scorers are considered much riskier borrowers, and fewer lenders are willing to offer them a given loan; those who do offer loans charge relatively high interest rates.
Source: Fair Isaac Corporation
The median FICO score is around 720. You generally qualify for the best lending rates if your credit score is in the mid-700s or higher.
Obtaining your credit reports and score
Given the importance of your personal credit report, you may be pleased to know that you’re entitled to receive a free copy of your credit report annually from each of the three credit bureaus (Equifax, Experian, and TransUnion).
If you visit www.annualcreditreport.com, you can view and print copies of your credit report information from each of the three credit agencies online (alternatively, call 877-322-8228 to have your reports mailed to you). After entering some personal data at the website, check the box indicating that you want to obtain all three credit reports, because each report may have slightly different information. You’ll then be directed to one of the three bureaus, and after you finish verifying that you are who you claim to be at that site, you can easily navigate back to www.annualcreditreport.com so you can continue to the next agency’s site.
When you receive your reports, the best first step is to examine them for possible mistakes (see the upcoming section “Getting credit report errors corrected” to find out how to fix problems in your reports). Several years ago when I did that myself, I found minor errors on two of the three reports. It took me several minutes to correct one of the errors (by submitting a request to that credit reporting agency’s website), and it took about half an hour to get the other mistake fixed (a small doctor’s bill was erroneously listed as unpaid and in collections).
You may be surprised to find that your credit reports do not include your credit score. The reason for this is quite simple: The 2003 law mandating that the three credit agencies provide a free credit report annually to each U.S. citizen who requests a copy did not mandate that they provide the credit score. Thus, if you want to obtain your credit score, it’s going to cost you.
You can request your credit score from Fair Isaac, but you’ll get whacked $15.95 for every request (that can set you back nearly $50 to see your FICO score for all three credit bureaus). Save your money. If you want to purchase your credit score, you can do so for less by ordering it from the individual credit bureaus when you obtain your credit report(s) via www.annual creditreport.com — Equifax and Experian, for example, charge just $7.95 to obtain your current credit score.
If you do spring for your current credit score, be clear about what you’re buying. You may not realize that you’re agreeing to some sort of ongoing credit monitoring service for, say, $50 to $100+ per year, an expenditure I don’t feel is worthwhile.
Improving your credit reports and score
Instead of simply throwing money into buying your credit scores or paying for some ongoing monitoring service to which you may not pay attention, take an interest in improving your credit standing and score. Working to boost your credit rating is especially worthwhile if you know that your credit report contains detrimental information.
Here are the most important actions that you can take to boost your attractiveness to lenders:
Get all three of your credit reports, and be sure each is accurate. Correct errors (as I explain in the next section) and be especially sure to get accounts removed if they aren’t yours and they show late payments or are in collection.
Ask to have any late or missed payments that are more than seven years old removed. Ditto for a bankruptcy that occurred more than ten years ago.
Pay all your bills on time. To ensure on-time payments, sign up for automatic bill payment, a service that most companies (like phone and utility providers) offer.
Be loyal if it doesn’t cost you. The older your open loan accounts are, the better your credit rating will be. Closing old accounts and opening a bunch of new ones generally lowers your credit score. But don’t be loyal if it costs you! For example, if you can refinance your mortgage and save some money, by all means do so. The same logic applies if you’re carrying credit-card debt at a high interest rate and want to transfer that balance to a lower-rate card. If your current credit-card provider refuses to match a lower rate you find elsewhere, move your balance and save yourself some money (see Chapter 5 for details).
Limit your debt and debt accounts. The more loans, especially consumer loans, that you hold and the higher the balances, the lower your credit score will be.
Work to pay down consumer revolving debt (such as credit-card debt). Turn to Chapters 5 and 6 for suggestions.
Getting credit report errors corrected
If you obtain your credit report and find a blemish on it that you don’t recognize as being your mistake or fault, do not assume that the information is correct. Credit reporting bureaus and the creditors who report credit information to these bureaus often make errors.
You hope and expect that, if a credit bureau has negative and incorrect information in your credit report and you bring the mistake to their attention, they will graciously and expeditiously fix the error. If you believe that, you’re the world’s greatest optimist; perhaps you also think you won’t have to wait in line at the Department of Motor Vehicles or the post office!
Odds are, you’re going to have to fill out a form on a website, make some phone calls, or write a letter or two to fix the problems on your credit report. Here’s how to correct most errors that aren’t your fault:
If the credit problem is someone else’s: A surprising number of personal credit report glitches are the result of someone else’s negative information getting on your credit report. If the bad information on your report is completely foreign-looking to you, contact the credit bureau (by phone or online) and explain that you need more information because you don’t recognize the creditor.
If the creditor made a mistake: Creditors make mistakes, too. You need to write or call the creditor to get it to correct the erroneous information that it sent to the credit bureau. Phoning first usually works best. (The credit bureau should be able to tell you how to reach the creditor if you don’t know how.) If necessary, follow up with a letter.
Whether you speak with a credit bureau or an actual lender, make note of your conversations. If representatives say that they can fix the problem, get their names, e-mail addresses, and phone extensions, and follow up with them if they don’t deliver as promised. If you’re ensnared in bureaucratic red tape, escalate the situation by speaking with a department manager. By law, bureaus are required to respond to a request to fix a credit error within 30 days — hold the bureau accountable!
Telling your side of the story
With a minor credit infraction, some lenders may simply ask for an explanation. Years ago, I had a credit report blemish that was the result of being away for several weeks and missing the payment due date for a couple of small bills. When my proposed mortgage lender saw my late payments, the lender asked for a simple written explanation.
You and a creditor may not see eye to eye on a problem, and the creditor may refuse to budge. If that’s the case, credit bureaus are required by law to allow you to add a 100-word explanation to your credit file.
Sidestepping “credit repair” firms
Online and in newspapers and magazines, you may see ads for credit repair companies that claim to fix your credit report problems. In the worst cases I’ve seen, these firms charge outrageous amounts of money and don’t come close to fulfilling their marketing hype.
If you have legitimate glitches on your credit report, credit repair firms can’t make the glitches disappear. Hope springs eternal, however — some people would like to believe that their credit problems can be fixed.
If your problems are fixable, you can fix them yourself; you don’t need to pay a company big bucks to do it.
Knowing the Difference between Bad Debt and Good Debt
Why do you borrow money? Usually, you borrow money because you don’t have enough to buy something you want or need — like a college education. A four-year college education can easily cost $100,000, $150,000, or more. Not too many people have that kind of spare cash. So borrowing money to finance part of that cost enables you to buy the education.
How about a new car? A trip to your friendly local car dealer shows you that a new set of wheels will set you back $20,000+. Although more people may have the money to pay for that than, say, the college education, what if you don’t? Should you finance the car the way you finance the education?
The auto dealers and bankers who are eager to make you an auto loan say that you deserve and can afford to drive a nice, new car, and they tell you to borrow away (or lease, which I don’t love either — please see Chapter 6). I just say, “No! No! No!” Why do I disagree with the auto dealers and lenders? For starters, I’m not trying to sell you a car or loan from which I derive a profit! More importantly, there’s a big difference between borrowing for something that represents a long-term investment and borrowing for short-term consumption.
If you spend, say, $1,500 on a vacation, the money is gone. Poof! You may have fond memories and photos, but you have nothing of financial value to show for it. “But,” you say, “vacations replenish my soul and make me more productive when I return . . . the vacation more than pays for itself!”
I’m not saying that you shouldn’t take a vacation. By all means, take one, two, three, or as many as you can afford yearly. But the point is to take what you can afford. If you have to borrow money in the form of an outstanding balance on your credit card for many months in order to take the vacation, you can’t afford it.
Consuming your way to bad debt
I coined the term bad debt to refer to debt incurred for consumption, because such debt is harmful to your long-term financial health. (I used this term back in the early 1990s when the first edition of this book was published, and I’m flattered that others have since used the same terminology.)
You’ll be able to take many more vacations during your lifetime if you save the cash in advance. If you get into the habit of borrowing and paying all the associated interest for vacations, cars, clothing, and other consumer items, you’ll spend more of your future income paying back the debt and interest, leaving you with less money for your other goals.
The relatively high interest rates that banks and other lenders charge for bad (consumer) debt is one of the reasons you’re less able to save money when using such debt. Not only does money borrowed through credit cards, auto loans, and other types of consumer loans carry a relatively high interest rate, but it also isn’t tax-deductible.
I’m not saying that you should never borrow money and that all debt is bad. Good debt, such as that used to buy real estate and small businesses, is generally available at lower interest rates than bad debt and is usually tax-deductible. If well managed, these investments may also increase in value. Borrowing to pay for educational expenses can also make sense. Education is generally a good long-term investment because it can increase your earning potential. And student loan interest is tax-deductible subject to certain limitations (see Chapter 7).
Recognizing bad debt overload
Calculating how much debt you have relative to your annual income is a useful way to size up your debt load. Ignore, for now, good debt — the loans you may owe on real estate, a business, an education, and so on (I get to that in the next section). I’m focusing on bad debt, the higher-interest debt used to buy items that depreciate in value.
To calculate your bad debt danger ratio, divide your bad debt by your annual income. For example, suppose you earn $40,000 per year. Between your credit cards and an auto loan, you have $20,000 of debt. In this case, your bad debt represents 50 percent of your annual income.
bad debt
annual income = bad debt danger ratio
The financially healthy amount of bad debt is zero. While enjoying the convenience of credit cards, never buy anything with your card that you can’t afford to pay off in full when the bill comes at the end of the month. Not everyone agrees with me. One major U.S. credit-card company says — in its “educational” materials, which it “donates” to schools to teach students about supposedly sound financial management — that carrying consumer debt amounting to 10 to 20 percent of your annual income is just fine.
When your bad debt danger ratio starts to push beyond 25 percent, it can spell real trouble. Such high levels of high-interest consumer debt on credit cards and auto loans grow like cancer. The growth of the debt can snowball and get out of control unless something significant intervenes. If you have consumer debt beyond 25 percent of your annual income, see Chapter 5 to find out how to get out of debt.
How much good debt is acceptable? The answer varies. The key question is: Are you able to save sufficiently to accomplish your goals? In the “Analyzing Your Savings” section later in this chapter, I help you figure out how much you’re actually saving, and in Chapter 4, I help you determine how much you need to save to accomplish your goals. (See Chapter 14 to find out how much mortgage debt is appropriate to take on when buying a home.)
Borrow money only for investments (good debt) — for purchasing things that retain and hopefully increase in value over the long term, such as an education, real estate, or your own business. Don’t borrow money for consumption (bad debt) — for spending on things that decrease in value and eventually become financially worthless, such as cars, clothing, vacations, and so on.
Assessing good debt: Can you get too much?
As with good food, you can get too much of a good thing, including good debt! When you incur debt for investment purposes — to buy real estate, for small business, even your education — you hope to see a positive return on your invested dollars.
But some real-estate investments don’t work out. Some small businesses crash and burn, and some educational degrees and programs don’t help in the way that some people hope that they will.
There’s no magic formula for determining when you have too much “good debt.” In extreme cases, I’ve seen entrepreneurs, for example, borrow up to their eyeballs to get a business off the ground. Sometimes this works, and they end up financially rewarded, but in most cases, it doesn’t.
Here are three important questions to ponder and discuss with your loved ones about the seemingly “good debt” you’re taking on:
Are you and your loved ones able to sleep well at night and function well during the day, free from great worry about how you’re going to meet next month’s expenses?
Are the likely rewards worth the risk that the borrowing entails?
Are you and your loved ones financially able to save what you’d like to work toward your goals (see Chapter 4)?
If you answer “no” to these questions, see the debt-reduction strategies in Chapter 5 for more information.
Playing the credit-card float
Given what I have to say about the vagaries of consumer debt, you may think that I’m always against using credit cards. Actually, I have credit cards, and I use them — but I pay my balance in full each month. Besides the convenience credit cards offer me — in not having to carry around extra cash and checks — I receive another benefit: I have free use of the bank’s money until the time the bill is due. (Some cards offer other benefits, such as frequent flyer miles, and I have one of those types of cards too. Also, purchases made on credit cards may be contested if the sellers of products or services don’t stand behind what they sell.)
When you charge on a credit card that does not have an outstanding balance carried over from the prior month, you typically have several weeks (known as the grace period) from the date of the charge to the time when you must pay your bill. This is called playing the float. Had you paid for this purchase by cash or check, you would have had to shell out the money sooner.
If you have difficulty saving money and plastic tends to break your budget, forget the float game. You’re better off not using credit cards. The same applies to those who pay their bills in full but spend more because it’s so easy to do so with a piece of plastic. (For information on alternatives to using credit cards, see Chapter 5.)
Analyzing Your Savings
How much money have you actually saved in the past year? By that I mean the amount of new money you’ve added to your nest egg, stash, or whatever you like to call it.
Most people don’t know or have only a vague idea of the rate at which they’re saving money. The answer may sober, terrify, or pleasantly surprise you. In order to calculate your savings over the past year, you need to calculate your net worth as of today and as of one year ago.
The amount you actually saved over the past year is equal to the change in your net worth over the past year — in other words, your net worth today minus your net worth from one year ago. I know it may be a pain to find statements showing what your investments were worth a year ago, but bear with me: It’s a useful exercise.
If you own your home, ignore this in the calculations. (However, you can consider the extra payments you make to pay off your mortgage principal faster as new savings.) And don’t include personal property and consumer goods, such as your car, computer, clothing, and so on, with your assets. (See the earlier section “Determining Your Financial Net Worth” if you need more help with this task.)
When you have your net worth figures from both years, plug them into Step 1 of Table 2-4. If you’re anticipating the exercise and are already subtracting your net worth of a year ago from what it is today in order to determine your rate of savings, your instincts are correct, but the exercise isn’t quite that simple. You need to do a few more calculations in Step 2 of Table 2-4. Why? Well, counting the appreciation of the investments you’ve owned over the past year as savings wouldn’t be fair. Suppose you bought 100 shares of a stock a year ago at $17 per share, and now the value is at $34 per share. Your investment increased in value by $1,700 during the past year. Although you’d be the envy of your friends at the next party if you casually mentioned your investments, the $1,700 of increased value is not really savings. Instead, it represents appreciation on your investments, so you must remove this appreciation from the calculations. (Just so you know, I’m not unfairly penalizing you for your shrewd investments — you also get to add back the decline in value of your less-successful investments.)
If all this calculating gives you a headache, you get stuck, or you just hate crunching numbers, try the intuitive, seat-of-the-pants approach: Save a regular portion of your monthly income. You can save it in a separate savings or retirement account.
How much do you save in a typical month? Get out the statements for accounts you contribute to or save money in monthly. It doesn’t matter if you’re saving money in a retirement account that you can’t access — money is money.
Note: If you save, say, $200 per month for a few months, and then you spend it all on auto repairs, you’re not really saving. If you contributed $5,000 to an individual retirement account (IRA), for example, but you depleted money that you had from long ago (in other words, money that wasn’t saved during the past year), don’t count the $5,000 IRA contribution as new savings.
Save at least 5 to 10 percent of your annual income for longer-term financial goals such as retirement (Chapter 4 helps you to fine-tune your savings goals). If you’re not saving that much, be sure to read Chapter 6 to find out how to reduce your spending and increase your savings.
Evaluating Your Investment Knowledge
Congratulations! If you’ve stuck with me from the beginning of this chapter, you’ve completed the hardest part of your financial physical. The physical is much easier from here!
Regardless of how much or how little money you have invested in banks, mutual funds, or other types of accounts, you want to invest your money in the wisest way possible. Knowing the rights and wrongs of investing is vital to your long-term financial well-being. Few people have so much extra money that they can afford major or frequent investing mistakes.
Answering “yes” or “no” to the following questions can help you determine how much time you need to spend with my Investing Crash Course in Part III, which focuses on investing. Note: The more “no” answers you reluctantly scribble, the more you need to find out about investing, and the faster you should turn to Part III.
_____ Do you understand the investments you currently hold?
_____ Is the money that you’d need to tap in the event of a short-term emergency in an investment where the principal does not fluctuate in value?
_____ Do you know what marginal income-tax bracket (combined federal and state) you’re in, and do you factor that in when choosing investments?
_____ For money outside of retirement accounts, do you understand how these investments produce income and gains and whether these types of investments make the most sense from the standpoint of your tax situation?
_____ Do you have your money in different, diversified investments that aren’t dependent on one or a few securities or one type of investment (that is, bonds, stocks, real estate, and so on)?
_____ Is the money that you’re going to need for a major expenditure in the next few years invested in conservative investments rather than in riskier investments such as stocks or pork bellies?
_____ Is the money that you have earmarked for longer-term purposes (more than five years) invested to produce returns that are likely to stay ahead of inflation?
_____ If you currently invest in or plan to invest in individual stocks, do you understand how to evaluate a stock, including reviewing the company’s balance sheet, income statement, competitive position, price-earnings ratio versus its peer group, and so on?
_____ If you work with a financial advisor, do you understand what that person is recommending that you do, are you comfortable with those actions and that advisor, and is that person compensated in a way that minimizes potential conflicts of interest in the strategies and investments he recommends?
Making and saving money are not guarantees of financial success; rather, they’re prerequisites. If you don’t know how to choose sound investments that meet your needs, you’ll likely end up throwing money away, which leads to the same end result as never having earned and saved it in the first place. Worse still, you won’t be able to derive any enjoyment from spending the lost money on things that you perhaps need or want. Turn to Part III to discover the best ways to invest; otherwise, you may wind up spinning your wheels working and saving.
Assessing Your Insurance Savvy
In this section, you have to deal with the prickly subject of protecting your assets and yourself with insurance. The following questions help you get started. Answer “yes” or “no” for each question.
_____ Do you understand the individual coverages, protection types, and amounts of each insurance policy you have?
_____ Does your current insurance protection make sense given your current financial situation (as opposed to your situation when you bought the policies)?
_____ If you wouldn’t be able to make it financially without your income, do you have adequate long-term disability insurance coverage?
_____ If you have family members who are dependent on your continued income, do you have adequate life insurance coverage to replace your income if you die?
_____ Do you know when it makes sense to buy insurance through discount brokers, fee-for-service advisors, and companies that sell directly to the public (bypassing agents) and when it doesn’t?
_____ Do you carry enough liability insurance on your home, car (including umbrella/excess liability), and business to protect all your assets?
_____ Have you recently (in the last year or two) shopped around for the best price on your insurance policies?
_____ Do you know whether your insurance companies have good track records when it comes to paying claims and keeping customers satisfied?
That wasn’t so bad, was it? If you answered “no” more than once or twice, don’t feel bad — nine out of ten people make significant mistakes when buying insurance. Find your insurance salvation in Part IV. If you answered “yes” to all the preceding questions, you can spare yourself from reading Part IV, but bear in mind that many people need as much help in this area as they do in other aspects of personal finance.