The four letter word of personal finance is debt. Most of us have it; none of us wants it. I’ve written a lot about how to get out of debt. Today I’m excited to have Liz Weston, author of Deal With Your Debt, on the podcast.
We cover a lot of questions about debt, credit, and even retirement. Here are some of the topics:
- Which debt should you pay off first
- Should you pay off all non-mortgage debt before investing for retirement
- How your credit affects getting out of debt
- Some mythes about debt
- A rule of thumb to help you determine how much to borrow for school
- How much you can save by driving your car for a few more years
You can listen to the podcast above. If you prefer, here’s a transcript of my interview with Liz:
Rob: Liz, welcome to the show.
Liz Weston: Thanks Rob.
Rob: I’m so thrilled that you were able to take a few minutes out of your busy day to talk to us. I’ve enjoyed your books and your writing at MSN and other places. Your book on credit scores was probably the first book I read. And it’s interesting… Our son, who is now 20, actually took that book without asking me because he wanted to read it from cover to cover.
Liz Weston: Wow!
Rob: Yeah, and he’s not really into that, “Let’s save a lot of money,” right now. He’s into that, “What kind of a car can I buy?” But he took that book anyhow and read it from cover to cover.
Liz Weston: Wow.
Rob: And I just read your, ‘Deal With Your Debt’ book and wanted to talk to you about that. I believe people listening to this podcast can learn a lot from that. Before we start to dive into your books though, for those who may not be familiar with you, could you just give us a little bit of your background?
Liz Weston: Yeah. I’ve actually been covering personal finance for two decades now which seems like a really, really long time. I started out as a newspaper reporter and was a reporter for the Los Angeles Times for several years. Then I went to MSN and started writing with them.
The credit scoring book kind of evolved because nobody else had written a similar book for the consumer market. You could find a lot of academic books, books for people in the industry, but nobody was explaining to the consumer how their credit score was affecting their ability to get loans, their ability to get insurance. A lot of insurers use the credit information and scores. They weren’t talking about how landlords were increasingly using credit scores to evaluate you. So I thought it was time to take some of the mystery out of it.
My timing was pretty good, too, because right about the turn of the last century was when FICO started lifting the veil a bit and letting us know a lot more about it. I think consumer advocates were really putting pressure on them saying, “Hey, look… This is such an important score.” And at the time you weren’t able to see your score. There were agreements between these companies, the credit bureaus, the lenders and FICO that they would not reveal the scores to consumers and that was just blatantly unfair. So little by little we started to learn that credit scores existed and here’s how they are used and here’s how they’re created. And we know a lot more about them than we ever did.
Rob: Yeah, we kind of take it for granted today how easy it is, whether you’re going to look at a FICO score or different formula but how easy it is to get your report free online, your credit score and the tools to analyze it—what’s hurting it, what’s helping it. When my wife and I bought our first home the internet didn’t exist the way it does today and I had no clue what a credit score was. Or what ours was. You just applied and you either got approved or you didn’t.
Liz Weston: Well, the way that I think people found out about them is that their mortgage professional might have said, “Hey, your credit score’s really good,” or “You’re credit score’s not that great.” That might have been the first time that a lot of people ever heard there was anything such as credit scores. The fact that there is credit scoring dates back to the 1950’s. This is something that started in World War II when we started to become more adapted to applications in retail and all that, through the 50’s, 60’s and 70’s.
Rob: Okay. And how long ago did you write your book on credit scores?
Liz Weston: The first edition… I want to say was 2004. It was right after my daughter was born and I still can’t figure out how I did that.
Rob: Am actually going to ask you about that in a minute so just hold that thought, you know the thing is the research for that book had have been a lot more difficult then than it would be if you were writing that book today.
Liz Weston: Well, yeah. I benefited from a lot of things and one was a really good relationship with Fair Isaac which became FICO, and that was because I really started diving into this when I was at the Los Angeles Times. So I had that institutional sort of backing so I could call up Fair Isaac and actually get a phone call back. I established a great rapport with Craig Watts, who happened to be the PR guy at the time, and just kept asking questions. Just having those reporter skills of being able to figure out who had the answers, go to them and get them to talk. That really came in handy back then.
Rob: Oh, I bet. And when did you originally write your book ‘Deal With Your Debt.’ I know you’ve revised it in the most recent version in 2013 which is the one I read most recently. But when did you originally write that book?
Liz Weston: That was the next book after ‘Your Credit Score‘ so I want to say it came out around 2006. I know it was pre-recession because when I went back to re-write it a lot of things had to change because the whole credit market had been blown up and it had to be re-assembled. But the basic principles I was talking about stayed the same. One piece of advice I actually lifted directly from the one book and put into the revised book is, don’t rush in to buy a home. Buy it when it’s right for you. And I said this before the mortgage mess and I’m saying it now. It’s just not a decision that you can rush into.
Rob: So a lot of people should have listened to you before the market— I can remember when the market was going up and up there’d be conversations at work and the folks that were renting… You could just see it on their faces. They were just downcast because these prices were going up monthly. It was almost an emotional toll on them. They felt like they were missing out. Then, of course, it crashed and they had smiles on their faces while the rest of us were all bummed out.
Liz Weston: But most of us giving advice would take a lot of crap for telling people to wait, and for telling people, “No you can’t afford that mortgage that your mortgage broker keeps saying you can afford.” It’s crazy. And you keep saying it and you keep getting this push back. I wish I had saved this letter because I got a letter from some 24 year old mortgage broker who told me that interest rates would never go up and that his clients would never have a problem re-financing these scary, scary loans he was going to put them in. And I just thought, “That’s the level of naive confidence you can only have at 24 years old.” Because if you were miles on you would realize, “Wait a minute. The world is changing and whatever goes up is going to come down and this is just not sustainable.”
Rob: Well everything reverts to the mean. So if they are too high they’re going to come down and if they’re too low they are eventually going to go up. And that’s true whether it’s interest rates or the stock market or whatever—
Liz Watson: You could have a spiral— you could start moving upward. But yeah, I think that’s something you really have to think about anytime somebody is telling you, “It’s different this time.” Listen to their rational but just remember that very few things really do change in the fundamentals.
Rob: Yeah right, right… You mentioned the credit crisis. Are there other things that led you to revise your book ‘Deal With Your Debt?’ What caused you to go back to that book and make some changes?
Liz Weston: Well it was actually my publisher’s idea, FT Press, which is an arm of Pierson. I had kind of let them know that my plate was really full and I didn’t want to write any books. But they said, “You know what? This a book that has been out there for awhile and a lot of things have changed.” It was true with the Credit Scoring book as well. It had come out in the fourth edition just before that, and the fourth edition was a complete re-write of the third edition because so much had changed.
So when I looked at ‘Deal With Your Debt’ I thought— as I just said the principle is still the same but a lot of the details are different, so we need to talk to people about this. There’s some debt advice that’s commonly repeated and it’s not necessary the best idea for a big chunk of the population.
I wanted people to have the skills that they would get from a professional, comprehensive, personal financial planner. Not everybody can afford a full-fledged financial planner from a fee-only planner. But if they could, they would be getting more sophisticated debt advice than they’d be getting in a lot of venues. I just wanted to get the information out there for those who want to take it that there are ways to manage your debt and get ahead financially, and they may not be what you have already been told.
Rob: Can you give us some examples? What are some of the common things that you hear about dealing with debt that you think are either wrong or perhaps not right in every situation?
Liz Weston: I really worry about people who are prioritizing debt over everything else. One of the things I know about people who get in debt is that they tend to be the kind that look for short-term solutions. It’s either instant gratification or, “I’m going to borrow some money to solve this problem.” So they tend to be wired for the short-term to start with.
Then when they finally realize what they’ve cost themselves, they want to get out of debt instantly and they want to do it as quickly as possible. But here’s the problem with that… Almost all of us— let’s say 90 percent of us are going to get to retirement age. And what we know is that people are not saving enough. We also know that retirement is very, very expensive and it’s probably going to go on for longer than you think. Most people that live to age 65 are going to go on for at least another 20 years, so that’s a big chunk of time to basically get by on your own savings and social security.
So what people really need to hear is that retirement savings have to be the top priority from day one— from your first job. Even if you have debt, you need to take advantage of that 401(k) at work. Hopefully it has a match. That would be great. Even if it doesn’t, you need to start chunking money away and you need to leave that money alone to grow.
The problem is, people are putting that off. And the longer you put it off the longer it’s going to take you to catch up. Pretty soon it’s impossible, or virtually impossible. If you look at somebody who starts saving in their 20’s, and they save 10 percent, 15 percent, they’re going to be fine when they get to retirement. They might even be able to retire early. If you put it off until your 50’s your going to have to save 40 to 50 percent of your income to match what you would have had if you had that earlier start. A lot of people simply can’t do that because they have too many expenses.
That’s a long answer to your question, but basically, people need to know retirement has to come first no matter what. Fit the debt repayment around that. Don’t be in such a rush to pay off things like a low-rate tax-deductable mortgage, fixed-rate tax-deductable student loans. Yes, you want to pay those off eventually, but if you start throwing all your money at those debts and you don’t take advantage of retirement savings options out there, you’re going to be poor in the long run. And I don’t want you to be poorer— I want you to be richer. So that’s the message I want to get out.
Rob: Yeah, I think that’s so important. You and I are on the exact same page because I know they’re a lot of folks out there saying, “Pay your debt off first.”
Liz Weston: That’s because they can’t do the math. And heaven love them— I know they’re really trying their best and they really want to help people with this advice, but if you do the math— if you really understand the power of compounding you wouldn’t give that advice. You’d understand what your costing people by telling them, “Yeah ignore retirement for 10, 15 years and deal with your debt.” That’s really costing people so much in the long run.
Rob: Yes. Thinking of the psychological component, if you had debt and you were very well disciplined and you paid it off in a year and a half then you start saving for retirement, that might not be the end of the world to take that approach. Except that’s not what people do. They pay off some debt and then get into some more debt. Right? And then they pay it off. And these may be very responsible people. This describes my wife and I when we were younger. But if you follow the, “pay off your debt first,” you’re going to end up, like you said, you could be 10 years out or longer before you start saving for retirement.
Liz Weston: Yeah. And the example I try to give people is, maybe you’re not saving for a year or two, follow that out. Every $1,000 that you’re not saving in your 20’s is going to cost you, probably $20,000 in lost future retirement income. Maybe even more. Even if you just adjust that for inflation, that’s a ton of money that your giving up. So it’s not just, “I’m not saving but, you know, I can catch up later.” Most people are not going to do that. And if they were extremely disciplined about the whole thing and could pay it off quickly and get back on the road that would be great. But a lot of people don’t.
Rob: Well, let’s talk about debt. I’ve got a few quotes from your book I’d like to throw at you. If you could just give us a little background. One is this, “Debt is a tool that if handled properly, can help you create wealth.” What does that mean?
Liz Weston: Oh, yes that’s one that makes the hair stand up on the backs of the anti-debt crowd. Here’s the deal. In certain situations borrowing money can help you get ahead, it can be an investment in your future. The example we commonly give is a mortgage. If you go to financial planner, they’ll talk to you about good debt and that’s an example of a good debt.
Now you can overdose on good debt, most definitely. But here’s the idea with a mortgage. You’re borrowing money and paying it back over time. You’re building equity and at the end of your mortgage you’re going to be wealthier than when you started.
Similar thing with Federal Student Loans. Notice I said Federal there? There are a lot of people who cannot pay cash for a four-year college education and we are very well aware that a four-year college education is increasingly the ticket to staying in the middle class. Not advancing, but just staying in the middle class. So a college education is going to become more and more important. If you cannot afford it the idea of just doing without it is kind of insane. If you want to be able to build wealth and grow your income and grow your wealth over time, that college education is really important.
So people need to be able to get it. And sometimes the only way they can get it is with a low-rate fixed Federal Student Loan. And so that’s a good debt. Again, you pay it down over time and it pays off in terms of increased income. Does it in every single case? No, there are people who can screw this up. They can borrow too much, they can major in the wrong thing. They can come out of school and not make any more than when they started. But those are the rare exceptions. Most people do significantly better once they have that degree under their belt.
Rob: I’ve got my nice well prepared notes for the interview today but am going to jump out of line because of what you just said. I’m scrolling down to some notes towards the bottom about student loans because you said something that I had never heard before…but I think it’s spot on. Here’s what you said. And I’m kind of re-phrasing— this is not a quote. But you said–Limit total borrowing for school loans to no more than your expected first year salary. Do I have that right?
Liz Weston: Yes.
Rob: So if you think you’re going to make $50,000 in your first year, that would be the total for the four years that you would borrow.
Liz Weston: Yeah.
Rob: How did you come to that? Maybe I’m just in the dark. Is that sort of a well-known rule of thumb for school loans?
Liz Weston: Yeah. It’s out there. When I originally did the numbers I looked at what career counselors, debt counselors and financial planners said about how much debt you should have. And they basically said, “Okay, about 10 percent of your income is the most that you should be spending to repay a student loan.” I kind of reverse-engineered given the interest rate at the time and went, “Okay, that could be about two thirds to 100 percent of what you expect to make your first year out.” Then I started shopping that idea around to a bunch of different sources and they all said, “Yeah it’s a general thing.”
I mean, if you are getting a law degree and you’re going to work in the public defender’s office for a couple years then go out into private practice, your income is going to soar, typically. So you know you might be able to stretch that a bit. But in general it’s a good idea to look out and see what you are training for. See what the incomes are likely to be, and make sure you put some kind of lid on your savings.
I’m not saying it’s a hard and fast line. I’m saying it’s something to keep in mind. If you go over that limit just keep in mind that it’s going to be tougher and tougher to pay that loan back. It’s going to start affecting your life and you’re going to wind up being one of those people who has to put off buying a house or have to put off other goals because you’ve got this student loan debt.
Rob: One of the things I like about the way you’ve approached it. Thinking in terms of your first year salary, as you said, it might be a little higher or lower which is just a rule of thumb, it forces you to ask some questions, like, “What degree am I going to get? And what’s its value?”
Liz Weston: Yes.
Rob: And what school am I going to attend?
Liz Weston: Because the schools won’t necessary tell you, “Hey, nobody’s getting jobs in this major anymore.” It takes awhile, institutionally, for them to re-vamp to the market. So we really have to be a little bit more savvy. And that’s a lot to ask a 17-year-old, frankly— to think that far ahead.
Rob: Yeah. I see CNN stories and whatever and just cringe. I feel sorry for the folks. But they’re in their early 20’s and it’s always a story of someone who owes like $200,000. And I always ask myself, “Okay, I think I know what degree they got.” And I scroll down and it’s a liberal arts degree from a private institution. And I think, “Why did you do that?”
I mean, I went to law school but I got a liberal arts degree. I got an English degree. I’m not criticizing a liberal arts kind of education because that’s what I have. But you really need to think realistically about what your job prospects are going to be and what you’re going to make before you go out and pile up that kind of debt. And depending on what it is, you can’t discharge it in bankruptcy right?
Liz Weston: Right. Exactly.
Rob: And it could be an anchor around your neck for a long time.
Liz Weston: Being a journalist I’m part of the media and I like those dramatic stories of the undergraduate who’s piled up a quarter million dollars of student loan debt. The idea that everyone is walking around with those levels of debt is nuts. Most people…I mean students graduating today definitely have more debt than they did several years ago and that’s because the net cost of college keeps going up. It’s basically doubled since the 1980’s.
And most kids are coming out with somewhere around $28,000, $29,000 in student loans. I’m not worried about that as an average. They’re going to be able to pay that off just fine. The ones with those crazy six-figure loans for the undergraduate degree? A lot of time those are first generation college students. They don’t have parents who could have told them, “Honey, I don’t think that’s going to pay off,” because their parents have no experience with the college system. So those are the kids I really worry about— the ones that are the first in their family to go to school.
They get their sight set on some dream school and they’re paying based on what their parents income and assets might be. And that could be substantial. Even if you haven’t been to college, in our generation you could still build up some wealth. Today they could be without very much financial aid, or the financial aid they get is all loans. Those are the kids that are greatly in danger because they’re not getting really good advice about limiting debt and making sure what they’re majoring in actually has a market that’s growing and is one that will pay them something when they get out.
Rob: Yep, yep. And one of the resources you mention in your book is the National Association of Colleges and Employers. I guess they have a website with starting salary data? I’ll have a link to that in the show notes.
Liz Weston: There’s also the Bureau of Labor Statistics that keeps those kind of numbers as well, but I just found that the other one is a little bit easier to navigate.
Rob: Alright, well let me go back to my outline here… Back to my notes. I know a college education is critical and the debt is a big issue for a lot of people so I definitely wanted to focus some time on that.
Liz Weston: Yes.
Rob: So let’s talk about tackling your debt. Which debt should you tackle first?
Liz Weston: I tell people to look at their toxic debt. Make that their highest priority. Again, assuming they’re getting on track with retirement savings, taking advantage of their 401k or whatever… now they need to look at whatever debt is really eroding their financial security. And that’s going to be the higher rate debt, the variable rate debt, the debt that has no tax advantages. So credit cards are a classic example. That’s toxic debt.
There’s worst debts, obviously. There are payday loans, bank bounce fees— you know, if you’ve been using your line of credit or bounce, overdraft kind of thing. That is very expensive debt. Title loans, pawn shops— all that stuff is really high-rate debt. And payday loans are something that really came up out of nowhere. If you look at the early 90’s, hardly any. If you look now, I been told there are more payday loan outlets than there are McDonald’s and Burger King’s combined.
Liz Weston: I’m not sure if that number is still accurate because what happen was, the military was getting sick of their soldier’s getting wrapped up in these awful high rate loans, so they essentially banned lending money to military folks for greater than 36 percent interest. Almost overnight, all those payday loans places disappeared from around the bases which was a blessing for the poor soldiers that were getting taken. So there were fewer than there were at their peak, but there are still so many of these outlets. And there are still so many people who don’t realize how dangerous that is. So that’s my little soap box— I’ll get off now. Basically though, if you have any of that kind of debt— credit card debt, payday loans or whatever, the high rate debt that is what you should be focusing on. Take care of that first.
Rob: Of course. You mention that in your book, paying the high rate debt first. You also talk about one alternative approach by paying the smallest balance first and the pros and cons there. But one approach that was interesting to me, was paying off a debt where you’re closest to maxing out your credit limit for that card.
Liz Weston: Yeah. If you had maxed out a card or even came close that’s going to affect your credit scores. That’s going to push it down. That’s still true. What’s not still true, is that in the past lenders were able to jack your exiting interest rate because of that. That’s when I started telling people to focus something that’s close to the limit. You want to pay it down because you could be chasing that interest rate higher and higher. It’s not true for existing balances but the credit card issuer can still do that for balances going forward.
So my feeling is, if you do have some maxed out cards, I might focus on those first just to give your credit score a break. Just to get that payment down. And the part about paying the small balances first? It doesn’t make sense mathematically, but there has been research to show that people who do that, tend to pay off more debt. So I’m not going to say, “Don’t do it!” Mathematically, it makes more sense to go for the higher debt first, but you know whatever works is what works.
Rob: Yeah. I think the key is for folks to understand the pros and cons of each approach.
Liz Weston: Yes.
Rob: And figure out what works for them. I’ve had readers email me, telling me they kind of did both. They started with the smallest debt because they needed that emotional boost to see something paid off. Then once they had one taken care of and felt more confident tackling the debt, they went to the highest rate because they had the confidence they needed which I thought was perfect.
Liz Weston: Yeah, yeah.
Rob: A question on the credit limit. Do you know Tom Quinn at FICO?
Liz Weston: Yes.
Rob: Great guy. I actually interviewed him actually in my podcast. We talked a lot about credit utilization. And, I don’t know if I asked him this question but I’ll ask you. Say you’ve got a $10,000 limit and you’ve got $10,000 balance. Of course you may have other credit cards and they may have a lot more credit available, so do the folks at FICO and other credit scoring models look at it on a card by card basis? Or do they aggregate all your revolving debt and look at your utilization for all of it combined?
Liz Weston: Both!
Rob: They do both, okay.
Liz Weston: And that’s why people who have a lot of debt on a single card would probably be better off spreading it around. It’s a little counter intuitive to do that. But actually, if you want to improve your credit scores fairly quickly, you do want to look at that credit utilization. Because, if you’re maxing out one card or two cards and you have a lot of other available credit, that really is hurting you because it does look at the overall, but it also looks at each individual card. So spread it around and then pay it off.
Rob: That’s good to know because you mentioned a little bit in your book about balance transfers, and that’s what my wife and I did when we were getting out of credit card debt. We just rolled it over until it was gone.
Liz Weston: As long as you use the low-rate balance transfers as a way to pay off more of your debt. That works. The people I worry about are the ones that keep skipping the balances from one card to another. And, I don’t know if Tom bought this up but, if you pay your balances in full every month which is what you should be doing, that’s the absolute… If I could tell everybody in the world one habit to develop besides saving regularly, it’s to pay off your credit card balances in full. Even you are affected by that credit availability thing. And that comes as a surprise to people because they think, “Why should I worry about it? I paid it off in full.”
The balance that’s reported to the credit bureau is the balance recorded on a certain day. It could be your statement closing date, it might be some random day of the month. So even if you pay the balance in full the next day, the credit bureau’s wouldn’t know that because that’s not the numbers they were given. And those numbers at the credit bureau are what goes into your credit score.
So if you are someone like me who loves credit card rewards and is out there getting them, make sure you don’t go over about, roughly 30 percent of your credit limit. If you’re starting to do that, you might want to make a couple payments during the month to pay it down or start using another card. Because, again, if you watch what happens to your FICO scores when you max out even a single card you’ll realize this is a powerful part of the formula. You want to pay attention to it.
Rob: So, yeah, they sort of take a snap shot on a given day of the month?
Liz Weston: Yes. And a lot at times it’s the statement balance. So, if I had my CHASE card and I’ve got it up to 60 percent of the credit limit on the day the statement closes? I could pay it the next day, but it’s still the higher balance that’s being reported to the credit bureaus and incorporated into my scores.
Rob: That’s good to know. I think I’m a lot like you where my wife and I use a reward card and we basically charge almost all of our monthly expenses to that card. I think it probably still keeps it below 30 percent of its limit but not every month. It just depends what craziness is going on in our lives. The thing about balance transfers that I’ve found is that when you first do a transfer it can hurt your scores, both because there’s an inquiry and because on the new card—your old card may have a zero balance now if you transfer it, but your new card can be maxed out. As you said, they look at it both ways.
Liz Weston: Yeah.
Rob: Although over time it actually probably helped my score because I got out of debt faster and when we were done with a ridiculous amount of credit because we didn’t cancel any of our cards—
Liz Weston: Yeah, that’s another point people need to know, is they fear having too much available credit. That’s not even a reason code in the FICO formula. That’s not a negative. The formula realizes that you’ve been handling those accounts responsibly and you’re not going to go out and run up a bunch of debt in all of a sudden. You’re not going to change overnight, typically. So having available credit is a good thing. You shouldn’t be asking your credit issuers to lower your credit limit and you shouldn’t be closing cards willy-nilly. I mean, you can and you still keep most of the information, but having lots of available credit that you’re not using is a good thing.
Rob: Okay, good. One thing you mentioned in your book, 720 as a FICO score. If you’re below that, you want to get your score higher. And I was curious, why 720?
Liz Weston: Well, that’s actually a little bit out of date. One of the things I explain in the book is that every lender is different pretty much. And every type of lending is different so what is considered a decent score – a good score by one lender might be kind of iffy for another. Here’s the deal.
You get the best rate and terms if you have FICO’s at 740 and above. If you want the absolute best rating terms on almost every loan, 760 is going to be the sweet spot. There’s very few lenders that cut lines above that. If you go below, some interesting things happen.
It used to be 620 was considered sub-prime and if you were below that you would have to pay a lot more for credit, if you could get it. After the financial crisis, the mortgage mess, the credit crunch and all that, what was considered sub-prime really moved up. There were people who had 660, 680 scores who were being treated as sub-prime so now that seems to be settling back down.
But the one thing to keep in mind now is… credit is a moving target. Your credit changes all the time. Your credit scores are changing all the time. The lenders are changing their policies all the time. So we try to get people some rules of thumb and general guidelines. But even that guideline of that says, “Don’t use more than 30 percent of your available credit…” even that’s blurry. Because it’s not as if 40 percent is awful. What it means to say is – 30 percent is good, 20 percent or less is better and 10 percent or less is best. It’s sort of a sliding scale. It’s just things to keep in mind rather than hard and fast rules. Does that make sense?
Rob: It makes perfect sense. There’s a practical side to this and that is, have a sense as to why you need your credit. In other words, if I were going to buy a home in the next 12 months, or if I planned to refinance my mortgage, I would not be doing a balance transfer for example. Or doing other things like getting other credit — unless I absolutely had to. And I’d be very mindful, as you said, of my credit card balances because my credit’s going to really matter in a very big way when I go to sign that mortgage.
But for my wife and I right now, we’ve got a low mortgage. We’re not moving. It’s not that we don’t care about our credit… I guess the point is, folks need to plan ahead. And there are going to be times when your credit’s going to really, really matter, so to do the things that you described, will help keep it up as high as they can.
Liz Weston: Yeah, because every point can count and you don’t want to be missing out on the best rate because you opened a Macy’s card, for example. If you’re going to be in the market for a major loan you just stop those other activities and wait until your done.
Rob: Alright. So here’s another question that you talked about in your book. On a credit card or maybe even a home equity line of credit, should you ever rely on those as an emergency fund?
Liz Weston: This was something I was first told by a financial planner in the early 90’s and I thought she was out of her mind because I was raised believing debt was evil. Debt’s a four letter word. You try not to have any of it other than your mortgage and you pay that off as quickly as you can. And she just sort of threw out this line, “All my high net-worth clients have home equity lines of credit.” And I’m like, “Really?”
I kind of dived into it and realized that, especially with those high net-worth folks— if things go wrong they can go catastrophically wrong! If you have a six-figure job and you lose your job, it could take months, years… or maybe you won’t ever get back to that level. She wanted her clients to have healthy emergency funds but she also recognized that life happens and emergency funds can go away so you want to have that backup. And also, as I started to research it more I realized that it takes a typical family years to build up even 3 months of emergency funds worth 3 months of their essential expenses. And that’s because even if you’re cutting you expenses and saving that money, it takes a long time to build the funds up.
So you want to have something in the mean time. Now, if you’re paying off your credit card you’re going to have available credit so in an emergency you could use that. But it could also be a good idea to have that home equity line of credit open an unused. And that’s the two important parts, because if you try to go get a home equity loan after you lose your job you’re going to have a tough time. And if you use all of your available credit on that home equity line to go to Walt Disney World and have a great trip, buy a car or whatever… it won’t be there when you need it.
So the whole idea is get it open before there’s a crises and keep it open and unused. Here in California, we have a lot of experience with earthquakes. The thing with earthquakes is, even if you have insurance, there tends to be a whopping deductable of 10, 15 percent. If you don’t have that money sitting in cash somewhere, having that home equity line open and ready to go is really important when you want to rebuild. The thing is, you won’t be able to get a home equity line of credit on the rubble that once was your house. That’s why you have to do it in advance.
Rob: We relied on our home equity line of credit when we were climbing out of debt. We didn’t have an emergency fund and the idea was, rather than sticking cash in a low interest savings account, we could put it to work getting rid of our debt while we continue to save for retirement. And we were fortunate enough never to have to draw on the home equity line of credit. But it was there if we needed it.
Liz Weston: That’s what a lot of people are really scared of using their savings. As I said, it takes so long to build that up. The idea that you would take that chunk and pay down your debt is frightening. It’s like, “What will I do?” But, knowing that you’ve got access to credit in an emergency can help you do the right thing with your money and get it, as you said, working for you.
Rob: Okay, one topic I think is always interesting to debate is one that you tackle in your book. Is your home an investment? What are your thoughts?
Liz Weston: I went through three regional real estate recessions. On the national scene, home prices were going nuts and people were saying, “These prices will never go down because they’re not making any more land.” I knew that was just total bunk. I kept saying, “Home ownership is not for everyone,” and “A house isn’t necessarily an investment and you have to plan for the possibility that you may get slow appreciation or even depreciation.” And at the time, a lot of people thought that was nuts because they hadn’t experienced it. But I been through it.
You know, Seattle had a period in the 70’s where prices went down. Then I moved to Alaska and prices went into the toilet— when oil prices went down that time. Then moved to southern California right in time for that big real estate recession. So I’d been through it so many times that I knew you couldn’t count on this endless appreciation that people seemed to think was guaranteed.
The other thing is, when you start doing the math on home ownership, you realize how much you’re spending in terms of property taxes, insurance, maintenance, repairs, upgrades… I remember sometime in the 90’s the Wall Street Journal actually looked at it and figured you pay for your house two or three times over a 30-year ownership period. So the idea that your getting all this wonderful appreciation and you’re not paying for it, doesn’t really work out. What people really get excited about is their parents buy a house for $25,000 and they sell it for $250,000 decades later. If you look at inflation over time they’re basically getting the rate of inflation, and no better. Even if you do a little bit better than the rate of inflation, probably once you factor in all the costs of ownership you’re back to inflation or even below it.
So that’s why I wanted to bring up the point that I think home ownership is great. It’s worked out wonderful for me and our family. But it’s not necessarily a ‘slam dunk.’ Your home is basically a consumption asset. It’s something that you’re using. It’s the place that you live. It’s not really an investment. If it works out that way in the long run, great. But don’t count on it.
Rob: Yeah, I think that’s how I think about our home as well. Particularly over the last half dozen years when the value went down— that wasn’t any fun for any of us. But I am just curious, where did you live in Alaska?
Liz Weston: In Anchorage.
Rob: Okay, have you ever been to Skagway?
Liz Weston: No, I’m sorry. I haven’t been to Skagway. I’ve been to Ketchikan and Juno but I’ve never got to Skagway.
Rob: I spent a fair amount of time in Skagway, believe it or not, representing a client. It’s a beautiful place, the mountains are just phenomenal. That’s where the cruise ships go in now. I think folks can take a train up the mountain.
Liz Weston: Yeah, a beautiful place.
Rob: Okay, I appreciate your time today. Let me just throw one last question at you, if that’s okay? I thought this was a fantastic part of the book. And I never thought of it this way, but it has to do with car loans. You compared two people; one who had a 5-year loan, who— as soon as they pay off their car, would go buy a new one to someone who pays off their car and doesn’t go buy a new one, but drives the same paid off car for another five years.
You looked at the difference first of all, in how much these two people would spend over a lifetime for cars, and how much the person who drives their car for five more years could have in the bank if they took the car payments they weren’t making and invested it. Now, I know you don’t have the book in front of you so you may or may not remember the numbers, I’ve got them written down if you don’t, but they were unbelievable!
Liz Weston: Was it like 1/4 million or was it higher than that?
Rob: What you had in there was, for someone who buys a car as soon as they’ve paid off the last one, they spent just under $470,000 over the course of their life. The 1/4 million was how much the other person spent. They spent a lot less because they drove their car for another five years. The thing that struck me was, if they had invested the car payment that they were not making while they drove this car for another five years, over a lifetime they’d end up with 2 1/2 million dollars in the bank.
Liz Weston: I’ve used that example a couple of times and I’ve revised it trying to keep the interest rate sort of in the ball park. But the reality is, anyone who writes about personal finance and has done this for awhile knows that a lot of times people are having trouble making ends meet. It’s either the house or what’s sitting in their driveway. And we’ve got this idea that we need a new cars. No one needs a new car! You may need a car if you don’t have public transportation, but you can get by with a gently used car. Yet we still have this idea that we need new cars and we need them frequently.
I just wanted to sit back and do the math to show people how much they could save over a lifetime. Now I know I’m never going to convince the car guys, who are in love with cars, have 16 cars— that’s their thing. If that’s how you want to spend your money, that totally fine. As long as you’ve got your retirement covered and you’re not getting into debt, buy as many cars as you want. I’m saying, for the rest of us who are trying to balance these different financial priorities, you need to see how much that vehicle is costing you. And you need to see how much more you would have if you just put a few restraints… And I’m not even saying hold the car for 15 years or 20 years. I’m not saying, “Never get a loan.” I’m just saying, look at the difference if you hold the car for five more years. And these days cars are built pretty well. They can last that long. You’ll have more repair bills at the end. Trust me, I know. But overall it’s a much better value proposition to just hang onto them a little bit longer.
Rob: Yeah, that is such a good point. You know, the debate of new versus used is a fair one to have and to figure out what’s best for you, but boy, just driving it longer—I’ll give a shout out to my wife who’s driving a car that we bought in 2002. She loves it and has no plans of getting rid of it so I’m her biggest fan. Well Liz, I appreciate you taking the time to talk with us. It’s a great book. And for those listening, I will leave a link to it in the show notes. You’ll like all of Liz’s books, but if you’re dealing with debt— for my money your book is a ‘one size fits all.’ You’re educating people so they can make the right and best decisions for their specific circumstances and I think that’s the way to go. But anyway, thank you so much for your time.
Liz Weston: Thank you Rob. And thanks for the nice words.
Well, I hope you enjoyed the interview. As always, if you have any questions about the interview or any questions for Liz, just shoot me an email at dr [@] doughroller [dot] net. I’ll be happy to answer your questions or forward them on to her and get her responses as well.