And now for something a little different...

We’ve been dwelling on credit cards for several posts now. So many financial planners and personal finance authors classify credit card usage as potential financial disaster. Credit cards are also, often times, the most expensive way to pay for something! In this post, I’ll present an introduction to budgeting and goal setting – powerful tools to help you avoid overusing your credit card. These guidelines can also help you get a grip on your financial situation. Most of the information in this post is taken from Peter and Jennifer Sander’s book, “Living on a Budget”. 

Budgeting, if done well, can be your KEY to financial security. It can help you achieve your financial goals like a professional. Budgeting requires incredible discipline and wisdom; this shouldn’t be frightening. This should be encouraging! Budgeting and goal setting will, in effect, help you sharpen your character AND your financial stability. It has helped me (goal setting, in particular) pay off a good chunk of student debt, pre-pay a European vacation, invest well and build a satisfactory retirement fund, for my age at least. It’s even helped me achieve the little things, like paying for all my family’s Christmas gifts by June so that I don’t feel the pinch in December.

First, you need to keep a close eye on your income and your expenses. I suggest tracking how you spend for 1 month. Personally, I record everything I buy/ spend money on in my planner. Some of you might think this is archaic. No, I don’t use an electronic calendar. Physically crossing off my to-do’s in my calendar is a simple joy in my life! You can adopt any system you’d like. If you want to write all your expenses on napkins and file them away in a shoe box, be my guest. Just make it so that you can go back to your files once the month is over, and total the amount.

You may consider splitting your expenses into categories: food, clothing, room/board, utilities, monthly debt and entertainment, for example. Categorize your expenses, total them, and analyze. Allot yourself a realistic budget for each category. As a rule of thumb, rent/ mortgage payments should not exceed 30% of your take-home pay.

The tracking tool is powerful because it can really make you aware of where your spending pitfalls lie and where you can better discipline yourself.

No more information in this article. I don’t’ like overwhelmed readers. I hope you start tracking your expenses today and we can expand on the next steps in the coming week! 

The Emergency Fund: What it is and why you need it

Emergencies – never fun events to plan for!

Everyone knows emergencies of some sort MIGHT happen, but thinking about them is a little depressing, don’t you think?

But I will tell you this: the smartest people in the room are the ones who plan for financial emergencies.

I’m going to explain to you the purpose, the components and the benefits of the emergency fund.

The title doesn’t hide the purpose.

An emergency fund, also called the "emergency cash fund" by some financial planners, is a rainy day fund to cover all your unknown expenses that always seem to hit at the wrong time.

Ideally, your emergency fund would be enough to pay for at LEAST six months of your living expenses. Cash should be your first line of defense against any emergency expenses – if you use a credit card, you’ll run the risk of incurring interest payments which will dig you into a deeper financial hole. 

Give yourself TIME to stash away the necessary amount. Personally, I was able to accumulate an emergency fund by taking a certain, pre-calculated amount from each paycheck, and depositing it into a certain interest-bearing savings account. Using a CD for such a fund is not recommended because you’re going to want to have complete access to it without incurring any penalty fees for withdrawing before the CD maturity date.

Also, timing is really important: you should concentrate on building an emergency fund when you have you credit cards, mortgage payments, or in my case, student loans under control. This is probably not a feasible financial step if you don’t yet have enough to live on, or you’re not done paying down your highest interest credit cards or debt. This should be a medium-term goal (1-5 years) to help you achieve a little financial security.

Benefits:

Let’s say you are laid off from your job – a situation not unlikely in today’s economic landscape. Your emergency fund can be used to keep you afloat by covering rent or your home mortgage. Let’s say you get into a car accident; your emergency fund can be used to pay your deductible in such an instance.

In my case, I left my job. However, I overestimated the amount of money I would need to keep me afloat during my time of unemployment. But with my emergency fund, I didn’t have to completely cut out eating out at restaurants because I planned for it in advance and stashed it away in the emergency fund.

Other benefits include: financial peace of mind and a greater net worth. You can sleep well without worrying that if unexpected, large expenses presented themselves, you would be able to pay for them.

You accumulate greater net worth because if you build up savings, and have more cash set aside, this lowers the ratio of debt to equity and makes you look like a champ if you ever need to borrow from a bank or other lending institution.

In action: 

Put away $100 per month at 2% interest and in 3 years, you’ll have $3,700; in 7 years you’ll have over $9,000!

Put away $200 per month at 2% interest and in 3 years, you’ll have $7,400; in 7 years you’ll have $18,000!

Put away $250 per month at 2% interest and in 3 years you’ll have $9,200 and in 7 years, you’ll have $23,000!

Just a little bit each month in an interest bearing account and you’ll enjoy a bit of calm when unexpected expenses present themselves.

How to Build Your Credit

I was blessed to have parents who were very responsible when it came to using credit lines and credit cards. They paid their payments on time and didn’t like to have a balance on any revolving credit (a credit card or line of credit from a bank). When I was of age, they put my name on their credit card so their good habits would help to build up my credit score and history. I realize that not many of us have had that opportunity. Here are some tips from various sources that can guide us in building up a good credit score.

From an article by Jilian Minger entitled, “Credit-Score Pitfalls of the Wealthy”, the author advises that “about 35% of the score comes from a person’s payment history. Paying on time helps raise the score, while late payments, lines and bankruptcies will reduce it.”

She also mentions that about 30% of one’s credit score is based on how much someone owes. So common sense leads us to believe the lower the amount of debt, the better.

In addition, the older the credit card or line of credit, the better. Ten percent of the credit score is based on what type of debt you have. Types include mortgages (some of us are there yet, but most of us aren’t), department store credit cards, student loans or auto loans (installment debt). According to the article and Suze Orman’s The Money Book from the Young, Fabulous and Broke, installment loans and mortgages are better for your credit score than just having a retailer credit card (or twenty retailer credit cards…!).

A great resource for researching more about your credit score is Fair Isaac’s website, www.myfico.com.

To build up your score, request a copy of your credit report from each of the three major credit reporting agencies. Better yet, use the website www.annualcreditreport.com instead of the individual websites to get your free reports.

Also according to the article, pay down your credit card debt completely every month. This is a sound financial habit. If you’re currently unable to do that, pay it down to less than half the available balance every month. Not doing so can really cause your credit score to fluctuate.

Here are additional “don’ts” to help your credit score, per the article:

1. Don’t consolidate your debt on another card unless the interest rate is significantly lower and you plan to pay off the entire amount in one year.

2. Don’t cancel your card once you’ve paid it down because the score considers longevity and availability of credit.

3. Don’t stop using credit cards altogether. Many individuals just pay cash and have been taught that credit card usage is evil. However, to build up your score, you need to have a usage history. Even if you just use it once a year and pay it down immediately, having a payment history can be beneficial to you once you apply for a home or car loan. It gives the lenders (usually banks) an idea of how responsible (or not) you are with credit. 

Credit Cards - A Topic Worth Dwelling On

I mentioned several terms in the last post which I’d like to define in case there’s any confusion.

GRACE PERIOD  (As defined by the book The Money Book for the Young, Fabulous and Broke – Orman) – “The period between the end of your billing cycle and the day your payment is due; you will incur no interest charges during this period. If you carry over a balance from a previous month, there is no grace period…Credit card companies love to shorten the grace period; always check your payment due date when you receive your statement to make sure you know when you need to get the payment in to avoid interest charges.”

For example, on a credit card I have, my billing cycle ends on the last day of the month, and my bill is due on the 18^th of each month. Per the instructions above, always check to see if they shortened your grace period, and in effect, demand payment from you sooner.

Another piece of awesome advice from the aforementioned book:

If you have multiple credit cards that all carry a balance, concentrate on the card with the highest INTEREST RATE (not the largest balance). An effective technique is to list the credit cards in order of interest rate – highest to lowest – write down the minimum and maximum your credit card company is asking you to send in, and pay as much as possible over the minimum amount on the credit cards with the highest interest rate. The book suggests at least $50 dollars over the minimum amount you must pay on the highest interest rate credit card.

Keep paying the monthly minimum on the lower interest rate cards until the highest interest rate cards are paid off. Do this for each card until the balances are gone.

I found this advice in particular to help so much in prioritizing which student loans and credit cards to concentrate on! Remember to check out www.bankrate.com as your go-to resource for credit-related information.