Elusive Wealth

One of the topics I would like to cover over the coming weeks is wealth and income distribution. There are several reasons why I want to cover it, first and foremost I think it is relevant to many people. There is concern about the shrinking middle class, increasing poverty and rising health costs. I want us to look at what might the contributors to that, and find some ways to address it.

To start this discussion, let’s take a look at some statistics on the distribution of income in the United States. Maybe from this there is something to learn, or perhaps its just interesting data.  First let’s look at some of the 2005-2007 census data. Statistics show that we have 111.6 million households. So what is the relative wealth breakdown of those households?

Income Levels (2005-2007 Census Data)

The median income during this time period is right around $50,000. If you are significantly lower than that, you might be struggling to make ends meet. If you are higher than that, you might have a good income, especially relative to the rest of the country… but even then you might not feel like it is sufficient. And if you are way off the charts, you might be Obama-rich (congratulations if that is the case)!

So how do these numbers differ from the past?  Below is the same data from 1993.  You can see the trend as fewer households are in the under $15k range, and significantly more households are in the greater than $75k range.

Income Levels (1993 Census Data)

In 1993, the median income was $31,553 compared to the $50,000 number for 2005-2007.  During this time period (1993 to 2005) the consumer price index grew from 213.7 to 284.3, an increase of 33%. The median family income grew over 58%. So why are incomes outpacing consumer price index during that time period?  One of my thoughts is that a certain portion of that increase is represented in the increase of dual income families.

At the same time that households appear to have more money relative to the cost of goods, people have felt increasingly more strapped. Take a look at some data from Pew Research (The Median Debt-to-Income Ratio for Households With Debt Holdings) that really highlights what I believe to be a major contributor, if not the largest contributor, to any disparity in wealth and the “fading middle class.”  This graph shows the median debt to income ratio of high, middle and lower income earners in 1992 and 2004:

Median Debt to Income (1992 and 2004)

Notice the tremendous growth in debt compared to income! We can consider what goes into that. For instance, I have no doubts that rising health care costs are a contributor. But I also believe that our excess is a factor as well — our Starbucks, BMWs, and our willingness to take on house we cannot afford.. If you compare the income data, it seems we should feel better about our position not worse. And certainly it is difficult to see the middle class disappearing from the income data. Compared to inflation it seems middle class should be getting richer. But this debt is a tremendous burden. And doesn’t Congress provide a wonderful example of keeping debt within reason?

What are your thoughts on what contributes to this drastic increase in debt?

So it is not generally recommended that a blog specifically focus on the blogger. Especially a blog that is just getting started. You don’t want to hear about me, and I get that.  But I do want to talk about our current financial plan, not necessarily because it is about me and my family, but mostly because it aligns with a lot of the recommendations I give to others regarding personal finance. Before I get into this, I also want to mention that I realize not everyone has the financial room to contribute a lot of money toward debt, or a lot of money toward retirement, or both. There will be future topics that can address boosting income, or spending less.  But this article is not about frugality or increasing income, it is much more about just having a plan.

Putting the Plan Together

Our Goals

We would not have a plan without first setting out some goals. While we have long term goals around our childrens college savings and our retirement, the short term goals are the focus for this topic. The short term goals are part of the longer term plan, but the 1-2 year goals really indicate what we need to be doing today.

Two primary factors have led to creation of these goals:

• Birth of our premature son – demonstrating the need for an emergency fund and more stability in our finances
• Upcoming reduction in income – my wife will be reducing her work within the next two years

So here we have a past event that encouraged us to take action. But we also have a future event that we control. Because it is our choice to reduce income in this case, we have set some predefined targets that we must hit before my wife can reduce work. This gives us real incentive to work together and hit the goals. Our two financial goals for the short term are 1) reduce our debt to the point where our home value is greater than our remaining debt, and 2) establish an emergency fund of at least 4 months expenses. When we started the plan last May, we had two 401(k) loans, a home equity loan, a student loan, and a mortgage.  And we had no sizable emergency fund.

Bringing our debt down below the current value of our home is advantageous because we could then sell the house and be completely debt free. With the housing market down, we do have to work harder than we expected when we started the plan!  Nevertheless it is still our target. Establishing the emergency fund is key to providing the stability we craved after the birth of our son.

Crafting the Plan

Our first decision to make was which loans to pay off and in what order. After some thought about each loan the decision was not all that difficult. The type of loan, the size of the loan, and the interest rate were all factors. Here is how we broke it down:

• 401(k) Loans – Generally speaking 401(k) loans are recommended against, which I will cover in a future topic. The only factor for making these loans the top priority was to have more freedom to change jobs (or withstand a layoff) without having to repay the loan immediately or owe interest and a penalty.
• Home Equity Loan – This became our second priority because of the relatively high 8.85% interest rate.
• Student Loan – Our interest rate on this loan is a very fortunate 1.75%. If it were 2 or more percentage points higher, I would be inclined to include it in this debt repayment plan. This became our lowest priority and would only be paid off in a medium to long term plan.
• Mortgage – The interest rate for the mortgage is 5.75%, and it is our largest debt balance. This is our third debt priority, but would have to be addressed after retirement savings and various other needs and wants in our medium to long term plans.

Our intention was to attack this debt with extreme focus. So while we have not followed Dave Ramsey’s Baby Steps exactly, the steps we have taken are not far removed from his approach.

Started a Budget and Reduced Spending

Where we had no formal budget before, we began to track our spending. We tracked our spending for the first month before establishing any budget. We identified areas to cut and began implementing those changes. The key point here is that we communicated what each of our priorities were within the budget, including some available money for non-essentials such as entertainment, eating out, and so on. Instead of eliminating all of the non-essentials, we put together a budget that reduced the number of smaller non-essential items like eating out. Where we really created room in the budget though was by eliminating and putting off the big non-essentials like out of state vacations, recurring monthly expenses, and cosmetic home improvements. Our income situation allowed for this, though if we had more debt or less income we would have had to focus on all discretionary expenses.

Created an Emergency Fund

Getting the budget completed allowed us then to put together a small emergency fund.   As quickly as possible we put in place $2000 for this emergency fund. We chose $2000 because while our expenses we under more control, they were still high enough that an expensive emergency could derail our plan. We keep this money in our ING Savings account in order to be able to access it quickly if an emergency required it.

We Threw Money at the Debt Constantly

All “extra” money we had went directly to the debt.  Well almost   With the 401(k) loans we had to pay them off in full, so we had to save the money first. This gave us extra perceived cushion on our emergency fund as well, but it requires much discipline to avoid dipping into the money that is saved to pay off debt.  All of our excess money went to paying off debt. By the end of 2008 we had our two 401(k) loans paid off. This had a fortunate side effect as well, at least for one of the loans. With the crash in the stock market, if we had all of the money from the loan still in our 401(k), we would have lost much of it in the crash. But instead it was like having a cash investment. We paid one loan off before the crash, so we lost around 40% of it in the downturn. But the other loan was repaid after the crash, coincidentally a great time to be buying into the stock market. This of course was luck, and I would not suggest trying to plan it this way.

Aside from the budget and reduced spending, we also made some other temporary changes:

• Reduced 401(k) contributions – we reduced our 401(k) contributions to just enough to get the company match.  If this plan were going to take more than two years, or if we were going to just incur more debt after we paid these debts off, then this would be a bad move.  All the money that previously went to 401(k) contributions now goes to the debt.
• Any extra income or money such as bonuses, income tax refunds, and reimbursements from Child Care Dependent Care account and our Health Savings Account goes directly to the debt.

Our Current Progress

These changes enabled us to pay off our two 401(k) loans by the end of last year, and cut our home equity loan debt in half. At this rate, we should be able to meet our goal of having less total debt than the value of our home by February of next year. Then within about 6 months of completing that goal, we should have our emergency fund established. So a plan that originally took us through mid 2011 is on track to be accomplished by mid 2010.  We are thrilled about the progress, especially given the current economic conditions. What we have found is that this focused intensity has enabled us to meet these goals much earlier than we imagined. It does not always work out that way for everyone, but my hope is that this provides some motivation for others.

Next Steps

Once we meet our target around mid 2010, our focus will shift slightly to medium range plans.  A major item for that time frame will include saving to buy our next cars.  Our current cars will reach 10 years old around 2013 and we want to be prepared to buy our next cars without incurring new debt. Once we have saved the money, if the cars are still running fine we will wait to buy them though. We own our current cars and are in no rush to replace them — we want them to last as long as possible.

Also during this timeframe we will re-establish fully funding our retirement accounts.  We will plan a vacation.  And my wife will be able to scale back her work.  So with that, I will provide more information on our progress and our medium to long term plans in future posts!

This is my second “Voting with Dollars” post. The first post covered Banking.  When it comes to money and specifically in a capitalist or moderately capitalist society, our actions speak volumes. For instance, we want better service when banking and higher interest rates from our banks, but the vast majority of people continue to use the monolithic banks.

The credit bureaus are a bit different — we do not directly use them like banking or other services, unless it is to get a copy of our credit report. However even here, our actions helped lead us to the credit bureaus we have today. And there are some things we can do to change how they work in our favor without additional legislation — but no doubt it is a long difficult process.

Avoid Debt

Just like in choosing how to bank, avoiding debt is the key way we can influence how credit bureaus work. One of the common complaints on Dave Ramsey’s show, for instance, is that without a credit score or a credit card certain products are unavailable or more expensive. Examples include cell phones, apartments, rental cars, some hotels, insurance and home loans. It is true, with a poor credit score and/or no credit cards, insurance premiums go up, deposits are required for cell phones, and home loans are significantly more difficult to get. This is all because credit scores work! The key to changing this behavior is to cause credit scores to be a poor, or maybe more achievable, a mediocre way to assess ability to pay.

Credit scores are so effective because so many people are in debt. If we can steer the masses away from debt toward cash, most of these groups will need to find other ways to assess ability to pay.  But assuming we could get the masses debt free, then some of the extra costs do not matter as much. Deposits for cell phones are really no issue (because you have the cash). Higher insurance premiums, although annoying, become less of an issue. Apartments, hotels, and rental cars would all lose a significant customer base unless they make it easier for those without credit cards to get their service. Home loans would have to go back to  manual underwriting.

Sure it might be idealistic and a bit of a pipe dream, but this is how capitalism works. And so far, we have been telling these companies we want it to work with the credit bureaus we have today.

Freeze Your Credit

Even if you still have debt, and even if you still want obtain more credit sometime in the future, freeze your credit!  It is one of the great ways to protect against identity theft. Do not buy the monitoring that credit bureaus provide, it only increases their pocket books and provides sub par and reactive protection.  You can get your free credit report, one from each bureau, every year from AnnualCreditReport.com. You can have coverage every 4 months if you spread out your credit reports.

Credit freezes can cost around $10 depending on your state. If you have been a fraud victim you can get a security freeze for free. TransUnion’s initial credit freeze is free, whether you have been a victim of identity theft or not. When you are looking to get credit in the future after you have frozen your file, you will need to “thaw” it permanently or get a temporary lift of the freeze. This usually costs $5 or $10.  Here are links to the three bureaus and their security freeze:

Experian (http://www.experian.com/consumer/security_freeze.html)
Equifax (https://www.freeze.equifax.com/Freeze/jsp/SFF_PersonalIDInfo.jsp)
TransUnion (https://annualcreditreport.transunion.com/fa/securityFreeze/landing)

If you are still concerned about identity theft after freezing your reports, you can then consider buying identity theft insurance which will help resolve the issue and reimburse for losses that are not covered elsewhere.

Conclusion

There has been some good legislation that has come about regarding credit bureaus, especially from states that required bureaus to provide freezes and consumer protections. However I still cannot help the feeling that even that legislation might not have been necessary if we were more in control of our money and eliminating debt.  Government some times gets it right, like the security freeze laws (though I am sure some disagree), but often government goes to far. So, let’s not wait on legislation and the government. Let’s continue to vote with our money on the products and services we want, preferably with cash

As a follow up to my Credit Card Accountability, Responsibility, and Disclosure Act (Credit CARD Act) post, I wanted to provide some additional information on the topic.  For instance, I stated in the article that I just cannot understand students falling for the “free hats.”  That is a bit of exaggeration because I know it happens, and I know marketers are aggressive.  So what are some of the numbers behind the changes in the Credit CARD Act?

Some of this information is provided by the GAO report on College Students and Credit Cards. Unfortunately the information is from 2001 and earlier. However, it does seem to be one of the early providers of information that led to the student specific changes to credit card rules.

So let’s look at how students get their credit cards. Below is a graph of how students applied for their cards from the information in the 2001 report:

Student Card Application MethodSource: GAO Report: College Students and Credit Cards

So from this data from the GAO report we can see that campus display is around a quarter of the applications. The Campus Credit Card Trap, a more recent report that was put out in March 2008 actually has a breakdown of the “gifts”. The most common incentive was a t-shirt, and many reported being offered multiple incentives. The most interesting thing about this report is that it does state that almost 3/4 of students said that they did stop at the tables / displays on-campus. So clearly, even if it does not result in the most applications it does get students attention.  And naturally if it did not work, the credit card issues would not continue the practice.

To that point, a Sallie Mae report How Undergraduate Students Use Credit Cards contends that an increasing number of students are getting credit cards before college, and as a result the number of campus displays are decreasing.

So with the changes brought about by the Credit CARD Act, it will be interesting to see how it impacts this trend. Will parents cosign for their children more often?  I seriously hope that is not the resulting trend. Instead, students should start their independent lives free of debt.

Sources and Other References

The Campus Credit Card Trap

How Undergraduate Students Use Credit Cards

College Students and Credit Cards