I have a question from Stilla Momma on debt reduction and college savings. OK, college savings first.
Let's start with the obvious. If you have a 0-year-old baby, you need to plan for 18 years in the future. This is tough. However, if things go really badly, we'll be fighting off cannibals and radiation sickness and won't have to worry about college, and if things go really well, we'll have an enlightened government subsidizing college in order to produce a generation of mental giants to colonize Mars... either way, college savings become obsolete. The best is to plan for a future that's much the same as today, but slightly worse.
I once used one of those calculators to look at how much it would take to fully fund sending an 18-year-old to Harvard. That was a mistake. It's not going to happen. My conservative estimate came out to $20,000 a year that you'd need to save. Unless you're at a very high income level, you should just save what you can realistically afford to save. Your child will hopefully be able to make up the difference using loans, grants and a part-time job.
One thing to guard against is inflation. If we go through a period of monster inflation just as you need to cash out the college savings, that would be a disaster. We haven't had serious inflation in a long time. Take a look at these figures:
Year | College Inflation (CB) | General Inflation (CPI) | Rate Ratio |
2006 | 5.9% | 3.23% | 1.83 |
2005 | 5.94% | 3.39% | 1.75 |
2004 | 5.97% | 2.66% | 2.24 |
2003 | 5.99% | 2.28% | 2.63 |
2002 | 5.80% | 1.58% | 3.67 |
2001 | 5.48% | 2.85% | 1.92 |
...
| ... | ... | ... |
1985 | 8.15% | 3.55% | 2.30 |
1984 | 8.03% | 4.14% | 1.94 |
1983 | 9.78% | 2.44% | 4.00 |
1982 | 14.35% | 6.48% | OH MY GOD
|
1981 | 13.95% | 10.73% | HOLY MOLY
|
1980 | 12.00% | 13.22% | WHOAH |
1979 | 9.05% | 11.27% | 0.80 |
What these numbers mean is that unless you are earning a high rate of return, the real value of your college savings will plummet, and they won't go nearly as far. If your child needs to go to college during those years, you'll take a big hit.
The easiest way to guard against this possible is to buy investments that are protected
against inflation. You may be able to do this within a 529 plan. Other ways are buying US Treasury I-bonds. These are savings bonds that are indexed to the rate of inflation, so if inflation leaps, the return on the bonds will also leap. Don't buy gold and silver. These might be OK investments in their own right, depending on supply and demand, but they don't always go up when inflation goes up.
Moving back a little bit to the basics, you should start by opening an account. It should be a combination of a 529 plan, savings bonds (like I-bonds) and maybe an IRA. Savings bonds are especially good if your household income is not super-high, because they give you a tax break that phases out after $98,000 in annual income.
Here is a chart you can use to compare college savings vehicles.Here are some things to think about when choosing a vehicle or mix of vehicles:
1) what is the most advantageous in terms of taxes?
2) If I think we will be earning more
now than in 18 years, we should try to postpone paying taxes, for example using a Traditional IRA. On the other hand, if we think we will be earning more in 18 years, we want to pay our taxes up front so we won't have to pay them later.
3) if I can't fund
all of college, our child will qualify for more financial aid. To qualify for more financial aid, income should be as low as possible. We want the kind of savings that don't "count" as much according to the measures that the financial aid offices use.
4) How active are you in managing investments? Do you want a "set it and forget it" type of plan, or one where you check in several times a year and try to maximize your returns by buying and selling mutual funds and stocks?
5) What happens if your kid doesn't go to college? If you think they'll go eventually, with most vehicles, you can hang on to the money, or use it for someone else. Generally, for educational expenses the only rule is that they have to be related to you. Or you can use it for yourself.
Here's a sample savings plan that is extremely simple. It doesn't have a 529 component because these can be complicated and need lots of research.
- Set up an internet account at TreasuryDirect. Link your bank account. Set up an automatic savings program that deducts $100 a month and buys I-bonds with it.
- Set up an internet account with a direct investment firm such as Fidelity or Scottrade. Open a Roth or Traditional IRA, depending on your projections about income. Begin an automatic investment program for a good balanced mutual fund. I like PAXWX, which is also an SRI (Socially Responsible Investment). After buying into the fund's minimum opening requirement, set up an automatic investment program of $100 a month.
If you start off with $1000 and do this for 18 years, not upping the amount, earning a very conservative rate of 5%, you'll have $72,000 for college. Taking inflation into account, this will be enough to pay tuition at a decent state college... room and board if you're lucky and your rate is higher, or the inflation is lower.
Debt reduction: I'll just give two tips. One is to read Dave Ramsey and his latte factor. You don't have to give Dave Ramsey any more money than he already has,
just read about him here and on other sites and maybe check out one of his books from the library. The latte factor means you should stop drinking lattes. Basically, examine your life for any expensive habits that don't have big payouts. This doesn't mean turn your life into a joyless desert. Just recognize that there is a vast marketing machine out there brainwashing you into believing you need things you really don't need.
Starbucks lattes are a good example. For example, I drink Starbucks maybe two or three times a month. It's not a habit; it's a fallback for when I need a coffee and I'm driving around or traveling. There are a lot of people at my office who insist on drinking Starbucks every morning, whereas I just drink the nearly-free coffee I make myself. Everything that you consume once a day or once a week, multiply it by 365 or 52 and then think about it! Expand the latte factor to include all fluids. Give yourself a fluid audit. Nobody should be drinking bottled water on a daily basis in the U.S., unless you live next to a Superfund site. If your water is clean but tastes bad, get a water filter device. Bottled water is environmentally unsound and sucks away your savings. As this reporter asks, "
what is Evian spelled backwards?"
So a good way to start debt reduction is to give yourself a wasteful spending audit. Determine how much money you're wasting a month, then set up an automatic payment for that amount to be applied to your debt as a payment.
The second tip is to go easy on yourself and recognize your flaws and imperfections when it comes to money. You need to work with the flaws you can't get rid of. Here is an example. Let's say you have a $10,000 loan at 7% interest. You have the opportunity to move it to a 0% offer on a credit card. The 0% lasts for a year.
Moving it all to the 0% would be a mistake if you can't pay it all off within a year. Yes, you might find another 0% offer, but if your credit tanks in 6 months, you might not. The safest thing to do might be to transfer $3000 to the 0%, because you
know you can pay that down within a year. On the other hand, this is all getting rather complicated. If you think you might screw up payments at any point, don't make the transfer at all, because the worst that could happen is messing up your credit and having the amount go up to 15% or 25%! Before you embark on payment plans, make sure you have a good banking and billpaying routine established. If you have a habit of being forgetful or putting things off, find ways to trick yourself.