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December 29, 2010

How to Reduce Your Debt

Debt is not in and of itself a bad thing; it is actually the grease that keeps the U.S. economy moving. However, debt has taken on a negative connotation during this economic recession with out-of-control consumer spending, people living beyond their means, and individuals borrowing more money than they can afford to pay back. These issues have all contributed to the current financial crisis. If you find that you have accumulated too much debt, there are various ways to tackle it. Here are a five suggestions to get you started.

Understand Your Expenses

You didn't get into debt overnight. First, there was the student loan payment. Then the new car. Then the house. Then the credit card debt, and pretty soon it all became overwhelming. The first step in reducing debt is to get a handle on it all.

Produce a list of all your expenditures: mortgage, cell phone bill, medical expenses/prescriptions, car loans, magazine subscriptions, etc. Then categorize them into fixed expenditures (i.e., mortgage and car loans); items that are necessary but not fixed (home phone bill, fuel, etc.); and items that are highly variable (clothes, dining out, etc.).

Create a Budget

After coming to a solid understanding of your expenditures, prepare your monthly budget. Include all of the expenditures you just calculated -- everything from that $2 cup of coffee that starts your day to the dry cleaning bill to your monthly car payment. Then make a list of all your debt obligations and the interest you're charged for each.

Create a line item in your monthly budget for debt payoff. This number needs to be above the minimum payments on your credit card statements. Once you determine the maximum amount you can pay off each month, pay down the debt with the highest interest rate first (which usually means your credit card balances). Once the debt with the highest rate is paid off, put your money toward paying the debt with the next-highest rate, and so on.

If you have debt besides your home, don't be overly ambitious in paying off your mortgage. Mortgages tend to have lower interest rates than other debt, and you can deduct the interest you pay on the first $1 million of a primary-home mortgage loan.

Lower Your Expenses

After you've created your budget, think about how you can dedicate more money to paying off your debt. Cut down on the extra items in your variable spending category, and put the extra money toward your debt payments.

For many people, reining in discretionary spending for a few months goes a long way toward tackling debt. But if that's not enough, move toward reducing your fixed expenses: think about lowering your household bills, refinancing your mortgage to get a lower interest rate, or asking the credit card company to lower your interest rate.

Increase Your Income

Consider whether there's any way to boost your take-home pay. Even though the job market is still struggling, it can't hurt to ask for that well-deserved raise or to post for an open position within (or outside of) your company. If you get a big tax refund every year, that means you're having too much withheld from your paycheck. If that's the case, you can reduce your withholding by changing your W-4 at work.

What Not to Do

It may be convenient to borrow against your home equity or your 401(k) to pay off debt, but that can be dangerous. It puts your home at risk and means that you may fall short of your retirement goals. Even if you can't manage your monthly debt payments, lenders are often willing to work with you to create a repayment plan that you can manage (without putting your home or your retirement at risk).

December 27, 2010

Do You Have Enough Retirement Funds?

Whether retirement is just around the corner or you are decades away from your final day in the office, knowing how much you will need and how your nest egg measures up is important. That knowledge should help you make necessary adjustments to your investment strategy to ensure a comfortable retirement.

There are many online retirement calculators available that can begin to give you a picture of the current condition of your funds as well as an idea of how much more you need to save before reaching your target retirement age. Yet most of these calculators' value ends there. How do you know if the retirement vehicles you are invested in are the best ones? What other vehicles might be better for you?

Know your goal. Knowing your target goal of how much cash you will need at retirement is the first step. Very simply, take your current gross income and deduct the expenses you no longer expect to have in retirement such as payroll taxes, the amount you are currently putting away for retirement, college funds (if your kids are already through), and mortgage payments (if your house will be paid off by retirement). That budget will create the framework for interpreting whether your current funds are sufficient.

Estimate your Social Security benefits and other sources of income. Utilize Social Security Administration online calculators to create a ballpark estimate of the monthly payment you might expect. Then think about other sources of fixed income such as company pension payments, for example, and add them to the tally.

Basically, by (1) finding your target retirement income and then (2) subtracting the estimated income from Social Security and any company pension, you will have the "magic number" of how much your personal retirement savings must contribute to your retirement income. From there, we move on to analyzing how your retirement savings are allocated.

Analyze which financial vehicles are best given your retirement road map. Many people who were approaching retirement last year were overinvested in equities. When the market crashed in March 2009, equity prices fell 57% from the market's peak in October 2007. Retirement balances fell $2.8 trillion, a full $1 trillion of that from baby boomer's accounts (Source: Huffington Post, 2010). While the magnitude of those losses is rare, it reinforces two general retirement investment principles:

Diversification is king. Being overinvested in any one area isn't wise. Blending stock and bond investments, large-cap and small-cap funds, and foreign with domestic choices can offer the best balance between risk and reward.

Appropriate asset allocation depends on your life stage. Generally, the younger you are, the larger share of your money should be in growth investments like equities. As you near retirement, transition into income-generating investments like bonds. (And while many people need both income and growth investments during retirement, the decreasing-risk rule still holds -- and there are a number of less-risky growth investments available.)

Once you know your goal, understand your retirement income and expenses, and have committed to diversification, then at that point it is a great time to review your retirement investments.

December 15, 2010

Evaluate Your Insurance Needs at Retirement

As retirement age approaches, you should reevaluate your insurance coverage needs. This will ensure you are adequately protected in all areas, while making sure that your premium costs are minimized. Below are some points to consider:

Health insurance: Since Medicare coverage doesn't begin until age 65, you'll need to consider other coverage if you retire before that age. Even with Medicare, many costs are not covered, so you'll want to consider supplemental coverage. With health insurance premiums so high, you might want to raise your insurance deductibles and copayments to lower your premiums.

Long-term care insurance: This insurance covers the cost of nursing homes or home health care. If you have significant assets, you may prefer to pay any costs yourself rather than pay for insurance. If you have few assets, Medicaid is likely to pay most of the cost. Those in most need of long-term care insurance are individuals with moderate assets who don't want to deplete those assets to pay for nursing home costs.

Homeowners insurance: Make sure your coverage is sufficient to rebuild your home if it is destroyed. Keep your liability limits high to protect you in case you are sued.

Liability insurance: Your auto and homeowners insurance should provide some coverage. If those limits don't at least equal your net worth, obtain liability insurance to cover the difference.

Life insurance: Whether you need life insurance will depend on your individual circumstances. You may not need life insurance if your children are grown and you have sufficient assets to support your spouse after your death. However, you may need life insurance to provide for a spouse or child or to provide for the payment of estate taxes.

Before you retire, review all your insurance policies to determine if it is appropriate for your new circumstances.

December 7, 2010

Strategic Mortgage Defaults: A Financial or Ethical Issue

The recent recession has been marked by reduced consumer spending and ballooning debt burdens, rising unemployment and falling home values, and considerable hardships for countless people. The pain is real for those who have lost their jobs (almost 8 million since the recession began) and their homes (1.2 million) (Source: MSNBC, 2010).

Most people who have lost their homes to foreclosure did so because they lost a job, suffered an unexpected illness, or had an adjustable-rate or interest-only mortgage note with monthly payments that skyrocketed. The dramatic decline in property values that we've seen since the peak of the real estate bubble (29% nationwide and much more in some areas) has made it difficult or impossible for people facing financial hardship to sell and move into a less expensive home or relocate for a job (Source: Standard & Poor's, 2010).

Yet, some people whose homes have lost considerable value have simply walked away...even though they can afford the mortgage payment. This trend -- strategic defaulting -- has been growing in popularity as homeowners decide to cut their losses and stop paying on a mortgage that is far larger than the current value of the home. Mortgages that meet this criterion are considered to be underwater, and recent statistics show 25% of mortgages meet that definition (Source: CNN, 2010). How popular are strategic defaults? Surprisingly popular -- they accounted for 31% of foreclosures during the first quarter of 2010 (Source: Housing Watch, 2010).

As with any issue of this magnitude, there are strong opinions on both sides. On one side are those who believe it is highly unethical for a borrower to walk away from a mortgage contract when he or she is still financially able to make payments. When borrowers enter into an agreement with a financial institution, a legal contract is signed, and the borrowers become obligated to make the payments required under the contract. This line of argument holds that walking away from a home and dishonoring the mortgage contract is a breach of good faith between the lender and the borrower and is, therefore, unethical.

On the other side of the issue are those who argue that a mortgage contract is nothing more than a business deal. Like many agreements in the financial world, if the terms no longer benefit both parties, the deal can be broken -- ethically and legally (in fact, contracts provide for default and repossession as a possible outcome). Thus, the fact that a home mortgage is just a business deal excludes any moral, emotional, or ethical underpinnings.

Either way, the decision to default -- strategically or otherwise -- is certainly not one to be taken lightly. First, the borrower's credit rating (based on a scale of 300 to 850) is likely to take a big hit, as much as 160 points (Source: CNN, 2010). Second, it could be difficult to obtain credit for a number of years, and if a future lender does agree to issue another loan, the interest rates may well be higher. Finally, in some states, lenders have a right to pursue a deficiency judgment in court -- to pursue the borrowers for any difference between the price the foreclosed home sells at and the value of the mortgage note.

This past summer, Fannie Mae announced future restrictions applicable to borrowers who strategically default, indicating that strategic defaulters will be disqualified for new Fannie Mae-backed loans for seven years after their foreclosures. Also, Fannie Mae says it will go to court where it can to try to recoup outstanding mortgage debt from borrowers who strategically default.

You need to consider your own financial situation when deciding if a strategic default makes sense for you. If you can afford your mortgage and you are not planning to move for at least 10 years, then it may not matter that your home is worth less than your mortgage today.

On the other hand, if you don't plan on staying in your home for very long, if you purchased your house solely as an investment vehicle, if it is significantly underwater, if you can stomach the effects your default will have on your neighborhood, and if you can save money renting, then walking away may be a financial option for you. Is that an ethical decision to make? That's up to your best judgment.


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