Thursday, October 13, 2011

Credit Cards

The use of credit cards is somewhat controversial among financial advisors. Some say it’s best to never use credit cards at all while others say their use is fine. Dave Ramsey, one of my favorite advisors, is opposed to using credit cards because studies have shown that people who use credit cards tend to spend more on unnecessary things than do people who don’t use them. Typically, interest rates on credit cards are high compared to rates for other types of loans such as houses and cars. By running up large debts on credit cards, you can end up spending quite a bit of money just on the interest. So, Mr. Ramsey recommends never using credit cards and, if you are currently in credit card debt, stop using them immediately and begin paying them off.

We personally approach credit cards with the same caution that the Bible recommends for drinking alcohol. Proverbs 23:29-35 says:

Who has woe? Who has sorrow? Who has strife? Who has complaints? Who has needless bruises? Who has bloodshot eyes? Those who linger over wine, who go to sample bowls of mixed wine. Do not gaze at wine when it is red, when it sparkles in the cup, when it goes down smoothly! In the end it bites like a snake and poisons like a viper. Your eyes will see strange sights, and your mind will imagine confusing things. You will be like one sleeping on the high seas, lying on top of the rigging. “They hit me,” you will say, “but I’m not hurt! They beat me, but I don’t feel it! When will I wake up so I can find another drink?” (NIV)

The Bible makes it clear throughout that drinking alcohol is perfectly fine as long as you control its consumption. However, as we see here, if you find that the alcohol is controlling you, then it is time to stop drinking it; cold turkey. We believe the same holds true for credit card usage. If you can control your spending, living within the budget you set for you and your family, then credit cards can actually benefit you. However, if you can’t control yourself, it is indeed time to follow Mr. Ramsey’s advice: cut up the cards now and pay them off as soon as possible.

Some of things we look for in credit cards are: no annual fees, no hidden fees, a 20-25 day grace period for monthly payments, and, most importantly, cash back bonuses. With a card like this, things you purchase will actually be cheaper because you will still pay the same at the store, but the credit card company will give you money back. For instance, we have one credit card that pays us 5% back each month for all gasoline purchases paid at the pump. We have another card that pays us 2% back on everything we purchase. Yet other cards pay us 3% back for purchases made at certain stores. The trick here is that you must pay off ALL your existing credit card debt and then begin to pay off all future credit card charges in FULL each month. By doing so, you will not be paying extra for interest and fees. Rather, the credit card company will pay you a percentage of all your purchases.

Be sure to pay off your credit cards each month ON TIME. If you fail to do so, interest will have to be paid as well as a substantial late fee. Most of the cards we use have a way to set up an automatic “pay-in-full” each month. Once set up, the credit card company will automatically remove your full balance each month from your bank or credit union checking account. If for some reason they are late transferring the money from your account, no late fees or interest are due because it was their responsibility. Of course, you must make sure you have enough money in your checking account to cover the bills when they come due, else you may find yourself facing overdraft fees from your bank and/or fees from the credit card company. Of course, you do not want to set up the automatic draft until you have paid off your existing debts and are ready to live according to your means.

To make sure you have money each month to pay off your credit cards, a budget item entitled “Credit Cards” needs to be added to the items mentioned in the previous post. Then, when a purchase is made with a credit card, the amount of the purchase can be transferred from the appropriate budget category into the Credit Cards category. For instance, suppose you spend $75 at the grocery store using a credit card. You have not actually removed money from your checking account, but you do want to account for the money in the Food category. So, when you next handle your budget, the $75 will be subtracted from the Food category and added to the Credit Cards category. This will let you know that you now have $75 less to spend for Food and, simultaneously, you have set aside $75 for when the credit card bill comes due. If you had used a check or a debit card at the grocery store, you would simply subtract the $75 from the Food category since the charge would have applied directly back to the checking account.

One last thing to keep in mind concerning credit cards. Some places charge a convenience fee when using a credit card. Usually these fees are more than what your cash back bonus pays you. In these cases, it is best not to use a credit card unless its use is truly more convenient and it’s worth the extra fee.

We’ll talk more about credit cards when we get into actually setting up a home budget in a spreadsheet.

Note from Randy: Be sure to check out my new novel. Just click below.
Cover Art

Monday, October 3, 2011

Expense Categories

When deciding what categories to use when splitting your expenses up for your budget, it’s a good idea to start with some broad ones. Should it turn out that you are lumping too many expenses into any of these categories, those can be divided up later to better refine your budget. Over the 29 years that we have been budgeting, we have modified our categories many times based on spending patterns and life style at the time. For instance, when our son was born, we had to create a category for costs associated with his care. When we finally paid off our mortgage a couple of years ago, we modified our mortgage category. The point here is that you don’t have to get the categories perfect from the get-go. You can hone them to perfection later and then modify them as necessary.

So, where should the money in these budget categories actually reside? We suggest a checking account with a financial institution like a bank or a credit union. While we know some families that like to keep separate checking accounts, we believe our budgeting system works best with just one account. This allows you to total the balances of all the budget categories and see what the current balance of that one checking account should be. Reconciling your money is easy in this case. But if for some reason you really need to have more than one checking account, it can still work. You will just have to decide which budget categories are associated with which checking account.

However you decide to divvy up your money between accounts and budget categories, we can’t over emphasize the trust factor. Total trust in each other is essential. If all parties are not 100% on board with the agreed upon budget, things can go awry quickly.

Here are a few categories that we suggest starting with:

Charity, Gifts, Mortgage, House Upkeep, Home Decorations, Utilities, Communications, Food, Medical, Transportation, Insurance, Debts, Personal, Miscellaneous, and Savings.

The Charity expense category should include any money you donate to charitable organizations such as your place of worship, medical research organizations, etc. Some of you might like to divide this category into two: one for tax deductible donations and another for non-tax deductible donations. This is fine but it might be a bit difficult budgeting between the two if you don’t know in advance how you will be splitting your money between the two. Personally, we just add (ntd), meaning not tax deductible, to the name of organization if it is nondeductible. If you and your spouse like to support different charitable organizations, you might want to split this category into two, one for each spouse. This will help prevent disputes over whose charities are getting the most money.

The Gifts category covers expenses for others. This would normally be for such things as Christmas, birthday, and anniversary gifts, but could also include taking friends out to dinner.

The Mortgage category is for the cost of paying back the loan on your house. If you are renting, then this category is for your rent payment. A mortgage payment usually includes an escrow account for paying your yearly property tax and homeowners insurance. So, when you reach that point in life when you have your house paid off, don’t forget that this category cannot be totally eliminated. You will still need to set aside money for taxes and insurance since you will be paying for these yourself rather than through the mortgage holder.

Originally we had the categories House Upkeep and Home Decorations combined into one category called House. House Upkeep is for anything you pay for that results in maintaining your house and property. This could include such things as plumbing and electrical repairs, lawn care, painting walls, and so on. Home Decorations is for things to make your home look better such as wall hangings, flowers, plants, furniture, and so on. The problem we had with combining the two categories was that Kathy shied away from using any money from the House budget for decorations for fear that the money would be needed down the road for repairs. Of course, simply dividing the category into two did not reduce the chances that repairs would be needed, but it did free Kathy to buy things for our house, knowing that we had both agreed that the amount allocated to the Home Decorations category was available for spending on decorations.

Utilities mainly include the cost of providing power to your house in whatever form that takes. It could be electricity, natural gas, and maybe even wood, oil, and propane. Additionally, it includes the cost of water, sewage, garbage pickup, etc. if your city or county charges for these services.

The Communications category covers the costs of landline phones, cell phones, pagers, TV, and Internet connection. Basically any services that allow you to communicate with the world or the world to communicate with you. We personally have landline phones and Internet service with one company, cell phone service with another company, and TV cable service with a third company. Therefore, we divide the Communications category into two: Phones and TV. However, since many companies now provide all these communications services in one big package, we are suggesting just this one category. But, if you so desire, you can divide it out as we do or in any way that makes sense to you.

Food is our favorite category. We love to eat. For this reason, it is the category we struggle with the most. Oftentimes we find we have spent more than we budgeted. Then we have to try to spend less to compensate. Keep in mind that this category covers both grocery stores and restaurants. Of course it is generally less expensive to buy food and prepare it at home, but that really depends on what you eat and where. For instance, it may be cheaper to eat a burger and fries at a fast food restaurant than to prepare steak at home, especially if you have restaurant coupons. Also, keep in mind that when eating at home you will be increasing the cost of utilities by using the stovetop, oven, and microwave, as well as using hot water for washing dishes. The key is to find the proper balance of eating in and dining out that works for your family.

Now for the dreaded Medical category. This is one category for which we hope your family needs to budget very little money because you are all very healthy. In reality we know that just one major incident can result in a huge bill. Hopefully, you have medical insurance that will cover the majority of your medical bills. This category will need to cover the cost of doctor’s visits, dental work, hospital stays, medicine, etc. Inherently this is a difficult expense category to budget for since there is no way to predict your family’s medical future. So, we suggest reviewing your medical expenses from the past and use them to predict future expenditures. If you don’t have these records, you will have to set a Medical budget that seems to make sense, then refine it as medical expenses occur over the following months.

In our modern society everyone needs a means to get from one place to another, and there are costs associated with doing so. This is what the Transportation category is for. It will need to include car payments, gasoline, vehicle upkeep and repairs, etc. If you are in a situation where you don’t own a vehicle and depend on public transportation, then you need to budget for bus, subway, and taxi fares. Don’t forget the tips! Also, if you don’t have wheels and need to go on a trip, you may need to get a rental car. If you do this on a regular basis, be sure to include money in this category to cover those expenses.

Some people, for the sake of saving money, like to take a risk and have no Insurance. For this reason, some states make certain types of insurance mandatory. For instance, in my state of Alabama, auto liability insurance is mandatory for anyone who drives. There are many kinds of insurance. To eliminate all risks you face in life would cost a bundle of money. There’s life insurance, vehicle insurance, homeowners insurance, medical insurance, dental insurance, vision care insurance, long term care insurance, and even pet insurance. There’s also flood and earthquake riders, personal articles riders, umbrella policies, cancer policies, burial insurance, and on and on. Unless you have a really good income, having all these insurance policies and riders would eat up a significant portion of your take home pay. In this case, decisions have to be made about which policies are the most important. Most people consider medical, homeowners, and vehicle to be essential. But even these can be expensive. So, choose wisely and in a way consistent with your budget.

Hopefully you do not need to budget any money to the Debts category, but the option needs to be here in case you do. This category does not include credit card debt. This will be covered separately later. It also does not include debts on your house, which is included in the mortgage category, or debts on cars, which is included in the Transportation category. However, all debts besides these should be included here. Examples of what might be included are student loans, personal loans from friends and family, loans for buying that dream stereo system you probably shouldn’t have bought (Randy had one of these loans back in the day), and other similar debts.

The Personal category is for individual family member expenses. We suggest you have a separate category for each family member. In our case we have three personal expense categories: one for Randy, one for Kathy, and one for our son. If you have children that are attending a private school or a university, then you may also want to create yet another budget category named Education and allot money for it separately. Personal expenses include such things as clothes, haircuts, movies, concerts, etc. In other words, any expenses that relate back to personal needs and desires. Some people like to set up a separate Entertainment category for the entire family. That is perfectly fine, but we decided that we like holding each person accountable for their own entertainment expenses. If one person chooses to buy a lot of clothes, he or she may have to forego movies to compensate. If others buy a lot of video games, they may not be able to replace those tattered jeans.

The Miscellaneous category is there to cover any expenses that do not fit nicely into any of the other categories. If you find that you have a lot of expenses in this category, you may want to determine where most of that money is being spent and create more categories to cover those expenses separately.

The Savings category is where any unbudgeted money goes. Your goal is to have as much money as possible going into this budget item. If you are allotting so much money in the other categories that this category ends up having a negative cash flow, then you are in trouble. It will only be a matter of time before your lifestyle will become unsustainable due to having no money. If, however, you control your spending on the other budget categories, you should be able to have a positive cash flow in Savings. Then, over time, when you find that you have a significant amount of money in this category, you can transfer the excess to a higher interest rate account such as a savings account, a CD, or another investment. If you are eligible, you might want to invest in some IRAs so you can get a tax deduction. There are many ways to invest, so this topic will be covered separately.

As we said before, there may be some expense categories relevant to your family that we have never considered. If so, add that category to the ones you decided to use from above. Once you have set up all the expense categories that are right for you and your family, it will be time to determine how much of your household income to add to each of them. This can sometimes be difficult, but much of it can be determined by examining past expenses. But before we move on to allocating money, we need to discuss another category: Credit Cards. This is not really an expense category, but it is wise to include it for reasons you will see in the next post.