Friday, April 17, 2015

Why You Don't Want a Tax Refund

In case you hadn't heard, Tax Day was this week.  As I was perusing my preferred news outlet, I came across a link to this article.  It explains how criminals file tax returns on behalf of others, both living and dead, taking advantage of several flaws in our tax system.  A young couple, for example, was supposed to get a $3,500 tax refund this year, but because someone else already filed taxes as the husband, it would be months or years before they see a dime.  This couple was going to use the refund to help with the downpayment on a house, but now they're going to have to move in with his mother.

I have two issues with this article:  
  1. While $3,500 is a substantial chunk of change, it should never be the difference between BUYING A HOUSE and MOVING IN WITH MOMMY. In other words, this couple is probably not even close to being ready financially to buy a house.
  2. Why in the world is your refund $3,500 in the first place?  
I know that most people see tax returns as "surprise" money, but it's YOUR money and you are loaning to the government, interest-free.  If this couple had set-up their W-4s correctly, they wouldn't be waiting for $3,500 or moving in with mommy, they'd have their money.

"Well, even if I put $3,500 in a savings account for a year, I'd still only get like 50 cents in interest.  So it's not worth the effort to fix my W-4."  If you've ever thought something similar to this, try thinking about it like this:  You could give yourself a raise of $300 per month with that $3,500 refund.  Now, you can obviously get by without this extra $300 a month, because otherwise you would have fixed your tax withholding long ago, right?  But if you paid even a dollar in interest on a credit card, mortgage, car loan, etc., you could've netted way more than 50 cents.  Here are a few examples (here's the math behind them):

Example 1 
Say in January 2014, you had a $2,000 balance on a credit card with 18% interest rate and $50 minimum payment.  If you pay the minimum payment until it's paid off, it'll take 5 years and cost ~$1,000 in interest.  Maybe you're a little better and only pay the minimum payments until April 2015, when you receive your $3,500 refund and then completely pay it off.  In this case, you pay the debt off in 15 months and pay ~$420.  If instead of waiting for the refund, you give yourself a $300/month raise and use it to pay off credit card ($350 monthly payments), the debt will be out of your life in 6 months and you'll have limited the paid interest to ~$90.  This approach saves you about $330, which, last time I checked, is substantially more than 50 cents! 
Example 2
If we replace the credit card debt in Example 1 with a student loan of $50,000 at 6% and $500 minimum payment, the same three approaches look like this:  
  • Only minimum payments takes almost 11.5 years and costs ~$19,200 in interest
  • Minimum payments with a lump sum of $3,500 each April takes just under 7 years and costs ~$11,300 in interest
  • Pay $750/month (initial minimum payment + $300 each month) until it's paid off takes just over 6 years and costs ~$9,900 in interest
This saves you ~$1,400 over 7 years or ~$200 a year.  Saving yourself $1,400 seems like a pretty good use of the 30 minutes it would take to fill out your W4 each year.  When was the last time you got paid $400/hour?
These examples require that you change NOTHING about your current lifestyle, spending habits, or career path.  All you have to do file a single page form with the US Government, and I didn't even take into account state income tax returns.  So you should definitely fix your W-4 (talk to your HR person if you don't know how to do it) and get super excited about the higher paychecks you're now getting instead being disappointed that you don't get to wait until April for a lump sum.

Also, in case it wasn't obvious, you should file your taxes as soon as you're able, so criminals don't have the chance to file them for you and cause you a massive headache.

IMPORTANT NOTE:  If you're like me, you might be thinking "Can I get a free loan from the government by underpaying my taxes until April?"  Answer:  No.  If you substantially underpay your income taxes, the lovely government will hit you with a penalty on top of the taxes you owed all along.  So the goal should be no money due AND no money paid at tax time.

Thursday, February 26, 2015

The Debt Spiral

Throughout the personal finance community, there's a lot of debate over what the best way to pay off debt is.  The two main approaches are the Debt Snowball (popularized by Dave Ramsey) and the Debt Avalanche.  Both methods say to pay the minimum payment on all debts except for one, focus all extra payments on that one debt until it's paid off, then repeat with the remaining debts.  The difference comes with the order; all the methods discussed below are included in this handy Debt Calculator I made.

From a strictly mathematically perspective, the Debt Avalanche is the best method because you end up paying the least interest. With this method, you order the debts by interest rate, starting with the highest.  For example, say you had the following 5 debts:
  1. $2,500 on a credit card at 8.5%
  2. $10,000 on a home equity loan at 3%
  3. $8,000 on a student loan at 6%
  4. $7,000 on another student loan at 5.2%
  5. $18,000 on a car loan at 5.5%
Using the Debt Avalanche, you would pay them off in the following order to limit paid interest: credit card at 8.5%, student loan at 6%, car loan at 5.5%, student loan at 5.2%, and home equity loan at 3% (i.e., A, C, E, D, B as shown in the animation).  However, the first few "wins" may take awhile, and it can be harder to stay motivated.  If you don't stay motivated, you'll end up paying more in interest no matter what method you use.

Debt Avalanche
The "wins" come the quickest with the Debt Snowball method.  I used to think this method made absolutely no sense, and to a financially rational person, it doesn't.  But the people who find themselves in debt probably aren't thinking in a financially rational way, or they wouldn't be in such a mess.  These types of people need the encouragement that comes with completely paying one of their debts off.  Using the same example, the Debt Snowball would pay off the debts as follows: $2,500 credit card, $7,000 student loan, $8,000 student loan, $10,000 home equity loan, and $18,000 car loan (i.e., A, D, C, B, E).

Debt Snowball
Despite the benefits of the Debt Snowball, I have a hard time conceding that you should pay off a $3,000 debt at 2% over a $4,000 at 20%.  So, I thought, "What if I used both the interest rate and the debt balance to determine the order?" instead of one or the other.  I call this the Debt Spiral (because of how the graph looks).  Basically, you divide the debt balance by the interest rate, and then order it smallest to largest.  If you have a debt with a 0% rate,  it goes last unless it's temporarily 0%, then use the eventual interest rate.  The Debt Spiral would pay off the debts in our example in the following order: 1) $2,500 on a credit card at 8.5%, 2) $8,000 on a student loan at 6%, 3) $7,000 on another student loan at 5.2%, 4) $18,000 on a car loan at 5.5%, and 5) $10,000 on a home equity loan at 3%.

Debt Spiral
So why should you use the Debt Spiral instead of the other well-known methods?  Because it simultaneously limits the amount of interest you have to pay like the Debt Avalanche while spreading out the "wins" to keep you motivated like the Debt Snowball.  Here's an example to illustrate (all the math can be found here).
John Doe makes $50,000/year and $3,300/month take-home.  At the end of each month he has just under $45 left to save, but he has the following 4 debts
  1. $5,000 on a credit card at 18%, minimum monthly payment $125
  2. $12,000 on a personal loan at 10%, minimum monthly payment $220
  3. $6,000 on a car loan at 3%, minimum monthly payment $75
  4. $2,500 on a student loan at 5%, minimum monthly payment $35.42
John would like to use the $45** to help him pay off his debts faster, but is unsure which method would be the best.. 
If John paid only the minimum monthly payments
Debt Balance Interest Rate Pay Off Time Total Paid Interest Paid
$5,000 18 % 61 months $7,599.81 $2,599.81
$12,000 10 % 73 months $15,977.28 $3,977.28
$2,500 5.0 % 84 months $2,959.36 $459.36
$6,000 3.0 % 90 months $6,693.31 $693.31
Totals $33,229.76 $7,729.77

If John added the $45 to his Debt Avalanche
Debt BalanceInterest RatePay Off TimeTotal PaidInterest Paid
$5,00018 %39 months$6,577.83$1,577.83
$12,00010 %57 months$15,515.12$3,515.12
$2,5005.0 %59 months$2,911.94$411.94
$6,0003.0 %64 months$6,620.72$620.72

If John added the $45 to his Debt Snowball
Debt BalanceInterest RatePay Off TimeTotal PaidInterest Paid
$2,5005.0 %34 months$2,677.03$177.03
$5,00018 %49 months$7,317.78$2,317.78
$6,0003.0 %60 months$6,582.06$582.06
$12,00010 %65 months$15,884.31$3,884.31

John now wants to determine which order the Debt Spiral method would generate.  So he calculates the debt to interest ratio for each debt and orders them from smallest to largest.
Debt BalanceInterest RateDebt / Interest RatioDebt Spiral Payoff Order
$5,00018%5,000/18 = 2781
$12,00010%12,000/10 = 1,2003
$6,0003.0%6,000/3 = 2,0004
$2,5005.0%2,500/5 = 5002
John would pay the minimum payments on his student loan, personal loan, and car loan while putting every extra dime he has towards paying off the $5,000 credit card balance.  In this case, it happens to be $170 ($125 + $45).  Once the credit card is paid off, he'll have an extra $170 each month to start paying off the $2,500 student loan.  So he'll be paying $205.42 ($35.42 + $125 + $45) each month to the student loan until it's paid off.  Once the student loan is paid off, John can use the $205.42 to help pay off his $12,000 personal loan.  And finally, the $425.42 ($220 + $35.42 + $125 + $45) that was going towards the personal loan will be added to his $6,000 car loan minimum payment ($75) until it's payed off.  Now that John is debt free, he has just over $500 to save each month and hopefully keep himself out of debt!
 If John added the $45 to his Debt Spiral
Debt BalanceInterest RatePay Off TimeTotal PaidInterest Paid
$5,00018 %39 months$6,577.83$1,577.83
$2,5005.0 %46 months$2,841.63$341.63
$12,00010 %59 months$15,661.03$3,661.03
$6,0003.0 %64 months$6,621.67$621.67
As expected, the Debt Avalanche produced the lowest interest paid.  But it only beat the Debt Spiral by $76.54 or 1.2%, whereas it beat the Debt Snowball by $835.57 or 13.6%.  Also unsurprisingly, the Debt Snowball wins the contest for earliest debt paid off by a few months, but the Debt Spiral actually ties the Debt Snowball for the average time between debts paid off.
MethodTime Until 1st "Win"Average Time Until "Win"
Minimum Payments61 months77 months
Debt Avalanche39 months54.75 months
Debt Snowball34 months52 months
Debt Spiral39 months52 months

So the Debt Spiral is a win-win!

**Paying off debt quickly requires you to live differently.  In the John Doe example, he doesn't change anything about his life and so it takes several years to pay off all four debts.  Cutting expenses, getting a second job, and selling stuff would have helped him cut years off his debt sentence.

Friday, January 9, 2015

Argument for Emailing Invitations

For some reason, whenever I bring up the idea of emailed invitations, people respond with a grimace and a "That seems tacky."  But why is it tacky?  I have yet to hear a sound, logical reason for this.  And even worse, I haven't found anyone truly arguing FOR email.

The main argument for paper invitations is etiquette.  That's what Emily Post says we have to do, and besides, it's tradition!  I understand some traditions come from culture, but this one seems to have stuck around because the wedding industry makes a lot of money off people who think they have to have double-enveloped invitations addressed with the finest calligraphy.

This reminds me of a story I heard several years ago.
Every time Sarah made pot roast, she would cut off both ends before putting it in the oven.  One night, her husband John asked why.  Sarah replied, "I don't know.  That's just the way my mom always did it."  So the next time Sarah and John visited her parents, John asked her mother why she always cut off the ends of the roast.  Her mother thought about it and said, "I don't know.  That's just the way my mom always did it."  John, really wanting to get to the bottom of the mystery, then called Sarah's grandmother to ask her why, and she replied, "So it would fit in the pan."
Tradition can sometimes force us into doing wasteful things for essentially no reason.

Another argument I've heard is "Not everyone is technologically savvy."  It's 2015 and all of my grandparents have computers and email addresses, so this reasoning's relevancy is fading fast.  But even if there are a few people on your invite list who don't have email addresses, this doesn't mean that everyone needs a paper invitation.  You could even use this opportunity to encourage them to get an email account.  "Grandpa, until you get an email address, you are grounded from all family events, including but not limited to weddings, showers, christenings, birthday parties, and funerals."

And the most ridiculous and infuriating argument:  "Compiling all of your guests' current email addresses can be a daunting task."  I'm sorry, but how is this any different than having to compile a list of their mailing addresses?  Actually, gathering email addresses is easier because people move way more frequently than they change email addresses.  Anytime I am about to get a formal invitation, my friends end up texting or EMAILING me to ask for my address, which I sometimes don't know, depending on how far in the future they plan on sending me something.

So now that I've dismissed all the half-baked arguments against emailing invitations, here are the reasons FOR email.
  1. The most obvious:  It's less expensive.  Whether you just send a regular email or use a service, paper invitations cannot compete.  Between envelopes, RSVP cards, stamps (don't forget the one on the reply card), other inserts, and then the actual invitation, the costs can really add up.
  2. Keeping track of RSVPs has never been easier.  Instead of asking your guests to mail back RSVP cards, which could get lost in the mail or be illegible, you can provide links or embedded RSVP forms which automatically populate all the responses in a spreadsheet.
  3. It's a lot easier to individualize each invitation.  Each potential guest can be sent a separate invite with their own RSVP card so it's obvious exactly who they can bring.  When using paper invitations, people tend to make a generic one and then count on the recipient understanding some ancient addressing rule that you can only RSVP for the exact names on the envelope and up to the number of guests indicated (see:  John Doe vs John Does and guest).  How are you supposed to learn this rule if you've only ever seen it addressed without a guest?  Most movies imply that you always get a guest so it's not crazy to assume that!
  4. You waste less.  Most guests will probably end up throwing the invitation away.  With emailed invitations, there's no trash and you don't have to worry about your identity being stolen because one of your relatives didn't shred the invitation (i.e., the piece of paper which has your full name, mother's maiden name, father's middle name, and town where you grew up).
  5. Speaking of which, you don't have to worry about your identity being stolen.  See above.
  6. If you have a typo, you find out right away.  If you make a mistake with the email address, the server should kick it back to you in seconds.  If you make a mistake with a mailing address, it'll take a couple days if at all.
  7. You can get notified when they've received/opened/read/clicked the link.  With paper invitations, you basically have to call or EMAIL each person to make sure they got it.
To me, this really doesn't even seem like a fair fight, but somehow, I'm in the minority.  Can someone please explain this to me?  Or give me more ammo to fight off the haters?

UPDATE:  So another argument on the paper side is that they are sometimes kept as keepsakes, which you obviously can't do with an electronic version.  While I can understand some people will actually do this, I think hosts tend to overvalue the sentimentality of the invitation.  The people most-likely to want the keepsake are the hosts.  Plus, if somebody REALLY wanted a keepsake, party favors can serve the same purpose and emailed invitations can always be printed out.