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Personal Finance

Debt-to-Income Ratio: Frugalist begs to differ

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So the Financial Wizard par Excellence is arguing that M’hijito, who earns a salary that is exactly at the median income for bankruptcy purposes, should be able to shoulder a great deal more of the Investment House mortgage than he agreed to. Our agreement was that he would cover one-third of it (having contributed a third of the down payment) and I would carry the other two-thirds. When we sell the chateau sometime in the future at an outrageous profit, we’re to divide our incalculable riches accordingly.

Fact is, he’s carrying more like 40 percent of it.

FW trots out the debt-to-income ratio to support his position:

The total debt-to-income, or back-end ratio, shows how much of your gross income would go toward all of your debt obligations, including mortgage, car loans, child support and alimony, credit card bills, student loans and condominium fees. In general, your total monthly debt obligation should not exceed 36 percent of your gross income. To calculate your debt-to-income ratio, multiply your annual salary by 0.36, then divide by 12 (months). The answer is your maximum allowable debt-to-income ratio.

Hm. Let’s think about that.

My gross income is $62,500. In theory, then, I should be able to tolerate a debt load of $1,875. A person with the state’s median gross income should be able to afford a total debt of $1,301.91.

And…uhm…what does such a debtor eat? Guess he doesn’t have to worry about dieting, eh?

My net monthly income is $3,000—actually, it’s more like $2,864 with the twice-a-month furloughs. The cost of operating my house and paying regularly recurring bills such as long-term care insurance and utilities comes to about $840 a month. In the winter it’s a little less, but one ignores the high summer bills at one’s peril. My house is paid off, so I have to self-escrow the costs of homeowner’s insurance and property tax, which when combined with the car insurance bill average out to around $350 a month. The combined cost of all other expenses—food, household goods, gasoline, car repairs, home repairs, pool chemicals, yard items, veterinary bills, medical and dental copays, and on and on and on—comes to about $1,200. I do charge these things on AMEX by way of collecting a couple hundred dollars in kickbacks once a year, but I pay the charge card bill in full every month.

I live pretty frugally: don’t travel, don’t subscribe to cable or cell services, rarely eat out, don’t buy many clothes (and none that have to be dry-cleaned), wash my own car, clean my own house, grow some of my own food, abstain from expensive hobbies, don’t even go to movies.The only debt I have is the $170 bill for the Renovation Loan (soon to be paid off) and my $800/month share of the house mortgage, for a total of $970. I presently put $400 a month in savings toward survival after the coming layoff. So…

  $840 monthly set expenses
  1200 all other living & unexpected expenses
     170 Reno Loan (second mortgage)
     800 Investment House mortgage
     350 tax & insuranceself-escrow
     400 emergency savings
$3,760

Tha’s funneh. Seems to come to more than I’m bringing home! Cut emergency savings to a more ordinary $200 a month, and we still exceed my net income by $696 a month.

Okay, I admit it: the $800/month is a drawdown from savings. So $3,760 – 200 – 800 = $2,760.

That’s right: a debt of a grandiose $170 a month brings my outgo to within $104 of my income…and that’s without any major bills: no pipes explode, no veterinarian proposes surgery, no dentist cries out for some expensive procedure, and the car’s transmission continues to run flawlessly.

If $1,875 of my income were committed to debt service, I would have a munificent $1,125 left to live on. But it costs $2,760 for me to live rather modestly (some would say “ascetically”) in a small middle-class urban tract house.

Is there any question why most people are up to their schnozzes in revolving debt? If my debt-to-income ratio were maxed, the only way I could possibly get by would be to live on the cuff!

Allow me to propose a different debt-to-income ratio, one that is based on net income, not gross.

Obviously, the amount of debt a person or family can afford is a function of the amount of money the household brings home, not a never-never-figure whose total is effectively meaningless. What matters, when calculating what you can afford, is how much you have in your pocket, not how much you putatively “earn.”

If you hope to live within your means and your net is, say, $3,000 a month, you need to subtract your known living expenses plus a little for emergency savings from your take-home pay. What remains is the amount you can pay toward debt. Let’s say I were not facing unemployment in a few months, so I put aside a more normal $200/month toward the emergency fund: my regular needs would come to $2,410 less the second mortgage payment: $2,240 (i.e., $2,410 -$170). This would leave $590 a month ($3,000-$2,410) available to pay toward debt. That is 19 percent of my net income.

On a “good” salary in my region, I can afford to commit about 20 percent of net to debt payment. Spend much more than that, and presto-changeo! My lenders get rich on the interest I owe now and forever, world without end, amen.

Take-home pay is typically about 60 percent of gross pay. So a person with Arizona’s $43,400 median income brings home about $26,040, or $2,170 a month.

That would make a reasonable debt load right around $435 a month (20% of $2,170). Yes. For your mortgage or rent, your student debt, your revolving credit-card debt, whatever you owe Mom or Uncle Ernie…

By this guideline, M’hijito, who has no other debt, is already contributing $165 a month more than he can afford to our combined real estate venture.

Figured traditionally, the debt-to-income ratio suggests he should be able to afford $1,301 a month, leaving him with a miserly $869 a month to live on!

Here’s what I think: the standard debt-to-income ratio calculation is utterly unrealistic and unfair to consumers. First, a number like 36 percent way too large. Second, figuring the amount of debt a person can carry according to his or her gross income works a complete disconnect from reality! No one lives on gross income. We live on our net income! Because net, not gross, is what we have available to spend, net income is the figure that should be used to calculate a tolerable debt load.

The take-home message: Figure the amount you can pay toward loans of any and all kinds according to your net income, not according to your gross. Obviously, if you want to spend no more than you earn, you need to keep the debt load low enough that it plus your total other spending and saving needs come to no more than your take-home pay.

debt-to-income ratio = (net pay – spending needs – saving needs) ÷ net pay

The decimal fraction you get from this formula is the fraction of your net pay you can afford to spend on debt.

How hard is this?

Well, of course, real hard: who do you know who’s paying $435 a month to keep a roof over his head? And how many own their cars free and clear? Not many, I’ll bet, who don’t have a roommate, a spouse, or a life partner.

Few exercises demonstrate more clearly that good financial health (at least on the household level) entails getting out of debt and staying out of debt. It means pinching pennies as tight as you can, creating more than one income stream to maximize net pay, and doggedly snowflaking down revolving debt first and then finally mortgage debt. Quite a challenge, this “getting real” business.
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Financial Records: Keep them forever!

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As my beloved dean and her crafty colleagues were feting me for my alleged 15th year of labor at the Great Desert University, it occurred to me to wonder, again, why they think I’ve been there 15 years when I think I’ve been there 16 years. If they’re right, then my CV is wrong. If they’re wrong, then I’m about to get shorted a significant amount of severance pay. Luckily, I keep every shred of paper that even vaguely resembles financial records.

Yesterday afternoon, I got into the dusty old file cabinet that resides in the garage. What should I find but a tax return strongly suggesting that GDU paid me for a lot more than one adjunct section! A little more excavation, and up came a file folder packed with old pay statements.

And yea, verily. My first full-time paycheck was issued in August 1993: sixteen long years ago.

This means HR is either one semester or one full year off in its records. That error is worth either $720 or $1,440 to me. When employees have been with the state for a while, their sick leave accrues. At 500 hours, it’s worth 1/3 of your hourly rate when you leave your job for whatever reason; at 1,000 hours it’s worth 1/2 your hourly rate. I have almost 1,200 hours.

At the time, sick leave was accruing at the rate of 4 hours a paycheck, adding as much as 96 hours to my present accrual (assuming HR’s records are a full year off). At $15 per hour, that totes up to a nice sum, even if they’re only off a half-year.

Keep your financial records! Store them in a safe place, and keep them forever, not for the seven years recommended by tax experts. If I hadn’t squirreled all my old paychecks away, I would have no way of proving when I really started full-time at GDU.

I learned this trick from my ex-husband, a corporate lawyer. He kept every scrap of paper that had anything to do with anything. He was so extreme that he had all our canceled checks returned to us, and he stored them tidily in a bureau drawer. Year after year after year of canceled checks, all lined up like little micron-thick soldiers…

Well, I’m don’t go that far, but I do keep my pay statements, my tax returns, and receipts for major purchases such as the roof job, appliances, and computers. Anything that’s tax-related probably should be stored permanently. Clutter? Yes. It’s a nuisance to find room for a four-drawer file cabinet and stash all this junk in it.

But. The squirreling habit paid off for me yesterday.

The Worst Financial Mistake You Didn’t Make

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Recently I was asked to describe the three worst financial mistakes I ever made. Well, that was easy… But later, it occurred to me that a more interesting question might have been “what was the worst financial mistake you didn’t make.”

Have you ever been tempted to do some damnfool thing and then later realized that you were smarter or luckier than you thought? What’s the worst mistake you could have made, almost made, but then didn’t make? And why didn’t you make it?

If you’re a blogger, please join the conversation with a post and link back to Funny. If you don’t have a site, please leave your story in the comments section.

To get the ball rolling, here’s this:

The worst financial mistake I didn’t make was to quit my job about a year ago. By the end of 2007, I was utterly fed up with the difficult personnel problem embodied inMy Bartleby. I had decided that if I could not get the Great Desert University to RIF her position by the time of the next performance evaluations (which occurred in spring 2008), I would take the earliest of all possible early retirements. It was her or me: either she left, or I did.

Luckily for me, after she went to visit her out-of-town son over Christmas break, she came back resolved to quit.

What serendipity!

The factotums in the Dean’s Office had already decided that we would RIF her job, and so at least I had the support of my betters in my little project. But really: she could have protested, she could have claimed I was unfair to her (I’d been hounding the poor woman for months, building a case to show not only that we no longer needed the services she’d been hired to perform, but that her editing skills were not up to snuff), she could have engaged all sorts of bureaucratic machinery to delay dismissal. We were required to give her several weeks of notice, and although our HR rep said in these cases the worker is normally told to go home and collect her money, Bartleby—you can be sure!—would have preferred not.

If she’d put up a fight and made my life even more miserable than it was, or if she’d managed to evade dismissal, I very certainly would have quit. I was determined to bring an end to the whole unhappy business.

{LOL!} Having a son of my own, I can hear the male voice, embued with common sense. He would have said one of two things:

MOM! If you’re that unhappy, why don’t you just retire?

or, knowing Bartleby’s nature as he must have,

MOM! Don’t give that bitch the satisfaction! Quit before she can fire you.

Whatever he said, it was the right thing. Bless him.

If I’d retired last spring, I would have been just getting by on the proceeds of my savings and a minuscule Social Security benefit. When the economy crashed and $200,000 of retirement savings disappeared, I would have been flat out of luck.

Don’t know how God felt about Bartleby, but She was on my side that time!

Snail-mail vs. electronic payment

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Are there bills that you refuse to pay electronically, or am I the only maverick running loose across the range?

These days, I pay all monthly bills by EFTs, except the phone bill. I never trusted Qwest, which in the past was prone to sending incorrect statements full of phantom charges. But because they had been OK for several years and because I no longer make many long-distance calls, I opted to let them engross money from my checking account. That was a mistake—it added even more aggravation to the late, great Qwest saga. So, when I switched to Cox, which after all is just another giant squid of a telecom corporation, I decided to keep its tentacles out of my bank accounts.

Cox’s statement hasn’t arrived this month. It’s usually here by now: last month I wrote a check on the 6th, meaning the bill would have been sitting around the house for several days by then. The bill actually isn’t due for another couple of weeks, but they claim you need to get the payment to them ten days before the announced due date, to ensure it posts on time. So I had to call them on the phone, navigate the infuriating punch-a-button system (is there any question why so many Americans have high blood pressure?), then find out what’s owing and what their mailing address is.

Snail-mail is so passé that the employees don’t even know what the company’s address is. It took the human I finally reached two tries to find what she thinks is the correct accounts receivable P.O. box.

There are some corporations, IMHO, that can’t be trusted. The phone company is one of those: I want to see the bill before there’s even any possibility of money being released. Ditto that for credit cards. I never pay credit-card bills electronically: I do not want Visa or American Express to have any access of any sort to my bank accounts, other than through a check. I want to be able to see and confirm each charge in each billing cycle before sending money.

A credit-union rep once remarked that it’s not a good idea to pay insurance companies electronically, either. I do: long-term care and life insurance premiums are EFTed to the relevant companies. But I don’t pay the annual homeowner’s and auto insurance that way. Too squirrelly: you never know when they’re going to run amok with the premiums, so I want to minimize potential hassle if I decide to switch insurers.

What bills, if any, do you pay the old-fashioned way?

Layoff Plans: Use savings or start Social Security?

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The other day I realized that in theory I have enough in savings, should the legislature’s proposed destruction of the Great Desert University and the resulting layoff occur, to get by for about a year if I use the money I’ve saved to pay off the Renovation Loan to live on instead of paying the loan.

It’s an interesting and reassuring idea. But let’s consider: would it be better to use savings to live on before I reach full retirement age, when (assuming Obama doesn’t reduce everyone’s payments) I will be eligible for $1,472 a month ($17,664 a year)? Or should I, instead, take the amount for which I’m presently eligible, $1,156 ($13,872 a year), use it for living expenses until I’m 66 (full retirement age), and then raid my savings to pay it back so that I can reset my payments to the full $1,472?

I have $21,000 saved to pay off the loan’s principal, which is a 30-year fixed-rate affair with a tiny monthly payment. If it were added to my total retirement savings, it would add about $840 (at 4%) to $1,050 (at 5%) a year to my annual drawdown.

Which route would reduce my total retirement savings the least?

Let’s say I’m laid off in February. That would leave 27 months until I reach full retirement age.

If I take Social Security today, my benefit would be $1,156 a month, which is $13,872 a year.

So, if I do start taking Social Security in March 2009, I draw down $1,156 x 27 months, or $31,212. This is the amount I would have to withdraw from retirement savings to reset my Social Security payments to $1,472 at age 66, if I start taking Social Security right away.

If I do not start taking Social Security in March, but instead live for a year on the savings pot and then start drawing Social Security, at that time I have 15 months until I’m 66. Let’s assume I would still get the $1,156 I’m entitled to now, even though in fact it would be somewhat more:

$1,156 x 15 months = $17,350. This is the amount I would have towithdraw from retirement savings to reset my Social Security payments to $1,472 at age 66 if I defer taking Social Security for a year.

However, by this point I’ve already spent down $21,000 of savings: $21,000 + $17,350 = $38,340. This strategy—using savings to defer taking Social Security for a year—ends up costing me $7,128 more than starting Social Security right away!

If I kept the $21,000 and the $7,128 amount is folded into my retirement savings, I can draw down 4% or at most 5% a year: this would add $285 to $356 a year to my total retirement income from savings.

But…it’s not that simple: I’m presently paying $2,040 a year on the Renovation Loan. If I don’t prepay the principal, that goes on for another 29 years, costing me $59,160 (should I live that long). Well, $59,160 is quite a lot to pay toward a $21,000 loan, eh?

Still, I have to think about what’s in my pocket to pay for groceries. Besides, let’s get real: I’m not going to live another 29 years!

In terms of what I have to live on, irrespective of the actual cost of the loan, the full-retirement benefit is $3,792 more than the annual age 63 benefit. That’s $1,752 a year more than the annual cost of the loan. Meanwhile, if I hang on to my $21,000 and roll it into my retirement savings, it generates an extra $840 to $1,050 a year, for a total of $2,592 to $2,802 more than the loan costs.

Evidently, if these figures are correct, it would be better not to pay off the Renovation Loan but instead to start collecting Social Security right away.

In fact, if I delayed taking Social Security a year, the amount I would collect then would be larger and so the amount I’d have to pay back to the system would be larger, putting me at an even larger disadvantage if I’ve used up the $21,000 of savings.

Clearly, my best course of action is to keep my $21,000, retain the debt, and start collecting Social Security right away. Then pay back the amount I’ve collected by age 66, reset Social Security to the full retirement age amount, and draw down 4% or 5% of the $21,000 as part of my total retirement savings drawdown, for a total income from savings of about $18,600 to $23,300 a year.

This would create a maximum passive income at age 66 of $40,660. Not adjusted for inflation. I could live on that…assuming taxes haven’t reached the astronomical level by then.

2008 Financial Strategies: What worked and what didn’t work

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As the year winds down, this is a good time to take stock of the various events, schemes, and impulses that drive our personal finance strategies, to consider which ones worked and which failed, and to think about how we can use experience to plan next year’s financial direction.

We all had our ups and downs. As we know, it feels like the “downs” took the race. But as I look back over my 2008 personal finance adventures, I see that quite a few ideas and strategies were successful. Like everyone, I took some big hits; some of those were beyond my control, or effectively so.

My Best 2008 Financial Strategies

Bar none, building a second income stream was the smartest move I made this year. At the start of the spring 2008 semester, I agreed to teach two sections of Writing for the Professions, a.k.a. “freshman comp for juniors and seniors.” When, hours before classes were slated to begin, I learned that both sections were double-enrolled and I was actually taking on the equivalent of four sections—the workload of a full-time lecturer—I threatened to walk; backed into a corner, the dean agreed to pay me for four sections.

It was a horrible job, but the pay was as much as I hoped to earn on the side during the entire year. And because the Great Desert University canned all its part-time faculty in the fall semester, the serendipitous overload meant that I made my 2008 side-income goal in spite of the faltering economy.

Starting a side business independent of GDU seems to have been a wise move, too. Between The Copyeditor’s Desk and my own freelance work, I have made an extra $1,000 to $1,200 a month since late last summer. If I’m laid off and so forced to begin taking Social Security now instead of waiting until full retirement age, this will be about as much as I will be allowed to earn. The two income streams—editorial work and Social Security—may (with luck) cover my expenses until I can draw the full amount of Social Security income and forestall having to draw down my sadly depleted savings.

Stashing all my post-tax side income into savings instead of using it to pay down the $23,000 owing on the second mortgage I took out to renovate the Investment House seems to have been a wise move. At the outset, I was uncertain whether I would stay in my own house, given the skyrocketing crime in the depressed apartment complexes across 19th Avenue, the unholy mess across the street from me, and the growing presence of undesirable renters. If I sold, the loan would be paid from the proceeds, and I might be better off with the cash in hand from the side jobs. As the economy began to collapse in earnest and more and more credible-sounding layoff rumors circulated, I was glad I had the 23 grand to double as an emergency fund.

Moving the savings from the side jobs out of stocks and into the money market. As it started to appear likely that I would need the cash to live on, I yanked the side-job money out of Vanguard’s Wellington and Windsor II funds, which were just beginning to stumble, and put it where I figured it would be at least moderately safe. Since then, Vanguard’s funds have followed the rest of the stock market into the tank. At least I managed to hang onto that much of my savings.

Restructuring my monthly budget to put biweekly paychecks into a “pool” account from which contributions are shifted to “piggy-bank” accounts containing enough to cover monthly expenses. This strategy has trumped the wacky disjunct between biweekly pay (which allows the university to keep a chunk of its employees’ pay in its coffers, earning interest on unpaid salaries while the flunkies try to figure out how to stay solvent) and the reality of monthly billing cycles. Over time, it has the effect of accruing part of the two so-called “extra” paychecks (which are not “extra” but simply represent six months’ worth of unpaid salary disbursed out of synch) in the pool, padding the emergency fund a bit.

Continuing to set aside the $200 a month I was saving toward the Investment House Renovation Loan self-escrow account, even after enough was stashed to repay the debt.This effectively doubles my monthly after-tax savings and has restored my savings account to its former, pre-disastrous-expenses glory. That also helps plump up the emergency cushion to fall back on in the event of unemployment.

Taking time to think through how I would survive after a layoff and to build a proposed post-layoff budget. As rumors of impending layoffs intensified, the Bush economy slid into its catastrophic collapse. It became clear I will not be able to use what little remains of my life savings to support myself in retirement; not for a long time, anyway. The prospect that I might soon be out of a salary forced me to figure how I could get by on a fraction of full Social Security—$1,040 a month, as opposed to the $2,094 I would get by waiting until full retirement age—plus whatever I could scrounge by freelancing and taking on part-time teaching jobs at the community colleges.

Although it would be very difficult, it appears possible that I could get by for a year or two without having to sell my home. After that, I can raid savings to return the amount I’ve drawn from Social Security to the government, which will reset my SS payments to the full retirement figure. That should keep me going until the market improves enough to revive my savings. The benefit of this exercise is that I now feel fairly confident that I will survive the recession, come what may.

My Worst 2008 Financial Strategies

Leaving savings in the stock market as it became increasingly evident that the Bush “recession” is no ordinary recession but indeed will probably devolve into a depression. My savings are conservatively invested, about a third in stocks, a third in bonds, and a third in the money market. Bonds, as it developed, provided little or no protection in the crash, and although Vanguard’s Prime Money Market fund has not broken the buck, we’ve seen that losses in the money market can happen.

If I’d had a crystal ball, I would have yanked every penny out of the market and stuck it all in laddered CDs. Lacking any such tool, though, I followed conventional wisdom and stayed the course. This, we can now see, was probably a mistake.

Jumping the gun on refinancing the Investment House. M’hijito and I got a much improved interest rate on the mortgage refinance we took out earlier this year for the house the two of us are copurchasing. However, had we waited a few months, we might have landed a 4.5% rate.

Maybe not, too: at this point we’re upside down on that house, and it’s questionable whether the credit union would give us a loan against what the property is now worth.

The problem with the refinance is that to get the 5.3% rate we obtained, we had to take a 30/15 loan. At the time, we figured the market would turn around before 15 years passed; in the event that we had not sold the house by then, we would have no trouble refinancing the remaining principal.

I no longer think that’s true. IMHO, the real estate market will not recover for another eight to ten years. By that, I mean we will not break even on the sale of that house anytime in the next decade. If I’m right about this, we may not be able to sell the house for a profit after 15 years. This will force us to refinance or to take a bath on the sale. And if by then mortgage rates are in the double digits, as they have been historically, we may not be able to negotiate a monthly payment that would be covered by rental income. Thus the 30/15 mortgage terms could lock my son into the house at a time of his life when he’s likely to marry or find better job opportunities in other parts of the country.

I failed to contest the county’s property tax valuation. This resulted in a breathtaking tax increase on a house whose value is less than the county claims. The reasons for my lapse were a) the county’s statement is well-nigh incomprehensible and I had no way of assessing whether it was anything like accurate, nor could I tell what its effect on my taxes were going to be (tax statements arrive several months after the property revaluation statements); and b) the window for protesting lasts only a couple of weeks after the valuation statements are mailed, so that by the time you realize what those statements mean, it’s too late for you to do anything about them. Clearly, I should have protested as a knee-jerk reaction, even though I had no idea what the statement implied.

All in all…

I’m way worse off financially than I was at this time last year, that’s for sure. So, I expect, are most Americans.

On the other hand, so far I still have a job. I’ve managed to salvage some of my savings—enough to pay off the small loan against my house, if push comes to shove. Our little editorial business has a couple of regular clients, and we’re working on landing some more. At this point, every week that passes without a layoff puts me in a better position to survive without a salary.

My plan… 

• …starts with continuing to stash as much as possible into savings.
• That dovetails with cutting back on spending so that I’ll be accustomed to living on less, should I find myself unemployed. As long as I’m still working, savings from the spending cutbacks will go straight to the emergency fund.
• Instead of trading in my 10-year-old vehicle this year, as I would normally do, I’ll drive that car until it falls apart like the minister’s one-hoss shay.
• This spring and summer I’ll continue to try to build Copyeditor’s Desk income; if that doesn’t pan out, in the fall I’ll sign up to teach composition at the community colleges. 
• And finally: Funny about Money is doing surprisingly well, considering that I don’t work very hard at it. The site’s page rank is 4, and its most trafficked post has a page rank of 2. I will try to focus Funny more sharply and develop its readership more broadly, and if it continues to draw readers, I’ll consider monetizing it.