The 250 Personal Finance Questions Everyone Should Ask

INTRODUCTION

As the ought decade (2000–2009) unfolds, people are confronted with ever more critical and ever more complex management of their personal finances. As people change jobs, financial guarantees like pensions disappear. As financial markets become more uncertain, as home prices, health care, and tuition costs skyrocket, and the complex tangle of tax laws evolves, there is more to worry about. Are the solutions simple and straightforward? Hardly. How much money will you need in five years? Twenty years? To support a thirty-year retirement? To cover the possibilities of disability and unforeseen health problems?

Most people can't figure out what they need next week or month, let alone twenty years from now. Meeting today's needs and wants is so consuming of their time and money that there is little left over for tomorrow. The reality is this: It takes considerable energy, foresight, discipline, contingency planning, and a certain amount of good fortune to make your finances work to achieve your future goals. It requires a certain amount of professional skill to quantify and manage your personal finances.

Many people choose to leave the professional skill part to others—financial advisors, CPAs, stockbrokers, insurance agents, and the like. While this leave the driving to us model works for some, it is very dangerous in other circumstances. Financial professionals have to make money, and the harsh reality is that most make their money by selling something—insurance, securities, mutual funds, mortgages, and tax services. Can you get a complete, unbiased, and actionable financial strategy from these professionals? Yes, sometimes. But in the same way that it helps to know about cars before talking to a car salesperson or that it helps to know about paint before talking to a housepainter, so it follows that it also helps to know something about personal finance before talking to a financial professional. Otherwise, you may get something that meets their needs more than your own needs, and it rapidly goes downhill from there.

So today's savvy shoppers gather up information before buying a car. They visit manufacturer Web sites, automotive portals like Autobytel.com, Kelley Blue Book, Car and Driver, and so forth. They look at pictures, features, prices, dealer costs, repair data, and testimonials from other owners. Do these resources make the decision? Hardly. But along the way, they collect some key facts and impressions. More importantly, they learn what questions to ask. They can separate the jargon from the realities, and they are able to understand the facts and numbers well enough to decide.

Whether you are an individual or the head of a family, you are the chairman and CEO of your own financial destiny. Regarding your personal finances, you may choose to do it all yourself, delegate it all to others, or some combination of the two. Regardless, you'll need to arm yourself with the basics—the questions and at least some of the answers—to proceed. The 250 Personal Finance Questions Everyone Should Ask brings you a structured list of questions and answers covering all aspects of personal financial planning. The questions are designed to help you learn important facts and concepts about personal finance. In some cases, they may be used in direct conversation or to design the questions you might ask of a financial professional. Questions range from the strategic and conceptual why questions to the more tactical and precise how questions about specific financial tools.

The first group of these 250 questions covers personal finance as a broad topic. Next is a large body of questions covering daily personal finances—the management of income, spending, saving, budgeting, banking, and credit. From there, questions move to the more complex and subjective areas of financial planning. Topics include the achievement of financial goals such as college and retirement and the successful building of wealth to achieve these desired ends. The next set of questions covers external forces affecting the achievement of these goals—risk and taxes—that can sink your plans unless navigated successfully. In the last set of questions, the topic of managing assets when you can't—estate planning—is addressed.

PART   1

Managing

Money

Chapter  

1

PERSONAL

FINANCE BASICS

The term personal finance makes the blood of many run cold. Uh-oh, here it comes. Too much month left at the end of my money. Not enough saved for retirement or college. Eight thousand dollars of debt on my credit card and growing. Budgets. Saving. Tax rules so complicated that even the enforcers don't understand them. The stock market, that emotional beast that ate so many for lunch in 2000–03. Insurance policies and contracts so complex that you hardly understand the reader-friendly version. Charts and graphs. The complex mathematical mysteries of compounding, making money worth more or less depending on time, an Einsteinian concept that might cause the genius himself to shake his head in confusion.

The truth is, unless you were raised in a firmly financially conscious household (and most of us weren't), most of the topics covered by personal finance represent scary, unfamiliar territory. Dealing with finances is, in two ways, a date with the devil. First, for most it uncovers the consequences and scary realities of what happens when you don't have enough money. Second, many of the solutions require that dreaded confrontation with the bank officer, insurance agent, stockbroker, or accountant, an encounter where you struggle to keep up with what they say and then somehow feel compelled to make a decision after listening to half an hour of incomprehensible stuff.

This chapter, containing the first 10 of the 250 questions, serves one of the main objectives of this book: to get you comfortable with the basic elements and philosophy of personal finance and financial planning. With this perspective, it should become easier to move forward.

Question 1: What is personal finance?

Boiled down, personal finance is nothing more than the management of your financial resources to meet your needs and achieve your desired goals. It is personal; that is, it's about you, your family, and your household. It is finance; that is, it concerns money—that which you have, that which you will have, and that which you need. It does not concern things—things are what you buy with money. It concerns how money is acquired, stored, and used.

The happy phrase make it, spend it, keep it, grow it summarizes the four major quadrants of personal finance. Personal finance requires attention to all four aspects in balance. Making money accomplishes little if it is spent frivolously. Consuming more than one produces is not viable in the long term. A household that makes and spends but doesn't save will achieve immediate gratification but will be caught short at some point in the future. A household that makes it, spends it, and manages to save some is on the right track but without growing it may fall short of achieving goals.

Personal finance involves planning both for today and for the future. The today part is managing current income, expenses, and savings. Planning covers aspirational goals and the many what-ifs of life.

The quadrant model of personal finance popularized by Robert T. Kiyosaki's Rich Dad, Poor Dad series is a good reference. The four quadrants are Income, Expenses, Assets, and Liabilities. The difference between Income and Expenses (net savings) builds Assets (good) or Debt (bad). The difference between Assets and Liabilities is Net Worth, which, of course, is good if positive and bad if negative.

Personal finance essentially comes down to managing the four quadrants of your financial life.

Question 2: Why is personal finance so important?

Life's goals—and the means for achieving them—have become more complex and at the same time less stable. Jobs and careers, employee benefits, and costs of vital goods and services like homes, health care, and college education are changing ever more rapidly. Financial markets are less predictable, and pensions and even government entitlements, like Social Security, are less dependable as long-term fallbacks. We are literally bombarded with promotions to buy or finance something every day. The bottom line: Income and expenses have both become more volatile for the average citizen, and against that backdrop, people are living longer and have more ambitious aspirations. More careful management and planning are necessary to make sure it all works out right.

Question 3: What personal character traits are required for financial success?

Granted, it takes more than character traits to be financially successful—it takes hard work, some degree of knowledge, and at least a little luck. Beyond the basics, three character traits repeatedly emerge among financially successful people:

1. Awareness. To get where you're going, the first step is to know where you are. Financially aware people keep track of their current finances, including how much they get, where it all goes, and how much they have. They track the impact of large and small actions in their finances. They know how much they have in their pocket, what's on their credit cards, what's in the bank, what their investments are worth, and so forth. They know the important parts of their financial plan, like their monthly budget, and how they are doing against them—not to the penny, that level of detail is unnecessary, but within a useful ballpark range.

2. Commitment—the ability and willingness to carry out the financial plan—follows awareness. Commitment must be universal in households; it doesn't work if only one family member is financially prudent.

3. Control. Control, in this sense, derives from commitment. It is the ability to control impulses, to make decisions with the big picture in mind, and to avoid temptations.

Successful personal finance requires a combination of all three traits. Any individual or family starting out should first take inventory of these traits, revisit them once in a while, and put proper rewards in place to reinforce their importance.

Question 4: Regarding our finances, what can and what should we do ourselves?

Personal finance can be a skill-intensive and time-consuming activity The answer to this question really depends on your own priorities and willingness to invest time to learn and plan finances. Most people spend at least a few hours each week managing routine household income and expenses. The opportunity to outsource personal finance really enters with financial planning—that is, planning for college, retirement, taxes, and managing wealth to achieve goals.

When remodeling a house, anybody can be a do-it-yourselfer. However, the process may be time-consuming and frustrating, and the outcome may not be what you had in mind—so you may decide to hire a contractor. Financial planning presents a similar choice. Many people choose to outsource, recognizing the loss of control and (usually) increased cost, but they make the tradeoff consciously. Still many more employ a mix—some do-it-yourself and some professionally managed, as with mutual funds. Unlike the remodeling project, the mix can be adjusted over time. But like the remodeling project, it can cost a lot to fix a bad job, and you as the owner must still take overall responsibility for the project.

Question 5: Where should I/we get started?

For many, getting started is one of the toughest assignments. People get used to a certain lifestyle. Then, confronted with the need (or desire) to improve their finances, they dread the necessary lifestyle changes. Habit changes and control issues between family members create tension and make it still harder to get started.

Experience proves it's best to start with a clear assessment of your current financial position—income, expenses, assets, and debt—almost like a company preparing year-end financial statements. Figure out where your income goes—the nature, frequency, and amount of each expense. It's okay—actually better—to group expenses into categories (e.g., Miscellaneous Personal) than to track down every $3.46 spent for a Starbucks latte. This thorough examination of past events to determine cause is called financial forensics. Count all assets and liabilities to determine net worth, and most of all, be honest.

The next step is to identify, quantify, and prioritize goals—things such as future home purchases, college education, retirement, vacations, and other aspirations. Then (and possibly with professional help) measure where you are today toward achievement of those goals, and the process is under way. Particularly for families, it works best if everybody works on this together, mainly to build the awareness, commitment, and control required to pull it off. Periodic review meetings support the process, and with a little success and reward mixed in, these sessions become part of the family entertainment repertoire.

Question 6: Why do people fail financially, and how can it be avoided?

The reasons for failure are many and varied, but most boil down to a lack of one or several of the following traits: awareness, commitment, and control. Simply writing checks or flashing the ATM card with no regard to where you are will bust a plan—if there was one in place to begin with. Many people spend too much, enjoying a standard of living possible in the short term—though often only with infusions of debt—but unsustainable in the long term. The problem is that they haven't even stopped to think about the long term! They have no awareness, and without awareness, commitment and control are impossible. It becomes a vicious cycle; once they get used to the standard of living, the long-term shortfall gets bigger and bigger. They become more reluctant to face the music, and awareness, commitment, and control are further put off, and so on.

Question 7: What should my net worth be?

Net worth—what you own minus what you owe—is the primary financial engine driving the achievement of financial goals and, ultimately, your future standard of living. Why? Because as you get older, you produce less income by working, ultimately relying on income generated by your assets, plus government entitlements like Social Security, to live. Obviously, your net worth should be as high as possible, and the true amount of net worth needed is geared to your own personal goals and chosen lifestyle.

A useful and specific benchmark comes from researchers Thomas Stanley and William Danko and their seminal work The Millionaire Next Door (Longstreet, 1996). Stanley and Danko found that average net worth for the households they researched was a function of income and age and that it amounted to a person's Age times the Annual Income, all divided by 10. So if you're forty-five years old and have an annual income of $50,000, your net worth should be $225,000 [(45 × $50,000)/10]. If your net worth is more than twice this figure ($450,000), you are a Prodigious Accumulator of Wealth (PAW), and if your net worth is less than half ($122,500), you are an Under-accumulator of Wealth (UAW).

So get out your calculator, add up your assets and debts (including house, retirement plans, insurance policies, etc.), and figure out where you stand! Are you a PAW, UAW, or somewhere in between? The Stanley/Danko benchmark is a good place to start for setting financial goals.

Question 8: I've heard a lot about the power of compounding. In plain English, what is it, how does it work, and why is it so important?

Compounding is the mathematical miracle adding so much to your financial potential if handled properly. Compounding boils down to this: When assets earn a return (interest, dividends, growth) and that return is left on the table, not only do the original assets continue to earn return, but so does the return. It is return on return, and as the years go by, it is return on return on return, and so forth. The more the return—and the more time elapsed—the more impressive the resulting figure becomes. One dollar invested at 5 percent earns 5 cents (becoming $1.05) in one year, but earns $1.65 (becoming $2.65) if left for twenty years.

The basic formula:

Future Value =

Today's Value × (1 + Rate of Return)Number of Years

The following table tells how much $1 will be worth when left to compound for different numbers of years and at different