There are hundreds of small tips and rules you will hear about managing your personal finances, but putting everything together into one coherent plan can be a daunting task.

You have probably already heard about budgeting, spending plans, savings strategies, credit cards, and all points in between – now we will put everything together to make a plan to build lifelong wealth.

Manage Your Income

Your saving and spending will always depend on how much income you can start with. Your career goals and personal finance goals are the same thing, so always start by looking at your career.

Making a Career Plan

Interviewers often as “Where do you see yourself in 5 years?” You should always have an answer to this question, because it helps build a clear roadmap forward.

Make a Career Plan by trying to define your ideal job (and salary), and set a series of obtainable goals for the next 5 years. Start by looking at job postings – not for jobs that you can apply for now, but for jobs you want to land in the future. These job postings have all the information you need to make an effective career plan:

• Experience requirements: Use these to define the stepping stones for jobs between now and then.
• Skill/Education requirements: See what kind of extra education you need to obtain, or skills you need to build on your own time outside your day job.
• Salary offers: Usually included in job postings, this will give you an idea of what kind of lifestyle you are building towards. This helps put a cap on the debt you take on today, since it gives a good way to see your ability to pay it off in the future.

Once you do this for your “dream job”, rinse and repeat for each of the “stepping stone” jobs you need to meet the experience requirement. Before you know it, you will have a fully-fleshed out Career Plan with some specific actions you can take today to get there.

Making a Debt Plan

Once you have an idea of how your career can evolve, you know how much space you have for debt. Student loan debt usually comes first, as you try to knock out the Education Requirements for your career path.

You can estimate how much your first jobs will pay after school by looking at job offers for entry-level positions, so your key is to see how much of a debt load you will have as soon as you finish school.

Use Your Spending Plan

Always set aside 20 minutes a month to go over your spending by doing a quick account reconciliation updating your Spending Plan. The key to financial success is knowing where your money is, how it got there, and where it is going next. No matter how good you are at keeping track of these in your head, there is no substitute for a few minutes of dedicated planning with a spreadsheet and your actual spending habits.

Your Four Accounts

There is a secret way to effortlessly build wealth, while barely paying attention: Split your income automatically, keeping different amounts in different accounts. Most adults with healthy finances use four accounts, but it may be more or less depending on your personal situation.

Account One: Checking Account

This is your primary checking account. Deposit your paycheck here, and use it for all your bills and shopping. You should have all of your bills paid automatically by setting up auto payments, going through this account.

Account Two: Savings Account

This is a standard savings account, linked to your checking account. Set up automatic transfers every month, set as soon as you deposit your paycheck. This will help with your “Pay Yourself First” savings strategy by making sure your wealth is always growing.

Account Three: Investing Account

Have a brokerage account, and use it. A certain percentage of your savings should be invested in the markets, which will have a higher percentage return than just a normal savings account. Whether it is invested in bonds, mutual funds, index ETFs, or a balanced portfolio you build yourself, investing your savings is the most effective way to help it grow.

You can even set up regular transfers from your savings account to your brokerage account, which will help keep it growing.

Account Four: Emergency Fund

This is either part of your savings account, or an entirely separate bank account set aside for emergencies. Your Emergency Fund fund will have 3 to 6 months of income standing by, ready to be withdrawn in case you have a monetary emergency. The purpose of your Emergency Fund is to make sure that you do not “steal from yourself” by withdrawing from your savings. Every time you need to withdraw from your Emergency Fund fund, fill it back up with your next paycheck – your goal is to always keep this account “topped up” in case you need it later.

Optional – Account Five: Spending Account

If you struggle to control your spending, you may want to have a secondary checking account, specifically set aside with your “Spending Money”. Here’s how it works:

1. Use your account reconciliation to determine the approximate amount of bills you have each month.
2. Set up your main checking account to automatically transfer your savings, plus pay all of your regular bills.
3. Transfer 80% of the money left over to this new “Spending Account” (also a checking account).
4. Disable overdraft protection on your Spending Account to ensure you cannot over-draw.
5. Use this “Spending Account” to go out with friends, buy things online, pay for groceries, and any other spending you do throughout the month.

Your “Spending Account” is the debit card you keep with you – if you are using a separate Spending Account, leave your normal debit card and credit card locked up at home, so you are not tempted to start spending out of other accounts.

By separating out your Spending Account, it ensures that all your bills will always get paid on time, and your savings will always continue to grow, regardless of how much impulse shopping or poor spending habits you might have. If you try to spend more than what you have in your Spending Account, the transaction will just be declined. The momentary embarrassment is well worth the damage you’re sparing your savings account!

Your Credit Card

Your credit card is an extension of your Checking Account or Spending Account, NOT extra money. It is important to use your credit card to build your credit score, but you should always avoid spending more on your credit card than you can pay off immediately with your checking/spending accounts.

Budgeting Guidelines

It is hard to know exactly how much money to allocate to different expenses, so let this guide help show how much money you should put to different types. These are guidelines based on your net (after-tax) income.

Housing

Look for housing that takes 20-30% of your net income. Any higher and you are pulling too many resources away from all your other expenses, and it will end up seriously hurting your ability to save.

This may mean stepping out of your comfort zone, but you need to exercise willpower. If you hate roommates, then make sure you find a better-paying job before upgrading your housing.

Savings

Shoot for 10% of your net income to go straight to your savings account. Going higher is always better, but saving less than 10% will hurt your long-term financial goals (like saving for a house, or retirement). Of this savings, transfer 80% to your investing or brokerage account, keeping the rest in your savings account.

So far, we’ve allocated up to 40% of our monthly income, just on housing and savings.

Bills and Groceries

Miscellaneous bills and groceries will take up another 30% of your income. This is another set of spending that will be fixed month-to-month, and should be easy to plan for.

This account also includes all your insurance and car payments. If you are making car payments, this percentage could go up to 35% or 40%, but at this point you are stretching yourself very thin.

Other Spending

After everything else is spent, you should still have at least another 20% of income left for anything else you want to spend it on. Going out with friends, saving for holiday gift-giving, and buying yourself something nice should all fall into this group.

A rookie mistake for most budgets is forgetting to include this group, but most people cannot go very long without some entertainment spending. Failing to set aside 20% of your income to spend on “whatever” is a major reason why people end up racking up credit card debt. This 20% chunk should be the spending that you could “cut” if you are having a rough month and need to replenish your Emergency Fund.

Get PersonalFinanceLab

This lesson is part of the PersonalFinanceLab curriculum library. Schools with a PersonalFinanceLab.com site license can get this lesson, plus our full library of 300 others, along with our budgeting game, stock game, and automatically-graded assessments for their classroom - complete with LMS integration and rostering support!

Learn More

[qsm quiz=158]

Challenge Questions

1. In order to build worth, you have to learn to manage your money and save some of the money that you earn. Is this true, and if so why?
2. How might your career over time help you build your wealth?
3. Does earning more money guarantee to build wealth? If so, why? If not, why not?
4. Why should you have a savings account and a checking account, rather than having one single account?

Raising a family is expensive. According to CNN, it costs over $230,000 to raise a child from birth to age 17 in the United States! Starting a family is the biggest change you can make to your life as a whole, but for your personal finances in particular.

Some say that no one is ever prepared to be a parent until it happens, but with a bit of wise financial planning, you can at least worry a bit less about money during the journey.

Laying the Foundations

New parents are not expected to get over $200,000 in a savings account before each child is born. However, if you are planning on starting a family, having your finances in order will make the experience much less stressful.

Modifying Your Budget

The $230,000 cost will average down to about $13,000 per year, every year, per child. Without any other lifestyle changes (although you absolutely will have many!), this means adding a new $1,100 cost to your monthly budget or spending plan for each child. This is on the low-end: if you want to start a college savings fund, add on another $100-$200 per child.

Very few people have $1,100 lying around unallocated in their budget, so first consider where this money will come from.

Savings Cushion

Re-allocating your budget is much easier if you have a savings cushion to fall back on, especially for emergency expenses that come up with babies. Besides your normal savings and investments, it is a great idea to have at least 1 paycheck worth of cash set aside in a separate savings account. Consider this a “Rainy Day” fund, which will help with short-term budget shortfalls.

Expenses with Age

Your budget will be evolving over time, but the nature of your expenses will change a lot as children get older. Surprisingly, the $1,100 extra fee does not change very much from birth until the end of high school, but where that money is going will move quite a bit.

Infants (Newborn – 6 Months)

Babies and very small children are expensive, as any parent will remind you. Some of these costs are consumables, like diapers ($100 a month) and formula ($0 – $300 a month), but the biggest cost is childcare. Infants need constant attention, and constant attention means full-time work.

Many childcare providers will not accept children under 6 months, which means you will need to take time off work for the first 6 months. Maternity and Paternity leave is not always given in the United States, meaning the biggest cost of infants is usually lost wages from the parents taking time off work.

Even though diapers might not be too expensive, losing wages for 6 months (or more) usually means infancy is the most expensive period for a child.

Toddlers (6 months – 3 years)

Very young children are out of diapers, but they are into clothes and solid foods. This is where children enter your grocery budget, at least as a small piece. Children at this age are also growing very fast, so you will expect to replace clothes every couple of months. Thankfully, clothes for very small children is still pretty cheap, so it likely will not be much more than your previous diaper budget.

The main cost will still be childcare. Once the infant is over 6 months, you should be able to find childcare providers who you can hire during the day. This means you should no longer be facing lost wages, but instead hiring a full-time childcare provider.

Children (3 years – 12 years)

Once children start normal school, the expense structure changes again. Childcare takes more of a backseat, since the children are in school all day. Childcare services are still normally needed for after school care, but the cost is less than full-day care.

Children in this category will have an ever-increasing grocery and clothing budget, but the biggest hit will come from housing. Growing kids need growing spaces – you may be able to get away with a crib in your own bedroom for infants, but toddlers usually need their own spaces. Some families add a bedroom (and see a rent/mortgage increase) earlier, but once the child is in school the cost can no longer be avoided.

Small children also introduce a new transportation cost – driving or transporting them to friend’s houses, social events, and school. This will also grow with age, with the youngest children spending the most time at home. Toys and other miscellaneous expenses will also start to add up, especially around the holidays.

Teenagers (13 – 17 years)

Teenagers typically have the lowest childcare costs, both because of participation in extracurricular activities, or because they can be trusted to spend slightly more unsupervised time at home alone.

Instead, all of those “Secondary costs” rise to the forefront. The biggest increases come from groceries (teenagers tend to be big eaters) and transportation. Transportation can be anything from bus tickets to helping buy a car, but either way tends to be a big cost. Rent/mortgage payments also tend to go up, as teenagers need their independence (and may resent being paired with a sibling) – this could add an additional bedroom. Other than the lost wages during infancy, teenagers will be the most expensive age.

Multiple Children

If you have more than one child, some costs get offset.

Clothing

Clothing can be handed down from one child to another, but this will usually be very low savings. Clothing is cheapest for the youngest children, but older children and teenagers are usually pickier about having their own style.

Rent

Most families pair children in bedrooms, so the second child will usually not add an extra rent cost, at least at first. This can change for teenagers, who may require their own bedrooms. This can also be a gamble, since it is easier to pair same-sex siblings (boy/boy or girl/girl) than different-sex (boy/girl).

Childcare

Childcare costs can either multiply or divide for multiple children, depending on your approach. If you need to send children to a childcare facility (daycare), it will usually just add another fee for each additional child. On the other hand, if you hire a nanny or babysitter a few days a week (particularly for older children), there will usually be a flat fee, with small additions for each additional child.

Cost Relief

The cost of raising a child will build up fast, but there are some programs in place to help offset the cost.

Earned Income Tax Credit

The Earned Income Tax Credit (EITC) is part of your income tax return designed to increase the income tax return for low-income adults and families. If you have children, the income threshold goes up, and the actual return amount gets multiplied. You can learn more from our article about Income Tax.

Supplemental Nutrition Assistance Program

The SNAP program is a grocery subsidy for low-income working families. Over 75% of SNAP participants are under 17, as the program is designed specifically to help families with children afford healthy food. You can learn more from our article about government assistance programs.

Children’s Health Insurance Program

The CHIP program is part of Medicaid, specifically to make sure every child has health insurance. If you do not have family health insurance coming from your work, you may qualify to have your children insured through the CHIP program. This can be a massive savings for families. You can learn more from our article about government assistance programs.

Raising Children and Your Budget

Ideally, your income will be steadily going up over your working life, while the cost of each child will be fairly constant. This means by the time your child is 17, childcare costs should be a much smaller percentage of your total income than the newborn.

This does not always work out, as many families start saving heavily to help with college and other education expenses. This means your budgeting during the earliest years will define your spending for the next decade (or more)! Keeping a solid budget and spending plan will be your keys for success.

Get PersonalFinanceLab

This lesson is part of the PersonalFinanceLab curriculum library. Schools with a PersonalFinanceLab.com site license can get this lesson, plus our full library of 300 others, along with our budgeting game, stock game, and automatically-graded assessments for their classroom - complete with LMS integration and rostering support!

Learn More

[qsm quiz=157]

Challenge Questions

1. How might budgeting help parents with being able to afford to raise a child?
2. How does your expense structure change with the different ages and stages of raising a child?
3. Other than the actual cost of paying to raise a child, what other non financial factors should also be considered in raising a child?
4. Are there any programs are out there, both government and private that are there to assist families and children in times of financial and emotional need?

Buying a car is usually the first big purchase a person will make. There is also no shortage of horror stories of people immediately regretting the decision, either by buying a new car and later struggling to meet payments, or a used car with hidden mechanical problems demanding costly repairs.

When you need to buy your first (or next) car, make sure these factors weigh in on your decision.

Establishing a Budget for Buying a Car

Before you get started, step 1 is establishing a budget for how much you want to spend on a vehicle. A common trap is picking the car you want first, then trying to find a way to pay for it.

Buying a car is not the same as buying a TV or most other big purchases. Your budget needs to factor in the life of the car’s loan, the interest rate you pay, and the cost of insurance. Most of these factors are negotiable, so a key is establishing your hard limits before you walk into a dealership.

Car Loan Life and Interest Rate

If you take a car loan, the price you pay will be a balance between the “sticker price”, the interest rate for your loan, and the length of the loan. Car dealers want to try to make cars seem as affordable as possible, so their negotiation point is usually the monthly payment (since this is the number in your budget), but smart shoppers know this is just a distraction.

Dealers want to lower your monthly payment to make the car seem affordable, so they might just extend the life of your loan. If you are concerned about the initial sticker price, they might be happy to lower it by a few hundred dollars, but give a slight bump to your interest rate.

This means when you are planning to purchase a car, you should have two budgets prepared. One is for the total cost of the car (including all interest payments over the life of the loan), and the other is how much you can afford in monthly payments. The dealer will always try to sell based on monthly payments alone, but make sure to keep the total cap in mind during negotiations. You can even keep a car loan calculator app on your phone as part of the discussion to keep both numbers in front of you.

Insurance Costs

All cars are not insured equally. When you are examining your options for vehicles, remember that while your car payments will eventually end when you pay it off completely, your insurance payments are for the life of the vehicle. Luckily, you can get multiple quotes for car insurance for any vehicle you are considering within a few seconds from insurance comparison websites. Get two or three quotes for any vehicle you are considering, and keep that number figured in to your monthly budget.

New Vs Used

The first choice you make will probably be deciding if you want to buy a new car or used car. There are some serious advantages and disadvantages of each, so keeping both in mind can end up saving a lot of money in the long run.

Depreciation and Resale

Cars lose value over time, but not at a constant rate. As soon as you drive a new car off the lot, it usually loses about 15% of its value (just because it is no longer “new”). Cars also tend to lose value every year older they get, so by the end of your first year, your car could be down 30% of the sticker price.

On the other hand, used cars do not have the same “lot” problem. If you buy a used car and try to sell it the next day, you will probably get back about as much as you paid for it. Used cars also lose value over time, but the dollar amount of loss is lower.

Example

Take two car buyers. One buys a $30,000 car new, while the other buys the same car 3 years later at its fair market value. This is what the resale value of the car looks like if each of the owners hold the car for 4 years before trading it in.

We can look at the direct loss of value over time for each buyer as well:

The used car buyer is both saving $14,339.81 in the initial purchase price, but is also getting $9,203.37 less depreciation over the life of the car.

Financing Charges

On the other hand, new cars almost always have more flexible financing options than used cars, usually with much lower interest rates (nearly half!). This is important because used cars are so much cheaper. It is rare for a potential buyer to look at the exact same car and decide new vs used – instead, it is usually an inexpensive new car versus a higher-quality used car.

To find out how they balance, try out our Car Loan Calculator.

Reliability and Warranties

The biggest difference between a new car and a used car is basic reliability. A new car will always have a manufacturer’s warranty, which covers nearly all repairs, replacements, and any mechanical problems with the car for the first three years. Used cars usually have no or very little warranty, pushing all of the risk of a breakdown onto the buyer. There are many databases available to help gauge the risk of a used car purchase, like Dashboard-Light.

Before you buy used, it is also a great idea to take the car to a mechanic for a check-up. Spending a few dollars on an inspection is far cheaper than replacing a transition a few months later!

Technologies and Mileage

One of the main reasons why people choose new cars is simply the improved technology of cars built today versus cars built a year ago. The same model of car will have new and better features, like better crash resistance, better gas mileage. New technologies are also introduced, like electric motors and self-driving options.

These new features are what pushes most buyers to spend a bit more for the new cars. The new technology should enter your buying decision in two ways:

Directly Offsetting Cost

This is especially true for cars with better gas mileage, or electric motors. A small increase in gas mileage means it costs less to fill the tank every week, which adds up very quickly.

For 30,000 miles driven, a car with 30 mpg saves 1,200 gallons of gasoline compared to 25mpg!

Value of Technology

Finally, you can try to directly estimate how valuable the new technologies are to you. If you have a crushingly long commute every morning, you will probably put a high value on a self-driving car, allowing you to do other things. If you have a shorter commute, the technology is still valuable, but saves you less time and effort, so deserves less of your hard-earned cash.

Getting a Good Deal

When you are at the dealership, your main concern is always getting a good deal. One of the oldest tricks in the book for dealers is the 4 Square Presentation.

The 4 Square Presentation

A 4 Square Presentation divides your attention between 4 factors impacting the sale:

• Sticker price
• Trade-In Value of your current vehicle
• Down Payment
• Monthly Payment

The 4 Square Presentation does not need to be as bad as the video makes it look, but one of the main drivers is to keep your attention divided between those 4 areas instead of focusing on one at a time. Since many buyers come into the dealer focused on making sure the monthly payments can fit into their monthly budget, dealers will move around the other “squares” to get the monthly payment down to what you can afford.

Unfortunately, the 4 Square Presentation does not really focus at all on the items that you should be worrying about: both your Interest Rate and the Length of the loan are absent from the discussion, which is what really determines how much you pay over the life of the loan. There are a few ways to push the conversation back to the numbers that really matter.

Trade In vs Selling

Most people trade in their vehicle when buying a new one, and almost every dealership is happy to accommodate. However, you always have the option of selling your car yourself, which changes the nature of the discussion when talking with the dealer.

Resale Value

When you trade in your vehicle, the dealership will take your old car and either try to resell it themselves, put it up for auction for specialized used car dealers to pick up, or simply scrap it entirely and sell off any working parts.

How much you can get reselling your car yourself vs trading it in to your dealer will depend largely on its condition. If your car is in good condition and is a popular model, you will likely have no trouble selling it on your own quickly, and will make more money than if you trade it in. This is because the dealership needs to factor in the cost of selling your car when they give a trade-in offer. If they need to store it, clean it, and sell it, it takes some of their resources, which get reduced from your offer.

On the other hand, if your car is older with mechanical problems, trading it in might get you a better deal. It saves you the time of trying to sell it, and since the dealership already has established scrapping and resale networks, they will probably get a better price for the parts than you would alone. Even if you have an old junk car, your salesman will probably try to offer you a better deal just to get you to buy at his dealership.

Total Price

One of the main advantages of selling your car yourself is that it removes one thing from the negotiations when buying your new car – helping you turn the conversation back to loan terms and interest rates. This is why it is important to have the total budget in mind for how much you plan on spending on the vehicle in total, not just monthly payments. Keep focusing on lowering the sticker price first – get this in writing as a quote, then focus on financing.

Financing Options

You are not tied to financing your vehicle through your dealership. The only advantage of doing so is usually that they make it required for trade-ins (which is another advance of selling your car yourself). The financing is also where you need to be the most wary of your salesman.

Precomputed Interest

With most loans, you can simply increase your payments each month to pay off the loan sooner. This is usually not allowed with car loans that you get from the dealership, which use something called “precomputed interest”.

Precomputed interest means no matter how much you pay and how quickly, your total interest charge is fixed. This means there is no advantage of paying off your loan early, since you can never lower the interest payments.

Avoid precomputed interest loans whenever possible. Ask your dealer up front if their loans use precomputed interest. If they only have precomputed interest financing options, then simply take out the loan from somewhere else (like your bank). Since you already got the sticker price negotiated, you can get your financing from anywhere with better terms.

Get PersonalFinanceLab

This lesson is part of the PersonalFinanceLab curriculum library. Schools with a PersonalFinanceLab.com site license can get this lesson, plus our full library of 300 others, along with our budgeting game, stock game, and automatically-graded assessments for their classroom - complete with LMS integration and rostering support!

Learn More

[qsm quiz=155]

Challenge Questions

1. What are the advantages and disadvantages of buying a new car?
2. In your opinion, is having a new or used car better for you and why?
3. Using examples, what do you understand by the term depreciation?
4. If you are to lease or take out a loan to buy a car, how does the down payment affect your payments?
5. Would you rather have a bigger down payment and a smaller monthly payment, or a small down payment and a larger monthly payment?

“Spending Shocks” are large, irregular expenses. According to CBS, more than 60% of Americans cannot absorb a $500 spending shock: spending shocks are the #1 reasons why budgets end up abandoned, and being prepared for large spending shocks is the best thing you can do to keep your personal finances healthy.

Types of Spending Shocks

There are two types of spending shocks: Budgetable and Unbudgetable.

Budgetable Spending Shocks

A “Budgeted” spending shock is a big expense you might only see once or twice a year, but you know it is coming well in advance. This includes things like buying gifts for birthdays or holidays, regular trips to the dentist, and shopping for school supplies.

Budgeted spending shocks, in theory, are easy to manage, since you can include them in your monthly spending plan or budget. Unfortunately, most people do not revise their budget or spending plan each month, so even expenses that you can expect well in advance can really hurt.

Unbudgetable Spending Shocks

These are unplanned expenses that you do not see coming. This includes things like car repairs, fixing a broken computer, or replacing lost/stolen items. Unbudgeted spending shocks can be devastating if you are not prepared, since they also tend to be very expensive.

Preparing for Spending Shocks

In a perfect world, there would be no “budgetable” spending shocks, since these would already be in your monthly budget. We do not live in a perfect world, so we need to be prepared for these shocks to keep them from wrecking our savings goals.

Method One: The Rainy-Day Fund

The first approach is building your own “insurance policy” in the form of a rainy-day savings fund. This is a specific amount you can put into a separate savings account, and keep it topped up with something between $500 and $2000, depending on your income.

This account does not count toward your savings goal, nor should it be money used as part of your normal cash used day-to-day. Your goal for this fund is to keep the balance constant, acting as a cushion for spending shocks that break your budget, but before it can damage your savings. The idea behind the rainy-day fund is that you already know these spending shocks will happen, so you have an “emergency reserve” stash of cash that you can add into your budget if needed.

Once you get an unexpected car repair bill for $250 that you cannot absorb with your regular budget, you can withdraw the $250 from your rainy-day fund. Now, in addition to your normal monthly savings goal, you need to add that $250 back to your rainy-day fund to make it whole. Once you’ve replenished your rainy-day fund back to its constant level, your budget returns to normal.

Method Two: Emergency Credit Card

If you have trouble squirreling away cash, your next option is having a second credit card specifically for emergencies. This credit card may or may not even be in your wallet – you may instead keep it locked up in a safe place at home. This will help prevent its use for any impulse purchases.

If you do get hit with a spending shock that breaks your budget, you can take advantage of this credit limit to cover the balance. This works a bit like the inverse of the rainy-day fund – your goal is to keep this credit card’s balance at zero.

If you do need to use the emergency credit card, you should never make the minimum payments. Once you set aside your normal monthly savings and pay off your normal bills, use as much of the remaining cash as possible to pay off your emergency credit card. This not only helps prevent interest charges, but it also restores that credit limit in case of another spending shock.

Method Three: Borrow from Savings

The last, and worst, method is borrowing directly from your savings to pay for the spending shock. In this case, if you are hit with a big spending shock, you make a transfer from your savings account to your checking account to pay it off. In the next few months, you pay back this loan, in addition to your normal monthly savings.

This works like the rainy-day fund, but without separating the “emergency cash” from your normal savings. This is a more dangerous method because it lets you avoid “paying yourself back”. Making withdraws from your regular savings account should be avoided whenever possible because it is so easy to forget how much you need to return, and on what time schedule. With the rainy-day fund or using an emergency credit card, you will always see the exact amount you need to pay back, which helps stick to the plan. Withdrawing from your savings directly just lowers your nest egg, and you may not realize the full impact until many years later.

Avoiding Spending Shocks

You can avoid most spending shocks with a bit of planning. By taking 20 minutes each month to do a basic account reconciliation and taking a look at your receipts, you can update your budget or savings plan and know exactly what shocks are coming soon. Getting any “budgetable” spending shocks figured in to your normal budget is a great way to stay on top of all your finances.

You can never truly prepare for the unbudgetable spending shocks, but taking a few minutes every couple of months to just check the status of things you own can help. If your car is making a weird sound, it will be a lot cheaper to budget in a mechanic check-up next month than it would be to pay for an emergency repair. If you own your home, taking a few minutes twice a year to check the roof for leaks will be far cheaper than finding mold and having to gut half the house.

Think of some of the most devastating spending shocks that could happen, then schedule appointments for yourself in your calendar to give yourself a check-up. Preventing emergencies is always cheaper than fixing them later!

Get PersonalFinanceLab

This lesson is part of the PersonalFinanceLab curriculum library. Schools with a PersonalFinanceLab.com site license can get this lesson, plus our full library of 300 others, along with our budgeting game, stock game, and automatically-graded assessments for their classroom - complete with LMS integration and rostering support!

Learn More

[qsm quiz=153]

Challenge Questions

• What do you understand by the term Rainy-Day Fund or otherwise known as an Emergency Fund?
• How would having a Rainy-Day Fund be beneficial for you and your family?
• Opportunity costs, is the cost of choosing one thing over another. How might this concept benefit you when spending?
• How might regular budgeting and spending assessment help you with your cash flow and savings?

Building your personal finances from the ground up is something most of us face.  You may already have faced times when you had very little or no income, and you were just trying to get to a point where you felt like you didn’t have to worry about paying your bills.  It can be a long struggle, and the government recognizes that.  That’s why there are several public programs specifically designed to help people get out of these situations.

In the real world, many people suffer for months simply because they do not know that help is available. These programs exist for people who have lost their jobs and for people who have jobs but still earn very little income.

Unemployment Insurance

Unemployment insurance is a program run between the state and federal governments. Every state has an unemployment insurance program, but the rules regarding unemployment assistance vary from state to state. 

Whenever you work for a company, that company pays unemployment insurance as part of the cost of hiring you. The employer pays 100% of the cost, and this item will not appear on your paycheck.

Unemployment insurance provides funds for people who have lost their jobs, as long as they can show a clear effort to look for new work.

Eligibility

If you are responsible for supporting yourself and your household and have worked for at least 3 months in the last year, you will probably be eligible for some unemployment benefits if you lose your job. Unemployment insurance is designed to fill a financial gap for individuals who are between jobs.  It is not an income substitute for permanent assistance, so there are some strict eligibility requirements.

Reason Leaving Work

Unemployment insurance is designed specifically to help people who were laid off. You get laid off when your employer does not have enough money to keep paying you or does not have enough work for you to perform.  This means you usually cannot claim unemployment benefits if you voluntarily quit your job.

Sometimes the line between getting laid off and fired can be a bit blurry too.  The general rule is that if you get fired from your job due to misconduct (i.e. deliberately hurting the company, or breaking ethics codes), you are not eligible for unemployment benefits. However, if you get fired simply because you were not good at your job and your employer wanted to replace you, chances are you can still receive unemployment benefits.

Number of Weeks

Under normal circumstances, you can claim unemployment benefits for up to 26 weeks. During economic recessions, the 26-week limit could be lengthened. There is also a cap based on how long you’ve been working.  If you were only working for a short time before you were laid off, you can only get unemployment benefits for as long as you were working.

Availability Requirement

To receive unemployment benefits, you must be able to work and must be actively looking for work. If you get a reasonable job offer while on unemployment, you should take it, especially if your benefits are getting ready to expire. Your local unemployment office will usually call you every week to verify you are still looking for work.  Some states have you create an online account and update weekly your job search efforts.

Legitimate Work

The job you were laid off from must have been a legitimate job, meaning it was a normal job where you received regular paychecks and taxes were withheld and reported to the government.  If you were paid in cash or your employer did not report that you were hired to the government, then you will not be able to receive unemployment benefits. Remember, unemployment insurance is insurance. Someone needs to pay the insurance premiums, so if your employer is not doing that, you cannot collect any benefits.

Benefit Amount

When your unemployment claim has been approved, you will get a check each week, usually between $200 – $400. Some states now use reloadable cards instead of checks to pay your benefits.  This is a safer and easier method to use.  The amount of unemployment benefits you receive is based on a few factors including

• How much you were earning before you were laid off
• If you have children or not
• Your state’s benefit cap

Any benefits you get from unemployment insurance is taxable, just like regular income. For all tax purposes, your unemployment benefits act just like a paycheck from a job.

Part-Time Work

If you work part-time, you will not automatically lose unemployment benefits. However, your benefits will be reduced by whatever you earn at your part-time job.

Applying for Benefits

The process of applying for benefits varies greatly by state, but it usually just requires an online application. You can find some help by clicking here.

SNAP Food Assistance

The Supplemental Nutrition Assistance Program (SNAP) is a program designed to help low income individuals and families pay for groceries.  It is formally known as the food stamp program. 

Eligibility

The SNAP program is open to all Americans whose income is below a certain level.  The limit is based on household income, not individual income.  This is important because the majority of recipients utilizing the SNAP program are children. The income threshold increases in proportion to the number of people in the household.

A single person living alone needs to earn less than $1000 to be eligible, but a family of 4 can earn a bit over $2000 per month and still receive benefits.

There is also a work requirement for SNAP benefits.  Any able-bodied adults in the household must work or be enrolled in a skills training program designed to help them find a job. If you are not working and are not in a training program, there are programs that allow you to do volunteer work for the state in order to be eligible for benefits.

Enrolling

The process to enroll for SNAP benefits is more difficult than collecting unemployment insurance. Since SNAP is a state-based program, the process will be different from state to state.  You will generally need to first apply online, and then complete an in-person interview so a case worker can assess your situation. The case worker will determine if you are eligible and the amount of benefits you will receive.

Collecting Benefits

If you are enrolled in the SNAP program, you will get an EBT Card.  The card works like a pre-paid debit card at all participating grocery stores. There will be one EBT card issued per household, and its balance will reset each month.

EBT cards are only accepted at grocery stores and not everything sold in the store is eligible to be paid with SNAP benefits.  SNAP benefits can only be used for healthy foods, so junk foods and some pre-made meals may not count.

Medicaid

Medicaid is the single largest provider of health insurance in the United States. It is designed to provide medical coverage for low-income individuals and families.  There are about 72 million people enrolled in Medicaid at any time. A subset of Medicaid called CHIP (Children’s Health Insurance Program) is specifically for children.

Eligibility

Eligibility is based on household income. The income threshold differs by state and it usually changes each year.  Children from low income will almost always be eligible for either Medicaid for CHIP benefits.

Enrolling

You can enroll in Medicaid through  the Healthcare.gov website.  The website will also provide assistance to help you determine the specific eligibility requirements for your state.

Housing Assistance – Section 8

If you are having trouble finding an affordable place to live, you can apply for housing assistance through the “Section 8” program (named after Section 8 of the Housing Act of 1937).

Section 8 provides housing vouchers to help pay rent and utilities for low income individuals and families. These vouchers can be used either at a “housing project,” a building built and designed to accommodate low-income persons, or with any participating landlord who accepts Section 8 vouchers.

Eligibility

Eligibility is based on income, but unlike the other programs, it is based on the median income of the area where you are living. If your family’s income is less than 30% of the average income in your area, you are given priority. Some vouchers are available for families earning less than 50% of the average, but these housing units typically have extremely long waiting lists, some as long as 5 years.

Even if you are eligible for Section 8 housing, there are a limited number of vouchers available each year. The government determines a budgeted amount for Section 8 assistance each year. This means that even if you do qualify, you may need some luck to get a voucher.

Benefits

The voucher covers most of your rent and utilities, with two limitations. First, you pay 30% of your net income to the landlord.  (This 30% is charged regardless of what your income is or what the total cost of rent and utilities are). The voucher will then kick in and pay the remaining amount, up to a cap.

The cap for benefits is based on the fair market value of housing in your area.  This means that vouchers in New York City (where rent is considerably higher) will have much higher caps than in Knoxville, Tennessee. Your cap increases depending on your household size, but there is a maximum of $2000 per month.  Families with children have higher caps than single people living alone,

If you are in a situation where your income is low, taking advantage of some or all of these programs can go a long way in helping make ends meet.  And they will allow you to spend time and effort focusing on improving your skills and increasing your income.

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This lesson is part of the PersonalFinanceLab curriculum library. Schools with a PersonalFinanceLab.com site license can get this lesson, plus our full library of 300 others, along with our budgeting game, stock game, and automatically-graded assessments for their classroom - complete with LMS integration and rostering support!

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[qsm quiz=152]

Challenge Questions

1. What do you understand by Unemployment Assistance?
2. Do you think it is a good thing?
3. How can it help families?
4. Using any resources available to you, list 5 programs of assistance that are available for unemployed and families in your area.

If you know something about personal finance, you understand how complicated it can be to make sure all bills are paid on time, that you are fully insured, and that your credit is healthy.

Juggling the different aspects of your finances usually means savings and investing takes a back seat to everything else on your plate. This is one of the reasons why so few people under the age of 35 have any real savings. Luckily, there is one easy technique you can use to make sure your savings are always growing:  Pay Yourself First.

Savings First, Bills Later

Most people start the month by paying all their bills, budgeting some cash for having fun or buying something extra, and then finishing by putting any cash remaining into savings. When you use the pay-yourself-first model, the order of these steps is flipped.

Here’s how it works.  On every payday, start by taking out money for savings and put it directly into your savings or investing account. Most banks have accounts that will let you do this though automatic transfers.  This is one banking service that you should definitely take advantage of.

Once your savings is taken care of, use the remaining cash to pay your bills.  Any money remaining can be used for fun and leisure. This method is a no excuses savings approach.  No matter what else is happening in your life, you are paying yourself by contributing to your savings.  This habit ensures that your savings and investments experience a steady growth rate.

Pay Yourself First in Action

Here is how it works:

1. Set up automatic transfers from your checking account to your savings account every month, ideally just a day or two after you normally get your paycheck. This is the paying yourself step.
2. Pay your rent, credit cards, and any other bills for the month.
3. The remaining cash is “free”. Use this for going out with friends, buying something you want, or contributing even more to your savings.

Why This Is Important

You already know the importance of having a well-developed budget or spending plan. The downside is that these require constant vigilance. On a regular basis, you should be using your receipts and account reconciliations to adjust your spending plan to match your actual spending. In the real world, very few people follow through on this for more than a few months at a time, even with the best intentions.

By always setting aside savings before dealing with any other expenses, you will ensure that it will be growing, regardless of what happens to anything else. This is the most effective way to save since it means you cannot “cheat”.

Do I Still Need a Budget?

Using a “pay yourself first” savings strategy is not a replacement for maintaining an up-to-date budget or savings plan, but it will make the process much easier.

Without this strategy, your budget or savings plan requires time and attention. You need to account for your income, keep an itemized list of your bills, budget for food and groceries, and finally see how much is left over for savings.

By paying yourself first, you no longer need to worry about setting aside money for savings.  This is done automatically before you have to think about the rest of your budget. Simply knowing that you are automatically building a large savings cushion to deal with emergencies, such as unplanned car repairs, lifts a ton of stress from your shoulders.

Best of all, since you know that your savings is already accounted for every month, your leisure spending will be guilt-free, so long as you use cash and avoid making too many purchases on your credit card. Your budget or savings plan is transformed from a task master, dictating what you can and cannot do each month, to a partner. Updating your budget will be easier since you no longer need to worry about having enough money left over to save.  If you want to increase the amount of money you are saving, you simply need to increase the amount of your automatic transfers.

How Do You Pay Yourself First When Cash Is Tight?

Paying yourself first makes sense if you have a balanced monthly budget, but what happens if you are behind on your bills?

With a pay-yourself-first savings strategy, your savings always comes first. This means dipping into savings is almost entirely off-limits. By following this strategy, you would rather pay a bill a month late than take money from your savings to pay it off.

This is also why the strategy works. The amount you save each month is entirely off-limits for any other type of spending. The only exception is if you are severely behind on debt payments and have no other options.

Cutting Spending

Building this mentality of “save first” is important. Everyone wants to save, but often people treat a savings account as just another source of money.  For example, people want to avoid credit card debt, so if there is something they want to buy, they know it might be irresponsible to buy the item on credit.  Instead, they will just dip into their savings since that money is already theirs.

This is dangerous thinking because withdrawing from your savings is a loan. You are borrowing money from your future self.  Unlike a credit card with required monthly payments, you are unlikely to pay back this loan to yourself, damaging your long-term wealth. By adopting a pay-yourself-first strategy, it removes spending decisions. If you really want to buy something today, use your credit card. If you do not want to incur the finance and interest charges from the loan, then re-evaluate if the purchase is really worth it!

Making Pay Yourself First Work

One way to make pay yourself first work is by keeping less of your savings as cash.  This helps prevent withdrawing cash unless it can’t be avoided.

One of the best ways to do this is by converting a high percentage of your savings into investments like stocks, bonds, and mutual funds instead of simply having cash sitting in your savings account. By moving your savings into investments, you kill two birds with one stone.

Less Liquid Savings

A “liquid asset” is something that can be quickly and easily converted into cash and spent. Savings accounts are extremely liquid assets, which is why some people have a hard time building up their savings fund: cash can be spent. By converting a large percentage of your savings account directly into investments like stocks, bonds, ETFs, and mutual funds, there is an extra step you’d need to take before the cash could be spent. Since you would need to sell your assets first in order to spend the cash, you are less likely to do so unless the spending is extremely important to you.

Making Money Work

Another advantage with turning savings into investments is that invested money will, on average, grow much faster than money in a savings account. Instead of receiving only 1-2% of growth from a savings account, you could see returns of 8-10% by investing in index funds or diversified mutual funds. Investments will help your savings grow much more effectively.

Skin in the Game

When you purchase investments, your brain reacts just as it does when you pay a bill.  Your mind sees this as “spent money,” not money that can be used to make purchases.  As your investment portfolio grows, it becomes exciting to watch your money grow, and you will be paying closer attention to how your money works for you.  This encourages increased saving and investing. Over time, this helps build a nest-egg of wealth you may have otherwise simply spent.

When Should I Use My Savings?

A pay-yourself-first strategy includes a mindset of making withdrawals from your savings account as infrequently as possible.  However, there may be times when making a withdrawal is beneficial.

It is okay to make withdrawals when

1. Investing in a physical asset, like buying property or a vehicle
2. Investing in a paper asset, like stocks, bonds, or mutual funds
3. Starting a business
4. Paying off big debts, like student loans or a mortgage

You should not make withdrawals when

1. You want to make a purchase you “deserve” but don’t have the cash for
2. You experience an emergency which will take fewer than 3 months to pay off without dipping into your savings
3. Buying holiday and birthday gifts.  (Making these purchases should be part of your normal spending plan or budget.)

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This lesson is part of the PersonalFinanceLab curriculum library. Schools with a PersonalFinanceLab.com site license can get this lesson, plus our full library of 300 others, along with our budgeting game, stock game, and automatically-graded assessments for their classroom - complete with LMS integration and rostering support!

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[qsm quiz=148]

Challenge Questions

1. What do you understand by the concept Pay Yourself First or sometime known as Save first, before you spend?
2. How might this help you budget?
3. If you were going to start Paying Yourself First today, how would you go about it?
4. What are the advantages of Paying Yourself First?

If you find yourself over your head in debt, there is always a light at the end of the tunnel. Credit counseling agencies, both for-profit and non-profit, exist in every state to help people build a clear, workable path back to a healthy personal financial situation.

If you do need the help of a credit counselor, this is what you can expect.

What is Credit Counselling?

Credit counseling is a service offered to help people bring their personal finances under control. A large part of what credit counselor involves is purely educational, usually with many free resources available. Just like your health, big problems are best addressed with prevention before the problem gets out of control. If you are reading this, you are already working through some course work that would be similar to what would be offered by a credit counseling agency.

Unfortunately, most people reach out for help only after debts start to spiral out of control. At this point, you will need to meet one-on-one with a credit counselor to chart a path forward and get yourself out of debt.

There are three main tools applied by credit counseling agencies before bankruptcy enters the discussion: budget building, debt management planning, and debt settlements.

Who are Credit Counselors?

Credit counseling is loosely regulated by FINRA, the Financial Industry Regulatory Agency, which sets rules for what can be advertised and advised. Reputable credit counselors have a professional certification, usually through the NFCC, the National Foundation of Credit Counselors.

There are both for-profit and non-profit credit counselors.  The NFCC usually works with non-profit institutions. The cost of getting credit counseling will vary from agency to agency, but it usually starts with a flat fee for your initial consultation, plus a percentage of the total debt settled if you require more help.

Budget Building

Building a budget is the first step when working with a credit counselor. You will usually sit down for a 1 or 2 hour meeting to discuss your current financial situation. This includes reviewing your total debt load, income, expenses, and how you are currently spending your money.

our counselor will review your financial information with you and recommend some educational materials or courses that present some advanced techniques for discharging your debt as quickly and cheaply as possible. They will also work with you to build a new budget based on what you can afford.

How Is This Different from My Own Spending Plan?

If you already have a strong budget or spending plan and have simply fallen behind on payments because of emergencies or income loss, this step of the process may not tell you more than you already know.

Statistically, most people do not have a budget or a spending plan in place that gets reviewed and updated with any regularity. One of the biggest advantages of speaking to a credit counselor is that this is a completely unbiased third party who is working to get you out of debt. The counselor will help create a stronger budget, based purely on facts and figures, not influenced by emotion or panic. Working with a certified credit counselor is also a good way to learn about tax incentives, subsidies, or other debt relief programs in your state that you may not be aware of.

Debt Management Planning

If your debt problems cannot be addressed by revising your budget, the next step is creating a debt management plan.

With a debt management plan, your credit counselor will work directly with most of your creditors, usually excluding secured loans like mortgages and car loans. Your credit counselor will negotiate to get as many late fees and finance charges waived as possible and will set up regular monthly payments to pay off the debt.

Instead of paying your creditors directly, you now make one monthly payment to your credit counseling agency, who then distributes that payment to each creditor according to the terms they negotiated.

Debt Management Plan and Debt Consolidation

Debt management planning is superficially like debt consolidation, where you take out one big loan to pay off many smaller debts. Debt consolidation is often also part of the credit counselling process, and your credit counselor will be able to help decide if it should be part of your payment plan.

When you work with credit counselors, their goals are to help you repay your debt as fast and cheaply as possible. They usually discourage taking out additional loans, unless that is the only option available to preserve your credit rating.

Advantages of Debt Management Plans

In theory, your debt management plan will not be very different from something you could build yourself, if you are able to successfully negotiate with your creditors.  However, it does have some distinct advantages:

• Experienced Negotiators. Your credit counselor is a professional credit negotiator, and so he/she knows the right buttons to push to get your fees lowered as much as possible.
• Relationship with Creditors. Your credit counselors already have established channels of communication with most creditors, so they know exactly who to talk to in order to get things moving forward. This can include things such as changing payment due dates to get everything all on one schedule.
• Leverage with Negotiations. When your credit counselor is in contact with your creditors, your creditors know that you are in a tight spot financially and are not making up some story over the phone. Your creditors are not interested in driving you into bankruptcy, since that means they do not get paid. They usually are more flexible when negotiating with credit counselors compared to when you speak with them directly.
• Clear Reporting. Your credit counselor will send you monthly reports about the exact status of all your debts, including how quickly each is being paid off.
• Lower Total Payments. In the lesson on juggling bills, we showed that it can be cheaper to pay off some bills completely instead of making minimum payments on everything. Your credit counselor knows this too.  He/she will optimize the payment schedules to pay off the most expensive debts the fastest, minimizing the total amount you need to pay.

Restrictions of Debt Management Plans

Debt management plans are not always a simple solution, and they may require some tight restrictions on what you can and cannot do.

• No New Credit. When you enter a debt management plan, it appears on your credit report. (It doesn’t affect your credit history or your credit score.  It just shows that you agreed to a debt management plan.)  This serves as a warning to creditors that you should not be extended any new credit. If you do get a new line of credit anyway, your credit counselor will terminate your debt management plan, putting you back at square one.
• Cancel All Credit Cards. Most household debt that requires credit counseling comes from credit cards. Debt management plans require you cancel all open credit cards and stipulate that you cannot open new ones until your current debt is paid off.
• Tricky Relationship with Creditors. Just because you are using a debt management service does not mean your creditors will stop calling. Once you are on a plan, most credit counselors will advise you to cease all communication with your creditors.  If one calls, you should provide the creditor with the credit counselor’s name and number and let him/her handle it. If you do speak with your creditors and say something that conflicts with the negotiations your counselor has been working on, it could sink your whole plan.

Debt Settlement

If your level of income will not allow you to pay off your debt reasonably by using a debt management plan, the next step is debt settlement. With debt settlement, your credit counselor will set up a monthly payment plan for you, but instead of paying your creditors, the money they receive from you goes into a separate savings account.  Then the counselor enters into “hardball” negotiations.  The position they take with your creditors is that you are on the verge of bankruptcy, and your creditors can either reduce the total amount owed to something you can afford or risk not getting paid at all if you go bankrupt. Once your creditor and your counselor come to an agreement on that new lower amount, your creditor gets paid from that savings account you have been paying into.

Advantages of Debt Settlement

Debt settlement is the end of the road when it comes to paying off your debts. The only step farther is declaring bankruptcy.

The major advantage debt settlement has over a regular debt management plan is that the total amount you must pay will be significantly reduced. This includes reducing or eliminating the finance charges.  It can also reduce the principal owed.  No other non-bankruptcy solution will reduce your principal owed. At this point, your creditors are trying to take whatever they can get, hoping to not be left with zero dollars in payments if you go bankrupt.

Disadvantages of Debt Settlement

Every other debt management solution works to preserve your credit rating, keep your creditors happy, and keep your budget on track. Debt settlement does not. It comes with some unique disadvantages, making debt settlement your last option.

• Immediate Damage to Your Credit. With debt settlement, you immediately stop paying all creditors while the negotiations are in progress. This means your creditors will immediately start reporting you as delinquent on all of your accounts. This will do a lot of damage to your credit.
• Long-Term Damage to Your Credit. Your credit report shows one of three statuses for each of your credit accounts:  OK/Paid, Late/Delinquent, and “Settled.” A “settled” status means the amount owed was discharged through a debt settlement negotiation. This is better than an unpaid account, but it is nowhere near as good as “OK/Paid”. This will remain on your credit report for at least 7 years.
• Increased Harassment. Your creditors will not be happy when you stop making monthly payments, they and will try to bounce claims off you and your credit counselor at the same time, trying to “catch” inconsistencies in the way you are managing your debt.  This will improve their bargaining position. Your credit counselor will usually advise you NOT to answer your creditors at all while debt settlement negotiations are in progress.
• Credit Restrictions of Debt Management. You will be required to close your credit cards and will be prevented from opening new lines of credit while the negotiations are in progress.

Predatory Credit Counselling Services

If you enter debt settlement proceedings, your credit counselors will usually be paid a fee based on a percentage of the total amount of debt that they are able to get “cancelled”. For example, if they negotiate a $1000 debt down to $700, they may charge you $150 as a fee for the service.

For large debt loads, this can be a real money-maker. This opens the door to potential predatory practices. A predatory credit counselor will usually advise debt settlement as a first step, or suggest it before exploring other alternatives. There are plenty of cases where debt settlement is the best option, but if it is the first suggestion, you should get a second opinion.

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This lesson is part of the PersonalFinanceLab curriculum library. Schools with a PersonalFinanceLab.com site license can get this lesson, plus our full library of 300 others, along with our budgeting game, stock game, and automatically-graded assessments for their classroom - complete with LMS integration and rostering support!

Learn More

[qsm quiz=144]

Challenge Questions

1. What do you understand by the term credit counselling?
2. Using the internet, research the two credit counselling bodies mentioned in the text, providing an overview of what they do and how they help people?
3. What restrictions do people take when addressing their debt?
4. What are the advantages and disadvantages of debt settlement?

If you start falling seriously behind on your bills, simple prioritization and negotiation may not be enough to help you catch up on your debt.  Even in this situation, you still have some options available to keep your finances under control.  One of the most straight-forward options is debt consolidation.

When to Consider Debt Consolidation

Most adults have at least half a dozen creditors, such as credit card companies, banks for a mortgage, car loan providers, student loan providers, and basic utility companies. If a unexpected event occurs, such as losing your job, you may start falling behind on payments for several creditors all at once.

Prioritizing your bills and negotiating with your creditors can get most people through tight money situations for a month or two, but it can only work for short periods of time.  After a couple of months, even the savviest negotiators will find themselves getting stuck with mounting late fees, finance charges, and angry calls from creditors. Each late payment also affects your credit score, which will hurt your chances for getting other lines of credit in the future.

What It Means to Consolidate Debt

This is where debt consolidation comes in. Consolidating your debt means taking out one big loan and using that money to pay off all outstanding balances from your previous loans.

While taking out a new loan may not seem like such a good solution, there are several reasons to consider a debt consolidation loan when you find yourself in hot water.

Preserves Your Credit Rating

Every time you make a late payment on your credit card or on another loan, your credit rating will take a hit. Miss enough payments and you will have a very hard time securing any loans, even years later.

On the other hand, if you consolidate your debt and pay off your consolidation loan quickly, your credit rating can actually improve. Paying off all the outstanding balances means no more negative reports on your credit history. Debt consolidation acts like any other loan.  Making payments on-time will boost your credit rating.

Keeps all your creditors happy

Remember: the most important concern for any of your creditors is that they get paid, and the sooner the better. Consolidating your debts quickly and getting all outstanding balances paid off builds goodwill with your creditors. This means they will usually be more flexible in the future if you hit another rough patch because they know you will come through.

Lowers Your Payments

Once all your outstanding balances are paid off, finance charges and late fees are gone too. This means the amount due each month is just a single payment towards the principal and interest, the same as for any other loan. The interest rate on consolidated loans is almost always lower than the late fees and finance charges you will get from each of the individual outstanding balances.

What this means for you is that a consolidated loan will keep your credit healthy and growing, and it will lower the number of monthly payments required to pay off the same principal in debt.

How to Consolidate Debt

Consolidating debt means taking out a loan to pay off other outstanding balances. Like all loans, there are two main types to consider:

Unsecured Loans

Getting an unsecured debt consolidation loan is very rare. Most creditors are very wary of people who need debt consolidation loans because it means they have already let their debts get out of control.

One unsecured loan type to consider is simply using your credit card to pay off all other balances.  This will require you having a sufficient credit limit on your card. If you already pay most of your bills using your credit card, you are consolidating your debts without even realizing it. Many people prefer this simply to keep all their payments in one place, making them easier to track.

The biggest downside of using credit cards or other unsecured loans to consolidate your debt is the finance charges. Unsecured loans almost always charge higher interest rates. This means you might not be saving much money by consolidating everything on your credit card rather than just making minimum payments.

You also cannot use your credit card to pay off other credit card debt. If credit card debt is one of your problems to begin with, you probably will not be looking at unsecured loans for consolidation.

Secured Loans

Most types of debt consolidation loans involve a secured loan, usually a home equity loan, also called second mortgage. This means you will use the equity built up from your home to take out a new loan. The amount of debt you can consolidate is dictated by how much equity you have to use as collateral. If your debts are greater than the equity you have built up in your home, you are considered insolvent.

If you are a renter, you won’t have a home equity loan as an option.  However, there are some types of secured loans that use your car or other property as collateral. Unfortunately, these usually fall under “Payday Loan” or “Pawn Shop” type lenders, which can charge excessively high finance charges. Taking these types of loans is more likely to drive you farther into debt than to help pull you out. If you are not able to find any other type of consolidation loans, you should investigate credit counseling services.

Risks of Consolidating Debt

Debt consolidation is not a “get out of debt free” card. You are simply using existing credit lines and equity to pay off a temporary hardship and preserve your credit rating.

Risks with Unsecured Loans

If you simply transfer other outstanding debts onto your credit card, you now must grapple with your new credit card debt. Credit cards typically charge fairly high interest rates compared to secured loans, which means the interest you pay will still be very high.  The interest charge itself could be nearly as much as you would be paying in late fees, but you would not be hurting your credit rating.

If you can only afford the minimum payments on your credit card, you are stretched dangerously thin.  Any other financial emergency could force you into default.

Risks with Secured Loans

Consolidating your debt with a secured loan is cheaper than using your credit card or an unsecured loan. This makes this type of loan a more attractive option, but it comes with its own serious drawbacks.

First, you are wiping out your equity. This means all the value you have been building up in your mortgage (or any other property used as collateral) is gone.  You will need to completely pay off the consolidation loan to get it back.

Second, your finances are still stretched very thin. Missing your payment on a consolidated secured loan is the same as missing a payment on your primary mortgage.  It could put your whole house into default and trigger foreclosure proceedings.

Taking Action

If you are in a position where you cannot juggle your bills or negotiate a 1-2 month extension with some creditors, you need to take action quickly in order to get out of debt and keep your finances healthy.

Consolidating your debt is often one important part of that process, but it is not a decision to make without consulting experts.  If you are considering consolidating your debt, speak first with a not-for-profit credit counseling agency to fully explore your options. Debt consolidation is usually one action taken as part of a larger personal finance plan, not an action to be taken on its own.

Any time you are working with debt, the clock is ticking. It is always better to ask for help sooner rather than just panicking later.

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[qsm quiz=142]

Challenge Questions

1. Using examples, what does it mean to consolidate debt?
2. What are the advantages of consolidating debt?
3. Are there any disadvantages to consolidating debt?
4. What is the difference between a secured and unsecured loan?
5. What are the current loan rate percentages being offered in the market place today for a loan of $10,000 over 3 years?

It happens to everyone: a monetary emergency happens, such as a car breakdown, draining your bank account. Bills are still coming in, and you know that you will not have enough money to pay for your debt obligations this month.

One of the first goals when developing a strong personal financial plan involves avoiding these scenarios by having a savings cushion, but this is not always possible. How can you get out of this situation with the least pain?

Example Scenario

For the examples in this article, we will assume that you have enough groceries for the month, you have $1000 in your checking account, and your next paycheck is a month away. You just received all of your bills today:

 The total of all these bills is $1630 – way above what you can afford. Instead of getting worried or depressed, develop a plan of action.

Evaluate the Damage

The first step is to take a look at what will happen for each of these bills if they are not paid. This is a good way to prioritize which bills to tackle first.

• If your rent is unpaid for one month, you will get charged a late fee, but you probably won’t be evicted.
• Utilities usually cannot be turned off unless there are several months in a row of failed payments.
• Your internet connection probably will take a month or two of failed payments before your service provider shuts it off.
• If your cell phone bill is unpaid, your provider most likely will shut off your phone within a few days.
• Missing a credit card payment will not automatically put you in default, but you have a high interest rate and a late fee to deal with. Plus missing a credit card payment can really hurt your credit. This also applies to your car loan.
• Missing your student loan payment can put you in default fairly quickly.  This is the stickiest kind of debt.  Not even bankruptcy will remove it.
• Missing a payment on your car insurance might void your policy. And if you lose your insurance, you can no longer legally drive to work.
• Missing your health insurance payments might also void your policy, although there are some protections against this, and getting back on the plan might be expensive.

By knowing those facts about your different bills, now we can make a “ranking” of how important it is to keep each one of your creditors happy in the short term:

This priority will shift a lot if you are facing multiple months of being behind on your bills. For example, if you are under direct threat of eviction, rent might jump near the top of the list.

Explore Your Options

Next, spend a few minutes to think about any other ways you can scrounge up enough cash to make all your payments this month. We discuss this in detail in our article on Short-Term Financing.

Borrow from Friends or Family

Borrowing money from friends or family members might be able to help bridge the gap. This is usually the cheapest and easiest way to get money to pay your bills, but many people are uncomfortable or unable to borrow money from the people they know.

Credit Card Financing

One option is to pay off your credit card first and then use the line of credit available to pay off all your other debts. You could then pay off the credit card balance with your next paycheck. This is the second fastest and easiest method. This will keep all of your creditors happy, and you will not accumulate much interest before your next paycheck, making this the least expensive option available.

Short-Term Unsecured Loans

A short-term unsecured loan is the type of loan you can ask for at a bank. Whether it is granted or not depends on your credit history, the amount you need to borrow, and the policies of the bank itself. If your bank offers you a loan, this is another workable solution. (This is NOT a payday loan. See our article on Short-Term Financing to tell the difference.)

Divide Your Paycheck

In the real world, dividing your paycheck is the most common course of action if the first 3 options fail. Some of your bills are completely non-negotiable and will cause major problems if you cannot make the monthly payment.  Pay those first.  Then for the remaining bills, divide up your paycheck proportionally and hope your creditors do not complain too much until next month.

Pay Off What You Can

Paying off only what you can also happens in the real world, but is more rare. When using this method, instead of dividing up your paycheck proportionally, you pay off several of the bills in full, leaving others to be completely unpaid until next month. The creditors you do not pay off hate this.  You may get angry phone calls or letters, and it could seriously hurt your credit.

Take Action

If you can borrow some cash, use your credit card, or get a line of credit from your bank, that will be the way to go. If not, you will need to determine which hurts less: dividing your paycheck or paying off what you can.  Let’s take a look at how this works.

Step 1: Subtract the Non-Negotiables

The top 3 things on our list are non-negotiable.  Any lapse in the bills will cause termination of your service entirely.

Non-Negotiable Bills = Health Insurance + Car Insurance + Cell Phone

= 250 + 30 + 50

= $330

We know that no matter what, we need to spend this $330, leaving us with $670 in cash for the remaining bills.

Step 2: Calculate Extra Costs Charged for Unpaid Bills

We want to decide if we are diving our $670 proportionally, or paying off a couple of bills entirely. To see which is best, we first need to know how much extra cost will be applied to the remaining bills if we wait until the next paycheck to make a payment

 $1,300 in bills today will grow to $1,549 next month if unpaid, or $249 more than it would be if we could pay everything today. We can see the biggest hits are coming from rent and credit cards.

We are not getting charged extra for missing payments for the student loan and the car loan, but missing a payment will damage our credit history, and we will accumulate more interest on the principal balance. We will estimate the damage to our credit history being $60 each for the credit card, student loan, and car loan payments.

There is also a chance that our landlord and utility companies will report the missed payments.  We will assume there is about 1/6 chance, so we will estimate a “credit damage” amount of $10 for each of those bills.

This means the total damage done by missing every payment this month is $459.

Step 3: Calculate Cost if Paycheck Is Divided

Next, we want to see what our cost will be if we divide our paycheck proportionally. This means we are not paying any bill in full.  We are looking at the proportion each bill represents of the total amount we owe, and dividing our paycheck accordingly.  We will still get charged late payments and some interest. However, we will assume that there will be 1/4 the amount of damage to our credit for a partial payment compared to making no payment at all.

 We are paying $150 in late fees alone. Now we factor in the interest charges and damage to our credit that goes with this payment:

To calculate how much this is costing us, we can add together our total late fees, total interest charge, and total damage to our credit:

Total Cost = Late Fees + Interest Charges + Credit Damage

= $150 + $53.57 + $52.50

=$256.07

The total damage is $256.07, which is just $202.93 better than paying nothing at all, but still a big amount.

Step 4: Compare with Paying Off Big Credit Debts First

What if instead of dividing up our paycheck equally, we just pay off what we can afford, and leave the rest? To prioritize, we can take our $670 remaining, go down the list of priorities, and simply pay them off.

 Now we have an unhappy landlord and an unhappy internet service provider, but our other bills are paid. We can now compare this option to how much damage skipping these bills entirely would do:

This gives us a total damage of $149.50, saving over $100 compared to dividing up our paycheck equally. We even still have $50 remaining.  Applying the $50 to the internet or rent bill would remove some of the credit damage and the interest charged, saving even more money.

Our calculations show that paying off most bills completely and leaving a few unpaid will be better dollar wise.  You will save money on late fees, interest charged, and damage to your credit.  However, the reason most people still divide up their paycheck and pay a little to each creditor when faced with a cash shortage is due to the human factor.  Every creditor who is not paid will send you emails and make phone calls as soon as your payment is late, demanding payment as soon as possible.  So people try to minimize the damage from each creditor instead of focusing on minimizing the damage from every creditor. By keeping the big picture in mind, you will do your spending plan a huge favor!

You can download a spreadsheet showing all of these calculations, and even change the values to match your own bills, by clicking here.

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[qsm quiz=138]

Challenge Questions

1. What reasons might there be that could cause someone to miss paying a bill?
2. In your opinion, how important is it to have an emergency fund?
3. After reading the text, would you pay a small amount to each creditor or prioritize and look to eliminate one bill at a time?
4. What are some of the effects of paying your bills late?

Every person makes hundreds of purchases every month. Think about how many individual items you choose when buying groceries, how often you eat out or use a vending machine, or how often you buy new clothes. Each purchase has a reason, but each purchase costs money.

One of the cornerstones of strong personal finances is knowing why you buy what you do and knowing how to research your purchases in advance.

Why We Buy What We Do

Coke or Pepsi? Large coffee or medium? Prepare your own bag lunch or go out to eat? You will make thousands of tiny decisions every month about how your paycheck gets divided.

It is not possible to carefully consider every single purchase you make.  This would lead to decision fatigue. Decision fatigue happens because every choice you make takes some brainpower. As you spend more time and effort considering each choice, you will get worn out very quickly.  This is why most people spend a lot more time researching “big ticket” purchases than every item in their grocery cart.

Once you break down your spending with a spending plan, you will see that all your minor purchases add up very fast. That’s why it is important to understand why you make each of those small purchases.

Advertising and Spending

You are susceptible to the effects of advertising.  Everyone is. Most people think advertising does not really affect them much, but no matter how savvy you are, you will be affected by ads.

When you are deciding whether or not to buy a product, you already have some pre-formed opinions about what benefits you will receive compared to the price you are paying. Where did those pre-formed opinions come from? They came from several prior experiences you’ve had that allowed you to interact with the product in rational and emotional ways.  Advertising was at work.

A successful ad is able to do three things.  First, it attracts your attention.  Bright colors, interesting people, music, humor, bold words, and familiar experiences are all at work to capture our attention. Next, the ad gets the name of the product stuck in our heads somehow. Third, advertisers put a positive spin on their products to convince us that this is something we truly want or need.  A good ad is able to hook your emotions and bypass your brain. Then when you see those products while you’re shopping, you are more likely to make impulse purchases rather than comparing products and choosing the one with the best value. 

Advertising has the biggest impact on our smaller purchases, where we only spend only a few seconds weighing pros and cons. A simple product endorsement from a social media website may be the reason you buy Product A instead of Product B. 

Previous Experience

Our own previous experience is the opposite of advertising.  We have used a product previously, and so we know exactly how well it works and the value it brings relative to cost. Smart shoppers should not rely solely on previous experience to make purchasing decisions.  Buying certain products out of habit means you are not taking time to compare one product to other available alternatives. 

Most of us have an older relative who has used the same products or visited the same restaurants for the past 30 years, even though newer, better alternatives are now available.  This happens because shoppers fall into spending ruts, where a positive previous experience has switched off the part of the decision making process where you consider alternatives.

Peer Pressure

When it comes to spending, peer pressure is not always a bad thing. Peers will share their personal experiences with a product or service, allowing you to gain knowledge of what you are buying before wasting your money. Getting a product endorsement from someone you trust is one of the best ways to feel the benefit of the product is worth the price.

On the other hand, peer pressure can also encourage over-spending. If you have more than a couple of friends, once they know you are shopping for a particular product, chances are you will get recommendations from each of them. Each may claim that different products are well worth the cost and the investment. Each friend might be right, but even if they are, buying more items just because they were recommended can really hurt your budget.

Think about watching TV shows.  You might have 4 different friends, each recommending a different TV show, which takes ½ hour to watch one episode. If you take the advice of all 4, you’ve already dedicated 2 full hours to watching TV, before you even get to the shows you privately wanted to catch up on!

How to Spend Your Time Researching

Researching purchases is mostly a time problem.  There are thousands of purchases to consider, but only one of you and only 24 hours in a day. Thankfully, there are some tools that can help with your research, making the process easier for you. 

Use Your Spending Plan or Budget

Before you make any purchase, your need to first decide what money you actually have to spend.  If you have created a budget or spending plan, this usually means looking at what you spent last week or last month and using those dollar figures as a starting point.

Next, decide if you can spend less on future purchases without missing out. For example, you may prefer name-brand products or getting your coffee to go instead of brewing it yourself, but could you save money simply by making small changes?  You might prefer that extra cash at the end of the month more than the drive-thru coffee you purchase in the mornings.

Conduct some personal research to determine how much each item is really worth to you. Try decreasing your grocery or clothing budget by a few dollars each month.  With less money allocated for these purchases, you may be forced to spend an extra few seconds thinking about each item that normally goes into your shopping cart.  Sometimes this is all it takes to save a lot of money in the long run.

Compare Online as You Shop

Most people today have a smartphone with full internet connectivity. If you are shopping at a brick-and-mortar store purchasing items that cost more than $20, it may be well worth your time to do a quick online price-check for those items.

This online price-check provides two major advantages.  First, you will see instantly if you can find the items at a cheaper price somewhere else. If the purchase can wait a few days, you can order online and save money. Second, online shopping sites usually provide user reviews from other people who have purchased certain products. These reviews will educate you on the product’s actual quality, how long it will last, and problems other customers have experienced. 

Delay Purchases

If you decide you want to buy something, there is a simple trick to help you save a huge amount of money.  Delay the purchase.  Simply do not purchase the item as soon as you’ve made up your mind that you want it, even if it is on sale.

Have you noticed when you’re shopping online for certain products that advertisements for those products seem to “follow” you around the internet? Ads for those new shoes you were looking at seem to appear in your email, your news feeds, and in your social media websites.  Let those ads do some of the research for you! When you find an item that you want but do not buy it right away, the ads that are following you will now be showing you some alternatives.  These alternative retailers or products might have better prices or better reviews that you did not see during your first round of research. The biggest advantage in delaying purchases comes by simply cutting out impulse purchases entirely. According to the BBC, most shoppers waste about $800 per year on impulse buys for products that they never really use and never needed in the first place. Delaying your purchase by a couple of days kills that impulse.  By delaying the purchase and killing the impulse, you just saved yourself the entire purchase price, plus you don’t have items around your house that you really don’t need.

Be Wary of Sales and Bundles

A shopper recently purchased a laptop from a major electronics store. It was purchased at a competitive price, was well-researched, and had all the desired specs. At the check-out, the salesperson offered a bundle.  The store would offer a full set-up of the laptop, complementary antivirus software with a 1-year subscription (which the store sold separately for $70), and a 1-year warranty for accidental damage, all for only $60.

This bundle exists at most electronics stores, with similar terms, but it really does not offer much more than simply an increase in cost. The bundle is offered at check-out specifically to give the buyer little or no time to research the purchase before having to make a decision.  This should raise a red flag for shoppers.  In reality, no part of the bundle was a good deal.

• There is no real “set-up” process for new computers anymore. Just entering your name and logging into your home’s Wi-Fi is usually enough to get up and running.
• Almost every new computer comes with a “trial” version of professional antivirus software, which lasts as long as the membership period offered in the bundle. The Windows operating system now includes its own built-in antivirus protection, known as Windows Defender.  And free versions of almost every other reputable antivirus exist for extra protection. Apple computer products also have their own free suite of antivirus software to choose from.
• The accidental damage warranty offered by the store was almost identical to the one already included by the manufacturer of the laptop, providing no additional benefit to the customer.

You can find a similar story behind almost any bundle ever offered at check-out. If you are being offered a bundle deal without being given time to do proper research on what you are buying, you will be better off by opting out and sticking with the purchase you have already researched.

Get PersonalFinanceLab

This lesson is part of the PersonalFinanceLab curriculum library. Schools with a PersonalFinanceLab.com site license can get this lesson, plus our full library of 300 others, along with our budgeting game, stock game, and automatically-graded assessments for their classroom - complete with LMS integration and rostering support!

Learn More

[qsm quiz=132]

Challenge Questions

1. Why is it important to consider comparison shopping?
2. Other than price, what other factors should you consider before purchasing something?
3. With the use of examples, what do you understand by peer pressure?
4. With your understanding of opportunity cost, how does this apply to purchases?
5. How might delayed gratification and delayed purchases help you with your budgeting?

When you are evaluating how to spend your money, most people make a fairly simple comparison.  If the benefit they believe they will receive from the purchase is greater than the cost, then most people go ahead with the purchase.

When you are working to master your personal finances, you might notice a problem with this idea. There are many potential purchases you can make that you believe are “worth the money,” so you spend money now instead of saving for the future.  In order to change your mindset, you need to start thinking long-term.  By building a toolkit that lets you think about a purchase and how it will impact you over time, you can begin making smarter financial decisions.

Opportunity Cost and Depreciation

When you start to plan for purchases instead of shopping with no plan in mind, you no longer just focus on whether or not a purchase is “worth the money.”  You start to think about how this purchase will impact you moving forward. To make this process easier, start by applying some economic and financial concepts to your purchases.

Opportunity Cost

The opportunity cost of a purchase focuses on what you are giving up when you buy something. For example, if you purchase a new smartphone for $1,000, the cost to consider isn’t just the $1,000 you spent on the phone but other things you could have done with the $1,000 including purchasing other products, saving the money, or investing the money and gaining interest on it down the road. 

When you make an expensive purchase, instead of just thinking about the cash in your pocket, keep in mind that you are making that money unavailable for other wants and needs. If you had that $1,000 currently invested in the stock market, would you be willing to pull it out of your investments to buy the smartphone? What if instead of the latest model smartphone, you only needed to pull out $500 for a 2-year old model, leaving the other $500 to continue to grow?  Would that be a wiser decision?

Amortization and Depreciation

Amortization means you spread the value of a purchase over the useful life of the item instead of counting it as one sunk cost now and then “free usage” until it breaks or you get rid of it. Thinking this way allows you to spread the cost over a span of time.  For example, if you buy a $1,000 phone and plan to use it for 3 years, you could view the cost as $266.67 per year.

Depreciation describes the fact that most items lose value over time. The new smartphone you purchased will start to get slower and less reliable in the coming years. The novelty you got when you first purchased it will wear off the instant a newer model is released.  However, that item still has value.  Your $1,000 new smartphone may only be worth $600 two years later, but it still has value.

More expensive, higher-quality items tend to depreciate in value slower.  This means you are getting more value over a longer lifespan.  Consider this when you are comparing higher-quality and lower-quality items.  It may be worth the extra money to purchase a more expensive item if it will retain its value for a longer period of time.

Combining Concepts

When you plan for a purchase, you should consider a balance of the value of the item, the monetary cost, your opportunity cost, and the depreciation rate of the purchase. The more expensive the item is and the longer you think it will last, the more important this balance becomes.  You’ve learned to look beyond the simple idea of whether or not you can afford it.

Keeping with our smartphone example, let’s assume you we still trying to decide between the $1,000 newest model and a two-year-old model priced at $600. To make a decision, we need the following information:

• On average, people keep their smartphones between 2 and 3 years. We will keep the phone for 3 years.
• We also need something to compare the purchase against.  The S&P 500 stock index has an average long-term return of about 11%.  We won’t be too optimistic, so let’s assume we can invest in the S&P 500 Index Fund (SPY ETF) and receive a return of 8% per year.

Step 1: Calculate Realized Purchase Cost

Our “realized” purchase cost will be the sticker value, plus the opportunity cost. In this case, if we buy the new phone, it costs $1,000 flat. If we buy the older phone, it costs $600, but we are investing that extra $400 savings at a rate of 8% for 3 years.

Using our compound interest calculator, we can see that our $400 will grow to $504 – an extra $104. Since this is cash we would not otherwise gained, we can subtract it from the purchase cost.

Now we are comparing a $1,000 new phone with a $496 older phone.

Step 2: Amortize the Cost

Next, we can amortize the cost over the phone’s useful life.

• Our $1,000 phone costs $333.33 per year for 3 years.
• Our $496 phone costs $165.33 per year for 3 years.

We can see that the older phone is still much cheaper per year, but we knew that before. We also knew that we value the $1,000 phone more than the $600 phone, or else we wouldn’t have needed to think about the trade-offs so much. The purpose of amortizing the cost is to give ourselves a yearly number that we can depreciate – what this phone is costing us per year.

Step 3: Depreciate the Value

Next, we need to figure out how quickly the value of our phone will disappear. If we use market data to assess the decay rate of our smartphone, we can see that our $1,000 phone will decay to $600, (a $400 decrease) within 3 years, 60% within 2 years, or 30% per year.

At this point, we have not yet specified how much we personally value each of the phones in front of us. It could be that the new phone has some amazing new feature that we would be willing to pay $3,000 for, and the $1,000 asking price is a steal. Or it could be that our value of the phone is just a little bit more than the asking price. When you depreciate the value of a phone, you are not depreciating the money it costs you to buy it.  You are depreciating the value you place on owning it.

Unfortunately, right now we do not know how much we value these phones (either by themselves or relative to each other). Instead, what we will assume is that we value the phones at least as much as they cost us. This means we will take our amortized value and depreciate that to give ourselves a minimum amount we must value these phones to even consider buying them.

These totals are less than the price, so now we can find our break-even value for each phone.

The break–even point is when the cost of the phone is equal to how much you value the phone, including how much value it loses over time. Regardless of the alternatives, you would not buy a phone for a higher cost than you value it.

New phone: $1,000.00 – $699.98 = $300.02

This means we need to factor in $300.02 in lost value over the life of the phone by adding it back in to our purchase price.

$1,000 + $300.02 = $1,300.02 break-even point

For us to consider purchasing the new smartphone, we need to value it at $1,300.02 or more. (Notice we are not even comparing the new and old phones.)  This is the minimum value we need to put on this phone for it to be an option. If we cannot say that we would get $1,300.02 of value out of the new phone, our decision is over.  Do not buy it.

Old phone: $496.00 – $346.39 = $149.61

 This means we need to factor $79.12 in lost value over the life of the phone by adding this back into our purchase price.

$496 + $149.61 = $645.61 break-even point.

For us to consider purchasing the old smartphone, we need to value it at $645.61 or more.  (Again, we are not even comparing with the new phone.) This is the minimum value we would put on this phone for it to be an option. If we cannot say that we would get at least $645.61 in value out of the old phone, our decision is over.  Do not buy it. 

Step 4: Make a Decision

What we calculated in Step 3 was our minimum values for how much we value each phone. Now we can calculate the difference in these values:

$1300.02 – $645.61 = $654.41

Now we can finally make our decision of which phone we want to buy. Do you think you will get $654.41 more in value from the new phone than from the old phone?

This is only up to you. Nobody can tell you how much you personally value either phone. The purpose of the 4-step process is not to tell you which choice is “best.” It is for you to see the full impact of your decision across time.

Once we factor in opportunity cost, amortization, and depreciation, the choice of phone looks a lot different. A $400 sticker price difference transforms into a $654.41 value difference once we look at how the purchase impacts us across time. This means a smart shopper will go for the older phone, unless they can justify to themselves why the new phone is worth $654.41 more.

If you want to try out this exercise for yourself, you can download a sample spreadsheet here showing the steps above.

Hold On, This Is Way Too Complicated!

Now that you have seen all 4 steps in action, you can understand the value of looking at a purchase over a longer period of time, but actually making all these complicated calculations when you are standing in a store considering two alternatives seems a bit unlikely.

And you are completely right!

It will be very rare when you compare two or more options using this full process. At most, you might sit down for the full calculation once or twice per year. The important thing is not that you calculate the exact realized purchase cost, amortized cost, and depreciated value, but that you remember all three of these factors should weigh into your purchase decision, not just the sticker value.

Calculate at the Check-Out

The next time you make a purchase for something you expect to keep for a long time, try thinking specifically about how long you expect it to last. Next, remember that the money you are spending is money you are not using for something else, like investing, so add in a bit of extra cost to account for what you are missing out on.

Now divide that full cost over its useful life, whether it is 6 months or 5 years. Every purchase you make has a useful lifespan.  Do not fall into the trap of thinking a purchase is good forever. Whatever the item is, it will break, a better alternative will enter the market and you will buy it, or the reason you originally bought the item will eventually disappear from your life. Always consider the maximum useful life of every purchase. This will at least give you some idea of how much this purchase will cost per week, month, or year of its life.

Finally, consider how fast the purchase will lose its value. A lot of technology loses its value fast.  Our cell phone example was decaying at about 30% per year. Better alternatives are always coming out and new apps are released that require newer hardware. Your clothes will also have a fast decay rate since they go out of fashion or are damaged through normal use. Other purchases, like kitchenware or furniture, will lose value more slowly.

You do not need to take out your calculator and get exact numbers for each step, but you do need to remember that all of these factors exist! Just keeping that in the back of your mind will make you a much smarter shopper and will help you see the true value and cost of your long-term purchases.

Get PersonalFinanceLab

This lesson is part of the PersonalFinanceLab curriculum library. Schools with a PersonalFinanceLab.com site license can get this lesson, plus our full library of 300 others, along with our budgeting game, stock game, and automatically-graded assessments for their classroom - complete with LMS integration and rostering support!

Learn More

[qsm quiz=128]

Challenge Questions

1. Using examples from your own life, explain what opportunity cost is.
2. Why should depreciation be a consideration when purchasing a product?
3. In the text above, what is meant by the real cost?
4. Explain what you understand by the term amortization and how would you explain it to someone else using an example?

Health insurance is usually the most complicated and expensive insurance you need. Unfortunately, it is also usually the most important, making it very difficult to avoid the cost.

With very few exceptions, health insurance is mandatory for all citizens in the United States, but the way you become insured will change drastically based on your age, income, and the company you work for.

Types of Health Insurance

Health insurance falls into three broad categories:

Public Insurance

Our government provides public insurance directly for some individuals. This includes Medicare, healthcare for the elderly, Medicaid, healthcare for low-income families and children, and some health insurance coverage for veterans. These public health programs are funded through payroll taxes, and the coverage provided is not free.  The covered persons usually must pay some amount out-of-pocket before the public insurance takes effect.

About 50% of all healthcare spending in the United States is through public insurance programs, the largest portion being through Medicare.

Group Insurance

Employers often offer group health insurance to their employees. With group health insurance, a business will split the cost of health insurance coverage with its employees. Eligible employees are usually required to participate in the program, unless they have better coverage from somewhere else. (Since a husband and wife may both have group health insurance options through their employers, the couple will decide which option is better and cheaper for the family.)  Group insurance is usually the cheapest option for individuals.  This is because it groups many people from different age groups and different risk levels together and splits the cost with the employer. Big group policies also have bargaining power to negotiate better deals with insurance providers. About 60% of Americans have health insurance coverage through their employer.

Individual Coverage

You may need to purchase health insurance directly from a health insurance provider yourself if you cannot get it through your employer. The cost of insurance you purchase as an individual is usually higher because you are not splitting the cost with your employer. There are some subsidies and state-run insurance exchanges that can make this cheaper. About 9% of Americans are covered through individual health care plans.

Health Insurance Terminologies

Health insurance is built upon the same core concepts of premiums and deductibles, like other forms of insurance. The premium is the monthly charge you pay to have health insurance coverage. The deductible is the amount you pay first for medical expenses before your insurance pays. As with all insurance policies, there is a balance between the premiums you pay, the deductibles you pay when there is a claim, and the level of coverage you receive.

Health insurance also has other concepts that you need to understand. 

Co-payments and Coinsurance

Co-payments and coinsurance refer to the amount of money you are responsible for paying, beyond your premium and deductibles. 

A co-payment is what you pay per visit to be seen by a health care provider.  There is no maximum to the amount of co-pays you would pay in a year.  For example, if your policy states that you have a $50 co-payment for a doctor’s visit, you will need to pay the first $50 out-of-pocket for each visit, with your insurance covering the rest of the cost.

Coinsurance requires you to pay a certain percentage of the cost for treatment.  For example, if your policy states a 10% coinsurance level, you would be required to pay 10% of any medical cost incurred.  Your insurance provider would cover the remaining 90%.

Coverage Limits and Maxima

Heath insurance policies may put a ceiling on how much in total they will pay for medical expenses in a year. Once that maximum amount is reached, you now pay out-of-pocket.

The coverage limit is the term referring to the total amount an insurance company will pay out for a single policy over the course of the year.  Sometimes, this applies to the maximum over your lifetime. Any additional expenses above this amount will be entirely passed on to the insured.

If your policy includes an out-of-pocket maximum,  that means there is a cap on the maximum amount of money that you would be required to pay yourself before the insurance covers everything else at 100%.  For certain policies, in order to keep premiums and deductibles low, the tradeoff may be a high coinsurance percentage.  These policies would most likely include an out-of-pocket maximum to ensure that individuals would not be bankrupted by very expensive medical emergencies.

Networks, Authorization, and Emergencies

You may have noticed that health insurance can be quite complex. Unfortunately, it gets a bit messier from here!

When health insurance companies keep their costs down, this means your coinsurance payments are lower. To keep costs lower, the insurance companies often make specific agreements with hospitals, doctors, and other healthcare providers to set standard costs for routine procedures. They also negotiate prices for more complex procedures. As the insured, you do not necessarily need to worry about these negotiations and specific contracts, but you do need to be aware of which doctors and hospitals your insurance provider has agreements with.

In-Network and Out-of-Network

In-Network healthcare providers are the providers that your insurance company has contracts and agreements with. If you visit an in-network doctor or hospital, your costs will be much lower. If you visit an out-of-network provider, your costs will usually be much higher, and your health insurance company may refuse to pay at all unless you can prove there was no viable in-network alternative. These agreements often apply to prescription medications as well.  Your health insurance may not cover all medications your doctor prescribes. You should always call your health insurance provider before visiting a specific health center to find out if they are an in-network provider.

Prior Authorization

For certain expensive tests and procedures, your insurance company may require that you get their authorization prior to setting an appointment.  This is usually done by getting an in-network doctor to confirm that the procedure or test is necessary. If your insurance provider refuses to authorize your care, you can appeal it to an independent third party to review your case.  It’s not that the insurance company doesn’t want you to have treatment. They just want to make sure that an in-network doctor truly believes it is necessary.

Emergency Care

Emergency Care is the exception to both your network and insurance pre-authorization requirements. If you are injured or very sick, you are entitled to use emergency services of almost any healthcare provider and your insurance will cover it.

Supplemental Health Insurance

Normal health insurance coverage does not cover many non-life-threatening health issues. Supplemental insurance policies exist to fill this gap.

Co-Insurance Supplement

If your insurance plan includes a high co-insurance percentage, you could end up spending thousands of dollars for an unexpected surgery and hospitalization.  In order to reduce that financial risk for you, some companies offer supplementary insurance plans.  Supplemental insurance provides an added layer of financial protection by covering the out-of-pocket expenses that your primary health insurance plan does not cover.  This can include the cost of copayments, coinsurance, and deductibles.  The policy coverage limit is normally set at the same level as your primary policy’s out-of-pocket maximum. This means that with both primary and supplemental insurance policies, your out-of-pocket costs could simply be the cost of your annual premiums. 

Vision and Dental Insurance

Most health insurance policies do not cover glasses, contacts, routine eye exams, or dental care.  You will need supplemental Vision and/or Dental Insurance Plans to cover these treatments and exams. Some vision and dental plans are designed to cover all costs at 100% after you pay the deductibles.  Others do not provide explicit coverage such as paying for the cost of an eye exam or a filling.  Instead they provide a list of “Network Providers” and the costs you will pay for specific treatments. These costs reflect a discounted price for Insured individuals. This works the same fashion as the provider network you get through your health insurance. Your dental or vision insurance provider negotiates with eye doctors and dentists to lower prices for the individuals covered through their insurance plans.

Specified Disease Coverage

Sometimes you are able to purchase insurance that explicitly covers one disease. For example, if your family has a history of breast cancer, it may be possible to get a specific breast cancer health insurance policy supplement.

These specific disease supplements generally emphasis preventative care and early testing. This helps catch the disease early which both improves survival rates and reduces total cost. Having specific disease coverage can reduce premiums on your primary insurance coverage. This is because it lowers the risk that your primary insurer will need to cover issues from that particular costly disease.

Why Health Insurance Is So Expensive?

For insurance companies, their ability to operate successfully comes from collecting more money in premiums and fees than they need to pay out in expenses. For individuals, they want to feel that the money they pay in premiums and fees will provide the coverage they need.  When balancing these two parties’ needs, determining the “right cost” is key.  How much to charge and how much to pay are questions that get re-evaluated on a regular basis.

Healthcare emergencies are often extremely expensive, and sometimes the needed care drags on for a very long time, accumulating hundreds of thousands of dollars in medical bills. This means even if your personal risk of having a medical emergency is fairly low, the potential cost for the insurance provider is extremely high. This is the main reason why health insurance policies are so expensive.  The company needs to plan for potential costs.  But there are a few other factors that contribute to rising costs as well.

The Self-Selection Problem

In the past, health insurance was not mandated for all citizens. Most people were insured through the companies they worked for or were covered by public insurance. Those who were not covered by these options could decide if they would purchase individual medical insurance or remain uninsured.  They could self-select to be insured or not.

Because medical insurance is so expensive, it meant that most of the people who enrolled on their own were people at high risk of having medical problems. This increased the likelihood that the insurance company would have to pay claims for a higher-risk individual, and this probability caused the rate of premiums to increase.  Preventing this “self-selection” problem is the main reason why health insurance is now mandatory in the U.S.  Having more low-risk individuals in the insurance pool should lower the average premium.

The Emergency Room Problem

In the United States, emergency rooms are required to treat every patient who arrives. Insured and uninsured individuals can get seen and treated there.  However, people may not know that getting treatment at the emergency room is by far the most expensive way to receive medical care.  Because ER doctors cannot turn anyone away, this means that an uninsured person with little savings and a chronic medical problem can use the emergency room to receive the treatment he needs. The emergency room provides the treatment, but who will pay the bill? 

The cost of providing medical care does not evaporate if the person is unable to pay the bill. Instead, the cost gets redistributed among all the other patients at a hospital who are able to pay. This means the cost of every other type of care at the hospital goes up. This is why you may have heard infamous stories such as the $15 hospital Tylenol or experienced extremely high costs for your own emergency room visit.  This financial dilemma causes a loop.  As the cost of other treatments goes up, more individuals who are uninsured find it difficult to pay their emergency room bills, pushing treatment costs  even higher.

Most people with insurance do not need to worry much about these costs.  Insurance companies usually negotiate directly with the hospitals to force these costs back down. The government pays for people with public insurance coverage, but they do not usually negotiate prices as much as private insurance companies do.

The Regulation Stability Problem

You may have heard about some of the major changes that have been discussed by Congress over the last couple of years regarding health care in the United States. Usually those discussions center around how much insurance will be subsidized, what levels of care are mandatory, and how many people might be covered by public insurance programs. For health insurance companies, all of these changes create problems to be addressed. For example, it makes it difficult to engage in long-term planning regarding premium costs for current customers when the government is enforcing changes in the industry.

When insurance regulations are being rewritten and reformed, the fee structure becomes unstable. Health insurance companies often raise their premiums to protect against big changes in their insurance pool, the group of people covered. For example, the government currently provides a subsidy to encourage insurance companies to cover more low-income families. If health insurance providers hear that Congress is considering removing the subsidy at some point in the next few years, it is probable that these low-income families could drop out of the insurance pool, raising the insurance company’s average cost. The insurance company would also lose revenue, since they would no longer be receiving the subsidy. To protect against this potential change in the future, they raise premiums slightly in the short term to act as a buffer.

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[qsm quiz=127]

Challenge Questions

1. In your opinion, is it worth having Health insurance?
2. Using examples, explain what a deductible is.
3. What is the opportunity cost when considering whether you should have Health insurance or not?
4. How do insurance companies calculate the premium they will charge people for their insurance policies?