Savings rates start to drop

Last week, the Federal Reserve cut the Federal funds rate from 4.75% to 4.5%. The relationship between the federal funds rate and the rest of the economy is complex and long term. You won't see mortgage rates drop by 0.25% straight away, for example, because they depend more on long term interest rates.

But we are already seeing rates coming down on high-interest savings account. ING Direct has dropped their rate from 4.30% to 4.20%. Countrywide Bank are down from 5.50% to 5.35%. We will see if Emigrant Direct (currently 4.75%) and HSBC Direct (4.50%) follow suit.

How to get started investing

Let’s say you’ve decided to start investing. How do you get started? This article describes the basics of investing, and gives some hints on how to get started.

Before you start investing, however, make sure you have the following covered. If you can’t put check marks against all of the following, then you aren’t ready to start investing yet.

• You have no high-interest debt (such as credit card debt). If you do have high-interest debt, pay it off first.
• You have an emergency fund covering expenses for a few months. If you don’t have an emergency fund, put your investment money into an emergency fund first. This will cover your living expenses if the worst happens – such as you lose your job, or your car gets totaled in an accident.
• You are contributing to a retirement plan (such as a 401(k) plan). Yes, this is a form of investing, but investing for retirement takes precedence over investing for the shorter term. You will want to balance your investments.

What investing is (and isn’t)

What is investing? There are really two ways that you can put your money to work for you. The first is “savings”. This covers things like putting money into a savings account or certificate of deposits. The thing about saving is that the money you put in (called the “principal”) cannot lose value. If you put in $1000, you will definitely get back at least $1000 (unless you, for example, withdraw from a CD before the term is up).

With investing, your principal (which, remember, if your money) can lose value. You could put in $1000 and get back only $500. This sounds like a bad deal, but people invest because they have the potential to get higher returns than savings.

For example, a typical savings account (such as ING Direct or HSBC Direct) currently pays between 4% and 5%. But on average, stocks have returned about 10%. But the risk with stocks is that 10% is a long term average. They might go up or down over the next week, month, year or decade. So investing should really only be done with money that you can (a) afford to lose completely and (b) won’t need for a long time (several to many years).

Investing Options

What can you invest it? There are three main options: individual stocks, bonds and mutual funds.

When you invest in a stock you are buying part of a company. Most of us will only ever by a tiny fraction of the total company, so we have no say on how the company is run. But if you did have enough money and went out and bought most of the stock of a company, you would become the owner of that company. That is how company takeovers (and buy-outs) often work. When you buy a stock, you hope to make money in two ways: first, you hope that the price of the stock will go up so when you sell it you’ll have made the difference between what you paid and what you sold it for, and second, you might get payments from the company – called dividends - a few times a year.

Bonds are almost the opposite of stocks. Whereas buying a stock is buying a part of the company, when you buy a bond you are loaning money to the company. In exchange for the loan, the company will (normally) pay your interest. As well as companies, the federal, state and local governments also issue bonds. People often thinks of bonds as less risky than stocks, and as a way of diversifying (that is, decreasing risk). This can be true, but not necessarily. In the same way that you could be a very risk stock, you can buy very risky bonds. But there are also very low risk bonds (the lowest risk probably being US Treasury bonds, which are more like savings accounts).

The third type of investment is mutual funds. Buying a mutual fund is like buying stock in many companies at once, without the hassle and cost of actually buying the stocks individually. Mutual funds come in two flavors: those that try to beat the market by actively buying and selling stocks, and those that try to track exactly how the market performs. The later are called index funds. As well as index funds that track the overall market (such as the S&P index), there are index funds that track specific industries (say, the retail industry) or other more specialized groups of stocks. You can also buy mutual funds that invest in bonds.

Getting Started

Buying a stock or fund is an easy process, but the difficult part is deciding which stock or fund to buy. Researching and understanding companies is complex enough, plus then you need to figure out if you think the stock will go up in the future. If you do want to research individual stocks, try a finance site such as money.msn.com, finance.google.com or finance.yahoo.com. Each of those sites has plenty of tools for finding stocks and understanding the company. Each stock has a stock symbol which you’ll see all over financial sites. For example, General Motor’s stock symbol is GM. Enter GM into the appropriate search box on a finance site and you’ll get all sort of information about the company.

Investing in individual stocks takes a lot of research. Unless you have time to learn how to research companies, it is best to start by investing in a broad market index fund, such as one that tracks the value of the S&P 500 index. Today, many index funds trade just like stocks. For example, the Vanguard Total Stock Market Index Fund is also available as a stock: Vanguard Total Stock Market Index (stock symbol: VTI). Funds that trade as stocks are called Exchange Traded Funds, and you can research them at the ETF area of financial sites.

To buy a stock, you’ll need an account at a “brokerage”. Some common low-cost brokerages are TD Ameritade, E-Trade and Fidelity. These companies typically charge about $8 to $16 per trade (a trade is a buy or sell). You can sign-up online, transfer money electronically from your bank account, and start buying.

Remember that stocks are best held for a long period of time. Don’t worry if the stock declines after you buy it -- over the long term, stock market indexes have performed quite well. That is no guarantee that they will in the future, but if you wanted a guarantee you’d keep your money in savings account or treasury bonds.

A note on taxes

Unless you are investing in stocks and mutual funds inside your 401(k) or similar retirement plan, you’ll have to pay taxes. You’ll owe income tax on dividends paid by the companies (due each year), and you’ll owe “capital gains” tax on any growth in the value of your investment (due only when you sell the investment).

How to reduce spending and start saving

My philosophy is that how rich you are depends not on how much you make, but on how much you spend. If someone earns $80,000 a year but spends all of it, they are less well off than someone making $60,000 who spends only half of that and saves the rest.

You might ask how someone who spends less can be richer. It depends on your definition of financial richness. I think that richness can be expressed in two ways:

• Financial richness: you know that are on track to save enough for retirement, you have an emergency fund, and you have low rates of debt. Overall, you can feel confident that you won't end up running out of money in retirement. You can handle any emergency expense that might come up, like a car repair.
• Material richness: you spend money on products and services now. You might not be saving enough for retirement, and might have a bunch of high-interest debt to pay for your lifestyle.

Everyone has to make a decision about what type of richness they prefer, and how much they are prepared to compromise on the other type. In effect, you have to make a choice between enjoying the fruits of your labour now (by spending the money you make now) versus enjoying them later (by saving for retirement and spending it later). In practice, these two are not exclusive but you need to get the balance right.

I have a preference to work towards financial richness. This doesn’t mean stopping spending, or living like a hermit. However it does mean avoiding unnecessary expenses, and spending money wisely. This article is about how you can reduce your spending and increase your savings for the future.

If you want to reduce your spending now and start saving, how can you do that? You probably have three types of expenses, each of which requires a different strategy. The types of expenses are regular low value expenses, occasional big-ticket expenses, and other expenses.

Regular low-value expenses

These are things you buy every day or week or month, and don’t cost a lot. Think of your daily lunch at work, or a coffee on the way in, or newspaper you buy on Sunday. With these types of expenses it is natural to think that they don’t cost much so how much can saving money really help? Surely a coffee a day doesn’t impact your long term ability to retire early. But the fact is that regular low-level expenditure does add up over years and decades. Even more importantly though is the psychological impact. If you don’t think about each small expense, it is easy to get into the habit of not thinking about what you are spending. If one coffee a day ir okay, why not two? If lunch out everyday is okay, why not dinner out every day as well? It is a slipperly slope towards spending all your income on little things.

What can you do about regular low-value expenses? Think about whether you need to spend the money at all. Do you need a coffee every morning? If you enjoy drinking coffee, why not limit yourself to one morning a week rather than every day? Could you reduce the amount you spend? If you buy lunch every day at work, could you switch to a lower cost meal? Or make your own lunch and bring it in? Or if making entire lunch is too much, what about bringing in some fruit for a snack during the morning so you aren’t s hungry at lunch time?

There are plenty of ways you can reduce spending, but one factor that will reduce your ability to make a change is habit. Habits are of course something you are used to doing. Many times, your regular spending becomes more of a habit than a need. Breaking a habit can be difficult. I used to eat the most expensive dish for lunch. It was a habit, and it made my lunch decision easy – I didn’t have to think about it, I just went to the counter and ordered. But I wanted to save money, and there were plenty of other options at lower cost. To change required breaking a habit, and going from a comfortable, unthinking process to a new process and having to think about what I wanted to order each day. It took a while to break the habit and feel comfortable with the new approach, but it works if you stick at it.

Occasional big-ticket items

In contrast to small value habitual spending, big-ticket items tend to be occasional expenses. You aren’t trying to break a habit here, but instead spend less on these large purchases. There are three approaches I take to big ticket items

• Do I need it? Many times, a big-ticket item is not needed. I don’t need a new flat screen TV because my 24" regular TV works fine. That doesn’t stop we wanting a flat screen TV, since it would be newer, have more features, fit better into my house and so on. But I don’t need it. I should wait until my old TV breaks before I buy a new TV.
• Can I spend less on it? If I do decide I need a big-ticket item, my next objective is to figure out how to pay the least for it. For a TV, for example, do I need a 42" model when a 36" would be adequate? Where is the best value place to buy it – somewhere online rather than a local retailer? This approach is all about reducing the amount I spend.
• How do I get best value over the long term? This is all about making sure I buy a good purchase for the long term. For example, it is false economy to save money by being an unbranded item that breaks after a year, when I could spend some more for a better brand item that will last ten years or more. In some ways, this objective opposes the previous one which was about spending less: this one is about spending more for long-lasting quality.

Other expenses

Then there are other expenses, from occasional (gifts at Christmas) to regular (electric bill). Of these, I am concerned most about regular bills. It is easy to get into the habit of paying a bill and not notice how much it adds up to over the years. Some bills are necessities, such as electricity, and all you can do is try to reduce them. But others are luxuries. Do you really need a Netflix subscription, or premium TV channels? Perhaps you do get enough use out of these to justify the expense, but if not, these are easy to cancel and can add a lot of extra money to your savings.

Understanding where your money goes

Do you know how much money you’ll have saved by the time your retire? Or how long before you’ve saved enough for a downpayment on a house?

If you are like most people, you probably don’t think much about what happens to the money you bring home. You no doubt pay a bunch of bills and expenses, maybe pay off a bit of debt or a mortgage, and if there is anything left, invest it for retirement or in savings. But if you don’t have a plan for where your money is going, you won’t be able to plan for financial future. With a bit of planning you’ll be able to answer questions like “when can I get a 10% downpayment on new house” or “can I retire at age 60”.

Before you can start planning your finances, you need to understand what happens to your money. Thing of your household like a factory: a bunch of raw materials go in at one end, and some finished products come out at the other. Except in your household, a bunch of money goes in at one end (your wages) and a bunch of money goes out at the other end (things you spend your money on, like bills). Hopefully your spending is less than your income, so you keep some money inside your household. This money is your savings.

Let’s break this down into a bit more depth. A typical household has one major sort of income: your wages.

If you are lucky, you’ll also have some income from interest on savings or dividends on shares, but that it normally a small fraction of your wages.

What happens to the income? It is split between three things:

• You spend on bills (such as cable TV) or other expenses (such as groceries)
• You use some of it to pay off debt (such as a mortgage or student loan)
• You put some of it into savings or investment – either for retirement (such as a Roth IRA) or other savings or investments

It is important to get the balance right between these three areas. If you spend all your money on unnecessary expenses, then you can’t save for the future or pay off debt. The amount you spend on each area depends on a lot of factors, such as how much you earn, how much debt you have, and so on. But in general, you should aim to:

Minimize your expenses

Minimize your expenses as far as practical. For example, if you buy a coffee everyday, maybe you can skip a day a week. Even small savings, when calculated over years or decades, add up to significant amounts of money. Of course, big savings are also good. Do you really need a new flat screen TV if your current tube TV works?

Pay off high-interest debt

If you run a credit card balance, then try to pay it off. Unless you have a teaser rate, you’ll be paying a high interest rate on this debt. You should try to reduce your credit card debt over time, with the aim of eliminating it. Look to see if you can move it to lower cost debt, such as a home equity line of credit (HELOC).

Save for retirement

You need to save for your retirement. Have you thought about where your income will come from when you are retired? Unless you have a company pension (increasingly rare these days), you shouldn’t rely on social security to pay you enough to live comfortably on. That means you must save your own money. If your company offers a 401(k) plan, use it. If not, put money into an traditional or Roth IRA.

You need to get these three areas in balance. If you aren’t saving for retirement today, start saving. If you don’t have enough money to start saving, then reduce your expenses. Similarly for high-interest debt – if you don’t have any spare money, reduce your expenses to start paying down your debt.

If you have got the above in step, then you can start to save and invest additional money. Why would you do that rather than spend it? Because savings earn your more income!

Creating a budget

You might think you don't need a budget. You have money coming in, and you pay the bills as they arrive. Why budget? Well, without a budget you are like a driver on unfamiliar roads without a map. You are going along okay, but you don't have a plan for where you need to get to, and you don't know the best way to get there.

A budget can help you get to were you want to get to, such as retirement or enough money for a new car downpayment. A budget can help you adjust your spending, saving money here to put more savings towards the kids education. At the very least, a budget lets you know where you are today -- how much do you spend? Where could you make savings?

If the idea of creating a budget seems overwhelming, don't panic. Here is a quick start.

First, decide what tools to use. You can use pen and paper. Or a spreadsheet to simplify the sums. Or a budgetting web site (such as mint.com, Yodlee or Wesabe). Or use some fancial software (Microsot Money or Intuit Quicken). I think the spreadsheet approach works fine (I use Excel for my budget, and Microsoft Money to track account details).

Ok, so now write down (or type in) a list of the main areas where you spend money. To give you are start, here is a list of items in my budget:

• Car - insurance
• Car - gas
• Clothing
• Food - groceries
• Food - dining out
• Gifts
• Household - furniture, etc
• Household - insurance (home owners/renters)
• Household - mortgage payment or rent
• Household - property tax
• Health insurance
• Healthcare
• Leisure - books and magazines
• Leisure - other
• Pet
• Utilities - cable tv
• Utilities - electricity
• Utilities - gas
• Utilities - phones
• Utilities - water/sewage

You might have a few more - maybe student loan or car payments, daycare feeds, or whatever.

Now figure out how much you spend in each category. In my Excel spreadsheet, I have two columns: per month and per year. Some categories are per-year (property tax) while most are per-month. I then divide the per-year amounts by 12 to get an equivalent per-month amount. Add up all the per-month values can I get my monthly budget. This is how much I expect to spend (on average) each month.

Now compare to your income. If income (after tax) each month is less than the total from the previous step, you have a problem. You'll need to find ways to reduce your spending. This is where the budget becomes really useful -- look at the per-month numbers. Are you getting value for money for everything you are spending? Can you reduce spending on dining out, for example? Or switch to cheaper brand groceries? Drive less and save gas?

If your income per month is more than your expenditure, then congratulations! Now you get to decide what to do with the extra. This is a whole other topic, but good things to consider are retirement savings (IRA, Roth IRA, etc), or moving the extra money to a high-interest savings account. Or invest it in the stock market. Less practical, but more fun, you could save it towards a big purchase (a car or house downpayment).

In any case, you can use the budget to figure out how long you'll need to save for, or when you could retire (these calculations will require more information, such as expected rates of return, inflation, and so on).

Here is how I use my budget. I direct deposit my paycheck into my savings account. Then I transfer the "per-month" total into my checking account. I pay all my bills from the checking account, so this forces me to stay under budget. It gets a little more complex when a large yearly bill comes due (since I need to have enough to pay the bill) so I normally have a small additional "buffer" of money in my checking account. But overall this keeps my expenses under control and gives me predictable savings that I can use to plan my retirement savings and future big-ticket purchases.

How to calculate your taxes

Ever wondered how to calculate your taxes? This article is a basic introduction to how the US tax system works for income tax (this is the tax applied to earned income, such as wages, and some other types of income such as bank account interested).

To work out your tax, you follow this basic process:

1. Add up all your income
2. Subtract your standard deduction (or you can add up your actual deductions and subtract that instead)
3. Subtract your exemption, which is an amount for each of your dependents (spouse, children)
4. Calculate your tax

The value your calulcate at step 3 is your total taxable income. You now use the IRS tax tables to calculate your tax. The tax tables split your income into bands (called "brackets"). Think of the bands like buckets - you start by "pouring" your income into the 10% bucket. That buckets gets full after you've poured in $7,825, so now start the pour income into the 15% bucket. When that bucket gets full, start pouring income into the 25% bucket, and so on.

Let's say your total taxable income was $7,000. You pour this income into the 10% bucket which can hold $7,825, so all your income fits into this bucket. Calculate the your tax based on the amount in the bucket:

• 10% of $7,000 (that is, $700)

Now let's say your total taxable income was $10,000. This time, you fill up the 10% bucket with $7,825 of income. The remainder goes into the 15% bucket. The amount in this bucket $10,000 minus $7,825, or $2,175. Your tax is the total tax owed for both buckets:

• 10% of $7,825 plus
• 15% of $2,175

Which comes to about $1108.

Your marginal rate is this highest rate bucket into which you poured your income. In the second example, you poured income into the 10% and 15% buckets, so your marginal rate is 15%.

Some people think this means they paid 15% of their income in tax. That isn't true. You still paid 10% on the first $7,825, and paid 0% (no tax at all) on your standard deduction and exemptions. The marginal tax rate is the tax rate you will pay on the next dollar of income. Let's say your boss gave you a raise of $1 (a pretty stingy boss). This raises your total taxable income to $10,001. Since your marginal rate is 15%, you would pay 15% of the $1 in tax. Of course, if your raise took you into the next tax bracket, then you would owe tax at 25% on the amount over $31,850.

While we are here, let's clear up one myth about marginal rates. Some people think that if they get a raise that takes them into the next marginal tax rate, then you'll get less take home pay. That is not true. Remember that tax rates are like buckets -- you'll only pay the higher rate on the amount of the raise that takes you into the next bucket. You will owe more tax. But your take home pay will never decrease solely due to a raise (I guess that there may be highly complex situations where this does occur).

But let's go back to a taxable income $10,000. To get a taxable income of $10,000, that means your gross income would be $18,750 (remember you get to subtract your deductions and exemptions from your gross income to get to your taxable income). So if you had a gross income of $18,750 your tax is $1,108.

What percentage of your gross income did you actually pay in taxes? Simply divide the tax by your gross income ($1,108 divided by $18,750). This gives an effective tax rate of 5.9%. So while your marginal tax rate is 15%, you only paid 5.9% of your gross income in tax!

This is a simplified view of how taxes are calculated, so don't rely on this to calculate your actual tax. For that, use a tax preparation program, use the forms on irs.gov, or see a tax preparer. However if you know your gross income you can use this method to work out your marginal tax rate and your effective tax rate.

Earn more money on your savings

Where do you put your savings? If you are like many people and move money from your bank's checking account to your bank's saving account, you are not getting your money's worth.

Despite the name, most bank "savings accounts" are terrible places to put savings. Consider Bank of America: their "Market Rate Savings" account sounds great. What could be better than market rate? But that account pays 0.20%. That's right, zero point two percent. Since inflation is around 3% today, this means your savings will be losing 2.8% of their value every year!

You should have your savings in an account that makes at least 3% a year, just to break even. There are many options, such as

• A high-interest savings account
• A high-interest term deposit (a "certificate of deposit")
• Invest in the stock market

All of these have a place, but for money that you might need in the short term, a high-interest savings account is the best bet. You should keep the minimum you need for day to day activity in your checking account, and move the rest from your checking account to a high-interest savings account.

The best rates tend to be offered online. At the moment, you can get 4.3% with ING Direct, 4.5% with HSBC Direct and 4.75% at Emigrant Direct. However the best deal seems to be Countrywide Bank, offering 5.5%. All of these banks are FDIC insured, which means that if they go bankcrupt (which is unlikely) you'll get all your money back up to $100,000 per bank.

Any of those make great choices for your savings. Since these are online accounts, they "link" to your checking account. You add money to the savings account by transfering it from the linked checking account into the savings account. To get money back, you do the reverse transfer.

Signing up for an online savings account is quite straightforward. You'll need details of your checking account (a check will give you all the information you need). If you want to get into the habit of saving regularly, ING Direct is the best choice because this is something they encourage.

But any account paying over 4% for your savings is better than most regular banks saving accounts. It is your money, don't let it waste away in a low interest account.