Simple rules for financial planning

Do not use second mortgage as substitute for cash reserves

I am a firm believer in cash reserves. Except for participating in a company retirement plan, you should not begin to invest in stocks, bonds, mutual funds, real estate, or any other asset class until you first set aside some money as cash reserves.

The amount you need in reserves is based on how much money you spend (not on what you earn) and on the stability of your income (not the income itself). For example, because a couple such as  Richard and Catherine are married and each have secure jobs, two months worth of spending is probably sufficient. However, a single mom, June  who earns sales commissions, ought to keep 12 months’ worth of spending in cash reserves. The point is that every person or family should maintain in cash reserves enough to get through those unexpected but inevitable rough times. As important as that is, it’s equally important that you maintain only enough in reserves, because the interest rate your reserves will earn is terribly low-lower, in fact, than what you’ll earn on virtually any other investment.

Once you determine how much you need for reserves, you must keep your reserves safe (meaning you cannot lose this money) and liquid (meaning you can get to it at any time without penalty). Only six places qualify: your mattress, savings accounts, chequing accounts, money market funds, Treasury bills, and short-term bank time deposits. Although most folks who are attentive to their finances agree with this concept, over the past several years, many have become unhappy with the idea of stashing $25,000 or $30,000 into low-interest bank accounts, where the money just sits for a rainy day that might never come, while their investments in stock and mutual funds have been earning 15% a year or more.

Increasingly, I have come across people who are not maintaining any money in cash reserves. Instead, they’re taking out second mortgages on their homes at the bank. It’s a great idea, they say. Because they bought their houses many years ago, they now have substantial equity in their homes, enabling them to obtain a $50,000 or sometimes even $100,000. This way,they can fully invest all their cash and, if the roof suddenly needs repairs, they can simply take out a second mortgage to pay the bill.

Although their plan sounds good, it is predicated on two things; good performance from their investments and a short-lived, although not necessarily inexpensive, crisis. I’m not sure I’d categorise a new roof as an economic crisis (at least, it shouldn’t be one). No, in my opinion, a real crisis would be you losing your job because your company went broke-rendering worthless all of your company stock and tying up in litigation your pension  plan because the management was stealing from it in a vain attempt to keep the company afloat.

That’s what happened to one of my friends. He lost his job when the company went broke, and fearing that he might be out of work for months, he went to the bank to seek a second mortgage on his house. When asked why he wanted the mortgage, he replied to the loan officer, “Well, I’ve just lost my job, so I want this to help tide me over.” Bad move. Not only did they deny his request, the bank cancelled his existing credit line! Remember, its called cash reserves for a reason. So, while you can be as clever as you want when it comes to selecting your investments, don’t get too creative when it comes to building and maintaining your cash reserves. Because when that crisis hits, you’ll agree: There is no substitute for cash.

Prevent credit record from becoming too good

When evaluating your application for a mortgage or other loan, lenders ask themselves one basic question: Are you likely to default? To help them answer that question, they utilise a credit scoring method devised by Moody’s which scores  individuals based on their credit histories. This practice, which compares your credit report with data compiled from thousands  of other borrowers, enables the system  to predict your likelihood of default. The point system, developed over the past four decades, gives a variety of values for the types of accounts you hold, as well as your history, such as delinquencies. The higher your  score, the better. In fact, merely asking for a new credit card can be as bad as being denied one. You lose ten points for each credit inquiry (an inquiry is made whenever you apply for credit), because Moody’s  has learned that those in (or expecting) financial trouble try to increase their lines of credit. Thus, completing a dozen applications in a brief period makes you a suspect credit risk.

If you’re among the “smart consumers” who have a credit card “just in case” you need it, you’re actually hurting yourself: You lose points if you have a credit card but never use it. Of course, delinquencies count against you, too. How much depends on their severity and how recent and frequent they are. And some delinquencies outweigh others — missing a mortgage payment is considered worse than missing a credit card bill. Because so much data is used to calculate your score, Bank’s do not disclose how your score is determined, although the company is quick to state that age, race, religion, colour, national origin, marital status, and sex are not considered.

To get a high credit score — which is important if you one day want to buy a home or apply for a car loan — you should: have and use few bank cards; close any unused credit card accounts;
* Keep your credit limits and outstanding balances down; satisfy any public records (such as tax liens or judgments); avoid late payments; and limit the number of accounts you open.