70% of Americans Can’t Answer These Three Questions Correctly

IF this is true, it’s very sad. According to Business Insider, 70% of Americans cannot answer all three of these questions correctly (not sure how they came up with that number, but we’ll go with it).

1. Suppose you had $100 in a savings account and the interest rate was 2 percent per year. After five years, how much do you think you would have in the account if you left the money to grow?

A) more than $102
B) exactly $102
C) less than $102
D) do not know; refuse to answer

2. Imagine that the interest rate on your savings account is 1 percent per year and inflation is 2 percent per year. After one year, would you be able to buy

A) more than
B) exactly the same as
C) less than today with the money in this account
D) do not know; refuse to answer

3. Do you think that the following statement is true or false? “Buying a single company stock usually provides a safer return than a stock mutual fund.”

A) true
B) false
C) do not know; refuse to answer

I would hope all AFM readers could get these questions correct. I’m going to ask my kids when they get home from school. I suggest you do the same.

AFM Reader Question: Roth IRA for Emergency Fund?

I received the following email the other day:

I read a blog post a few weeks ago at Mint.com about using your Roth IRA as an Emergency Fund. Here’s the blog post: Does Using a Roth IRA as an Emergency Fund a Good Idea?

I’ve been following your blog for several years now (you even wrote a blogpost about a question I wrote to you in 2009).

Anyway, I used to contribute to my Roth IRA regularly, but then stopped amid job transitions. I have a decent sized emergency fund set up, and recently decided to target 6 months expenses. I understand not having the entirety of an emergency fund set up in a Roth, since the value can actually go down when you might need it. I was just wondering what your take is on the blog post linked above?



Here are my thoughts:

First I would focus on getting 3 months’ worth of expenses socked away in a cash account for the bulk of the emergency fund. Then, I would invest through a Roth IRA and use it as a backup if necessary. So, I think the strategy has some merit. Yes, there is some risk involved due to volatility but if you already have 3 months saved up in cash, you may never need to take from the Roth.

The most important thing regarding emergency funds is to make sure you use it just for real emergencies (like the air conditioner goes out or for an insurance deductible). Too many people think new shoes are an emergency.

PLEASE Make Your High School Kids Watch This Financial Planning Video Series!

I just found this on YouTube this morning and have been working my way through the videos. This is very well done except that it’s hard to hear the questions from the audience. Regardless, if you want to give your kids something that will have a positive impact on their lives, have them watch this series. I have listed them all here to make it easy for you. The financial planner’s name is Marnie Aznar and her firm is Aznar Advisors (UPDATE: Her link doesn’t appear to work at this time).

Personal Finance from Rothman Institute on Vimeo.

The Basics: Setting and Reaching Financial Goals

One of the most important areas of personal finance is setting and reaching financial goals. Why are financial goals important? Without them, it’s likely you won’t save and invest your money wisely. Having goals tends to help us focus on what’s important. Without them, we tend to allow life to just happen to us.

What Are Financial Goals?

There are many different kinds of financial goals:

• Get out of debt

• Create an emergency fund

• Pay cash for a new (or used) car

• Downpayment on a house

• College fund

• Retirement

The Goal-Setting Process

I’m not a goal-setting expert but I was able to come up with six steps in the goal-setting process:

1. Determine your goal and the amount of money needed to meet the goal.

2. Set a due date for meeting the goal.

3. Decided what investment vehicle that will be used to meet the goal.

4. Calculate the lump sum or periodic payment that will be needed to meet the goal.

5. Track your progress.

6. Reach your goal.


Let’s look at what the process looks like for someone saving up for a downpayment on a house. Let’s say in 5 years you desire a 20% downpayment on a $200,000 house ($40,000).

1. $40,000

2. 5 years (60 months)

3. Since the goal is relatively short-term, the savings will be kept in an interest-bearing savings account. For this exercise, we’ll use an annual interest rate of 1.28%.

4. To determine the lump sum or monthly payment necessary to meet this goal, you can use any number of online calculators, a regular calculator, or you can download this simple Excel Spreadsheet I put together for this post. Because interest rates on savings accounts are so low, the lump sum needed to meet a $40,000 goal in 5 years is really high at $37,500. If you’re going to reach the goal with monthly savings, you’ll need to save $645 per month.

5. For short-term goals, you’ll want to track your performance on a regular basis (monthly or quarterly) and make adjustments as necessary.

6. If all goes to plan, this goal should be met in five years (sooner if interest rates are higher or you can add more to your savings).

If you’ve never set and reached a financial goal, I urge you to give it a try.


Should I Liquidate My 401(k) In Order to Pay Off My Credit Cards?

I was talking with a friend of mine the other day. He asked me whether or not he should liquidate his 401(k) in order to pay off his credit cards. Here are some of the details:

• credit card debt around $15,000. Interest rates of 19% and higher.

• 401(k) balance of $16,000 from a former job. No other retirement savings.

• will not be able to contribute to his 401(k) until next year.

• he has an extra $1,000 per month that he could put towards paying down his credit card debt. (I’m not sure what he’s currently doing with the $1,000.)

Here’s what I told him to do:

1. DO NOT LIQUIDATE THE 401(K)! Why? Because nearly $5,000 would be lost to taxes and a penalty. Not only that, he’d be losing out on the future growth of his 401(k).

2. I would then commit to paying $1,500 (using the $1,000 mentioned above plus current credit card payment amounts) towards paying off the credit card bills. I did some quick math and found that he could have his credit card debt elimated by February of next year:

It’s amazing how quickly interest charges can come down as long as you pay a sizeable amount each month towards the balance.

3. Then, about that time his credit card bills are eliminated, he will be eligible for the 401(k). I would then contribute $1,375 per month to the 401(k), which is the current employee maximum allowed.


The main thing is to have a plan and stick to it.

Reader Question on How to Determine How Your Investments Are Doing

The following comment was left on this post from last week:

Have a question:

What reasonable standards should investors use to measure how well or poorly that they are doing?

I’m sure that an answer would include “it depends” but if so, depends on what?

We are about 10% under our 12.31.07 balances and we are pleased but how pleased should we be? There is always someone who well fare better or worse but I’m at a loss as to which reasonable “standards” that I should use to know how I’m doing?

That’s a very good question.

Unfortunately, the appropriate answer is: it depends.

From a general standpoint, your portfolio’s performance should be judged against the appropriate benchmark or benchmarks.

For instance, if you have a portfolio of 50% large-cap stocks and 50% bonds, you would not base your performance on solely on the S&P 500 Index. Rather, you’d base it on a 50/50 split between the S&P 500 Index and the appropriate bond index.

If your portfolio is comprised of large-cap, mid-cap, small-cap, bonds, and real-estate investment trusts, then you need to base the performance on benchmarks for all of those asset classes.

The reason for this is that it’s easy to say, “Wow! We did awesome last year. Our portfolio was up 8%!” The reality could be that a benchmark portfolio might have been up 12%, making your 8% return not so stellar.

Of course, another way to judge your performance is to do what BG suggested in the comments of that post and that is to base your performance on whether or not you’re meeting your future goals. It doesn’t matter how your portfolio is doing if it’s not helping you meet your future goals.

For example…

Let’s say you have a retirement goal of $1,000,000 (purely hypothetical, ignoring inflation). Your retirement is 20 years away and you have $100,000 saved up so far. You are contributing $500 per month into an S&P 500-based fund. You don’t expect your contribution amount to change (again, hypothetical).

Using the RATE function in Excel, I figured that the required rate of return to meet that goal is .78% per month (9.79% annualized). Given that the monthly geometric average total return on the S&P going all the way back to 1926 is .77% (9.64% annualized), you most likely will fall short of your goal by around $25,000.

This leaves you a few choices:

1. You can accept the lower amount at retirement.

2. You can take on more risk by moving into small cap stocks, which have a higher expected return but also are a lot more volatile (more on that in a future post).

3. You can increase your contributions. Based on my numbers, increasing the contribution amount to $540 per month, put’s the expected account value at a little over $1 million.

I realize that we are talking about math based on linear growth, which never happens in the real world. But, it can still be beneficial to have some sort of basis in reality. If your goal is $1 million and you’re investing a certain amount per month, it would be wise to know if you have a shot at meeting your goal.


This is One Crappy Car Loan! Lessons on How NOT to Buy a Car!

I received this email earlier today:


I’ve been subscribing to AFM for quite some time now and I really appreciate almost all of your blog posts. My room mate just bought a car yesterday and because he has little to no credit (and may have been an easy target) got a 24.99% 6 year loan (his payments are around $380/month making the $13,000 car actually cost close to $30k!). He says he’s going to refinance in a year and hopefully will get a better interest rate after establishing more credit. The salesman said that he could pay extra towards the loan to pay it off early, etc. Let’s say he could afford to pay $480/month, would it be better to pay the extra $100 every month on this higher interest rate, or pay an extra $1200 once he gets on the lower interest rate? I hope my question makes sense! You always do a great job explaining things with your spreadsheets! 🙂



Your room mate made a really bad decision for a couple of reasons:

1. Running the numbers, I come up with a principal and interest payment of around $350 per month. R says his room mate is paying around $380 per month. This means that the sales guy either talked the room mate into buying insurance or he slipped it in under the radar. Regardless, it’s some expensive insurance that will cost him over $2,100 over the life of the loan. Your friend would be wise to go back into the dealership and DEMAND that they take the insurance off. UPDATE: It was a warranty.

2. He most likely will NOT be able to refinance his loan because the car will depreciate in value very quickly. It’s hard to refinance a loan on an asset that is worth less than what is owed on the loan. Due to the high interest rate on the loan, your friend will be upside down on this loan unless he pays substantially more towards the loan than his payment. That said, given how crappy the financing is, I wouldn’t be surprised to find that this loan has some sort of prepayment penalty.

Your friend would have been smart to have done some homework BEFORE he made such a commitment. It sounds like he made a decision with his heart and ignored his head.

Now, concerning your question:

Let’s say he could afford to pay $480/month, would it be better to pay the extra $100 every month on this higher interest rate, or pay an extra $1200 once he gets on the lower interest rate?

Here is a look at your friend’s car loan amortization summary:

Car Loan Amortization Summary

Assuming there’s no prepayment penalty, your friend would be wise to pay as much extra towards this loan as possible. I’m skeptical that he will be allowed to refinance this loan. I ran some numbers and found that if he paid an extra $100 per month towards the principal, he could pay the car off in less than 4 years, saving himself over $5,200 in interest.

I just hope that his decision hasn’t started him down the path of one bad decision after another. Usually people who get upside down on a car, stay that way for A LOOOOOONG time.