Guidelines for personal finance

Here we'll cover a few investing topics as well as important personal finance topics not directly related to investing.

Click to move to each section:

• Carefully consider whether to rent or buy your home
• Focus on financial weak points
• Minimize risk of catastrophic loss - emergency fund
• Pay debt or invest?
• Fraud prevention - banking footnote - credit freeze footnote
• Always designate beneficiaries

 

Carefully consider whether to rent or buy your home

It is an article of faith for many people that owning a home is a pillar of long-term wealth and a sign of financial success. But anyone willing to do the math will find that renting can be a wise decision, regardless of whether you’re wealthy enough to buy. The right choice for each individual situation should be assessed instead of assumed. Slogans like “renting is throwing your money away” or “rent is paying someone else’s mortgage” reflect serious misconceptions. The discussion below will show how to accurately compare the costs of renting and buying.

A renter has to pay rent, (usually) utilities, and possibly renter’s insurance for their personal property. Renter’s insurance is far less expensive than homeowner’s insurance, because it doesn’t cover the dwelling. One other tiny cost is that the security deposit is held by the landlord, and is not available for investment beyond the savings account it sits in. A renter's costs are relatively predictable and easy to understand.^[1] Aside from utilities, there are several costs and risks which homeowners have to bear that renters do not:

• High transaction costs when moving
• Property tax
• Homeowner’s insurance
• Maintenance and improvement, including surprise repairs
• Possible HOA fees (or similar fees by another name)
• Possible mortgage interest
• Possible private mortgage insurance (PMI; a small expense)
• Idiosyncratic price risk of a single property, enhanced by leverage
• Opportunity cost of home equity
• More cash needed on hand before the purchase (for a down payment) and after (for emergency repairs)

A common argument for the inherent inferiority of renting is that all the costs of ownership are implicitly passed on to the renter. It's assumed that because landlords buy properties with the goal of generating profit, renters are the exploited losers in a zero-sum game. This description is quite incomplete. Let's consider the details of some of the costs of housing.

What about the high transaction costs? Buying or selling a home entails fees (and sometimes taxes) that total thousands of dollars and can reach well into the ten-thousands. Real estate transfer taxes tend to be highest in major cities, where the local tax is added to the state tax. For instance, in Philadelphia a transfer tax of 4.278% is typically split evenly between the buyer and the seller. A buyer of a $500K home in Philadelphia would pay $10,695 in transfer tax alone, on top of several other closing costs. Title fees tend to be 0.5% to 1% of the sale price. The seller would pay the same $10,695 transfer tax, plus an agent commission of $25,000 to $30,000 (5-6% of the sale price), the costs of short-term housing or overlap with a second home while selling, and more. So the cost of a round trip on this home (buying and selling) could easily be $60,000. The total transaction costs can vary widely — Arizona prohibits any state or local transfer tax, so the tax cost of $21,390 in Philadelphia would fall to zero in Arizona and numerous other states. Transaction costs of a round trip total about 10-15% of sale price. A landlord who keeps their property for long periods of time, which many do, does not pay frequent transaction costs, so there is little cost to pass on. This leads to one of the chief advantages of renting, which is that a renter can move at much lower cost than an owner. Unless you're pretty certain of a long stay, renting can become the superior choice due to transaction costs alone.

The costs of basic maintenance can be cheaper for landlords because they have ongoing relationships with contractors and can benefit from economies of scale. A handyman who services a large apartment building or many houses owned by a single company can charge less per job than someone you called to visit your house once. Landlords also bear the risk of unexpected repair costs. If you’re a homeowner, you’re responsible for keeping cash on hand in case of emergency repairs, and for all the time and energy involved in arranging repairs (or doing them yourself). Surprise repair expenses can range from trivial amounts to tens of thousands of dollars for mold remediation or fixing a faulty foundation. The need to keep more money in cash or low-risk investments reduces the expected return of a homeowner’s assets. This is also true in the years preceding a home purchase: to preserve money for a down payment, future homeowners tend to keep money in low-risk investments.

With any amount of money, we can access the returns of a globally diversified portfolio of thousands of stocks or bonds by purchasing shares of a fund. In contrast, enormous amounts of money are required to directly own a diversified portfolio of real estate. By purchasing a single home, you’re exposing yourself to the general risk of residential real estate, as well as the idiosyncratic risks of your property. Broadly, US home prices crashed in the late 2000s and have fallen less drastically at other times.

As with stocks, it’s very hard to predict what the asset class return of real estate will be over any time period, let alone the return of a single property. Those who owned homes in San Francisco for the last few decades are generally very happy with the price appreciation; those who owned in Detroit were not so fortunate. Can you predict the price behavior of your home? I wouldn’t count on it. If housing prices in a given area have appreciated rapidly in the recent past, that should provide no confidence that they will continue to do so. Real estate is a risky asset class, and individual properties in particular — like individual stocks — can experience long drawdowns. Imagine putting a huge chunk of your life savings in a single stock. That is akin to the risk most people accept when they take out a loan to buy a single property. Part of this risk is due to leverage. Someone with a 10% down payment, which is common, has 10x leveraged exposure to the price of their home. If the price drops more than 10%, they owe more than the house is worth. On top of the direct financial consequences, some people who are underwater on their mortgage can lose residential mobility because they're trapped by their debt. They cannot sell their home because they wouldn't have enough money to pay the remaining loan to zero. A renter simply avoids this risk.

Homeowners are quite aware of the cost of interest on their mortgage loan. But most people don’t consider the opportunity cost of home equity. The prevailing view is that it's ideal to own your home outright. Certainly, it may feel great to own a home with no debt, and you can decide if that’s right for you. But we can illustrate why home equity has an opportunity cost. Let’s say we own a home worth $300K. We could keep the home, or we could sell it and switch to renting. If we sell it, we’ll pay some thousands in closing costs. We can then invest perhaps $275K in risky assets like a stock fund, which has much higher expected return than a home.

This betrays many people’s intuitions about the merits of owning a home. It’s especially counterintuitive that a home with no remaining mortgage has the highest opportunity cost. But that’s the nature of an opportunity cost: when you buy a home and lock up all that money in home equity, you sacrifice the greater potential gains from investing in assets with higher expected return. This is not an out-of-pocket expense that shows up on a bill, but it is a real cost. It means that the net worth of a renter can easily keep up with the net worth of a homeowner, if the renter invests the money they would have spent on higher housing costs.

One way to reduce housing costs is to share common spaces with others, if you're willing to do so. Living spaces are more efficient with shared resources: the bathrooms, washer and dryer, kitchen, common room. Want to rent a multi-bedroom house with a few people, or share a two-bedroom apartment with a friend? That's relatively easy to start, and allows people to move in and out with flexibility. Want to buy a home with others? That is less flexible, more logistically difficult, and entails a lot of risk and liability.^[2] Renting facilitates the use of multi-room units with common resources. (Even with no roommates, living in a multi-unit building is more resource-efficient than living in a single-family house, but of course you have the choice to buy or rent that kind of home.)

All of this amounts to an observation that landlords do not (and cannot) simply pass on costs and risks to tenants while adding some profit for themselves. Renting has potential benefits that can make it a better choice for some people during some parts of their lives (even if they can afford to buy). Landlords bear the risks of surprise repairs and price declines; tend to pay lower maintenance costs and transaction costs; and facilitate lower-cost, multi-room living arrangements. Renters can move more cheaply and easily, and they keep more of their wealth liquid, giving them the opportunity to invest in diversified assets with higher expected return than a residential property. Landlords are not engaged in a zero-sum relationship with their tenants.

There are numerous potential benefits to home ownership. One practical concern is that the kind of housing you want to live in may not be available as a rental. In a rural area, you may have a hard time finding a three-bedroom house to rent for your family. Moreover, some people love the feeling of owning their home, and the freedoms provided by not having a landlord. Many people would be willing to increase their housing costs in exchange for this benefit. But rather than appreciate that owning a property can be more expensive than renting a similar property, many people believe that owning a home is consistently a great investment. In my view, it’s much better to recognize that while home ownership is not guaranteed to be a great financial decision — even if you live in the same place for a long time — you may think that the freedom and stability provided by ownership easily make it the better choice for you.

Neither renting nor owning is right for everyone at all stages of life. Much is left up to chance: renting can turn out to generate more wealth if your investments perform well, and owning can turn out better if your home happens to appreciate greatly in price. But failing to understand the benefits and drawbacks of each approach to paying for housing can lead to poor outcomes. In particular, the societal pressure to own a home can lead people to desperately pursue ownership regardless of whether that means settling for a bad deal or buying too early in life.

Rent is not comparable to a mortgage payment

These videos from Ben Felix are great quantitative explanations of the points above. He discusses the issue in more detail in a podcast episode. I strongly recommend watching them. As he emphasizes, it's important not to compare rent to mortgage payments, but instead to compare the unrecoverable costs of renting and buying. What makes a cost recoverable or not? When you pay for an asset and can later sell it for its residual value, the cost you paid was recoverable. You can buy company stock or equity in a home and later sell for the remaining value. The value may be more or less than you paid for it, but it has some residual value. Unrecoverable costs include rent, property tax, and HOA fees. You pay them and receive no asset you can sell later.

As a renter, all costs are unrecoverable: rent, utilities, and possibly renter's insurance. A homeowner's principal payments and improvement expenses are recoverable costs, because those expenses have an associated residual value — even though selling the home doesn't mean they'll recover the same amount of money they paid. An owner also has many unrecoverable costs: utilities, property tax, maintenance, HOA fees, homeowner's insurance, transaction costs, private mortgage insurance, and the cost of capital: mortgage interest plus the opportunity cost of not investing in stocks. Several unrecoverable costs — the first five listed above — are out-of-pocket expenses that never end, and we'll call these "ongoing expenses".

So unrecoverable costs can be understood as a kind of rent you pay to own a home. We can add up the unrecoverable costs of renting and buying to establish a basis for comparison. Ben Felix suggested the 5% rule, a simplified guideline which suggests that renting is advantageous if your annual rent is less than 5% of a similar property's purchase price. In Ben Felix's formulation of unrecoverable costs, 3 percentage points arise from the cost of capital, and 2 points arise from ongoing expenses like property tax and maintenance. In my view, 2% is on the very low end of the spectrum of ongoing expenses.

• Property tax alone is about 1% on average in the US, and exceeds 3% in some areas!

• HOA fees can be absent in detached, single-family homes, or less than 1%. But they can reach above 3% in some multi-unit buildings with amenities. If you buy a condo in a building with its own gym, parking garage, or doormen, be prepared to pay high fees every month for as long as you own the unit. Even if you live in a single-family house, HOA-supported amenities like a pool and clubhouse can be expensive. You generally can't opt out of using and paying for what an HOA provides; even if you don't want the lawn care and snow removal, you accept the fees when you buy the home.

• Maintenance is perhaps another 1%, but can be higher. If you decline to maintain your home, its value will depreciate, so it costs you either way. Maintenance is not only the regular small expenses, but also entails saving enough to occasionally replace major appliances, roof and siding, sewage and plumbing, etc. These costs don't include home upgrades and renovations, which are an expensive temptation on which most homeowners gladly spend additional money. Maintenance has some overlap with HOA fees: if you live in a condo you won't have to maintain a driveway or exterior yourself, but HOA fees are used to maintain the building's exterior (and parking area, if there is one). HOA fees in a condo also cover services like garbage disposal, which are usually a separate expense for owners of single-family houses.

• Homeowner's insurance is a minor expense for some properties, and a major one for others. Premiums are a growing burden, especially in high-risk areas like parts of California and Colorado with wildfires, or parts of Florida, Texas, Louisiana, and Mississippi that are vulnerable to floods. Even if you live in an area of (say) Florida with low flood risk, regulations prevent insurance companies from accurately pricing risk, leading homeowners with low risk to subsidize those in disaster-prone areas of the same state. Some people forgo homeowner's insurance because of the cost, which is extremely risky. The national average is roughly 0.5% of dwelling coverage, with a great deal of variation. Very expensive homes tend to carry disproportionate premiums. As with other types of insurance, a high credit score can reduce your premiums (except in a few states that don't allow credit scores to be factored into premium calculations). Meeting your deductible, as well as paying for types of damage not covered by your insurance, should be factored into your emergency fund. Keeping a relatively large amount of money in low-risk investments is another cost of home ownership. You could decline to hold sufficient low-risk assets, if you'd prefer to convert the expected cost of cash drag into a greater risk of selling stocks at a loss during a spending shock.

Clearly, adjustments to the 5% rule are needed depending on the characteristics of each property. The 3% premium for investing in stocks can also differ depending on your portfolio and how your gains are taxed. Some stocks have higher expected return than others, as we'll discuss later.

Here's a table providing a sense of out-of-pocket housing expenses if you buy a home with a 30-year, fixed-rate mortgage and assume 2.5% annual ongoing expenses from property tax, HOA fees, maintenance, and so on. The numbers below combine ongoing expenses with principal and interest payments. Interest rates on the mortgage vary between 4% and 8%, and the down payment is a standard 20%. If 7% or 8% seems unusually high because you know people with 3% mortgage rates, see the historical data on average 30-year mortgage rates in the US. Rates above 8% have been a lot more common than those below 4%, and the average rate since 1971 is well above 7%. You can reduce your mortgage rate by ensuring you have a high credit score, checking with multiple lenders for a competitive rate, and saving for a 20% down payment — most buyers put down less, usually because they can't afford 20%. There are many mortgage calculators online, including mortgagecalculator.org.

Annual housing expenses with a 30-year fixed-rate mortgage, 20% down, and 2.5% ongoing expenses

Price	20% down	4% rate	5% rate	6% rate	7% rate	8% rate
$150K	$30K	$10,625	$11,480	$12,384	$13,330	$14,316
$200K	$40K	$14,166	$15,307	$16,511	$17,774	$19,088
$300K	$60K	$21,250	$22,960	$24,767	$26,661	$28,632
$400K	$80K	$28,333	$30,614	$33,023	$35,548	$38,177
$500K	$100K	$35,416	$38,267	$41,278	$44,435	$47,721
$1.0M	$200K	$70,832	$76,535	$82,557	$88,869	$95,441
$2.0M	$400K	$141,664	$153,070	$165,114	$177,738	$190,883
X	20% of X	7.08% of X	7.65% of X	8.26% of X	8.89% of X	9.54% of X

 

Let’s take the example of a $400K home with an $80K down payment and 5% interest rate. The annual out-of-pocket expenses are $30,614, but what are the unrecoverable costs we can compare to a rental? Under the 5% rule for a $400K property, we would calculate annual rent of $20K or monthly rent of $1,667. But Ben Felix’s simplified example assumed the cost of capital is the same for borrowing money and paying into home equity, 3% either way. Here, the cost of capital is 5% for the borrowed money, and we’ll keep a low estimate of only 3% for the money locked up in home equity. We'll assume 2.5% ongoing expenses instead of 2%. In the first year of this mortgage, the unrecoverable costs will be 2.5% of $400K ($10K) plus mortgage interest ($15,893) plus 3% of the average amount of money committed to home equity ($2,464). That adds to about $28,357 annually or $2,363 monthly. So under these rough assumptions, the total cost of owning this home is similar to paying $2,363 in monthly rent.

Finding the rental equivalent of an owned home can also be useful if one member of a couple owns their home, and the other lives with them and needs to pay them rent for (say) half the home. Many people don't know where to start when faced with this situation, and confusion can lead to conflict over how to calculate a fair rent.

When estimating a rental equivalent, you would also want to consider: (a) the price risk of buying a home you might sell; (b) the transaction costs of buying (and probably selling); (c) whether the mortgage interest tax deduction could reduce your tax bill; (d) that your assets would be more liquid and more diversified as a renter; (e) that your expenses over the lease term would be more predictable as a renter, entailing less need for cash on hand; and (f) that regular payments are more stable in the long run if you buy, compared to uncertain future rent prices. But future regular payments can't be fully anticipated because property tax, insurance, and HOA fees will change at uncertain rates, and surprise repairs are a wild card.

The tax laws Ben Felix discussed are Canadian. When you sell a primary residence in the US, you pay tax on capital gains that exceed $250K (if you’re single) or $500K (if you’re married). If a married couple bought a house for $1M, documented $100K of improvement over 15 years, and sold it for $2M, they would owe tax on $400K in capital gains. The $100K of improvements would increase the tax basis from $1M to $1.1M, and the $500K capital gains exclusion means that they would pay tax on only $400K of the $900K capital gain. They did regular maintenance on the house, but that didn't increase their basis because only improvement counts. For the $500K capital gains exclusion to apply, the house must have been their primary residence for at least two of the five years before selling. The section on taxes describes how capital gains are taxed, and its second footnote outlines potential tax advantages of home ownership.

Home ownership = building wealth?

Why do many people think owning their home is so important?

(1) A mortgage enforces discipline. Many people struggle with the habit of saving and investing money. There are no immediate consequences for someone who stops contributing to their investment portfolio. A mortgage gives someone no choice but to keep paying every month and build equity in an asset that will probably appreciate. Separately, it may be more motivating to pursue a goal with a natural endpoint — paying off the mortgage — than to simply build wealth. If you're a renter, you can mitigate this by committing to savings or net worth goals, especially if you link particular rewards to meeting these goals.

(2) Many people feel more secure with tangible investments like homes instead of intangible securities like stocks (even though the stock represents ownership of a tangible company). Unlike stocks, you can't check your phone and see the constantly fluctuating price of your home every day. Real estate is volatile, and the prices of individual properties even more so! But if you can't see the volatility, the investment feels steadier.

(3) Investing in stocks, bonds, and other liquid assets used to be less accessible and carry much higher fees. For many people in (say) 1970, buying a home was the easiest way to purchase an asset that was likely to appreciate. Even though it’s now easy to build a diversified, low-cost portfolio of publicly traded assets, many people feel that owning a home is still central to securing personal wealth.

(4) People usually sell their homes at a higher price than the purchase price 10 or 20 years prior, and think the difference between the two illustrates what a sound investment their home was. (Sometimes it's true, of course!) They typically don’t subtract (or even record) all the expenses, and almost no one considers the opportunity cost of home equity. The costs of owning a home are less visible than the costs of renting.

(5) They think renting is nothing but a loser’s game that makes someone else rich. People don't like to be ripped off, so to avoid squandering money, some people will work hard to get on any rung of the "property ladder". Hopefully I’ve complicated the narrative that renting is losing and owning is winning.

The subreddits r/RealEstate and r/FirstTimeHomeBuyer are great forums for learning about the varieties of home-buying experience.

 

 

Focus on financial weak points

Earning more vs. spending less

Saving is the foundation of building wealth, and the two main ways to save more money are earning more and spending less. Which is more important? It depends on your current weaknesses.

Take Alex on one end of the spectrum: he earns hundreds of thousands per year, yet has little savings and relies on the next paycheck to pay his bills. He sometimes carries credit card debt and has no idea where all his money goes. He has an expensive car but doesn’t really enjoy it. The payments on his vacation home make him doubt whether it's worth two visits a year. He doesn't ever shop around for better deals on his largest expenses. Alex needs to focus on tracking his spending, making a budget, and deciding how to reduce his expenses in ways that are best for him. Earning more should not be the priority, because he’s currently the kind of person who spends an entire raise instead of taking the opportunity to save more. If this kind of person seems unrealistic to you, just ask Nicholas Cage how bad overspending on a high income can get.

Alternatively, Taylor makes $15/hr and is highly frugal. She tracks her spending categories in a spreadsheet and knows how much she tends to spend in each category. She frequently reviews what spending she might want to cut, shops at multiple stores to keep track of where the best prices are, and has multiple credit cards with high cash back rewards in various categories. She has a roommate to keep housing expenses low, keeps the temperature a little uncomfortable to save on utilities, and sometimes declines fun opportunities like restaurants and trips because of their cost. She owns a used Toyota Corolla and the A/C broke a year ago, but that’s fine. Taylor needs to focus on finding the most effective ways to increase her income, without fully surrendering her frugality. With better pay, she can save more money every month while doing more of what she enjoys.

Are you more like Alex or Taylor? Could you increase your savings each month more easily by improving your earnings or reducing your expenses? Consider this and focus your energy accordingly.

Earning more vs. investing better

Combined with proper judgment, greater knowledge of investing can potentially lead to higher returns. Let’s contrast another pair of people.

Martha is 60 years old and has $3 million in liquid assets. She earns a $100,000 annual salary in a senior position and would find it difficult to greatly increase her pay beyond this level. If she improves her investment returns this year by 3 percentage points — either by increasing gains or reducing losses — she’ll be $90,000 richer. For Martha, learning how to invest more effectively is worth a great deal! Expending effort on a 5% or 10% raise would be less lucrative.

Michael is 24 years old and has an investment portfolio of $15,000. He makes $50,000 annually in a junior position. If he improves his returns by 3 percentage points this year, he’ll be $450 richer! Nice, but not much compared to a significant increase in earned income. If he can secure a $10,000 raise, that would blow away any likely gain from spending more time learning to invest.

Are you more like Michael or Martha? Where should you focus your efforts at this point in life? Of course, there are good reasons for people who haven’t accrued great wealth to understand investing. If you commit to a whole life insurance policy as soon as you start earning decent income, you’ve locked yourself into a wealth-destroying scam that you can’t easily exit once you’ve learned better. Your lowest-earning years are the most tax-efficient time to contribute to Roth retirement accounts, and you wouldn’t want to remain ignorant of this for long. But for Michael, it's not yet wise to spend a great deal of time researching the characteristics of different small cap value funds, if he can use that time to increase his earnings.

If you’re great at X, your energy is not best directed by figuring out how to squeeze a little more benefit out of X. Concentrate on Y instead.

 

 

Minimize risk of catastrophic loss

First: always have insurance for extremely valuable physical assets like your car and home, as well as health insurance. Even if your car has low value, liability coverage is vital for car insurance. Without it, you could find yourself paying the medical bills of someone you injured in a car accident. Understand the coverage you’re entitled to, so that you’re not subject to surprise denials. Once you’ve achieved some financial stability, seriously consider purchasing disability insurance. Many people's most valuable asset is not something that comprises their current wealth — it is their capacity to earn income. Social Security disability payments may not be enough to support you if you’re unable to continue earning income. It’s difficult to provide general advice about buying individual disability insurance policies, because they can be very specific to one’s line of work (e.g., surgeon). You may be able to purchase disability insurance through your employer. This can be less expensive (or your employer might pay for it entirely) but it may not be tailored to your needs and lacks portability if you change employers.

Second: if anyone else depends on your future income, purchasing life insurance is a way to safeguard them. There are two broad types: permanent life insurance, which can last indefinitely if you keep paying, and term life insurance, which is meant to last for a limited time. The most suitable type for nearly everyone is term life insurance. For instance, a 30-year-old who was married last year and has a kid on the way would be well-advised to seek quotes for 20- to 30-year term life insurance.^[3] If they're healthy, they will pay a cheap, fixed premium every month or year for the term of 20-30 years, and their beneficiary will receive a tax-exempt payout if they die during the term. Coverage varies but, in general, death due to an accident, natural causes, murder, or even suicide under certain conditions will qualify for a payout. Remember: the purpose of life insurance is to protect those who rely on your future income (or unpaid labor like childcare). Don't let insurance salespeople distract you from this central purpose. Most people should not mix insurance and investing by purchasing permanent insurance policies like whole life insurance, which greatly benefit the commissioned salesperson at the expense of the client. Two Cents has a great video explainer, and The White Coat Investor has many good articles on this topic. For nearly every benefit that whole life insurance purports to offer, there is another financial product that offers a better version of that benefit. And if no one depends on your future income, you don't need any type of life insurance right now!

Third: avoid extreme investment risks. Investing can be most hazardous when using debt or leverage: borrowing money to invest in stocks or real estate, for instance. Leverage is not always dangerous, but it puts you at greater risk of large losses. Any use of borrowed funds creates the possibility of losing more than you invested, replacing what was once an asset with unexpected debt. Although I wouldn’t discourage all uses of leverage — a home mortgage is a form of leverage — none of the investment options recommended here use it (outside of the advanced topics).

Emergency fund

Finally, your most basic financial priority should be to build or maintain an emergency fund after paying off credit card debt. An emergency fund keeps you prepared for spending shocks — major expenses you didn't anticipate — and income shocks — major reductions in your household income. Money market funds are a great location for your emergency fund. They're mutual funds with the unique characteristic of always being priced at $1 per share, and you buy them through a brokerage account like any other investment. They pay out like savings accounts, with a monthly dividend based on the amount invested each day in the past month. But they have higher yields than virtually all savings accounts. You can buy shares of SWVXX at Schwab, SPRXX at Fidelity, and VMFXX at Vanguard (also available at E*Trade and JP Morgan). Of those, VMFXX has the lowest expense ratio and highest yield. These funds optimize for high yield before tax, so people in high tax brackets should check whether other money market funds would give them a higher after-tax yield. The three broad types of money market funds are prime, municipal, and government. Prime money market funds like SWVXX are very safe but not completely risk-free, so holding other types of money market funds that invest in federal government debt can be preferable for those who don't want to accept any risk for their emergency fund.

Income from municipal bonds issued by your home state is exempt from federal, state, and local tax. This motivates single-state muni funds like Vanguard’s California municipal money market fund, which is fully exempt from federal and CA tax. It has a relatively low yield, but the absence of tax makes it better for some high-income Californians. National municipal money funds like VMSXX and SWTXX are not exempt from state and local tax, since most of the income is from bonds issued by other states. These funds avoid federal income tax, so they would be tax-free only if you live in a state with no tax on income or interest and dividends. Municipal bonds should never be held in tax-advantaged accounts, since their lower yield is not compensated by lower taxation in an account sheltered from tax. Although all money market funds are very conservative investments that almost never lose value, municipal bonds carry higher credit risk than government bonds.

US Treasury bonds are exempt from state and local tax. If you seek the maximum safety of very short-term debt issued by the federal US government, SGOV (available anywhere) and VUSXX (available at Vanguard, E*Trade, and JP Morgan) have the lowest expense ratios. Some funds like SNVXX at Schwab, SPAXX at Fidelity, and VUSXX at Vanguard invest broadly in US government debt. However, not all federal debt carries the privilege of evading state and local tax (and neither do repurchase agreements, which you don't necessarily need to understand). To fully avoid state and local tax, you need to choose a fund that invests only in US Treasury bonds and certain federal agency bonds like SGOV, SNSXX at Schwab, or FDLXX at Fidelity.

Because Series I savings bonds have no downside risk and are indexed to inflation, they can also be a great location for your emergency fund after the one-year lockup period. They’re exempt from state and local tax.

Interest from a savings account is subject to federal, state, and local tax. Even the highest-yielding savings accounts generally have lower yields than US government money market funds, which are as safe as FDIC-insured savings accounts. (There is no situation in which the federal government undergoes a major default while banks, which depend on payments from the trillions of dollars of federal debt they hold, are able to continue meeting their obligations.) The difference in after-tax yield is even greater, since savings accounts have no state and local tax advantages. So even people who don't want to tolerate any risk for their emergency fund are giving up yield by using a savings account. Those who don't insist on a government money market fund can select the highest after-tax yield among all options: a prime money market fund like SWVXX; a broad government money fund like SPAXX with some state tax-exempt holdings; a state tax-exempt government money fund like FDLXX or a similar ETF like SGOV; a federal tax-exempt national muni fund like VMSXX; and a tax-exempt home state muni fund like VYFXX. The higher your marginal tax rates, the more likely you'll prefer government or municipal money funds over prime money funds.

In addition, consider keeping some physical cash in case of power outages. The section below on estate planning discusses how to keep documents safe from fire, and this applies to cash as well.

How large should an emergency fund be? It varies greatly depending on your circumstances. Consider a married couple with stable incomes and no kids who rent their residence. They save 40% of every paycheck, have an investment portfolio currently worth a few years of expenses, and have multiple well-off family members who could help them in a crisis. Their emergency fund can be pretty light, perhaps a couple months of expenses (but can be larger if that makes them feel more comfortable). What about a single mother with chronic illness and no family to rely on? She works in a cyclical industry prone to layoffs, and struggles to save 10% of her paychecks under normal conditions. She should try to build a large emergency fund relative to her expenses — perhaps six months of expenses, including potential health care bills.

If part of your plan for emergency money in a crisis would be to sell assets like real estate and physical possessions, keep in mind that most people find themselves in crisis around the same time: during broad economic recessions. Your assets will tend to be worth less when most potential buyers have less money to buy with. Here are some questions you can ask yourself to assess your level of need for emergency funds:

• How long could you live on your savings if you sold all your liquid assets today? What if your stocks were worth half as much?
• How long could it take for you to get another job if you're laid off or fired?
• How stable is your main source of income when it's not zero?
• How much could you reduce your expenses if you absolutely needed to?
• Who else can help you pay expenses if you need it? Would you be willing to ask? How likely are they to be financially squeezed at the same time as you are?
• Do you have health problems that could, at some point, reduce your ability to earn income for an extended period?
• Do you have disability insurance? What kind of coverage is provided?
• Could you take on extra work, including gig work, if you needed to? Potential obstacles are kids, health problems, and lacking access to a car.
• Do you rent or own your home? Renters have more predictable expenses within the term of their lease, and may be able to downsize their housing expenses with lower frictional costs.

If you have a long-term partner or spouse, all these considerations need to be placed in the context of your combined finances. Only after you've built an emergency fund should you start investing in risky assets. The peace of mind provided by a stable foundation will make it easier to tolerate the volatility of your long-term portfolio. There are people who may not need an emergency fund. To pick one extreme, I wouldn't suggest to a billionaire that they need to have some risk-free assets (aside from physical cash). They would be okay even if their net worth fell by 90%. Even without attaining billionaire status, if your portfolio is worth several years of expenses, it would be objectively fine to hold only risky assets. But partly for psychological reasons, I think maintaining an emergency fund is an appropriate practice for a vast majority of working people.

Many people don’t take these actions or, if their finances are chronically strained, are unable to. But if you neglect to protect yourself, there will be an ever-present risk of financial ruin. Insurance may seem like a waste of money when times are good, but never forget that unpredictable, unavoidable events can shatter your life in an instant. Nothing can bankrupt you faster than expensive tragedies like a health crisis without health insurance.

 

 

Pay debt or invest?

Someone with low-interest loans should not invest in low-risk bonds or hold large amounts of cash beyond an emergency fund. This often includes someone with a home mortgage. There's one clear exception, which is when you can earn more from risk-free bonds after taxes than you can save by paying your loan.^[4]

Someone paying high interest — a 7% APY student loan or a 20% APY credit card loan — should not invest in stocks or other risky assets. A tax-free and risk-free 7% annualized return is achieved by every payment on an 7% APY loan. This is preferable to the higher average return from stocks, because the latter carries far more risk and will be taxed. Of course, you should address debt with the highest interest rate first; for many people this is credit card debt. All super high-interest loans like these should be paid off before investing in risky assets or even building a full emergency fund. The exact interest rate threshold before you can invest depends on your risk tolerance and marginal tax rate. See this footnote^[5] for an example that works out the mathematics of comparing debt payments to investing. If you've done the math and still find yourself uncertain, splitting your money between debt payments and investing is a perfectly fine solution.

One other consideration is important. If needed, money invested in stocks or bonds can be easily liquidated. In contrast, a drawback of paying debt is that the decision can’t be easily reversed. The money is paid back, and would need to be borrowed again if you had an unexpected need for it. However, paying debt can be a very attractive counterpart to investing, as the footnote illustrates.

Ensure you know the distinction between APR and APY; banks advertise APR for loans and APY for savings accounts. You can convert between them and read an explanation here.

 

 

Fraud prevention

Financial fraud is unfortunately a common occurrence. There are a number of simple actions and habits anyone can use to drastically lower the probability of being a victim of fraud.

The fraud protection for credit cards is fundamentally better than the protection for debit cards. If someone fraudulently charges your credit card, your money stays in your bank account. Once you dispute the charge, you won’t be responsible for paying it unless your bank investigates and concludes it was legitimate. You can also dispute charges if you didn’t receive the product or service you were promised (e.g., receiving damaged goods in the mail). Chargebacks with credit cards tend to be more reliable than with debit cards, and disputes tend to side with the cardholder more reliably among premium credit cards than mass market credit cards. Some credit cards have additional benefits like extended warranty protections and rental car insurance. In contrast, if someone fraudulently charges your debit card or uses it to withdraw cash from an ATM, your account balance is immediately reduced. Your bank may not reimburse you in a timely fashion (or ever). If your rent or mortgage payment is due tomorrow and you were depending on that bank balance to pay it, that would be a problem! Fortunately, many banks allow you to lock and unlock your debit card at a moment's notice, rendering it unusable by anyone when it's locked. Some banks reframe it as turning your debit card off (locked) and on (unlocked); it's the same thing.

The best policy is to lock your debit card with your bank's mobile app and temporarily unlock it only when you need it for deposits and withdrawals. For spending, use credit cards exclusively. This will prevent any unauthorized use of your debit card or its information. Locking (AKA freezing) your debit card does not prevent use of your checking account, like direct deposit or credit card payments. It affects only the debit card. There are many people who would've been saved from fraud by simply locking their debit card. People have found that thousands of dollars rapidly disappeared from their account due to multiple ATM withdrawals or debit card charges. Note that the need to enter a PIN does not reliably prevent debit card fraud, and a criminal does not necessarily need your physical card to spend your money. If you're unable to be approved for a credit card right now, see the personal finance subreddit for advice on building credit. It's a fantastic resource for all topics in personal finance (their guide to credit is here).

Dave Ramsey — host of one of the most popular financial podcasts, whose books on personal finance have sold millions of copies — famously advocates the opposite of what you just read. He has persuaded many people to abandon their credit cards and spend using debit cards and cash. For those who have something like an addiction to spending, this is often a good idea. Except as a true last resort, you should never carry an interest-bearing balance on a credit card. But people considering a Total Money Makeover should be aware of three drawbacks of his advice: as I described above, credit card fraud protection is superior. Dave Ramsey has unfortunately insisted for many years that debit card fraud protection is substantially equal, but this is not accurate. Keep your debit card locked so that no one can drain your bank account. Second, you can improve your credit score without paying a penny of interest by using credit cards responsibly. Third, credit card rewards are not a source of life-changing wealth, but they add up. Dave Ramsey is fond of the weak argument that no one ever became a millionaire from their credit card rewards. But if your household spends $40,000 on expenses in a given year that could be charged to a card, a simple 2% cash back credit card would save you $800 that year. The credit card subreddit is a great resource for easy ways to save even more than that. It's true that credit card points can encourage additional spending if they're redeemable for flights and hotel stays. If you're concerned about that, don't get those cards! Just enjoy your cash back. Again, if someone desperately struggles with spending discipline, cutting up their credit cards may be worth it. Most people should not.

Check your bank account and credit card accounts regularly, at least once a week. Sign up for alerts. I personally receive an alert whenever there is a withdrawal from or deposit to my bank account, whenever a card is charged, and whenever personal information on file (like my address) is changed. I strongly encourage you to activate two-factor authentication so that you confirm all logins using your phone or email. This may seem tedious but it greatly enhances the security of your accounts. Most phones now make the process seamless by autofilling with the number received over text, although verification that uses something other than SMS is more secure. Many brokers offer two-factor authentication. Schwab, Fidelity, and E*Trade all offer Symantec VIP, which I use.

Keep your electronic devices locked and don't share passwords with anyone unless you completely trust them. Most people do not consider how much of their information is vulnerable after bypassing the lock on their phone or computer. Perpetrators of fraud are sometimes family members or significant others, and because most people would be reluctant to pursue criminal charges in these cases, they may have no recourse. Features that provide a high level of security like two-factor authentication and long passwords generated by password managers are only as secure as your devices. Don't assume that your unlocked phone or laptop is safe simply because it's always with you. In one story reported by The New York Times, a man's phone was stolen while he was hospitalized and the thief used his phone to steal and spend thousands of dollars.

In addition, ensure that your wallet and physical cards are in a known and safe location at all times. Contactless payment is the most secure method, either with your card or through a digital wallet like Google Pay, Apple Pay, or Samsung Pay. A process called tokenization means that your card information is never revealed to the merchant. This is true for online shopping as well, so use those digital wallets or others like PayPal during checkout when possible.

Many ATMs allow you to use your debit card from your digital wallet, which is more secure because it protects you from card skimmers. If possible, go inside your bank and do deposits and withdrawals with a teller. Not only is this more secure, it avoids ATM malfunctions which are surprisingly common. ATMs from both local credit unions and the largest banks sometimes eat your cash or check. If the amount of cash I'm depositing would be stressful to lose, I do not trust it with an ATM. For checks with routine dollar amounts like a paycheck, you can use mobile check deposits or see a teller. But for larger amounts, always deposit in person with a teller. Because checks are such a frequent source of fraud for banks, you may find a totally legitimate large check flagged as potential fraud if you don't deposit it in person. The consequences can range from delayed availability of funds all the way to closure of your account (yes, even for a valid check!).

Warning: bank employees may lightly pressure you to use the ATM instead of occupying a teller's time with a simple deposit or withdrawal. They may even mistakenly believe — and try to inform you (a stupid customer) — that ATMs don't experience the errors you can read about endlessly on the personal finance and banking subreddits. Modern ATMs do perform well in almost every case, but they're fallible like any other machine. Don't submit to the pressure from bank employees: kindly insist that you'd like to see a teller.

Know who has access to each of your bank and credit accounts. If you notice activity you can't explain, you need to know who to contact before reporting fraud. There are two important reasons: (1) you want to avoid false positives, in which you report fraudulent activity but soon find out that it was normal; and (2) you want to be able to report real fraud as soon as possible, so you should know who could be responsible for activity in your account. To reduce this potential confusion, minimize the number of accounts and cards to which anyone else has access, and be very careful about who is allowed access. Your accounts are only as secure as the weakest access point, and that access point could be the negligence of another person you've trusted with your account.

Don't use the same password for Netflix and your bank account. You don't need to generate a different series of 20 random characters for every account in your life. But you'll naturally be less secretive about your Netflix password and it may seem like no big deal to share with a family member or friend. Keep passwords for your banking and investing activity utterly separate from others. Your email is how other passwords can be reset, so ensure that your email password is also unique. Good password managers are the best way to generate and store your passwords. They are extremely secure as long as you use a strong master password. There are numerous options, but for most people I recommend Bitwarden or 1Password. These are more secure than your browser's password manager. Please don't make any passcode, including your debit PIN, something that's easily guessed by someone who knows basic info about you, like your birthday. Password managers like Bitwarden make it possible to securely and conveniently access randomly generated passcodes, so you don't need to rely on memorable passcodes.

Consider keeping a categorized budget and recording your spending in a spreadsheet. The act of comparing your accounts against your recorded spending will keep you from overlooking small, dispersed fraud. Many people fail to notice these kinds of purchases because their account value is not strongly affected at any one time, and they don't pay close attention to their account activity. It's easy to let a busy life get in the way of keeping track of your money — try not to let it. If you don’t want to manually track your spending, a quick weekly review of all your card charges and bank activity can serve this purpose too. Recording your spending is also important for planning your future, because you have to know how much you spend in order to know how much to save and invest.

Go paperless. Change your settings so that you minimize mail from your bank, broker, insurance provider, retirement account administrator, and others with any sensitive information.

To some people, focusing on security to this degree may seem like overkill. I'll simply say that these measures would have appeared paranoid to many people who became preventable victims of fraud. Like insurance, security measures are not meant to feel convenient or make you happy. Hopefully imagining the feelings of regret and stress that accompany a fraud investigation will motivate you to take the steps described here before anything bad happens. Reading posts on the personal finance subreddit by people requesting advice after being defrauded may serve as additional motivation.

See this footnote^[6] for info on good banking practices, some of which are related to security and fraud prevention.

See this footnote^[7] for info on how freezing your credit protects you.

 

Scams

Scams are abundant. While some are too obvious for anyone but your oldest relatives to fall for, others can require uncommon knowledge to recognize right away. For instance, if a stranger sends you money with a service like Venmo or PayPal, and contacts you saying it was an accident, do not send the money back. This is a well-documented scam. Their transaction using stolen credentials will eventually be reversed after being identified as fraud; you will be stuck with a loss of whatever you willingly sent them. It's in the same family as fake check scams, although it is much easier to fall for the Venmo scam if you're not aware of it.

A common tactic by fraudsters is to induce panic and a sense of urgency. This discourages you from thinking clearly or taking the time to consult others. One form of this tactic is the so-called grandparent scam, which is so widespread that I personally know three people who have been targeted. A parent or grandparent receives a call telling them that something terrible has happened to their child or grandchild. It often involves a claim that they've been arrested (perhaps due to hitting a pregnant woman in a car accident). Other variants include being stuck in a foreign country or suffering an injury. Sometimes the caller will claim to be the grandchild; sometimes they will play the part of a lawyer, police officer, or doctor. They may have gathered personal information from the internet to create a plausible story, although usually they will not even know the grandchild's name. The interaction will quickly reach a request for money, which is urgently needed for lawyer's fees, bail, or medical bills. The prospect of your grandchild being in jail for hitting a pregnant woman is so daunting that many people fail to step back and consider whether the situation and the proposed solution make sense. If someone is urging you to send money quickly for any reason, you would be well-advised to question everything they say. In a funny local news story, one grandmother quickly recognized the scam and had the caller arrested after she pretended to hand him money.

This viral story from The Cut is a perfect illustration of wearing down a victim by building trust and credibility, then injecting panic and urgency.

Many fraudsters live outside the US, because targeting victims in other countries makes it easier to dodge law enforcement, and because they often live in relatively poor countries where swiping small amounts of US dollars can make a prosperous living. Poor English or even manners of speech can be a hint that someone on the internet is not who they claim to be (e.g., they're not someone in your area who wants to buy your car). A surprisingly widespread cue is the word "kindly". Fraudsters in countries that are former British colonies, like India and Nigeria, don't seem to realize that frequent use of the word "kindly" is not a hallmark of North American speech. Of course, I'm not implying that those who speak the Queen's English have a penchant for fraud — only that you should watch for this clue. It's hard to believe how strongly this word is associated with scams until you see it for yourself by reading the scams subreddit.

It’s not uncommon to receive texts, calls, or voicemails that claim to be from a trusted party like Amazon, Medicare, or your bank. The most prevalent tactic is to pose as a representative of the trusted party and ask you to “confirm” some of your info, often by telling you that fraud has already occurred in your account. You should never call a phone number provided through these channels. The identity of someone texting you over SMS or calling you should never be trusted. (SMS is the universal texting protocol; unlike the WhatsApp or iMessage protocols, it is not secure and identity is commonly spoofed.) The same goes for email addresses: the display name will show that it's from Google, then when you check the specific address, you find that it was sent from <mypr871@v7T3.ismn.us> (not a real address). URLs that are highly similar to their legitimate counterparts can also be deceptive. You can be certain that you’re speaking to the trusted party by contacting them through the official channels listed on their website (or on the back of your credit/debit card). This is the only condition under which you should provide sensitive info, like your Social Security number or a verification code sent to your phone.

See this article for an example of someone who fell for such a scam: "In Mr. Faunce’s case, it started with a text message that appeared to come from Wells Fargo’s fraud department, asking him to verify whether he had made a payment through Zelle." Mr. Faunce also didn't consider why the bank would urgently need his help to correct the fraud, using a method that would be convoluted and silly if it were real. It doesn't matter how much information a caller has: they may know your name, your address, and the last four digits of your credit card number. Your phone may have indicated they were calling or texting from your bank. All of that can be faked. A scammer will try to make the matter of fraud in your account seem urgent. No matter how urgent it may sound, you should never give sensitive information to anyone who called or texted you. Be cautious and patient: hang up and call an official customer service number.

Some of the largest frauds target real estate purchases. There are crime rings that deceive people into sending six-figure bank wires to the wrong accounts. As detailed in this disheartening Bloomberg article, people have lost entire down payments for houses they were about to purchase — $400,000 in one example. They usually don't recover any of their losses. You should always confirm account info with the recipient before wiring money.

In general, follow your gut: no one will ever award you money if you didn't enter a lottery; no one will ever try to overpay you when you're selling your couch on Facebook Marketplace (see fake check scams); no one will ever honestly want to be paid in gift cards or Bitcoin, and no legitimate business (aside from a street vendor) wants you to pay through Zelle or CashApp. When selling items in person to unknown parties, transact strictly in cash. (For large transactions, a buyer can meet you at their bank or credit union and give you a cashier's check that the bank can verify for you.) If something doesn't seem to make sense, take the time to think, ask others, and do research. The scams subreddit is a great forum to ask about scams or see posts by those who have been targeted. If you read enough posts, the common hallmarks of scams will soon become glaringly obvious.

 

If you conclude with confidence that someone has stolen your money or spent it fraudulently, it is best to file a police report as soon as possible. This alerts your bank to the gravity of the situation, and will encourage them not to drag their feet, for which they are notorious. If your fraud claims are unsuccessful, you may also want to file a report with the Consumer Financial Protection Bureau and/or the FBI.

 

 

Always designate beneficiaries

Estate planning is the process of preparing your assets for your death (as well as potential incapacity before death). It can be daunting even for financially literate people, with jargon like "probate" and "irrevocable trust". I'll suggest a few simple actions that everyone should take regardless of their age or expectation of death, as well as more complicated steps that may require an attorney. Why does estate planning matter?

Think of estate planning as an obligation to your loved ones

Many people don't put a moment's effort into preparing for their death because they intend to live for many more years. When such people die suddenly, some of their loved ones are thrown into a confusing process. On top of grieving, someone is charged with figuring out where their assets are located, whether they had life insurance, and how to navigate the legal fallout of a person who died without indicating what should happen to their children, their pets, their assets, their possessions, and their own bodily remains. Even if the deceased had a complete estate plan at one point, they may have neglected to update it to accomodate changes in their wishes or the estate itself. Everyone dies, and many people die suddenly in car accidents, homicides, medical emergencies, and natural disasters every day. They weren't expecting it. Your premature death would be hard enough for your loved ones: you can make it slightly easier by occasionally reviewing whether your estate planning is up to date. There may never be a time at which these tasks announce themselves as urgent, which is why some people die before getting around to them. You should just start doing it. If there are people whose estate planning (or lack thereof) would affect you upon their death — such as your spouse, parents, or siblings — you may want to help them complete the tasks described below.

The easy parts

An estate plan can be started by making an informal "in case of death" document that your loved ones can access. In the event of your unexpected death, it would be extremely helpful to have a document listing the institution that custodies each financial account (with the account number), any debt you owe, valuable items you own, and any other information or directions (such as wishes for disposal of your body). If you have an accountant, attorney, or financial advisor, their name and contact info should be added. Creating such a document is often part of an estate planning program with an attorney, but everyone can and should do it on their own. If you have any product with survivor benefits, like life insurance or a joint and survivor annuity, it should be among the assets in this document as well. Creating this document makes all the other steps easier. A Google Doc with shared viewing permission works well, since you can update it anytime, it can be easily accessed by others, and it can't be physically destroyed by a fire or flood. Personally, because a Google Doc is not very private or secure, I use Bitwarden's trusted emergency contact feature. My "in case of death" document is stored in Bitwarden's secure notes, and my trusted contacts can request access. As long as I'm not around to deny access, they'll gain access to my document after a period of time I can choose. This allows me to disclose information I wouldn't want to share while I'm alive, like my account passwords and the passcodes to my phone, computer, and safe.

The first task has given you a convenient list of all your financial accounts. The next easy win is to designate beneficiaries for all of them. These include bank accounts, brokerage accounts, retirement accounts, health savings accounts, employee ownership programs, US Treasury savings bonds, and life insurance. A beneficiary can be a person or an entity (such as a charity). Many institutions provide an option to name primary beneficiaries — who inherit the account by default — and contingent beneficiaries, who typically inherit nothing but would inherit the account if all primary beneficiaries died before you did. Adding a per stirpes designation leaves a beneficiary's share to their children in equal shares if that beneficiary pre-deceases you.

Bank accounts usually have "payable on death" (POD) designations that are more limited. Many banks allow you to name only a single beneficiary on each account. Some banks, like Chase and Wells Fargo, require that you visit a branch to name your beneficiary. Others, like Capital One and Bank of America, let you do it easily online. Although this is not universal practice, you can usually confirm that your bank account has a beneficiary by checking your monthly statements: instead of printing only your name at the top, it will typically read "[Your name] POD [Your beneficiary's name]".

Without drafting a last will, you can name beneficiaries to ensure that your accounts would be inherited by the right person or persons upon your death. In fact, beneficiaries named on an account supersede your will. The assets in each account can be transferred directly to the beneficiaries after the institution is presented with a death certificate. This transfer is unaffected by any debt the original owner may have owed. The estate aside from financial accounts, such as physical possessions, still has to pay debt before distributing the remainder to beneficiaries. This is especially true of collateralized debt: a vehicle with an outstanding auto loan, or a home with an outstanding mortgage. These assets can be repossessed by the lender to pay the loan, so the executor of someone's estate may need to sell assets like these to settle the loan.

[More incoming here]

 

 

Click here for the next section — Building a stock portfolio

 

All sections:

• Cover page
• Introduction to index funds
• Thinking about risk
• Tax-advantaged accounts
• Your psychology
• Investing for retirement
• Guidelines for personal finance
• Building a stock portfolio
• Fund proposals
• Advice
• Practical information for execution
• Taxes
• Vocabulary and further resources
• Advanced topics

 

 

Footnotes:

¹ These expenses assume a renter is in a typical lease rather than, say, a triple net lease. ↩

 

² If you decide to buy a residence with a person who's not your spouse or long-term partner, it is generally in everyone's best interest that the owners be tenants in common (TIC) rather than joint tenants. However, all tenants are usually still jointly and severally liable for the mortgage loan and property tax. Buying a home with a friend or acquaintance is no joke. ↩

 

³ This person's need for life insurance isn't constant over the 30-year period. As they (hopefully) build wealth over time, their loved ones can count on inheriting more money from them directly, so they don't need to pay for as much life insurance. This person could (say) buy $500K of insurance for a 30-year term, $500K for a 20-year term, and $500K for a 10-year term. The total death benefit would be $1.5M for the first ten years, $1.0M for the next ten years, and $500K for the final ten years. This technique is called laddering. Decreasing term life insurance is also a product, but the death benefit is generally linked to the remaining balance on a loan (most commonly a mortgage).

An easy mistake to make when considering insurance needs is to relate them only to income. Imagine Spouse A is a stay-at-home parent with very little income, and Spouse B earns about $200K annually to support the family financially. Because Spouse B is the breadwinner, it may be tempting to think that they should buy life insurance for Spouse B and call it a day. But the labor performed by Spouse A has a high implicit value: it would cost a lot of money to replace if Spouse A died. To determine the amount of life insurance needed for each person, they should consider not only the lost income but any extra expenses that would arise if each person died. The insurance payout would be tax-exempt and could be invested, so using a naive method like multiplying the person's pre-tax income by the number of years in the policy would almost certainly overestimate the insurance need of a full-time worker like Spouse B. A final, uncommon consideration is whether life insurance should be used to help with liquidity concerns. If estate tax would be owed on an illiquid inherited asset like real estate or a business, it could help pay the estate tax without having to sell the illiquid asset. ↩

 

⁴ Let's say you have a four-year auto loan at a low promotional rate, and you can earn interest two percentage points higher by investing in a risk-free fund like SGOV. (Situations like this are not rare, because banks and credit unions often use auto loans as a loss leader for customer acquisition, sometimes charging less interest to prime borrowers than they could earn from buying US Treasury bonds.) You calculate that after taxes, the rate earned from VMFXX is still higher than the interest rate on your auto loan. Let's say you have the money to buy the vehicle in cash. It's still a no-brainer to put that lump sum in VMFXX instead, and guarantee you'll be richer in four years when the loan is paid off. If the money market fund's yield ever drops low enough that paying your loan becomes a better deal, you can sell your shares and plow that money into your loan. ↩

 

⁵ To compare debt repayment to investing, we need to account for taxes that would be paid on the investment. Let's imagine that we're someone with a typical level of income for investors, so we're subject to a 24% marginal federal tax rate for ordinary income and a 15% federal tax rate for long-term capital gains. And let's say we live in a state that taxes both short- and long-term capital gains at 5%. So for short-term capital gains, we will be taxed at a rate of 29% (24% federal + 5% state), and for long-term capital gains, we will be taxed at a rate of 20% (15% federal + 5% state). We have two sources of debt: a student loan accruing interest at 5% APY and a home mortgage accruing interest at 3% APY. Payments on the 5% debt are equivalent to annualized short-term capital gains of .05/(1-.29) = 7.04%, and annualized long-term capital gains of .05/(1-.2) = 6.25%. Payments on the 3% debt are equivalent to annualized short-term capital gains of .03/(1-.29) = 4.23%, and annualized long-term capital gains of .03/(1-.2) = 3.75%. If we anticipate chiefly long-term capital gains from investing in stock funds, we can estimate that payments on the student loan are equivalent to a risk-free annualized return of 6.25%, and payments on the home mortgage are equivalent to a risk-free annualized return of 3.75%.

It would be sensible to recognize that the equivalent of a risk-free 6.25% annual return is a great deal, and to first pay off the student loan while making no more than minimum payments on the home mortgage. During this period we would not invest, or save large amounts of cash beyond an emergency fund. (The main exception would be contributing to tax-advantaged accounts with employer matching, as discussed in the previous section.) After completely paying off the student loan, we could begin allocating money to a stock portfolio. Our expected return from the stock portfolio might be 8-10% annually before taxes, which is about 6.4-8.0% after taxes. This is significantly higher than the risk-free 3% gains from making extra payments on the home mortgage. A stock portfolio also has the benefit of liquidity, while the cash value of home equity is hard to access if it's needed. The amount of the student loan or the mortgage is not relevant to these considerations, although some people irrationally might want to pay off smaller debts first. Ben Felix explains in this video why it often makes sense to pay off your mortgage instead of allocating a large fraction of your taxable portfolio to bonds. After paying off the mortgage, we could begin increasing the allocation to bonds in the taxable portfolio, so that it fits whatever level of risk we find appropriate. However, this reasoning may not apply if we're investing in very high-risk bonds instead of an aggregate bond fund, as described in this section.

Someone might challenge this and say I haven't covered all the possibilities. What if instead of paying debt or adding to a taxable brokerage account, we invest additional money in a tax-advantaged account? This eliminates the drawback of paying taxes on realized capital gains. Indeed, these calculations are worth going over, but tax-advantaged accounts carry penalties for unqualified withdrawals. People should exercise care and ensure they have a sizable emergency fund if they choose this alternative. If we were to lose our job and the ability to pay our debt from our paycheck, liquidating investments in a taxable brokerage account is much easier and less costly than doing so in a tax-advantaged account. The only penalty-free distributions from tax-advantaged accounts we can call on at any time before age 59½ are (1) withdrawal of contributions (but not earnings) from a Roth IRA (but not Roth 401(k)), and (2) reimbursement for previously paid bills from an HSA.

There's a final point about taxes. As discussed in the second footnote of the tax section, mortgage interest can be tax-deductible, which effectively reduces the interest rate. Taxes can be bad for investment returns, but they can also reduce the incentive to pay interest. But if all your itemized deductions are not much larger than the standard deduction, then the mortgage interest deduction may offer less benefit than it seems. Student loan interest can also be deducted sometimes, and even those who take the standard deduction instead of itemizing are eligible. ↩

 

⁶ Banking practices

We've already covered locking your debit card, spending only with credit cards, turning on activity alerts, using two-factor authentication, using a digital wallet, keeping your devices locked, using unique passwords, going paperless, and minimizing use of ATMs (mainly for large deposits). In this footnote I'd like to add a few assorted pieces of advice.

In 2019 The New York Times published an article called "Safe deposit boxes aren't safe". It reported on people who have lost extremely valuable items that were stored in safe deposit boxes, and how banks successfully reject liability for such losses. The article featured a watchmaker who lost millions of dollars in rare watches that he had entrusted to his bank's safe deposit boxes. He was quoted saying, “My impression about safe deposit boxes was that it was like you were putting things in Fort Knox." Many people make the same mistaken assumption.

Keep a checking account with more than one bank. I think most people are unaware that banks can terminate their relationship with you at their discretion, and that this happens to normal people with unremarkable financial situations. In a majority of cases, this is due to the customer's poor conduct, like overdrawing the account or leaving it dormant for a long time. It could also be due to depositing a bad check, even if you fell victim to a scam and did it unintentionally. But banks can also close your accounts on mere suspicion of fraudulent activity, with the motivation of avoiding the paperwork and perceived risk that accompanies such a customer. Most customers are worth very little (or even have a negative value) to their bank, so a customer who causes issues is a needless expense. It doesn't matter whether your activity is truly fraudulent or if it seemed completely normal to you: they don't have to prove or explain anything. Bank accounts are involuntarily closed all the time (also see here, here, here, here, here, here, here, here, here). Financial institutions may also close your account if your financial activity or the source of your money is associated with industries they perceive as a fraud or regulatory risk: online gambling, cryptocurrency, and marijuana sales — which are still not federally legalized — are among the common reasons.

Let's consider the core services used in the checking account of a typical person: money goes in from direct deposits, and throughout each month money goes out for rent or mortgage payments and various credit card payments (at a minimum). This train cannot stop for long without causing serious trouble: without an account, they won't be able to receive direct deposits, and they may not be able to pay their bills on time. If the account is frozen, they won't have access to their money; and if it's merely closed, they'll have to wait for the check with their remaining balance to arrive in the mail. (Even aside from closure or freezing, major glitches can cause interruptions in service.) If their credit card is issued by the same bank, the credit card account would likely be closed at the same time. In the best case scenario, sudden loss of a bank account is a major inconvenience. How can you prepare so the impact will be minimized if this happens to you? Personally I keep checking accounts with multiple major banks. I divide each direct deposit between them, and I alternate credit card and rent payments between them so that if I lose access to one account, I know I can pay from the others because I've already been doing it on a regular basis. I can move money between them almost instantly using Zelle. All accounts have ACH connection to other financial services I use, like Venmo and my brokerage accounts. All of them allow me to lock my debit card from the mobile app, which is an essential security feature. They all allow a beneficiary to be named. I have two taxable brokerage accounts for the same reason (but splitting IRAs between institutions is unnecessary, because ongoing access is not vital).

Before moving to the next item, we should clarify some terms. A credit card issuer is the institution that approves you for a credit card and extends credit. Issuers are banks and credit unions like Capital One, Chase, and Bank of America. This is distinct from the payment network, like Visa or Mastercard. Some cards are associated with a third party, the co-branded partner. A co-branded partner might be Apple, Amazon, Target, Verizon, or American Airlines. For example, the Apple Card is issued by Goldman Sachs, its payment processor is Mastercard, and its co-branded partner is Apple. Unlike the other institutions mentioned so far, American Express and Discover occupy two roles: they are credit card issuers and payment processors.

Use more than one credit card, and don't rely on a single issuer for your credit cards. The first reason for this is related to the comment above on bank accounts: it is unwise to rely on a single institution for essential financial services. Some people are unwittingly in a precarious situation: they depend entirely on a single bank for their checking account and their credit card. If the bank decided to terminate the relationship, they would suddenly be without a bank account or a credit card. This would temporarily limit them to cash, prepaid debit cards, and money orders (or help from family and friends, which not everyone has). If a credit card is permanently closed, or needs to be replaced and is temporarily unavailable, having access to multiple cards preserves your ability to spend money (even if a bank account closes at the same time). There's some benefit to diversifying between payment processors: only a Visa, for example, is accepted at Costco in the US (and until 2016 this exclusive deal was with AmEx). At Costco in Canada, only a Mastercard can be used! When visiting Japan, I found that I could load the PASMO card only with my AmEx card. Rewards are an additional compelling reason to use multiple credit cards. You can choose cards with complementary rewards: a card with a high flat reward rate like 2% cash back on all purchases, supplemented with other cards that provide higher rewards in certain spending categories. See the credit card subreddit for compiled information on how to earn more rewards. Finally, using multiple credit cards can help your credit score, partly because increasing your total credit limit decreases your credit utilization rate. This rate should ideally be low at the end of each monthly billing cycle. You can reach high utilization during the billing cycle, because your utilization throughout the month is not part of the FICO score algorithm. If you want to optimize your credit score, you can read about the all zero except one method, but that's a minor nuance. Note that leaving (say) a 1% balance on a credit card does not mean you would pay interest — you should never pay credit card interest! Paying off your entire statement balance each month prevents interest, but you can still have a nonzero current balance at the end of the cycle. To summarize the last few paragraphs: for the sake of convenience and continuous access to financial services, use multiple bank accounts and multiple credit cards.

Your account and routing numbers may seem like information that isn't very private. You freely provide them to your employer for direct deposit and to numerous other institutions for ACH transfers. The numbers are even printed on your checks in machine-readable block letters! This may give some people the wrong impression. Your account and routing numbers should be provided strictly on a need-to-know basis. You might notice that to pay your credit card bill, linking the bank account that pays the bill requires no authentication. This is how certain payments work in the US: all you need are those two numbers. While of course an unauthorized use of this information is illegal, I have tried to emphasize repeatedly that addressing fraud after it has occurred is perhaps 100-1000x more effortful than preventing it. Your account and routing numbers should never be posted publicly. There are also job scams that pretend to hire you and collect information that a legitimate employer would need. This might include account and routing numbers, as well as your SSN, address, phone number, date of birth, previous employers, and other data that help an identity thief.

For the interested reader, Bits about Money is a great weekly newsletter written by an industry professional that explains the inner workings of banking and finance. His post on how credit cards make money is relevant here. ↩

 

⁷ Credit freeze

There are three main credit bureaus to which your credit-related information is reported: Experian, Equifax, and TransUnion. If you haven’t, you should create accounts with each and ensure that the credit information is accurate. Experian and Equifax have decent websites; TransUnion’s website is hellish and designed to extract money from you. Unlike the other two bureaus, TransUnion doesn't provide your FICO credit score for free. There are a few accounts you can open, such as a Bank of America credit card, that provide a free monthly TransUnion FICO score. The FICO score is one of two proprietary algorithms for calculating credit scores, the second of which is the VantageScore. The FICO score is predominant and it's the score you should be most concerned with; the VantageScore is not usually attended to by lenders. (The credit bureaus like to push the VantageScore because it’s their own jointly created product.) In addition, there are many variants of each score. Credit bureaus are also called credit reporting agencies (CRAs).

As explained here, a credit freeze prevents anyone from opening new credit accounts in your name. Even if someone has obtained your Social Security number — which is much easier than it should be — they cannot use it to open a new account when your credit is frozen. An unfortunate exception is if the potential creditor has a pre-existing credit relationship with you. If you have a credit card with Citizens Bank, someone else might be able to fraudulently open a new line of credit from Citizens even if your credit is frozen. So you should still check your credit info monthly.

An assumption that some people make when they hear the word "freeze" is that freezing your credit information will stop your credit score from changing. This is not true: freezing your credit information has no effect on your credit score, and it will not stop changing. Your credit score will continue to be affected by ongoing payments (or lack thereof).

Freezing your credit takes a single click at Experian and Equifax once you've found the right page, which is relatively easy. To maximize difficulty, TransUnion has a separate "Service Center" login process for credit freezes. When signed into your account, see the following links for freezing your credit at Experian, Equifax, and TransUnion. The same pages are used for unfreezing your credit.

There are a few other companies with which you should place a freeze. ChexSystems is a company used by most banks to screen applicants for checking and savings accounts. Freezing your credit at the credit bureaus will prevent others from opening new credit accounts in your name, whereas a freeze with ChexSystems will provide an obstacle against others trying to open a bank account in your name. The freeze webpage is here.

The Work Number (TWN) is a service owned by Equifax that collects employment information with a creepy level of detail. Prospective employers (and others like landlords) can use TWN to view your employment records and prior compensation. TWN collects info on individual paychecks, including how much of each kind of tax was withheld and whether you paid for health insurance through your employer (but those doing background checks don't necessarily see details). You can view your own report and freeze your info to prevent it from being accessed. If a party still needs verification of income or employment, they can request paystubs.

There is a fourth, smaller credit bureau called Innovis, and their credit freeze link is here. They don't provide the same easy access to information that the big three do and the website is terrible, so it's not a website you'll visit often, but you should freeze your credit with Innovis as well.

You need to unfreeze only when a party with whom you do not have a pre-existing credit relationship needs to perform a credit inquiry. Common examples are applying for a new credit card, an auto loan, or a home mortgage. Anytime you need to allow an inquiry, you can temporarily lift the freeze, unfreeze, or give them an access code that permits a single-use inquiry while your credit remains frozen. Personally, I temporarily lift the freeze. You need to unfreeze only at the bureau that will be queried, not all three. See this link for more information on those options. I don't suggest using weaker alternatives to freezing like fraud alerts. Even a credit freeze is not perfect given the lax security at the credit bureaus, but it is the best measure you can take. Security flaws are another reason to check your credit info monthly.

Upon reading this you may again question how necessary it is. Why would someone steal my identity? I’m no one special. I don’t have enemies. Let me emphasize that identity thieves don’t need to have ever encountered you personally. They may have stolen your data from a credit bureau, a bank, an insurance company, a brokerage firm, an employer, a landlord, or one of the other parties to which you’ve supplied your precious Social Security number. Not having much money doesn’t make you an undesirable target; you may be more desirable because you lack the resources to pursue identity thieves with expensive legal procedures. In response to the charge of paranoia, I will simply state again that pre-emptive action is less bothersome than a fraud investigation after some stranger has saddled you with thousands of dollars of debt in an account with your name on it.

A final note: the credit bureaus are for-profit businesses. They're even publicly listed: see TRU, EFX, EXPN.L. All three, and especially TransUnion, will try to get you to pay them. Products range from "credit lock" to programs that claim to help you boost your credit. I don't suggest paying them for anything; however appealing the products may sound, everything you need is available for free. If you feel inclined to take one of their credit card recommendations (for which they're paid), be sure to research the alternatives first. ↩