With so much riding on the financial decisions you make today, it's no wonder that I often receive letters from O readers who want to know whether they're doing all they can to create a secure future. This month I'm answering three of those readers, to tell them exactly how close they are to financial independence—just in time for Independence Day. I invite you to test your own knowledge by giving each person a grade from A to F, before reading on to see my take. Learn from each of these scenarios, and you'll be well on your way to letting your own financial freedom ring.
I received an inheritance in 2010 with which I was able to pay off my debts. My bills now consist of rent, utilities, car insurance, and car lease payments. Is there any downside to paying off my lease in full? I have two and a half years left on it, and I planned its maturity to correspond with my retirement.
How's She Doing? Select one:
B. Not bad but could do better.
C. Just okay.
D. Making a big mistake.
E. Are you kidding me?
Suze's Grade: D
I know this grade seems harsh, but if you read between the lines, it's clear that this woman isn't really building long-term financial independence. It was an inheritance that allowed her to get out of debt—meaning that, in the monetary sense, she got lucky when that money landed in her lap. If she'd paid off her debts by learning to live below her means, I would've given her a much higher grade. I'm also concerned about the fact that she leased a car in the first place. A lease is just an expensive rental; when the lease term is up—typically in three years or so—you don't own the car. You have to either buy it from the leasing company or do what they hope you'll do: Lease a new car. That means you'll be starting all over with a new set of lease payments for three years or more. As I've explained before, it's smarter to buy a used car outright, or if you need to borrow to finance the purchase, to limit yourself to a three-year car loan. That way, after you've made your last loan payment in month 36, you own the car and can continue to drive it for many years without wasting more money on payments. Now for the good news: That this woman is thinking of buying out the lease is a step in the right direction, assuming she will then keep driving the same car for many years. If she never leases a car again, and learns how to make ends meet with her income instead of the inheritance, her grade stands to rise dramatically.
My husband and I would like to retire at 62; he's 60 and I'm 59. We have $425,000 in a thrift savings plan, $40,000 in my IRA, and about $500,000 in real estate assets. We have no credit card debt. We owe $9,000 on a 2008 car and $58,000 on our home mortgage at 5.33 percent (and own another home free and clear) and have a HELOC (home equity line of credit) on which we may owe up to $162,000 once we're through renovating the second property. When we retire, we'll have about $65,000 a year in retirement income from our two pensions and our Social Security. Are we okay?
How Are They Doing? Select one:
A. More than okay! Enjoy the early retirement!
B. Inpretty good shape but could do a little better.
C. Aren't as financially secure as they think.
D. Retiring early would be a mistake.
E. They're kidding themselves!
Suze's Grade: C
I hate to say it, but things are not as rosy as they seem. In one breath this couple says they own their home free and clear, and in the next they say they're planning to run up a $162,000 HELOC on that home. So they won't own it free and clear after all. And a home equity line of credit is especially risky in this current economic environment. The interest rate on a HELOC is variable, and it's important to understand that while interest rates are at historic lows, they won't be forever. When interest rates rise, so, too, will the cost of a HELOC. Anyone with a HELOC should be aware of that risk, but it's especially dangerous for retirees living on a fixed income.
Speaking of retirement: There's no way I can give a grade higher than C if this couple retires with debt. It's interesting that they share their income in the letter but not their fixed expenses. I get the sense that they aren't entirely clear what their monthly living costs are. Most people don't have a clear picture of those expenses; typically, people underestimate those costs by at least $1,500 a month.
The fact that they have $65,000 in annual retirement income sounds great. But my guess is they're not factoring in taxes. I will. Let's estimate that after paying federal and state taxes they have $50,000 or so in net income. Is that enough to cover their expenses? And they should think carefully about the $425,000 in the TSP retirement account. Yes, it's a large sum, but given how young they are, they'd need to withdraw just a small amount each month to ensure they don't run through it too fast. How small is small? A basic rule of thumb is to start your annual withdrawal rate at just 4 percent a year, and then adjust that sum each year to keep pace with inflation. So that's $17,000 in the first year, or about $1,420 a month. After tax that might come to about $1,100 or so. Add it all up, and it looks like their combined income could be about $5,300 a month after tax. If they can honestly say that will be more than enough to live on comfortably in retirement, great. But I think after they assess their debt and living costs, they may find it makes sense to keep working for a few more years so they can retire debt-free.
I'm a 49-year-old recently divorced woman, and my annual salary is $94,000. I have $5,000 in savings, an IRA of $6,000, credit card debt of $9,000, and a personal loan of $12,000. I have a two-year goal of paying off my credit card debt, then paying off my personal loan. I will also be putting $500 a month in savings. I contribute 10 percent of my salary to a 401(k). Am I putting my money where I should? Is it better to put more money into savings while taking longer to pay off my debt?
How's She Doing? Select one:
B. Okay but should focus on retirement rather than paying off the credit card and personal loan.
C. Has it backward; should pay off the debts before saving a penny for retirement.
D. On thin ice.
E. In serious trouble.
Suze's Grade: A
Surprised? I admit, I'm giving this woman an A in part because she's being honest with herself about her situation. She's willing to acknowledge the truth and set realistic goals—and that is how you build long-term financial independence. (Yes, you can get an A for effort!)
Of course, I would have loved to hear that she had no credit card debt and $600,000 in retirement savings; it's clear that she's made some missteps in the past, and they've cost her a lot—both in terms of the interest she's paid on her debt and the time she's lost to boost her retirement fund. But mistakes aren't half as important as what you do to correct them, and what I admire is that this reader has come up with a clear, step-by-step plan to get herself on track: Get out of debt, keep building up her emergency savings, save more aggressively for retirement. That's exactly what she needs to be doing right now. I also love that she's so determined to pay back her personal loan. That tells me she respects both money and the person who loaned her that money. Honoring the value of a dollar is a fundamental requirement for a secure financial future.
It's also great that this reader recognizes the need to pay off debt and save simultaneously. It's not an either-or proposition—these are both high priorities. I want her to keep setting aside the $500 in savings until her emergency fund contains enough money to cover eight months of her living expenses. She needs that security. Once that's in place, she should then direct the $500 toward paying off her debts even faster. When the debts are eliminated, the $500 should go toward building up her retirement savings even more. She's already gotten an A, which is terrific—but staying diligent about her finances long-term is what will help her keep earning those high marks.
Suze Orman is the author of The Money Class: Learn to Create Your New American Dream.