You will inevitably confront this question in your pursuit of financial security.

The problem is the answer is far more complex and confusing than generally understood.

The intuitive response is to get out of debt. We all want the security of owning our castle free and clear with one less expense to deal with. The prospect of making monthly payments for the next 30 years is antithetical to freedom.

However, there are times when intuition and finance disagree.

The decision to pay off your mortgage early isn’t just about getting out of debt because complicated equations involving return on investment, time-value of money, and inflation are involved. Remember, this is finance. You can end up with “Alice in Wonderland” scenarios where debt is the cheapest solution and a dollar paid tomorrow might actually be preferable to debt freedom today.

Curiouser and curiouser…

In this article I pull back the curtain exposing the many dimensions to paying off your mortgage early. The objective is to balance your intuition with financial savvy so you can make a smart decision. The correct answer is not cookie-cutter but must be custom fitted to your personal financial situation.

Let’s explore how this complicated process works…

How To Pay Off Your Mortgage Faster

If you decide to pay off your mortgage early there is no shortage of advice on how to get the job done. Unfortunately, it all boils down to the same three little words – “pay more principal”. There is no magic secret. The only real difference is form, not substance.

Paying mortgage principal early is a powerful money saver because small debt reductions compound dramatically over the life of the loan thus eliminating many times the payment in interest.

For example, this mortgage payment calculator shows you that a 30 year, $100,000, 6% mortgage has a monthly payment of 599.55 with only $99.55 going to principal in the first month. If you add just $100 to that monthly payment you literally double the principal paid in the beginning, eliminate 108 payments over the life of the loan, save $64,751.46 in interest costs, and shorten the payoff time from 30 years to 21 years.

Not bad for an extra $100 per month…

If that sounds appealing then here are the various strategies for early mortgage payoff starting with the simplest and moving toward the most complex…

• Add Principal to Your Current Monthly Payment: Assuming your mortgage doesn’t have a prepayment penalty (check first) the simplest early payoff strategy is to just add principal to your monthly payment. You could try a one-time lump sum where you put the proceeds from selling a boat, motorhome, or unused jewelry to good use. Alternatively, you can add a little extra every month by sending your raise or bonus directly to the mortgage company. The concept behind this strategy is you got by just fine without the money before so you’ll never miss it if you never see it.
• Biweekly Payment Schedule: Rather than make one mortgage payment per month, try making half the payment every two weeks. Since there are 52 weeks in 12 months that causes 26 half-payments or 13 full payments instead of the usual 12 – one extra payment per year. Depending on your situation this can cut up to 6 years off the life of your 30 year loan. Check out the details first because some mortgage holders offer this payment schedule without charge and others will hit you with a fee. I suggest you try using this bi-weekly mortgage calculator with extra payment capability to test both this early payoff strategy and the previous one to see how fast you can be free and clear!
• Refinance to a Lower Interest Rate: Another strategy is to refinance to a lower interest rate mortgage while keeping the term (pay off date) the same. The key is to not take any money out or extend the term when you refinance. Your new loan should offer a lower payment due to the reduced interest cost so that when you keep making the same payment as before all the extra will go to principal payoff. The nice thing about this strategy is it doesn’t require any additional money out of your pocket to achieve the desired result (unlike the two previous alternatives) because all the savings comes from reduced interest costs.
• Refinance To A Shorter Term: Rather than pay over a 30 year amortization try reducing the term to 15 years. The monthly payments will be higher but the interest rate is usually lower thus offsetting some of the monthly outflow. Another variation on this theme is to keep your 30 year mortgage but make your payments as if it were a 15 year amortization. You won’t get the reduced interest rate of a 15 year term, but you also won’t pay refinancing costs either. Some people prefer this variation for its increased flexibility and reduced cost while others prefer the enforced discipline of the required monthly payment. Either way, you can use this mortgage payoff calculator to estimate the monthly payment required to be free and clear for any date you choose.
• Downsize To A Lower-Cost Home: Changing homes isn’t for everyone, but I would be remiss as your financial coach to exclude this strategy. You could move to a lower cost area or buy a smaller house in the same area. The smaller mortgage principal means you can be debt free faster using the same monthly payment.

The key point to notice about all these early payoff strategies is how they aren’t mutually exclusive. You can combine them in various ways to turbo charge results.

For example, you could downsize your home while financing that less expensive home at a lower interest rate on a biweekly mortgage. Then you could sell that boat and jewelry you never use putting those lump sums toward the mortgage while also dedicating this year’s raise to additional monthly principal payments. You will be amazed how fast you can get out of debt following this prescription.

The only limit to how fast you escape the bondage of mortgage debt is your creativity and dedication to this noble cause.

Pay Off Mortgage Early – The Pros…

Now that we know how to pay off your mortgage early let’s look at the benefits to following this strategy…

• Save Money: The first and most obvious reason to pay off your mortgage early is it can save you tens of thousands of dollars in interest costs.
• Peace of Mind: The second reason is peace of mind from owning your own home. It gives you a warm-fuzzy to know you have a secure place to live and you won’t be put out on the street at the first temporary setback in employment.
• Reduced Cost Of Living: For most people, mortgage payments are your biggest monthly expense after taxes. Without a mortgage payment you can save more, work less, or take that dream job you always wanted but couldn’t afford because of the lower salary.
• Get Rid of PMI: When you accelerate paying down principal your home equity will reach a threshold where PMI should no longer be required. This saves you money long before the mortgage is paid off and allows you to accelerate the principal pay-down while still making the same monthly payment.
• Asset Protection: Many states have laws that protect home equity in the event of lawsuit or other legal proceeding. Homestead rules can provide substantial home equity protection. Also, retirees sometimes use home equity as an estate planning strategy to protect assets for the surviving spouse should one partner consume all available resources in a prolonged illness or nursing care facility. In short, there are many situations where home equity can represent a more secure asset with special legal privileges when compared to other investments.
• Retirement Planning: A free and clear home takes on additional significance for near retirees. If you are entering retirement with a fixed income (Social Security, pension, fixed annuity) then it can be a real benefit to pay off all debt rather than put money in fluctuating investments. This allows you to reduce financial variables and more reliably match forecasted income to expenses. Additionally, after retiring, that mortgage payment can require pulling money from tax deferred accounts when that money would be better off left to grow. Finally, if your taxable income is reduced in retirement it can reduce the benefit of the mortgage interest tax deduction tilting the equation in favor of payoff.
• Guaranteed Return On Investment: With the stock market and real estate going up and down like a roller coaster, it is comforting to put your money toward your home and know with certainty what the ROI will be. You get the imputed rental value of a place to live and the immediate return of eliminated interest expense. The certainty of this return stream is a huge benefit for investors who feel beat-up by unreliable financial markets that supposedly will pay more… but may not.
• Achievable: Paying off your mortgage feels more motivating than most financial goals because it is concrete. It is big enough to get excited about yet tangible enough that you can wrap your head around it. It is achievable and will make a significant difference in your life. Contrast this to retirement planning which feels more ethereal and hard to grasp for most homeowners.

In short, there are many benefits to paying off your mortgage early – and some are very compelling!

Payoff Mortgage Early – The Cons…

Before you break out the champagne and burn your payment book it is important to consider the downside to paying off your mortgage early. This isn’t the slam-dunk decision it appears at first glance because of some complicated financial issues…

• Lose The Tax Break: I start with the tax break issue not because it is the most important but because it is the most commonly cited and misunderstood. Yes, mortgage interest paid is generally deductible on your tax return if you itemize, but there are some important “caveats” to this deduction worth considering: (1) The rules are complicated and may cause you to lose some of the deduction you thought you were getting. (2) In certain circumstances you may get as much value by taking the standard deduction as by itemizing deductions meaning your mortgage interest payments merely replaced the standard deduction and provided no real savings. (3) Even if you get the deduction you are still paying $1 to get a 35 cents (or comparable) tax break – not a very good deal. (4) And the effective value of the deduction diminishes over time as the loan matures and you pay less and less interest with each payment. In short, there are many tax rules and situations where you won’t be able to fully utilize the mortgage interest deduction. The rules are complicated so talk to your tax professional if this issue is important to your decision.
• Low Return On Investment: A home mortgage is likely the cheapest money you will ever borrow – and the interest is usually deductible further decreasing the effective cost. For example, if you are in a combined state and federal tax bracket of 35% then a 6% mortgage could have an effective cost under 4%. This means two things: (1) Higher cost, non-deductible debt should be paid off first and (2) long-term investment returns will likely provide a higher return on your capital as evidenced by Ibbotson and Associates research showing a diversified portfolio returning in the 8% range.
• Savings Are In Cheap Dollars: A key point to consider is how all the savings you are expecting only come after the mortgage is paid off meaning those savings must be discounted for inflation. For example, let’s assume you pay off your mortgage in 25 years instead of 30. Using this present value calculator you’ll see that $1,000 saved 25 years into the future is only worth $375.12 in today’s terms at a 4% inflation rate. In other words, you have to discount all savings by inflation because the payments you avoid will be in depreciated dollars. This is quite important.
• False Sense Of Security: You’re not going to like this idea, but you never really own your property – even if it is mortgage free. This is a throwback to feudal times where the king (“royal = real” relating to the latin for “king” connecting real estate to royal estate) was the owner of all land and received “tax” for the right of possession. Today, our local governments are the modern equivalent to feudal lords who collect property tax annually. In other words, you always pay rent to someone whether the bank is out of the picture or not. If you are not completely clear about this truth just stop paying property tax for a few years and see what happens. The truth is your monthly payment is merely a question of degree and to whom – not whether it exists or not. This ugly truth makes the idea of true mortgage freedom an illusion.
• Lost Diversification: This one is “the biggie” so pay close attention… Most investor portfolios are denominated in their domestic currency and thus carry the risk that inflationary government policies will depreciate their investment purchasing power over time. A residential real estate mortgage is the only practical way for most people to short their domestic currency and hedge against inflationary economic policy.

  In other words, the way mortgage financing works is you borrow (short) your currency and use the proceeds to buy an inflation adjusting asset (real estate). Few people understand how conventionally financed real estate is little more than a leveraged play on inflation. That is why it’s such a powerful wealth building tool more than 90% of the time, and it blows up horribly when the rare deflationary event strikes (i.e. 2008).

  When you pay off your mortgage you are unwinding your short currency hedge. This means you lose the ability to be short today’s more valuable dollars and repay them with depreciated dollars in the future. The importance of this financial fact cannot be overstated given today’s record government indebtedness and overt government policy directed toward creating inflation.

  I repeat… this is a HUGELY IMPORTANT factor in deciding to pay off a mortgage early or not! It is critical.

  But don’t trust me on this issue. Consider these two facts…

  1. This inflation calculator (which likely understates inflation’s true impact) shows you how the Federal Reserve has destroyed more than 95% of the U.S. currency’s purchasing power since they began monetary policy. If that time period is too long, then look at various 30 year time periods (the life of a mortgage) for similarly dismal stats.
  2. In a February interview with CNBC, Warren Buffett called mortgaged real estate “as attractive an investment as you can make”. He further stated, “If I knew where I was going to live for the next 5 years or 10 years, I’d buy a home and I’d finance it with a 30 year mortgage. It’s a terrific deal… If I had a way of buying a couple hundred thousand single-family homes… I would load up on them. And I would take mortgages out on them at very low rates…”

  Did you get that? Read it twice! Warren is a pretty successful investor who has some clue on these matters so strong statements like this are worth listening to. He’s telling you about the value he sees in locking long-term, low cost interest financing on an inflation adjusting asset. The last time this strategy paid off was in the inflationary 1970’s when the Savings and Loan industry went bankrupt for being on the wrong side of the transaction and homeowners literally laughed all the way to the bank with ridiculously cheap mortgage payments on appreciating real estate.

  Are you going to be able to do the same on this next time around?

  When you prepay your mortgage you give away that advantage so tread carefully on that decision.

• Interest Rate Below Expected Inflation: Given record low mortgage interest rates as of this writing, it is entirely possible that the interest rate on a fixed rate mortgage (forgetting the fact that it might also be deductible) could turn out to be lower than the inflation rate. If that ended up being true (nobody has a crystal ball) then a bizarre financial situation is created where you are literally paid to borrow money in real terms (after inflation) even though you are paying interest every month. In other words, you make more by owing than by owning. Strange but true. When you prepay your mortgage you give away that financial advantage.

What’s important to note about this entire list of negatives is how they aren’t intuitively obvious. 

The list of positives to paying off your mortgage discussed earlier are easy for anyone to see, but the negatives require a fair degree of financial sophistication – from esoteric tax strategy to long term inflation effects, short hedges on currency, and discounted present value equations. It is heady stuff – financial geekism – yet it is every bit as valid to your bottom line as the more intuitively obvious reasons for paying off your mortgage early.

That is why there is so much misinformation on this subject. The concepts are complex and sophisticated once you get past the obvious reasons for wanting to get out of debt.

In short, the decision to pay off your mortgage is an intellectual battle where the emotional-intuitive desire to be debt free is matched against the intellectual realities of modern finance.

Unfortunately, this makes the decision process complex…

How Do I Make The Right Decision For My Situation?

If you are somewhat confused right now then you are in the perfect spot. You get it, and that is a good thing. The confusion results from the tug-of-war between emotion and intellect trying to sort through the complex factors explained.

The next step is to give you a structured way to sort these issues so you can make order out of chaos and formulate a well-reasoned decision whether paying off a mortgage early is the best decision for your situation – or not.

The key is to realize there are two steps to this decision process…

1. Personal Finance Considerations: This is a decision between paying off your mortgage early or taking care of other personal finance issues first that better reflect your personal values. This decision is prioritized ahead of any investment considerations.
2. Investment Return Objectives: This is a decision between paying off your mortgage early or investing the difference. This decision only comes into play after the personal finance issues in the previous step are satisfied first.

Let’s take each of these steps one-by-one…

The First Step Is To Figure Out What Is More Important Than Paying Off The Mortgage

I’m a firm advocate of getting your financial foundation in place before pursuing more advanced financial strategies. Your wealth can only grow as high as your financial foundation can support (similar to how a skyscraper’s height is limited by the depth and strength of its foundation).

Below is an order of priorities for building your financial foundation that may take precedence over paying off your mortgage…

• Guaranteed 50% Return: Many employers still offer 401(k) retirement plans that include employer matches – typically 50% of every dollar you put in up to 6% of annual pay. This guaranteed 50% return on investment is pretty hard to beat so it usually makes sense to make sure you are maximizing this benefit before prepaying your mortgage.
• Maximize Tax Deferral: Even if your company doesn’t offer a 401(k) plan it may make sense to maximize tax deferred and tax free retirement savings before paying off your mortgage. Granted, tax issues are complex and vary based on individual circumstances so it’s impossible to make a blanket statement, but every tax deferred savings opportunity you don’t use is lost forever and can never be recovered because annual limitations apply. In other words, use it now or lose it forever. The investment math often tilts in favor of maximizing every tax deferred investing opportunity available… before paying off the mortgage.
• Pay High-Interest Debt First: Even after maxing out all your retirement savings options it still may not make sense to pay down your mortgage early when you have other debt. The reason is most other debt will be at a higher interest rate – particularly credit card debt where the interest is much higher and not deductible. Use this debt snowball calculator to figure the fastest way to get out of debt. The order of precedence is to pay off the highest interest/non-deductible debt first followed by low interest/deductible debt (i.e. mortgage debt) last.
• Financial Stability: Once you’ve maxed out your retirement plans and paid down your high-interest, non-deductible debt you may want to consider building a 3-6 month cushion should unemployment strike. Some naysayers claim a home equity line of credit serves the same function making this step unnecessary. The thinking is that mortgage prepayments increase equity thus providing a positive return while you don’t need the funds but can still be withdrawn through a line of credit should you fall on tough times. Either way, developing a safety cushion for difficult times is a prudent step in building your financial foundation.
• Insurance and Financial Security: One of the main goals for paying off your mortgage early is financial security, but there are many dimensions to financial security beyond just being out of debt. For example, medical bills are a primary cause of bankruptcy so does it make more sense to increase your medical insurance coverage before paying off your mortgage? That’s a tough question because each choice manages risk – but in a different way. Similarly, the Council for Disability Awareness claims you have roughly even odds of being disabled for 3 months or more at some point during your career with 1 out of 7 workers being disabled for 5 years or more. Would disability insurance give you more financial security than prepaying your mortgage? Again, an interesting question to consider…
• Kids College Funds: Do you have kids? Then funding a 529 college account, prepaid college tuition, and/or Coverdell IRA are additional ways to maximize tax deferred savings that should probably take precedence over paying off your mortgage.
• Underwater Mortgage: If you are upside-down on your house (owe more than it is worth) then really think twice about throwing good money after bad. I’m not going to get into a big discussion about strategic defaults here, but suffice it to say there may be more secure assets for you to invest in than a house that is underwater.

Should I Pay Off My Mortgage Or Invest?

Once you’ve built your personal financial foundation (maximized tax deferred savings both for college and retirement, paid off high interest debt, and properly insured) then the question becomes, “should I pay off my mortgage or invest?” Notice how this question only becomes relevant after the prior issues are handled.

The answer to the “pay off mortgage or invest” question is actually quite simple – whatever gives you the highest after tax return on your money is the right decision.

Financial advisers will quickly point to research showing long-term historical returns for a low cost index portfolio around 8% (+ or – depending on assumptions) and match that against much lower mortgage rates (as of this writing) and proclaim immediate victory… but it’s not that simple.

Investment returns are highly variable with periodic “lost decades” where even pathetic mortgage interest rates represent a superior return over a traditional investment portfolio.

The problem is the future is not the past and returns vary, but mortgage interest saved is a bird in the hand. With that said, you would be hard pressed to find 20-30 year periods (the life of a typical mortgage) where an investment portfolio would not provide a higher return than recent mortgage interest rates.

The problem with any investment return comparison is nobody has a crystal ball. Unless you have a direct connection to the Higher Power then you are stuck right back where you started with a decision between a guaranteed (but low) return for prepaying your mortgage versus an unknowable but potentially higher return for investing.

In other words, you are left deciding between the certainty of mortgage payoff versus the uncertainty of investing. While financial science provides a relatively clear answer (investing should provide the higher return over the long term), this is really an emotional decision about your risk tolerance, confidence in the future, and belief in the science of investing.

It is why so many prefer to get out of debt despite the relatively compelling math.

Final Thoughts – The Human Variable…

With all that said, there is still one very important element missing from this conversation…

Life doesn’t usually go as planned. We humans are not computers who implement our brilliant plans with mathematical precision. Life throws obstacles our way, plans change, stuff happens, and that is just the way life works.

It is foolish to make long-term plans in an intellectual vacuum that fails to account for the random nature of life.

With that in mind, below are some fun ideas worth adding to this discussion…

• Flip The Logic: If you choose to invest instead of paying off your mortgage then consider this question – would you be willing to refinance the equity out of your mortgage (thus increasing your debt) to add to your investment accounts? If not, then you are logically inconsistent. (BTW, I write this with a wry smile because it is describing me perfectly – see below…)
• No Discipline: For every 10 people who claim to be making the minimum mortgage payment and investing the difference I would hazard a conservative guess that more than half fail to follow through on the investment part of the equation. The road to financial mediocrity is paved with the best intentions. In other words, an optional savings program that requires self-discipline is frequently no savings program at all. Contrast this with someone who places a 15 year, biweekly mortgage on their home thus creating enforced discipline. One happens with certainty regardless of life’s wrinkles… the other is optional.
• Expect the Unexpected: Nobody expects to lose their job, have a major medical problem, become disabled, or invest in a fraud; yet, over the course of a 30 year mortgage the odds that you will experience one or more of these admittedly rare and unfortunate events are far greater than you would like to believe. When your home is paid off it is easier to weather these storms with a minimum of personal adversity. Plan for the unexpected because eventually it will happen.

Conclusion:

I suppose the best way to conclude this lengthy analysis is by sharing what I’ve chosen to do with my own mortgage(s).

The truth is I used to be in the pay-off mortgage early camp. I hate debt and have a high value on freedom. In the late 1990’s I paid off my mortgage only to watch my investment portfolio double the next year while all that capital was tied up in my house.

Ouch! That was expensive…

Admittedly, things could have worked out very differently. I could have paid off the mortgage in 2007 instead and seen a decline in investment values the following year. However, in general, my investments outperform mortgage interest so it generally makes sense for me to prioritize investment capital.

With that said, I also find that I’m not fully rational on this issue. I would never refinance my home and invest the equity to pursue those higher returns. From a pure logic standpoint that makes no sense: I’m not willing to liquidate investments to pay off the mortgage, and I’m not willing to increase the mortgage to fund investments. Hmmm…. I guess I’m not as rational as I would like to believe.

The truth is the decision to pay off your mortgage is quite complex.

Fast forward to current times and I’m several years into a 30 year mortgage on my current home that, prior to writing this article, I would have refused to pay off. The interest rate is pathetically low, tax deductible, will likely end up below the inflation rate over the life of the loan, and it gives me some measure of inflation protection with a small short position against the dollar.

So I’ve been at both extremes – pay it off fast, and never pay it off – only to now end up somewhere in the middle of the road going forward.

I now firmly sit on both sides of the fence as follows…

• Because my retirement and kid’s college are fully funded I don’t need to prioritize those accounts.
• I have no debt besides the mortgage so no issue about paying more expensive debt first.
• I have all the insurance I need.
• Which means the discussion literally comes down to paying off the mortgage or investing.
• The math is clear that my highest return is with investing, but I’m also emotionally connected to having no debt and love the freedom of minimizing my cash flow needs. For that reason, my decision is to funnel a portion of increased revenues from this business toward prepaying the mortgage even though it is technically irrational from a return on investment perspective.
• In summary, I’m not willing to dedicate any of my investment capital to paying off my mortgage, but I’m also not willing to leverage my house to increase investment capital. This is irrational, but it is the honest truth where I stand on mortgage vs. investing. Regarding new income production, I’m fine with dedicating a portion of the revenues from this business toward paying off the mortgage rather than perpetually building investment capital while retaining debt. I guess the logic is that I’m getting a diminishing emotional return on more investment capital when compared with less debt. For economics geeks, it means I have a higher marginal utility on debt reduction than capital increases.

 I would like to declare this a balanced perspective in that I’m comfortable with my portfolio “as is” so I’m willing to “diversify” and lower risk by paying off mortgage debt with extra income, but in the end I know the truth… it is my emotional desire to be debt free and reduce risk that is driving the decision. I know the math and I should be investing – exclusively.

So there you have it – I’ve personally lived at both extremes of the decision and now stand firmly in the middle. The decision doesn’t have to be either/or: you can pay a little to debt reduction and save for investing at the same time.

Like everything in life, happiness is often found in the balance. I guess paying off your mortgage early is no exception.

So now that you know my situation, where do you stand?

How has this analysis helped you sort through the decision and what conclusion did you reach? Which issues hold the greatest sway in your decision? Please share in the comments below…

You Might Also Like…

• Mortgage Payment Calculator With Amortization Schedule: How much will my mortgage payment be?
• BiWeekly Mortgage Calculator: How much interest can I save by making biweekly payments or extra payments?
• Debt Snowball Calculator: How fast can I become debt free?
• Debt and Credit – The Only Guide You Need: Another in my “complete guide” series where I fully analyze a subject giving you a one-stop source for the information you need.

Financial Mentor Around The Web…

• My writing was featured in several blog carnivals including the Carnival of Financial Camaraderie, Totally Money Blog Carnival, Carnival of Wealth, and the Financial Simplicity Carnival.

Yet, it has become the biggest personal finance problem most people face.

How can something so simple create so much difficulty in people’s lives?

In this article I explain the deceptive nature of debt problems, the simple rules to keep you out of trouble, and the best way to solve any debt or credit problems you already have…

The Real Problem Isn’t Debt…

First off, debt is a symptom – not the problem.

Tracing the problem back to its root cause works like this…

• Your money problems result from excessive spending or insufficient income.
• Excessive spending and insufficient income problems are caused by life habits.

That is why debt and credit problems are so difficult to resolve for most people. It is a personal life problem masquerading as a financial problem. You look for financial solutions but they don’t exist because you’re looking in the wrong place.

Everybody knows the cure for debt and credit problems is to make more money or reduce spending. Duhh! So what? Getting it done is the surprisingly difficult part because the solution looks financial but is actually personal.

That is why extremely popular blogs exist on this topic. We want to believe there is a missing “secret” or “insider tip” that will solve our problems so we continue to search for more information. Unfortunately, more information won’t solve anything.

The real problem is inside you – money is just the symptom. There is no magic solution because you are a complex human being.

As a money coach I used to accept get-out-of-debt clients and it was a fascinating journey. With few exceptions the client’s financial problems were a mirror reflection of the underlying habitudes (habits and attitudes) that governed all of their behavior. Money problems were merely reflecting those habitudes financially just as other aspects of the client’s life (poor relationships, health, unhappiness) were reflecting the same habitudes.

In other words, people who ended up with credit card debt through overspending (as opposed to being caused by catastrophic events like medical bills, divorce, accident, etc.) shared some or all of the following common characteristics…

• Misplaced Priorities: They chose consumption and current lifestyle over investments and freedom. Their consumption decisions reflected the underlying belief that happiness was connected to more-better-different stuff. It’s not.
• View Credit As Money: They used credit to extend purchasing power. It doesn’t work that way (except in the short-term).
• Instant Gratification: They chose instant gratification over delayed gratification. They generally operated from the perspective of “today” and ‘this year” but failed to connect those actions to results 10-20 years later.
• Procrastination: Instant gratification leads to putting off the hard stuff until tomorrow. This multiplies short-term inconvenience into long-term disaster.
• Victim: They don’t own the source of their problems as caused by themselves. Someone else or some unfortunate event did it to them.
• Emotional Spending: They buy for ego and emotional satisfaction instead of utilitarian value. Self is emotionally connected to stuff.
• Entitlement: They are entitled to the good things in life. Why shouldn’t they have designer clothes, a big screen TV, and a nice car… everyone else does? (Answer: they can’t afford it – that’s why – but neither can most of the other people.)
• No Plan: Spending and earning are disconnected. There is no budget, no system for growing assets, no tracking of numbers, no plan for leverage, and no strategy for increasing earnings. In short, there is no discipline.

What’s amazing (and obvious in hindsight) is you can flip every one of these characteristics upside down and you have a short list of habitudes that produce wealth. In other words, my wealthy coaching clients had one set of habitudes and my debt clients had the mirror opposite.

I was amazed! But this was not a coincidence.

As I said earlier, debt is a symptom… not a cause. The cause of your financial problems is not financial (with the sole exception of unusual circumstances such as medical, catastrophe, etc.)

Now that we understand the root cause of debt and credit problems (your habits and attitudes), let’s look at some simple rules for habits and attitudes that cut through all the information clutter so you can avoid debt problems…

Proper Use Of Debt

Debt isn’t all bad.

Let’s start by looking at two acceptable forms of debt – financing large capital purchases and income property acquisitions.

For example, a perfectly viable wealth strategy using debt financing (a mortgage in this case) is to purchase a rental property that produces more income than expenses (positive cash flow).

Similarly, it can be a very smart wealth building strategy to leverage a business using debt as long as the income produced by what you purchase with the debt exceeds the cost of the debt.

These are both intuitively obvious examples of “good debt” because they put more money in your pocket than they take out while growing a valuable asset. The income produced by the asset exceeds the cost of servicing the debt. It is a straightforward application of financial leverage to multiply wealth.

The analysis gets confused when large non-consumption capital expenditures are purchased where no income is produced.

For example, debt is acceptable for buying your home. The reason is because you need housing so you either throw money away on rent in perpetuity or pay a mortgage and build equity. The key distinction is the asset has enduring value and isn’t “consumed”. It is not like a car that you use up and dispose of. It is a capital item that produces a utilitarian good (a place to live) without being used up (assuming you maintain it). It can even increase in value over time (except during a credit deflation).

These two situations (large capital expenditures that are not consumed and income producing property) are the two situations where debt can make good business sense.

These are both examples of good debt.

Now let’s look at bad debt…

3 Rules To Never Get In Debt

Bad debt is when you use credit to increase consumption beyond what you can afford to pay. The key point is the spending is for consumption – not an asset.

The rule is simple when spending on lifestyle: if you don’t have enough money in the bank then you can’t afford it.

That means the only acceptable function of credit cards is for transaction convenience. They should never by used to extend purchasing power.

In addition, you should pay your cards in full every month. Never roll a balance over from one month to the next.

Your objective is to be a credit card “deadbeat” by paying off your balance every month and incurring zero fees for the privilege of using the card.

Another advantage to credit cards are the various incentive programs that give free airline tickets, trips, hotels, and even cash back. Again, the rule is simple: only use these cards for spending you would already be doing anyway. Never increase your spending to get bonus awards.

You should never spend a dime more than you would if no credit was available and you should never carry a balance or incur monthly fees. Only then can the benefits of incentive credit cards exceed the costs (the annual fee).

I don’t promote credit cards on this site because my focus is building wealth, but if readers are interested in finding the best credit card promotions, offers, and deals I encourage you to look over these links from several friends in the financial blogosphere who “eat their own cooking” and consider using the same cards they recommend…

• FreeMoneyFinance has researched the best cash back credit cards and uses the top choices from this list for his own purchases.
• PT Money keeps both the Chase Freedom card and the Chase Business card in his own wallet.
• Ben Edwards over at MoneySmartLife likes the American Express Blue Cash card for his personal use.

Finally, always look first at the fees charged so that you can determine if the incentive program will give you more benefit than the costs of owning the card.

In summary, the three rules to avoid getting in debt trouble are as follows…

• Debt should only be used to finance income producing property or large, non-consumption, asset purchases.
• Debt should never be used to extend purchasing power for consumption. Lifestyle should never be bought on credit.
• Credit cards should only be used as a transaction convenience and never to extend purchasing power.

That’s it! Those are the rules that will keep you out of trouble (if you follow them) – 3 simple rules that convert the complex world of debt and credit into straightforward, actionable guidelines.

Unfortunately, for many readers it is “too little, too late”. They are already in debt. If that is you then below is an equally simple, step-by-step guide on the best way to get out of debt and start building habitudes that will take you to wealth…

How To Get Out Of Debt

If you are in debt bondage then your starting point to freedom is you must create a positive spread between how much money comes in and how much goes out.

It is an inescapable fact. You must live on less than you make. There is no way around it. It is not negotiable because debt is paid off from the income leftover after expenses are paid. You can’t pay off your debt if you spend more than you make.

The way you start this process is by fully owning responsibility for your financial problems and developing a plan for solving them.

You must be proactive. Don’t bury your head in the sand because the problem won’t go away on its own. You must take serious action. The longer you wait the worse it will get.

There are two ways to achieve the goal of living on less than you earn – reduce spending and/or increase income. Seriously, I know this sounds obvious when written but this is literally all there is to it. It is not rocket science and there is no greater complication or missing secrets than what is described here.

Let’s start with a five step process for reducing spending…

5 Steps To Reduce Spending…

Step 1 – Stem the Bleeding:

Contact your creditors immediately and try to negotiate special terms. You may be surprised how helpful they can be if you just ask. It costs you nothing and the worst that can happen is they refuse.

If your existing lender won’t work with you then look into balance transfers and consolidate all loans onto the lowest interest card. Just be careful of balance transfer fees and other hidden costs. Examine the fine print first to make sure it’s really a benefit.

Your objective is to negotiate reduced rates and favorable terms to stem the bleeding. Eliminating fees and reducing interest on current debt can go a long way toward helping you ultimately payoff the debt.

Next, you must stop adding to the debt by cutting up the credit cards, locking them out of reach, or freezing them. You have already demonstrated a spending control issue so you must eliminate access to the vehicle that allows you to spend excessively – easy credit. The objective is to put obstacles between you and credit so that it is inconvenient.

Do it now before moving onto the next step. This will force you to live within your means – now!

Step 2 – Raise Awareness Through Tracking

Once credit is inaccessible and you’ve done everything possible to reduce the bleeding, the next step is to track your spending. This is not a budget. You are simply tracking where the money is going to raise your awareness…

• Is it to entertain yourself when you are bored?
• Is it on spontaneous purchases instead of planned needs?
• Is it on the latest gadgets?
• Is it on fees or interest because you are in debt?
• Do you spend for personal collections (curios, music, etc.) that you enjoy but aren’t necessary?
• How much goes to recurring expenses (rent, car payment, utilities, etc.) that can be reduced or eliminated?
• How much is wasted on fees for unnecessary convenience (ATM fees, advance ticket sales, etc.)
• Do you spend on expedient solutions that are little more than a convenience such as going out to dinner or expensive coffee instead of cooking at home (see our Latte Factor calculator for the true cost of these expenses)?
• For ego gratification (expensive clothes, latest trends, to show off to friends)?
• Name brands instead of generics?
• Processed food instead of whole food?
• Full price items instead of seasonal or sale discounts?
• New instead of used?

When you track your spending it raises your awareness about where your money goes and what your patterns are. This will point to a personalized solution that exactly fits your individual needs. Look at every aspect of your spending to figure out what is truly necessary and what isn’t.

And if you are looking for a budgeting spreadsheet to help with the process here is great list of free budget templates and spreadsheets so you can find just the right one to suit your needs.

Step 3 – Reduce Your Spending

Now that you are living within your means and tracking your spending, notice how every dollar you spend either takes you toward your goals or away from your goals.

You simply decide what priority you make certain goals – like financial freedom over current lifestyle. Remember, debt is caused by choosing the opposite. In fact, every day you are making literally 100s of these decisions that will make or break your financial future.

Your spending is a reflection of your values (once you become aware of your money). You want to align every dollar spent with your goals so that all spending moves you toward what you want most. You can’t have everything so you must decide what the highest priorities are.

The truth is you need far less than you think. The goal in this step is to get your spending down to your true “baseline” required spending so you can move away from lifestyle and toward financial security. The amount you save each month will determine how fast you can get out of debt so it is critically important.

Cut your spending ruthlessly. All excess and waste must be eliminated. Look at the big ticket items like housing and transportation first to make the biggest impact fast. Consider moving, getting rid of a car, using public transportation. Don’t assume any item is sacred no matter how entrenched, and at the same time don’t overlook any item no matter how inconsequential.

It all adds up.

Step 4 – Accountability To Supercharge Results:

Tell the world about your goal to be debt free. Pick a date, form a plan, and tell those closest to you.

Your objective in this step is to literally build a box around yourself that doesn’t allow squirm room so that you enforce your new spending patterns until they become habit. Enroll a parent, spouse, coach, or friend as an accountability partner so you have someone to report your results to. Create the tracking system.

Heck, go whole-hog and tell all your friends and enroll them to support you. This might mean they don’t invite you to eat out or go shopping but that’s okay. They shouldn’t tempt you with high cost adventures. You could even email them monthly on your results, blog about it, or report it on Facebook. Seriously! Why not? Do you want the goal or not?

Accountability is a magically, powerful force for shaping human behavior so use it to your advantage. The whole reason we resist accountability is because we intuitively recognize its power.

The question is – do you want to get out of debt or not? Accountability gets results. Use it!

Step 5 – Get The Right Attitude:

Don’t think in terms of sacrifice and all that you are giving up. Instead, think in terms of the peace-of-mind, freedom, and security you are heading toward. This is essential.

The cup is either half full or half empty. You choose the reality you live under. When you focus on where you are headed (peace of mind, security, and fulfillment) the reduced spending never feels like a sacrifice. In fact, it can be positively addicting because you are moving toward your financial goals – finally!

The Other Side Of The Coin – Increasing Income…

Now that you’ve reduced spending as far as possible the next strategy to getting out of debt is to look at all the ways you can increase income…

• Can you work overtime temporarily to get your financial situation under control?
• Is there seasonal, freelance, or part-time income you can add?
• What new job skills or education/certifications would increase your salary?
• Can you convert a hobby into income?

There are fundamentally two approaches to increasing income – short-term quick fixes and long-term permanent solutions.

The short-term quick fix is to increase the hours you work either through overtime, freelancing, or similar. This can be helpful to provide an immediate injection of cash but can lead to burnout over the long-term.

That’s why you also want to look into ways that permanently increase your income without having to work 24-7. This involves launching some type of business that begins as a sideline but can transition to full-time, or it involves gaining new job skills or certifications to increase salary in your current occupation (or possibly changing occupations).

A Few More Tips To Help Your Savings Grow Faster

Getting out of debt is a serious goal meriting serious action.

Below are a collection of additional tips in no particular order that can help you wage war on the debt monster…

• Debt results from a pattern of behavior (habitudes) so examine all patterns causing the problem and break them. This might involve changing friends or spending less time with the spendthrifts in your social circle. Any habit that results in unnecessary spending should be reconsidered.
• Don’t overlook radical measures that can make a huge difference. Rent is one of your biggest expenses. It may not be fun but moving in with friends or family, or living in your motorhome for a period of time can make a huge difference in your budget. Radical? Yes, but no more radical than putting up with the noose of debt strung around your neck.
• You absolutely must put a barrier between you and overspending. That means getting rid of your credit cards and other sources of easy credit. I said it before but I’m repeating it here because it is critically important. Cut them up or lock them away. You must live on less than you earn.
• Consider selling anything you don’t regularly use and apply the proceeds to your debt – fur coats, jewelry, a boat, motorhome, extra car. Craigslist, Ebay, and garage sales can convert an amazing amount of stuff into serious cash that can make a dent in your debt. Sure it is a short-term solution to a long-term problem, but it can also give you a jump-start while simplifying your life at the same time.

Putting it altogether, this gives you a four pronged attack for making forward progress on getting out of debt…

• Start by reducing spending to produce immediate results.
• Increase the spread between income and outflow by adding overtime or freelance work to provide a short-term income boost.
• Sell your stuff for a quick payoff.
• Add new job skills or start a business for long-term income growth.
• Rinse and repeat until you are out of debt.

While this sound simple on the surface (because it is), I also want to acknowledge how difficult many people find these action steps to implement even though they intellectually understand the process. After all, you already know what you should be doing. The problem isn’t knowing what to do: the problem is getting it done. Again, that’s because the problem appears financial when it is really personal, and there is no simple solution to personal issues like discipline, determination, and prioritization.

I encourage you to seek out support systems and apply all accountability tools at your disposal. Unfortunately, there is no royal road to the destination. Your success or failure will depend on your commitment and clarity to getting out of debt.

You wield the power to get yourself in debt; therefore, you also have the power to get back out of debt. You just have to complete the steps.

Once you create a positive spread between income and expenses the next step is applying the right debt payoff strategy to become debt free in the fastest way possible. There are two similar but distinct strategies that I will cover below…

Debt Snowball vs. Accelerated Debt Payoff

Start the debt payoff process by making a list of all your debts. You’ll find this information on the monthly statements your get in the mail.

Note the creditor’s name, interest rate, amount owed, and monthly payment. Enter all the information in this debt payoff calculator to help manage the process and estimate how long it will take you to get out of debt.

You can order your list of debts in two separate ways…

• Debt Snowball: Order the debts from smallest balance at the top to largest balance at the bottom. This gives you greater emotional satisfaction because you see results much faster. The small debts get eliminated quickly giving you immediate positive feedback and reinforcing discipline. This costs you a little more in interest than the alternative below but many consider it worth the price because the emotional satisfaction results in a higher probability of sticking with the process long enough to succeed.
• Accelerated Debt Payoff: The other alternative is to order your debts with highest interest rate at the top and lowest interest rate on the bottom. This is mathematically the best way resulting in the fastest, lowest cost payoff because it targets the highest interest rate debt first. The problem occurs if you have a large debt that is also high interest because it can feel like it takes forever to make any progress. This causes many people to give up.

There is no right/wrong answer to which debt ordering system is best. One is financially superior and the other is emotionally superior. The key is to decide what will work best for you so that you stick with the process long enough to succeed.

Next, enter the amount of income leftover each month that can be applied toward paying down debts in the box at the bottom of calculator. You get this number from the 5 step exercise above where you figured out how to spend less than you earn.

What this calculator will do for you is apply the minimum monthly payment on all debts except the top listed debt. That one gets the additional money from the step above to help pay it off as fast as possible.

Notice how the size of this additional payment determines how long it will take to get out of debt. I encourage you to play with different numbers and see how much difference it can make. It might be motivating to go back to the previous section and figure out how to increase your monthly savings so you get out of debt faster.

As the first debt is paid off you dedicate 100% of the money that went to that debt to the next one on the list. You repeat this process creating a snowball that concentrates an increasing amount of your total monthly payment to fewer and fewer debts until they are all paid off – in full. Yay!

Go ahead and punch your numbers into the calculator and give it a try. You might just be surprised how fast you can be debt free.

In Summary…

There are many ways to slip into debt. You might become underemployed, suffer a salary reduction, divorce, high medical bills, or simply lack good money management skills.

These life problems don’t necessarily translate into debt. Good money management skills combined with the following three rule system can save you from financial difficulty…

• Use debt only to purchase assets that increase in value or produce more income than expenses. Debt used this way leverages your balance sheet which can be a valuable wealth building strategy, but it can also increase your risk so be careful.
• Never use credit to increase consumption. If you don’t have the money in the bank to pay for lifestyle expenses then you can’t afford it.
• Credit cards should only be used for transaction convenience and should be paid in full each month.

These three simple rules will keep debt and credit problems from occurring regardless of life circumstances.

Credit is an expedient, short-term solution to life’s difficulties, but it is usually not the lowest cost or best solution in the long-term.

Once you have a problem the only way out is decisive action to solve the problem: it won’t solve itself. There is only one way to get back out of debt. You have to do the work. There is – unfortunately – no magic fix to debt and credit problems.

From the moment you commit to taking action until the day you are debt free will likely require many months or possibly years… so plan accordingly. Set yourself up to win.

• First you must stem the financial bleeding by reducing expenses. This involves tracking all expenses and aligning your spending with your values so no money is wasted. It may also require cutting up credit cards or freezing them so you eliminate easy access to credit. (Did I say that before?)
• Second, you must increase income to widen the gap between how much you spend and how much you earn. This can include both short-term strategies such as overtime and long term strategies like adding career skills or starting a business.
• Next, take the amount saved each month and dedicate it toward paying down debt using either the debt snowball or the accelerated debt payoff method.

The key point is to realize that debt and credit issues are a personal problem masquerading as a financial problem. This deceit is why so many people have trouble managing debt and credit. They look for financial solutions when the answer is personal – not financial.

Always remember the financial strategies for getting out of debt are simple to understand and implement. The personal obstacles that stand between you and debt freedom are far more complex and difficult to overcome.

This is the nature of the debt beast. That is why slaying the debt dragon is the greatest path of personal growth for anyone who has the problem.

So commit to your growth and freedom! Make this year a time where you finally break the bonds of consumerism and debt slavery.

Get out of debt and begin the journey to financial freedom.

It may not be easy… but it certainly beats the alternative.

You Might Also Like…

• Payoff Debt Or Build Wealth – Which Should I Do First? Explains the critical differences between the art and the science of paying off debt.
• 6 Steps To Recover From Financial Disaster: If you are suffering from a serious financial setback don’t worry – you’re not alone and there is a solution.
• The Minimalists Guide To Financial Planning: Financial planning is so simple it can be explained in two sentences. The principles and habitudes that lead to wealth are the mirror opposite that result in debt.
• Debt Snowball Calculator: A simple calculator that does all the heavy lifting. Just punch in your numbers and it will show you how fast you can be debt free!
• Faster, Better Results Now – A Boring Tool That Really Works! A step-by-step guide to using accountability to achieve any goal faster and with less effort.
• Are You Living In Financial Integrity? You can never be happy as long as you live out of integrity with your values. It’s a major cause of debt and financial mediocrity. Discover the solution…

Financial Mentor Around The Web…

I recently began entering my writing in financial blog Carnivals (think of  a carnival as a competition among financial bloggers where best posts are selected and celebrated.) I’ve only entered a few and you can see the results below so expect to see more of this in the future…

• Ken Faulkenberry runs the “Self-Directed Investing For Retirement Carnival” where my writing on investment strategy topics won placement in October, November, and December.
• The Best of Money Carnival elected my one and only submission, a guest post titled “The Complete Guide To Building Wealth In 2 Sentences” as the best financial article for all of 2011! Wow! Nice acknowledgement for a first effort.
• If you want to keep up with all my educational efforts that don’t appear on this site make sure to like my Facebook page here for future updates.

Oh yes, and please share your thoughts and ideas about this article in the comments below. BTW, it is a new comment system so try it out and tell me what you think!

Thanks!

“I am aching to be free of my student loan debt (roughly $60k), so I’ve been religiously following a debt-payoff plan thanks to your ADP calculator. At the same time, I’ve been struggling to put 10% of my monthly income towards savings, and another 10% towards my IRA (though, I know it’s not enough). I’m 26 years old. Years away from retirement. And aching to be debt-free….

What’s more important? Quick debt-payoff? Or maxing out IRA contributions and saving 10% of my income?

If I cut back on contributing to my savings and retirement even 50%, I could be free of debt 2 years sooner (saving $5,000 in interest) than if I continue to save/contribute the way I am. If I were debt-free, I could travel at will, put away more for retirement later on, save for a house… Oh, the possibilities! But, then I slow down my savings and retirement accounts. Any advice?”

Patty, first off, I want to acknowledge your clear focus and dedication to your financial goals. I’m confident you do well regardless of which choice you make with this decision.

Also, thank you for the kudos on the accelerated debt reduction calculator. I’ve put a lot of work into the free financial calculators and free retirement calculators on this web site, and I encourage every reader to make best use of these valuable resources. I use them personally and with financial coaching clients regularly.

To answer your question… the scientific, 100% accurate response is, “you should do what gives you the highest after tax return on your capital”. Unfortunately, this answer is useless for real world application.

The problem with the scientific answer is you have to know the future after tax, compound return for every investment alternative (which is impossible since the future cannot be predicted with any accuracy).

So much for science in the world of personal finance…

The practical answer is a blend of art and science. It combines the personal aspects of financial success (money habits, psychology, etc.) with proven financial principles. I point this out because the art-science principle is going to have broad applicability to most financial decisions you face over your lifetime. Science roots your financial plan in hard numbers while art incorporates the emotional/human aspects of building wealth. Both are important.

Putting the two together, there is a huge tax deferral value to retirement savings given your age that can never be recaptured if you don’t make use of it now. In addition, getting started early on retirement savings is one of the single smartest financial habits you can develop. I walked-the-talk on this one and it is a major reason I was able to “retire” at age 35.

My personal bias is to always max out tax-deferred and tax free retirement savings first unless there is a really compelling reason (higher after tax return elsewhere) not to. This is just a solid rule-of-thumb. The tax advantages provide great value over a lifetime, and the penalties provide a good fence around your fortune so you don’t raid your nest egg during life’s inevitable setbacks. Both are important to your lifetime wealth equation.

How you prioritize your remaining funds is a question of values. In other words, you clearly have a high emotional value on being debt free and will likely feel a great a sense of achievement and forward momentum when you reach this goal. The importance of this can’t be overstated. Since you are already playing offense (building wealth) with your retirement accounts it is perfectly reasonable to put on a good financial defense (pay down debt, reduce risk) with your remaining capital.

The counter-argument to the above logic would stress that student loan debt has a known cost in terms of interest rate. Post-tax, regular savings has an unknown benefit which is a function of your investment skill and market opportunity. Therefore, it is unknown which will provide the highest after-tax return (but it is relatively clear which will provide the highest emotional return).

After weighing all the various arguments, my suggested order of prioritization based on the limited information provided would be to…

1. Fully fund all tax-deferred retirement plans first.
2. Pay down debt second with remaining capital.
3. Build post-tax savings only to create a small nest egg for temporary hardship until debt is paid off and then go big after that.

I would add one more point to this equation… you should dedicate an equal focus to building your investment skill while your capital remains small and you are paying down debt. Learn the investment ropes now and make your mistakes early with smaller dollar amounts. The lifetime value of this early education compounded over a lifetime is literally worth a fortune to you.

Anyway, I believe this formula should strike a reasonable balance between the various conflicting needs for limited funds. It should come close to balancing both the art and science of building wealth.

What do you think? Do you agree or disagree? What principles discussed here can you apply in your own life? What did you like about this plan and what did I miss? Share your thoughts in the comments below…

“…I’m an architect suffering under this dreadful economy like so many of us are, and I need to do something to help carry me through… What I’d like to do is use a portion of my IRA funds to educate myself further in the investment arena, pay back the loan, and use the remainder of the IRA to actively invest for income and growth. In other words, keep a portion of the earnings to supplement my income and reinvest the rest for growth. Does that sound like a reasonable idea?”

To paraphrase the question I’m really hearing two separate questions…

1. Is it okay to spend (or borrow) retirement assets as an expedient way to accomplish an objective prior to retirement?
2. Is it reasonable to take up active trading as a way to increase investment return to supplement current income and still grow my IRA?

My short answer to both these questions is “no” and “no” and I will explain why below…

Is It Okay To Spend Retirement Assets?

The number of situations in which it is acceptable to withdraw money from your IRA accounts prior to retirement can be counted on one hand with fingers left over. It is generally almost always a bad idea. You will pay penalties, taxes and do irreparable damage to the compound growth necessary to fund retirement.

The reason people raid their retirement fund for current spending is because it is easy. It is money they have access to providing an expedient solution to a problem. Alternative solutions can nearly always be found but they are also more difficult… IN THE SHORT RUN. But in the long run spending your retirement accounts is usually the most difficult solution and should be avoided.

In summary, you should always try to avoid spending retirement accounts until you actually retire. There is usually a better long-term solution – even if it is more difficult right now.

Active Trading…

Regarding the active trading question, my concern is their may be a false belief about what is possible with active trading. While I support active trading as a risk management tool there are a lot of hucksters making unrealistic claims of high returns to promote their active investing courses. Don’t believe them.

Active trading isn’t nearly as effective at increasing returns net of expenses as it is at lowering risk. It is very realistic to expect a better risk adjusted return but don’t expect to knock the ball out of the park just because you take an active investment approach.

If you are not sure whether to believe me or the hucksters marketing the courses then I suggest studying the returns of hedge funds with special note on the percentage of funds that fail (a database without survivorship bias). Hedge funds attract the best and brightest of active trading; yet, the results are not impressive over the long term. It is exceedingly rare to earn better than a 1:1 risk to reward ratio over the long term (net of expenses and taxes). Sure, there are stars every year with amazing investment results, but over the long-term you will find very few who produce better than a 1:1 risk/reward ratio.

What that means is that depending on the size of your IRA and your particular abilities in active trading, it may not be realistic to supplement current income and still build retirement security from the same account. There may not be enough to go around net of inflation and growth requirements (not to mention the penalties and taxes associated with premature distributions).

I’m sorry, but it isn’t as easy as all the promoters make it sound. Active trading is great for risk management but don’t expect outsize returns over the long-term.

In Summary…

My suggestion is if you want to take up active trading then that is fine but recognize it has a learning curve like any other profession so set realistic time and training expectations. Keep your day job because it is not a slam dunk (despite what the huckster promoters may claim). Don’t spend your IRA money – figure out another way to accomplish the objective. If you are truly committed to this path (which you will need to be in order to succeed) then you will find another solution.

In other words, there is nothing inherently wrong with your overall objective – to become an active trader and to figure out solutions to your economic difficulties. I would just be careful how you implement these solutions to protect yourself from the downside risk.

My two cents worth…

Let me know your two cents worth in the comments below. What do you think of his question and what do you think of my advice?

One guy is doom and gloom claiming the world will fall into a cataclysmic depression by the end of the month. The next guy is optimistic that the Fed/Dr. Bernanke have cured all economic ills so that we are on our merry way to perpetual prosperity and bliss.

Such hype sells well but serves nobody.

The truth is our economic ills were not cured by bailouts that transferred bad debt from the private sector to the public, and we’re not likely falling into the abyss next week but will trade our way to whatever eventual economic outcome is our destiny.

That is why I liked the following post from Zero Hedge as a breath of fresh air because it succinctly points out a few economic facts that everyone needs to know and understand. The long term implications are important.

No hype – just solid facts that I think all my readers would like to know about.

As you read this article please notice your thoughts and share them in the comments below. I really want to know…

It really doesn’t matter if you are a U.S. citizen, Japanese, European or beholden to any number of other country’s debt laden fiscal policies, governments trained by John Maynard Keynes are “kicking the can down the road” by going deep into debt rather than solving current financial problems. This has introduced unprecedented levels of risk and undermined citizens sense of financial security.

So what can you do to protect your own portfolio?

This is a sticky question because every reader’s financial situation is different so please do not take this post as personalized financial advice. Instead, it is a guideline pointing a direction where I will share three generalized principles to consider if you become concerned about your government’s fiscal health…

1. The first obvious answer is to move assets out of an unstable country into a safe haven currency. The reasons behind this strategy should be self-evident although deciding what currency/country qualifies as “safe-haven” isn’t as straightforward as it used to be.
2. Another alternative is to purchase positive cash flow real estate with low leverage, fixed rate, fully amortizing financing (30-60% debt to equity). The income producing real estate provides a real asset that will command revenue that adjusts to currency changes and the asset value will adjust over time as well. The fully amortizing, fixed rate financing locks in your highest cost of ownership creating positive operating leverage to inflation (but also deflation should that occur first) and the low leverage level and positive cash flow increases the odds you will survive the interim volatility and fluctuations long enough to emerge a winner in the end.
3. Gold and related assets (other precious metals and metals producer stocks). In a world where all countries are sacrificing their currency and the question changes from “which currency is best” to “which currency is least-worst” means gold emerges as a likely winner. Just be careful because it doesn’t mean gold can’t fall 50% between now and then. It is an incredibly volatile asset class and there is a solid possibility that we could experience tremendous asset deflation between now and the time inflation rears it’s ugly head. In other words, this is not the slam-dunk that many pundits preach… so walk carefully.

However, with that said, those are the three primary strategies for protecting your wealth in world gone mad with debt and funny financial games at the highest level of governance. The implied assumption is that inflation will be the long-term result, but beware because it is entirely possible for deflation to occur first prior to long-term inflation taking charge. This can cause tremendous volatility and should make you cautious.

You may notice that stocks are conspicuously absent from this list even though they are equity and can benefit from long-term inflation. The reason is complicated to explain in a blog post but in general results from various valuation models that cause stocks to perform poorly in the initial instability caused by inflation and rising interest rates. This is not just a theoretical consideration but in fact exists historically in the data whether you look at Weimar Republic style inflation or more manageable problems like the U.S. in the 60′s and 70′s – stocks tend to lag before they run.

In summary, if you share the concerns expressed by some of my other readers then those are the three primary strategies to consider to protect your wealth in times of extreme monetary adversity.

Most importantly, I would like to point out the name of the game during adversity is “he who loses least wins”. In other words, with all the volatility it is tempting to play it big but the downside risk is equally large.

With that said, there are a couple of strategies from that list that can protect your wealth regardless of the outcome. In other words, you don’t have to be a genius forecaster and predict the world economy to preserve your portfolio because a couple of the strategies are relatively safe bets either way. Heads you win – and tails you win as well.

In times like this that might just be about as good as it gets…

Please let me know your thoughts in the comments below or share any of your favorite strategies or resources I might have missed so the rest of us can benefit…

You want to believe that trained financial experts know what they are doing. You assume they know something you don’t given their credentials and education. After all, don’t they have connections to resources you will never be able to access? Aren’t they insiders with specialized expertise?

Some of those thoughts may be true, but what overwhelms all those advantages are the conflicts of interest, bias and other problems that can taint the financial advice you receive and make it far less reliable than you might ever imagine.

In the latest addition to the “Featured Articles” section of this website – 6 Reasons Why It Pays To Be Your Own Financial Expert - I explain the hidden problems behind financial advice so that you can protect your portfolio from biased and dishonest financial experts. Below are some of the issues you will learn to overcome in this new article…

• Conflicts of interest.
• Incomplete or inaccurate advice.
• Advice from experts that can negatively impact your critical thinking abilities.
• Financial experts who may be dishonest.
• Financial advisors who may be self-deceived.
• How the whole idea of a “financial expert” is incongruent with the probabilistic nature of investing.

The reason you should care about these problems is simple – they can cost you money if you don’t protect yourself. If you don’t understand this information you may put yourself at risk of relying on advice that is simply not trustworthy. By learning the inherent problems underlying financial advice you can protect your portfolio from faulty and expensive investment decisions.

I hope this new article helps you improve your investing and grow your financial intelligence to the next level.

Let me know what you think of it…

Further Reading

• 6 Reasons Why It Pays To Be Your Own Financial Expert: Reveals the conflicts of interest hiding behind financial advice so that you can make smarter, more profitable investment decisions.

Below are some educational articles published in the last week that no investor should be without…

1. Forbes published a great synopsis of the government debt crisis both in the U.S. and abroad. This is a very likely catalyst for the problems building in the markets. Remember, CDS rates expanded prior to subprime blowing up in 2008 thus providing the first clues before everything came unwound. Now government CDS rates have begun to expand. Make sure you understand this stuff…
2. David Galland published a great interview with Andy Millerof the Miller Frishman Group providing the inside scoop on why the real estate decline is far from over. It explains the catalysts that could cause the next break and makes clear just how much downside risk remains in both commercial and residential real estate. If you invest in real estate or are considering an investment this is a must read. Even if you don’t invest in real estate you will want to know this stuff because its impact will likely affect all markets you do invest in…
3. The Pragmatic Capitalist blog published a brief, two paragraph piece explaining that Investor’s Business Daily market model has officially turned bearish as of last Friday. They have a solid record of market calls during all the volatility of recent years using a well-reasoned model so this is not something to dismiss without serious consideration.

I hope you find these insights helpful. I will continue to bring you the best of the web so that you can advance your financial intelligence to the next level and become a more consistently profitable investor. I hope these articles help…

To answer that question we must make a distinction between personal financial advice and investment advice. While they may sound similar, they are actually as different as night and day.

Personal financial advice (insurance, savings, budgeting) is usually uncomplicated. The correct actions to take are well-proven and straightforward with few conflicting opinions. The reason this is true is because the risks, costs, and outcomes are known and fairly predictable. Because the action steps are uncomplicated the conflicts of interest resulting from the advisor receiving a commission are manageable and acceptable. You can do your own research, apply business common sense, and make a reasonably intelligent decision.

Investment advice is different. It is subtle shades of gray because investing is a risky bet on an unknowable and unpredictable future. Five different experts will provide five different opinions – each conflicting with the other. It is a dynamic, evolving process where the quality of your investment returns is dependent on the expertise and decision process of the person managing your assets. In short, it is anything but straightforward making commissioned sales incentives a bad idea.

My rule is to keep things as simple as possible by not mixing insurance sales with investment advice. I have never purchased an insurance product for an investment or an insurance product from someone who sells investments. I don’t go to generalists who sell all financial products (investments, insurance, etc.) to purchase specialty products. In other words, I don’t mix things up. I keep things simple and straightforward.

If I want insurance I shop for insurance from insurance salespeople. If I want specialized investments I seek the appropriate vendor who specializes exclusively in those products, and if I want generic investments (stocks, bonds, ETFs, etc.) then I shop for brokerage services based on my brokerage needs for that portfolio. I buy only from specialists – experts in their unique fields. I suggest you do the same to minimize conflicts of interest. Don’t collapse your various financial needs into one vendor – keep it separate.

For example, the guy I buy my home insurance and auto policies from represents a single company and has sold this one insurance line for his entire career. I am buying the insurance company as much as his expertise in this specific line of insurance. I love the fact that I can call him with any question regarding the insurance products he sells and he knows the answers off the top of his head. He is an expert in his field, and the company is top of the line. He receives a commission on the sale, and I see no conflict of interest because he has no hidden incentive – it is all easy to understand and straightforward business.

The woman I buy my health insurance policy from is a specialist in health insurance – that is all she sells and she is paid a commission as well. She represents many different health insurance carriers and helps me choose the right insurance policy to fit my specific needs. While this could represent a potential conflict of interest to direct me to a higher compensation policy, my experience in working with this individual is that she does represent the client’s best interests. The policy she recommended was carefully matched to my needs from the many available, and when we had a problem with the company her staff intervened on our behalf to resolve the problem in our favor. I appreciate her service and expertise, and I would never begrudge her a commission. She earns and deserves every penny.

Notice that each of my insurance representatives are specialists – that is all they sell – and they usually represent a single company or type of product line. They are experts in those product lines and receive commissions on what they sell. I have no problem with a commission in that situation because I shop them based on their expertise and the insurance product they represent – commission included. The incentive to sell me the insurance is overt and nothing is hidden.

That is very different from investment advisors who recommend investments from basically the same menu of choices as other competing advisors offer while also pitching insurance and anything else financial. They are basically “used stock salesman” offering the same stocks, bonds, ETF’s and similar mutual funds as everyone else. They are in the “relationship” business where they seek to establish your trust then use that trust to satisfy (sell) all your financial product needs. In this case, you are paying for their relationship and service, but seldom are you getting a true expert in all the financial products they represent. In that situation, a commission is a problem.

Below are some simple guidelines summarizing how to minimize the conflicts of interest when shopping for investment and personal financial products:

• Never mix personal finance product sales with investment product sales because nobody can be an expert at all of them. A jack of all trades is a master of none.
• When purchasing personal finance products always buy from experts who specializes in their specific product line or niche area.
• It is okay to pay a commission for expert service on personal finance products like insurance – just use business common sense and do your homework first so you are a knowledgeable buyer.
• Don’t mix investment advice with investment product sales because it is a conflict of interest. Keep investment advice separate from investment product sales by paying for each service separately.

What you will notice in these rules is how they narrowly define the service rendered to match the compensation provided so that conflicts of interest are minimized. The other thing I like about these rules is how it connects me with experts in each narrowly defined niche so that I benefit from a deeper level of knowledge from each vendor.

My concern in your question is you may not be clear about these distinctions causing you to collapse the issues.

Hope that clarifies.

Further Reading:

• How Simple, Free Investment Advice Can Cost You A Fortune
• Learn About The Hidden Conflicts Of Interest Behind Investment Advice Compensation Models
• How To Find Financial Advice You Can Trust

To gain a greater understanding of the ongoing and ever-escalating bank bailout insanity read John Hussman’s recent post revealing the latest shenanigans snuck under the radar while everyone was out for the holidays. The title should be self-explanatory – “Timothy Geithner Meets Vladimir Lenin”. It is essential financial education for every American voter. 

I’ve made no secret that I dislike bank bailouts. It violates the very economic principles that made this country great, and it creates negative incentives that will hurt this country for decades to come.

As Vladimir Lenin stated, “The best way to destroy the capitalist system is to debauch the currency”. It appears Timothy Geithner was a student of this philosophy.

Educate yourself, write your Congressional representative and vote your conscience. Something seriously wrong is going on in Washington, and the beginning point is to educate yourself and establish a greater understanding.

As I uncover more quality educational content on these issues I will share it with you in these pages.

Hope this helps.