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 the latest offers here are a few links to several friends in the financial blogosphere who “eat their own cooking” by 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 your 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 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 the 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 you 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.

Look carefully because these are amazing statistics! For the first 400 years of our economic history inflation was benign at under one percent and then suddenly in the last 100 years it jumps dramatically.

Many people may not think a five or 10 fold jump in inflation is a big deal because the number is still relatively small at five percent. However, that difference compounded over nearly 100 years was enough to destroy the purchasing power of the money you carry in your pocket by over 90% – not just once, but twice in the last 100 years. 

That is a VERY BIG DEAL! (Yes, I’m shouting, and I rarely do that!) Think about it for a moment – every dollar held in 1914 is worth just a few pennies today. Just imagine what would happen if you retired in 1914 and were still trying to live off your savings today (I know nobody lives 100 years in retirement, but you get the point.)

Some readers may try and argue with the stats above claiming inlfation is closer to 3% since 1914 or try and shave hairs off the stats prior to 1914. Save your breath because it is not relevant to this discussion. My point is inflation was benign prior to 1914 and escalated dramatically after 1914. No manipulation of the statistics is going to change that point.

If you save, invest and build your wealth then inflation is your number one enemy. It dramatically effects how much money you need to retire, how much you need to save for your kids education, and how to invest your savings. In short, it effects every major financial decision you will make. Again, it is a very big deal. And the inflation problem grew dramatically after 1914.

So what caused the sudden and abrupt change in inflation? What occurred beginning around 1914 that would instantly change 400 years of relative monetary stability? Simple – the Federal Reserve bank was established.

As Milton Friedman once said, “Inflation is always and everywhere a monetary phenomenon.” And who controls monetary policy? The Fed (or to be a little less U.S. centric – the central bank).

(Brief sidenote: another great saying is that inflation is a monetary phenomenon, but hyper-inflation is a political phenomenon. I agree, and that is why it is so important to keep a strong boundary between the Fed and Congress. Allowing the administration and Congress to encroach on central bank independence any more than already exists would be an extremely dangerous precedent and something to worry about.)

Getting back to my main point, why should you care that inflation has jumped dramatically since the Federal Reserve came into existence? Because inflation is how the government taxes savings, and my readers are savers and wealth builders so you should care. It makes every dollar you acquired worth less.

The government doesn’t have the political will to directly tax wealth so it does it in an underhanded way by destroying the value of the currency that the wealth is priced in. They spend money that isn’t theirs thus destroying the money that is yours.

Always remember, the goal isn’t just nominal wealth, but real wealth (inflation adjusted wealth). It is not how many dollars you have, but what those dollars purchase that matters. Unfortunately, the Federal Reserve maintains policies that destroy the purchasing power of your dollars over time. They are the enemy of your wealth.

Let me be ruthlessly clear: the government literally steals your savings through a monetary policy that allows them to spend what they don’t have thus causing a high rate of inflation. The henchman for this financial bludgeoning is the Federal Reserve (central bank). Don’t take my word for it – just look at the statistics. Results never lie. You don’t need to get caught up in all the details of esoteric economic theory – just look at the results.

Before the Federal Reserve existed inflation was mild: after the Federal Reserve was established inflation went wild (maybe that is a little dramatic, but you get the point – it grew by multiples). The gold standard existed both before and after inflation accelerated so that wasn’t the cause. It is a monetary phenomenon, and the central bank is responsible. 

How Inflation Changes Everything…

The whole inflation reality is so ingrained in the Amercan psyche that we hardly even notice it. Like the frog that is comfortably lounging in water slowly brought to a boil until he finally dies, Americans have watched the value of their currency erode with such consistency it feels almost natural. But now things are starting to get uncomfortable. People are taking notice that something doesn’t seem right in the world of banking, and of course the key player in the middle of it all is the Federal Reserve.

I recently had an experience that woke me up to how ingrained the inflation assumption is in my own thinking. I asked myself the simple question, “How would my life be different if every dollar I have today would still be worth a dollar when I am 90 years old, and worth a dollar when my grandchildren are 90 years old?” I was stunned by my response! It would change everything (financially speaking).

Inflation and an unstable currency cause most of the financial uncertainty, volatility, and risk that I currently must plan for. Financial planning could be so much simpler. Just imagine calculating the amount of money I need to retire without having to compensate for inflation’s destructive power over a 50 year time frame. Imagine investing without having to speculate in an effort to grow capital faster than inflation destroys it. In short, a stable currency and non-inflationary environment would change almost all financial planning. 

It is that big of a deal. It is shockingly huge.

Try it yourself, you might just be amazed. Really, don’t just gloss over this. Try it right now. Close your eyes and imagine a world where the dollar you have today would still be worth a dollar 200 years from now. The purchasing power of your savings does not decline with time but holds constant instead. Now consider how all your financial planning is affected by that reality. You will be amazed how much easier your financial life could be than it is right now.

Thanks a lot, Federal Reserve! Thanks for the uncertainty and difficulty you cause through a monetary policy that results in inflation. Thanks for methodically stealing my savings.

And please share your comments below. How does the reality of inflation effect your thinking? How would your life be different if we returned to monetary stability?

Related Articles:

• Bank Bailouts Are Wrong: Pay particular attention to the quotes in this post from Thomas Jefferson, etc.
• Jim Rogers On The Government Bailout: Why inflation is the inevitable outcome once this deflation has run its course.
• Ultimate Retirement Calculator: Use this free retirement calculator to quickly and easily estimate your retirement savings needs under a variety of economic assumptions.