Dave Says: The Foundation of Good Finances
Laying a foundation
Dear Dave,
My wife and I are both in our mid-thirties, and the only debt we have is $14,000 in credit cards, student loans and a car payment. We’ve got $40,000 in our 401(k) plans, plus we have no children. What steps can we take toward becoming good investors?
– Kirk
Dear Kirk,
A rock-solid foundation is a must, whether you’re building a house or building wealth. Without this, everything will fall apart. The first brick you want to lay in your financial foundation is to become debt-free. The second one is to have an emergency fund of three to six months of expenses in the bank. This is money that you never, ever touch except in the case of a real emergency. It doesn’t go toward Christmas, a vacation, or anything else.
When you’ve got these elements in place, they help form a firm foundation from which you can build wealth. Most people skip these steps and jump right into funding 401(k)s, Roth IRAs and mutual funds. These are all great things, but the problem in doing it that way is that you’ve started work on the house before you’ve laid the foundation. This can cause all kinds of problems and setbacks down the road!
Basically, we’re talking about the first Baby Steps in my plan. Baby Step 1 is to get your emergency fund started with $1,000 in the bank. Baby Step 2 is pay off all of your debt, except for your home, using the debt snowball. And Baby Step 3 is to finish growing your emergency fund until you have three to six months of expenses saved.
The debt you have is not the problem, Kirk. It’s the symptom of you guys buying a bunch of stuff you couldn’t afford. Get on a written budget, and give every dollar a name before the month begins. I want you guys to break the debt cycle by having a permanent game plan. Once you do that, you’ll have freed up your largest wealth-building tool—your income!
– Dave
Does Dave recommend home equity lines?
Dear Dave,
Can you please explain how a home equity loan works? Do you ever recommend them?
– Patti
Dear Patti,
It’s simple. A home equity loan is a second mortgage. You’re borrowing money against your house. Some people in the banking business call it a HEL, but considering what these things can put you through, I think they left off one “L”.
I don’t like home equity loans, and I never recommend them. Most of the time the terms are crummy, with higher, variable interest rates, and they usually have annual calls or a balloon payment tacked onto them. I would never recommend putting your home at risk to pay off credit card debt that piled up while you were out buying that fancy restaurant steak you couldn’t afford. Talk about financing a depreciating asset!
Right now, lots of people who thought they were being smart or financially sophisticated by taking out home equity loans because the interest rate was lower than the one on their credit cards are really stuck. Their houses have gone down in value and created a real mess. Plus, the banks have been handing these things out like candy, and they’re feeling the pinch, too.
Stay away from home equity loans, Patti!
– Dave
