The 9 Steps to Financial Freedom (27 page)

Michael’s plan was to invest $9,000 a year. What if he had invested the entire amount in January, when the market happened to be at its highest? He would have paid top dollar for that mutual fund. Let’s see how this would have played itself out. If the mutual fund he wanted to buy was at $15 a share, Michael could have bought 600 shares for his $9,000. But now let’s see what would have happened if he had just stayed in the 401(k) and continued to put his $750 a month in this mutual fund over time, rather than all at once.

The price of the mutual fund at the end of the year was $10 a share, which means that Michael’s $9,000 investment would now be worth $7,753 (775.27 × 10), for a loss of $1,247. That’s a 13.9 percent loss on paper.

But if you look at what happened to the shares, they dropped 33 percent in value from 15 down to 10. So here is a fund that went down 33 percent from the start. This is what Michael’s loss would have been on paper if he had invested all at once. With dollar cost averaging, however, his loss was only 13.9 percent. Let’s look at the actual dollars and cents of it. If he had invested the entire $9,000 in January, when shares were $15, he would have only 600 shares, not the 775.27 he would have had with dollar cost averaging. His fund on paper would be worth $6,000, not the $7,753 it could have been worth. Dollar cost averaging can really cut your risk. Michael lost money, but he didn’t lose his shirt.

Michael is investing here for the long term, not just for a year, and this fund is not going to stay down forever. Let’s take dollar cost averaging through another year.

Let’s say the market starts to rally, as it always does sooner or later, and he keeps putting in the $750 every month. Since the market is going up, by the end of the year he has been able to buy 685 shares, fewer than the year before; the fund ends up the year at $15 a share.

In total, he has put in $18,000 over the two years, in a fund that started at $15 and ended at $15 but was considerably down in between. He now owns a total of 1,450 shares, 765 from the first year and 685 from the second. But since the market was down so much of the time, what’s the best you think Michael can hope for—that he broke even? He did better than that. At $15 a share his total shares are worth $21,750, which is a 21.7 percent gain on his money over the two years of market fluctuation. Not bad, huh? If you’re not going to be cashing out for years to come, the more shares you accumulate the better. When the market does skyrocket, you will have made very good money.

This is not to say that if you buy stock that starts to go up, you should be sad—but here is a no-lose case, because you win in the end with a downslide as well. With dollar cost averaging you don’t lose as much as you could have if you had invested in one lump sum just before the market goes down. If the market goes straight up from the time you started, you won’t make as much, either. In my opinion, this is a really safe way to take risks—the best of both worlds.

Michael also wasn’t trusting the principle that time creates money. At forty, Michael had twenty-five years for the money to grow before he would turn sixty-five, well more than the ten it generally takes to watch your money really grow. I am always thrilled for myself and others when the market goes down and we have money available to buy more shares. The best investment advice I could give Michael was to go back into the 401(k) and take that $750 he wants to put into it every month. But this time he should diversify the money among two or three other good funds in the plan, be patient, and wait for time to touch his money.

This kind of investing is being respectful to what you have and respectful to what you want to have. It is not going out on a financial limb or taking a gamble with everything you have.

But you also have to watch over those things that whittle away at the money you want to create. You must also be respectful to the money you don’t have.

Your money is governed by how you treat it; it’s that simple. It thrives when you are being responsible, respectful, and doing honorable things with it. For many of us, debt is too big a part of our overall money picture not to give it the respect that it is due. How we treat our debt and the people who are a part of that debt plays a major role in our path to financial freedom.

Credit card companies are very smart and seductive, and they know exactly what to do to get you deeper and deeper into trouble. Have you ever noticed, for example, if you’re one of the many among us who are susceptible to credit card debt, that you find that as your balance keeps creeping up and up, your “available credit” total keeps going down and down? Before the financial crisis, what typically happened was right before you used up your total credit limit, all of a sudden, without even asking for it, you get a letter in the mail, saying that because you’re such a great customer, they’re raising your credit limit by $2,000. What a great company! With financial “friends” like this, who needs enemies? Before you even know it, you had used up that extra $2,000 limit, and were in more debt than ever before. Not to worry.

You also need to realize that how you handle your credit cards and all your debt will have a large impact on so many parts of your financial life. That’s because every credit and debt move you make is tracked and then used to compute a FICO credit score for you. Trust me, if you somehow don’t know about your FICO score, that doesn’t mean you don’t have one.

Your FICO credit score is used by mortgage and auto lenders to determine what interest rate to offer you on a loan; it is also used to determine the interest rate on your credit card. A version of your FICO score is often used by insurance companies when they set your premium rate. It also can come into play when you try to rent a home; landlords will check your FICO score to see if you are reliable. And cell phone companies might require a
deposit if your FICO score is too low. The bottom line is that a good FICO score is a financial boon for you, while a low FICO score is going to cost you money, and maybe even more.

If you don’t know your FICO score, I want you to find out right now. While the truth is that many companies offer to tell you your credit score—some of them for free—there is only one company that offers the gold standard of credit scores: FICO. The FICO score is the only one you should care about, in my opinion. That’s because the vast majority of mortgage lenders, auto lenders, and other financial types use the FICO score when sizing you up. So what good does it do to get a “free” credit score that businesses don’t use? More important, if you are applying for a mortgage and the lender is going to use your FICO score to set your interest rate, don’t you think it makes sense for you to know your FICO score in advance so you can do everything possible to make sure it is super high?

As of 2011 you could obtain a FICO credit score for free at
www.myfico.com
. You actually have three FICO scores (more on this in a minute), but unless you are buying a home, it is fine to just get one of your scores.

Your FICO score will range between 300 and 850. If your score lands in the 300–620 range, you have some serious financial problems. Basically no lender or company will want to do business with you without charging you some mighty hefty fees and interest rates.

Above 620, the FICO computers sort you into one of six basic ranges:

Congratulations if your score falls into the 760–850 range. You are in the highest FICO range and that typically means you will be offered the best terms on loans and other financial products. For example, in mid 2011, here is the interest rate on a thirty-year mortgage you might qualify for based on your FICO score. And in the right column is the monthly mortgage payment you would owe on a $200,000 mortgage.

Now you see what I mean when I say your FICO score can cost you a lot of money. If your score is between 620–639, your monthly mortgage payment on a $200,000 loan will be nearly $200 higher than if you land in the top FICO range of 760+.

Your FICO score is the result of how you rate on five broad measurements of your financial personality. Here’s the breakdown:

The biggest factor is your tendency to pay your bills on time. You don’t have to pay the entire bill; all that matters is that you at least send in
on time
the minimum payment due each month on your credit card bill and other debt payments. In the eyes of FICO and the financial world, your ability to make your payments on time is an indication that you are a responsible person who would make a good credit risk. One important note: paying on time means the money arrives on the due date, not that you put it in the mail on the due date.

Your debt-to-credit limit ratio is the next most important factor in determining your FICO score. Your debt is the combined balances on all your various credit cards: the sum of what you owe. Your credit limit is the combined total of the maximum amount each credit card company is willing to let you charge. (Included along with that calculation is whether you carry balances on other accounts, and how much debt you have left on loans such as a mortgage or car loan, compared to the original amount borrowed.) The lower your ratio, the better.

How long you have had a traceable credit history accounts for about 15 percent of your FICO score. That’s one reason I do
not recommend ever canceling a credit card that you no longer use. Another reason is that when you cancel, you wipe out the available credit limit for that card, and that will cause your overall debt-to-available-credit ratio to rise. It is smarter to simply stick an unused card in your desk drawer, or if you think you will be tempted to use the card, then simply take a pair of scissors and cut it up. You can’t use the card, but your history is not wiped out.