Optimized Personal Finance
by Jon Shea
Oct 12, 05:23 PM
Last year I set out on a quest for Optimized Personal Finance. With the help of The Motley Fool, Bankrate, and Marketplace: Money I have arrived at the solution. I’m posting it here, on the Internet, as a service to the world.
Checking / Short term savings: Everyone should have [their monthly income * 3-6 months] in cash on hand, you know, just in case. Right now the best place to keep this is Bank of Internet USA “Freedom Checking” account. This account requires a $1000 minimum balance, but gets you 3.10% interest and $7 a month in reimbersed out-of-network ATM fees in addition to all of the normal online banking perks. The fee for going bellow the $1000 minimum balance is pretty low.
I think online banking is the way to go. I almost never need to go to a bank in person, and I don’t know why so many other people do. If your bank has buildings, then you are paying to staff, power, and heat those buildings. You might be paying in the form of lower interest rates and higher fees, but you’re paying.
I’m moving over to Bank of Internet (I know the name sounds sketchy, but they’re legit) from E*Trade Bank. E*Trade’s checking plan is almost as good, but I’ve recently had a spat with them over fees, and so they’re being punished.
Downside: Occasionally, you may need a special bank service, like a Medallion Signature, and every local bank will turn their nose up at you. This has never happened to me, but it might happen to some people. Also, Bank of Internet, as far as I can tell, doesn’t operate any ATMs itself, so to remain optimal you’ve got to limit your ATM withdrawals to the $7 fee / month reimbursement max. That’s not such a big deal.
Credit Card: This choice is difficult to optimize. I’m going to assume that you will use your credit card for convenience but not for credit, ie you will never carry a balance. With this assumption in place we can limit our optimization to rewards programs.
There are three types of rewards programs: cash, airline miles, and bonus points. If you assume that you would use every airline ticket you get from your credit card on an expensive flight, then miles can significantly outperform cash back. That said, miles are complicated and may have blackout dates or other limitations. Furthermore, airline miles are an unregulated currency. Currently they are an enormous outstanding liability for the struggling airline industry. If airlines decide tomorrow that it’s going to take 100,000,000 miles to get a free ticket instead of however many miles it currently takes (and I think they will), then you’re SOL.
Personally, I go for the cash back. Cash is like generalized airline miles. You can still use it to buy a plane ticket if you want, but you don’t have to. I haven’t seen any bonus points programs that out perform my cash back, but they might exist.
I use the Motley Fool branded MBNA Mastercard right now for 1% cash back on everything. Some cards, such as the Citi® Dividend Platinum Select® MasterCard® offer 5% back at gas stations and grocery stores, and 1% back everywhere else, but I’ve been rejected every time I’ve applied. The reason: no revolving balance. Oh well, they still might be worth your time, some of my friends had better luck.
Medium term savings: You should put aside money for large, foreseeable expenses you expect to incur in the next 2-10 years. Buying a new car, or making a down payment on a home, for example. This page at Bankrate lists the top 100 yielding savings and money market accounts in the country. For the past 6 months Emigrant Direct has been parked at the top, and I think they’re likely to stay there. They seem to have a powerful devotion to keeping costs low, and yields high.
The way Emigrant Direct works is interesting. They don’t have local branches, you don’t get checking privillages, and you can’t even mail them checks for deposit. The only way yo get money in and out is by Electronic Fund Transfer from another banking account. From my E*Trade account this procedure is pretty much trivial. I set things up so that some money gets transfered over every month, right after I get my stipend, in observance of the old “Pay yourself first” motto of saving.
Downside: ETF take a couple days to go through, so you don’t have immediate access to your savings. I don’t find this to be a problem, my checking account or credit limit has been big enough to float every expense that has less than 2 days lead time. Also, make sure your bank doesn’t charge for ETF. I’ve never had a bank that did, but I’ve also never banked with Bank of America.
Retirement savings: If your employer offers a contribution matching on their retirement plan, then you should max out their offer. Otherwise, start an IRA. There are two important types of IRAs, called Roth and Traditional. With a Traditional IRA you don’t pay income tax on the money you put in, but you do pay income tax on the money you take out when you’re retired. Roth IRAs work the other way, you pay full income tax on the money you put in, taking money out is entirely tax free. The math to determine which is optimal is woefully intractable, but Roth seems to be the popular choice, especially for those of us who are currently in the lower tax brackets.
My Roth IRA is in a Vanguard Target Retirement 2045 Fund. Vanguard specializes in index funds. This fund automatically adjusts its composition from aggressive/high risk to conservative/low risk as I get older.
Oct 13, 01:33 PM
Now Jon, you know what I think but these other kids don’t. How much medium term savings are we talking about? If you’re keeping $1000 + one month’s expenses in your checking account at 3.1, I find it hard to justify having an additional savings account even if it gives me a whopping 4 at the sort of dollar numbers consistant with grad students having.
Let’s say you’ve got the checking topped off at 2-3k.
But true you do want to keep some liquid assets around for cars, the root canal I’m going to have, whatever. You can buy some fund (Vangaurd target 2045 for instance) and have it be taxed a little bit. As far as liquid, you can find funds with small penalties or those that phase out quickly.
My point is that the savings account offers neither convenience nor return. Until my income and expenses have both doubled or trippled I am happy to live between my checking account and index funds. In other words, that checking account is a sufficiently large capacitor to filter out sub-month frequency noise.
BTW, you can cash out your IRA for a first-house down-payment, so don’t worry about squireling that away in the bank. Unless you reasonably expect to buy a car within the penalty period of the (non-IRA) fund, I wouldn’t worry about that one either.
Oct 13, 02:02 PM
Personally, I have a savings account because I don’t want to see that money in my checking account.
Let’s say I need a new car in five years, that I plan on spending $10,000, and that I want to linspace() the money I set aside for car between now and then. With your system, two years from now, when I get money out of the ATM I’m going to be looking at a balance of around $8000. Seeing that much money is going to make it a little to tempting for me to buy a Back to Basics TEM500 Egg & Muffin 2-Slice Toaster and Egg Poacher , and any number of other things I don’t really need, and probably wouldn’t buy if I instead were looking at a number only a little bigger than my minimum balance. For me the benefit is primarily psychological, I admit.
That said, 1% of $10,000 is almost certainly greater than the added hassle of the extra account.
I think it is a bad idea to keep medium term (2-10 years) money in a mutual fund, and there’s absolutely no reason to keep it in an IRA. A mutual fund that’s likely to return much more than 4% is too likely to lose value, and even 10 years isn’t enough time to bank on the overriding upward trend of the market. If my retirement fund losses half it’s value in 10 years, then I still have 25-30 years for it to recover. If my car savings halves in value, then I don’t have a car.
The tax exemption on IRA withdrawals for home purchase isn’t nearly big enough to cover even a down payment on any apartment in Boston.
Oct 13, 04:46 PM
There you go with that non-linear utility of money, that makes things harder. If you put in a corner at “car”, then you might be very risk averse near there.
The part that I worry about is the “discount factor” i.e. money will be worth less to me in the future since I will be making more of it, that or I might die. If I were close to finishing my resedency for med school for instance, I wouldn’t be putting my extra nickles in the jar. I’m not sure exactly how this changes the risk profile. It definitely make the egg poacher more appealing.
Just think about how many root beer barrels you forwent so that you could save up those dimes. If you had some forsight you’d know that within a year you’d be mowing the lawn and making $5 per week and you’d buy the root beer barrel.
Oct 17, 02:59 PM
w/r/t “cashback as generalized miles:” it might help to think of accruing frequent flier miles as one of your virtual savings accounts. Cash back that I might have otherwise spent at the bar is locked into miles, so that I can only use it when I decide to go on that Big Trip I’ve been planning.
Oct 17, 11:11 PM
Fair enough, Evan. Secretly, I think I just don’t like travel.