My Credit Score

I was given a year's credit monitoring with Transunion, as a result of some of my personal information having been exposed. As part of that I get my FICO score.

My score is 773 of a possible 850. But several years ago, I had a score over 800. What made it decline? There are no late pays, inquiries, or other negatives. And I pay off my credit card balances every month.

Along with my score, I got the following analysis of how to improve it:

There are not enough accounts in good standing on your credit report. Having credit available to you is a sign that you are able to manage your finances responsibly. Lenders like to see that consumers have a large amount of credit available to them, but not so much that they could spend more than they could afford to pay back. If you currently have multiple accounts open with high balances, try reducing your balances below 35 percent of your limits to improve your score. If you do not have many open accounts, consider opening a new credit account or asking your creditors to increase your limits in order to improve your credit score.

There are not enough bank installment accounts on your credit report. A healthy balance of credit and loan accounts is key to achieving a high credit score. It is important to build a record of responsible credit use over time with different types of accounts. Consider opening a new account to strengthen your credit report and improve your score.

The difference appears to be that when I had the higher FICO score, I also had a mortgage which I have since paid off. Since I then had no debts, my score declined.

I'm not about to buy something on time just to pump up my FICO score. A 773 score puts me ahead of 87% of the population, according to the report, and should be respectable enough to keep from negatively impacting my insurance premiums. I am thinking of getting a third credit card, the EmigrantDirect 1.4% cash back MasterCard to use instead of my DiscoverCard.

How much should you save every year? Let's be realistic.

FMF has a comment on his Free Money Finance blog about the book "The Net Worth Workout:...". That book points out that someone who had invested $1000 annually for 44 years would have retired with $600,000.

I find this ridiculous -- not the numbers which may be mathematically accurate. What I object to is the scenario. There's been a good deal of inflation in 44 years. Forty-four years ago, in 1962, the average wage was $4291, and that's yearly, not monthly. $1000 is more than 23% of a pretax income of $4291. In 1962 $1000 was bit much to expect of someone in their 20's starting a family and probably earning less than this average wage. On the other hand, in 2005 the average wage was $36,952 and $1000 would be less than 3%, hardly an adequate savings rate for someone about to retire.

A more realistic scenario would be someone who invests a fixed percentage of his income, adjusting the contribution to his nest egg as his salary increases. I have a spreadsheet available online that shows that someone who earned the Social Security average wage and invested 10% of his income in stocks beginning in 1962 would have have $754,269 at the end of 2005.

While a more realistic scenario than the one in the book, there are still flaws. One flaw is that earning the Social Security average wage throughout your working career is improbable. More likely it will be lower than the average when you're young and then increase as your career develops.

A major flaw in the spreadsheet is that it does not compute the effect of taxes. The actual value of the nest egg would be less, because a significant part of the S&P 500 return is dividends, which are taxed when paid so less is available to reinvest. There are also the taxes to be paid on unrealized capital gains. While tax-free returns on your investments were not an option in 1962, they are an option today, in a Roth IRA. The contribution limit is high enough that someone earning the average wage can contribute more than 10% of his income. So ignoring the tax aspect is a flaw only in the historical sense.

In the end, however, I agree with the main point of the book and of FMF. You should have more than $44,000 in assets (other than personal property) when you retire. And a steady (but realistic) savings rate should get you there.

Budgeting for mid range goals

As I discussed previously, I budget for retirement savings and also for midrange expenses, leaving the remainder to handle monthly recurring expenses which I don't track in detail.

Midrange expenses that I need to save for are those such as:

• Taxes and Insurance that are billed annually or semiannually
• Major repair items for my house
• Car depreciation

When I had a mortgage, the mortgage company set up an escrow account to handle property tax and insurance premium payments. Every year I would get a statement showing the balance and expected expenses for the following year (based on the prior year). Then it showed the required monthly contribution so that the estimated minimum balance would be several months expenses.

Now that the mortgage has been retired, the taxes unfortunately are not. Without a mortgage I could drop property insurance but choose to keep it in force. To avoid a big impact to my finances when these expenses come due, I set up my own escrow account which I track in my spreadsheet. Since this works well for housing related expenses, I also track tax and insurance payments for my vehicles the same way. Future expenses are based on prior expenses with an inflation adjustment. The spreadsheet can predict balances based on monthly contributions and estimate a low balance. If necessary I adjust my contribution so the lowest estimated balance is still a few months expenses.

And being a property owner, I don't have a landlord to harass when problems arise. I've had to have the roof reshingled and the central furnace / air conditioning replaced in the last few years. I've been setting aside $100 / month to cover these expenses, and when these expenses came up I was able to handle them without going into debt.

Most people have car payments, and then view the cost of driving a certain distance as the cost of the gas they'll burn getting there ignoring the depreciation on the vehicle. Since I've paid for my last two vehicles outright, I view the cost of driving a certain distance as the added depreciation due to driving that distance, which far exceeds the cost of gas even at $3/gallon. So I estimate the cost (other than gas) to drive a mile as the price of a vehicle divided by 100,000 miles. So a $20,000 vehicle is depreciated in my system at 20 cents a mile, to which I add a couple of cents a mile to handle tires and other maintenance items. Every month, I put my odometer reading into my spreadsheet and it computes how much to set aside for depreciation.

Yes, I know that a vehicle depreciates fastest when new whether driven or not, but since I keep my vehicles for several years it averages out. You might also point out that vehicles should last more than 100,000 miles. True perhaps, but the older the vehicle the more often repairs are needed. With my system I should have enough saved to replace the vehicle after having driven it 100,000 miles.

While my method could perhaps use some refinement, it still has served me well. I know how much to keep in more liquid assets to handle these expenses, and can keep retirement savings separate to be kept in longer term investments. I plan to continue this approach even into retirement, but adjusting as a go along if any changes come up, including lifestyle.

The Power of Compounding

This article points out the power of compounding. Someone who saves $100/month for 10 years between the ages of 22 through 32 and then stops saving has more money at the age of 64 than someone who waits until the age of 32 to begin saving at the same rate and saves for 30 years. (Assuming 8% interest).

Not arguing with the math, but rather with the practicality. When I was in my 20's, $100/month would have been a significant hit to my budget, whereas now it's not such a big deal. Not only has my income increased in real terms, but there's been a good deal of inflation since then, including a few years of double-digit inflation.

These articles point out the power of compounding when it comes to savings, but leave out the power of compounding when it comes to inflation. Even at today's more modest inflation rates the compounding can be significant. At 3.5% annual inflation, the value of a dollar is halved in 20 years.

In the example given, the person who saved in his 20's was saving more valuable dollars than the person who waited until his 30's to start.

My point is not against saving, nor is it against saving while at a young age. Rather my points are that (1) effects of inflation can't be ignored and (2) your savings rate should not stay level over long periods of time.

Start young, save what you can, and adjust your savings rate for inflation and improvements in income. And hope that the earnings on your investments keep ahead of the inflation rate.

Mortgage != Debt

Usually I listen to audio books while driving, but as my book was complete I instead listened to the radio while driving to the New Year's Eve party. A commercial came on that began "Start 2007 debt free!!!!", and then went on to pitch a mortgage refinancing scheme to pay off your credit card. Funny -- I always thought a mortgage was a debt. Unless they offer a special kind of mortgage that you don't have to repay.

Unfortunately too many people won't question the commercial. They'll refinance and become "debt free", and then max out their credit cards again.