The savings rate in the United States has had a terrible history for the last ten or twenty years. When I was a kid, the savings rate in the United States was about 10 percent, meaning people saved $10 out of every $100 they earned. The graph below, courtesy of Billshrink, Inc. shows both the savings rate and the tremendous expansion of consumer debt over the last 60 years. (click image to view full size)
If looking at this makes you shudder, you are not alone.
The early success of use-anywhere credit cards resulted in an explosion of cards from many issuers. You can see from the red line in the graph how popular that idea has been. In spite of the credit crunch, if you are a creditworthy person, you still get many solicitations every week.
The credit card was like giving a match to an arsonist, and people predisposed to that immediate gratification gene proceeded to blow up their financial lives with awesome debt burdens. It now appears that Americans have begun saving again, which is a good thing. I don’t think that there is any question about the proposition that the credit crunch shocked people back to reality.
Now let’s talk about the New Year’s Resolution part.
I would sit the family down and have a Council of War on the family finances. Changing your financial habits, particularly spending habits, will likely not go over well with teen-agers who may feel that they are entitled to do whatever they want. No longer, and this is a great opportunity to help them make a giant leap toward responsible adult behavior. Okay, now on to the money.
So let’s assume that you have cut back on your spending and now have excess funds. What should you do with the money? These are important questions when you can earn a mere 1 percent on bank deposits and only slightly more with CDs of a longer maturity. That’s still a skimpy return. Here are some other choices.
First, you should look at paying off any outstanding credit card balances. Now this doesn’t mean closing your accounts. Credit cards, if used properly, are a great way to build and maintain excellent credit and credit scores. And having excellent credit is more important now than it has ever been. The best way to utilize your credit cards is to charge only what you can comfortably afford to pay off at the end of the month. Not only does this save you from paying interest on the balance each month, but it’s also a great strategy to ensure that you stay out of debt.
Second, you can contribute to your retirement account, especially if your employer will match some of your contribution. When an employer matches a percentage of your contribution, you should maximize the benefit by contributing up to the employer match at the very least. Failing to do so is like turning down free money!
Third, you can contribute to a Roth IRA where the money can grow and you don’t have to pay taxes on withdrawals when you retire. The 529 education savings plans offer tax advantages as well if your kids are still looking forward to college.
Fourth, after you have done some work on the first three, one of my favorites, and the purpose of this article, is that you can make additional payments on your mortgage to reduce your principal balance. If the rate on your mortgage is 5 percent, the savings would be the same between investing in something with a 5 percent return and paying off your 5 percent mortgage.
The nicest feature of this plan is that the return is guaranteed; it is a “risk-free” investment. When you make a principal reduction of, say, $1,000, that is $1,000 you never have to pay interest on again, ever. Not only that, but you cannot lose that principal as you might with another investment.
The lender cannot come back later and give you money and ask you to start paying interest on it again. Plus, it compounds because every normal payment you make afterwards diverts less to interest and more towards principal reduction and pays off your loan earlier. To see how additional payments on your mortgage can benefit you, check out these mortgage calculators.
Finally, I know a large number of retirees and those getting close to retirement. Some still have gagging mortgages for the reasons we discussed above. But others planned well and made extra mortgage payments, and have paid off their mortgages. Guess which folks are happier?
Randy Johnson – Author of How to Save Thousands of Dollars on your Home Mortgage and Savvy Borrower articles, Randy is a mortgage broker who has financed over $1 billion in properties. He writes about home buying and real estate finance topics for CreditBloggers.com.