Last month the advisors at Ruedi Wealth Management covered five more important topics in their "101" columns. Make sure to look for them every Sunday in The News-Gazette’s Business Extra section, but in case you missed them this past month, below are the Investing 101 columns from November.
What is a Credit Score?
Daniel Ruedi, CFP®
A credit score is used by banks and other lenders as a metric for how responsible a borrower is with his or her debt. This score was first conceptualized by the Fair Isaac Corporation or FICO for short, and is by far the most commonly used credit scoring system.
Your credit score is calculated based on a number of factors. The first is payment history, whether or not you pay your debt and other bills on time, which accounts for 35% of the score. Naturally, borrowers who pay their bills on time are preferred and are rewarded with higher credit scores.
The second factor is your credit utilization ratio, the amount of debt you have relative to the credit that is available to you, which accounts for 30% of your credit score. If you are able to borrow up to $10,000 and have $4,000 of debt, your credit utilization ratio would be 40%. A general rule of thumb is not to let your credit utilization ratio go above 30%. Those striving for an excellent score may want to keep it under 10%.
Length of credit history accounts for 15%, with longer credit histories being considered less risky. For this reason, it is important to establish a credit history early. This may mean opening a credit card (even if you don’t need one) for the sole purpose of spending a small amount and paying it off completely each month.
The type of debt you have, whether it be credit cards, mortgages, student loans, etc., accounts for 10% of your credit score. Recently opened lines of credit account for the final 10%.
Credit scores are numbered from 300, the lowest possible score, up to 850, the highest possible score. Scores above 800 are considered excellent. Scores in the 740 – 799 range are considered very good, and scores in the 670 – 739 range are considered good. The 580 – 669 range is considered fair, and anything below 580 is considered poor.
Your credit score is important because it is used by lenders to determine how much you can borrow and at what interest rates. You can receive a free credit report annually from one of the credit bureaus, like Equifax, to confirm that there are no mistakes in your credit. If there are mistakes, and you don’t correct them, it may cause you to pay higher interest rates, or even prevent you from getting a loan. For this reason, it is important for everyone to be aware of what their credit score is, and take steps to increase it as much as possible.
Emotions and Behavior
David Ruedi, CFP®
So far, in our columns, we have focused on the technical aspects of investing, but today I want to discuss something that is even more important: investor behavior. Though setting up a diversified portfolio with the appropriate asset allocation is important, investor behavior has a far greater impact on success or failure as an investor.
It sounds easy to practice discipline and good behavior as an investor, but in reality, it isn’t. We, as humans, are emotional beings. Most of our thoughts and actions are driven by emotion, even if we backfill them with logic. The two that are always creating havoc in investors’ brains and their portfolios are fear and greed. Both are conjured up at different times under different circumstances, but both can be devastating to investors.
When investors are fearful, they are likely to make big mistakes. The most obvious example that comes to mind is when investors let fear take over and sell their investments during a large temporary decline. It is only natural; the market goes down because many people are doing the same thing, and humans find safety in acting with the crowd. But this behavior is one of the most detrimental because it often causes people to sell at the very worst time, and they usually sit on the sidelines as the market recovers. If investors sell when the market is down 30% or more and do not participate in the subsequent recovery, it is a devastating loss they can never get back.
On the other end of the spectrum is greed. This generally happens when the market has been rising, perhaps some parts more than others. When people look around and start thinking, “everyone else is getting richer than me,” greed takes over, and investors start taking on more risk or concentrating on a subset of the recent star performers. But this often happens at the height of investor euphoria, where expectations and prices are so high they are bound to disappoint.
We have seen both emotions play out this year. It was amazing to watch how fast investors went from fearful of the market decline at the beginning of the year to greedy when the tech-heavy Nasdaq index had such strong performance later in the year. The results of the first emotion have played themselves out, as the market as a whole has recovered substantially. I suppose we will have to wait and see how the second one plays itself out.
Health Savings Accounts
Ryan Repko, CFP®
A health savings account, or HSA, is an account that enables you to set aside tax-free money that can be used for qualified medical expenses. The money can be held in cash, or invested in stocks or bonds. In order to save money in an HSA, you must have a high-deductible health insurance plan (HDHP), which is defined as a $2,800-$6,900 individual deductible. In 2020, an individual can contribute $3,550 into an HSA, while a family can contribute $7,100. For those that are 55+, you can contribute an extra $1,000 catch-up per year.
Health savings accounts are special from a tax perspective because they offer a rare triple tax advantage! First, contributions are made tax-free because they are either excluded from your taxable income up front, or they are added as a deduction from your tax return when you file your taxes. Second, any interest or growth in the account accrues tax-free. And third, funds can be withdrawn tax-free if they are used for qualified medical expenses - and this list is quite broad.
Any withdrawals that are not used for qualified medical expenses are subject to income taxes and a 20% penalty for people under age 65. However, if you are 65+, the 20% penalty is eliminated, and any non-healthcare distributions are only subject to income taxes. For this reason, the HSA is sometimes referred to as a “stealth IRA” because it can eventually be used to purchase anything! So for people who do not need to use their HSA money to pay their yearly healthcare costs, it can be another tax-advantaged savings account.
For most people however, contributions to HSAs are generally best held in cash, to cover short-term healthcare expenses. Though investing in an HSA to save for future medical expenses has tax benefits, you should only invest an amount you can afford to not use in the short-term, because there is always the risk of loss. To keep yourself out of trouble, remember that this is a health SAVINGS account first and foremost!
You shouldn’t choose a high deductible health plan just to be able to contribute to an HSA. These plans are a good deal for people whose costs won’t reach their high deductible, but it will likely be more financially beneficial for people with high health care costs to choose a plan with a lower deductible to save on out-of-pocket expenses. If you are not sure if a high deductible health plan combined with an HSA is the right option for you, you may want to talk to a financial professional.
How Much Life Insurance Do I Need?
By Paul R. Ruedi, CFP®
Everyone likes feeling safe against uncertainty and the idea of leaving behind something to take care of loved ones in the event of your early passing – that is why life insurance exists. But this insurance comes at a cost, a cost that must be balanced against the potential benefit that insurance provides. Having too little can set up the ones you leave behind for financial hardship, but having too much probably isn’t worth the extra cost.
How much life insurance a person needs is primarily determined by their life circumstances. Some people may not even need life insurance at all. A young, single person with no dependents, and enough assets to cover any debt and funeral costs probably doesn’t need life insurance. Additionally, someone who has dependents but has enough assets to cover any outstanding debt and provide for their lifestyle in the future probably doesn’t need life insurance either.
But people who, for example, are the sole income earner for a household of dependents, or who have more debt than they have assets, may want some form of life insurance. That of course begs the question – how much life insurance death benefit do I really need?
Thinking about insuring your entire financial life is overwhelming, but if you think about why you usually need insurance, the math becomes a little more simple. If you are getting insurance to cover a debt, for example a large outstanding mortgage, you should make sure you get a high enough death benefit to cover that debt. Some lending institutions even have coverage that allows you to pay premiums now so the debt can be forgiven in full upon your passing.
If you are getting insurance to replace your income and provide for dependents, you will need to figure out what lump sum will be able to provide your dependents with the same lifestyle they are accustomed to. It may take some complicated math to figure that out, but your death benefit should be multiples of your salary. Many insurance companies suggest six to ten times salary, but there is no one-size-fits all recommendation. All things equal, a younger person who has more years of income to replace may need a higher multiple than an older person with fewer years to replace.
Like all financial decisions, how much life insurance you need depends more on your personal situation than anything else. Take a realistic look at what would be needed to keep life running for any loved ones you may leave behind and plan accordingly.
Types of Life Insurance
Paul R. Ruedi, CFP®
People who need life insurance have many different options. The two main categories are “term” life insurance, that only provides coverage for a certain number of years, and “permanent” life insurance that provides a benefit at death whenever it may occur.
Term life insurance provides insurance coverage for a specific time period, which can be as short as one year or as long as 30. If the person pays their premiums and passes away during that period, their beneficiaries will receive the death benefit. If they do not, the policy expires and there is no payout. Term insurance is usually the cheapest type of life insurance for this reason.
Permanent life insurance usually lasts all the way until your death, without an expiring term. There are several different types of permanent insurance policies that have different features and fall into four main categories: traditional whole life, universal life, variable life, and variable universal life.
Whole life insurance premiums are usually fixed, as is the death benefit, and over time a certain amount of cash value builds in the policy and grows at a fixed rate of return set by the company. It is typically one of the most expensive types of policies.
Universal life insurance is similar but slightly more flexible. With a universal life policy, the death benefit may be changed, and once you have accumulated enough money in the cash savings portion of the account you have the option to lower your premiums or stop paying them entirely if there is enough cash built up to cover them. Universal life insurance can be “guaranteed” with level premiums and a death benefit up to a certain age, but with a minimal cash value component. There are also “indexed” universal life insurance policies that tie the cash value of the policy to a stock market index like the S&P 500 – though usually by a set formula that caps gains at a certain amount and materially limits growth.
Variable life insurance policies are named after their savings component of the policy which can be invested in stocks, bonds, and mutual funds. The cash value and death benefit will vary depending on what those underlying investments do. Variable universal life is similar in that it has an investment component, but with the added flexibility of being able to adjust your premium and death benefit.
Insurance is complicated and there is no perfect one-size-fits-all policy. Make sure to do your due diligence or talk to a financial professional when making this decision.