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Vital Signs: Checking Your Post-Divorce Financial Health

Divorce can do a number on your health – emotionally, physically, and financially. After the dust clears, it’s important to check yourself over so you can set yourself up for success. Though I’m not qualified to address your physical or emotional health, I can help with your financial health. This article will cover the five things every divorcee should put in place to get and stay financially healthy.

Emergency Fund

An oft-cited 2018 study from the Federal Reserve Board[1] tells us that four in 10 adults in the U.S. do not have resources sufficient to cover an unexpected expense of $400 or more. In other words, they have no emergency fund. An emergency fund is vital to your financial health. Consider this scenario: You commute to work each day using your car. On the way to work one day, you see smoke coming from under your hood. One expensive tow and diagnostic later, you are handed a $2,000 repair estimate. If you don’t come up with the money for the repair, you have no way to get to work. With no cash in the bank, you have no option but to put this on your credit card. Interest rates on credit cards tend to average 20% annually. So now you’ll pay much more for this repair because you had to borrow from a credit card company instead of your own bank account.

Modern life is full of the unexpected. Roofs get damaged, medical emergencies come up, car accidents happen, jobs can be lost – the list goes on and on. All of this begs the question: how much should you keep in an emergency fund? Like most personal finance topics, it depends. Since you’ve just emerged from divorce, you are likely a single-income household and may have dependent children. If your risk of unemployment is high, consider keeping cash equal to six months of living expenses. If your risk of unemployment is low, you might be able to get by with cash equal to three months of living expenses. Keeping more than nine months of living expenses in cash may be excessive, unless you have more exposure to risks like medical emergencies or job loss. In order to know how much to keep in an emergency fund, you need to know what it costs you to live; that means you need a budget.

Budget

Budgeting – just reading the word may have made your eyes glaze over with boredom, but stay with me. For the purposes of our discussion, a budget is a list of priorities that guide how you use the money you take in. Having a clear understanding of where your money comes from and where it goes will help you make important decisions – like how much to keep in an emergency fund. Your life has likely changed radically. Knowing what adjustments you’ll need to make can keep you from finding yourself in a situation where your income no longer supports your spending. I address this topic in depth in my article The (Almost) Magical Power of Budgeting (April 2019), and I encourage you to refer to it for details on the budgeting process. I promise, it’s not as painful as you think. 

Good Credit

Navigating the modern financial world without a healthy credit history – or any credit history – is difficult. You may have goals and needs, like buying a home, new furniture, or a newer car. These will be hard to obtain without credit, or costly to obtain if you have poor credit. At this stage, you are likely cash-poor and should not consider using your emergency fund (except for a genuine emergency). If you already have a well-established credit history and healthy credit score, you can skip this next part. If not, read on.

A lender will decide to extend you credit and determine how much to charge you for that credit based on your credit score. Your credit score is driven by your credit report. There are three major credit reporting agencies that maintain a file on every borrower in the U.S.: Experian, TransUnion, and Equifax. Federal law mandates that each of these private companies provide you with a copy of your credit report annually, for free, on demand. If you have no credit or poor credit, start by pulling your report from at least one of these agencies. Check for errors or omissions. Report those to the agency and have the record corrected.[2]

Next, build your credit. The best way to build credit is to use it responsibly. That means paying your bill on time, every time. Consider using a credit card for everyday expenses that you pay off every single month. This may feel like a chicken and egg situation (I need to use credit to get credit), and you may have to start with a secured credit card.[3] Be careful and diligent, and you should see your score rise gradually over time.

Good Debt Ratios

It’s very common to emerge from a divorce with debt. The process is costly, and many clients try to preserve cash where they can. Not all debt is bad, but too much is not good for your financial health. Too much debt can lower your credit score and put a strain on your monthly income.

There are two lenses through which to view your debt. The first is to examine only housing-related debt. Divide your monthly house payment[4] (or rent payment) by your gross monthly income. If you come out with 0.28 (28%) or less, that’s a green light. If you come out with a number higher than 0.28, you should look for a way to reduce your costs to come as close to 0.28 as possible.

Now consider your total debt. Total up all your monthly debt payments (house payment, credit cards[5], student loans, automobile loans, etc.) and divide that by your gross monthly income. If you come out with 0.36 (36%) or less, you again have a green light. If you come out with a number higher than 0.36, debt reduction should be a priority. You want to get as close as possible to (or even under) the 0.36 threshold.

To get started, begin with the most costly piece of debt — that is the one with the highest annual interest rate. Pay the minimum on all other debt obligations and focus all extra resources on this most expensive debt until it is paid off. Then, move on to the next most costly debt obligation.

An alternative method that’s less optimal (but maybe easier to adhere to) is to focus on the debt with the smallest balance first. In this scenario, you’d put extra resources toward that smallest debt balance until it is paid off, and then move on to the next smallest remaining balance. These small chunks of debt can seem easier to tackle, and you’ll build your confidence as you pay each one off. Either way, if your debt ratio is out of whack, make a plan to pay it down and stick to that plan. 

Financial Plan

If you’ve built an emergency fund, know and stick to your budget, have good credit, and maintain healthy amounts of debt, congratulations! You are one of a select few who are taking care of your financial health. But don’t sit back just yet; there is a piece missing: a Financial Plan. All of the discussion we’ve had so far has focused on your present-day financial health. A Financial Plan will focus on your future financial health.

A Financial Plan doesn’t need to be fancy, though it can be. Start simply by figuring out where you want to go and defining your goals. Those goals might include buying a house, sending children to college, traveling, or enjoying a secure retirement. Be specific in your goal setting. Saying to yourself, “I want to travel,” isn’t helpful. Saying to yourself, “I want to take a five-day cruise to a different destination each summer starting next year and ending when I’m 80,” is much more meaningful. Now you can estimate what a five-day cruise costs and make a plan to set aside money for your cruise each year. Longer-term goals like retirement might be more of a challenge to plan for. Your goal setting there might sound more like, “I will save 5% of my gross income each year in a retirement account that I will invest in mutual funds.”

Some individuals are very comfortable doing such planning on their own or with minimal assistance. Some aren’t. If you are the type who wants some guidance in the planning process, consider engaging the services of a CERTIFIED FINANCIAL PLANNER™ Professional (CFP®). These individuals are specially trained in Financial Planning, Insurance, Income Tax, Estate Planning, and Investments, and they can work with you to craft a thoughtful and resilient plan. Having just emerged from divorce, you might consider looking for a candidate who also holds the Certified Divorce Financial Analyst™ (CDFA®) designation. Such a person will have guided other newly divorced clients through the planning process, and will likely be more sensitive to your distinct needs.

May you go forward from your case in good health – not just financially, but physically and emotionally. You deserve it.


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[1] Report on the Economic Well-Being of U.S. Households in 2017, published May 2018. Find a copy at https://www.federalreserve.gov/publications/files/2017-report-economic-well-being-us-households-201805.pdf

[2] The process of correcting errors requires some very specific steps. This guide from the Federal Trade Commission is a good place to start: https://www.consumer.ftc.gov/articles/0151-disputing-errors-credit-reports 

[3] A type of credit card that is backed by a secured payment used as collateral on the account; think of this like the security deposit you pay on an apartment.

[4] Mortgage principal, interest, insurance and taxes

[5] Only include payments on balances that you are paying off over time. For example, you have $5,000 on a credit card that you are paying off over two years. Include a payment of $255 in your monthly debt payment calculations.