Americans are earning more than ever before — and yet are deeper in debt. Two experts propose how to fix that.

Are you better off than your parents were at your age? Probably not.

The average two-income family today earns 75% more (adjusted for inflation) than a one-income family earned a generation ago. Nonetheless, today's two-income family has significantly less discretionary income once the basic bills — mortgage, health care, education and so on — are met. And thanks to the proliferation of credit cards, the average household today carries 100 times more debt (adjusted for inflation) than their parents' generation did.

That debt has become an enormous burden. Consider this: In 2004, more Americans filed for bankruptcy than graduated from college, suffered heart attacks or were diagnosed with cancer. The single best risk factor for bankruptcy? Having a child.

Today's working-hard-but-carrying-more-debt reality calls for new rules about handling money, says Elizabeth Warren, a professor of bankruptcy law at Harvard, and her daughter, financial consultant Amelia Warren Tyagi. Their new book, "All Your Worth" (Free Press, 2005), offers a formula that the authors say will help today's families manage their money for a lifetime. We recently asked them to share their thoughts on how to play today's money game.

SmartMoney.com: You have been studying the financial problems of middle-class Americans for more than 20 years. What has changed the most over this time?

Elizabeth Warren: More people are worried about money than at any time since the Great Depression. Families are divorcing over money, they're fighting over money; 51% of Americans just responded to a survey saying money is the most sensitive topic in the household.

Families need tools to cope with a rapidly changing world. That's what we're trying to give them. When I started doing this work 25 years ago, there were some people in financial trouble, but their numbers were small, and they usually were people who had been hit by extraordinary crises. Today people see their neighbors, folks in their own families, crumbling financially and they worry about their own safety.

Amelia Warren Tyagi: Another big shift I see is that Americans are more and more on their own. The safety net that was there for their parents just isn't there for us. We have to figure out our own health care, our own retirement, our own child care. We're on our own, and the only way to deal with that is to get smarter.

Elizabeth Warren (left), a professor of bankruptcy law at Harvard, and her daughter, financial consultant Amelia Warren Tyagi

EW: A generation ago it wasn't possible to overspend on a home. When your mom and dad wanted to buy a house, they had to sit down with a banker who carefully examined their income and their savings, to make sure that they would have no difficulty paying off that mortgage. Today, a young family buying its first home has to fend off those real estate agents and mortgage brokers who tell them they can afford to spend two and three times more than they really can afford. The same changes have taken place with credit cards. A generation ago the people who got credit cards were those who could show that they could repay their debt. Today, small children, large animals and a few inanimate objects have been approved for credit cards.

SM: You base your book "All Your Worth" on the premise that the rules of successful money management have changed. So what are the new rules?

AWT: The first new rule of money is that you cannot take it for granted the way your parents could. You can't assume that just because you're working hard and you're not going crazy that it's all going to work out.

EW: The second rule is that (to manage your money wisely), you have to take care of the basics first. No one is going to develop a financial plan based on cutting out the lattes and using double coupons. That's a little like moving into a house that's falling down and the first thing you do is change the curtains. We believe that at the heart of a meaningful financial plan is balance. It's a principle that works up and down the income ladder.

AWT: You balance your money in three categories. You start with the must-haves: These are things like your mortgage or your rent, your insurance, your car payments, the stuff you have to pay month in and month out, no matter what. The second category is your wants: This is the stuff that's just for fun because life should be about more than boiled vegetables. This is for a bikini wax or a car wax, a great new sweater, a new set of speakers. And the third category is about saving for your future.

SM: How do you prioritize those three categories?

AWT: We don't just prioritize, we actually give some numbers. And think of these numbers as the center of the bull's eye, to let you know what you're aiming for. You may not be able to get here tomorrow or the next day, but it's good to know over a lifetime what works for most people most of the time. Start with the must-haves and aim for 50% of your take-home pay. Then it's 30% for your wants, and 20% for your savings. And if you're carrying debt, that 20% goes toward paying down your debt first.

The Balanced Money Formula
50% Must-Haves (such as mortgage payments, health insurance and food)
30% Wants (the fun stuff) / 20% Savings (for retirement, college costs and other long-term goals)
Source: "All Your Worth," (Free Press, 2005)


SM: How easy would it be for people to adjust to and stick to this formula?

EW: A big part of the book is helping families get there. We step-by-step diagnose where they're at and then help them bring their money in balance. Not everyone will have the same set of problems. We've counseled people who were way over on their must-haves and quite frankly, weren't spending enough money on fun. We've also counseled people who had their must-haves well under control, but who are out of control on the fun stuff.

SM: In your book, you wrote that even if people are doing everything right, the system is against them. Credit card companies keep increasing interest rates, there's a new bankruptcy law that will prevent many people from filing for bankruptcy...

AWT: That's true: It is a tougher world financially and the deck is stacked against people. No doubt about it. It is harder to live a middle-class life on a middle-class salary. And at the same time, everybody can make steps to make it better.

EW: That really is the philosophy of this book. No, it's not fair, but fair isn't what counts here. I've been very active in this bankruptcy debate, and I have pressed Congress as hard as I humanly know how about how this bankruptcy bill presses down on hardworking families while it lets credit card companies and millionaires walk free. I think it's not fair. But I might as well shout to the wind. Families need to help themselves today. And we're trying to give them the tools to do that. SM: Some of your advice is pretty contrarian to what the majority of financial planners would typically recommend. For example, people who hold a lot of credit card debt are often counseled to take a home-equity line of credit or a home-equity loan. The interest rates are much lower and the math seems to work out. But you are totally against that.

AWT: Look at it this way. If you have a few thousand dollars on credit cards, that's not worth taking a home-equity loan because it's not worth the transaction costs: You can get that debt paid off. If you have tens of thousands of dollars in credit card debt, you have a big problem. And if you have big financial problems, this is the worst time to go betting your home that it's going to work out right. This is the time to be conservative with the roof over your head, even if it does cost you an extra point or two in interest.

EW: Over the past generation, foreclosures have more than tripled. No one ever mentions that in a home-equity ad. Home-equity loans are a bad idea for anyone — (but) they are a worse idea for someone in financial trouble. They take debt that might be a strain for a long time and they turn it into a wrecking ball dangling over your home.

AWT: One other piece of contrarian advice we have — we're not interested in finding the best deal on a credit card. We think all credit cards are dangerous. They can change their terms in 15 days without your permission. So how do you deal with that? You take them out of your wallet. Just get rid of them all together. Life is simpler without credit cards.

EW: We think people should have a more personal relationship with their cash. Peeling off six 20-dollar bills for a pair of jeans feels very different from signing a credit slip. Research has shown that when you spend cash instead of using credit cards, you spend less.

The Lifetime Savings Plan (How to Save 20% of Your Income)
Stage 1: Save $1,000 (this is a small emergency fund that provides a safety net when paying down debts)
Stage 2: Pay off debts that keep you from saving, especially credit card debt
Stage 3: Build a six-month security fund (six months worth of living expenses held in a cash account)
Stage 4: Lifetime of Wealth Creation:
Source: "All Your Worth," (Free Press, 2005)

SM: Another unusual route you take is suggesting that people put "fun money" before their savings. Surely, most folks would be more than happy to do that, but how can they make it work?

AWT: It's true. There are a lot of books out there that say, I don't care about the rest of your money, just take $200 a month and put it in a savings account. The problem is, they don't tell you where to come up with that $200 and what to change in your life to make room for that $200.

Our strategy is this: Focus first on the day-to-day changes you need to make in your life, so that savings can become automatic. We put savings last not because it's last in importance, but because by the time you think about savings it should be really easy. Trying harder to save doesn't mean anything. It's like telling someone try harder to lose weight without telling them how to eat and exercise better.

EW: We think there should be room in every diet for some cake. We're not saying spending on fun is somehow more important than saving, but we're not saying it's less important, either.

SM: You also draw a clear line between saving and debt: You recommend paying off debt — what you call "steal-from-tomorrow debt" — before even stashing away an emergency fund. That's very unusual.

AWT: The truth is, having a six-month emergency fund while you're carrying around debt is just fooling yourself. That's really just hocus-pocus. Paying off debt clears the deck in case an emergency comes. When you're carrying around debt it's like walking along with a giant weight in your backpack. If you hit a bump in the road, it'll be really hard to climb that bump. But if you get rid of that backpack, it'll be much easier to handle any bumps that come along.