An Engineering Approach to Money

One of the best ways to improve your financial position is to reduce or eliminate as many of your financial liabilities as possible. If you are not a very disciplined person it is easy to spend a bit too much every month by using your credit card, or to purchase something that is a little bit more than you needed, but was financed with a loan, such as that shiny new car.

But long after the newness and excitement of the purchases has moved on, the payments remain. Easy credit has done more to both increase most people’s standard of living and hurt their long term financial position than any other single factor.

If you want to be wealthy you have to get rid of most of your financial baggage. This baggage includes most loans such as credit card, student and auto loans. Paying off your Home Mortgage might be a good 30 year goal, but until all those others are gone don’t worry about your home.

It won’t be easy, expect to spend several years digging yourself out of debt.  Tricia at Blogging Away Debt shows an interesting example of how one woman and her family have made outstanding progress in paying down their Credit Card debt. It is a slow process and requires that you live well below your means for a long time, but the payoff will be worth the trouble as you join the ranks of the debt-free on your way to becoming wealthy. The first step in getting ahead of the power curve is to get out from under your past mistakes. I have tremendous respect for Tricia’s decision to take control of her families finances and plan for her family’s future. Atta Boy Tricia!

If you have any loans at all, start cutting back on your expenses. Find ways to save and put that extra money toward paying off your loans. Once you are debt free then you can start to worry about longer term issues like how much cash cushion to keep, where to invest, and how to make every dollar work as hard as possible.

There is some good news here. You are currently paying interest every month on all this debt. Trust me, your lenders are going to be certain to get their pound of flesh. Each reduction you make on that debt reduces this cost and allows you to put a bit more money toward paying off your debt next month. In essence even though you do not have a single dollar saved, by paying off your loans you are taking advantage of compound interest and the Magic of Compounding to improve your financial position.

I bet you didn’t think you would get to earn compound interest until you had some savings did you? Well, there are lots of ways our financial system indirectly rewards people who make smart choices. This is just another one of those.

Don’t put this off, Don’t wait another day, start making choices that will allow you to pay off all your debts as soon as you possibly can. A small improvement made today is much more effective than the best intentions for next year.

My wife and I are pretty frugal people. We try to find ways to get good stuff as inexpensively as possible. One of the things we have used extensively over the past several years is to buy second hand kids clothes. Here in our town there are several stores that sell second hand children’s clothes on consignment. It seems that kids are constantly growing out of clothes, often well before the clothes have seen any significant wear.

By buying clothes that other people have gently used you can get a whole bag of clothing for what a single outfit would cost at Baby Gap or some other retail store. Even as our kids have gotten old enough to care about what they wear (currently 10 and 12) they are often happier to have 3 or 4 outfits from a consignment store than the single outfit we’d be able to afford at a retail store.

As a nice side effect, this is also teaching them the value of a dollar, and that there is often a significant extra cost in buying something new. A used item may be just as good and you can get much more value for the same dollar.

If you have young children, be sure to check out the local children’s consignment shops. It’s a great way to save a buck or two. If you are into sports try a second hand sporting goods store, another great way to save a buck.

I know you’re going to be shocked, but just like the fact than All Assets are Not Equal, the same holds true for liabilities. A liability is something that you owe. Most liabilities are loans of one form or another. I’m sure you’ve all heard how bad credit card debt is, this is a clear example of a bad liability. Any time you are borrowing money to purchase anything other than an good asset you are incurring a bad liability, I’ve talked about this before. The worst of the worst is to use debt to purchase a service. While reading blogs the other day I stumbled across a guy who was going to finance his Honeymoon with credit card debt. This is a huge mistake, and is incurring the worst kind of debt. If you are putting “fun” stuff on your credit card because you have not saved the cash for them, then you are simply living beyond your means. In this case Matt simply can’t afford this Honeymoon and would be much better spending less, perhaps much less. How about a nice camping trip at a National Park Matt?

Good liabilities are those where you are borrowing money to purchase an asset that will return you more than the liability will cost. An example of this was that I took about $20,000 out of my home equity when I refinanced by house back in 2001 and put that money into the stock market. In my case it was in the Mathews Pacific Tiger Fund. I purchased 2,809.2 shares @7.15 on Oct 16th, 2001. I ended up paying about 4.75-6% for that money (I refinanced again in 2003), but those shares are worth $25.12 today (4/20/07). To borrow that money for 5 1/2 years cost me approximately $6,000, but returned about $50,000. I could sell my shares to cover the original $26,000 loan + interest and still have $44,000 left over. In this case I got very lucky and hit a jackpot investment. But even if it grew much less I have an asset in my hands to pay off the loan with. Compare this to Matt who will have to use future earnings to pay off the credit card debt he is going to take on.

Some rules of thumb

• Never take on debt to purchase something “fun”. If you will have fun spending the money don’t do it with borrowed funds. Save first, then have fun spending the money.
• Never borrow money to buy anything that is not a good asset.
• Borrowing money, even for good assets increases your risk. What would you do if the value of the asset you purchased with your borrowed money lost half its value? Beginning investors should try to never borrow money.

But Kit, what about borrowing money to buy a House or a Car, is that bad? As with most things, it depends. I’m not a fan of car loans at all. The only time you should be borrowing money to purchase a car is if you absolutely need that car for basic transportation. In this case borrowing the money will allow you to increase your income, because you can now get to work, over what it would be without the car. But there is no real excuse for buying anything more that basic transportation this way. If you are spending more that $10,000 or so on your car, you should not be borrowing the money, just buy a cheaper car.

The argument that you need a car to hold down a job, and thus borrowing the money to buy the car is a good financial move can hold water. But only if you are buying the most inexpensive car that will meet that basic need. If you are borrowing money for a BMW then you are incurring bad debt. If you want an expensive car then you need to save the money first and then buy that trophy car. Hey it’s your money, spend it any way you want. But don’t try to convince me that you job requires you to have a certain image and thus a certain car. I’m not buying any of that.

Home Loans are even more complicated. Because your home is both an investment, and consumption. In addition, it’s not realistic to save $200,000 or more for a home before you make the purchase. So a decision to borrow money to purchase a home can be a good thing. But you should be very careful about the kind of loan that you take. Any time you take any loan you are increasing risk. Even if the asset drops in value you still have to make payments on the loan, and if you sell the asset you must pay off the full value of that loan, even if the value of the asset does not cover that loan.

Consider a house purchased with only 3% down. You are immediately in the hole because to sell a house you have fees to Realtors and other costs that can run between 5 and 8% of the value of the house. You may also have to drop the price below market value if you are in a hurry to sell. All this means that unless you are putting at least 10% down on a house you are counting on the value of the house to go up to get you out of the situation. For the past 4 years prices have been rising so fast that it has covered everyone taking this risk. But there is no guarantee this will continue. In fact, prices have risen so far so fast it is likely that prices may stay flat or even slowly decrease over the next few years.

I believe this is the reason why traditionally a 20% down payment was required to purchase a house. With 20% down the odds of your ending up in a bad situation is significantly reduced. Therefore, I believe that unless you can afford to put down 20% to purchase a home you can’t afford it. Either save more money, or buy a cheaper house. According to this about 80% of the people are purchasing more house they cannot afford. From what I’ve seen that’s probably not that far wrong.

The biggest mistake that most people make is spending more money than they have. Easy credit and taking out bad loans is what allows people to make this mistake. It also can hide the effects for years. But eventually it will catch up with you. By paying with cash or doing without you will already be in an elite class of people who take responsibility for their own actions, are willing to live within their means, and are on the road to financial success.

Full Disclosure: I don’t have any car loans, but I do have a Mortgage on my house. I put 20% down, and the loan to value ratio on the property is now about 50%.

Earlier we talked about totaling up your assets and your liablities on a regular basis to know your net worth. At the time I kind of skipped over exactly what is an Asset and what is a Liability.

What is An Asset

So let’s start with assets. An asset is anything that you can turn into cash. It does not need to be cash, it can simply be something you can sell for cash. It should be valued at its fair market value. But please don’t be overly aggressive, some things can fetch a big premium if you take the time to find exactly the right buyer and get full value. This is not a realistic valuation though. What I try to do is value all my assets at whatever I could get if I needed cash in a hurry. A stock can be sold in a hurry for the market value and the cash will be there in 2 or 3 days. A car is trickier. If you needed to sell it in a hurry you might have to sell it for 10 or 20% below market value to get the cash in a hurry. Houses are the same. Furniture and hosehold items are worse, you might only get 50% if their value if you had to sell them in a hurry.

I think it is important to take this kind of worst case approach to valuing assets for many reasons. Things like household items are crummy assets. This is because they are almost certain to be worth less next year than they are this year. Ideally your assets should all be growing over time.

This is one of the big differences between the wealthy and the middle class. The middle class take their money and buys services or poor assets like cars, boats, furniture and big houses. The wealthy take their money and buy good assets like stocks, bonds, and rental properties. This brings up the important point that…

All Assets are Not Equal

If you truly want to be wealthy you need to buy good assets. Those items that put money in your pocket over time. A good asset will be worth much more over time than you originally spent on it, as well as any costs you spend to maintain it. Most good assets aren’t much fun while you own them. You can’t water ski behind them, you can’t show them off to the neighbors. They don’t make your life much easier today. But the income or capital gains that they generate over time will grow your net worth making life much easier down the road.
In general buying good assets means putting off your gratification until another day. Instead of buying that PS3 you buy 3 shares of Goldman Sachs. Instead of buying that new living room sofa you purchase 100 shares of Cisco Systems. It won’t be very comfortable to sit on while watching TV, but it will grow your net worth over time instead of just filling up your house.

If you want to be wealthy spend your money on good assets, not on simply acquiring more stuff.

It is a good idea for everyone to know their Net Worth. It’s easy to calculate, just total up all your assets and all your liabilities. If you are using a tool like Quicken it will do all the work for you.

After I had been out of College for 3 or 4 years and before I started using Quicken full time, my then Girl Friend (now Wife) and I would total up our Assets and Liabilities every year, print it out and save it. This allowed us to track the progress we were making every year. Being a pack rat I still have this stuff. I can see that the money saved in my investment accounts went from $24,114 to $47,112 from April 15 to Dec 31 1991. I think I was making about $60K/year at the time working as a computer programmer. Dana, my girl friend, was a grad student, and we were living like grad students saving about 40% of my paychecks. By writing down exactly what was in our investment accounts at the time we could track how we were doing and what progress we were making toward our long term goals.

This is not to say we didn’t spend money on things just because it was fun. Shortly after this statement we dropped $20,000 on an Airplane that we owned for about 4 years. As any private pilot knows an airplane is a huge money pit, worse than a boat. But by tracking our expense we knew we could afford it, and what the effect of that purchase and it’s running costs would be on our savings.

We each had about $15,000 in student loan debt at the time. so our total net worth was just barely positive. But we were making good progress and could see our assets growing every year. To know where you stand and from that project how quickly you will meet your goals allows you to make decisions about how much to spend and how much to save.

I believe the old saw that people don’t plan to fail, but simply fail to plan is not far wrong. It is important to know where you stand on a regular basis so that you can now how you are doing and if your current choices will get you where you want to be.  You will also know if you need to change something up. Take the time at least once a year to track down all your assets and all your liabilities and calculate your net worth. Pull it out a couple of times a year and see if you are still making good progress.

A tool like Quicken makes that much easier since it allows you to graph your net worth over time, look at the current values at any time, and watch it on a much more regular basis.

Saving money is not about giving up everything that is fun in your life, but it is extremely important to know where you are, where you want to go, and if you are making progress toward your goals. This allows you to know if spending that money is okay, or is going to put you in a pickle.

So take the time to calculate your net worth every year and use that info to track your progress toward your goals. If you don’t know where you are or where you are going, how will you know how long it will take until you get there?

Back in early March, I decided to fund our Roth IRAs for 2007. That’s right, this was not a late funding for 2006, I already did that back in december, this was early funding for 2007. By putting the money to work early we allowed it to begin compounding early. Given how well the market has been doing lately, I wondered how much that decision has been worth.

As I’ve said before, I keep all my financial information in Quicken, so it’s easy to go back and look at all previous decisions and see if they were good or bad. On March 9th we purchased $8,000 worth of the Vanguard S&P 500 Index Fund, that’s $4000 for me, and $4000 for my wife. The cost of shares back then was $129.62 and we purchased 61.718 shares. As of Friday (April 20th) shares closed at $136.77, so we made $7.15/share or $441.28 in a bit over a month. Sweet! Because this money is in our Roth IRA we will never owe any taxes on those gains, provided that money stays in the account until we turn 65.

Now we have $8441.28 instead of $8000 growing for the next 20+ years simply by putting that money in early rather than later. If we had waited to fund our Roth IRA we’d have missed that gain. But remember even those folks who waited to fund their 2006 contribution until April 15th missed that $441 gain, but they missed it with both their 2006 and 2007 contribution. Thus my wife and I are $882 richer than if we had waited until the last minute, because we funded early in both 2006 and 2007, and it’s all tax free, my favorite kind of money.

Let’s look at an extreme case, if you had funded your 2006 contribution on Jan 1st 2006 S&P 500 shares would have cost you $116.82/share, on April 16th 2007 those shares were worth $135.30/share. That’s the difference between a Roth IRA worth $9,265 and one worth $8,000. It’s actually even a greater difference because there would be reinvested dividends probably worth about another $100 or so.

Let’s not forget those tax advantages. If you had left that money in your taxable account you might have to report another ~$1300 in income at the 15% cap gains rate that’s another $200 in taxes you’d have to pay.

The moral is, when you are deciding where to invest your money, fund your Roth IRA first, get that money into the Roth Protection in a good safe long term investment as soon as you can, and out of your taxable accounts. The difference could be significant, you want every dollar out there working as hard as it possibly can. That way you won’t have to.

This post was included in this week’s Carnival of Personal Finance over at We’re in Debt.

Well, I just got my Tax Refund for 2006 back, just a bit over $2,000 this year.

I generally hate getting a refund that big, it means I planned wrong. But if you’re going to plan wrong, I guess it’s better this way than to owe Uncle a big bunch of money. Looking back on things there were a bunch of items that caused me to overestimate my withholding. Here are a few of them.

1. I took 12 weeks off work last summer, about 5 of them without pay. That reduced my earned income which kept me under the threshold of losing part of my $1,000 tax credit for both my kids.
2. I’m still burning off $3,000 each year in earned income from some fairly big investment losses back in 2000 and 2001. I did some careful selling at the bottom of the market. This allowed me to build up $15,000 or so in capital losses. Remember webvan? Well that cost me a few thousand dollars. I’m trying to use that negative to my advantage by not selling my current positions out so that I can use this $3,000 ever year to reduce my earned income.
3. I didn’t end up selling anything again this year, and my mutual funds didn’t distribute much in capital gains either. So my unearned income came in lower that expected. It can be very difficult to judge how much will show up in December and how much selling you’ll do over the year.
4. A fair spike in property taxes last year due to a reassesment. Paying the bill is painful, but the write-off it’s a nice bonus at tax time.

I used TurboTax for the first time this year, that worked out pretty well. It was very easy to get everything done. My Father used to do taxes professionally, and has done for me for the past 6 or 7 years. The new computer programs make in really easy. It also helps that things were not much different this year from last year, so I could go through last years 1040 line by line and make sure everything matched up this year, just with new numbers.

Once other tidbit, since I was due such a big refund I filed as soon as possible, back in Late February, so that my refund would arrive as soon as possible. I want my money back so that I can put it to work in the market. No, we’re not spending this money, I’m going to put it to work in the Market.

The other step to take is to readjust my withholding for this year so the same thing does not happen again. Because several of these items were one time issues, and I got a nice raise this year, I’m expecting that my current withholding is probably not that far out. My current plan is to check things in June and decide then if I need to change my withholding. Who knows, maybe I’ll be able to reduce my withholding, it will be like a mini-raise.

For a new investor the task of deciding when to invest can be daunting, but I have a secret for you, you can’t time the market wrong when you are starting out, no matter which direction the market is moving you’ll win because of the broad trend upward that the markets always maintain.

But if the market is going down, or going to go down in the short term shouldn’t I wait? If you are certain the markets will be down in the short term then, yes, you should wait. But how can you be certain? I have been at this for 20 years and I’m still constantly surprised by the short term moves of the market.

The trick here is to use dollar cost averaging so that no matter which way the market moves you’ll be a winner. By putting a fixed number of dollars in no matter which way the market is moving you have the advantage of winning if the market is up and winning if the market is down. You can look at movements in both directions as positive for you.

Here is how it works, say you can buy into an total market index fund that invests in all companies and is currently trading at $20 per share and you have $200 a month to invest, the first month you get 10 shares. Now lets look at the two possiblities:

1) Stock goes up $1

In this case during the 2nd month the price is $21 per share (and your original shares are now worth $210). Your $200 now buys only 9.52 shares so you own 19.52 shares worth $410.

2) Stock goes down $1

In this case the price is now $19/share (your original shares are worth $190). BUT your $200 now buys 10.52 shares so you now own 20.52 shares worth $390. So while your investment is, in fact, worth less, you own more shares, so that each upward move over the next 20 years will be with more to you. In 20 years when each share is worth $200 instead of $20 that extra share you got this month is worth another $200.
If the market went up your investments value went up, but if the market falls your value went down, but each new investment buys more shares and so your total number of shares is greater.

Since the total market has a broad upward bias, that is the market always goes up over a long enough time period, if you are planning to be invested for the long haul (the next 20 years or more). Then a short term correction means the broad market just went on sale and by purchasing now you get a bargain price.

By spending the same amount every month you win if the market goes up in the short term, and you win more if the market goes down in the short term. The only way to lose is to not invest your money at all and piss it away on consumer goods which we know will be less tomorrow than they are today.

I just sent off checks for my wife and I to contribute to our Roth IRAs for 2006. I’ve been fully funding our Roth IRAs since they were first introduced about 7 or 8 years ago. For those of you unfamiliar with them they give you no current tax advantage, but the earnings will never be taxed, provided you follow the IRA rules about not taking anything out beyond the principle before your are 59 1/2. You can always take out the money you put in with out any penalty, but the earnings will only be tax free if you use them for retirement.

As with most investment things, to really win big you have to start when you are young. In my case I didn’t get started until I was about 35 or so. But I’ve been fully funding for several years now and between my wife and I we are approaching 70K in our Roth accounts. We are invested in the Vanguard S&P500 index fund, this has traditionally returned about 11% so thats ~7K next year tax free for retirement that will compound year after year to hopefully grow to something substantial over the next 20 years so that when we are finally ready to draw on it will be a big chunk. Let’s see assuming an 11% annual return with a 8,000 annual contribution for the next 10 years that amounts to ~650K in constant 2006 dollars when I reach 65 in 2029 if we’re still throwing off 11% that’s 70K of tax free money (constant 2006 dollars again) every year.

I also have a traditional IRA and non-IRA investments to supplement this so that if things don’t go as well as expected I should still be good. One of the great things about a Roth IRA is that it gives you a 3rd kind of account to draw on. By mixing withdrawls from a traditional IRA, roth IRA, and normally taxed accounts each year we should be able to minimize the pain of taxes eating away at our retirement funds in any given year.

Consider a Roth IRA or a Roth 401K, especially if you have kids as your taxes will go up once you can no longer claim them as deductions. Since my wife doesn’t work and we have 2 kids in grade school and a big home deduction we’re in about the lowest tax bracket we will ever be for our income level, this is the best time to Roth. Once the kids are grown we’ll want all those current tax deferals we can get.

Compound interest is the best friend of a young investor, and by young I mean anyone who will be saving for more than about 20 years.  Which is probably everyone under the age of 50.  The ability to earn interest on your interest can over time turn a small amount of money into a large amount of money, if there is one thing you need to know as an individual investor it is the advantage of putting your money away and letting your interest earn interest.

Fundamentally the concept is so simple, but the effects are so powerful.  Take $1000 invested at 10% with earnings reinvested and see how much you earn every year.

• Year 1: $100
• Year 2: $110
• Year 10: $236
• Year 20: $613
• Year 30: $1586
• Year 40: $4114

Without putting another dollar away after 26 years you are getting a return equal your original investment.
As you can see there is huge money to be made by putting cash aside and not touching it for a number of years.  The advantage of compounding is lost if you spend the investment returns, or dig into the principle.  The advantages are also lost if you wait to long to start.  This is why waiting until you are in your 40’s to begin saving for retirement makes thing much more difficult than if you start in your 20’s.  That extra 20 years of compounding can make a huge difference in the size of your retirement savings and the earnings those savings can throw off during your retirement.

It is the magic of compounding that allows people in their 20’s to become wealthy with a small amount of savings every month.  The compound interest on those small amounts can add up to a very big pile of cash over a number of years.

So don’t delay, begin saving today, even small amount now will pay off big later due to the magic of compounding.