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.

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.

I read an interesting book yesterday titled The 5 Lessons a Millionaire Taught Me About Life and Wealth, one of the things that had not occured to me is that if you want to change the way you live the first step is to make a consious decision to be wealthy.  It is not going to happen by itself.  Unless you change the way you approach your finances things are not going to change.

The author also quoted some interesting statistics, one was that “Nearly one-third of lottery winners become bankrupt”.  I’ve stated before that being wealthy seems to have little to do with income, this sure brings that home.  The problem is that winning the lottery does not increase the winners income, but because lottery winners have so much money all of a sudden they increase their spending. Evidently what happens is that folks who have lots of money all of a sudden, feel rich and begin spending money on expensive stuff; fancy vacations, gifts to friends and family, etc.  And then in a couple of years they look up and their big chunk of cash is mostly gone, but they have this large set of expenses they didn’t have before and their income has changed to much.  As a result they are not even close to spending less than the earn, and end up blowing everything in a few years.

Another point the author makes is that you need to spend the time to become the expert on your personal finances.  There are always going to be others smarter on the subject of money in general, but you need to be the expert on your money.  You need to know where every dollar comes from and where every dollar goes.  I’ve talked before about the importance of using a tool like Quicken, but this just brings that point home even more.  You need to know where all your income comes from and what all your expenditures are.  You need to be able to sort this info by category so you can see how much you spend on your cars, including all expenses like tax, insurance, etc.  The same for housing, food, entertainment, etc.  By knowing how much things really cost you can make intellegent decisions about where to cut back and what does not matter.  Yes, it takes time to do this, but without being an expert on your personal finances you allow others to determine where your money goes, if for no other reason than you don’t have enough information to really know if you can afford a purchase.

All in all a good book, lots of interesting ideas and some good little stories about how and why the ideas work. And the sooner you wake up and realize that more money is not going to solve your long term financial problems the sooner you can take the first step and decide to be wealthy by becoming the expert in your money.

It never ceases to amaze me that no matter how much people make they seem to have no trouble spending it as fast as they make it. I have worked with people who make $20,000 a year, and those making $200,000 a year, and the people who make the most seem to be no better at saving than those who make the least. I think it is just written into our psyche that our wants are only limited by our ability to pay. Unless you limit yourself artificially your stuff will expand to consume your earnings.

One of the best lessons I ever learned was to pay myself first. This neatly gets around this tendancy by taking your savings out of your paycheck before you start spending each month. This is the exact opposite of what most people try to do, which is to save whatever they have left at the end of the month, and surprise, most months there is nothing left, so nothing gets saved. Uncle Sam figured this out a long time ago, that is why your income tax comes out of your paycheck before you ever see it. No matter what you make, your take home pay is less, because Uncle Sam always gets his cut first.

What you need to do is something similar. Call up your bank and set it up so that $100 is transferred out of your checking account into a savings account every month right after payday, or $50 twice a month of you are paid twice a month. Never take money out of that savings account to pay everyday expenses, this will for the beginning of your cash cushion. At the end of a year you will have $1200 you didn’t have the year before and most likely you’ll never even miss that extra money, because in essence you never had it to begin with. Once you are comfortable with your new spending say after 3 months you could consider increasing this amount an additional $50. Then keep upping your savings until you reach the highes savings level you can deal with. If you can get yourself up to $200, $300 or more a month you’ll be really starting to make progress toward paying down your debt and achieving your savings goals.

But don’t wait, start saving today. You’ll never reach your goals by sitting on your butt. You must set your priorities, take action, and start moving things is a direction of your choosing. Even a little movement in the right direction will eventually get you to your destination, it might take a long time, but if you don’t move it will never happen. If you pay yourself first, then every month you know you will move a little bit closer to your goals.

If you do not have a cash cushion then you are at serious financial risk. A cash cushion is a block of savings that is used to cover an unexpected turn of events. In a sense it is your “oh crap” money. It’s money that you hope you never have to spend, but can get you out of an unexpected problem. Some examples of unexpected problems are:

1. Car Accident
2. House Fire
3. Loss of a Job
4. Family Member getting hospitalized

These are big expensive events that do not happen often, but when they do you’re going to be way stressed out and not having to worry about where you are going to get the money to pay for the crisis will give you one less thing to worry about. It is your own personal social safety net. You don’t have to got begging for a loan, or visit your local pawn shop to figure out how to meet the costs of these events, you just dig into the cash cushion you have created for these events. As soon as you spend a dime out of the cushion you must immediately start building it up again so that it is there should lightning strike twice.

I recommend that your cushion be enough to cover 3-6 months spending, if you are not sure of your spending keep 3-6 months of your after tax take home pay. Once you have this cushion in place you can use it as a form of self insurance. A great way to save money is to increase the deductible on your insurance to as high as you can. I have $1,000 on my cars, and $5,000 on my house. This saves me about $400/year and I have yet to make a claim on either in the last 20 years so that’s a savings of $8,000 during that period. So your cash cushion can not only give you peace of mind, earn you interest, but also will save you money. What’s not to love about that?

Plan of Action

If you don’t have a cash cushion, start building one today by saving as much as you can, even $100 a month will get you there eventually, once you have $1000 in your account go to your auto and home owners insurance policies and increase your deductible to $1000 and plow the savings into your cash cushion. For now just keep it in your regular savings account. Eventually you’ll want to move it somewhere that while still has a small risk to principle earns you a better rate of return. I’m always a fan of making every dollar work as hard as possible.

My personal cash cushion is 6 months expenses, how much is yours?

Okay now that I’ve talked about why buying a car with a loan is a bad idea, its time to offer a practical solution that will allow you to get off the cycle of always buying your car with borrowed money. The way to do it is quite simple really, it just requires disclipine.

Step 0:

Buy, don’t lease. Leasing is only a good deal if you are getting a new car every 2-3 years, but getting a new car that often is expensive and stupid. If you have that much money to piss away every year then you don’t need to read this blog If you currently are leasing your car, either buy it out at the end of the lease payment, or buy a different car when your lease is up. But in any event do not lease, buy!

Step 1:

Drive your current car into the ground. If you own your current car then take good care of it, make sure to get it all scheduled maintence, and change the oil as recommended by the owners manual. Take good care of it, own and drive it well past the end of its loan. A modern car should easily last you at least 10 years, at some point it’s not worth the trouble to own anymore, but a car will last a long time if well cared for. If you are in the habit of buying or leasing a new car every 2 or 3 years get out of that habit right now! This habit is costing you between 5 and 10 thousand dollars a year, in essence you are probably working 2-3 months a year just to pay the freight on your car. Our oldest car is now 9 1/2 years old and going strong, I’m going to try to make it last another 5.

Step 2:

Okay so now you have a car that you own, you are either still making payments on it or not, depending on how long you owned it. In any case when the loan is payed off you must still make car payments, but this time instead of making them to someone else you make them to yourself. Take that car payment that you would have made on your loan and put that same amount in your savings account each month. Once that amount reaches 1-3 thousand dollars set up a separate short term savings account for it to get a better rate of return (More on how to do this later). If your car is paid off and you are not making payments, congats, but it’s time to start making payments again, go look up what your old car payments were and start making them to your savings account. If you don’t do it now you’ll have to do it next time you buy a car, and I guarentee you that you’ll be paying more than your old payments next time you buy a car if you don’t start saving now. If your budget won’t support a car payment and you don’t have the savings to buy your car with cash you are in financial trouble.

Step 3 - Buying a new car:

If your current car has not died then do not buy a new one until your can pay for it out of the cash reserve you are building up with your car payments. If your car did die then it would be best to buy a car for the amount in your account, a 2 year old used car may get you to within your budget. If this is not possible then go ahead and finance the car, but do the following. First determine the payment for 100% financing, say $500/month. Then take out the loan, but use your cash reserve as a down payment, your new payment will be significantly less say $300/month. Write a check for $500/month on the loan. This will pay off the loan much more quickly and reduce your interest costs, once the loan is paid off put that $500/month into your car savings account. If you can’t afford this $500 payment then buy a cheaper car! Never stretch your car payments to the edge of your ability to pay. That’s a recipe for disaster, always live below your means.

This way of purchasing cars requires discipline, but if you stick to it you will never have to borrow money to buy a car again, eventually you can reduce the amount you are putting into your car purchase account depending on how long you can make your cars last. The interest in that car account goes to you so intead of paying interest on your car your car account will be earning interest for you! This is an example of how once you get ahead of the game life gets easier. It hurts to get there, but once you do things get so much easier.