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%.

Looks like gas prices are headed down again.  National average price is down to $2.38 a gallon and headed lower.  Sounds like odds are good we’ll get below 2.00 a gallon by the end of the year.  Other than this being a nice bonus in general, is there a way to take advantage of the falling prices?

The first is make sure that you buy your gas from somewhere that moves a lot of volume.  I’m a big fan of Costco for gas.  They generally have very good prices, and are very quick to drop or raise prices as the spot price changes.  This is great when prices are falling.  What you don’t want to do is to buy your gas from a mom and pop place that may only reset their price when the truck comes in, and in any case they are not going to be nearly as interested in lowering prices to match their dropping costs as they are to raise prices to match their increasing costs.  Most people don’t really pay enough attention to what is happening and may not notice.

The other day I paid $2.98 at the local place (for 5 gallons only, I was desperate) and the next day filled up at costco for $2.57.  $0.40 per gallon is enough to get my attention.  That’s like $5 on a single tank of gas.  In an evironment of quickly falling prices you’ll see a big difference between the cheapest and most expensive stations so pay attention, you could save $5 a tank if you keep your eyes open.

Insurance is a requirement for a sound financial plan. To pay a bit every month to help you recover from a catastrophe is money well spent. But most people have so little capability to recover from any setback that they are buying the wrong kind of insurance. The biggest place I see this is Health Care, we don’t have Health Insurance in this country anymore, we only seem to have prepaid Health Care. When you have to provide insurance information for a routine $200 doctor visit then it’s not really insurance which is meant to cover a catastrophe, but getting reimbursed for your pre paid health care.

This is a silly way to operate. If you’re going to pay hundreds of dollars every month for something whether you use it or not, you can be sure that people will use it at every reasonable, and many unreasonable, opportunities. This is not what Insurance should be. Another example is people who have a $200 deductible on their auto insurance. I mean $200? please. It’s hardly worth filling out all the paperwork and going through the insurance hoops unless you get $500 or more for your trouble. And if you make the claim they’ll probably raise your rates anyway.

Remember that by its nature on average insurance must be a losing game. That is the average premium must be enough to not only cover the average loss, but also the overhead of fraud, taxes, and running the insurance company. Likely your premiums are on average twice as expensive as the amount you will ever claim. But, you might be that unlucky sod who’s house burns down, or gets an expensive disease, or has his car totaled. In this case you’ll be very happy that you bought into this losing game. So what should you do when confronted with a losing game that you have to play? My idea is to make the game as cheap as possible, and opt not to play if at all possible. Buy the least coverage I can to do the job.

Use insurance to only cover the big high risk things. The best way to do this is to raise your deductible as high as you can reasonably cover. I have $1000 deductible on my car insurance as well as on my home owners policy. This means that for any minor issue less that $1000 I don’t even have to deal with my insurance company, but if my car is totaled I’m covered. I’m covered by health insurance at work, but if I wasn’t then I’d buy a policy to cover only catestrophic issues, and pay for all my doctor visits out of pocket. The cost for that kind of health insurance is a fraction of a “full coverage” policy.

I figure raising my deductible from $200 to $1000 saves me about $300/year in premiums on my auto and home owners policies. In 10 years I’ve never had a claim on either one so I’m currently $3000 ahead on that deal, plus the return on that money over the past years. So get your cash cushion in place and raise your insurance deductibles, there is money to be saved there.

We all make mistakes, generally due to not paying enough attention to something. And we all should strive to learn from our mistakes, but don’t let making a mistake consume you, and don’t try to be perfect, it’s way too much work.

My wife and I have a philosophy that $50 mistakes are okay, the things we try very hard to avoid are the mistakes that cost hundreds or thousands of dollars. If your spouse makes a few of those annoying $50 mistakes it’s best to just let them go, even at one of those a month it’s only $600 for the year, just let it go.

This is not to say you shouldn’t make an effort to avoid doing stupid things, the less wasted dollars, time and effort due to mistakes the better, but mistakes are going to happen, it’s part of life, just try to keep them to a minimum and don’t beat yourself up when they happen. Unless the number of them get out of control, it’s probably not even worth worrying too much about how to avoid them in the future, just chalk it up to “cosmic rays” or “shit happens”. But those $3,000 mistakes, those you really want to try to avoid, those can add up fast.

Don’t worry about popping a bicycle tire. Do worry about driving the car into the garage with bicycles still on the roof rack, repairing both the bikes and the garage door can get expensive.

Don’t worry about breaking your wrist watch. Do worry about breaking your car.

Don’t worry about Staining the new blouse. Do worry about staining that new Couch.

The small stuff will add up, but one time small stuff is just not worth beating yourself up about, save your energy and effort for those things that will make a difference.

Continuing monthly expenses are the bills I hate the most to pay. I’d much rather pay $200 once than pay $10 a month. Part of this is my tendency to make things last, I tend to keep things well beyond their expected lifetime. Over the years this have saved me stacks of money, but if I was paying for those things with a monthly fee, well then I would not have saved much, would I? I think the classic example for me was my new Tivo, back in the summer of 2000, I bought a brand new Series one Tivo, and plunked down the $200 for the lifetime service. So far I have used that Tivo for 6 years, my lifetime service cost $200, if I’d paid monthly it would have been $10-$12 a month for 72 months or well over $700.

In essence paying monthly for something is like renting it, or financing it, and you all know how much a fan of those I am. It’s also much harder to figure the true cost of something when you pay for it in dribs and drabs over many months. Consider how much money you’d have to save to cover that monthly cost before you take it on. For example $10 a month is $120 a year, if you can get 8% return on your money ($5% after taxes) it’s going to take $2,400 in capital to throw off that $10 in earnings that you are about to spend every month.

The same goes for trimming expenses, every $10 in expenses you trim out of your monthly budget is like an additional $2,400 in savings. So watch the small dollars that occur every month, there’s gold there if you can save and ruin if you let those expenses get out of hand. So don’t sweat the small onetime things, but taking on any additional recurring expense is worth serious thought, even the $10 items can add up quickly.

Yes Virginia, housing prices are officially insanely high right now. The amount of price increase we have seen is recent years in clearly unsustainable, and many people are overpaying at the moment. The recent surge in prices is, however, part of a natural cycle of relatively flat housing prices followed by a sudden jump. This has happened before, and it will happen again. The price surge in the late 70’s and early 80’s was the previous run. Unfortunately, people who do not know what is going on can get themselves in big trouble by assuming current conditions will last forever.

The big problem is that a house costs so much that people stop thinking about it as a $500,000 house, and just look at the monthly payments. This is a huge mistake. When the house loses 5% of it’s value, you still will be on the hook for that $25,000. It’s not about the monthly payments, A clever loan officer can make the monthly payments, at least for the first year of a 30 year mortgage, any number they want, but that doesn’t mean you can afford that house.

There was very scary cover story in Business Week about toxic mortgages recently. With brokers getting less concerned about defaults, and more creative in their lending practices, people are taking on much more house than they can afford. Since this is a home, people are likely to figure out how to keep the payments up for a while, but with interest rates rising, yes these are variable rate loans, defaults are going to start increasing.

So how can you figure out how much house you can really afford? The best idea is to figure out what it would cost to buy the house with a traditional 30 year fixed loan, if you can’t afford that monthly payment, then you can’t afford that house. If you can’t put at least 10% down, then you can’t afford that house. This isn’t to say you should take a 30 year fixed mortgage. I have a 5/1 ARM, but I could afford to pay for the 30 year fixed, I just decided it was better to take the lower interest rate for now. I can always refi later.

My gut says that housing prices are likely near a peak, and at the very least price appreciation will slow way down. Never chase a market that had a good run recently, things get priced assuming the current huge price increase will continue forever, and it won’t. Be patient, wait for the market to turn. In three or four years people will be expecting housing prices to stay flat or decline forever, such is the herd mentality of a market.

When I was a kid, the family down the street had 3 kids, and those kids used to just destroy their toys. By March they would not have any of their Christmas presents left. You’d go to their house and they’d have the toys they just got for their birthday but literally nothing else. I remember saying to my mom, I have toys that I got so long ago I can’t remember when it was, how come Steve’s toys always break so fast? “Because he doesn’t take care of his things, honey”, she replied.

I have always been able to make my stuff last well beyond what most people can. I try very hard to be careful with my stuff, and make it last. I think this trait is one that you have to have if you’re going to save your way to wealth. You have to make every penny count and one of the best ways to do that is to make every item that comes into your house serve as long as you possibly can.

The battery on my electric razor appears to be going, I’ve had it for 11 years. My car is just comming into the middle of it’s life, it’s almost 10 years old. We just bought a new barbeque grill today, the old one lasted 8 years. I’ve been in the same house now for 9 years, and my stereo speakers are 18 years old.

Replacing these things are expenses that we never had to pay. Each dollar saved in this manner is another dollar that is in our portfolio compounding and growing our assets. So my advice to you all is take care of you stuff, make it last, and your dollars can be off earning more dollars instead of buying more stuff.

“You need to buy a house so you’re not throwing money away on rent every month.”

I can’t remember how many times I’ve heard this or silimar statements, my wife and I rented until we were well into our 30’s and our bank account was the better for it. During this period in our lives we moved around a bunch and each time we moved out transaction cost was near zero. With a house it would have been thousands of dollars.

We’ve been in a boom market in residential real estate for the past 5 years or so. I can imagine it’s even tougher now for the renters seeing housing prices rocket through the roof over the last several years. If you are trying to save for the classic 20% downpayment, which I strongly recommend, you’ve been losing ground at like 10-20% a year as price of housing keeps climbing. No matter what current prices are doing it makes little sense to buy a house just because a bunch of other people have made money. The same way “everyone” was making a killing in the stock market in 1999 everyone is making a killing in Real Estate today. Buying a house today is a bit like investing in Internet Stocks in late 1999.

Back in the early 90s I watched several of my landlords take a beating because they bought property at the top of the market and there was a lack of tenants out there. So their rent would not even cover their cost every month. Some were even upside down on their mortgage. You think being upside down on your car is bad, try it on something as expensive as a house! When you only put 5% down you can easily get stuck if prices don’t rise and you have to sell. Remember that your real estate agent wants their 6% no matter what. If you put less than 6% down then you are already upside down on your house.

As to this argument that rent is throwing money away, and house payments are not, well that’s just silly. First only about 5-10% of your mortgage payment goes to paying down the principle the rest is interest. That money is exactly as gone as your rent payment. In addition things like homeowners insurance, repairs, and property taxes are all costs above and beyond your monthly mortgage payment. But the real thing that kills you owning a house is the combination of owning the wrong size property, and the transaction costs to sell.

First the issue of owning the wrong size property. Back when I was renting I had a place to live that was in exactly the right place and exactly the right size. If at the end of the year it was not in the right place or too small then I just dumped that apartment and got a new one with better attributes. So when my then girlfriend moved in we got a bigger apartment to share. When we had our first child we got a larger apartment for the baby. With our second child we got a slightly bigger place. Each time we were paying for exactly as much apartment as we needed, where we wanted. If we had bought a house we would have either gotten something much bigger than we needed, or had to eat the transaction costs of several houses.

Second is the transaction costs. To sell one house and buy another is going to run you at least the 6% broker commission, plus two or three thousand for a new mortgage. All of these costs are things renters never have to deal with. You are also beholden to the current state of the housing market. If things are moving slow and you have to move you could end up paying for a house you don’t live in anymore, that can get very expensive very quickly.

So let’s hear it for renting. It’s not the right thing for everyone, but contrary to popular belief it’s not the wrong thing either. And when you own there is no one to come fix that leaky water heater, you have to pay for the plumber yourself!

Full Disclosure: I now own my home, but by saving money by renting in my 20’s and early 30’s I was able to put 20% down and be in a good financial situation before I bought a house.