An Engineering Approach to Money

The other day I’m driving home in the car and an ad comes on the radio telling me how easy it would be for me to get a home equity loan. The ad further went on to tell me how I could use this extra cash for those needed home improvements, paying down credit card debt, or that great vacation I’ve been longing for. I was dumbstruck, yea it’s an ad and the entire point is to get you to purchase the loan, but still, taking out a home equity loan for a vacation! That’s just several flavors of stupid.

It occurs to me that people may not know when taking out a loan is a good idea, and when it a bad plan. The short answer is that loans in general are almost always bad, if you are not a business, or you are not purchasing an asset that will throw off more cash than the cost of the loan then don’t take out the loan.

Don’t take out a loan and then spend the money on services or something that you won’t be able to sell for more than you paid for it. So vacations are right out, cars and most consumer goods are out as well. A home loan is okay, but you want to put at least 10% down and 20% is better. Student loans for college are okay as they will allow you to increase your earnings over your lifetime much more than the cost of borrowing the money. But be smart don’t use a college loan to get a degree in underwater basket weaving, as that’s probably not going to add to your future earning potential.

The only loan I’ve had in the last 10 years is my home mortgage, but I did refinance and take cash out a few years ago to put that 4.8% money back to work in the stock market. This is an example of taking a loan to buy an asset that will earn more than the carrying cost of the loan. That’s leverage, and a little bit of leverage is a good thing, though too much can hurt much more than it will help.

Good rule of thumb from old Mr Franklin, “Neither a lender nor a borrower be”.

“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.

I think that one of the reasons so many people have trouble handling money well is that they don’t understand what it is and what it represents. This article is my attempt to explain how I think about money and what it represents to me. My hope is that it will give you a new perspective and perhaps a better feeling next time you think, it’s only money.

Money is canned effort, or put another way it is the way that we trade our efforts for someone elses. Each time I go to purchase something I think, is that worth N minutes, hourse, days, years of my life? Because that is in essence what it represents. In order to make money I have to do something for someone else. Whether it’s wash a car, write a program, fly a plane, whatever. Most of the time when we do something for someone else they pay us, that payment represents our ability to then go out and pay for something we want. Food, housing, a new car, whatever. Like most people the only significant way that I can increase the number of dollars I have to spend is to work. This actually is not a bad model, to think of money as canned effort. If you make $1000 a week, then each $1000 in your bank account can be thought of as one week of your effort that you can now use at a later time.

Of course, not all effort is the same, thus the market decides that a weeks worth of Bill Gates time is worth much more than a week of my time. But then my effort is worth more than a high school dropout flipping burgers at McDonalds. Money simplifies our lives in that we don’t have to make all these decisions about who is worth what and find the proper person to trade our services with. Everything is reduced to a single number, its price, and we decide if that price is worth and equilivent amount of our time and effort providing services to others.

Thinking about money as stored effort gives you better tools to determine if you should purchase that item, do you want to trade an hour, month, year of providing services to others instead of doing what you want? If you think of things in this way you see how insane it is to borrow money to purchase stuff. You are committing yourself to future services in order to have something now. Rather than you owning that new car, it owns you. The only way you were able to get that car was to borrow money and commit yourself to working to no end other than your obligation to the car you already own, oh yes, and you have to pay extra for the privledge in the form of interest.

The idea of money as stored effort means that a large bank account represents freedom, freedom to not work for someone else, freedom to spend your time in the way that you want. Freedom to instantly call on the effort of others, whether it is to have them make you a car, a house, cook your food, or provide you with the results of some cutting edge medical research to keep you alive. Money is the ability to have the scarce resoure of another human’s time, energy and effort commited to you at a moments notice.

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.

Anyone remember this old addage? I think it still rings true. The idea here is that if you don’t have the money to afford it today you probably should not be buying it. As with anything there are exceptions, the most notable being a house. If we waited until we could pay cash for our houses I think we’d be waiting a long time. You’re also probably thinking that cars are another example. I would disagree on that one. You will be far better off financially if you buy your car with cash than if you finance it. The last time I financed a car was in 1991, the two cars I’ve bought since then were both new, and I walked into the dealer with a cashiers check to pay for both of them. The look on the sales doids face when you do that is priceless. If you can’t pay cash for the whole thing, at least pay cash for some of it. Financing 100% of the value of your car is a good way to get upside down with your loan and be stuck with it. As with most things you can pay me now or you can pay me later. When you opt for later you will be charged a premium for the privledge. I’m not a fan of paying one cent more that I have to for anything.

So what is a thoughtful person to do?

1. Don’t take out a loan for a depreciating asset (Car, Boat, Other Toy, Vacation).
2. Always try to put at least 10-20% down when making a loan so that you don’t run the risk of being upside down.
3. Never put something on your credit card that you are not certain you can pay off at the end of the month.

Consider the case of that wonderful boat that you just can’t live without. If you borrow money for it you are basically saying that some percentage of your paycheck for the next several years will go to paying for that boat. When you do this are you buying the boat, or is it buying you? I prefer to own my toys rather than have them own me.

Pay with cash or do without. If you are not certain that you have enough cash to make that purchase then wait. Put it on your list of things that you want to save for, use it to motivate yourself to save. Once you have saved the cash for the item then go buy it. It will result in more savings, less stress and an overall better financial position.

In my previous post I discussed the importance of spending less than you earn. The best way to know how you are doing is to closely monitor all your income and expenses and plot this month by month. That way you’ll know how you are doing each month, and whether things are improving or not.

My wife and I have used Quicken for this since 1994 and all that data is there to go back and review if we need to. We can easily see the difference between our income and our spending each month, and for the entire year. You can see that there are months when we spend more than our income, and other months when we spend much less. Mostly this is due to the fact that we pay for things in the most efficient manner possible which often means paying for things like a years worth of auto insurance in one lump sum, or property taxes all at once rather than paying month by month.

We can also go back and review our spending at any time to see how it compares to past years, where we piss money away and where we spend it very carefully. We can decide if we want to save more or spend more and have a very good idea about how that will affect our ability to reach our short and long term personal and financial goals.

This past summer we took a 7 week car trip with our kids to the East coast. I had to take several weeks without pay to get that big a block of time. Since we knew what our spending was, and could estimate the cost of the trip and make a very informed decision about the value of making this trip vs the amount it was likely to cost us in lost income and how much extra cash we’d have to come up with to make it happen. This kind of detailed information is truely empowering whether you are trying to figure out how much you can save, or if you have enough money to make that big purchase.

Here is how we do it.

1. We have an account for each credit card (2 or 3 of those), each credit card purchase is recorded and categorized when the bill arrives.
2. We have a cash account that gets money each time we take cash out of the bank, each time we make a cash purchase we save the reciept and write that down in the cash account. In essence it’s like a 4th credit card account.
3. Every few weeks we count of the cash in our wallets and if it doesn’t match (it’s usually off by $50 or $100 depending on how careful we are being we put a charge against miscellanous for that amount.

In this way we can track our net worth too since we also have accounts for our big items such as the house and cars. To be able to fire up Quicken and get a quick picture of our current finacial situation is critical for making good decisions. Yes, you can do it with pencil and paper, but for $50 every two or three years Quicken will do much of the tracking and it files things away much more efficiently than I ever could.

Quicken is a key tool and I can’t imagine living in the modern world without it.

This is so basic you would think it’s a no brainer, but it is critical to financial success. Now I don’t think that people actively attempt to live above their means. It’s not like people wake up one morning and say, “Let’s see if I can spend $2500 this month even though I only earned $2000.” I’m convinced that most people have no idea if they are spending more than they earn or not. Keeping track of how much you spend is a big pain and it’s so much easier to just spend it if you have it. This is yet another case of people failing to plan, rather than planning to fail.

The interesting thing is that our society has set things up so that as long as you are able to make the monthly payments on this overspending there is no negative feedback. You won’t realize that you are making a huge mistake that over the next 20 years will leave you destitute and dependant on the charity of others. Credit cards make it easy to borrow more than you should and allow you to think that you are doing well if you can make the minimum payment, this is just wrong.

I love my Credit cards as much as the next guy. They allow me to do lots of great things, but if you are not absolutely sure of your spending it is very easy to overspend and not realize it until you are in a hole. Easy credit is very convenient, but it used without thinking it will kill you. Being able to borrow money on a moment’s notice is a powerful concept but it is also ripe for abuse, and as far as I can tell more than half of the people out there use it incorrectly, this is expensive and a really bad idea.

So how do you tell if you are in trouble?

The best way is to keep track of exactly what you are spending and what your income is and compare the two numbers, more on easy ways to do this soon, but if you cannot do that here are a few danger signs.

1. If you don’t pay off all your credit cards each month.
2. If you don’t save 10% of your paycheck (in non retirement accounts) in a typical month.
3. If you borrow for anything unusual and more than $100 or so such as repairs, furniture, vacations, etc.

I would expect that more than half of the people reading this are spending more each month than they earn. It’s a huge problem and until you figure out how to either earn more (unlikely) or spend less you will never be able to get out of living on the edge of financial ruin.

They say the hardest thing to do is get started. Last night I decided that it was time to get off the stick and start my own blog. After about a 20 minute net search I found this nice blog software which could be easily put up on my web site so I’m now off and running.

I have a friend who’s in some financial trouble and from being around and about it never ceases to amaze me how many people live on what I consider the edge of serious financial trouble. So I’ve decided to put my thoughts on the matter into this blog and hopefully over time I can help some people make changes for the better.

Lots of folks have written blogs on this topic as it’s an issue we all have to deal with, but my wife and I have been pretty successful in this area and hopefully there is something useful I can add on the subject. My wife and I are both Engineers and understand numbers and approach most aspects of our lives with a problem solving approach. Collect information, consider the results of various actions, then pick the best one. This kind of technical or engineering approach seems to work well for us, and I figure others could benefit from this approach to the issue.

Hopefully I can keep at this and over time will collect a useful set of information for you on how to be financially successful.