An Engineering Approach to Money

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.