Don’t Make this Mistake

Do the Math

Now that gas prices are eating into your lifestyle, you may be considering getting rid of that SUV or becoming a Prius owner. Before you head out shopping, let’s look closely at how mpg will affect how much you spend on gas.

Pat & Joe own two cars, a small sedan and a SUV. They drive each vehicle 10K miles a year. The sedan gets 20 mpg while the SUV gets 8 mpg. With 4 kids they need at least one large vehicle. Given the price of gas, Pat & Joe are considering making a car move.

Option 1 Sell the SUV and get a minivan

At 8 mpg, no doubt about it that SUV is a gas hog. If they can replace it with a 20 mpg minivan, a 12 mpg difference would certainly cut down on fuel consumption.

Option 2 Sell the Sedan and purchase a very efficient small car that will get 50 mpg.

Wow, 50 mpg, a 30 mpg improvement.

Based solely on Pat & Joe’s desire to spend less on gas, which option should they choose?

Most people answer this question wrong – did you?

Here’s the math:

10,000 miles / 8 miles per gallon =1250 gallons of gas x $3.50 =$4,375 to keep the SUV rolling

10,000 miles / 20 miles per gallon =500 gallons of gas x $3.50 =$1,750 for a minivan

Pat & Joe would spend $2,625 less on gas if they replace the SUV with a minivan.

10,000 miles / 20 miles per gallon =500 gallons of gas x $3.50 =$1,750 for the sedan

10,000 miles / 50 miles per gallon =200 gallons of gas x $3.50 =$700 for the high mpg car

Pat & Joe would only save $1,050 if they replace the sedan with a high fuel efficiency car.

This is yet another example how our intuitive answer is often wrong.

Rick Larrick & Jack Soll write about this at their scientific blog, The MPG Illusion.

Fool

You are a self-sabotaging, irrational but often altruistic toad – however I say that with love in my heart. It’s not just me who thinks so; turns out there is a whole science devoted to the “how and why” we make the choices we do. Guess what they discovered – we are all hopelessly irrational.

Behavioral Economics is a rather young science that merges economics with psychology in order to study how real people make choices. When making decisions, we would think people choose the option that maximizes profits and benefits to themselves, right?

Let’s think about it. Are the decisions you make about your money, your health or your future rational?

Have you quit smoking or paid off your debt? Do you exercise and eat right? Are you saving enough for retirement? In short, are you doing the things that you know will lead to your goals?

Smart people behave irrationally (so do dumb people). It is a scientifically proven fact that we knowingly make decisions in direct conflict with what we want to happen. In addition to choosing poorly, we often sabotage our futures by refusing to choose.

David Laibson, Professor of Economics at Harvard writes; “There’s a fundamental tension, in humans and other animals, between seizing available rewards in the present, and being patient for rewards in the future,” he says. “It’s radically important. People very robustly want instant gratification right now, and want to be patient in the future. If you ask people, ‘Which do you want right now, fruit or chocolate?’ they say, ‘Chocolate!’ But if you ask, ‘Which one a week from now?’ they will say, ‘Fruit.’ Now we want chocolate, cigarettes, and a trashy movie. In the future, we want to eat fruit, to quit smoking, and to watch Bergman films.”

I know Laibson is talking about me. I definitely want to eat better and exercise more – later.

When it comes to our money, we buy stuff on credit even though using credit reduces the amount of stuff we can buy. We walk away from free money in the form of our employer’s match on our 401k and we fail to make a budget or set aside an emergency fund even though we readily agree that these are all things we want to do.

How do we overcome our irrational desires?

I win with my money not because “I’m oh so smart“, but because I’ve finally accepted that guys like Laibson and Ariely are right. To paraphrase Pogo, “I have seen the enemy and she is me”.

Recognizing that the biggest danger to my financial future is my own irrational decision-making, I have set in place a system of pre-commitments that force me to follow through my rational plan.

Here are things I do that will work for you:

Make a budget in ADVANCE of the month and sign off on it with your spouse or accountability partner. Hold each other to the commitment.

Don’t give yourself easy access to money or credit. Cut up the credit cards or at least hide them. Make your savings harder – not easier to get to.

Make savings automatic – have your savings direct deposited or at least moved automatically as soon as it hits your account.

Post the Wish List on the fridge – don’t buy things that aren’t on the list even if you have the money.

Want to learn more about Behavior Economics?

Dan Ariely, Professor of Behavioral Economics at Duke has a podcast at ITunes U called Arming the Donkeys. The segments are really short, interesting and easy to understand. Give it a listen.

A Tale of Two Families

Young Ned and his wife Sally really want a home of their own. Ned has been at the same job for a couple of years and Sally stays home with their 1 year old. They have been reasonably careful with their money. They have an old, but reliable, Honda Ned’s parents gave him when he graduated from college and no credit card debt. Ned makes $50K a year and Sally’s parents have given them $10K to use as the down payment. Ned and Sally go to an online lender to get pre-qualified for a mortgage. Using the lender’s “Home Affordability Calculator” Ned and Sally are told they can afford a monthly payment of $1,499.76 including taxes and insurance. Estimating taxes and insurance at $5,500, Ned and Sally start shopping for a $200,000 home.

Not too far away another young couple is dreaming of a home of their own as well. Paul and Janet have a new baby and are finding their tiny apartment rather cramped. Paul makes $50k a year but has 15% of his pay going to his 401K. Paul and Janet never see that money, so they budget as if it doesn’t exist.

Paul and Janet have recently struggled and sacrificed to pay off the credit card debt they ran up when they were in school.

Janet has been reading money management books and knows that they should put at least 10% down on a house and that their mortgage should be no more then 25% of their take-home pay. Using Paul’s take-home pay after taxes and the 401K deductions, Janet calculates a maximum mortgage payment of $764. She knows they can afford a $100,000 home with a 15 year mortgage.

Before they can go home shopping, they know they must save the down payment and build their emergency fund to equal at least three months of expenses.

Paul takes on as many overtime hours as he can get at work and Janet takes the baby to the neighbors three times a week to watch their 3 year old. With this additional income and cutting their expenses as low as they can go, Paul and Janet are able to save $2000 a month for 8 months.

Ned & Sally end up with a $200,000 home. Their mortgage payment is $1,019 a month and taxes & insurance add another $450 per month. Paul & Janet have found a nice little starter home for $100,000. Financing their home over 15 years gets them a lower interest rate and shortens the term by half. Their mortgage payment is $671 and taxes and insurance add $200 a month.

Ned & Sally Paul & Janet

Take Home Pay	$3550	$3056
Housing Cost	$1469/41%	$871/29%
401K After 5 years	$0	$43,436
Interest paid on Mortgage after 5 years	$45,614	$16,185
Principal Paid after 5 years	$15,526	$24,083
Net Worth Increase	$25,526	$77,519

Ned & Sally’s budget allows them to live on $2031 after housing costs. Paul & Janet get just a hundred dollars more but their utilities and maintenance costs are about half of Ned & Sally’s. They have their retirement saving working for them and enough room in their budget to save and pay for a better car.

Paul & Janet were careful, after learning their lesson with credit cards, not to be lead astray by lenders who make more by lending you more. By the time they managed to pay off the old debt, they could not even remember what they had bought. They swore it would not happen again. They vowed to live on less then they make, to save aggressively and to give. We hope Ned & Sally get a wake up call soon.

The Monster under the Bed

Whatever sneaky, creepy, grow in the dead of night, problem you have, there is there’s a way to solve it and keep it from ever coming back.

Some problems seem to just sneak up on you; that little bit of credit card debt that quietly over months or years somehow becomes $10,000. Those papers that you just can’t find a minute to deal with that take over your desk and then the credenza and then the multiply creating several baby piles on the floor. Maybe your sneaky problem is that 5 extra lbs that is now approaching 50.

These types of problems grow because when they are small they don’t really command our attention. “It’s no big deal, I’ll handle it next month” is what we think about the $300 credit card balance we don’t pay off. And then, next month rolls around and something else seems more fun or more important and that $300 becomes $360. Before we know it, that little non-problem has become something big and daunting. Now it’s an unruly monster that is going to take a lot of time and effort to tame. Our issue that was once too little to worry with has now become a problem too big to tackle – so we continue to ignore it and it continues to grow.

Awareness and Your Accountability Partner

To avoid being blindsided, regularly take stock. In our house, we have a budget meeting the last day of every month. Sometimes I’m lazy or disinterested and don’t want to attend. My accountability partner makes me. We spend 10 minutes and look to next month’s spending, deciding on any unusual or large purchases. We also record the current balance of all our accounts and calculate our net worth. It is quickly clear if we are headed in the direction we want to go. I also use Mint.com – who’s annoying little emails tell me in real time if I’ve exceed a budget amount; allowing me to get back on track before the next budget meeting.

Your accountability partner can be your spouse or a friend or family member. Just someone you can trust that will help make sure that you actually do the necessary regular measurement.

Cut the Monster down to Size

“That’s great!” you might say, “I’ll measure weekly from now on to be sure my monster doesn’t grow. But what am I supposed to do with the 500lb beast I have right now?”

My advice is to shave – don’t chop. Drastic changes in diet or lifestyle rarely work. It doesn’t take long before you think, “I’d rather be broke and happy”. So start small. Make a few cuts this month, see how they feel and make a few more next month.

Some of my spending that was cut first in the first round:

Books – I had a book-or-two-a-week habit, usually on impulse. I still read a lot and I still buy some books, but most of the time I read library books – Savings $50 per month.

Cleaners – I like my shirts crisp. I used to have five shirts a week laundered and pressed. I wash and iron my own shirts now, frequently hanging them on the clothesline when the weather is nice. Not only do I save the money not taking them to the cleaners, but my shirts last longer – Savings $35 per month.

Phone – We dumped the home phone for our cells and the real fax line for an internet fax service and bundled our business line in with the cable – Savings about $100 per month.

We went through several rounds of cuts and what works for us is: If something really matters to you, be OK with spending money on it – but cut sharply on those things that aren’t crucial to your happiness.

No matter what you issue is; whittle away at it, charting your progress as you go. Regular measurement insures that monsters don’t quietly grow under the bed.

Charting your progress makes it much easier to stick with your plan. A little success is very motivating.

The Joy of Work

Several of the bloggers I enjoy espouse “minimalism” as a way to escape the need for a job – among other benefits. I can really get excited about some of the other benefits; for example I know renting or owning a house big enough for your stuff, rather than just big enough for you, can have long-term financial consequences and certainly, relying on the accumulation of stuff to feed your self-esteem is harmful. But to embrace simple living so that I could quit work? I don’t think so.

Work is what I do – not what I avoid. I met many of my very best friends through work. How better to forge and cement a relationship than by working side by side to accomplish or create something?

When I look around our self-remodeled home I see the results of many hard, but joyous hours of work. One of my best-ever summers was spent with my four young nephews building our dock. It was very hot and incredibility strenuous work – requiring the sinking of new pilings, the driving (by hand!) of about a bazillion nails for stringer joist hangers and also the hauling, cutting and fastening of a lot of very heavy composite lumber decking. We did not work for pay. We worked for the challenge of trying to build something way over our heads. We enjoyed puzzling out each problem as it arose (including how to un-stick the eight year old who had been jet sunk in the mud just like the pilings). We loved the team synergy.

I’m blessed to have been happy with my work for most of my life – be it corporate, small business or self employed. I love solving problems, being challenged, and making a difference. You can find these kinds of opportunities almost anywhere. If your current employment circumstances don’t allow you to experience the joy of work, then you are really missing out, plan a change. Do not indefinitely forgo the joy of work in exchange for money.

Bad Influence

When you were in middle school I bet your parents started eyeing your friends more carefully. They asked about their parents and how they did in school and what kind of rules they had in their home. If they saw a group of kids hanging at the mall or on the street corner goofing and smoking, they wanted to be sure none of them were your friends.

Your parents were worried about bad influences. They fretted about Johnny, who you might skip a class with, or Brenda, who might encourage you to drink that first beer – while they remained totally oblivious to the influencers that would torpedo your ability to accumulate wealth.

BMW, Lexus, Infiniti, Rolex, Prada, Dooney &Burke, Ralph Lauren, Sony and Apple are the influencers your parents should have warned you about. These influencers and others like them have helped way too many high earners become low accumulators of wealth.

Wealth is not how much you make and it is certainly not how much shiny, (and rapidly depreciating) stuff you have. Wealth is what you have managed to hold on to.

In The Millionaire Next Door, Stanley & Danko gave this little formula to gauge how you are doing at building wealth.

(Age x pre-tax Income)/10 Should Equal Net Worth

For pre-tax income include all sources, other than inheritance.

This formula is just a quick and dirty estimate of what your net worth should be. To be in the top 25% (where we all should want to be) your net worth needs to be twice the result of the calculation.

If you’re not in the top 25%, it has everything to do with your spending. Having been bombarded your whole life with slick ad campaigns about what purchases you need to make to be happy, you have fallen prey to professional influencers.

I have nothing against any of the companies mentioned. They all make great stuff, and if you are going to have stuff, at least have good stuff. I just want you to think. Just as your parents did when you were in middle school, I’m going to tell you to make your decisions based on what’s right for you and your future. Don’t do something just because everyone else is.

How to Say No

One of the fundamental principles taught to lifeguards is to protect their own life and health. This same principle is vitally important when a loved one asks you for financial assistance.

Rule 1: Protect yourself – you are no help to anyone if your drowning loved one pulls you under.

One important way to protect yourself is never to co-sign a loan for a friend or family member. This is very easy in theory but surprisingly hard in practice. When someone you care about comes to you and makes their case about how things will be so much better for them if they could just get this loan; it is very difficult to tell them no. Saying no feels like a vote of no confidence from you to them. As unsure as we are of exactly what our loved one needs, we can be certain they need someone to believe in them.

But, there is a reason they cannot get the loan without a co-signer; the cold hard statistical facts predict that they will default on this loan. Co-signing puts you fully on the hook for the debt and places your relationship in serious jeopardy.

Loaning money to our friend or family member in crisis is likely to have the same consequences as co-signing. They may not be willing or able to re-pay the loan; placing you in the uncomfortable position of playing debt collector to someone you care about. This is not likely to end well.

When faced with saying no to a loved one’s request for money, try one of these strategies:

Make your refusal to co-sign or loan money part of your personal code of conduct. This takes some of the sting out of your refusal. You are not refusing to co-sign this loan, you refuse to ever co-sign any loan. Stating this part of your personal code occasionally when the opportunity arises may save you from ever being asked in the first place.
Blame it on your financial advisor. No sane advisor has ever recommended co-signing a loan for a friend or family member.
Offer something you can do that will help resolve their issue “No I cannot so-sign that car loan, but I could give you a ride to work for a month”.

Your goals need to be to protect yourself, protect the relationship and to leave a door open in case they really need help – not just a quick solution. There is nothing wrong with giving money to someone in need as long as: a) you can afford it; b) you are fairly certain that giving will not just enable continuing their bad money behavior.

If you’re the kind that feels bad for saying no, stop! Chances are you did this person a great favor; a few more no‘s and they might just starting looking inward for the solutions to their problems.

It’s all about what you want

Finally, we get around to your favorite subject. Personal Finance is very personal. What you want and what I want may be quite different.

Winning with money is about using your earnings to get what you want from life.

As long as you are progressing toward your goals at a pace you are happy with, there is no need to feel guilty about lattes, dinners out or your fancy car. You should spend money in ways that make you happy. Just don’t make the two fundamental errors that will prevent you from winning.

Fundamental Error #1: Failing to set Personal Financial Goals

This was me, and I bet it is you too. To count, a goal has to be clearly defined, measurable and have a completion date attached.

I want to retire comfortable someday is not a goal; it is a Dream.

I want to retire with a monthly income of $2500 in six years. That’s a Goal.

I want to get out of debt – another Dream.

I want to be completely out of debt, excluding the house, within 36 months. – Goal.

I want to buy a house – Dream.

I want to save $20K for a down payment on a house by this time next year – Goal.

Ok, you’ve got it. Now take some of your dreams including your “great-big-won’t-happen-for-a-long-time-dreams” and turn them into goals.

Fundamental Error #2: Failing to have a plan

When people make error #2, their behavior does not align with their goal. It is not that they lack self discipline; it’s that they have no plan.

If your goal was, I want to save $20K for a down payment on a house by this time next year, how are you going to do this?

How much a month do you need to save? Do you need to cut back expenses to get there? Can you increase you income? How?

Break your goal down into the little actions required to get there; draw yourself a map. Put in on paper and then tell someone about it. Check back on your progress frequently.

Whether you are on baby step 1 or 7, you need to have a goal if you’re going to win.

Good Debt vs. Bad Debt

In the world I grew up in there were two kinds of debt, good and bad.

Good debt was debt used to buy things that are going up in value, real estate, home improvement or education.

Bad debt was debt for depreciating stuff like clothes, vacations, dinners out etc.

Cars, even though they depreciate like crazy, got a pass and were ruled ok debt.

This is no longer that world.

In today’s world there is Bad Debt and Worse Debt and Toxic Debt.

Bad Debt is a 15 year fixed rate mortgage on a home that the payments are no more than 25% of your take home pay. How can this possibly be bad? It is debt. It has risk. It costs you money in the form of interest. It is as close to being “good” as a debt can get but let’s call it bad to remind us we want out of it as soon as possible.

Worse Debt is secured debt on rapidly depreciating cars, boats and other toys. In the old world, advisors would say a car loan was fine if paying cash would wipe out your reserves; after all you need a car. Depending on where you live and what you do for a living you might convince me you need a car, but you will have a very hard time convincing me you need a car loan. Buy a car you can afford. Can’t pay cash for a new car? Guess you don’t get a new car. Can’t pay cash for a 5 year old car? Try an 8 year old car. Maybe you really have to have a car loan but if so, it should be a very small loan on a used car and you need a plan to pay it off really fast.

Toxic Debt paying 12-25% interest on stuff that has virtually no resale value is financial suicide. You did not need the stuff in the first place. If you carry a balance on your credit card it proves you could not afford the stuff. Don’t buy stuff unless you can pay for it.

Another form of Toxic debt is the school loan. This is new world. The price of tuition has gotten so high and the lure of easy loans is so strong that many graduate with huge loans that are totally out of line with their probable earnings.

The Financial Aid Officer sitting across the desk from you is the devil incarnate. You are selling your future. Be very, very, very careful.

Wake up! If you have been living by the rules you were taught and you’re not winning, it’s because the world has changed.

There is no good debt and right now is a great time to assess how you can adapt and win.

Bad Dog

Quick, you’re in a dark alley in an unfamiliar part of town. Which would you rather meet up with, five yapping Chihuahuas or one big, mean pit bull?

Me? I know I can deal with the yappers. They definitely can aggravate with their incessant barking and they might even nip; but they can’t eat me.

Welcome to debt consolidation. This is where you take all your little aggravating debts and create one big monster. You might even put the big vicious thing on steroids by consolidating all your debts into your home equity line.

DON’T DO IT.

This is what people do when they can’t stand to listen to the yappers one more second. If you’re here, unplug the phone and find a way to get a quiet moment to think.

You cannot borrow your way out of debt. No way, no how, it will not happen. If a consolidation lowers your monthly payment, it does it by stretching out the term. You will be in debt LONGER and it will cost you MORE- even if the interest rate is lower.

I have read many articles by so-called money experts that advise taking out a home equity loan to pay off credit card debt. YIKES! This advice is so bad I have to believe they are getting kickbacks from the credit card companies. Thankfully, these loans have become much harder to get. Can you think of anything more stupid than to risk your home for the shoes, TV, or dinners that you bought with your Visa?

If you are so sick and tired of carrying your debt; that the late-night TV promises of the debt consolidators are starting to sound tempting, what should you do?

1. Know you are not alone. I can’t say it was smart to get into this position but at least you are in good company.

2. STOP borrowing. Cut up the cards; freeze them in a block of ice; do NOT carry them in your wallet under any circumstances.

3. Make a rational and reasonable plan to live on less than you make and start paying off the debt.

You knew all along that it would take discipline, commitment and hard work to get out of debt. It was only when you were tired and alone and ashamed that you wanted to believe the to0-good-to-be-true promises of the debt consolidators.