Financial Literacy

An acquaintance in his early 50s drove himself home with a new blue Porsche convertible, just in time for summer. I asked him a few questions about it, but he quickly said that he is more proud of how he funded it than cruising around town. What was his trick? Did he plunk down cash, or borrow against his house?

He told me that he had around $60,000 saved up in his car fund, plus he had sold some silver. He put all that money into a short-term bond fund with a nice yield paying a monthly dividend. He put up enough of a down payment so that the bond fund dividends covered his entire monthly payment on his 2-year lease. He said, “I’ve never had a sports car and figure the desire will have been burned out of my system by two years. At the end of the lease term, I’ll still have my entire principal to purchase my next vehicle for the long term.

So, his goals were to:

• Have a fun car to drive for a couple years, in the most hassle-free manner
• Eliminate any car payment
• Preserve his car fund balance

I think he did a great job. Of course, no car is free, he did lose out on the opportunity cost of the profit of his fund. However, that is the exact purpose of his car fund, to cover his transportation expense. And he’s grown it large enough that he has some creative options for how he acquires his transportation.

For those with the option to purchase a home or rent, inflation is a big consideration to evaluate.

To start with an example, let’s compare a $1,000 apartment rental vs. purchasing a condo that will cost $1,000 per month; including the normal purchase expenses such as mortgage, property taxes, insurance, and association dues.

What happens over time? In this example, the rental rate may increase an average of 3% per year. So in 10 years, the apartment rental would rise to $1,344 per month.

Meanwhile, for the condo purchase, the mortgage payment would remain fixed. If the other components also rose by 3% per year, the total monthly payment might be $1,131.

After 10 years, the rental payment would be 20% more than the monthly condo payment.

The inflation effect on rent affects the entire amount. However, for a purchase the inflation impact does not affect the mortgage (the largest portion of the monthly cost), just the smaller components.

Each cost component of housing is impacted by inflation and exogenous influences at a different rate. Sometimes property taxes or association assessments can explode upward. And there are periods where there is no notable inflation. I know people that have been priced out of their home from rent increases, property tax increases, and even association fees that multiplied by +400%.

Whichever housing option you choose, be aware that every expense component will be impacted by inflation. Those affects must remain affordable for your level of income in order to maintain financial stability and keep your home.

There is an old phrase, “100% of bankruptcies result from a debt.” In order to avoid defaulting on a debt, you must have reliable income that is high enough to pay the monthly interest plus pay back the principal balance. Everybody knows this. Unfortunately, so few seem to take this into consideration when making a purchase on credit. How about a couple examples…

I was getting gasoline this week and the guy in front of me needed 2 credit cards to buy his $20 in gas and a cheap lunch. His first credit card could only fit $11 on it and his second card could barely fit the remainder. He was chatting with his friend about where his money went. He was strapped because he had just purchased two items for his car: a sound amplifying exhaust tip and an add-on turbocharger. While they may be fun, if they are not affordable he may never be able to dig his way out of his debts.

A few years ago, a friend’s neighbor was really excited when he started making overtime at work for a new project. First he bought a new car, then a new fishing boat, and finally a new ATV. A year and a half later, the project finished and so did all of the overtime pay. One by one, his new toys were repossessed by the repo man. He had purchased all of them with borrowed money that he was unable to support without the overtime pay. Understand: by making the most money he had ever earned in his life, he was left financially worse off with bad credit. It sounds impossible but this same phenomenon occurs to the majority of lottery winners and professional athletes as soon as they retire. The lesson is always the same: if you cannot manage money then receiving more money will magnify and exacerbate your mismanagement.

Small businesses are not immune to the temptation of inappropriate debt. A small business owner asked me if I knew anyone that would loan him $31,750 to make payroll. I told him, “The business is already insolvent and you won’t have the cash for any subsequent payroll payments. Your own business plan shows you need cash to cover +5 months of expenses and you have zero in the bank. Close the doors now and find another way to rebuild because this one has already gone off the cliff.” He ignored obvious reality, borrowed for 4 more payrolls and then closed the company – with a needless and additional $127,000 in debt that he could never repay.

Whether you’re buying iced-tea and a burrito at a gas station, or making a payroll payment to employees, the decision-making is the exact same. Your income must be high enough to support the loan repayment, plus interest, with on-time payments. Only by using the foundations of financial literacy can anyone create a sustainable financial plan that illuminates what is and is not affordable to purchase.

There are people that find themselves totally broke from problematic events or circumstances: divorce, illness, civil lawsuit, business failure, investment losses, prison sentence, gambling or drug addiction, uninsured disaster, prolonged unemployment, home foreclosure, chronic overspending, and many others. As I write this, a neighbor’s brother is 61-years-old, and although he’s always been employed, the legal bills and alimony from a recent divorce have forced him to live on a friend’s sofa.

If there aren’t any relatives or friends to temporarily take you in, then what do you do? There are numerous online communities that share information about how to transition from surviving to thriving while getting back on your feet. There are strategies for:

Housing:

• How to find people that need house sitters for free housing
• Living in a car and bathing at a cheap gym
• Living in a cheap converted van or cheap RV on public land for free
• WalMart and Cabella’s allow free overnight RV parking for traveling
• Joining the military

Food:

• Food banks
• Food stamps
• How to forage from fields, forests, rivers, lakes – what you can and cannot eat
• Making the cheapest meals surrounding proteins like peanut butter or cheese or eggs

Income:

• Employers looking for people to do day-work
• How to earn cash today by selling simple skills (cleaning, chores, errands, handyman)
• Nearly free internet for online jobs

There are ways to cut expenses to the bone for: paying off debt, building up money for a specific purchase, surviving until pension or social security kick-in, or surviving on a small social security payment. I took a niece to play at a park with a lake one Sunday and noticed several people fishing off of a bridge, in what appeared to be their church dresses and suits. I started chatting with them and learned they save money by having a couple meals each week from the fish they catch on Sunday mornings.

Getting online for free at a library can provide access to all kinds of ideas and resources for your particular situation, and then next steps as your situation improves. There are numerous people that have been forced to start over from scratch and their collective wisdom and feedback awaits you in these online communities.

Many people have several debts and classes of debts. Sooner or later, a debtor may consider digging themselves out of their debt obligations. In order to reduce your debts, each month there is a decision to make: to accelerate this process, which debt should I choose to make a payment larger than the minimum payment?

You can rank your debts by the highest interest rate, the smallest debt amount, or the largest debt amount to select the first one to pay down. None of those methods are correct. The optimal way to pay down your debts is to rank them based upon the ratio of the payment to the debt amount. This ratio measures how much or how little a particular debt is impacting your personal cash flow. Debts with a high relative payment are inefficient to your monthly cash flow while debts with a low relative payment are economical to your monthly cash flow. In general, the higher the interest rate and the shorter the loan term, then the debt payment is more inefficient. When you pay off one of these inefficient debts, then it has a greatest relative improvement upon your monthly cash flow. Extinguishing this debt will free up relatively more money to be available to pay down the next most inefficient debt.

There are several different ways to calculate this ratio. For example: annual payment/debt balance or debt balance/monthly payment. It really doesn’t matter. The point is to select a calculation method that works for you and apply the same calculation to all of your debts to rank them consistently. Let’s choose the calculation method of: Debt divided by the Monthly Payment for the following examples.

1) Mortgage (30 years at 5%)

Balance $180,000

Monthly Payment $996.28

Ratio = 180.6

2) Auto Loan (4 years at 7%)

Balance $20,000

Monthly Payment $478.92

Ratio = 41.8

3) Credit Card (at 16%)

Balance $8,000

Monthly Payment $213.33

Ratio = 37.5

To understand the meaning of the ratio, it is measuring the size of the payment to the outstanding principal balance. When comparing debts, the lower the ratio infers that the payment is a large amount compared to the balance. When a payment is large to its balance, then it is consuming more of your monthly cash flow.

Using this ratio, the mortgage has the most efficient payment schedule and the credit card has the least efficient payment schedule. In this case, the optimal debt to apply extra principal payments is the credit card. Once the credit card balance is paid off, the next most inefficient payment is the auto loan. So the $213.33 that used to pay for credit card interest, plus the additional principal payment you were making, should now be applied to the auto loan principal. One by one, knocking out these debts, including your home mortgage, frees up your monthly income to increase your contributions to savings, investments, and spending.

Whether you elect to collect social security early (age 62) or late (age 70) will result in a difference of a few hundred thousand dollars over the remainder of your lifetime. Nearly 50% of retirees count on social security for at least 90% of their income, so this is a very big decision. In my opinion, this financial decision should only be made with expert advice because there are too many variables and rules to consider in making the best choice.

There are several factors your adviser will need to know:

1. Your health and likely longevity
2. Marital status, along with their age, health, and expected social security benefits
3. Are you working and how long are you planning on continuing to work
4. Do you have other savings and sources of income

If you’re looking into advisors, beware that all of them are not equally qualified to assist you. Ask them up front if their plans include elements such as “provisional income rules,” “restricted application strategies,” and the “Tax Torpedo” (where your required mandatory IRA distributions force you into higher tax brackets on your social security income). There is such a maze of rules that software is commonly used to come up with the best customized decision for you and your spouse.

If you decide on your own when to collect social security, as most people do, the above chart shows the percentage of your full retirement benefits that you’ll receive, based upon age. So collecting at the earliest age, 62, you’ll start at 70% of your full-retirement benefits. Each year, your benefits increase 8% per year until age 70 when you’ll receive 124% of your full-retirement benefits. Some people evaluate their choice based upon breakeven dates. For example, if you wait until age 67 to receive benefits, you’ll break even on waiting for higher benefits if you live to age 78. If you wait until age 70 to receive benefits, then you’ll break even on waiting for higher benefits by age 82.

I find that people that need the income the most will file immediately, locking themselves into the lowest income level, and later regret it. (Today, the average retiree will live to age 85 and 20 years is a long time for prices to rise against you). Meanwhile, the people that are strategic wait several years to receive a far higher social security payment. I’ve also observed that if someone sadly passes away in their mid-60s then everyone around them files as early as possible, “because you never know.”

To anyone considering retirement, I highly recommend getting a full financial planning proposal from a professional. There are many federal and state rules, regulations, and scenarios that must be considered for calculations for electing social security benefits, let alone integrating it with the rest of your financial plan. You can do this on your own, but it is an undertaking to become proficient, thorough, and up to date before making some irreversible decisions.

A survey by Brandtrust revealed that eating out was the number one reason for breaking a budget for all ages. This makes sense because meals are: times for social and family gatherings, a reward, an entertainment, and a source of enjoyment for foodies and non-foodies alike. However, adding a few alcoholic beverages can double the bill, or more. (This is confirmed that those between age 20-39 in this study were most likely to overspend on alcohol). Regardless of the attractiveness of dining out, budget discipline cannot be ignored.

From assisting others with financial difficulties, I can anecdotally confirm that those who eat out the most also have the most financial struggles. Unfortunately, these people are also the least able to change their spendthrift ways of frequenting restaurants and bars. (I can understand the attraction of dining out: the first time I could read a menu I ordered the Surf & Turf dinner. After the waitress left, my mother reacted, “When the menu item says Market Price, that means you have to ask your father before you order.” Meanwhile, our usual dinner at home could be navy beans on a piece of bread, or tomato soup and crackers. So eating out was like hitting the lottery!)

Any weakness can create a financial calamity and many people associate overspending with a big ticket item. For example, buying a boat that you cannot afford (besides paying for all of the operating and maintenance costs), leaving your credit in bad shape and your savings accounts underfunded. However, it is just as financially damaging to have an unaffordable habit over time – even if it is just one meal out a week that is beyond your budget.

Financial stability is built upon a foundation of realistic budgets and the discipline to maintain them. In order to maintain my budget, I’ve eaten many lame sandwiches and soups to make up for an unexpected expense. It is highly recommended that you do not follow the average herd to financial struggle by repeatedly blowing your budget on dining out.