Financial Literacy

There are many locations where you may have money, but there are two that you should be evaluating the closest. There is one money location to minimize and the other to maximize. First, the definition of these two types of money locations: dead money and paying investments.

Dead money = is the label for your money that is not paying you anything. Examples include: excess emergency cash, excess money in a checking or savings account paying nearly nothing in interest, or value in items you no longer use (jewelry, ATV, unused laptop, etc.), plus equity in items that you do use, such as your home and cars.  

Paying investments = provide you a monthly or quarterly return and is the most desirable type of location for your money. Examples include: dividend paying stocks, interest paying bonds, and high yield savings accounts with FDIC insurance, small business ownership paying you dividends, and real estate investments paying out distributions.

Paying investments is easy to evaluate: you can’t have enough of this and you want the investment income re-invested as much as possible while you’re accumulating assets. Paying investments is critical to growing your investment income in the most robust manner. This is the type of income that can slowly support more and more of your expenses as it grows in size. At some point you will want to retire and paying investments is the most important income to make this happen for you. Otherwise, to get spending money you are forced to sell some of your investments and reduce their principal balance which permanently reduces its future earning potential.

Dead money is more difficult to analyze. Avoiding dead money is impossible and some dead money is fine for several purposes. But in general, dead money is an expense in opportunity costs. As an example, let’s say your family has an extra car that isn’t being used, worth $5,000. If you sold the car, that $5,000 could be placed into a paying investment making you richer with each payment. These missing investment payments are your opportunity costs for leaving this dead money where it is. Not only do you have opportunity costs, the car is falling in value with time and decay. This is the same for most dead money in physical objects that are unused or no longer serve a purpose for you.

The dead money (equity) in items such as your home and vehicles needs to be evaluated against your financial capability. In general, if you are a poor money manager, then you want money out of your hands and into places like your home equity and car equity where you won’t spend it. However, if you are a skilled and knowledgeable money manager and investor, then you may want to reduce your equity in home, cars, etc. (if you can do it at a low interest rate) and instead have some of that prudently invested in paying investments at a higher rate so that you are favorably leveraged.

Dead money and paying investments are your two locations for money that are the most important for you to track and evaluate. This is because they directly impact your net worth on a monthly basis, one favorably and the other unfavorably. Your financial goal is to minimize the dead money that you have (and its corresponding opportunity costs). Recover that money to be a part of your continual additions to your paying investments.  

When you make more money, you move up into higher income tax brackets. This progressive tax rate has been called a “success tax,” because the more you make, the higher the rate you are taxed. But this isn’t the only success tax, the other one is your increase from lifestyle spending.

When you were age 19, whatever level of quality you were content to own (from socks to cellphone) or consume (from alcohol to shampoo), it ratchets upward as your income increases. The items we buy today serve the same function as their cheaper competition, but we no longer consider purchasing the cheaper versions. This is called “lifestyle inflation” and it consumes an increasing amount of your income. An article by Derek Thompson highlights data indicating that on average, no matter what your level of income, 50% is spent on housing and transportation. So whether you make $40,000 or $400,000, the average American spends the same: half on housing and transportation. (This ratio is similar for Canada and UK as well).    

Increasing your financial stability would be greatly advanced if instead, you controlled your lifestyle spending. Not just housing and transportation, but all areas. The average person does not control their spending and many require credit cards to pay for all of their over spending. It is always best if your personal ratios for any spending be FAR below the ratios for the average person (because the average person is always a very-poor money manager).

Let’s examine an item that most of us purchase – shoes.

1. Were you content or in utter agony with a cheap pair of shoes when you were age 19?
2. Sitting alone at your kitchen table, does it really matter if you have an expensive logo on your shoes?
3. Are you able to experience appreciation for a new pair of shoes you just purchased, or do you immediately search for an even better pair to add to your large collection that you rarely use?
4. Would you prefer to own a cheaper pair of shoes today or when you are elderly, being forced to wear a cheap pair of shoes when you need a more expensive pair with support and comfort?
5. At the end of each month, do you have plenty of money to save and invest or do you increase your credit card balances?

The more perspectives and long-term thinking you can apply to each purchase that you make, you may be better able to distinguish between the proverbial “wants vs. needs” and make better financial choices.

To help control your spending, avoid the usual budget busters:

• Moving to a neighborhood where your income is well below all of your neighbors
• Failing to meal-plan each week out, in advance, and eating out for a much higher price and convenience instead
• Keeping up with the Joneses (whose credit cards are maxed out)
• Trying to impress others with your glamorous Instagram lifestyle
• Routinely spending time at bars or mindless shopping
• Leasing cars or borrowing most of the money for new cars

The best thing you can do for your financial stability is to NOT impose a success tax upon yourself by ratcheting up your lifestyle just as fast as your income grows. In particular, keeping your housing and transportation below 50% of your income.

Loan efficiency refers to how much cash a particular loan takes out of your monthly budget. Some loans are relative Hogs while others are relative Hummingbirds. It is best to have flexibility in your financial life, and having loans with high efficiency enables this over low-efficiency loans. You can usually make extra payments on a loan to pay down the principal balance sooner.  However, the loan Hogs require you to do this and the loan Hummingbirds do not. Your financial position may change and having flexibility is helpful.

Let’s examine a scenario, let’s say you need a $10,000 loan. You could get a 4-year installment loan (with an interest rate of 8%) and your monthly loan payment would be $244. Or, you could get a line of credit (with an interest rate of 8%) and your only monthly payment would be just the interest of 8%, or $66. In this scenario, the $66 payment would be the Hummingbird and the $244 payment would be the Hog.

For loan efficiency, in general:

• The longer the term, the higher the efficiency
• The lower the rate, the higher the efficiency

The objective way to categorize your loans (and potential loans) is to divide the outstanding balance by the monthly payment. This equalizes and indexes each loan to a single discrete number. This allows you to rank and compare alternative funding, payoff , and re-financing possibilities. The higher the ratio, the higher the loan efficiency. Likewise, the lower the number the lower the loan efficiency.

Similarly, investments can also be ranked for efficiency, the criteria is just flipped upside down. Again, monthly payments to you is better than quarterly or annual payments. You can rank investments with similar risk by their payment efficiency.  Unfortunately, you need a financial calculator that includes compounding, called ‘discounted cash flow.’ For example, if you are paid monthly, you have that cash that can earn a little more money for you by reinvesting it, rather than one payment at the end of the year. An online calculator can perform these discounted cash flow calculations for comparison: https://www.calculatorsoup.com/calculators/financial/present-value-cash-flows-calculator.php

Whether you are borrowing money or making investments, you want to replace inefficiency with efficiency, and these calculations reveal exactly how to rank your options. So, if you’re on a debt-reduction plan, start paying down the low-efficiency Hog loans first. Or if you’re trying to increase your investment income, move your money into higher discounted-cash-flow investments.

The concept of a financial reserve will make or break your actual savings and financial goals. When you save money, it is set aside from your current spending. This savings could reside as cash or in your checking or savings accounts. However, what is this money’s exact purpose? If it does not have a very specific assignment, then any financial need or desire may consume it: a medical bill, car repair, attending an out-of-town wedding, replacing worn-out shoes, or used for being a tech ‘early adopter.’ Then, poof your savings are gone. So when a large expense comes along without savings assigned to cover it, the money to pay for that must be borrowed money. And borrowed money with interest charges turns you around in the wrong financial direction. There is one way to make sure this does not happen – it is to employ the concept of reserves.

A financial reserve refers to an assignment of money to serve a specific purpose. Simply living life requires many expenses, and many of these are known in advance and can be roughly estimated for both price and timing. For example, if you are currently driving a vehicle then it is a certainty that, sooner or later, it will require:

1. Maintenance (oil & fluids changed, new tires, spark plugs, battery, brakes, wax and detail, etc.)
2. Repairs (failed water pump, new muffler, or minor damage from a parking lot incident)
3. Replacement (once your current car is no longer viable or serves your needs)

These three types of expenses are known in advance and can be estimated. We know today that we must pay for these expenditures, sooner or later. The way to prepare is to assign some of your ongoing additions to savings to: vehicle maintenance, vehicle repairs, and vehicle replacement. So when the brake light appears on your dashboard then you will have the money waiting on standby to pay for new brakes without going into debt or financial struggle. The rate of adding money to these vehicle reserves should be estimates based upon the age, type of vehicle, mileage, etc. For example, a brand new car will need no maintenance for a few years while a 15-year-old car will need a lot of repairs as parts fail.

If you fail to have savings assigned to vehicle replacement, what happens when your car dies? You make the financial mistake of a car lease or loan, making you poorer from interest charges. An accounting supervisor I spoke with did not understand this and was SO happy that she was just 3 months away from finishing off the car payments on her car loan. As kindly as I could, I pointed out, “You still have the vehicle expense for your next car. As long as you are using a car, your vehicle assets are depreciating and you have to replace that depreciation in an ongoing manner.” Sadly, she replied, “That is just for rich people, I can’t afford that.” I later learned that most of her family and relatives go from car loan to car loan, or car lease to car lease. Over their lifetime, they are transferring a huge amount of money to lenders, money that they could really use. And this extra expense is unnecessary: if only they would delay buying their next car until they could afford it from their car replacement reserve. If they could do this just once, and get ahead of their expense, then it would save them the remainder of their lifetime in car payment interest and extra lease fees. With one car replacement with cash, you can break the loan-to-loan cycle. This way, you will buy your subsequent car from building up your vehicle reserve and earning interest each month instead of paying that interest to a lender.

What are some other expenses, known in advance, that should have a reserve and a place in your budget? You may include medical bills, apparel, vacations, holiday gifts, home repairs, appliance replacements, emergency fund (for losing your job), and the big one: retirement. When you financially map out all of these potential expenses for the first time, it can be a shocking amount of money. True, but it is also the financial REALITY of your current lifestyle. You are viewing your financial life, in numbers, perhaps for the first time. These expenses can either be funded with savings up front or with debt after the fact. Which option do you think is best for your financial future? If you do not have reserves for those categories, when these expenses arise they will drain your “savings” to zero, and beyond.

More importantly, if you fail to reserve money for known expenses and your savings is constantly under pressure, then you will likely never have a meaningful amount of investments to fund your future. Having little or no investments will eventually translate into no retirement for you, or a retirement of financial struggle. My net worth did not start making notable advances that were sustained until I began fully reserving money for all of these known and common expenses. Use paper, a spreadsheet, or any manner to list out all your physical possessions and then estimate how much money is required for normal maintenance, repairs, and eventual replacement. For a simple example, if you’ll need to replace your lawn tractor in around 3 years, find the model you will want (and we’re estimating it may be $2,000) and divide that by 36 ( $2,000/36 months= $55), and you’ve calculated how much money you need to set aside in a reserve to replace your lawn tractor in 3 years. Your reserve list will have both dates and amounts for each item to replace, along with an estimate of annual maintenance and repairs until then.

If you want to protect your savings from life’s expenses, and thereby avoid unnecessary interest charges, then you must have allocated financial reserves. Setting up and maintaining these reserves needs to be involved in any budgeting or financial planning that you perform. There can be notable problems when you do not have specific reserves, in retirement for example. I know someone who retired with an imminent need to replace his dilapidated roof and one of his two cars – but his financial planner failed to point this out (and he didn’t ask me). So within one year of retiring, he was forced to go back and get part-time work, at a lower wage, to make payments for some of these obvious expenses where he had no reserve to cover them. It is my best advice that you begin to fund specific reserves for your lifestyle and refrain from spending that reserve on anything else.

The bank manager of a large Florida branch told a friend of mine that, “Every day we stop one of our elderly customers from trying to wire $1,500-$4,500 to a Nigerian Prince who will send them millions of dollars in return, that will never arrive.” But this isn’t the only wire transfer scam. Business servers are often targeted, and lately, an increasing number of real estate wire transfers to purchase homes are being intercepted by thieves.

Thieves target and hack into the e-mail accounts of realtors and title companies. Once they discover an upcoming purchase, they send an e-mail (posing as the realtor or closing agent) to the buyer stating: “The home closing has been moved up, we need your funds today, wire the money to this different account.” Once you send it your money is long gone – because there is almost no law enforcement you can turn to for help to recover any money. The local Sheriff isn’t equipped to chase down the money, and the FBI isn’t successful and tells some victims that they are too busy.

My own bank branch recently warned me about wire fraud for a recent transaction that I was making; but I had already dealt with this party several times before. The banker told me that a few days earlier, she had stopped a customer from making a wire transfer who was buying a home. The banker asked the customer a few questions before finalizing the wire, which prompted a quick phone call to their realtor. It turned out that the customer was just about to unknowingly transmit a little over $400,000 to a scammer. 

When sending or receiving wire transfers, triple check with everyone involved to make certain the money is going to the correct account and routing number. Make arrangements in person when it is possible, verify over the phone, and then be on alert for any fake instruction changes from a last-minute e-mail.