Posts
Three Principles of Personal Finance: All You Need to Know for Financial Success
Source: Aaron Patzer
More than 10,000 books have been written about personal finance. You could spend a lifetime reading them. Some of them are great1; others are 99% motivation, 1% actual, actionable information2.
The truth is personal finance is simple. Every one of these books can be reduced into three basic principles:
- Spend less than you earn
- Make the money you have work for you
- Be prepared for the unexpected
While the principles might sound like common sense, the real trick is to truly understand them, and more importantly, to apply them.
Spend Less Than You Earn
Put another way, “spend less than you earn” means: live within your means, don’t overspend, don’t get yourself into debt and start saving. Easy to say, not so easy to do — especially given the appeal of a new car, a sweet home theater, a couple nights each week out with friends, and a posh tropical vacation every once in a while. You have a job for a reason — you want the good things life has to offer.
You could forgo dining out for cooking at home, always buy generic, get your clothes on sale at the end of the season, and save a few dollars whenever possible. But really there are four big decisions that affect your expenses (and therefore your ability to save for other things) more than anything else.
These are the areas where you need to go in understanding the costs involved, so that you come out remaining financially strong.
1. Buying a House
A house is likely the most expensive purchase you’ll ever make. And it’s not just the mortgage, its property taxes, home owner’s insurance, maintenance, and the time it takes to mow the lawn. Too many people think that buying a home is automatically a good investment, since you’re “not throwing money away on rent.” While owning a home of your own may be the American dream, it doesn’t always make economic sense.
If you live in California, the Northeast, or Southwest where housing prices have doubled or tripled in the last 10 years, it’s almost always better to rent and invest the difference (more on this in principal #2). Even if you live outside those regions, if you move within the next five years (and if you’re in your 20s that’s almost a certainty), the closing costs and 6% realtor fees will eat away your gains.
By contrast, if you plan to stay in the same area indefinitely, a house may be one of the best investments you make. To determine what’s right for you, I like the NY Times Rent vs. Buy Calculator. It’s the best one on the web, and easy to use: just enter your rent and the price to buy a comparable place3.
2. Kids (and when to have them)
Children can be an amazing source of joy in your life. If you’re planning to have some, it’s important to realize the expense involved, so you can make the best decision on when to do so.
Kids mean more money spent on a bigger house, a bigger car, food, clothes, healthcare, and education. The cost of raising a child calculator at BabyCenter does a good job of breaking things down by region and household income level. In today’s dollars, most estimates approach $200,000 per child (excluding college). That’s about $11,000 per year per child.
This cost can be lessened dramatically by waiting a few years. If you wait to have kids for 4 years, and instead invest that $11,000 per year at a 10% return, you would have $67,000 by time your child is born. As you begin to take $11,000 per year out for child-related expenses, part of your original investment continues to grow. In the 18 years spent raising your child, you will expend only $100,000 out of pocket. It’s like having a child at half the cost.
3. Where you live
You probably choose where to live based on job opportunities, proximity to family and friends, or a great climate. But where you live has a big impact on how much you can save. For example, if you make $75,000 a year in Austin, you would need to make $135,000 in San Francisco to maintain your lifestyle. That’s an 80% increase in cost of living. Unfortunately, moving from Austin to San Francisco, salaries typically increase by only 30%.
To compare major cities, I like BankRate’s cost of moving calculator. It shows the difference in housing costs, doctor’s appointments, and even the cost of a haircut.
4. Car (new or used)
Automobile manufacturers and dealers spent more than $16.3 billion in 2006 to convince you to buy a new car4. Seriously, that’s billion with a “b”. Let’s say you cave and decide to get a 2007 Chevy Malibu because it will “only” cost $20,000. Three years later, the car has depreciated by $10,500 and you’ve paid more than $3,500 in finance charges - a total expense of $14,000. If you bought a used 2004 Malibu instead, depreciation and finance charges add to only $3,800. That’s a $10,000 difference. You can see the calculation yourself at Edmunds.
Maybe you want something better than a Malibu. Buy a 2004 BMW 545i for $37,000 instead of the 2008 550i for $64,000. It will cost $27,000 less to buy used, and you’ll save $15,000 in depreciation and finance charges over the next 3 years. Always buy used, even if only last year’s model (I myself own a ‘94 and a ‘96). Impressing the neighbors (or the ladies) with an ever so slightly better model probably isn’t worth it.
If you saved $10,000 a year for the next 40 years and earned no interest, you would have $400,000. If you invested $10,000 a year and earned a 10% return each year, you would have $5,267,155. Why the difference? Because your interest earns interest, and its interest earns interest, and so on. The result is exponential growth. Remember calculus? This time it actually works for you.
To obtain real wealth, you need to redeploy your money. And that means investment. It’s how capitalism works. You can put your money into stocks where you own a part of a corporation; bonds where you loan your money out and earn interest in return; real estate; or start your own business.
Managing real estate can be a full time job, and owning your own business certainly is. Since both of these may require radical changes in life style, we’ll ignore them to focus on investments open to everyone: stocks and bonds.
Stocks vs. Bonds:
Over the last 200 years, stocks have consistently and reliably outperformed bonds. Not counting inflation, stocks have averaged 10% a year; and 14% for the past 20 years. Accounting for inflation, stocks have provided a “real” return of 7% annually, doubling their value every 7 years. By contrast, bonds have produced an average real return of 4.5%, doubling only every 16 years1.
For money you need in the next four years, stocks may not be the right choice. In the short term, the market may swing widely up or down. You can lose money. In the long term, however, a portfolio weighted heavily in stocks has consistently outperformed one weighted towards bonds or other fixed-income investments (such as CDs or money market funds).
Individual stocks are risky. Any one company might go out of business, suffer an accounting scandal, or miss their quarterly earnings. To distribute your risk (or in investment terms “diversify your portfolio”), buy a mutual fund. But be aware of the big differences between those that are “actively managed” vs. “indexed”.
Some mutual funds are actively managed by professionals. This active trading comes with a cost: management fees, administrative fees, and transaction costs can eat up to 2% of your investment each year. Active trading also means more taxes in the form of short term capital gains. Are they worth the cost? Often, they’re not: 80% of mutual funds under-perform the S&P 500 index. You should also be aware that choosing the right mutual fund is nearly as hard as choosing the right stock.
By contrast, index funds are “passive” - these funds invest in specific set of stocks designed to simply mirror the market instead of trying to out-guess it. The result: fees at index funds like the Vanguard S&P 500 are less than 0.20% annually.
Pay Yourself First:
You pay the government. You pay your rent (or mortgage). You pay your bills. How about paying your (future) self for change? They key is to do it automatically, every paycheck, before you get a chance to spend or even see the money.
If your company has a 401k plan, start contributing. This money comes out of gross-pay and is not taxed. Even better, companies often “match” employee contributions. You put in $1, they put in $1; it’s like doubling your money immediately. Even if you company matches only $0.50 to the dollar, that’s still an instant 50% return.
If your company does not have a 401k (or you’ve maxed it out), you can setup “automatic” investments with E*Trade, Fidelity, Vanguard, and most major brokerages. Each month, they’ll take $1,000 from your checking account, and put it towards the investment (hopefully an index fund!) of your choosing.
Prepare for the Unexpected
The best laid financial plan can be quickly ruined by a streak of misfortune: job loss, fire, theft, or health problems. You need to protect yourself, but it’s not nearly as hard as you think.
Emergency Fund:
Without savings, living paycheck-to-paycheck leaves you vulnerable. You need a buffer, a way to get back on your feet if disaster strikes. Save enough for at least three months’ expenses. For most people, that should be $10,000-20,000. This is savings separate and distinct from your vacation fund and your investments. It’s your “open in case of emergencies only” fund.
Build your emergency fund. Earn rates 11 times higher than that of the national average. Just pay careful attention to the minimum balance require to avoid fees; amount required to open account; and amount required to maintain yield.
Insurance:
Yes, if you’re an adult, you need insurance. And no, not just car insurance. What you need depends on where you are in life.
Medical bills are cited in about half of all bankruptcies1. And it’s no wonder. Break your leg rock-climbing and you could be stuck with a $5,000+ bill. If your company doesn’t provide it, you need health insurance.
If you’re in your twenties or early thirties, choose an inexpensive plan with a high deductible. You want something to protect you from disaster, but without breaking the bank. In most states, you can find a plan with a $2-3,000 deductible for $50-100 per month. You may not have the prescription drug benefits, or the low co-pay of those $300 per month plans, but if you only go to the doctor once or twice a year, you’ll come out way ahead.
If you rent, you need renter’s insurance. Sadly, only about 33% of renters actually buy this coverage2. Renter’s insurance protects you against fire, theft, and most natural disasters. Step back and think about how much it would cost to replace your computer, TV, couch, bed, and everything else you own. With renter’s insurance, you can get $20k in coverage for only $10-15 a month. It’s dirt cheap and worth it.
Renter’s insurance also protects you outside your apartment. If your car window is smashed and someone grabs your laptop, your car insurance will only cover the window, not the laptop. A good $20,000 renter’s insurance policy would give you up to $2,000 to replace your loss. Keep in mind that roommates’ possessions are not covered; your roommate needs a policy of his or her own.
Takeaways:
- Save $10-20k in an emergency fund. Keep that fund in a high-yield savings account like CapitalOne Bank or HSBC.
- If you need health insurance, consider a $50-$100 a month high-deductible plan. Being without health insurance leaves you too vulnerable to bankruptcy or worse.
- If you rent, get rent’s insurance. It’s only $120-$160 per year.
——————
References:
0 comments:
Post a Comment