The New Rules of Money
Rule #5: If you want to avoid financial failure, watch the pennies you spend - not the dollars.
In the old days, your ability to save was predicated largely upon how much money you spent on a house, car and other big-ticket items. Today you have far less discretion over your spending.
Consider taxes. Under the current tax law, you have few deductions, and therefore little opportunity to lower your tax bill. And because your total tax burden has never been higher, you are devoting more and more of your income to tax payments. I'm not just talking about federal income taxes (28% for most people). I'm also talking about state income taxes (6% is the national average), Social Security and other payroll taxes (15.3% of earned income), sales taxes, property taxes, gasoline taxes and many more.
All told, close to 50% of your income is lost to taxes.
Then there's housing. As explained more fully in Rule #22, most people spend 28% of their income on rent or mortgage payments. Add another 7% for home-related expenses, including insurance, repairs and maintenance, and you've just spent another 35% of your income.
So before you eat dinner, before you buy a pair of pants, and before you hail a cab or buy a car, 85% of your total income is already gone. And since a college degree is a virtual requirement in today's workforce, you can regard the money you're saving for college to be a tax of sorts. Clearly, your remaining 15% must go a loooooooong way.
With those precious few remaining pennies, you decide to buy soda with lunch. No big deal, you say. After all, it's only a dollar. Considering the huge amounts you're spending on taxes, homes, cars, clothes, insurance, food and day care, what possible difference could one little dollar make?
An $190,000 difference, that's what.
It's true. Spending one dollar a day (instead of investing it) for 40 years - a normal working career - on sodas, candy bars, even the daily newspaper, translates to $190,000 that you won't have when you retire. Can you afford to throw away nearly two hundred grand? Because that's what you're doing by buying that soda or ice cream.
Under The New Rules of Money, you simply are not in daily control over most of the money you spend. That is why it is crucial that you carefully allocate the money that is in your control. So the next time you reach for that soda on the supermarket shelf, or head to the fast-food joint, or subscribe to all the premium channels on cable, ask yourself one simple question: Is this expense going to help you achieve your financial goals?
Rule #15: Forget about buying a starter home.
That headline might be misleading, because I'm not sure that buying a "starter" home ever made any sense. When did this idea start, anyway? And what's the point of it?
The idea is that you buy a small, inexpensive home - usually when you're single or newly married - with the intent to sell in a few years. Ostensibly, your income will have grown by then, allowing you to afford a larger, more expensive home, or by then you'll have started having kids and the needs of your growing family will simply demand a bigger house.
You see this concept frequently put into action by young couples. They buy a condo or a townhouse, and then they sell it in a few short years, and move into a single-family house.
From a financial perspective, this makes absolutely no sense. Consider:
Newlyweds Bill and Susan were renting an apartment for $650 per month. He was earning $20,000; she $25,000. They had no children, but figured that would change someday. Based on their combined income, they were able to qualify for a $120,000 mortgage, so they took their $3,000 in savings, borrowed $15,000 more borrowed from Bill's parents, and started looking to buy a house.
It didn't take long to find one (about two weekends, actually ) - a new end-unit townhouse, in a new community not far from the center of town (well, not too far, anyway). They put down 10% ($13,000), leaving them with a $117,000 mortgage at 8%. The monthly cost: $858 plus taxes and insurance. Not bad, considering the rent on Susan's apartment was $650. Besides, they figured, the mortgage payment would give them a hefty tax deduction they didn't get from renting.
Like all first-time homebuyers, they were excited but nervous - yet confident that they could afford the house. After all, they considered everything, hadn't they?
They discovered their first miscalculation on settlement day. The settlement agent showed them the total costs involved, and it turned out that they needed cash for a lot more than just the $13,000 down payment. When they got approved for their loan, they were worried that interest rates might rise, and therefore Bill and Susan had agreed to pay 2½ points to lock in that 8% rate - but they forgot that doing so meant they had to pay an additional $2,925 right now, at settlement. It created a bit of a cash-flow crisis, but they told each other that it'd be worth it in the long run, because paying the points enabled them to obtain a lower interest rate, which in turn lowered their monthly mortgage payment. There were other charges, to, so the total settlement costs - including the points - came to about $19,000, or $6,000 more than they had anticipated. Susan wrote a check.
Next came the move. The first expense was renting a truck ($500). Then, after a long day aided by friends paid in the form of pizza and beer, they finally finished. Susan decided to take her first shower in their new home, and Bill, with his last bit of energy, collapsed onto the bed. Suddenly, Susan screamed, and Bill bolted upright and darted into the bathroom.
"I can't use this bathroom!" Susan shrieked.
"What's the matter?" Bill asked, quickly scanning the master bath for signs of a problem.
"Look!" Susan yelled, waving her arm at the far wall. Bill looked. He turned to Susan, then looked at the wall again. "What?" he asked, unable to see the problem. He knew his next sentence would land him in trouble. "I don't see anything."
"There are no curtains in here!" Susan yelled, pointing to the unadorned windows. "Our neighbors can see us from across the yard!"
She was right. By purchasing a new home, it had no curtains on the windows, and no blinds. Bill tacked a couple of bath towels onto the wall, covering the windows for the night. The next morning, he headed for Home Depot. He came home with blinds for every window in the house, plus contact paper to line the shelves in the kitchen cabinets, along with door mats, a hose, and sundry other items. Cost: $350. "Well," Bill said to himself as he reached for his VISA at the register, "this certainly wasn't expected."
Nor did he expect the sight that he beheld outside his house the next Saturday. Every family, it seemed, was busy gardening. Susan, acting like she had just come from a Monty Python movie, was already talking shrubbery. Bill knew he'd soon be returning to the Depot.
Several months and nearly $1,000 later, Bill and Susan had become expert landscape designers. It's money well spent, they figured, for the new bushes and flagstone would certainly add to the property's value.
So will all the paint we're buying, they said as they began covering their home's rental-white walls with more pleasing colors - the kind that an owner would have. They spent $175 on paint and materials.
During their first summer, they bought a lawn mower ($300); that winter, a snowblower ($400).
Over the next four years, they added a deck ($3,000), track lighting in the living room ($1,200) and chair rail in the dining room ($350). They bought a grill for the deck, and continued to upgrade the flowered planters alongside their sidewalk. They stopped counting how much they were spending, but it was a far cry more than the $675 Susan had paid in rent for her old apartment.
By now, they had one child and were preparing to have another. Increasing the number of people in the house by 50% when Cindee was born was challenging enough, but Susan was adamant that a second child would stretch their needs further than the home could handle.
"We need to move, Bill," she said one evening. Bill said nothing. His mental math was giving him a headache. He calculated that over the past four years they had spent about $25,000 in cash to buy, move into, decorate, maintain and improve their home. They also spent about $3,000 a year in property taxes (something renters don't have to pay). So, Bill figured, their total outlay had been $37,000, and to recoup that money, they'd have to list their townhouse for about $167,000.
When he added it up, Bill was upset with himself for having spent so much money to maintain a house that he knew from the beginning they wouldn't live in forever. At least they'd get most of it back when they sell, he figured, and they'd be able to use that money as a down payment on their next home.
Then their real estate agent, Carol, gave them some bad news. The real estate market has been soft for the past couple of years, she told them. There had been substantial overbuilding in the area, and there were many builders still constructing new townhomes. There were about a dozen units for sale on Bill and Susan's own street - including three of their same floor plan - and the two most recent sales were for $120,000, or $10,000 less than what Bill and Susan had just paid four years ago. And that was before counting all the extra money they spent. Nor did this include the real estate commission, which would lop off another 6% - $7,200 - from the total.
Their mortgage balance was now about $112,000 and, Carol told them, that's about what they could expect to net from the sale of the house. So if they still wanted to sell, she said, they would probably walk away with nothing. And they should consider themselves lucky that they won't actually have to bring money to the settlement table.
"That's happened to some of my other clients," Carol said.
Perhaps buying a starter home once made sense. Perhaps in the heyday of the 1980s, when real estate values were quickly escalating in pockets around the country, buying a home with the intention of flipping it in just a few years might have made sense. After all, if Bill and Susan's townhouse had grown by 8.2% per year, the property would now be worth $178,000 - exactly enough to let them pay the real estate commission and still walk away with the money they had spent on the place.
But assuming your home will grow in value at an annual rate of 8.2% is pure speculation. It's a poor basis for deciding to buy a home, and such a stance certainly does not work under The New Rules of Money.
Of course, Bill and Susan are now left with a dilemma. They need to move to a bigger home - and they can forget about getting money out of their current house to help them afford it. So what should they do? Should they sell the townhouse and take the loss, or rent it and wait for property values to recover? To find the answer, read the next Rule.
Rule #30: Know when it's time to stop climbing the mountain.
I was very impressed with Jack and Candy. When I first met them, Jack had already been retired for a year. Candy was a stay-at-home mom. They put five kids through college on his working-class salary, and have never received an inheritance. Still, they owned a portfolio worth more than $1.2 million.
"How'd you do it?" I asked. I love to hear rags-to-riches stories.
They looked at each other as if they didn't know, hoping the other would have the answer. "We just saved all our lives," Jack said rather embarrassed.
"We were careful with our money," Candy added sheepishly.
Careful indeed. Their portfolio consisted of several dozen blue chip and technology stocks, along with a smattering of stock mutual funds. There were virtually no bonds in the portfolio. "You've got a pretty aggressive portfolio here," I observed.
"Is it?" Jack asked rhetorically. "We just recognized that if we wanted our money to grow, we needed to own stocks."
Candy said, "But we were careful never to place too much money into any one investment."
"Well, it's obvious that you've done quite well. So what advice can I offer you?" I asked.
"Now that I'm retired, we'd like to earn more income from the portfolio," Jack answered. Scanning down their list of stocks showed that most of their stocks paid dividends of 2% or less. All told, they were receiving about $20,000 a year in dividend income. Not much to show for a $1.2 million portfolio.
"Well," I started, "we can increase your income easily enough. But it'll require you to sell most of your stocks and replace them with other investments. That means you'll incur some transaction costs and a tax liability. Are you willing to do that?"
"Sure," they replied. "Our investments have done well for us, but we understand that they might not be what's best for us today."
"Okay," I said. "Then let me tell you how we'll proceed." I described for them how we'd replace their pure stock portfolio with one containing all nine major asset classes. And we'd use mutual funds, which have a feature called the Systematic Withdrawal Program, which allows you to receive a monthly income. Through a SWP, they could receive an income of 7% to 8% per year. Through these changes, I estimated that their income would increase to about $75,000 per year, or roughly four times more than their current income.
They didn't look happy.
"You want to put some of our money into bonds?" Candy asked.
"Yes, and real estate, too." I replied. "Also gold, natural resources and some international securities as well. We need to build for you a highly diversified portfolio, to help reduce your exposure to the U.S. stock market and stabilize your portfolio. This will help insure that the portfolio will be able to produce the income you want on a more consistent basis."
"But how much will a portfolio like this grow?" Jack asked.
"Well, anything can happen in any given year," I answered. "But historically, over long periods, portfolios like these have always produced competitive returns. Of course, that doesn't mean that this will occur in the future. But at the least, you shouldn't expect much growth, Jack, because you'll be withdrawing money from the portfolio at the rate of 8% per year. So even if the portfolio earns 10%, you'll only have 2% growth after you get your income."
Now they were looking truly dismayed.
"We were hoping to see the portfolio grow to about $2 million. Maybe we should just leave everything in stocks."
"But if you do that," I reminded them, "you'll be stuck with the same $20,000 income that you get now. The only way to boost your income is to convert the portfolio into investments that produce more income, or to slowly sell some of your stocks and use the proceeds as a substitute for income. But that's much more aggressive, since a decline in the stock market could seriously undermine your ability to do that."
"But we're used to watching our assets grow in value each year," Candy persisted.
"I know, and thank goodness, too," I explained. "But, Candy, you have to understand that you are no longer in the same situation as before."
"What do you mean?" they asked, almost in unison.
"Well, you two have devoted a lifetime to building and accumulating wealth. You've done an absolutely terrific job at it, too. Few other Americans have been able to save as much money as the two of you did, especially considering that you started with as little as you did.
"But those days are gone. You no longer need to save and accumulate money. You've already done that. Now, it's time to start enjoying the money."
They didn't look like they understood, so I continued.
"Look at it this way. It's like you've spent a lifetime climbing a mountain. Well, now you've reached the top of that mountain, and the actions you now need to take to stay on top are different from the actions you needed to take to get you there. If you keep climbing like you've been, you'll fall down the other side!"
This made sense to them, so they took my advice and are now enjoying themselves immensely.