Last week we talked about some tips for reducing your basic living expenses. This week we'll discuss what financial planners call 'discretionary', or optional, spending.
The Fine Print
The articles in this series do not offer specific financial advice. Instead they will present financial tips, with occasional smart-aleck observations and commentary, that may or may not be useful in the reader's particular situation. You should always seek advice from a professional who is familiar with your personal circumstances before acting on any of the information presented in this series.
No Shortage of Ideas
As I mentioned last week, many advisers suggest that we plan for our monthly expenses, with about half of our take-home pay going toward the necessities, about 30% toward things that we'd like to have and the remainder toward improving our financial health. I won't talk too much about the things we'd like to have but don't need to keep body and soul together. Most people have no trouble coming up with interesting uses for their money, and there are some fairly obvious ways to economise in order to be able to afford more. For example, those of us unable to pass a bookstore without going inside can finance their book habit through regular visits to the local library, saving their money for books that they want for personal collections. Many cities and towns have programmes that offer free or inexpensive activities for children or older adults, and a university is often a treasure trove of free and stimulating activities. The alert spender can find plenty of options for cutting costs to stretch his entertainment money.
Good Debt, Bad Debt
The last 20% or so of your take-home pay should go toward creating a safety net for your family. This means 1) getting out of debt; and 2) creating a nest egg to help smooth over life's bumpy patches.
We'll talk about debt first, since it seems to be the fastest road to financial misadventure. First off, there is good debt and bad debt. The good kind can be thought of as an investment in your future; examples include a mortgage that allows you to buy a house and loans to further your education. In such cases you end up with an asset: a house that you will either live in (eventually) rent-free or sell, and an education that allows you to get a better job. Bad debt, on the other hand, is basically a method of transferring your hard-earned money into the pockets of people who already have a lot more than you do. It is also a method of paying way too much for consumer goods. Let's look at a person who decides he wants the latest-and-greatest big-screen TV1. He can't afford to pay cash for the TV, but he figures that if he uses his credit card, he can make the minimum monthly payment and eventually pay off the debt. Here are the eye-popping details of this deal, using typical prices and percentages found in the US today:
- Purchase price of the TV, including taxes: $3209
- Credit card interest rate: 18.5%
- Minimum monthly payment: $48.14 (calculated at 1.5%)
- Time needed to pay for the TV: 601 months (just over 50 years!)
- Total amount of finance charges paid: $33778.77
- What the TV really cost: $36987.77
What many consumers don't understand is the effect of compounding on interest payments; this is what sends the total amount of interest through the roof. One interesting thing I discovered during this exercise: several on-line calculators wouldn't accept the calculated minimum as a payment because the balance became unacceptably large! That oh-so-attractive minimum payment that many credit card companies trumpet as a selling point is in fact a tar pit that traps the unwary in perpetual debt. It's easy to see how people can get themselves into real trouble while not being particularly extravagant.
My personal rule of thumb for debt is: going into debt in order to purchase an appreciating asset like a house or an education is a sensible thing to do, but all other debt should be approached warily if at all. Of course it's possible to take on too much 'good debt' as well. If you do find yourself up to your ears in debt, there are things you can do short of declaring bankruptcy to get yourself out of the mess. There is a lot to be said on this topic, and it will get a more thorough discussion in the future. For now I'll just comment that, in order to secure your financial future, the most effective thing you can do is to whittle down the amount of bad debt you've accumulated, so this should be your first order of business.
Saving and Investment
Once you've got your debts under control, it's time to consider building a nest egg. Financial advisers generally recommend having two separate 'pots' of money. The first is money you've put away for a rainy day, so to speak, that can cover several months of your current expenses. The amount can vary, depending on your financial commitments and how secure you feel your job is. Obviously someone who is working at a high-tech start-up company that can go bust at any time or who may have to endure a long period of unemployment should set aside more than someone who is working at a fairly secure job or who could find another position fairly quickly. Similarly someone who is supporting a family and paying a mortgage should set aside more than an unmarried, childless person who is renting a flat.
This 'rainy day' money should be in a form that is easily accessed and where its value is not at risk, such as in a savings or money market account. Some people are tempted to invest their emergency money in the stock market to make it grow quickly. This is a mistake, as they may need the money just when the market has fallen. (In fact there seems to be a Murphy's Law of investing that says the market will always fall when you need the money.) So think 'dull and safe' for your emergency stash.
The second pot of money consists of your savings toward your retirement. Nowadays in the US, the traditional pension that provides an income for the remainder of a retired person's life is going the way of the dodo bird. Together with our lengthening life spans and increasing medical costs, these factors mean that the average person who doesn't want to work until he drops dead will need to amass a sizable nest egg. Fortunately there are a number of programs that make saving for retirement an attractive option. Some programs like a 401(k) plan2 or traditional IRA3 are tax-deferred, which means the worker pays no taxes on the money that he sets aside until he actually withdraws money from the account. This allows his account to grow much faster than an account that is taxable. Another program called a Roth IRA is taxed immediately but the earnings on the account are completely free of taxes. (The rules governing these accounts are actually more complicated than this, and deciding which of the programmes is right for you involves sitting down with spreadsheets or other financial calculators and a crystal ball to help determine future events. The topic deserves its own article and will be covered in the future.)
In short, though, saving for retirement is a good idea and you want your retirement funds to grow as much as possible. There are a whole host of places for you to invest your retirement funds and, in fact, the mutual fund industry in the US owes its phenomenal growth to workers saving for their retirements. There is a lot to be said about appropriate investments and this will be a topic for more articles in the future. In summary, though, here are my basic rules for investing wisely:
Time is your friend. The earlier you start to save, the better. It is almost impossible to make up for the years in which you didn't save unless your income rises dramatically and you save most of it.
Any investment has to be right for you. Owning stock is one of the best ways to grow that nest egg, but a lot of people are leery of it. If worrying about your money keeps you awake at night, you need to put it into something less volatile. This is perfectly OK. Don't let anybody make you feel stupid or guilty because you don't trust a particular investment.
Low-risk means low returns (or earnings). High-risk means potentially high returns. There are no exceptions to this rule. If someone tries to interest you in an investment that is 'guaranteed!!! high returns!! with no risk to your principle', run away.
If you don't understand it, don't put your money into it.
As with all things financial, there are a lot of complications (and yes, they'll be topics for future articles). The what-ifs, the why-nots and the yes-no-maybes of investing keep the financial services industry gainfully employed and often scare off the average person who may not have the time or desire to understand all of it. However, just about everybody can understand the four basic rules I've listed and these basics can help to steer you in the right direction and help you evaluate any advice you're given.
Next week: buying vs leasing.
References and More Ideas
Bankrate.com offers free financial calculators — in particular check out the various credit card calculators.
Sound Money is a radio program in the US that offers information on a wide variety of topics related to personal finance,