Saturday, June 20, 2015

Two Problem Children

In dealing with individuals who are threatened by their financial problems I find I almost always meet with resistance on two points, convincing them that a problem with debt can’t be solved with more debt and the threat of living on a budget.

With the exception of medical expenses, debt is a free will decision. You didn’t have to sign up for that credit card. No one held a gun to your head and made you carry a balance on the thing. You didn’t have to run up the average $29,000 student loan bill. Working a $15 per hour a job while living at home could generate that kind of money without any interest, dividends, or capital gains. Note: This is another bad example of an average. Many students graduate with a zero balance. You certainly didn’t need to take out the $27,000 average car loan. A $3,000 car can get you back and forth to work for a few years until you can afford to buy something better. Even a mortgage is a decision that needs to be balanced against the cost of equivalent rent and a clearheaded evaluation of the risk of foreclosure.

God lists debt as a part of the curse. He also states the ability to lend money is a blessing. Do you want to be a part of the blessing or part of the curse?

When asked, Warren Buffet as well as a number of his billionaire buddies state the best financial decision that a young person can make is the decision to avoid debt like the plague. If you find yourself in debt, don’t beat yourself up about it; instead make a plan on how to get out of debt.

That brings us to the budget. If your net worth is dropping on a regular unplanned basis, you have a problem. You need to be living on some kind of budget. If you don’t manage your money, it is a certainty that over time your lack of money will come to manage you. The full press monthly zero sum budget is the gold standard. Why monthly? Because it is likely that most of your bills, including rent, car payments, credit card statements, and utility bills arrive in your mailbox once a month. The prospect of planning for and living on a to the penny monthly budget isn’t a pleasant prospect, but neither is bankruptcy court or a visit from the repo-man in the middle of the night.

If you are seriously ill you are in need of serious medicine.

Is there a simpler way? This blog is not a one size fits all, my way or the highway financial class. It is an opportunity to explore different pathways to financial freedom. If you can make it work there are options short of the zero sum budget. You can start by tracking your expenses (every one of them to the penny) for a month. Not only will this simple exercise lead you in the direction of mindfully choosing how you use your money rather than throwing it this way or that on impulse, it will also begin the budgeting practice in your mind as you decide whether or not you really want to explain a $5.00 latte to yourself when you can’t make the minimum payment on your credit card balance.

I have proposed the lazy man’s quick and dirty budget test. Just list your monthly take home pay on one side of the page. Then on the other side of the page list all your expenses in broad simple categories to the best of your ability without spending a lot of time on the process.

Here is a quick and dirty scale to go with this quick and dirty budget.

Green Light: If you are living on 70% or less of your take home pay
Amber Light: If you are living on 90% or less of your take home pay
Red Light: If you are spending more than 90% of your take home pay

If this simple exercise produces an amber or a red light, you need to consider stronger medicine.

Richard Jenkins proposes the 60% solution as a sound method of budgeting that is actually easy to practice. The goal is to live on 60% of your gross income. This money covers the basics food, clothing, essential household expenses, insurance, charity, all bills (including nonessentials like music lessons for the kids or cable TV), and taxes.

The remaining 40% is divided up in priority order as follows:

1) 10% Retirement. In the author’s case, this all went into his 401K.

2) 10% Long term savings. This amount should be automatically deducted from your pay. You should never see it. It should be relatively illiquid. If it takes a little work and a couple of days to get at this money you are less likely to use it.

3) 10% Short term savings for irregular but somewhat predictable expenses such as Christmas, vacations, car repair, and new appliances. This money should be held is something like a money market fund that makes it easy to spend when it is needed.

4) 10% Fun money. This money can be wasted on whatever suits your fancy. Maybe you might want to think about a pink checkbook for the wife and a blue checkbook for the husband for this one.

The author admits that this method will not work in every case because sometimes more than 60% of your gross income is already spent at the beginning of the month.

Unless you are rich enough that your accountants perform this service for you on a quarterly basis, calculate your liquid net worth on the first day of every month. There is nothing that can tell you so much about the direction and magnitude of your financial vector with so little effort.

Just add up all your liquid assets, bank accounts, brokerage accounts, retirement accounts and such. Don’t include the value of any physical possessions, such as cars, furniture, appliances, or your house in this calculation. Even though your stuff is worth something, everything but the house is a depreciating asset that you are currently using. If you sell something then you can add that money to your liquid assets.

Then subtract the balance on all your loans and credit card balances except for the mortgage. The resulting number is your liquid net worth. If it is getting more positive on a regular basis, you are probably doing OK. If this number is headed in a negative direction, especially if you don’t know why, chances are you need to live on a formal monthly zero sum budget. Once you know where all your account user names and passwords are located this process should not take longer than 30 minutes a month.

Treat the question your mortgage (remaining interest and principal) and the equity in your home as a separate calculation.

Then there is always the envelope system (physical envelopes containing cash or digital envelopes containing digital money). This system has proven itself for about 100 years. An actual factual envelope containing cash is particularly good for problem areas like restaurants or cigarettes.

No money in the envelope? No smokes.

Your excuses don’t matter. They are not going to make your world a better place.

If you believe you have to have credit card balances, you won’t solve your problems.

If you believe you have to have a new car even if you can’t pay cash, you won’t solve your problems.

If you believe you have to borrow $100,000 in order to have a life, say goodbye to the first ten years of your adult life, even if you are lucky enough to find a good job.

Don’t tell yourself you don’t earn enough to budget. If you can’t learn how to budget $20,000 a year, you won’t do any better on $40,000 a year. There are people living paycheck to paycheck who earn $100,000 a year or more.

Don’t tell yourself you can’t budget because you live on an irregular income. The budget forms for irregular income exist. Learn how to use them.

“They” want debt slaves and tax donkeys. They want victims.

Instead of taking the easy path that leads to destruction, wake up and become free.

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