The Financial Genome Project (FGP) is an ambitious project designed to map out the entire financial genome. It’s a comparison to the Human Genome Project. Too many of us try to navigate through the financial world without knowing where we’re going. It’s like playing Monopoly with a group of friends and not knowing all the rules.
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“As soon as the land of any country has all become private property, the landlords, like all other men, love to reap where they never sowed, and demand a rent even for its natural produce.” ~Adam Smith, Wealth of Nations In Chapter 8 – Renting, we discussed reasons why renting makes financial sense: it’s for … Continue reading "Chapter 20 – Exploring the Rental Market" The post Chapter 20 – Exploring the Rental Market appeared first on Financial Genome...
“As soon as the land of any country has all become private property, the landlords, like all other men, love to reap where they never sowed, and demand a rent even for its natural produce.” ~Adam Smith, Wealth of Nations
In Chapter 8 – Renting, we discussed reasons why renting makes financial sense: it’s for the short term, you may not have enough money for a solid down payment, or it’s the rare case that the cost of renting is cheaper than buying. Additionally, some people don’t want the liability of a mortgage or they like the freedom of renting. Either way, in this chapter, we’ll further explore the rental market.
Normal financial advice recommends all housing costs should account for/take up no more than 35% of your (post-tax) income. We discussed this principle in depth in Chapter 7 – Housing. When you’re renting, the costs normally include the initial security deposit (usually amounting to the cost of one month’s rent), monthly rent, and utilities not covered by the property (or rental contract). You don’t have to pay for any repairs except for some minor wear and tear, but renters should carefully read the details of the contract for specifics of repair responsibility. Some renters treat the property like it’s their own, however, others may have little regard for the property. For many property owners, having tenants destroying their property is their #1 fear of owning a property.
If you are a property owner, you calculate rental yield by 12 months of rent divided by the value of the home. If you plan on renting out your property, you should consider the average rental yields for your state. Rental yields are affected by interest rates, and the market’s supply and demand. Most property owners look for passive income generated by renting their property, and capital appreciation of the property by using the rental income to pay down the mortgage and/or the home value going up over time. If you’re a renter, you’re providing the rental income, while the house may or may not appreciate. Property owners retain all the risk and profits of the rental, while the renter retains less risk but typically doesn’t “profit” by renting.
Although it’s rare, some cities with little demand for home ownership may see mortgage costs exceed rental costs. In this case, renters profit off the opportunity cost (or gain in this case) by choosing the cheaper option. This is a trade off between renting and buying: over the long term, renting doesn’t contribute towards the renter’s net worth, but there’s also a lot less risk or liability incurred.
Remember in Chapter 8 – Renting we discussed that there are different types of property owners. You have an owner, which is an individual that owns one or several properties; private investors are companies that invest in properties to rent out; and public companies which invest in properties such as Real Estate Investment Trusts (REIT).
In Chapter 19 – Economic Power of an Individual we discussed that you have economic power in the financial genome. As a renter, you have a lot of power over an individual property owner that owns a single property. Bad renters can cause significant damage, they may not pay or be late on rent, or they can continuously call for repairs that are basic wear and tear. For those who own many properties, risk is decreased as there are more properties that may have good renters, depending on how good the tenant screen policies are. Without proper screen policies, the risk may increase if there are more renters. Conversely, being a good renter to that individual with one property can positively impact the owner and contribute to his or her future financial goals.
We discussed that people can positively or negatively influence your financial goals as well. As there are good and bad renters, there are also good and bad property owners. For example, I rented a house from an elderly property owner who did not use a property management company and it was an unpleasant experience for my family. He was unresponsive to maintenance issues and difficult to work through administrative processes.
Some property management companies professionally manage apartments or condos and can provide a pleasant, professional experience, while some company portfolios are so large that customer satisfaction is irrelevant to the company, leading to a negative experience for the renter. Similar to my experience with my property owner, these companies can also be unresponsive to maintenance issues or have complicated contracts leaving tenants with outrageous miscellaneous costs.
I’d like to discuss the economic power and influence a property owner and a renter have on the financial genome separately. But before I can do that, I want to discuss how money works. This will be a subject discussed in many Financial Genome chapters in the future.
In most developed countries, we have central banks that uses fractional reserve banking. This means someone deposits $100 in a bank and then the bank can use $900 in loans. So, at any time, any bank in a developed country only actually has a fraction in reserves. We as humans all agree that the $900 is real and is part of different types of money calculations. Similarly, as a property owner, you gave a bank a deposit and they give you a loan to buy a property. The only actual money is the initial reserve in issuing bank and the deposit the property owner gave the bank.
The bank uses a small amount of deposit (its reserve) to lend a large amount of money to property owners to give to other banks. The receiving banks can then use that money to make other larger loans. The real money is paid monthly with interest back to the banks. All the other money is tracked with modern accounting, enforced by our laws, and our acceptance in the process.
THE PROPERTY OWNER
As mentioned above, property owners could be individuals, private companies that own many properties, or public companies (REITs). The owner may or may not have a loan on the property, but will always pay property taxes. Under ideal conditions, the rent charged covers the loan payment, escrow, taxes, possibly a property manager, and profit.
From an annual average high of 16.63% in 1981 to an annual average low of 3.66% in 2012, interest rates on loans and the down-payment requirements were so low that it was more financially advantageous to buy a house than to rent. Now that interest rates are increasing and down-payment requirements are increasing, renting may become more viable. However, the biggest factor facing property owners is they own all the risk.
Property owner risk comes from the possibility of defaulting on the mortgage loan, property damage, and defaulting on taxes. The traditional “American Dream” means owning a house. While I believe home ownership is an essential part of financial planning, it must be at the right time and under the right conditions, or else comes with the risks I mentioned above, possibly destroying your financial plans. Vanilla, mainstream financial advice often carelessly minimizes the real risk owning a property.
For example, if you buy a stock for $5,000, you face the risk of losing the entire $5,000. But you are protected from losing more than that initial investment. If you mortgage a property that’s overvalued, then you face the risk of losing money you never had in the first place. For example, you buy an overvalued house for $300,000 and the real estate market drops, you may now own a house that is only worth $200,000, but you STILL have a $300,000 mortgage on a property that you can only sell for $200,000! You just assumed a $100,000 loss on the mortgage loan. You’ll remember that this reality came true for millions of Americans in the 2008 housing and financial collapse.
Owning properties allows you to exert influence on others in many ways, the first being by setting rent prices. If you own only a few properties, then the rent charged is limited to what the market will allow for your location. If you own many properties or own a company that owns many properties, then you can influence the overall market. Large private and public companies can not only influence the local rent market, but they can drive the overall market, increasing or decreasing rent prices as they’d like to increase profits.
Some individuals, companies, and REITs do exactly this: they buy up as many properties as they can for a location and then choose the rent price they want for the type of tenants they want. Some companies buy apartments or single-family homes, partnering with the United States Housing and Urban Development (HUD) office. The intent is to provide low-cost housing for people in need. This program is great, but comes with risks. Sometimes the low-cost housing tenants have little regard for the homes or apartments. Also, in the case of my own hometown, the affordable housing brings crime and entitlement abusers.
A 2016 Standford Graduate School of Business analysis shows that low-income housing installed in low-income neighborhoods can boost property values, while low-income housing installed in high-income neighborhoods can decrease property values. Housing availability is the main driver in prices. When there’s limited supply, demand increases, so home prices increase.
Another way property owners exert influence is through Homeowner Associations (HOAs). Many suburban communities have HOAs that allow property owners to control what happens in the neighborhood through voting systems, where property owners have one vote per property owned in the neighborhood. When companies own many properties in one neighborhood, they are able to control the future, for better or worse, of the neighborhood. This program may prove useful in maintaining the look, feel, and value of a neighborhood, but it too comes with risks. Some companies have used their power and control to keep communities segregated or increase the rents so high that they control the demographics to upper-middle income households. You can read examples of HOAs infringing the rights of homeowners at this link.
Renting out properties is a great way to earn passive income through the principle called other people’s money, and is a key principle of becoming wealthy. You use a small amount of money for a down payment and then rent out the property. The rent may earn you a profit and someone else’s money pays the mortgage. The equity you’re building is yours to keep for savings or additional investment.
There’s a lot of vanilla financial advice that I disagree with, and one of them is “renting is throwing your money away.” Like I said in Chapter 8 (http://financialgenomeproject.net/2017/09/24/financial-genome-project-chapter-8/), there are several reasons why renting can make more financial sense than buying a home. One of the reasons we’ve already explained above and that is home owners exposing themselves to liability. When you rent a home, the initial cash outlay you have is the security deposit, usually one month’s rent, and any utilities you may have to turn on or transfer into your name. Assuming you’re a good tenant, you’re likely get the security deposit back when you vacate the property.
Some jobs, like the military, require you to move frequently, and so renting can be a good option. It’s important for the economy to have a healthy amount of renters; too much home ownership can over-commoditize the housing market. This is where homeowners treat properties solely as profit-making investments instead of providing a basic human need for housing. Additionally, a healthy renting market empowers renters and ensures they have equitable rights.
Many financial planners compare effective retirement planning to a 4-legged chair. One of the “legs” of the chair, is to retire with no mortgage and/or have some passive rental income. If you rent too long, and don’t purchase property, that leg of your retirement plan may be missing. If you’re renting and have a longing to invest in the housing market without actually buying a property, you can buy REIT stocks. REITs have done relatively well because of the high-dividend yields they offer.
UPDATED FINANCIAL GENOME
Below is the updated financial genome. If you’re a homeowner, your rent should cover the mortgage and escrow which goes to your lender, property taxes, which often goes to your lender and are paid on your behalf. Additionally, if there’s profit, it will come to you as income. If you’re a renter, your rent goes to the property owner to be disbursed above.
The key takeaway is owning your own home is an essential part of a sound financial plan, but not always the best decision as determined by your personal financial position. Renting can be a good option if you move frequently, are saving for a down payment, are uncomfortable with the liability, or the market is more favorable for renters.
“You had said that you saw no difference between economic and political power, between the power of money and the power of guns… You are learning the difference now.” ~Galt’s Speech, For the New IntellectualIn my first chapter, I told you that YOU, the individual, are the most important part of the financial genome. Then … Continue reading "Chapter 19 – Economic Power of an Individual" The post Chapter 19 – Economic Power of an Individual appeared first on...
“You had said that you saw no difference between economic and political power, between the power of money and the power of guns… You are learning the difference now.” ~Galt’s Speech, For the New Intellectual
In my first chapter, I told you that YOU, the individual, are the most important part of the financial genome. Then we started the Financial Genome Project with you working and earning a salary, and some of the salary taxes taken out. We spent the last several chapters discussing the various types of expenses you will have. In the following several chapters, we’ll start to look at how we exert influence in the financial genome. We’ll really dig into Individual Economic Power.
We can exert influence by having power and by how much wealth we have. The more we understand about the financial genome, the greater the power we can have and/or the greater wealth we can amass. The good news is that you can control the influence you have on the financial genome. The bad news is that others can exert their influence on you.
WHAT IS INFLUENCE?
I consider influence as the ability to impact other people in the financial genome. We do this by our daily interactions in our roles as laborers, consumers, savers, investors, and with the power our occupations and positions give us.
The entire financial genome is designed by humans. We created the rules, the laws, and the systems. It’s a giant, complex system built on trust, reinforced by the consequences of not following these rules and laws. We give a single person an insane amount of economic power over hundreds, thousands, and millions of people. If the system were to collapse, that person would not have any true power. As money becomes completely digital, we rely on financial databases keeping track of, to many of us, an invisible financial ledger. It’s a complete system of trust.
Power and wealth are not always mutually exclusive. I think Showtime’s “Billions” captures the difference perfectly. One person has immense power as the Attorney General, but he is not necessarily rich; the other person has immense wealth as a hedge fund manager. People with power can exert influence on the financial genome by passing laws and changing systems and processes. People with wealth can generate more wealth at a faster pace than the less wealthy, just because that’s how our system is designed. Ever hear the saying, “it takes money to make money?” This wealth can be used to influence those in power.
People in power can exert influence on you. We give family members, peers, bosses, employers, businesses, CEOs, and politicians the ability to positively or negatively influence us. The intent of this website is to give you insight on how others have power over you and how they can impact your place in the financial genome.
The most extreme example is the economic power the United States Federal Reserve Chairman has. The Federal Reserve’s mission is to “foster the stability, integrity, and efficiency of the nation’s monetary, financial, and payment systems so as to promote optimal macroeconomic performance.” The Federal Reserve’s weapon of choice is decreasing and increasing interest rates. The smallest fractional change in the US’ interest rates can cause ripple effects across the entire world. The Chairman is usually not a wealthy person, relative to corporate wealth; yet, same may argue the Chairman is the most powerful person in the world.
We see the power of wealth everyday. People with money live different lives than people without money. The more money someone has, the more influence they may have on others. An extreme example of wealth is when Warren Buffett invested $5B in Goldman Sachs in 2008, convincing America that the economy was still stable. Another recent example is LeBron James’ investment into a school program he calls iPromise in Akron, Ohio.
Power and wealth have the ability to create and destroy. The more power and/or wealth you have, the more you can influence others. In most developed countries, the financial systems reward those with money and power with more money and power. The good news is, if you understand how these systems work, you can get power and wealth in the same way. Understanding how the financial system works is the first step and is my primary goal of this website.
SO, WHAT DOES THIS HAVE TO DO WITH ME?
No matter how little power or money you may think you have, YOU STILL CAN POSITIVELY INFLUENCE OTHERS. Every dollar you spend or save is a vote on what you feel is important in the financial genome, and in your circle of influence. Each dollar you save gets you closer to financial freedom and retirement. Each dollar you spend is either consumed immediately, purchases a depreciating asset, or an appreciating asset.
Purchases like entertainment and travel are consumed immediately. You receive nothing tangible in return for the exchange of your money. You receive intangibles like memories and stress relief though. Purchases like cars and clothes are depreciating assets. You receive assets but they immediately depreciate, and for the most part, you can never resell them for more than you bought them for. Purchases like houses and rental properties can appreciate. If bought at the right time, these assets can be sold at a greater price than what you bought them for, thus increasing your wealth.
We discussed the economic multiplier in many different chapters, but we’ll cover it in more detail here. An economic multiplier is when there’s a greater output than the original amount spent. In simpler words, when you spend money, it multiplies and has a greater effect throughout the financial genome. This is one of the reasons why local businesses and your friends and family doing Multi-Level Marketing (MLM) businesses become overbearing when you choose to spend your money at a major store.
The multiplier is felt more for a local business or family member’s MLM. When you buy something from a major store, your purchase is just one of millions or billions of sales, for a local business it could be the only sale it receives that day. Local businesses and MLM operators feel the loss greater as well. Unfortunately, MLMs like Pampered Chef, Scentsy, and Younique, offer goods that are more expensive than the major stores.
This is where you get to vote with your dollars. This is where your power, and your wealth, exert influence on others. If you buy a $2 wax candle at Wal-Mart, then you’re voting for bigger corporations with lower-cost goods. If you buy the same wax candle for $8 from a friend with the MLM, Scentsy, then you’re voting to support your friend for a higher-priced good. It’s a difficult choice.
For most of us, the influence we have on others disperses and grows weaker as it travels through the financial genome. Where you decide to shop has a bigger influence on local businesses than it does on major corporations. Amazon has had a negative influence on local businesses, but has provided us with cheaper goods and convenience. We have voted for Amazon’s dominance over local businesses with the money we spend.
It’s the same with voting in elections. Your vote has a big impact on your city elections, but it lessens as you vote on county, state, and federal elections. Citizens are authorized to contribute $2,700 to a single candidate’s campaign. This $2,700 means a lot more to a town’s mayoral election than it does to the U.S. Presidential election.
In the previous chapters, we went through the most common expenses that consume our income. If you haven’t already contributed, read the Variable Expense chapter and add an expense you’d like discussed. In the next several chapters, we’re going to explore each expense in greater detail. We’re going to unravel and explore all the connections you have with each expense.
In some cases, you’ll have the ability to influence others with your power and income, and in some cases, you’ll have barely any influence. For example, gas is a common expense for many people living in a developed country. Gas is a homogenous commodity. This is when the product is indistinguishable from other supplies, and we usually buy the cheapest product available. There is almost no brand loyalty, and as such, gas companies usually rely on rewards program to lure customers in. Refer to my Rewards and Referrals chapter for more information.
It’s in the small details where I believe we can find the best personal finance lessons, and use positively use our influence. It’s also in these small details where we can protect ourselves against others that may exert negative influence on us. I look forward to the next several chapters, and I hope you do too.
“Beware of little expenses. A small leak will sink a great ship.” ~Benjamin FranklinIn chapter 15, we discussed the difference between fixed and variable expenses. We went through fixed expenses such as housing, food, and clothing. Then we went through the fixed-variable expenses which should be fixed but can vary depending on lifestyle choices. Examples … Continue reading "Chapter 18 – Variable Expenses" The post Chapter 18 – Variable Expenses appeared first on...
“Beware of little expenses. A small leak will sink a great ship.” ~Benjamin Franklin
In chapter 15, we discussed the difference between fixed and variable expenses. We went through fixed expenses such as housing, food, and clothing. Then we went through the fixed-variable expenses which should be fixed but can vary depending on lifestyle choices. Examples include transportation and saving AT LEAST 10% of your income. In this chapter, I’d like to discuss a variety of other expenses that are purely variable. You have complete control over these types of expenses, and if your financial situation starts to get strained or you want to increase your savings rate, you can reduce or eliminate these.
“Bring the whole tithe into the storehouse, that there may be food in my house. Test me in this,” says the LORD almighty, “and see if I will not throw open the floodgates of heaven and pour out so much blessing that there will not be room enough to store it.” (Malachi 3:10) I feel it’s important to talk about this initially because if you’re a Christian, then tithing is fixed, and it’s 10% of your income BEFORE any other expenses. The point of this chapter is not to get into a theological debate, and we will dissect religious finances in much later chapters. Just a quick fact to whet the appetite, the Vatican Bank has about $8 billion in assets. Religious entities are major centers of gravity in the financial genome.
Entertainment may be the easiest place to reduce or eliminate expenses if you’re struggling with finances or looking to increase your savings rate. I would caution eliminating all your entertainment. Like we’ve discussed in previous chapters, budgeting can be like dieting, and it can be hard. If you don’t allow yourself some entertainment, then you may find budgeting to be too difficult. Or worse, you may regress and spend more than you were originally. Common examples are movies, video games, music, board games, and sporting events. We’ll explore all of these in future chapters as each one of these is a billion-dollar industry.
INTERNET, PHONE SERVICE, AND TELEVISION SERVICES
Some would argue that living a normal, modern life requires internet and phone service. This may be true, but you can certainly reduce your expenses for these variable expenses as well. For many people, internet expenses have become akin to car or home insurance: they don’t understand what they’re paying for, and often end up spending too much for services they don’t use. Sometimes cutting internet services to the basic package can save a lot of money.
The prices we pay are for the phone themselves (and sometimes the added insurance), data, text messaging, and on the seemingly rare occasion, actual cell phone service. The phones and plans are incredibly expensive and mobile phone usage becomes ubiquitous for every human.
Not having the right plan can be costly. If you exceed your data limits, the overage charges are punishing. The type of plan needed is specific to each person and each family. The author of Creating Commas blog saved $112 a month by reducing the plan. The author also calculated that the total savings was $33,641 using a common “25 times your annual salary” calculation. Most people save money by not upgrading to the newest phones and/or reducing data usage by maximizing free Wi-Fi or the Wi-Fi you already have at home.
Sometimes internet, phone, and television services can be duplicative, and we pay too much money for all of them. It seems increasingly popular to reduce or eliminate the television or cable services first and just use streaming services like Netflix or Hulu. The author of the Poorer Than You blog switched to streaming services back in 2009—probably saving quite a bit of money this last decade. Television/cable providers are true oligopolies, where few companies control the majority of the market share and take advantage of rapid prices increases instead of pure competition which can reduce prices. You basically only have the choice between DISH Network, DirectTV, or a cable provider. These companies lure you in with small introductory rates then rapidly increase the prices and/or limit services. It’s no wonder why so many people are ditching these companies and moving to streaming services.
Daycare expenses can be costly. For 25 years, daycare prices have outpaced inflation. While it may seem facetious, each year you wait to have kids, the more expensive they will be. Often times, couples find themselves “working just to work.” This means that when the second person gets a job, his or her pay is equal to the incurred expenses one has because of the job – meaning, daycare, transportation costs, clothing, and meals out with coworkers. This shouldn’t stop people from getting a job because you can still gain work experience and compete for promotions. Day care becomes fixed if both people of a couple are working or a single parent works, but having kids is an option so I put it as one of the variable expenses. Once you have kids, the related expenses become fixed. Here’s a great article on why and how the author of the Chief Mom Officer blog chose to save money on daycare.
VACATION SPENDING (Added: 7 Jul 18)
A reader suggested vacation spending. Some may consider vacations as part of entertainment, but I feel it deserves its own section. Vacations are important for mental health—especially when traveling to different countries is involved. Traveling to foreign countries has been the favorite part of my military service. The average vacation costs $1,145 ($4,580 for a family of 4). There are too many variables to specifically write about all the possibilities of saving money when vacationing. Before you do travel though, do a quick Google search on saving money at your specific location (i.e., “Saving money on a Las Vegas vacation”). There are hundreds, sometimes thousands, of articles on how to save money while traveling.
SELF CARE/BEAUTY PRODUCTS (Added: 7 Jul 18)
A reader suggested self care and/or beauty products. As a male personal finance blogger, you may assume I would recommend eliminating self care or beauty products first, to save more money. Full disclosure though, I spend nearly $50 on beauty products a month. I take self care, healthy eating, and fitness seriously. Just like investing, small investments when you’re young can pay huge dividends when you’re older. Taking care of your skin when your young is easier than worrying about it when you’re older. Our spending habits in America agree with that statement as well. 24% of those surveyed spend over $100 on beauty products when they are 18-29 years old; compared to 18% for 30-59 and only 8% for those 60 years and older. If you want to increase your savings rate, this is a good place to reduce expenses, but I don’t recommend eliminating it.
I NEED YOUR HELP!
This list is not inclusive, and I’d like to keep it updated with suggestions from readers! What expenses do you consider variable? Tell me about your variable expenses, and what decisions you’ve made to cut back on them by contacting me through this blog by leaving comments, or through my Facebook or Twitter accounts. If you’d like to be featured, be sure to leave your social media information!
“Only when borrowers have access to efficient credit networks can they escape from the clutches of loan sharks, and only when savers can deposit their money in reliable banks can it be channeled from the idle rich to the industrious poor.” ~Niall Ferguson, The Ascent of MoneyIn the last several chapters, we discussed housing, food, … Continue reading "Chapter 17 – Why Debt Is So Bad" The post Chapter 17 – Why Debt Is So Bad appeared first on Financial Genome...
“Only when borrowers have access to efficient credit networks can they escape from the clutches of loan sharks, and only when savers can deposit their money in reliable banks can it be channeled from the idle rich to the industrious poor.”
~Niall Ferguson, The Ascent of Money
In the last several chapters, we discussed housing, food, clothing, and transportation expenses, as well as saving AT LEAST 10% of your income. Based off the standard advice discussed in those chapters, you may/should have already spent 60 – 70% of your income on these expenses. If you have debt (excluding your mortgage), you’ll have to add this as an expense as well. So why is debt so bad? Debt is so bad because it exposes you to many risks and can be like a noose around your neck. As your debt increases, interest rates rise, your income reduces, or you experience an emergency, the minimum payments can increase and it will tighten the noose and may force you to reduce other expenses until possible bankruptcy. Before we go too far, though, let’s look at what debt really is and how it started.
HOW IT ALL STARTED
Debt truly started when banks started using fractional reserve banking concepts. This is an important concept to understand because it impacts interest rates. Fractional reserve banking is where a bank has (for example) deposits and uses those as a “reserve” to issue loans in excess of its deposits. People don’t often need immediate access to their money, so banks can take on additional loans. These banks of deposit started as early as the 1200s with Alexander the Great in Damascus and Barcelona in the 1400s. The true start of banking as we know it today started in Venice in the late 1300s.
The banks loan you this money so you can buy things you may not have cash for. The two types of debt are installment loans and variable-rate loans. Installment loans are normally your mortgages, student loans, and car loans. Variable-rate loans are normally your credit cards, adjustable-rate mortgages, and student loans. Installment loans have a fixed rate and the interest is “front-loaded” into the loan, so the bank gets its money sooner. This process is called amortization. The amount of interest you pay upfront can be shocking to first-time home buyers. I’m well read on the banking process and personal finances, and the mortgage process still shocks me. Before buying your first home, Google an amortization calculator and see how little your mortgage actually goes to paying down principal for the first 5-10 years.
Variable-rate loans are assessed a monthly interest rate based off the current interest rates, and a minimum payment is required. Your authorized credit is based off your income and credit score. Depending on the type of loan, your interest may be front loaded or evenly split through the life of the loan.
Valueless instruments are given to another person for an exchange of goods that are valueless themselves. Instead of exchanging goods like food for leather, a patron can give a seller something that is inherently valueless that represents value. There is a long history of these exchanges going back to the prehistoric days where Mesopotamians used clay tablets to conduct trade. Then coins were produced in the Roman times. Credit coins and charge plats were used in the 1800s and then finally credit cards in the 1950s.
This is a very quick overview on the origins of banking and issuing debt. We’ll dedicate several chapters on the banking industry once we’re done discussing most of the major expenses people typically have. The key takeaway is, in the current banking system, we use fractional banking which allows a bank to loan out money above and beyond what it has in deposit reserves. To keep deposits, banks pay interest to keep your money in the bank so they can loan out more money. There is typically a large spread between the low amount banks pay in interest for deposits and the high amount banks charge in interest for loans. This is called the net interest rate spread—the spread is never in your favor and is always in the bank’s favor.
SO WHY IS DEBT SO BAD?
Like mentioned above, being in debt exposes you to many risks. The most common risk, and the one I’m most concerned with in the immediate future, is interest rate risk. This is where rising interest rates limit your access to housing, cars, and possibly student loans. This is also a concern for the people spending 100% of their paycheck at current interest rates—barely making it to the next paycheck and only making minimum payments. If the interest rates rise, the minimum payments will increase as well.
Higher interest rates can make the cost of homes and cars go up drastically. The U.S.’ long-term interest rate hit an all-time high in 1981 and then went down to nearly zero from 2008-2015. The U.S. was even remotely considering a Negative Interest Rate Policy (NIRP) where we’re charged to keep our money in the bank. This is because our entire U.S. economy is dependent on people getting loans and immediately consuming things. For us to get out of a recession our only hope was excessive consumerism and debt. In 2016, interest rates started to increase. Banks immediately changed their loans and interest rates to continuously keep the net interest rate spread in their favor. So, the first reason why debt is so bad is because you’re exposed to interest rate risk, mainly with variable-rate loans. Depending on the interest-rate environment, fixed loans can protect you from the risk of rising interest rates. In the picture below, we see how rising interest rates increase your payments and can reduce the money you have available for other expenses and savings.
Another reason why debt is so bad is because you become dependent to the “system” of debt. Once we get into debt, we must work and/or earn an income. It’s the same philosophy behind taxes. Once you venture out on your own, you must work and/or earn an income and pay taxes. To become financially independent, you must make the money you save and earn make money itself from retirement plans, interest, dividends, and side job. So we get a job and our income becomes our means. We then voluntarily decide how we live from there.
Some live below our means, where our expenses are lower than our income and we save the discretionary income. We become financially independent earlier than the “system” recommends. Some live within in our means where our expenses (to include AT LEAST 10% savings) is exactly our income. We become part of the system and retire when it allows us to. Unfortunately, many people live above their means and rely heavily on loans and credit cards. For example, in the housing chapter we discussed that all housing expenses, to include your mortgage or rent, should not exceed 30% of your income. Below your means is well below 30%, within your means is 30%, and above your means is above 30%. If you’re living within or above your means and something happens to your job, then you’re at risk of financial ruin.
Your job is always at risk no matter what industry you’re in and being in debt exposes you to this risk greatly. To reduce costs, many companies outsource or automate operations. Industries are always at risk to new technologies that can make entire industries disappear. The economy can change and we can experience high unemployment. There are hundreds of risks to any job in any industry. If you live exactly within your means or above your means, then you’ll continually need to maintain those means.
And this is exactly why debt is so bad. If you use debt incorrectly, like many people do, you basically become a battery to the system and can’t unplug. Many of us accept this fate—but what if you hate your current job or what if an emergency in your life happens? To clarify, mortgages and student loans can be considered an investment. Wealthy people use debt as a tool, and when used wisely, can magnify your returns. Mortgages within your means, or rental properties, can give us equity, and passive income, as time goes on and higher education can yield higher paychecks, better benefits, and more stable employment. Home buying and choosing which degree (and its resulting debt) are lifestyle choices we can choose to make.
People who become debt free often claim that a weight has been lifted off their shoulders. People who are in debt often claim to feel a heavy burden or, as I mentioned above, like a noose is around their necks which is slowly tightening. The entire system benefits creditors, and fractional-reserve banking can create massive corruption and disruptions. Being debt free allows you to unplug from the system (except for taxes). As we discuss other expenses, know that increased debt payments, whether by higher interest rates or disruption to your income, can eat into your voluntary expenses such as entertainment, travel, and short- and long-term goals.
“Cars are lousy investments; they never rise in value.” ~Suze OrmanIn the last chapter, we discussed the difference between fixed and variable costs and how budgets can help you track those. We’ll use the next couple of chapters to discuss various expenses. The first variable expenses you have almost total control over are your transportation … Continue reading "Chapter 16 – Transportation Expenses" The post Chapter 16 – Transportation Expenses appeared first on...
“Cars are lousy investments; they never rise in value.” ~Suze Orman
In the last chapter, we discussed the difference between fixed and variable costs and how budgets can help you track those. We’ll use the next couple of chapters to discuss various expenses. The first variable expenses you have almost total control over are your transportation expenses. Your first opportunity to influence control over transportation is the necessity. You have control over how much and what type of vehicle you need, or if you need a vehicle at all. The farther and more frequent you drive, the more reliable of a car you’ll need, and vice versa. Some people don’t use a car at all in locations where public transportation is readily available.
How much you should spend on your car? The vanilla, certified financial planning advice recommends the 20/4/10 rule. This states that you should make a down payment of at least 20%, finance a car for no more than four years, and not let your total transportation expenses exceed 10% of your gross income. Another popular vanilla advice is the total value of your car should not exceed half your yearly income. So if you make $50K a year, you should look for a $25K car or less. The most I’ve ever spent is 17% and my most recent car purchase was 8% of my gross annual income. It’s important to live within this framework or below, because making the wrong transportation decisions, like the majority of America does, can literally cost you millions. Check out this article in the blog, Modern Personal Finance, where the author shows you how continuously financing new cars can cost you millions.
The appetite for buying cars above our means is strong, and car dealerships and banks are more than happy to loan us the money to satisfy our appetites. The default rate is lower on auto loans than any other type of loans. As such, banks will even allow you to roll over loans above the value of a car by establishing negative equity. This is where you owe more than the car’s worth, and the dealer tacks more on top of the new car loan. For example, when he was 26, the author of the Chain of Wealth blog, bought a $30K car tacked with the $20K negative equity making him $50K in debt for a $30K car. This seems like a high amount of negative equity to me, but the total authorized amount of negative equity for 2018 is $5,100. States have various laws controlling how much can be rolled over each time you trade in a vehicle. This rolling over negative equity is a major contributor to the all-time record high for auto loan lending. Total American debt keeps reaching all-time, records highs at $1.22 TRILLION, at the end of the fourth quarter of 2017.
BUYING VS. FINANCING
A big decision for many of us is to decide between buying a car outright or financing a car. My focus is not to help you make that decision, but just provide useful information, because there are too many variables. Plus, like we’ve discussed in many chapters, there is a behavioral aspect to financial decisions. Some people really like cars and keep them as their life’s major focus. For a good article about buying a used car, check out this article on the Hungry Being blog. Additionally, here’s 5 tips on how to buy a car from a former salesman on the Get Rich Quick’ish blog. Most people recommend the following order: 1) Purchase a reasonable used car in cash. 2) Finance a reasonable used car using the 20/4/10 rule. 3) Purchase a nice car outright, not to exceed 50% of your gross income. 4) Finance a nice car using the 20/4/10 rule.
Buying a car outright isn’t always the best return on investment. As we’ve discussed many times, all financial decisions come with an opportunity cost. Check out this article on why the author of the Win at Life Finance blog loves his car payment. In the current low-interest rate environment, he’s able to get a higher rate of return on the money he invests than he would’ve if he bought his cars outright. As long as the return on investment is greater than the interest on the loan and the car’s depreciation, then investing the money can be a better investment. Cars depreciate quickly, and it doesn’t make sense to spend money on maintenance costs while also paying down a car loan. Banks now offer a 7-year (84-month) loan. According to Bankrate.com, the downside of these loans are a greater cost over time (more interest paid over a longer time), depreciation (9% percent immediately, 20% one-year later, 63% by 5 years), and paying for repair issues while still paying for the loan. Like I said, there are too many variables for me to help you make a personal decision.
THE AUTO INDUSTRY
There are three ways people typically buy or finance a car. The most common method is to go to an auto dealership or its internet site. Auto dealerships are typically owned by franchisees. According to the National Automobile Dealers Association (NADA), the average franchise cost is $11.3 MILLION. Most dealerships offer new cars directly from the manufacturer and used cars of all types. They buy the used cars when you trade them in or at special auctions. In this case, the dealership makes profit, and the manufacturer makes money.
The next most common way is to sell it yourself, known as a private purchase or peer-to-peer. Under normal conditions, sellers can get more money by privately selling a car versus a trade in at an auto dealership. You can see the price differences by going to Kelley Blue Book (www.kbb.com) and compare the Private Party Value to the Trade-In Value. Selling cars on websites is also becoming popular. Craiglist.com is the most commonly used website to sell cars privately. In this case, because of the rapid depreciation of cars, the seller doesn’t necessarily make a profit, but he or she receives money in exchange for the car.
These used to be the only two ways to purchase cars until Tesla Motors began selling luxury electric cars directly to consumers. This caused major controversy at the federal and state level, with many states banning the practice altogether. In 2015, the Federal Trade Commission supported Tesla, a new startup company called Elio Motors, and the direct sales model; however, also recommended regulating it closely. The FTC concluded, “Absent some legitimate public purpose, consumers would be better served if the choice of distribution method were left to motor vehicle manufacturers and the consumers to whom they sell their products.” In this case, the manufacturer profits from the sale.
We’ll explore the auto industry in more detail in future chapters. The auto industry faced a crisis in 2008 at the same time as the housing market. Exactly like the banking industry, the auto industry consolidated as big companies bought smaller or struggling companies. We’ll explore the auto industry family in later chapters.
To implement the 20/4/10 rule, you need to track your expenses to ensure you’re not spending more than 10% of your annual gross income on transportation expenses. Some people confuse not having a car payment with saving money on transportation expenses, while they spend more than 10% of their gross income on repair costs. Here’s the current financial genome.
“Look everywhere you can to cut a little bit from your expenses. It will all add up to a meaningful sum.” ~Suze OrmanTo this point, we’ve discussed what I feel are the fixed costs: housing, food, and clothing. In the last chapter, we discussed saving at LEAST 10% of your paycheck. I consider the remaining … Continue reading "Chapter 15 – Do You Need A Budget?" The post Chapter 15 – Do You Need A Budget? appeared first on Financial Genome...
“Look everywhere you can to cut a little bit from your expenses. It will all add up to a meaningful sum.” ~Suze Orman
To this point, we’ve discussed what I feel are the fixed costs: housing, food, and clothing. In the last chapter, we discussed saving at LEAST 10% of your paycheck. I consider the remaining expenses variable costs. You have control over these costs. You definitely need to track your remaining expenses, but do you need a budget? Let’s look at the difference between fixed and variable costs and then decide, if you personally, need a budget.
In terms of expenses, fixed costs are expenses that we must pay and have little influence over. We have influence of what kind of housing we choose, but shelter is a necessary fixed expense including your mortgage or rent, insurance, and the utilities that come with it. In the housing chapter, we discussed that all these costs should be 35% or less of your income. You also have a lot of control over your food and clothing expenses; however, you MUST eat and, at least in the American culture, you MUST wear clothes. Although I call those expenses fixed, people can find the most savings in these areas. I would also like to change our culture to believe that saving at least 10% of your income is a must too. The 10% can be considered fixed, but you can and should save more.
In my opinion, all your other expenses in life are variable costs. You can choose to have these expenses and choose what percentage of your income they will be. The most common are transportation, gas, entertainment, internet, and TV service. I’m a firm believer in tracking all your expenses. Knowing where your money is going at all times is the key to financial success. The closer you track your expenses, the more control you’ll experience. In this blogpost from the Simplified Motherhood blog, the author gives us 58 of the most common budgeting categories that can help you better track your expenses. The further you breakdown your expenses, the deeper you’ll have control. But the real question here is, do you need a budget?
DO YOU NEED A BUDGET?
For most people, I highly recommend a budget. The more detailed the budget, the better. You simply track all your expenses for 30 days and then create a budget. We discussed all the apps and methods for tracking your expenses in this chapter. Once you’ve tracked your expenses, create your budget. This may involve spending less on some expenses, so you can spend more on others. After a couple of months, revisit your budget. After nearly two decades of helping people with their personal finances, I’ve found that some people do not do well with budgets. Building a budget is as simple as listing your income to the left, and then list out your expenses to the right. You can see how much money is allocated to each expense and make adjustments as needed.
For some, budgets become stressful and feel like dieting. To lose weight, many people seek the newest diets, suffer for a couple of weeks, and then go back to their old ways. This creates a negative Pavlovian response to dieting and makes it increasingly difficult to attempt dieting in the future. I have found that people respond the same to budgeting. If you want to properly control your finances without a budget, you have to keep good track of your expenses. On her blog, I’m Poorer Than You, the author states simply, “I just track and plan.” She just tracks what she spends, plans out future expenses, and then knows what’s normal and what’s not normal. I’d argue that this is still a budget, she just has enough expenses to track it all in her head. Same with the author of Reaching for FI, who admits to not having a budget but “meticulously” tracks spending via an app called Personal Capital.
Some people are also worried about apps and software having access to all their personal finance data. Apps and software that track your expenses are considered aggregators. They aggregate all the accounts you give them access to and then they track your expenses, investments, and savings for you. Capital One and Chase both warn that they aren’t liable if your information is hacked while using a third-party software. That being said, many of these apps are secured using the same methods as the banks that warn you about using them. The risk may zero sum, while the risk for some people of having not having a budget may be great.
Like the blog The Simple Dollar writes, “When you don’t have a budget, getting into debt is a piece of cake.” This is because we lose track of small expenses that add up quickly. One I’ve noticed in the military is snack bar expenses. A fifty-cent soda for lunch and a dollar candy bar in the afternoon. Then the next day, something for breakfast, lunch, and the afternoon. At the end of the month you’ve spent $30-$45. Increasing interest rates on credit cards is another thing people lose track of.
My emergency savings account bank is generous and lets me know when my savings account interest rates have been increased. They send an e-mail like this.
Unfortunately for credit card holders, you don’t get the same message when your credit card interest rates rise. As the Federal Reserve increases interest rates, so do credit cards. Credit card interest rates rise quicker than savings account interest rates. Three years ago, the national average for credit card interest rates were 14.89%, a year ago they were 15.44%, and now they’re at 16.41%. If you’re not tracking them closely, your minimum payments can keep increasing and you could be going further in debt. Maintaining a budget can help you keep track of all the moving pieces. The only problem I have with budgets is how people interpret fixed and variable costs.
I once helped a person that had a tight budget and put actual cash into individual envelopes. She would put $20 in her entertainment envelope and $20 in her dining out envelope every two weeks, among all her other expenses. The entertainment and dining out expenses became fixed costs for her. If at the end of the week she didn’t spend $20 on entertainment, she would go somewhere and blow it on something not value added. She could’ve saved that money or used it to pay down debt. Her budget busted when she had some car problems that were greater than her emergency savings account. She came to me when she was struggling week to week, barely making it to the next paycheck. I was happy to see a budget, but surprised that she “couldn’t find savings anywhere in her budget.” She felt that since she had a budget, those expenses were all fixed and couldn’t be reduced.
So, do you need a budget? It’s a personal choice. For most people, I highly recommend a budget. You can let the free apps I discussed in the tracking expenses chapter create and maintain your budget or develop your own. There are many free budgeting tools on the internet. If you choose not to create an actual budget, then make sure you’re keeping a keen eye on all your expenses. We won’t go into each expense here, but I plan to give the rest of the expenses their own chapters. For example, I’d like to explore transportation in its own chapter.
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