In my opinion having a realistic perspective of what exactly an asset is will go a long way toward keeping you out of financial trouble. It’s a word we through around a lot (particularly if we’re sophisticated), yet too often it’s attached to the wrong thing. I’m not sure when it happens, but somewhere along the road of life we’re programmed with a somewhat misleading representation of what assets are.
In the strictest sense of the word assets are things you own, and liabilities are things you owe. So your net worth would be your assets minus your liabilities (what you own minus what you owe). For example if you took out a $15,000 loan to buy a $20,000 car then you have a $20,000 asset and a $15,000 liability. Same thing for a house – a $100,000 loan for a $120,000 house means you have a $120,000 asset and a $100,000 liability.
We’re in the black in these two examples right? Yes. If we’re sticking to accounting rules then both the car (you owe money on) and the house (with a mortgage) would go on the left side of the balance sheet – assets.
This kind of reasoning from academia can get you in a lot of trouble in my opinion. Real life isn’t as simple as which side of the balance sheet something goes on and this simplistic (not sophisticated) view isn’t painting a complete picture.
When dealing with personal finance I think Robert Kiyosaki has more accurate definitions:
An asset is something that makes you money. A liability is something that costs you money.
Let’s go back to that $20,000 car. Anyone have a car that makes them money? Unless you’re running a escort chaffeur service your car is costing you every month in repair, maintenance, and operational costs. And what about your home, isn’t that the biggest investment most people will ever make (according to real estate commercials)? I hope not. Your home has huge maintenance and tax bills accompanying it monthly as well.
I’m not disagreeing that you can sell either of those and get more then you owe, but I am arguing that these are costing you money to possess. When you think about assets from this perspective you’ll be much more likely to avoid biting off too much. Want to trade up to a $500,000 house? Maybe, but that’s quite a liability (even if it’s paid for).
So don’t just look at the left side of your balance sheet without taking into account what kind of cash-flow those things are generating. Your income (not your assets) is your most powerful wealth building tool. That’s why we pay off debt fast, and that’s why we take a good hard look at what is really an asset.
If you’ve spent much time on this site or asked me any questions about handling money you know that I always go back to the Financial Blueprint. It’s such a powerful framework to help you make smart decisions with your priorities. Well there’s one time when you should take a step back from whatever blueprint step you’re working on and focus on something else – when there’s trouble on the horizon.
If you spot trouble (or potential trouble) on the horizon it’s time to shift your focus a bit. The new highest priority becomes bulking up your emergency fund. If you’re paying off debt in Step 2 then go back to minimum payments. If you’re saving for retirement or kids college then cut it off. Even if you’ve already passed Step 3 and you’ve got a fully funded emergency fund, go ahead and build it up more. Whatever you’re working on, hit the pause button and pile up as much savings as you can until the skies are clear.
For example, in May I decided to leave my job running the operations for a web startup. It was a great job at an awesome company, but it wasn’t a good fit for my life anymore so it was time to move on. I had about 8 weeks leading up to my final day so we could see potential trouble on the horizon. What if I couldn’t get another job immediately? What would it be like without my paycheck coming in every month? Our priorities had changed (at least temporarily).
Our focus for those 8 weeks was on piling up cash because storm clouds were building on the horizon. Now I certainly won’t say it was easy, but we knew it was the smart thing to do. We had planned to vacation in Mexico in August, but suddenly that didn’t fit in with our new priorities. There were home improvement projects we were excited about that had to be postponed indefinitely. It was difficult to put these things off when we had plenty of cash saved!
My final day rolled around and I still didn’t have a new job lined up. I can’t say it was an awesome feeling, but it did feel good that we were prepared for this possibility and it allowed us to relax and make better decisions. I remember the horrific, shocked looks people gave me when I told them I left my job and didn’t have another one lined up yet. In retrospect we’re so thankful we didn’t go to Mexico. We’re thankful we didn’t get a new TV or repaint the upstairs. Because who would’ve thought we’d wind up here five months later?
Long story short, I decided to take some time working full-time on Bedrock Coaching and I’m loving it. Things would be a whole lot different right now if it we hadn’t prepared for this possibility. We may have missed a beach getaway and our guests are still sleeping on an air mattress, but our lives are stable in the midst of uncertainty. Our marriage has grown stronger during this time instead of suffered cracks from stress.
When you see storm clouds on the horizon it’s time to get to work building shelter. If the storm never comes then just take that extra cash and throw it at whatever blueprint step you’re working on. And if it does start pouring then being prepared could make all the difference in the world.
No matter who you are or how much money you have there’s a good chance you’ve experienced the deprivation cycle. It’s that feeling of entitlement that you need and deserve something because of x or y. Work was tough today so I’m going out to happy hour. I haven’t spent money on ME lately so I’m cashing in on a new video game. This is something that I have to battle with often even though I consider myself to be great at handling money.
On Friday afternoons I have a habit of treating myself to a tasty burger or sandwich at a local eatery. Since I work at home most of the time I cherish the chance to be out mingling with the rest of the world and of course I never pass up a tasty meal! It’s fun for me. So fun in fact I’ve caught myself wondering if food is filling some sort of void in my life. Good news, it’s just filling me and providing me with a fun reason to be out.
The hard part for me comes at the end of the month when my food envelope is a little low. I’ve got plans to take my wife out for dinner this weekend and I don’t have enough cash to eat lunch out Friday and take her out. So what do I do now? This is when the deprivation cycle kicks in. Dr. Maria Nemeth describes the deprivation cycle like this:
Doing/Working hard -> Feeling tired/deprived -> Rationalizations -> Spending Money -> [repeat]
The “I deserve it” attitude can provide a reason to buy almost anything! It’s such a powerful force that even though I’ve studied it I still find myself at Firehouse Subs ordering a large hook and ladder because I’ve had a hard week and I need to get out and enjoy the world a little bit. It’s costly to consume this way and has caused me to bust my budget on way too many occasions.
Dr. Nemeth continues:
To make matters worse, we have to build up to this “deprivation state” in order to get enough punch to justify our demands. It’s often this very state that interferes with our enjoyment.
What to Do About It
Everyone is different and what works for some may not work for others. Here are a few strategies to try to overcome the deprivation cycle.
- Get Tough – Now that you know about the deprivation cycle you’ll start to recognize the pattern in your own life. Don’t let it overcome you!
- Refocus – For me a good strategy is to refocus on my goals. If I overspend in one category it limits my progress toward my goal. If my goal is big enough it can easily keep me in check.
- Establish True Values – Dr. Nemeth suggests figuring out what is really of value to you. If your house were to burn down and you had two minutes to gather anything you wanted to keep, then what would you grab? Use these as clues towards what you ultimately value in life. Knowing this can help you break the “must have -> must work -> must have” cycle that consumes us.
I’m not saying it’s wrong to treat yourself every now and then, but making a habit of it can cause you to spend significantly more than you should. It’s one thing if you’ve got the money and are still on track to meet your goals, but too many of us are off track because of this cycle.
Do you ever find yourself spending because you deserve it? What helps you break this cycle?
If you’ve got access to IRAs, 401(k)s, and Roth accounts then where is the best place to put your money? It’s probably not immediately clear from the pros and cons, but there’s a straight forward method to ensure you’re getting the most from your accounts.
In Step 4 of the Financial Blueprint we start saving 15% of our pre-tax income for retirement. This may sound high to some people and it will probably feel high if you’re not doing these steps in order. For those of you who cut out retirement savings (like you were supposed to) to work these steps in the optimum order, this is where you will catch up and blow by those who tried to do too much at once.
So the first step is easy. Figure out how much you need to be saving.
- Take 15% of your pre-tax income (what’s on your W-2) and divide it by 12. That’s how much you need to save each month.
Get the Full Match
Now you need to figure out which accounts to invest in. If your employer’s 401(k) plan offers a match incentive then you don’t want to pass that up. For example, they may offer to contribute 50 cents for every dollar you invest up to 6 percent of your income (“match 50% up to 3%” in their jargon). That means that if your take home pay was $5,000 a month, and you invested 6% of that into your 401(k) ($300), your employer would kick in $150 (3%) as a match.
If your employer doesn’t offer a 401(k) or doesn’t match it then just skip this part.
Get the Tax Savings
Next comes my favorite accounts: Roth IRAs! If you invest $416 a month ($5,000 a year) for 35 years for retirement in a Roth account earning between 8% and 10% interest then you’ll have over a million dollars. Because you saved it in a Roth account however all the taxes have been paid. It’s all yours to keep! How great is that! That’s why the next place to save for retirement is in a Roth IRA account.
- If you’re taking advantage of a 401(k) plan from the first step, then figure out how much more money you need to invest to get to the full 15% of your pre-tax income.
- Now use your Roth IRA to save as much as you can! You can only contribute $5,000 annually (as of 2010) to these accounts (if you’re married you can each have your own Roth IRA so that’s $5,000 each).
Top it Off
If you’ve gone through the 401(k) match (or skipped it), maxed out your Roth IRA(s), and still need someplace to invest to get to the full 15% savings goal, then go back to the 401(k). Because of the higher contribution limits on a 401(k) most people can easily finish their 15% pre-tax savings here.
Method to the Madness
As I discussed in the Retirement Account Basics post, an IRA is a better place to save for retirement then a 401(k) because of the control. Your investment choices are only limited by your broker which means you can choose from the best funds available. 401(k)s have a very limited number of funds you can choose from and they frequently have fees you would really like to avoid. If you’re taking advantage of a free match from your company then that more then offsets these negatives, but otherwise we want to make the most of the tax-free Roth accounts first.
You’ve of course heard that it’s important to be saving for retirement, but the jargon and choices can be intimidating when you’re first getting started. It’s a shame our education system doesn’t teach us something that everyone must understand to retire, but at least we all know the chemical formula for salt (give it a second, you know it).
Retirement savings is different then regular savings because it’s set aside in it’s own account. These accounts are tax advantaged in one way or another to incentivize you to save (because we all know how awesome social security is). With a few exceptions, once you put money into retirement savings accounts it’s stuck there until you retire.
The most common types of retirement accounts are 401(k)s and an IRAs.
A 401(k) is an employer-sponsored retirement plan which means you can only invest in one if your work offers it. Each plan has a limited selection of investments you can choose from. When you participate in a 401(k) you designate the amount of money (or percentage of income) you want to contribute from each paycheck, and which funds you’d like to invest it in. Your employer takes that money, deposits it into your 401(k) account and it’s invested without you having to do a thing (other then setting it up in the first place).
It’s common for employers to incentivize employees to contribute to the plan by offering a match program. For example, they may offer to contribute 50 cents for every dollar you invest up to 5 percent of your income. That means that if your take home pay was $5,000 a month, and you invested 5% of that into your 401(k) ($250), your employer would kick in $125 as a match. Hey, free money!
- High annual contribution limits ($16,500 limit)
- Easy. Just set it up once through your employer and put it on autopilot
- Employers frequently match contributions
- Very limited investment choices (each plan is custom to the employer)
- Pay taxes at current income levels when you withdraw
- You can’t get one unless your employer offers it
While a 401(k) is an employer-sponsored plan an IRA (Individual Retirement Arrangement) is an individual plan. Anyone can open one of these accounts regardless of whether or not they already have a 401(k) or other retirement savings. An IRA is much more flexible then a 401(k) because your investment choices are not limited to the few included in the plan. You’re free to invest your IRA savings in any investment offered by your broker. This is a huge bonus because you’re free to select the best performing lowest cost investments which are not commonly offered in 401(k)s.
There are many subtle differences between 401(k)s and IRAs, but most are specific to niche situations. One big one though is contribution limits. In 2010 you can contribute up to $5000 annually to IRAs, but up to $16,500 to a 401(k).
- Invest in anything your broker offers
- Self managed
- You can get one regardless of employers retirement offerings
- Low annual contribution limits ($5,000)
- Self managed (it’s a con if you don’t do it!)
- Pay taxes at current income levels when you withdraw
No one likes to talk about taxes, but the difference in how retirement accounts are taxed is crucial to understand. Both IRAs and 401(k)s are “tax deferred” accounts. This means that the dollars you contribute to the plan have not been taxed (yet). Why would Uncle Sam be so generous? You will pay income tax on this money when you withdraw it at retirement.
IRA/401(k) investment -> then income tax -> then take home pay
Pay taxes when you withdraw money during retirement (income tax levels)
Roth accounts on the other hand are tax-free. When you invest money in a Roth IRA or a Roth 401(k) you do so after you pay income tax. When you withdraw the money at retirement however it’s tax free. This is one of the best deals the government gives you for saving!
Income tax -> then take home pay -> then Roth investments
Withdraw money tax free during retirement (you already paid the tax!)
As of 2010 everyone is allowed to take advantage of Roth IRAs (no more income limits). The pros and cons for Roth IRAs and Roth 401(k)s are the same as regular accounts. Basically the “Roth” part just modifies how taxes are paid on the account (and you thought this was going to be confusing).
Keep in mind these are just the accounts, not investments. Within these accounts you can hold stocks, bonds, mutual funds, and other types of investments depending on the plan.
When people hear the term opportunity cost they are transported magically back to their tenth grade economics class. Their eyes start to glaze over as they enter their mental time accelerator and wait to emerge on the other side of the “conversation.” Now I know no one wants to sit around and talk about opportunity cost, but it hits you where it counts so listen up.
Opportunity cost is really just what it sounds like. It’s an opportunity that you were cost by doing something. If the term was “dollar cost” I’d be talking about the number of dollars you had to give up to get something. If it were “Oreo cost” then it would be the number of Oreos you had to forgo to acquire an item. Ten Oreos might equal roughly three servings of cookies (okay okay, one awesome serving) and could maybe get part of your economics homework done for you.
So what is the opportunity cost of spending money? It’s the opportunities you must give up in exchange for an item. Opportunities? You mean there are other things I could do with this money other then make this one purchase? Of course! Let’s say for example you want to buy a $100 Obama collectors edition “fighting for change” action figure with freedom lightsaber. Twenty minutes ago (if you’re a slow reader) you would’ve said it costs $100, but now you’ve got to think a little harder about the opportunity cost.
Buying posable Obama costs you anything and everything else in the world you could do with $100. What about spending that money on a lawn guy for a month or two? Now it’s costing you 4 Saturdays of grass covered labor. Or what if it were an awesome date with your spouse? What about investing it for retirement (yawn)? Well now we’re really getting into some higher level opportunity cost thinking.
The point isn’t to make you feel guilty every time you spend money thinking of all the other things you could do with it. The point is to be aware of each dollar you spend knowing it’s true cost. President Obama costs a lot more then $100. It’s $100 + a date with your spouse + mowing the lawn for a month. If you add all those things up and you still want to buy it, awesome. Go for it. I hope it’s worth a fortune someday. But most times you’ll find the trinket you’ve got your eye on just isn’t quite worth the opportunities it will cost you.
What awesome, once in a lifetime purchases have you passed over recently in the name of opportunity cost?
For those who think $100 is a small price to pay for an Obama action figure, here you go
What exactly do people mean when they say that Wall Street caused the financial crisis. If the pin that burst the housing bubble was people defaulting on mortgages, then who’s to say anyone but the overextended home owner is to blame?
CNBC aired a show last week about the unsettling role Goldman Sachs played in the events leading up to the mortgage meltdown. They interviewed a city official from Cleveland who despised the financial giant because of the 10 thousand plus homes in foreclosure in his once fine city. Although Goldman didn’t originate the loans that razed Cleveland, many argue they added gasoline to the fire.
So why is no one picketing the hundreds of banks responsible for lending to homeowners unlikely to repay? How come no one is singling out specific banks the way Goldman is being attacked? The (short) answer is because of the secondary market.
When banks make mortgage loans they turn around and sell them immediately. Institutions who purchase these loans do so in huge quantities and sell them to investors as Mortgage Backed Securities. The bank that originated the loan now has it’s cash back to turn around and make another loan (thereby amplifying the poor decisions). Leading up to the mortgage meltdown investors appetites for mortgage backed securities was insatiable. The demand was so high that banks could sell even poor quality loans. If it weren’t for the secondary market the bank that originated the loan would be stuck with it for better or for worse.
So what do you think? If investors are demanding a product (Mortgage Backed Securities) and you can provide that product is the outcome really your responsibility? Isn’t supply and demand what makes capitalism such a powerful force?
How do you know when the time is right to take the plunge and purchase your first home? This is a very common question for first time home buyers and you will no doubt have an easy time finding differing opinions. The great thing about the answer I’m about to share with you is that it’s constant. The response isn’t influenced by prevailing interest rates or current housing inventory. Instead it’s based on a proven framework for success.
The right time to buy a home is when you’re out of debt and have a fully funded emergency fund (steps 1 through 3 of the Financial Blueprint). Having a strong foundation is essential to ensure your first home winds up being a blessing and not a curse. There will always be lawns to water, furniture to replace, and garage doors to repair. If you don’t have an emergency fund and are still servicing debts these inevitable duties will be a tremendous strain.
This always winds up being a touchy subject because people get so emotional about buying a home. My wife and I went through this right after we were married. We shopped online constantly and each day it seemed our target price increased a little bit more. Luckily we never contacted a realtor or actually went inside a home our I’m certain we would’ve been doomed.
Our culture is constantly telling us we need to buy a home.
“Stop throwing away money on rent!”
“Interest rates are at 30 year lows!”
“Now is the best time to buy a house in over 20 years!”
It’s hard to resist that message. But buying a home (and every other financial decision you make) should be based solely on your internal environment rather then the external environment. You buy a home when YOU are ready to buy a home.
As emotional as purchasing a home can be it’s crucial that you keep it in perspective. That’s one great thing about applying the Financial Blueprint to your decisions. It can take a difficult decision like “are we ready to buy a house” and allow you to objectively asses that goal against competing financial objectives.
Personal finance author Ramit Sethi (I Will Teach You To Be Rich) has a great mantra: Stop debating minutia. Our human nature loves to nit pick and debate the subtleties of decisions and methodologies. “Be sure you start your day with a high protein breakfast to help you slim down.” “Well actually, eating more omega-3s is much more important if you really want to take the weight off.”
I don’t know if the information overload paralyzes us or if we just love engaging in an academic debate, but we never act. We just talk and talk and talk until we’ve convinced ourselves that making an informed decision is impossible given the number of variables. We’d probably be better off just doing what we’re doing.
The 80/20 Rule
The 80/20 rule is this: 20% of your effort will be spent getting you 80% of the way there. However, 80% of your energy will be spent getting you the final 20% of the way. It takes so little effort to do a really good job, but so much effort to do a perfect job. When we debate the minutia of personal finances what we’re typically talking about is the very last bit that takes you from “really good” to “best plan ever.” We can see the effort required to get us there and we’re stalling out before we ever get going.
Instead of debating minutia let’s just get going. Let’s get a really good financial plan and do it. How about we go 80% of the way right now and worry about the 20% another time. How much should you invest overseas? How much should you keep in liquid savings? Should you pay off your debts smallest to largest, or largest to smallest (a common debate)? Don’t let these questions keep you from investing a dime or paying off any debts.
It’s more important to be moving all the time then to be right all the time – Seth Godin
One of the most important characteristics of successful people is intentionality. These people are happening to things instead of things happening to them. It’s so crucial to your success that it’s discussed over and over and over by success leaders. Zig Ziglar says “You can’t go through life as a wandering generality. You’ve got to become a meaningful specific!” And Dave Ramsey talks about how “most people go through life like Gomer Pyle on Valium.” To get where you want to go you’ve got to be intentional.
Money is no different. If you want to succeed with money then you’ve got to have a plan. You’ve got to have a vision. You’ve got to decide where you want to go and then start going that direction.
When I first graduated from college I practiced the “budgeting by balance” technique where you just check to see if there’s any money in the account before you buy something. I had a vague notion of a goal where I hoped to be able to transfer $500 to my savings account at the end of the month. I didn’t know where I was spending my money and I didn’t have a specific goal in mind.
If you aim at nothing you’ll hit it every time. – Zig Ziglar
Too many of us fall into this category. We know we want to do better, but we don’t know what that means. Example:
I want to save for a house.
How do you reach this goal? How do you plan for it? What do you need to do to get there? Better Example:
I want to save $10,000 for a down payment on a house this year.
Much better. Now I can back into how to get there. I know I need to save $833 a month to have $10,000 at the end of 12 months. Each month when I sit down to do my budget I know what the budget should be aiming towards. I know I need to make saving that $833 a priority in my budget or it’ll get devoured by restaurants and DVDs.
This is how it’s done. This is what I mean when I say you’ve got to be intentional with your money. It’s not enough to have a vague notion that you want to save $500 each month. It’s about identifying where you want to go and planning how to get there.