How To

Three Principles of Personal Finance: #1 Spend Less Than You Earn

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More than 10,000 books have been written about personal finance. You could spend a lifetime reading them. Some of them are great1; others are 99% motivation, 1% actual, actionable information2.

The truth is personal finance is simple. Every one of these books can be reduced into three basic principles:

  1. Spend less than you earn
  2. Make the money you have work for you
  3. Be prepared for the unexpected

While the principles might sound like common sense, the real trick is to truly understand them, and more importantly, to apply them.

Our Stance:

Mint.com was founded to make personal finance simple, understandable, and ultimately life-enhancing. Money, after all, is a means to an end. It’s a tool for doing more, and having more time. It’s not just about increasing your net worth or saving for retirement. As we say at Mint, money is for living.

Spend Less Than You Earn

Put another way, “spend less than you earn” means: live within your means, don’t overspend, don’t get yourself into debt and start saving. Easy to say, not so easy to do — especially given the appeal of a new car, a sweet home theater, a couple nights each week out with friends, and a posh tropical vacation every once in a while. You have a job for a reason — you want the good things life has to offer.

You could forgo dining out for cooking at home, always buy generic, get your clothes on sale at the end of the season, and save a few dollars whenever possible. But really there are four big decisions that affect your expenses (and therefore your ability to save for other things) more than anything else.

These are the areas where you need to go in understanding the costs involved, so that you come out remaining financially strong.

1. Buying a House

A house is likely the most expensive purchase you’ll ever make. And it’s not just the mortgage, its property taxes, home owner’s insurance, maintenance, and the time it takes to mow the lawn. Too many people think that buying a home is automatically a good investment, since you’re “not throwing money away on rent.” While owning a home of your own may be the American dream, it doesn’t always make economic sense.

If you live in California, the Northeast, or Southwest where housing prices have doubled or tripled in the last 10 years, it’s almost always better to rent and invest the difference (more on this in principal #2). Even if you live outside those regions, if you move within the next five years (and if you’re in your 20s that’s almost a certainty), the closing costs and 6% realtor fees will eat away your gains.

By contrast, if you plan to stay in the same area indefinitely, a house may be one of the best investments you make. To determine what’s right for you, I like the NY Times Rent vs. Buy Calculator. It’s the best one on the web, and easy to use: just enter your rent and the price to buy a comparable place3.

2. Kids (and when to have them)

Children can be an amazing source of joy in your life. If you’re planning to have some, it’s important to realize the expense involved, so you can make the best decision on when to do so.

Kids mean more money spent on a bigger house, a bigger car, food, clothes, healthcare, and education. The cost of raising a child calculator at BabyCenter does a good job of breaking things down by region and household income level. In today’s dollars, most estimates approach $200,000 per child (excluding college). That’s about $11,000 per year per child.

This cost can be lessened dramatically by waiting a few years. If you wait to have kids for 4 years, and instead invest that $11,000 per year at a 10% return, you would have $67,000 by time your child is born. As you begin to take $11,000 per year out for child-related expenses, part of your original investment continues to grow. In the 18 years spent raising your child, you will expend only $100,000 out of pocket. It’s like having a child at half the cost.

3. Where you live

You probably choose where to live based on job opportunities, proximity to family and friends, or a great climate. But where you live has a big impact on how much you can save. For example, if you make $75,000 a year in Austin, you would need to make $135,000 in San Francisco to maintain your lifestyle. That’s an 80% increase in cost of living. Unfortunately, moving from Austin to San Francisco, salaries typically increase by only 30%.

To compare major cities, I like BankRate’s cost of moving calculator. It shows the difference in housing costs, doctor’s appointments, and even the cost of a haircut.

4. Car (new or used)

Automobile manufacturers and dealers spent more than $16.3 billion in 2006 to convince you to buy a new car4. Seriously, that’s billion with a “b”. Let’s say you cave and decide to get a 2007 Chevy Malibu because it will “only” cost $20,000. Three years later, the car has depreciated by $10,500 and you’ve paid more than $3,500 in finance charges – a total expense of $14,000. If you bought a used 2004 Malibu instead, depreciation and finance charges add to only $3,800. That’s a $10,000 difference. You can see the calculation yourself at Edmunds.

Maybe you want something better than a Malibu. Buy a 2004 BMW 545i for $37,000 instead of the 2008 550i for $64,000. It will cost $27,000 less to buy used, and you’ll save $15,000 in depreciation and finance charges over the next 3 years. Always buy used, even if only last year’s model (I myself own a ’94 and a ’96). Impressing the neighbors (or the ladies) with an ever so slightly better model probably isn’t worth it.

Easy Ways to Maximize Your Savings

Beyond the “big four” financial decisions, there a few things everyone can do to maximize savings. And they can all be done without radically altering your lifestyle.

Get a credit card that pays you:

Always use a credit card – instead of a debit card, checks or cash – if you pay off your balance in full each month. A credit card gives you a 30-day interest free loan, more rewards, and in conjunction with a tool like Mint, better visibility into exactly where your money goes.

Turn the tables on your credit card company and make them pay you with a rewards card. Whether you opt for points, miles, or cash back is up to you, but don’t settle for anything less than 1% back (or 1 mile per dollar). Usually, you can do much better. American Express’ Blue Cash offers 5% cash back on purchases made at supermarkets, gas stations, and drugstores, and 1% on all other purchases. Citi’s Driver’s Edge card gives you 6% back on gas and groceries for the first 12 months.

The catch is that most cards offering 3-6% back have a cap on rewards. For the two cards above, you can earn up to $1,000 back each year but no more. Keeping track of all the restrictions, and calculating whether it’s better to get 3% on restaurants, or 5% on gas is difficult. Fortunately, Mint does all that work for you. Based on your unique spending categories, Mint finds the card that maximizes your rewards.

If you carry a balance on your credit card, maximizing your rewards is secondary. Paying down your debt comes first. A $5,000 credit card bill paid off at a $100 minimum monthly payment takes 9 years to pay off. In that time, you will have spent $5,100 in interest charges alone! You can do the calculation yourself at Yahoo Finance.

If you switch to a 0% introductory rate card (and keep switching when the introductory rate expires), that $100 a month payment means you’ll be debt free in less than half the time. Both the Discover More and Open Road cards charge no interest on balance transfers for the first 12 months and they offer rewards.

Upgrade your bank account:

This year, US banks are expected to charge consumers over $55 billion in fees5. To add insult to injury, the average savings account pays you only 0.50% interest (and most checking accounts earn no interest at all).

Banks work by accumulating deposits, then loaning that money out as a mortgage or to a business. Those loans are paid back at an interest rate that (as of September 2007) is typically around 6.00% ~ 9.00%. If the average bank pays you only 0.50%, they’re taking that difference as profit — profits that could go to you. Get a savings account like HSBC Direct or Capital One Bank that pays 5.00%+.

 

Better rates, better savings. Why settle for 0% from your checking or 0.50% from your savings? When compared to an account at 0.50%, a savings of $20,000 in a 5.00% account can earn you an extra $1,000 per year!

 

Upgrade your bank. Here is a high-yield account for your checking and savings.

Get a lower price on your bills:

No one likes to overpay, but most of us do. Are you sure you’ve got the best price for your internet, TV, or mobile phone service? Probably not. New plans, equipment, and promotional rates come out every day.

Instead of searching for the best prices and latest deals, Mint brings them to you automatically. From your transaction history, Mint knows which services you’re using and how much you’re (over) paying. Mint then finds a lower price for the things you buy most.

Frequently, the biggest savings come from bundling multiple services together. By switching to Comcast or AT&T triple-play you can get phone, TV and internet all for about $115 a month (including taxes and fees). That can save an average household $300-$800 each year.

A dollar saved is many dollars earned:

Lower prices on everyday bills, a credit card that pays you, and a bank account that earns maximum interest add up. On Mint, we’ve found that the average household can save nearly $1,800 each year. If you start when you’re 30, investing that savings at a 10% return means $569,000 by age 65. And that leads us to our next topic: the power of compound interest. Check back tomorrow to learn more about the second principal of personal finance: “Make the money you have work for you!”

Takeaways:

  • Consciously weigh the financial impact of buying vs. renting, when to have kids, & where you live.
  • Buy your cars used.
  • Get a credit card like Blue Cash or Driver’s Edge that pays you up to 6% back.
  • Pay off your credit cards, highest interest first.
  • Put your savings in a high-yield account like HSBC (5.05%)
  • Use Mint to manage your finances and find a lower price on your monthly bills

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Notes & References:

  1. My favorite personal finance books are:
    • The Richest Man in Babylon, a great starting place on the power of compound interest;
    • The Only Investment Guide You’ll Ever Need, a comprehensive guide to investment vehicles, retirement accounts, insurance, and ways to save on everyday costs.
    • Stocks for the Long Run, a well-demonstrated call for long-term, equity (stocks) heavy portfolio.
  2. Rich Dad, Poor Dad is particularly guilty here. In my opinion, while popular, it is largely fluff with only one specific, actionable suggestion: buy real estate as an investment and rent it out.
  3. Under the “General” settings for the Rent vs. Buy Calculator, you should try these settings: increase your investment return from 5% to 10%, and income tax rate from 20% to 35%.
  4. Source: TNS Media Intelligence.
  5. Robert Hammer of investment banking firm R.K. Hammer, cited in MSN Money.