Nothing is Purchased in Isolation

Everything costs more than it seems. Well that’s a general statement but what I mean is that anytime you budget for something you’re going to purchase be assured that it will invariably cost more than that original amount. You see, there is a universal law that says:

“Nothing is purchased in isolation”

Take for instance something as simple as an ipod. Lets say you budget $150 and then you go buy it. Well now that you have an ipod you might be compelled to buy some music to listen. So you say download music for free. Fine, but what about storage. Now with so many songs and video you downloaded you need a new usb drive to store it, or a whole new computer. You’ll at least buy a new skin for it, or a replacement set of earphones.

The point is that your one purchase will most probably beget more purchases. As items get more expensive so do the correlated items that go with it. A car begets gas, oil changes, tires, car washes and air fresheners. A house begets furniture, home improvements, etc.

So my friends, remember that if you’re ready to spend on that new item realistically budget for twice that amount over its useful lifespan.

Redlining your Home Finances

Have you ever revved up your car in first gear (or 1 on automatic) until the rpm gauge went all the way to the red? It was fun wasn't it? You probably experienced great acceleration and the thrill of the engine noise, even though you weren't really going that fast. Revving your car all the way to the red produces tremendous acceleration and it is at that point that your engine produces its maximum horsepower. However, you can't hold that for long because the engine will wear out and it will overheat or blow up.

Well I bet that you're probably doing the same thing to your finances. If we call your take home pay 100% then your financial gauge is probably all the way in the red at 90, 95 or even 105%! If you were saving 50 to 60% of your take home pay then your financial gauge would be running at a nice and sustainable 40 to 50%. But you're not aren't you?

My friend you are probably overheating your financial engine. When you were single you had one income and you managed fine. Then you got a married and became DINKs (dual income no kids). Your financial engine got about twice its horsepower over night. However, within a few months you revved your lifestyle from 50% to probably 80%. Then came the kids and now you really put the pedal to the metal at 90+. The last time you got a raise you just stepped on the accelerator to maintain your neckbreaking 90+% pace.

If you save 50% of your income every year or even 15% you would have no choice but to be wealthy. Lets assume on average you make $60,000 a year and you save 15% or $9,000 a year, $750 a month. In 10 years you should have at least $90,000 in the bank. Actually with compound interest assuming a 10% return you should really have close to $154,000. Did you do it? Do you have it? I don't want to give you the 20 years figure because I'll depress you.

You'll come up with a thousand excuses of why your situation is different and why you have no choice. Think again. It took you many years to get up to your current lifestyle speed so don't expect to brake on a dime. However you can slow down considerably and not notice much of a difference. That 3,000 sq. ft. house might seem like a necesity but many families manage to get by on 1,200 sq. ft.. Some families with two kids can actually fit inside of a Toyota Corolla so don't think that huge $40,000 SUV in your driveway is a necessity either.

If you have saved at least 15% and your rate of return is at least 10% annually congratulations, you are the very small minority. The rest of us have been driving an overheated financial car.

Don't pay off your house

This is somewhat of a controversial statement and it is not for everyone but bear with me and I'll explain to you why.

Your home is probably your biggest source of equity. When you bought your home you probably put down 5, 10 or even 20% down. If it has been a few years since you bought it then appreciation has probably given you free additional equity. Furthermore If you have been diligent you have been sending extra payments to principal to pay if off sooner, very commendable. These three forces combined have probably pushed your loan balance to value to less than 60% (Ratio of what you owe vs. what the home is worth).

Intuitively you might think that the more you lower your loan balance, the more you contribute to principal and the more equity you have in your home the safer you will be financially. However, you would be wrong. The more equity you have in your home the more at risk you are financially.

How could this be? Shouldn't paying off your home be one of the most financially sound and rewarding goals you should have? Well yes and no. Very few people have the financial fortitude to pay off their house. If you can pull it off and you want to get rid of that mortgage you should but not the way you're doing it.

Let us examine the risk with an easy mathematical example. Let's say you purchased a house for $100,000 and you put 5% down or $5,000 so your loan balanace starts out at $95,000. After five years the house has appreciated and it is now valued at $135,000. Also assume that you diligently sent extra payments and your loan balance is now $80,000. At this point your equity is $135,000 - $80,000 = $55,000. Are you safer now than when you just bought it and you only had $5,000 in equity? I don't think so.

What you have in the $55,000 equity scenario is your capital at risk. At risk of what? Life events come to you unexpectedly and you might find yourself one day without a job or without means of generating income for a while. If you call the bank and say "Hey I've been making exta payments to the loan so could you apply that extra money to the next six months of payments because I'm in a bind?" they'll promptly and vehemently deny your request. Furthermore the bank will have a big incentive to foreclose on you because of the equity. If you had to negotiate payment terms with the bank which position would you rather be in: a) with $55,000 in equity or b) with $5,000 in equity? The bank is more likely to negotiate with you in position (b) because they stand to lose a lot money if they foreclose. If the bank forecloses on you in position (a) they'll come out ahead.

Here's a better alternative. Instead of sending extra payments to the bank save that extra money, build an emergency fund and invest it. If you ever have trouble making the payments then you can tap into your emergency fund and save your house and your hard earned equity. If you already have a lot of equity in your house you should refinance and pull out all the equity you can. Then you can take that extra cash out and create your own emergency fund. If you keep growing your emergency fund to the point of exceeding your loan balance then you can pay off your mortgage in one lump sum. Isn't this a better and safer alternative?

Hopefully I have convinced you that having equity in your home is actually a very risky proposition. Taking your equity out and investing it instead of spending it requires discipline but it is well worth the effort. Look for part II of this article to learn an even better reason to not have large equity in your house.