I am not by any means a financial advisor nor am I advocating that one particular avenue of investment and spending will lead you to riches. In this post, my intention is to highlight the way I approach these topics, and invite you to also consider the ways in which you are approaching these topics in your own paradigm.
When we were young
Back in the 90's with the technology craze that was erupting, I learned fairly quick how to save up for things that I really, really wanted. Video Games were a 'nice to have' and my parents weren't interested in spending their money on them. Sure like many kids, my parents would occasionally splurge to get me something for my birthday, but my dad was a roofer and my mom a service rep for a larger financial firm, two jobs that didn't leave them much in the way of spare money when raising 2 kids and paying for their first (and current) home. Oftentimes they cut coupons at night and had change jars where they'd save up loose spare change for maybe a dinner night out, or some other 'treat-yo-self' moment. The effect those early days have on us as an adult are oftentimes unappreciated though it is written, "Train up a child in the way he should go: and when he is old, he will not depart from it." Fundamentally, these habits we have now start at an early age, deep-rooted habitual patterns of thought, and money habits are no different. I ended up copying their habits because that's what I saw them doing, starting my own little caches of money here and there for various things, thinking about haggling and saving on purchases, and even haggling them into going halfsies on some of my video game purchases. Over time I found my mom would cave if she became annoyed with my pleading, so that's usually the route I took to getting what I wanted. My dad on the other hand was not one to negotiate with. All things around money in the early days of our family was calculated and carefully planned.
Growing up, saving change, going to extremes
By middle school my saving habits were in full swing, as I had a constant $100 or so saved up somewhere. I accelerated my savings in the worst possible way - I would skip lunch and pocket my lunch money. At a meager $20/week, the saving was slow and my eating habits horrendous. My parents probably thought for awhile that my excessive eating was just obesity in full swing (I weighed a whopping 220 at this point), but in truth, it was just hunger. At the time it seemed like a good idea!
By high school I had saved up enough that my parents opened me my own bank account as a joint signer on it. My freshman year I had wanted to get an Xbox 360, so I had went to work for my uncle in Oregon for cash, making more money in a week doing manual labor than I had made in months of grueling saving in the past, which gave me some new ideas about working, saving, and planned unemployment (retirement) - was I missing out on an important part of the whole money management scheme, 'working'? Nonetheless, for $600 at age 14 I had my first of three Xbox 360s, paid for by my efforts, a feeling that as a non-working kid is hard to describe years later, to an audience that can score a PS4, fully loaded, for half that cost (back in the day, if you were a gamer, you were deemed by definition either hardcore enough to pay the costs of early adoption, or wealthy enough to be an annoying twat to the rest of us).
That freshman year my money efforts were augmented by a bet I made with my Aunt Leslie, a bet that, for $400, I would get straight A's for my first year in high school. Suffice it to say, the carrot was enough for this horse, and I was able to nail straight A's that year, landing me more spending money. Whether her intention was to keep me in line (middle school was a tough time, facing school expulsion, doing 'time' at an alternative school, and getting detained by the Police for something really stupid), her bet was well-played, and for $400 she kept me focused on the right things that mattered, as I would find out years later.
By this time, you're probably getting a sense of how instrumental my family has been in my upbringing. As a student, I absolutely learned from the many classes I had in school, but this learning was all academic and not extremely fundamental in the building of a member of our society. School didn't help broaden my creativity, it didn't foster any financial fundamentals, and the lessons from public school were for the most part solely intellectual. You could learn more about human nature on the playground than in a classroom studying it. The choices you make in raising your family - the environment they're in, the habits they see and emulate, and continued follow through on the your part as the role model are crucial in shaping these habits.
College years - what are interest rates anyway?
So far we've covered some of my history and background, some of the habits I learned early on, but now I want to highlight that none of these habits helped me when applying for college. Now, I bring this up in regards to opportunity cost and being financially savvy because I lacked this foresight when applying for loans. Blindly I rushed into not 1, but 3 variable rate loans with a private lending firm over the course of my university years, the last of which ran a nasty 6.5% interest rate (the other two were a modest 4.5% during the interest accruement period). Thank goodness my dad had outstanding credit, otherwise these loans would have maimed me solid for the rest of my life... Once all was said and done from the university costs perspective, I was about $36,000 in the hole, with an expected payout of $55,000 over the repayment period of 15 years. Some of you may have payed more or less, but let the focus be here on ignorance - ignorance to the fact that I had bought into variable rate loans that could change over time, and contingent on the hope of graduation, getting a good job to pay off these debts.
I did in fact graduate, and in my final year, I had help from my sister to pay for costs I incurred (at the time, in the oil field, she was raking in a massive amount of money). I managed to pay $2,000 towards one of the loans before graduating, a proactive step that I believe to have set the tone and pace of my repayment years (2013-today).
Opportunity costs in life
So after the university I landed a fantastic job at the United Services Automobile Association (USAA), which enabled me to start paying down this debt. To complicate repayment, during my first year at USAA, Cassidee, my partner and best friend, was still going through school on her last year at the University of Arizona. Unfortunately, due to some wonky FAFSA guidelines in our country for 'what your parents should be paying towards your college education', her scholarship was downgraded a good $7,000 for her final year ('full ride', to 'barely just cover tuition') due to her dad making slightly more money the previous year, and her sister Dana no longer being in school. I mention this because the $5,000 offered for relocation costs to San Antonio could have been spent on my own repayment efforts; however, there is one rule of money that has to be honored if you are to win at managing it - you must pass on all blessings you've received to those in need. My sister helped me get through my final year, enabling me to not take out another hefty loan, and so I helped out Cassidee similarly, paying for much of the housing costs of our apartment in Tucson on top of San Antonio bills, so that she could focus on finishing out school.
All of these decisions are opportunity costs, giving up something in return for something else. You will be faced with these decisions the rest of your life, and the way in which these decisions are navigated will leave a lasting impact on every decision to follow. It is also noteworthy that this idea extends beyond just financial decisions, but is essential in every kind of decision made, ever. Do I eat pizza today, or should I eat something healthier? Do I enjoy my evening watching TV, or dedicate it to continued study, learning, and reading? Do I spend my money on the present, or do I spend it on my future?
We're now getting to the heart of the entire topic - opportunity costs. Do I do x, instead of y? Constantly we are faced with the cost-benefit analysis of situations, and constantly, either consciously or not, we are making these decisions on charting the course of our future. So how do spending habits and your car have anything to do with these decisions?
First and foremost, the one thing most of us will be doing the rest of our lives is spending money - spending money on food, spending money on housing and utility bills, and spending money on just about everything we want as a means of trading our time and efforts for something. The rate at which we spend this money and how this money is spent will largely impact everything around you, and your future. You can dine out every night with your friends, buy clothes every weekend at the mall, and pay down that new car over the course of 7 years all the while digging yourself into a financial trench, with the walls getting higher and higher with each transaction. Juxtapose that with only dining out once a week during a happy hour special, only buying clothes every few months at an outlet store like Ross, and paying just the insurance on the car you've had since college. These two habitual lifestyle differences do not have to be income based either - you could make very little money and still spend it all without thinking.
From the example, you could understand how someone making $20,000 a year would not be able to maintain this spending-filled lifestyle, right? What if I made the argument that even those making $60,000 a year would be fools to live such a lifestyle? You may say 'wow, that's a bit harsh... They make enough to have fun', but let's do some math.
Let's say the person earning $60,000 a year takes home about $45,000 after tax (Uncle Sam always gets his share) if they were to invest nothing into their retirement. Let's also say that rent on average where I live in San Antonio, for a decent place, is close to $1,000 and if they're really 'hip and with it', they're paying the downtown tax which may bump that cost up to say, $1,400 a month. Let's not forget bills, utilities and other essentials, which can be roughly $250 a month. After all is said and done, fixed costs for just living are $45,000 - $15,000 ($1,250 x 12 months) a year, or $30,000 remaining money for 'other things'. Where I live, the average cost of a decent lunch (not Burger King or Subway, but real food) is around $10, and dinner, say, $15 with tip. So, if this same person was going to eat out each day, what's that look like? $25 * 365 turns out to be $9,125 and that's not including price fluctuations on the meals chosen. $30,000 - $9,125 = $20,875 left to go for the year. What about that new car? On a new 2017 Toyota Corolla, I placed a hefty 6% yearly interest on the loan, for a $19,000 MSRP, then divided the total repayment over the course of 7 years, which came out to be $324.77 a month in payments. Right now, on our older cars, we pay around $120 a month for insurance, but on newer cars, you can bet the insurance companies will be charging more to protect their investment, so let's put that $200 a month. In total for that 'new car smell' we're sitting at $524.77 a month for an entry level new car. That's $6,297.24 for the year, given that the dealer throws in free services such as changing your oil and whatnot. $20,875 - $6,297.24 = $14,577.76 remaining for the year. Not bad aye?
Here's where I burst the bubble of the new generation of yuppies that are charging headfirst into their future - this amount of money will not save you from life's happenings if you do not plan for that money to do so. Unless this money is explicitly set aside for the 'shit happens' moments in life, you will suffer the consequences. Most importantly, most Americans are not setting aside money for these occasions. Note the footnotes in the full report issued by Bureau of Economic Research post, "The personal saving rate is personal saving as a percentage of disposable personal income". So, we take our DPI figure of $45,000 .055 (5.5% savings rate on DPI) and we get $2,475 per year saved (assuming a person is saving the same % each month, averaging over the entire year). I would bet, however, that this number is much lower, as people tend to put aside saving for last.. Worst case scenario is $14,577.76 .055 which is a meager $801.78 per year savings cash flow... Scared yet?
You may also be saying at this point, '$60,000 a year income is higher than average, so shouldn't these individuals save more money?' Probably not. We haven't factored in at this point other miscellaneous spending that may occur over the course of a year. Also of importance, this individual has yet to contribute financially to their retirement at all in this scenario. That other $13,000 if not saved, has to go somewhere, right?
If you're looking for a practical approach to breaking this spending cycle, there is no easy solution. Like all other habits, such as exercise, studying, and writing blog posts, you have to practice, practice, practice.
Let's consider modifying the spending habits of the individual in our $60,000 scenario. Let's say this individual spends $100 a week on all the food which they will consume for the week, including breakfast, lunch, and dinner. I speak with experience from this number - it is very doable, even with the cost of a 6 pack of craft brew factored in per week. So if we start out at $30,000 again, since our fixed costs will remain the same, we now deduct the costs of $400 per month for the total cost of food for the year. $30,000 - ($400 x 12 month) = $25,200 left for the year. Not bad right? Let's also knock down that car payment a bit, and use the model I proposed - paying insurance each month with some money set aside for maintenance. $25,200 - (($120 insurance + $80 maintenance) 12 months) = $22,800 left for the year. Now that we have a normalized DPI to evaluate this individual's savings, what does that look like giving the savings rate reported by the BEA? Supposedly the same $2,475 per year savings cash flow that we computed earlier. Worst case scenario, again, we're looking at $22,800 0.055 = $1,254 saved per year, 156% of what the individual in the first scenario saved, just by adjusting expenditures. This individual fundamentally has a different paradigm on spending, or their 'worldview'. This individual, over time, will be more successful in saving and likely turn towards investing at some point, if they adhere to this worldview wholly.
It is also good to note now, that in both situations we have neglected to take into account the explicit line items that erode the remaining lump sum available for the rest of the year. Think about spending on gas, paying down other debt, and other goods or services as factors that slowly hack away at this remaining amount.
Putting your best foot forward, first
So how should we factor in savings into the budget without inflicting the most suffering to our way of life? Pre-tax contributions to a qualified retirement account is the best for those not wanting to take a huge hit to DPI, the money you take home. When you put savings first in the equation, the math looks a bit different - let's explore.
So we'll continue with our $60,000 a year person and we'll assume again that across the tax brackets, they lose out on about 1/4 of their actual pay due to taxes across those brackets (this is an estimate). Before we take the tax out, however, we'll take out the maximum allowable pre-tax 401k contributions, around $18,000 at the time of this writing. $60,000 - $18,000 = $42,000 is quite a lot less for the government to tax. At this lower amount, you may even fall into lower tax brackets depending on your situation. If you're head of household, for instance, based on the linked tax schedule, the cutoff for a 25% tax on your money is $47,351, meaning dollars over that amount are taxed at 25%. Below that, money within a tax bracket is taxed at a lower rate, which is the bracket rate times the amount of money made in that income bracket. For instance, money made between $12,401 - $47,350 is taxed at a 15% rate. For the simplicity of the example we will keep the 25% rate, but it is important to know that these tax advantages exist, and you as an employed person should be aware of the benefits of pre-tax deductions.
Once we have this $42,000 amount, Uncle Sam is going to take his bit out, so let's take 25% again: $42,000 - ($42,000 .25) = $31,500 take home pay, or DPI (wait, that looks higher than the first situation?). If you consider this action as 'saving' in a kind of way, this person is already at 30%. Using the BEA standard, we have $31,500 .055 which equates to $1732.5 saved per year under the revised plan. Let's again take out the fixed expenses, $31,500 - ($1,250 x 12 months) = $16,500, and let's assume too they have taken the frugal meal route, $16,500 - $4,800 = $11,700. Let's assume the frugal car route as well, $11,700 - $2,400 = $9,300 left for the year. In this scenario we deduct the savings too, leaving us at $7,567.5 per year for miscellaneous expenses, or $630 a month! Wow!
This individual is living life high as a kite if they adhere to this plan. If their employer is contributing 8% into that pre-tax account, they're making an additional $4,800 per year on their money. If you take that contribution out 20 years at a horrendous 6% return rate, this individual is still looking at $4778,324 by age 40 in their retirement account, $869,715 at age 55, and $1,147,390 at age 65, if they began this plan at age 20. A more favorable rate of return on investments, 8%, yields $1,191,923 at age 65, and 12% yielding $1,287,769 all things held equal. The person who waits to pay for their future ends up paying quite a lot of money for their procrastination.
Note: these calculations are estimates! Do not take them as facts, as they are just predictions based on calculations done on an HP 10bll financial calculator, with entry level to intermediate understanding of how these calculations are performed. The rate at which your funds or stocks issue dividends or stock repurchases highly affects these projections. Be sure to review the prospectus for your funds and stocks.
Coming full circle
Now that we've gotten through the example scenarios, let's tie it back into my situation from before. With $36,000+ in notes payable to financial institutions, at a decently high rate, no matter what I could make from investments, I'd lose out that payable percentage each year to the financial institution owning the loan. No matter what, their note is guaranteed to chip away at my net worth! Three years later, at $1,000 or more a month in loan payments, I can say that I'm near the end of my repayment journey and happy to have come so far, adhering closely to the frugal mindset depicted in the example.
The opportunity cost of my education is that house buying and other 'adult' things have taken a back seat to paying down non-negotiable student loan debt (see #7). My car is from 2003 but still running exceedingly well through routine maintenance and taking servicing my vehicle into my own hands for the bigger jobs (forum boards are a great place to learn DIY fixes for common vehicles, for the mechanically inclined), and my partner Cassidee and I still pack our lunch. These habitual practices are not just because the food in the cafeteria is awful (which it often is), but moreso that these habits put up guard rails for us to stay on track for the things that matter.
Cassidee and I still have fun from time to time, going to San Antonio's many social events like the beer festival and coffee festival, we still go out to eat once or twice a week usually to Thai Bistro for lunch or dinner, and these habits ensure we can still have those moments now and in the future. As a treat to ourselves, once a month, we drive out to the hill country, out to Middleton Brewery and Brewster's Pizza, for a good night out of the city.
Always weigh the opportunity costs as they shape the world around you. Does the latest in fashion mean more to you than plane tickets to see family, or to invest in your child's education? If you or your significant other were laid off tomorrow, how long could you alone support the household? What kind of modifications to your habits can you make today to plan for these possibilities and create a buffer against them? What would change in that situation? Based on the examples given above, do you think you're saving enough? Given that 4% of $1,191,923 is $47,676.92, a decent expected payout in retirement while your investments grow (8% - 4% for fees and inflation), could you retire off that amount per year? Are you eligible for a Roth 401k or Roth IRA, and would that be beneficial to your situation?