Friday, February 15, 2013

Rule #25 Live like a student as long as you can.

"The essentials of life are cheap. Only the luxuries are expensive." - Ron Muhlenkamp

Remember when you were a student at college or university? Remember how much fun it was and yet how broke you were? You didn't have a luxurious place to live in, or a car, and you walked to everything, or maybe skateboarded everywhere?  The TV you had was the TV the previous tenants left behind because it was too bloody heavy to move... you know.. the Radiation King with the wooden case, and you certainly couldn't afford cable TV.  You stayed in and hung out with friends, choosing potlucks instead of going to fancy restaurants.  You made coffee at home, and brought sandwiches for lunch instead of buying it.  Cheap Poutine and Pitcher of Beer night at the local pub was the best night of the week because you and your friends could nurse your drink and wax poetic all night long at discount prices.  Life was simple.  You had few financial liabilities and it was fun living this way.



But then something happened.  There was this temptation that with a new career must also come a car, new furniture, fancy clothes, an expensive watch or phone, a big flat-screen TV,  and instead of frequenting the local watering hole, you feel compelled to hang out in the more expensive places with the foreign or micro-brews on tap instead of the cheap domestics.   Your big adult paycheque deserved a big adult lifestyle.   That big TV meant a cable-TV plan, and high-speed internet and a phone with a big data-plan.  Whoa! This is starting to sound expensive.

I always tell young people I meet to resist this temptation as much as possible, for as long as possible.  It is extremely difficult to save, pay down debt, and generally get ahead if you jump into a higher standard of living without the financial base to make it happen first, and that is just what many recent grads do.  Once people get used to a high-status high-consumption lifestyle, it is often very difficult for people to reign in that spending if needed, so the longer you can prolong your student lifestyle, the better.  I can not emphasize enough how much financial sacrifice plays in to financial well-being and resisting many of these adult lifestyle trappings can be a boon to your bottom line and mental well-being.  In my opinion, spending money on luxuries in life such as cars, expensive clothes, and expensive monthly liabilities such as Cable-TV should only be done once the basics are covered such as eliminating bad debt and having some savings.  Another thing I've noticed is that people with high standards of lifestyle without a financial base often worry a lot about maintaining that lifestyle...  and I generally like to sleep at night, so a simple carefree lifestyle suits me just fine.

When I was in grad school, we lived just like in the first paragraph.  My wife and I lived in a very modest apartment, we didn't own a car, and we didn't have have a TV let alone cable TV.   When I got my first employment position as a technical professional, there was a temptation to buy all the fancy things people come to expect with such a position.  But we resisted.  We did however buy a house after  I had been working for 3 months only because we were going to be evicted from our apartment due to a coming renovation.  While we did own a house, it would be another 4 years before we would buy a car.  It wasn't that we couldn't arrange for a car-loan to get one, it was that cars are money pits, and we weren't interested in digging new financial holes while we were trying to pay off our student loans.

With two adult salaries, but without many of the liabilities many adults take on, we were able to slay both our student loans ($58 thousand worth) in just over 3 years, save up enough to pay for a used car four years after I started working, begin to max out our RRSPs, and give to worthwhile charities.  We were essentially saving 50% of our take home pay.... By comparison to many in our field and experience level, our standard of living was modest, but we were very happy because we maintained that interactive social face-to-face lifestyle by continuing pot-luck get-togethers and Cheap Beer and Poutine nights.  We still lived with "student" quality furniture because it still met our needs.  It was still functional, though certainly not fashionable.  We only bought stuff out of necessity, not because of some feeling or self-imposed obligation around keeping up with others.    We never focused on what status items we were missing out on, but rather focused on relationships and building a solid financial base to give us more flexibility and freedom as we got older.  Once the essentials of living have been taken care of, then we focus on adding the luxuries.

At our current stage in life, which is late-thirties with young kids, we have adopted many of the liabilities that come with adulthood: A nice car, high-speed internet, club memberships etc, but we only added these lifestyle choices when we could afford them.  To this day we still walk or bike everywhere we can, we do not have Cable-TV, dont frequent fancy restaurants more than once a year, and Cheap Beer and Poutine are still our favourite nights out.

Thursday, February 14, 2013

Rule #24 Borrow money for things that appreciate, pay cash on things that depreciate.


"The price of borrowing money is interest—and worry. Keep all borrowing below the worry point and don’t borrow to buy things that depreciate; you will lose on both ends." - Ron Muhlenkamp from his Basic Maxims I Want My Kids to Know.



Cars, vacations, iphones, new bicycles, dinners out at restaurants etc... all lose their intrinsic value the second they are purchased.  Yet people put them on credit cards or take out loans to buy them and carry the balance for months or even years.  So not only is that meal you spent $100 on long gone, but you are now going to pay an additional 10-20% (or possibly more) because you didnt pay it off right away.  Bad idea, Genius.  One of our rules is that we don't buy anything on credit or loan if it depreciates over time.  We view paying more to buy something by spreading the payments over time for something that goes down in value as a silly thing to do.  I know people who buy stuff on credit cards because an item is on sale and then don't pay it off for up to a year or more, essentially negating the sale price.

But the biggest sting is on big ticket items... so let's look at a big ticket example.  One that most people can relate to would be a car purchase. Suppose you bought a car for $25000 and you financed 100% of it for 5 years at an interest rate of 5%. You'd pay about $471 a month in payments.  The car will depreciate 10-15% per year depending on make and model.  For this example, lets assume 15% depreciation.  After 5 years you are still paying the $471 per month, but your car is now only worth a little over $11000.  When you finish paying for it, you will have paid about $28306 once you add in all the interest.  By paying for the car in full at least you would avoid paying the extra $3306 in interest.  A big part of my apprehension is psychological. I recognise this, but I still think its worth thinking about,  You will pay $5600 in the final year in monthly payments, and your car will only be worth the equivalent of 2 years worth of payments...  yeah, that stings.

What if you did without a car for a few years and saved $471 up front each month, how long would it take to save up the 25000 in cash?  Lets also assume you can get a 5% return on your savings. According to this handy online calculator, it would take 48 months to save up 25000 to pay for the car in cash.  You would actually only have to put up $22600 of you own money, and the compounding at 5% per year would do the rest.  You've saved yourself $5700 dollars and you own the car outright.  You can keep saving $471 in your account for your next car that you will pay for in cash.  Since we know you can probably replace your current car for $25000, you will be able to save up the money for your next car in 4 years!  This is generally how we operate.  Save and then buy.  Not borrow, buy and then pay down.

But I'm not against borrowing.... I just dont like to borrow on things that depreciate.   I do however like to borrow money for safer investments or assets that provide some cashflow.

Lets look at borrowing to invest in something that appreciates in value, rather than depreciates.  (NOTE: you should know by now that I don't usually fuss too much over capital appreciation in the short term, but for this example lets assume that capital appreciation is the goal.  We will also not consider taxes for this example even though I know taxes will take some in the end if you sell the investment)   We will borrow at 5% and buy a $25000 investment that appreciates (and therefore compounds) at 5% a year instead of depreciating like the car.  After 5 years, you will have paid the same as the car, $28306, but now the investment is worth $31,907.   So in the case of borrowing to buy a car vs investing, I could borrow to buy a car that will cost me 28k over 5 years and then its only worth about 11k when I pay it off, OR I can borrow and pay the same amount over those 5 years on something that appreciates over time and it would be worth about $3600 more than what I paid for.  So to compare both scenarios with their bottom lines, the depreciating car has lost about $17300 of what you've put into it, and the investment is up $3600.  That's a difference of nearly $21000.  Well, when you put it that way Ryan, that IS a huge difference.

This is the way we've set up a portion of our finances. We only borrow for things that increase in value such as investments, and we save up to buy all things that depreciate.