Looking at the Way We Spend Money

If I had a Netflix account, I would definitely use FeedFlix (found at feedflix.com). I just read something Leo Laporte posted on Twitter. He is spending an average of $92.97 per movie. On the $20 plan, that’s about one movie rented every 3.5 months or so.

FeedFlix is free and provides some great stats (see image from FeedFlix’s website below).

FeedFlix Stats

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We’re giving away four copies of Money: A Memoir to new registrants to the newsletter today.

Sign up in the sidebar and we’ll randomly select people at the end of the weekend.

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Back in 1980, Andrew Tobias (who also wrote “The Only Investment Guide You’ll Ever Need“) wrote a book called “Getting By on $100,000 a Year.” It’s a humorous look at what it was like to live in the financial industry at the beginning of what turned out to be a long stock market boom.

Things have changed since then, and $500,000 is the new $100,000 for bankers. The New York Times wrote a piece about getting by on $500k and what it might mean for some bankers, including enrolling children in public schools (rather than private ones).

The article can be found here.

The thing that stuck out to me was the co-op management fee on housing in NYC. When you buy an apartment in New York, there is a monthly fee that is similar to a Homeowner’s Association fee. The example they use for a $1.5 million apartment has a monthly payment of $8,000.

When you stop to think about what $8,000 per month could buy you, the list grows quickly. Most telling, though, is that a 30-year, $1,490,000 loan with an interest rate of 5% would have a monthly payment of $8,000. If a buyer had put 20% down on their home, the loan would actually cost less than the co-op fee.

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Yesterday, I talked about the Dutch Tulip Bubble, where tulip bulb prices reached outrageous heights. Today we’re heading west toward England to talk about the Railroad Bubble of the 1830s.

As the steam-powered locomotive emerged in the first decades of the 19th century, it was seen as the answer to drive commercial trade between large cities, as well as to small stops in between cities. It also allowed for the hauling of mined products (iron, coal, etc.) in mass quantities from the mines to the places they were needed.

In the 1830s, 6,000 miles of new railroad tracks were laid. For a country that is less than 100,000 square miles, this is a significant amount of track.

All of this would probably have been fine except for some people with fewer scruples than Mother Theresa realized they could capitalize on the excitement. Protections for investors were less stringent than they are today, and some people began developing companies that may have laid some railroad tracks, but their real reason for existence was to gather investments to make the founders of the companies rich.

In order to grow people’s excitement, they began paying out dividends from capital (rather than earnings). Investors didn’t realize what was going on, so they poured more money in because of the great returns offered by these companies.

Eventually it all collapsed, a la Enron, and investors were left holding the bag. Although the tracks laid were of use to  the country, they didn’t generate enough income to make money for the investors.

Tomorrow, we’re going to learn about the Florida Land Bubble of the early 1920s.

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Episode 4 of the FrugalPod podcast is online and ready for download. You can also subscribe to the podcast via its RSS feed or through iTunes. As always, we encourage you to post your comments, questions, and suggestions for future episodes in the comments section on the blog. Thanks for listening and we hope you enjoy the show.

Episode 4 Show Notes – Talking about methods of paying off debt.

Do you pay off highest interest rate or lowest balance first? Paying off highest interest rate will save you the most money, but paying off the lowest balance may make you feel like you’re getting ahead faster.

Example: You have a credit card with a balance of $5,000 and it has an interest rate of 12% per year. You also have a credit card with a $2,000 balance at 6% interest. The $5,000 credit card costs you about $10 in interest per month for every $1,000 you have on the card and the $2,000 card costs you about $5.00 in interest each month for every $1,000 you owe.

Let’s also assume that your minimum payments are $175 per month for the two cards, but you can pay $200 per month toward your debt. By paying the minimum payment on the high interest rate card and the remainder of the $200 each month on the low balance card until it’s paid off and then pay $200 per month on the high balance card, you will:

• Pay $1,475 in interest
• Pay off the first card in 23 months
• Pay off the high balance card in 44 months

By paying the minimum on the low interest rate card and paying as much as you can on the high interest card, you will:

• Pay $1,303 in interest
• Pay off the first card in 37 months
• Pay off the high balance card in 42 months

The choice you must make is whether you want to have made clear progress by paying one card off in under two years or save  $172 in interest.

Should you pay off debt or keep money in the bank?
From a mathematical standpoint, it makes sense to pay off a loan that has a higher interest rate than you’re earning on your savings, but sometimes it makes sense to keep money in the bank.

First, if you accelerate your payments on a 30-year home loan, you may not see the benefits of the extra payments until year 25 or 28. Second, the home is illiquid, so even if you do pay off your home faster, if you need money in the future you will either need to borrow with a credit card or take out another loan against your home. Finally, you may find yourself in a position where you can’t borrow because credit lines have been frozen.

The rule of thumb is to have 6 months of expenses in your savings account. So if you spend $4,000 per month you would need $24,000 in the bank for emergencies. If you’re not there yet, it makes sense to put 70% of extra income into a savings account and 30% into some sort of investment account.

Good debt vs. bad debt
Typically, good debt is borrowing to pay for something that increases in value. Borrowing to go to college or buy a home typically makes sense. Borrowing to buy a reasonable car to get you to and from work is also reasonable.

Borrowing for electronics or clothes is typically not so good. If the asset goes down in value, it’s probably best to buy it without credit. (Yes, the car in the “good” example goes down in value, but if buying the car allows you to get a job so you can make ends meet, it’s a bit of a different story.)

Things to think about when taking on debt
Borrowing for assets that increase in value is considered to be good, but borrowing to buy things that decrease in value isn’t.
Figure out what you can afford. Borrowing $150,000 for college if your career ambitions will only pay you $35,000 per year doesn’t make a lot of sense.

Links to Other Resources
The National Foundation for Credit Counseling is a non-profit organization whose members help people with their credit problems.

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Speculation in financial markets didn’t start during the dot com boom (and bust) in the late 1990s. In this three-part series, we’re going to take a look at bubbles of the distant (and sometimes not-so-distant) past.

The Dutch Tulip Bubble
In the 1600s, the Dutch went crazy for tulips. So crazy, that the prices for tulip bulbs went up. And up. And up some more.

At the peak of the tulip craze, it is recorded that 40 tulip bulbs sold for 100,000 florins. To put this in perspective, according to Tulipomania, written by Charles MacKay in the 19th century, a skilled laborer might have earned about 150 florins in a year.

According to The International Institute of Social History (and a little bit of conversion from Euros to U.S. Dollars), a Dutch florin in 1634 would be worth about $11.50 today.

In other words, 40 tulip bulbs sold for the equivalent of $1.15 million dollars in 2008, which means each bulb cost about $28,750.

Today, at Breck’s, you can buy tulip bulbs for about a dollar a piece.

The End of the Tulip Mania
As the trade in tulips grew, buyers and sellers began entering into futures contracts that obligated buyers to purchase bulbs at some point in the future. The Dutch parliament passed a law that allowed buyers in these contracts to cancel them for a small fee.

This caused those with buyer’s remorse to get out of the contracts, thus causing the prices to sink.

Tomorrow: Railroads
Railroads used to be the thing. Then they weren’t. The ties on these old railroads disappeared, but not as quickly as the money invested in them.

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As interest rates have dropped, many people are looking at re-financing their home mortgages. When you look at what the effect of a one or even two percentage point difference can make in monthly payments, it’s no wonder.

There are basically three methods to re-finance a mortgage with a lower interest rate.

1. You can re-finance and have a lower payment while paying off the loan over the same amount of time. In other words, if you have 22 years left on a 30-year mortgage, you would take out a 22-year loan at a lower interest rate (and thus a lower payment). If you were to move a $200,000 balance in this manor from a 6.5% loan to a 5.25% loan, your payment would drop from $1,425 to $1,311, a savings of $1,368 per year. (This is after taking into account adding an additional $5,000 into the loan balance to cover points and closing costs.)
2. You may re-finance and stretch out the terms to another 30-year loan. I’m not a big fan of this option since it pushes out the payoff of the debt another few years. The effect of a now-longer loan and the lower interest rate can dramatically lower the monthly payment, so for some people who are struggling to meet their mortgage obligation, this can make sense in rare occasions. By choosing this and using the same numbers as the first method your payment would go from $1,425 to $1,132, a savings of $3,516 per year. (Again after taking into account adding an additional $5,000 into the loan balance to cover points and closing costs.)
3. You can re-finance at the lower interest rate and keep your payments the same, which shortens the length of the loan. For example, re-financing a $200,000 balance at 6.5% with 22 years remaining to a new loan at 5.25% while keeping the same monthly payment shortens the length of the loan to 19. (Again after taking into account adding an additional $5,000 into the loan balance to cover points and closing costs.)

As homeowners look at these options, some look at the monthly savings, while others look at the savings in interest over remainder of the loan.

In example #1, the amount of the interest paid over the next 22 years would be $138,580. In #2 the interest over the next 30 years would be $200,751. In example #3, the loan would have $117,593 in interest payments over the following 19 years.

The savings of over $20,000 in interest between option #1 and #3 is clear, but what is not as clear is how someone would do if they invested the savings in the payment.

Investing in a fairly safe mix of stock and bond funds that yields 8% per year would provide you with more money in investment accounts after 30 years than paying off the home loan early (ex: 23 years) and investing for seven years. A full examination of the results of different payoff strategies can be found in this PDF.

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When most peoples’ retirement accounts increase at a good pace, few people care that huge profits are being made by a few investment wizards. (Note that in the five years from January 2003 to December 2007 the S&P 500 returned an average of over 12.8%.)

When you can turn $1,000 into $1,826 in five years, you probably aren’t going to complain much that the person who made this possible pocketed $40 or $50 (assuming you invested one time in a low-cost S&P 500 index fund).

A few reasons seem to account for the ire toward investment companies.

• First, even though $1,000 invested in 2003 could have increased by 82 percent over the following five years, in the sixth year, that would have fallen to $1,189, an amount that doesn’t quite keep up with inflation.
• Second, most people didn’t simply invest $1,000 in 2003 and wait. Most investors continued to invest all the way until the middle of 2008. If a person invested $1,000 at the beginning of each year between 2003 and 2008, they would have invested a total of $6,000, but at the end of 2008 they would have only $4,777 in their investment account. When taxes, commissions, and other expenses are taken into account, this number could be much lower.
• Third, this decrease of investments of about 20% hurts quite a bit more when the CEOs of the investment companies pocketed hundreds of millions of dollars over the same period.

I recently read an interview with Moha ed El-Erian, the CEO of bond giant PIMCO in Kiplinger’s Personal Finance (3/09). In talking about the call by many for increased regulation of financial markets, he says,

“After what we’ve seen recently, society will not leave unchanged a system that privatizes huge gains and socializes huge losses.”

This is one of the clearest things I’ve read about why we’re seeing a rush to regulate the financial markets. El-Erian’s quote sheds light on the value Americans place on fairness and equality.

On the one hand, Americans love rooting for the underdog. We love knowing that someone from a troubled background can rise to the top. But equally important to many of us is our belief that once the underdog rises to the top, he should remember his roots.

As we look at the executives at many financial companies, we feel they have looked out after their own interests while neglecting those of their customers. This sense of unfairness is magnified as we see tax dollars go to the companies that we perceive as putting us in this spot.

It can also be difficult to see the difference between money going to save the financial institutions vs. the people running the institutions.

The efficacy of the government’s response to our financial situation will only be known in time, but the impact of the government’s response has been felt by the psyche of the average American with investments. As we move forward, hopefully the response will ease the emotional impact as companies become healthier, home prices stabilize, and the unemployed begin to find work.

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Episode 3 of the FrugalPod podcast is online and ready for download. You can also subscribe to the podcast via its RSS feed or through iTunes. As always, we encourage you to post your comments, questions, and suggestions for future episodes in the comments section on the blog. Thanks for listening and we hope you enjoy the show.

Episode 3 Show Notes

Budgeting is what we all know we should do but many of us don’t.

Your budget breaks down into two categories: fixed costs and discretionary spending. It’s more important to track your discretionary spending because that’s where most of us have a breakdown in our budget. It’s a lot easier to go overboard in dining out or buying clothes than it is on your rent.

How sophisticated does your budgeting solution need to be?
It’s most important to do it. Doing it is more important than what you use. Pen and paper can be easier than learning a new software program.

Why is Categorizing Important?
Categorizing brings cohesion to your budget. When you put things in categories you begin to get a better picture of what’s going on. If you wrote down where you spent every dollar and listed each gas station separately you’re going to end up with a list of gas stations, not something that’s helpful.

By categorizing you can see how things change over the months. Simply looking at one month’s worth of spending isn’t all that helpful. It’s when you start to compare the same category over different time periods that it becomes more helpful.

How Granular Should Your Budget Be?
It’s more important to be granular in discretionary spending because that’s where we make excuses and our budgets often fall apart. It’s not until you begin digging into the actual service or product you’re purchasing that the record of your spending becomes valuable.

Saving money in structural stuff (such as your cable or telephone bill) gives some people the excuse to spend somewhere else. If you spend $80 a month on your cable bill and save 10%, that’s about $100 a year. Are you going to take that $8 per month and truly save or invest it or are you going to spend it on something else.

When you start to save money across several structural areas, you can get into saving $1,000 or more per year. At that point, you have to start asking what you’re going to do with the money.

The software programs such as Quicken, Mint.com, and Wesabe.com have a few things going for them, primarily automation, categorization, and automatic tracking of finances. David’s used Quicken for years, but has also tried Mint.com and liked the interface. If he was starting from scratch today, he’d use an online system.

Sticking With Your Budget
Turn spending into a game.If you have a significant other, competition can be a good thing. Try to have no-spend days…days when you don’t spend money. Brown bag your lunch, eat at home, and celebrate not spending.

Simply saying, “I’m not going to go to Starbucks today and I’m going to miss it,” places a lot of power on the trip to Starbucks. Do you really care about your latte that much? Yeah, they’re tasty, but the latte represents more than a drink to you.

Busyness can cause you to spend too much, especially in your dining habits.

Coming back to your budget, once you know where you’re spending your money you start to see where your priorities are. You can then ask yourself, “Do I really want to make eating out or vacations a priority, or do I want to make debt repayment a priority?”

Financial planners will often put clients on the envelope system – a system that is old, but it still works for some.

Links to Mint.com, Wesabe, and Quicken

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