Wednesday, April 4, 2012

How to Save Money


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Personal financial literacy is the first step towards developing true financial security and realizing a dream of quitting a job or having a comfortable retirement. I received an MBA in accounting and now I use my knowledge to help others. People and businesses have a lot of difficulty managing cash flow. Most people don't understand how to save money and illusions of financial security can further irritate the issue. The answer is really obvious... or is it?

The way to save money is to stop spending.

You are probably saying "duh... stupid." The catch here is that it isn't as straightforward as it sounds. If you have been following my series of posts so far, you may have built a personal balance sheet and income statement. You may have even looked at cash flow at this point. Going back in time, you probably have the same savings account that you have had since you got your first $100 as a kid. Over time, you have probably been taking part of your income and "saving" into this account. You have probably seen the balance increase over the years and have seen the interest payments come in at between 0.5% and 2% annually. You say to yourself "Cool, I'm covered because I have savings."

Since you started placing money into the account as a kid, I can guarantee you that you have immediately lost 2-5% annually due to inflation and missed out on returns between 3% and 20% due to missed opportunities. The problem with inflation too is that it has an exponential effect. Assume that you placed 100$ as a kid into the savings account. How much have you lost? It isn't a question of monetary loss because the amount has never gone down (in fact, it has probably gone up). What you have lost is purchasing power. Instead of being able to buy 100 gallons of gasoline (in the 1990s), you can now buy less than 30 (based on early 2012 prices). Ouch! So where does a 60% decline in purchasing power come from?

Most savings accounts produce returns of 0.5% to 1% annually. Cash produces a return of 0% annually. On average, the economy increases the costs of goods and services at a rate between 2.5% and 3.5% annually, with some sectors (ex. Oil and Gas) increasing faster than others. So in an average year, the "saver" loses 2.5-3% with their savings account.

In a way, 3.5% is really the new 0%...

This graph illustrates that even with 1% growth in the economy, you will still lose about 14% over 15 years. With 3.5% growth, you lose over 40%.



Another area where this bites people are periods of years where wage growth is negative or zero. If someone doesn't receive a raise of at least the inflation rate each year, then they are actually poorer every year by working with the same organization. Right now, it is widely agreed that the median income has dropped in both real (inflation adjusted) and nominal (non-inflation adjusted) terms. This illustrates one of the problems that the Occupy Wall Street movement was loosely against with the growing wealth gap. People with more wealth can generate the 3.5%+ returns required to keep a constant or increasing amount of wealth.

Another area that is painful for a lot of people is the amount of interest they are paying on debt. I cover loan and interest calculations in this post, but the average person paying the minimum amount on a 30 year mortgage pays at least 100% of the principal amount in interest over the life of the loan. The graph below shows the interest amount for a $100,000 mortgage at certain rates.



Remember that this chart only shows interest paid, so the unfortunate person who has an 8% home loan pays almost 175% of the principal in interest and the principal. In the $200,000 example, this is more than $550,000 paid to borrow $200,000. To save money, fight for every point of interest and negotiate hard to the bottom line value.

If home loans were credit card debt, you would be paying a ridiculous amount for interest. Over 30 years at 27% (a typical credit card rate), the individual would pay over $1.4 million in interest. With even relatively small balances on credit cards, the interest adds up.

To save money, pay off the highest interest loan as fast as you can (while paying the minimum amount on all other loans). When the highest interest amount is paid off, take the entire amount that was applied to the highest interest loan and apply it to the next highest interest loan. Continue this pattern and there is a high probability that the debt will vanish within a few short years, or at least significantly cripple the investor's return and minimize the total interest paid.

To further reduce expenses, identify all of your expenses and cut from both the top down and the bottom up. Make simpler meals at home, renegotiate your rent or mortgage payment or move closer to a job/school. Simplify and/or eliminate your cell phone plan (this was a big one for our family). Eliminate cable/satellite TV and use various streaming services or read more books (Our family successfully switched to Netflix from Comcast, and now we are looking at other streaming services to replace Netflix). Take the money that you are now saving and invest in sources of passive income (I'll describe how to set these up in future posts).

Other ways of saving money are to eliminate unneeded parts of health, life, and auto insurance policies. Take it from a money expert that most people overpay for car insurance and health insurance (especially through their employers).

Saving water and energy probably won't make a big difference financially (though most power companies and municipalities push this because of their capacity issues). Additionally, other "green" measures typically are not worth the investment unless they are heavily subsidized. People usually have a personal need to make their life "greener" to invest in measures like solar panels.

There are lots of ways to save money, but ultimately this involves reducing and eliminating both large and small expenses and applying cash to positive net present value (NPV) investments. I will cover these and other passive income activities in future posts.

Back to...
Retirement in the 21st Century




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