CHAPTER FIVE
Many people believe that it’s too hard to run a surplus. There are just too many demands. It can’t be done. They can’t even figure out how to run a balanced budget. Their kids need this and that; they have to go on two vacations a year to keep their sanity; they can’t make do with a used car—their safety is important so they just have to get the latest SUV, etc.
There are many reasons for this kind of thinking. Three stand out:
1. the keeping-up-with-the-Joneses phenomenon;
2. lifestyle inflation; and
3. the monthly payment trap.
THE KEEPING-UP-WITH-THE-JONESES PHENOMENON
We live to compare. Or perhaps we compare to live. Natural selection dictates that only the fittest survive and so we may be hard-wired to compare ourselves to our peers. If someone buys a fancy new car, perhaps we should buy a fancy new car. The problem is that we don’t know what that person’s finances look like. He or she might be up to their eyeballs in debt, not sleeping at night, and living on a knife’s edge. Once you get a fancy new car, after about a month it becomes transportation, just as your old car was. However, it costs more on an ongoing basis. It might attract a few extra glances when you drive around, but who cares?
Well, clearly a lot of us do.
But you can have more than your peers today, or a lot more than your peers tomorrow. By delaying consumption as long as possible, you can build up wealth much more quickly. Suppose you’re in the market for a new car. You could afford $800 per month for a fancy German luxury cruiser (that spends 95% of its time taking one person to and from work). Or you could buy a compact car for $200 per month. Insurance will probably be cheaper, and you’ll save on gas as well—perhaps another $100 per month in total. Altogether you’re saving $700 per month for perhaps 5 years. You could have an all-inclusive trip for two to somewhere tropical once every 3 months, a total of 20 trips, during that same period if you bought the cheaper car. Or you could just put the difference away in a savings account earning 1% interest and have $43,000 after 5 years.
Or consider this: even if you are a car guy (as I am), chances are that 360 days of the year you use your car to simply get you from A to B. Perhaps, at most, you might go for a Sunday drive or a weekend road trip and really want to enjoy the sight and sound and visceral feel of a highly tuned car for a handful of days per year. If that is the case, instead of buying that BMW (or whatever), maybe you should buy a Honda Civic (or whatever) instead. That way you can drive a Ferrari every now and then.
Say what?
Yes, that’s right. Let’s say you were willing to spend $700 per month more on that BMW, but then decided not to: that works out to $8,400 per year in savings. You could rent a Porsche 911 Cabriolet for eight weekends ($799.95 per weekend + $99.95 insurance + 13% tax at Affinity Luxury Car Rental in Toronto). Or rent a Ferrari 360 Spider for three weekends ($1,999 + $99 insurance + 13% tax, GTAExotics.ca also in Toronto). The best of both worlds would be to rent the exotic car for only one or two weekends to get your fix, and pocket a few grand.
But restraint on spending doesn’t have to be limited to cars. One of the biggest expenses (and headaches) you’ll have in life can be your home. Some people have a tendency to buy a home based on the most amount of money the bank will lend them. Big mistake. Your goal should be to buy a house that will require the smallest possible mortgage from the bank. The fact that you may not be able to find the perfect house at a lower price range could be an indicator that house prices are too high, or that you’re aiming too high. It seems that the days when you lived in a less than ideal house and gradually worked your way up are long gone. Today we see people clamouring to find their “forever house,” which has to be perfect and spacious and great for entertaining, etc. But “forever” apparently is about 10 years.
LIFESTYLE INFLATION
Economists keep a close eye on inflation as measured by the consumer price index (CPI). It tells us how much more the stuff we regularly buy costs us over time.
We tend to get pretty worked up about the everincreasing cost to fill up at the pump—so much so that most people think about various ways to save on gas. What we don’t have a good grip on is “lifestyle inflation”: the increase in the amount or type of stuff we want to buy over time.
Inflation in prices is something we have no control over as individual consumers. Just ask anyone close to retirement what they paid for their first house and compare that to what they paid for their latest car. My parents’ first house in Ottawa was $34,000 in the 1970s and their most recent vehicle purchase was about $40,000. Extrapolate that to when I hit retirement age and a mid-sized sedan might cost $250,000. That’s CPI inflation. Lifestyle inflation means that, by then, I’ll want a sporty little convertible that could cost $500,000.
Truth serum: I want one of those right now. Really badly. I’m a car guy of the first order, so frivolous spending on all things automotive is high on my want list. I believe that one or two spending vices are okay. It might be travel, sports, home, fashion, or fancy coffee beans. As long as you’re not spending beyond your means overall, you can indulge. The problem is that we want to indulge in everything.
As our incomes grow, so do our expenses. You make $30,000 per year, you’ll spend $30,000 per year. Fast-forward 10 years and you might be earning $60,000, but spending $60,000. On the lower side of the income spectrum, it’s harder to put money aside for savings, because there is a floor of spending required to maintain a basic lifestyle. But everyone has good intentions: we all mean to use our next raise to accelerate debt payments or increase savings, while maintaining our current level of spending. Unfortunately, all too often, the debt payments and savings are not increased but the spending rises.
When a big raise is in the cards, or perhaps a big payment is eliminated, you might ask if now is the time to upgrade your home or cars. “We’ve got an extra $500 in cash flow. What can we afford to upgrade to now?” The absolute maximum lifestyle inflation you might be able to afford would be to fill that $500 momentary surplus with a new continuing $500 monthly commitment. That would be perennially living at the limit of your means, not within it.
Some of that extra $500 is going to be consumed by CPI inflation. What you are already buying is going to be 2–3% more expensive than last year. The difference between what CPI inflation claims, and what your additional wants claim of that $500 plays a large part in determining how successful you are going to be with your finances. If you don’t think seriously about it, you’ll discover that every penny of the raise finds a way of getting spent. You’ll never get ahead. Too much inflation of either kind is a bad thing. We can’t control CPI inflation, but we can control our lifestyle inflation.
Having money doesn’t relieve money stress. Spending less than what comes in the door does. This applies to those who make very little, and to those who make a lot.
THE MONTHLY PAYMENT TRAP
More and more people think of big purchases today in terms of monthly payments because we are part of the credit generation. We’ve been conditioned to finance purchases instead of saving up for them in advance. And it could be one of the main reasons you’ll continue to live on the edge with your finances.
The lifetime cost of the interest we pay can be huge. Consider a $30,000 car purchase. If you financed it over 7 years, your total out-of-pocket cost to buy the car would have been just a tick under $35,000 after factoring in the interest. If you had saved up for it in advance, then the out-of-pocket cost was closer to $29,000. That’s a $6,000 difference.
I took a look at the same monthly payment for financing the car ($410.06 per month at 4%) and instead put that money into a high-interest savings account to see how long it would take to end up with $30,000. With an interest rate of 1.5%, it would take 5 years and 10 months. If you really do think in terms of monthly payments, then think of this: by financing, you’re committed to making that payment for 7 years, whereas you can save the same amount in less than 6 years. If you take a step back and look at the total out-of-pocket cost, it’s $34,445.04 to finance (84 months × $410.06) and $28,724.19 to save up in advance (70 months × $410.06).
Of course, in the real world it’s not quite that simple. Anyone looking at the above figures would clearly see the benefit of being a saver instead of a borrower. But when you are already spending what’s coming in the door (and sometimes more), how do you make that switch? How do you delay purchasing a car for 5 years when you need one today? The answer lies in two underappreciated concepts: discipline and delayed gratification.
It requires hard work and discipline to become more physically fit. The same is true of sorting out our finances. If it was easy, everyone would have an enviable six pack and everyone would have more income than expenses. No one is going to flip the switch for you. You have to want it.
And while there may be some people who really need a new car today, there are many more people who can delay getting a new car for a few years. You could also get a less expensive car for now and put away the monthly difference until you can pay cash for the car you want. There’s no law that says your next car always has to be nicer than your last one.
We don’t need to limit the conversation to cars. We could be talking about a new stereo, a vacation, or any other big-ticket item. Anything you are financing applies.
The best way to start is to start small. Take baby steps and open up a high-interest savings account with a $50 pre-authorized contribution on the days you get paid. After a few months, if you don’t feel a pinch, increase your savings amount until you do. The recipes for physical and financial success are both basic but hard to stick to. No pain, no gain.
Not all debt is the same. Good luck buying your first house with your savings. Ditto for a car. Plus you may have just gone through school, met your future spouse, got married, and had a child. In fact, debt is a necessary evil for younger Canadians. Your education and home are appreciating assets. A car is a depreciating asset, but it could take a while to be able to pay for a reliable car. Beyond these almost inescapable items, you really shouldn’t be borrowing money for much else. Certainly not for vacations. Not for gifts. And not for eating out.
WE ALL NEED A HOBBY
Hobbies are supposed to be relaxing, a way to distract yourself from day-to-day stresses and activate a different part of the mind. But they also have a way of bleeding bank accounts. And when people think they have money to burn, which is different from whether they actually have money to burn, that bleeding can turn into a gush.
Why do people feel compelled to spend big money on hobbies? Some justify it as one aspect of their workhard-play-hard philosophy. Others do it because they simply believe that bigger is better. And when it comes to sports, people often link winning with the level of enjoyment they get out of the activity and throw lots of money at top-of-the-line equipment and accessories.
For example, I like to golf, but I wouldn’t call myself a golfer. I’m more of an aerator of lawns. The way I see it, I don’t need a $400 Tiger Woods Nike driver made out of unobtainium to beat the heck out of the tee box. I do just fine with my no-name clubs.
But I’ve hit the greens for networking reasons with players who look like they have stepped right off the fairways at the Masters. In the quest to look and play like a pro, they have filled their bags to the brim with the latest clubs and gadgets, such as special golf-course GPS units or laser-based rangefinders. When they took that first swing, though, the jig was up: the thousands of dollars they had spent on tarting up their golf bag did nothing to improve their handicap.
Sometimes it’s not how much money you spend on your hobbies, but how you spend it that’s the real waste. Auto racing used to be a serious pastime of mine, and the track was littered with drivers who poured thousands of dollars into performance parts to end up only a few tenths of a second per lap faster. Sometimes they were even slower. If they had instead spent a small fraction of those expenses on professional race-driver training, they might have seen an actual improvement in their performance.
Less athletic hobbyists can also fall victim to poor financial trade-offs in the quest to be the best. Take stamp collecting: it takes a lot of money to amass a decent collection. But if you let go of the idea of being at the top of your hobby field, and just enjoy the act itself, it can bring as much pleasure at a much lower cost. A lifelong stamp collector told me that the true joy of collecting comes from the community, the sharing of knowledge, and a common love. The fact is that having a hobby need not be a strain on your bank account—period. The investment of time, which, remember, is free, is all that is needed to ignite the passion. So try to resist the temptation to pour irrational sums of money into your hobby, especially when picking up a new one. Focus instead on that initial investment of time. Once you have a sense of how much pleasure you’re actually going to get out of the activity, and how serious a participant you intend to become, you can think about how you want to spend your money.
In the end, your bank account can probably only withstand one serious hobby. If you dump a lot of money into every new activity you try, you will have less to spend on your passion when you do find it.
Thinking of taking up golf? Think twice before buying the best equipment. A big investment can turn into a big waste if you end up not sticking with it. Consider the cost of outfitting yourself with top-of-the-line golf gear:
• Driver: $450
• Fairway wood: $280
• Set of irons: $1,050
• Wedge: $140
• Putter: $300
• Bag: $200
• Golf shoes: $230
• Course-appropriate outfit: $400
• Gloves: $30
• Balls, tees, and miscellaneous: $60
• Total: $3,140 before setting foot on a course
You could instead settle for an entry-level outfit combined with training and green fees on an easy course:
• Complete starter set of clubs, including bag: $250
• Two days of golf school: $500
• Lower-end golf shoes: $100
• Gloves: $30
• Balls, tees, and miscellaneous: $25
• Unlimited season pass to nine-hole course, driving range, chipping and putting greens: $1,000
• Total: $1,905 and you could play all day, the entire season1
LIFESTYLE INFLATION WITH HOUSING
We all know someone who’s worn love goggles. They start dating someone new and their whole world starts revolving around that special someone who can do no wrong, even though everyone else seems to think otherwise. Once the honeymoon phase is over,
the goggles come off, a dramatic breakup ensues, and suddenly everything seems so clear. “Why didn’t you guys say anything?” the friend asks. Human psychology is a powerful force.
Meet Ben Rabidoux. He’s a friend who has been trying to warn Canadians about the love affair we have with home ownership. Mr. Rabidoux is the president of North Cove Advisors, Inc., which is a market research firm covering Canadian macroeconomics, housing, and credit for institutional investors. His website, TheEconomicAnalyst.com, provides easy-to-digest graphs that essentially explain themselves, but he also weaves together ideas that combine to reveal a sobering new reality we may soon be facing. Already offended by the premise? He’s used to it.
Here are a few pieces of hard data from his site: in 1975, the average size of a house in Canada was 1,050 square feet. Fast-forward to 2010 and newly built homes almost doubled in size to an average of 1,950 square feet. This increase has been accompanied by a decrease in the average number of people living in a household. In 1971, it was 3.5; by 2006, that number had fallen by a full person to 2.5.
Whereas in 1999 the price of a home was 3.2 times income, this multiple had ballooned to 5.9 times income in 2010. Essentially, the amount of money we are willing to pay for a house has increased much faster than our incomes. Instead of buying beer, we’ve switched to champagne, but we still can afford only beer. That’s some serious lifestyle inflation.
RENOVATING IS AN INVESTMENT?
We are the generation of the renovation. Granite countertop upgrades, hardwood floor installations, take a wall down here, feng shui there, etc. There are so many shows on TV centred around renovation that you might start to feel abnormal if you aren’t refurbishing your home. Then again, with so many people living at or beyond their means, why would you want to be normal?
There are two main reasons why you would undertake home renovations. The first is because you want to improve your living space. The second is the belief that you are making an investment that will increase the value of your home more than the cost of making the changes. My beef is with the people who use the second reason to justify their financial irresponsibility.
Don’t get me wrong, I don’t have anything against upgrading your living space—even if you don’t get a positive return on investment. You just have to be able to afford it. (And it would be nice if it didn’t end your relationship with your significant other too!) Let’s say your $50,000 renovation increases the value of your home by $75,000. That’s a total return of 50% on your investment. That’s great if you’re a flipper, but what if you live in that home for another 10 years? Your annualized rate of return is only 4.14% if there is no change in the overall value of your property in those 10 years (which can happen), and that assumes the upgrade is as desirable 10 years from now as it is today. It doesn’t factor in the increase in price of the property, but keep in mind that properties can have negative growth over 10 years too. You are also forgoing the use of that $50,000. If you borrow it, your cash flow is tied up paying it off. If you paid for it in cash, you have to weigh the opportunity cost of other investments.
So, as I said, I don’t care if you renovate. Your new environment may bring you great pleasure and pride. And that’s wonderful. There are also many renovations that make great investments. If you can afford it, go nuts. If it puts a strain on your finances though, don’t fall into the trap of justifying because it’s an investment.
Listen, I’ll be the first person to tell you that I’m not normal, but I really dislike most renovations. Not because they don’t make a house prettier or more functional: it’s fun to see the before and after pictures of a reno. I get a kick out of seeing body transformations from people who start a new diet or exercise plan too. The problem I have is that one of these things is a true investment, and while the other is often justified as one, it is really nothing more than conspicuous consumption.
Eating better and getting proper exercise is an investment in your health. It doesn’t have to cost much either. A friend of mine recently showed me his rockhard six-pack abs, which Jersey Shore’s “The Situation” would envy. His entire workout routine requires a chin-up bar ($50) and two chairs. He started out more like the rest of us, with a midsection another friend described as “The Predicament.” This is the kind of investment I like to see: low investment, great return.
Renovations are a different kettle of fish. I’m well aware of projects that can increase the value of a house, and flippers can make a comfortable living by finding hidden gems and quickly turning them around for a substantial profit. But let’s be serious. Many home renovations are falsely justified as a long-term investment. The justification helps some people rationalize their urge to spend and consume. And upgrade.
If you have the money in hand, and your finances are in order, I’ll be the first person to tell you that if you want to build a staircase made of ivory (synthetic, natch), then be my guest. I couldn’t care less what floats your boat when you can afford it. The problem is that many people can’t afford it. They finance it instead. And here is where it gets tricky. Borrowing money to invest is speculative. If you do the same thing in the stock market, you’re immediately assumed to be in the medium-high-to-totally-bonkers category with respect to your appetite for risk. The amount of paperwork you have to sign to acknowledge the risk is cumbersome because financial institutions want to cover their butts if things go sour.
Borrowing to invest in a home reno is different. You can enjoy tangible benefits right away. Your house is easier on the eyes and more functional. It makes you feel good. Perhaps you’ve one-upped your friends. Now you’re the ones with a “situation” and they’re the ones with a “predicament.” But the investment works out, psychologically at least, because we’re in what may be the longest secular bull market in real estate history in Canada, and enjoying 30 years of falling interest rates. If the housing market doesn’t change, we could easily tease out the value of renovations by seeing how much more you sell your house for than you paid for it. If the increase is more than the cost of the reno, it’s a profitable investment. But the housing market is dynamic: it doesn’t go up forever, no matter what the current trends are, and you might find that one day the overall decline in the value of the house is more than the increase attributed to a reno.
This is the point at which people chime in to say that the reno was for themselves, not an investment. And this is where I say, yes, that was the real reason all along, and if you financed it over many years, then you couldn’t afford it. It was just conspicuous consumption.
Guess what? We’ve covered everything you need to know to be financially better off than most people. As I said at the beginning of this book, the rules are not hard to understand, but they are hard to implement.
Once you’ve mastered them, then you can go on and pursue that A+ in personal finance. You can do that by reading more books (and I’ll provide the titles of a few more to consider in Part 2). You can manage things on your own, or you can find an advisor. (In fact, I believe the vast majority of people need an advisor, so I’ll provide some tips on how to find a good one.)
And you can also always check with me for general guidance. Follow me on Twitter (@preetbanerjee) and I’m more than happy to answer any questions you might have.
1All prices before taxes. Golf school and training academy membership rates quoted by Deer Creek Academy in Ontario at time of writing. Prices may have changed.