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Spending and Saving

Millionaires save 20 percent of their income compared to 1 percent for the average American. Where does all the money go? According to the U.S. Bureau of Labor Statistics, the average family spends $43,395 a year on household expenses1. The table below shows the breakdown of spending. The top three expenses are housing, transportation, and food. Let’s look there for the biggest savings.

 Housing  $13,918
 Transportation  $7,801
 Food  $5,781
 Personal insurance and pensions  $4,823
 Health care  $2,574
 Entertainment  $2,218
 Apparel and services  $1,816
 Cash contributions  $1,408
 Education  $905
 Miscellaneous  $690
 Personal care products and services  $581
 Alcoholic beverages  $459
 Tobacco products and smoking supplies  $288
 Reading  $130

A shortcut to riches is to subtract from our desires.

Home Sweet Home
Your house will probably be the biggest purchase you ever make. It’s a big decision, not only because of the money at stake, but because it’s a long-term commitment—most millionaires live in the same house for more than 20 years. Buying a home can be a very emotional decision. When you walk into the right place, it just feels like you were meant to live there. You can’t wait to sign the papers and move in.
Before you take the plunge, it pays to step back and think like an investor. An investor’s goal is to make money by buying something that goes up in value. For real estate, a useful measure of value is the “capitalization rate.” This is the ratio of cash flow to the purchase price of the property. Think of cash flow as the money you could make by renting out the house, after deducting expenses such as repairs, taxes, and mortgage payments.
For example, assume you buy a house for $150,000. You put $25,000 down, and take out a mortgage for $125,000 at 8 percent. This means your annual mortgage payments are about $10,000. Based on comparable rents in the neighborhood, you figure you can rent out the house for $2,000 per month, or $24,000 per year. Annual repairs, taxes, and other expenses are $7,500. Therefore, the cap rate is calculated as ($24,000 - $10,000 - $7,500) / $25,000 = 26 percent annual return. So even if the value of your house doesn’t increase, you have the option of renting it out and earning a 26 percent return every year.

Overall, a cap rate of 10 percent or more is a good indicator of value, especially considering that a return of 7–10 percent is what you can expect from stocks and other investments.

Finding an Investment Property
  1. Follow these steps to get good value for your housing dollars:
  2. Find a house you like, and find out the purchase price.
  3. Walk around the neighborhood, and find out how much it costs to rent a comparable property.
  4. Calculate the mortgage payments. For annual repairs, taxes, and other expenses, a quick estimate is 5 percent of the purchase price.
  5. Calculate the capitalization rate. Your goal is to find a house with a cap rate of 10 percent or more.
  6. Before purchasing the house, determine the exact costs of repairs, taxes, and other expenses. Also, hire a home inspector to look for hidden problems and repairs.

Shrink Your Mortgage

There are three ways to save big money on a mortgage. First, buy only the house you need. Two people living in a 6-bedroom house is a waste of space. Second, shop around for the best mortgage rate. Compare quotes from mortgage brokers, and ask your friends if they know of a better deal. It’s a shame that some people put more effort into buying a new LCD TV than finding the best mortgage. Finally, pay off your mortgage as fast as you can. Choose a mortgage with a shorter term, and make lump sum payments when you have extra money. On a $100,000 mortgage with an interest rate of 7.5 percent, you’ll save $79,255 in interest payments with a 10-year term instead of 25 years.

25 $789 $221,697 $121,697 $0
20 $806 $193,342 $93,342 $28,355
15 $927 $166,862 $66,862 $54,835
10 $1,187 $142,442 $42,442 $79,255
*Savings on a $100,000 mortgage at an interest rate of 7.5 percent.

Used Cars
Transportation is the second biggest expense for most families. Just like houses, buy only the car you need. A Honda Civic or Toyota Corolla is less fun to drive, but much more economical than a Hummer or BMW. When you buy a car, try to purchase it outright rather than leasing or taking out a loan. You’ll save on interest payments, and have more money to invest. Also, interest is paid with after-tax dollars, whereas investment returns are taxed at a lower rate than income.

According to the American Automobile Association (AAA), the average annual depreciation is $2,461 for a small sedan such as a Honda Civic or Toyota Corolla2. Most of the depreciation happens in the first or second year of ownership. Buy a used car and let someone else pay for the new car smell. Better yet, take the bus or carpool. It’s better for your wallet and for the environment.

That man is the richest whose pleasures are the cheapest.
-Henry David Thoreau

Frugal Food
The average American family spends $5,781 a year on food. This breaks down to $3,347 for food cooked at home, and $2,434 for eating out. To save on groceries, check out the sales flyers from your neighborhood grocery stores. Stock up when things go on sale. You can save 50 percent or more if you’re patient and know your prices. If you brown-bag your lunch twice a week, you can easily save $10–$20. Over the course of a year, it adds up to an extra $500–$1,000 to invest, or pay off your mortgage faster.

Set aside a certain number of days, during which you shall be content with the scantiest and cheapest fare, with coarse and rough dress, saying to yourself the while, “Is this the condition that I feared?”

Save Big on Travel
It’s expensive to travel for business or pleasure, especially with the rising price of oil. But with a few minutes of searching, you can save 50% or more on airfare and hotels.

  1. There are a number of search engines that compare airfares across the major carriers. Start your search with www.kayak.com, www.flightnetwork.com, and www.hotwire.com.
  2. Before you book your ticket, check with a travel agent and see if he or she can beat the price you found online.
  1. If you don’t need to stay at a specific hotel, you can get incredible deals at www.priceline.com. On Priceline, you bid the price you’re willing to pay for a hotel in a specific geographic area. For example, you might bid $80/night for a 4-star hotel in downtown Boston. Priceline checks instantly with hotels in the area to see if any will accept your bid. Hotels would rather give you an amazing deal than let their rooms sit empty.
  2. To know what to bid, consult websites such as www.betterbidding.com and www.biddingfortravel.com to see recent winning bids. A general guideline is to start bidding at 40% of the hotel’s suggested price. For example, start bidding at $80 if Priceline suggests that $200/night is the regular price for 4-star hotels in downtown Boston. Increase your bid if the first one is unsuccessful, or try again on a different day.

Smart Spending
Have you heard the phrase: “penny wise, pound foolish?” Some people get so caught up in pinching pennies that they lose sight of what’s important. A burger and fries from McDonald’s may be cheaper than buying fruits and vegetables, but you’ll pay for it in the long run when you get a heart attack. It’s worth paying a bit more for things that improve your life. For example, the average American spends $288 a year on tobacco products, and only $130 on reading. Life would be a lot better if they stopped smoking, and spent the money on more books, or other things to improve their lives. Quitting smoking saves a lot of money. Over 25 years, non-smokers accumulate a net worth that’s $8,300 more than heavy smokers3.

Family Money
One of the easiest ways to save money is getting married (as long as you don’t splurge on a fancy engagement ring or lavish wedding). It’s because two people can live as cheaply as one or one-and-a-half. Jay Zagorsky is an Ohio State sociologist. He studied the net worth of married and unmarried Baby Boomers, and found that singles increased their net worth by 8 percent a year, compared to 16 percent for married people4. By their mid-40s, married people had accumulated 77 percent more wealth than singles. But if the marriage ended in divorce, their net worth plummeted by 77 percent, and they ended up worse off than those who had remained single.

It’s impressive that married people save so much more than singles, especially considering the cost of kids. A typical middle-class family spends about $10,000 a year per child, with $3,500 going to housing, and $1,500–$2,000 going to food5. From birth to age 17, the total cost of raising a child is about $240,000. Then there’s the cost of college. In 2006, the average cost of tuition, room, and board at public universities was $13,425 per year6. This soared to $36,510 per year for private universities. Whether your kids are going to Ohio State or Harvard, it’s a good idea to start saving now.

Automatic Saving
Saving is hard because it’s human nature to live for the present. In a study of self-reported undersavers, 35 percent said they planned to save more in the next few months7. Four months later, only 14 percent had actually done something about it. That’s why millionaires pay themselves first. You can’t spend money if it’s not in your pocket. Most banks or employers can help you set up an automatic savings program, where a certain percentage of your paycheck is transferred to a savings or investment account before you have a chance to spend it. But what if you’re already struggling to make ends meet? After paying for essentials, 28 percent of Americans say they have nothing left over for the month.

To solve this problem, economists Richard Thaler and Shlomo Benartzi developed a savings program called “Save More Tomorrow” (SMarT). SMarT works by automatically saving a percentage of your future salary increases. This way, your paycheck stays the same and your lifestyle stays the same. When SMarT was introduced to workers in a manufacturing plant, the results were dramatic. Seventy-eight percent signed up, 80 percent stayed enrolled, and the average savings rate rose from 3.5 percent to 13.6 percent over the course of 40 months and four pay raises. SMarT works because it doesn’t require any effort or willpower. Set up something similar for yourself. Talk to your boss or banker, and start saving for your future.

Expenditures rise to meet income.
-C. Northcote Parkinson

Down with Debt
With the money you save, your first priority should be paying off any high-interest debts. About 43 percent of American families carry a balance on their credit cards8. On average, their credit card balance is $5,100, and the Annual Percentage Rate (APR) is 12.7 percent. APR is the interest rate you pay for carrying a balance, taking out a cash advance, or transferring a balance from another card. At an APR of 12.7 percent, it takes 10 years to pay off a credit card balance of $5,100 by making the minimum monthly payment9 (and that’s only if you don’t buy anything else). In the process, you end up paying $1,655 in interest, or roughly $155 per year. If you had invested that money, $155 a year for 10 years grows to $3,000, assuming a 10 percent rate of return. Don’t be a financial slave to your credit cards. Scrimp and save until they’re all paid off.

Debt is the slavery of the free.
-Publilius Syrus

Easier Than You Think
He was a champ in the ring, but a sucker for spending. Boxer “Iron” Mike Tyson earned $400 million over 20 years10. But in 2003, he was forced to declare bankruptcy. Where did all the money go? Mike’s extravagant spending habits included $400,000 a month to maintain his lifestyle, $410,000 for a birthday party, $300,000 for limo rides, and $1.6 million for a watch and diamond bracelet. His wife’s divorce lawyer said, “He spent enormous amounts of money that were inappropriate at best. Part of it can be attributed to a lack of willpower. Part of it can be attributed to people who he let get close to him, and depended on his goodwill, and took advantage of him11.”

Don’t be like Mike. Pay yourself first, buy only the things you need, and stay out of debt. Otherwise, it won’t matter how much money you make because you’ll spend it all. According to the World Bank, more than 2 billion people live on less than $2 a day12. That’s less than the price of a coffee at Starbucks. It makes you realize that there are lots of ways to save money.

  1. Bureau of Labor Statistics. (2004). Consumer Expenditure Survey, 2000–2004. United States Department of Labor.
  2. American Automobile Association. (2007). Your driving costs. 2007 Edition.
  3. Zagorsky JL. (2004). The wealth effects of smoking. Tobacco Control. 13:370–374.
  4. Zagorsky JL. (2005). Marriage and divorce’s impact on wealth. Journal of Sociology. 41(4):406–424.
  5. Lino M. (2005). Expenditures on children by families, 2004. U.S. Department of Agriculture, Center for Nutrition Policy and Promotion. Miscellaneous Publication No. 1528-2004.
  6. U.S. Census Bureau. (2007). Back to school: 2007–2008. CB07-FF.11. June 14, 2007.
  7. Thaler RH, Benartzi S. (2004). Save More Tomorrow™: using behavioral economics to increase employee saving. Journal of Political Economy. 112(1):S164–S187.
  8. ACNielsen. (2005). Large number of U.S. consumers continuing to live paycheck to paycheck. Press Release. June 13, 2005.
  9. Alderman N. (2006). The devil in your wallet. Motley Fool. July 8.
  10. Sandomir R. (2003). Tyson's bankruptcy is a lesson in ways to squander a fortune. New York Times. August 5, 2003.
  11. Steward C. (2004). Tyson's spending saga is pathetic. Oakland Tribune. February 12, 2004.
  12. Chen S, Ravallion M. (2007). Absolute poverty measures for the developing world, 1981–2004. World Bank. March 2007.

Copyright © 2009 by Paul Lem, M.D.
Buy the book at www.MasterLifeFaster.com