004, Liabilities

Liabilities…Do you want to be Average in your Financial Progress? The little cutie above is Emilee. She’s above average in my book. She doesn’t have any liabilities. Liabilities are like the alligator she’s riding. If you don’t stay on top of them, then can drag you down.

Liabilities are simply what you owe. Everyone is trying to get into your pocket to get your hard earned money. In the traditional sense, liabilities are thought of as loans. But I argue that in personal finance, liabilities cover a broader range of obligations that require them to pay them every month. These are those seemingly small “I can afford it” things that really take a toll on you over the long haul. These are very important to get right. The idea behind these transactions is that the company wants you to think these obligations are a small insignificant thing. Don’t be fooled. This is financial death by a thousand cuts. They only want no or a small down payment and for a low monthly payment. Those really add up over the years.

I’ve personally experienced this in car buying more than anywhere. Unfortunately for me, I didn’t realize I was being taken to the cleaners in enough detail to act accordingly. I’m a slow learner and being in the military can be a bad influence when it comes to finances. Banks know your income is secure. They know if you are late on payments they can call your commander to put pressure on you. They also know “giving the car back” is not an option unless the military guy wants disciplinary action. It may have changed a little today with not being able to call someone’s commander, but there are still very real consequences to not paying on time. Anyway, early on I would buy a car and then trade it in before I paid it off. I did that several times before I finally made it to the big time! I could “afford” a brand new car they said. It was a 1990 Pontiac Grand Prix. The new V-6 model. You know, I’m going to get the small rocks right and save gas! But boy did I miss the big rocks on this one. I financed it with the 5 year plan to keep the payments affordable. I took it hook, line, and sinker. They smelled this sucker a mile away.

My numbers will likely be a little off, but in the ball park. I bought it for say $25,000. By the time I was done with the “easy” payments which really weren’t easy for me, I’d paid like $35,000. So at the end of the 5 years I was finally the proud OWNER of a 5 year old car that was driven daily by a young father with two kids. It was scratched and dented on the outside. The inside was not any better. Carpet was stained, headliner was stained from when someone opened a can of Coke and was starting to come loose and hang down. I would be lucky to get $10,000 for it on a good day. So, bam. In 5 years I turned $35,000 into $10,000 by buying that car. But I had a nice car for about 2 years and saved some gas! I got the little rock right, but missed the big rock. I never bought a new car again. I’ve reached the pinnacle of the financing sucker with cars. If I would have burned my Honda Accord to the ground in the parking lot of Greenville Dodge as soon as I wrote the check for it, I would have lost less money! If I would have invested that $25,000 I lost in the new car deal in an appreciating asset that got 10% interest, today that $25,000 would be worth approximately $223,857 today (23 years later). The car dealer doesn’t tell you that. That’s compounding interest. It works both ways. I lost $25,000 on 1995. The bank has $223,857 today. Who won? I guess that’s why banks have awesome buildings and I don’t. I got the numbers from here: http://www.moneychimp.com/calculator/compound_interest_calculator.htm. The picture below is from the EZ Calculator app you can download for free dollars. The numbers are not exactly the same, but close enough to prove my point. That difference is a small rock. I missed the boat with that purchase.

When you get the big rocks of assets, liabilities, and net worth right, you’ll win. Instead of death by a thousand cuts, you’ll be successful by a thousand small wins! The average consumer will spend hundreds of thousands of dollars during a lifetime bleeding money (and compounding interest) to finance charges, administrative fees, and interest. They will pay some on cars, some on consumer goods, maybe some college loans, and a bunch on a 30 year mortgage. These folks don’t pay all the interest and fees up front or at once. Doing so would highlight just how crazy expensive financing costs right in your face. Instead, they keep their hand in your pockets, and just take just a little, for a long time causing you to loose opportunities to invest.

Now, armed with how this stuff works, think about reversing it. Now you are aware. So, let’s say Average Joe spends $400,000 towards servicing liabilities. The $400,000 is a low number for average folks, but just trust me for now. Smokey Joe on the other hand at least gets the big rocks right. He will cut this figure drastically. He still messes up on some small stuff, but gets the big rocks right. Smokey will likely save say 80% of the $400,000 in interest and fees over his lifetime. Yes, I made up the 80%, but it surely isn’t unrealistic. That 80% will keep $320,000 in his family’s pocket. Or use a more conservative figure of 50%. He’s keep $200,000 in his family’s finances. He doesn’t get a large pile of cash up front or long down the road some day. By efficiently using his hard earned money, he still buys what his family needs. He doesn’t give 50% – 80% of his money away to liabilities, and instead invests it in a slowly growing appreciating asset. Over time, he’s sitting back receiving dividends from from the money he invested in appreciating assets, or letting it continue to grow for his family’s legacy. Or whatever he wants, he did well by spending wisely to accumulate a nice pile of money.

I’m sure most know that loans are an expensive way to buy things. The only worse way, in personal finance, to finance a car is to lease it. But, there’s even more to the story than just an expensive way to spend your valuable money. You can make financing something good a very bad deal. Remember the appreciating and depreciating asset discussion? Average Joe finances only depreciating assets. So, when he’s done paying the purchase price, fees, and interest, he looses big time. Whatever he purchases, is worth less than the original purchase price. So, he pays more and ends up with less. Now Smokey messed up a few times along the way. But he remembered the difference in assets. He would only finance things that are appreciating assets. While he still paid more than he could have by being inefficient, at least Smokey Joe was left with an asset that was worth more than the day he bought it.

Let’s math this up a little.

Average bought a $1,000 flat screen TV, sofa, bed, or something like that. He financed it. Say he financed the TV at 10%. Since he has great credit, he gets the premium 10% interest rate versus the more common 18-21% on the folks with jacked up credit. Say it takes him 2 years to pay off the credit card or loan. He would pay $1,107 for the TV or 10.7% more than if he had paid cash. You can check it here: https://www.bankrate.com/calculators/mortgages/loan-calculator.aspx. Let’s also assume that 5 years later, Average wants to buy a new TV. He lists it on Craig’s List and sells it for $200. The cost of this deal is what he paid for the asset, minus the cost of selling the TV. Running the numbers, he bought the TV for $1000 plus the $107 in interest. His cost is $1,107 minus the selling price of $200. His ultimate cost is $907 in real dollars. Of course, Average repeats this over and over again throughout his life and can’t seem to get “get ahead”.

Smokey financed $1,000 of investment grade gold, silver, or maybe he just got a great deal on a small business. He got the same 10% interest rate for the same 2 years. He financed the $1000 for the appreciating asset. At the end of the finance terms Smokey’s paid $1,107 just as Average did above. Now fast forward 5 years as Average did in his TV purchase. Smokey’s asset appreciated a measly 10% in 5 years. It didn’t do nearly as well as he had hoped since he knows when buying low cost index mutual funds historically return more than 7+ percent over time. So, basically his asset’s growth and the interest he paid cancel each other out. When Smokey decides to sell his asset at 5 years, he gets 10% more than he paid for it. But the interest wipes out his gains. While this doesn’t seem good, he’s still in way better financial shape as Average. The value to his financial position from this transaction is zero dollars. Not good, but remember Smokey makes mistakes too. If he would have paid cash at least he would have about $107 dollars more. Why not $100? Compounding interest is the reason. More on that later. Smokey could use that $1000 to buy a TV for cash or try investing again. He has $1000 in in pocket. But for Average to buy a $1000 TV for cash, he would have to use his $200 from the sale of his TV and also come up with another $800!

These aren’t huge numbers. Both were only doing a $1,000 deal. Let’s look at percentages.

Average spent $1,107 and sold it for $200. That amounts to a $907 loss or approximately an 82% loss of position or 18% efficiency. Smokey broke even at zero percent. So, Smokey achieved an 82% higher efficiency of his valuable money.

You’ll have hundreds or even thousands of transactions like this over your lifetime. If you can be 80% more efficient on every purchase, how far do you think you can go? Let’s see the kind of difference makes over a lifetime. Average Joe and his wife make $45,000 per year, the average American income. Smokey’s family makes the same $45,000. To bring it back to some math and numbers let’s say Average worked 30 years and earned $1,350,000. Average’s efficiency is 18% from the numbers above. So, his $1,350,000 will yield approximately $243,000 of value. He finally OWNS his home, but he’s still financing his car. Sounds like the average American right?

Smokey worked right next to Average and earned the same $1,350,000. But since his efficiency is even, his $1,350,000 is worth $1,350,000. That’s $1,107,000 ($1,350,000 – $243,000) more! His money is much more efficient. That’s assuming Average JOE continues to finance things and Smokey never has investments that make money. He owns the house next door worth $243,000, both the family’s $30,000 cars, and has the remaining and has the rest is invested in $1,043,000 in gold, silver or a business that never appreciated. His lifelong investment broke even too. The more money you put into appreciating assets the better off you will be over the long haul. It’s pretty hard to invest in conservative appreciating assets and do as poorly as Smokey did. But he still has over $1,000,000 in assets. This is a simplistic view of two transactions extrapolated as if all transactions were the same. The big rock is that the percentages very different and are significant enough to make a large difference in your personal finance.

That’s the power of knowing the big rocks. Numerous small decisions like Average made above over an extended period of time can really drag your financial independence down. Most people are Average Joes.

Don’t be Average.