012, Financial Ratios, It’s all About the Numbers

What’s in a number? A number standing alone is meaningless. Especially in personal finance. Something like $10,000 without comparing it to other factors is surrounding the number is just an amount of money. If that $10,000 is buying someone’s car outright with cash for someone who makes $30,000 a year, it’s a significant amount to that person. That same $10,000 paid as a down payment on someone’s $250,000 Bugatti sports car who is making $5,000,000 per year is less significant in that person’s personal finance. That $10,000 is hardly anything compared to the $5,000,000 annual income. But someone who’s buying a $100,000 car outright with cash for someone making $300,000 per year, the financial impact is exactly the same as the first person buying the $10,000 car in the first example. The ratio is what matters in these examples.

We started to touched on Ratios a little bit in the last Post with Warren Buffet’s house. In that example we were comparing his home’s value to his net worth as a percentage. His house is really a very, very small part of his net worth. This post will look at important financial ratios that banks, landlords, and many other people who try to manage personal finance.

Financial Ratios Everyone Should Know, Wallet Hacks and Millionaire Mob are just a few sites that give some ratios. The first is the most basic. Then each one after that give some more ratios to understand. I give you those three so that you can dig in at your own time and at your own pace.

Since several of the readers have asked about buying a house in the near future, we’ll cover a few ratios for buying a house. I first heard of a ratio for buying a house when I purchased my first house. During the application process, the loan officer informed me that I could get a loan for up to 28% of my income for the house. But there was a caveat. The total of all my debt could not be more than 32% of my income. Since I was an Average person, I had more than 4% (32% – 28%) in consumer debt. This limited my first home to less than the standard 28%. I don’t remember exactly what the numbers were at the time. The point is that I had a lot of credit card debt and it effected my loan to buy my house. That was one of the earliest wake up calls that I may be in trouble. So, I started tracking these ratios periodically.

I’ve never really thought about that ratio for several years now. While writing for this Blog, I’ve noticed these ratios have changed! They haven’t changed for the better either. The newer ratios are 28% for your house and 36% for the total debt ratio. While that may seem better, it’s not. This is not in your best interest at all. Here’s why I don’t agree with the ratio.

The 28/36 ratio allows for 4% more than the old ratio. That’s a 100% (4% to 8%) increase in consumer deb! So what they are doing is allowing you to charge more depreciating assets! They haven’t increased from 28% for the generally appreciating asset called your house. Not that I’m a fan of financing to the maximum, but the above shows where the banks interests are focused. What they did was basically allowed for the Average consumer to borrow more money for the highest interest rate category. That means they make more money and you lose more money to interest.

So, you loose the flexibility to use that second 4% that you could put towards an emergency fund, for food, or for investing. You are also loosing the opportunity cost of that 4% compounded over the years if you invest it in your retirement. That’s worth you seriously considering before you decide to max out how much you can borrow on a house and credit cards. Let me say it again:  That’s worth you seriously considering before you decide to max out how much you can borrow on a house and credit cards.  The old 28/32 ratio was hard enough to recover. The 28/36 ratio would be much harder. So, don’t be Average and max out your credit. Live below your means and invest the remainder in your future.

By now, most of you by now have read about how much credit can cost you. You know to avoid it on depreciating assets. Assets that don’t appreciate in value or provide income should never be financed.  So, when buying a house, don’t forget that wasting money on depreciating assets can really mess up your chances to minimize your interest costs. Remember all numbers in relation to your objectives of financial independence. Don’t get caught up in the Average American dream of owning a house at the expense of your financial future.

Maxing out your credit to purchase a house will significantly hinder your ability to save for your future. It will strap you for cash and for emergencies if you don’t have those in place before you finance a house. So, before you even consider buying a house make sure you have a fully funded emergency fund and an appropriate down payment.

Why is the down payment of 20% or more stressed by so many financial people? Because of two major reasons. Fist, it shows the mortgage company that you have skin in the game. You have 20% equity, so the bank has less risk. You are more likely to pay on time and not walk away leaving the bank with a house. They are not in the house buying business. They reward you for this by giving you a favorable interest rate. So, you’ll be financing less and at a lower interest rate. Over the life of your loan, the reduced financed amount and the lower interest rate will be a significantly less amount you pay to the banks.

Secondly, you won’t have to pay for Private Mortgage Insurance or PMI. PMI is insurance that the bank makes you pay for to insure that they actually get the money back that they lent you. That’s right, they make you pay insurance for them! You get absolutely no value for this either. So, you are losing money here too. In most instances, 20% down will eliminate this PMI. PMI increases with the cost of your house. More expensive house will require a more expensive PMI payment. So, just save at least until you get the 20% down to avoid throwing this money away by paying for the bank’s insurance for your home loan. Don’t do it. If you can’t afford this 20% down, wait until you can.

So, don’t be Average. Learn your financial ratios so you get a better picture of your major purchases such as a house.

006, Always “Bee” Learning

In the first five blog posts we’ve covered the basics. As was mentioned you can literally get advanced degrees on this stuff. The degrees don’t guarantee that you’ll be successful. Nothing really does. However, once you have a solid understanding of the basics, continue to learn. Strive to learn new things throughout your life. The more you know, the more likely you’ll make a well informed decision. The more you make well informed decisions, the higher your chances of success will be.

In today’s fast paced environment continuously learning is more accessible than ever before. Frequently, that learning doesn’t even have the high cost of a college education. There are websites for almost any topic you can think of to learn about. Granted, not all are great. But a website that doesn’t deliver will quickly be left in the dust by good ones. With the advancements in equipment and the ease of publishing something on the internet, a crowd of followers will point out any mistakes or poorly supported ideas presented as facts quickly. So, if you search for educational based websites that have a large following you’ll generally wind up with sound advice. When something is presented, you can cross check facts with another website quickly as well. Sitting in uncomfortable chairs listening to an instructor is not the only way to get educated today.

Podcasts are another development in recent years. Yes, I’ve been learning before podcasts were available. But you don’t have to even read websites if reading isn’t your thing. Some people learn from reading and some from listening. Many of the websites out there on financial independence and personal finance have both websites and podcasts. The podcasts range from just the host’s opinion, experiences, or advice to discussions among a group of people. Often times the guest hosts will either be someone who has achieved success or are well on their way. The guest could also be the authors of books, other podcasts, or other experts in the topic of the day.

Audio Books are another option to learn. While websites and podcasts can be very educational, the author needs a little more room to explore or explain the topics. Podcasts and websites tend to be more focused on a particular topic in a format that’s a quick read or listen. But a book isn’t limited to those formats. They can be as detailed as necessary to fully explain complex topics, stories, or ideas.

By now, you may be questioning the amount of time required to actually learn personal finance and financial independence. Everyone is working these days. Generally married couples both work too. So, how can you get to advance your education? When will you find the time?

My morning commute is about 45 minutes. During that time, I’m usually listening to a podcast of some kind to learn something new. Over the years there have been many topics I’ve leaned about on this commute. Dave Ramsey Podcasts about how to get out of debt when in debt. Choose FI and the Mad FIentist are podcasts about personal finance. Bigger Pockets is about real estate investing. I’ve also listened to many podcasts about deer hunting, turkey hunting, and even cooking. So, rather than just listen to the latest song by a random artist, I’m learning new stuff on the podcasts. If you can think of a topic, chances are there is a podcast about it.

Podcasts can also be listened to during other times. Anytime you can wear headphones, you can learn. Instead of being that person bobbing his head up and down in ignorance, learn something. You can learn while exercising, while your partner is watching TV, or even sneak in a quick topic in a waiting room. You may even be able to listen to a podcast in a deer stand! Just make sure you download it first if there’s no cell coverage in the woods.

I’m also an early riser. Maybe you’re a night owl. Whatever your schedule is, carve some time out to better yourself either before the kids or wife get up or after he or she goes to bed. If you are going to get ahead in life, you need to spend some time educating yourself. Early or late in the day is generally a good time to sit alone and learn.

Almost all of this information is available for free, in many formats, and pretty much hassle free. Just as you want your finances to be efficient, so should your learning. It isn’t necessary to lock yourself in a classroom, office, or basement to learn. Don’t be stung by wasting your time being idle, learn something. Look for opportunities to be efficient with your time and always be learning.

Resources, Stepping Stones for Success

If you just skim things, click on the books to be taken to Amazon and you can buy the book directly from the link and have it delivered straight to you door.

Here are a few of the many books I’ve read over the years. They are very good books that have had an impact on me and my personal finances. I wouldn’t recommend them if I didn’t read them and they were worth every penny. I assure you that if you buy, read and apply the books, they are worth more than the cover price. You won’t get a check, you can’t sell them, and they aren’t going to magically turn into money. But when you understand the ideas in them, you’ll make more on interest, dividends, or growth of your investments. You will also save many more times their value by reducing how much you pay in interest over your life. Remember, you don’t have to do everything exactly correct in every detail. You only have to get the Big Rocks right to reap significant financial benefits from them.

I also explain a little bit of each book to help guide your through them. Depending on what you are seeking, one may be more right for wherever you are in your financial standing.

I’ll update these books periodically when a book or something catches my attention.

Total Money Makeover, Dave Ramsey

This is a tried and true guide to getting out of debt. Dave explains in simple terms the quickest way to pay down, and eventually pay off your lenders. It’s a 7 step program. I highly recommend tackling the first three as fast as possible.

The Wealthy Barber, David Chilton

The core of this book is getting the Big Rocks right. It shows shows that you don’t have to have a big income to become wealthy. It covers debt, investing, and even keeping living costs efficient. This is a quick and easy read.

The Millionaire Next Door, Thomas Stanley and William Danko

The authors studied self made millionaires for over 20 years. They explain several common characteristics of what made the millionaires, well millionaires. You may be shocked that many self made millionaires may look like every other person in your neighborhood. He or she was just better and more efficient with their personal finances. It’s a really good read too.

Your Money or Your Life, Vicky Robin

Vicky takes a very unique look at the value placed on time and money. The first several chapters are a bit loose for me. But then it gets into some really interesting topics explaining how money and time are intertwined. It goes into quite some detail to guide you the true payment for your time from your employer or business. There are examples that lay out the details to get the true monetary benefit of working. It’s worth a read or two.

Full disclosure notice: The above books are links from the Amazon Affiliate advertiser program. I do get a small percentage if of the sale if you use the links above to purchase the book or books.

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.

002, Big Rocks

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The Big Rocks of Finance

Get the Big Rocks right and you’ll be well on your way for financial success. The Big Rocks are assets, liabilities, and net worth. More on those later.

When I first joined the Air Force I really thought I was doing okay. Oh, ignorance is bliss. The reality was as a young Air Force airman basic (yes, that’s a real military rank) I was only making about $700 – $900 per month with two kids. I was really poor and had little to no savings. My family was getting food stamps, eating deer meat and government cheese. The kids were on a government program called Women, Infants and Children (WIC). That program provided formula, milk etc. for the kids. The driving car, a Bronco II, was financed, so I didn’t own it even though when you finance a car everyone says things like “Hey, I like YOUR car”. It was the bank’s car that I was driving. If I stopped paying for that Bronco, they would come get it. I did have another car, but it rarely ran. It was a hot rod that was a money pit and not practical at all. While financially it was tough, we were able to get by with help from the government and an occasional family gift. The household net worth was negative.

By the time I was in my mid 30s, or 60% of my life to date, I thought I knew a few things about finance. Nice cars were in the driveway, silk curtains hung on the walls, big HD TV complete with an upgraded audio video system, antiques from my tour in Italy. I had some mutual funds, a couple of shares of Pepsi Co, a little bit of savings, savings bonds, a car and a truck. But I also had way more debt than that young airman basic above. I had more and better stuff in my possession, but again, just like my first car, most of it was financed. My family had tens of thousands of credit card debt. Financially speaking, I was not much better off than I was when I first joined the Air Force! It was not readily apparent, but the debt was killing me financially. There was more nice stuff, but it would only take a month or two without income and we would be on the streets and the nice stuff would have to be sold. The household net worth was still negative.

I’m sure we’ve all heard financial terms before like assets, liabilities, net worth, investment, insurance, trusts, and the list goes on. There’s no shortage of advice from numerous sources and especially advertisers. Commercials on the television are frequent. Brokers, advisors, banks, credit cards, insurance, annuities and more. Why are there so many commercials coming your way? Because they are all trying to get a piece of your finances! There’s lots of money being made by handling your money. I sure paid my fair share to those companies.

There are literally thousands of financial products out there. Which ones do you choose? How do you even begin? It’s easy to get overwhelmed by trying to learn about these products. It can be difficult to figure out which one you need to meet your financial needs. If you are not well versed in these topics, there’s lots of information to learn about them even before you can make a decision as to which one is right for you. Right? Don’t get overwhelmed. Navigating them doesn’t have to be overly complicated.

You can make finances as complicated as you like. Universities offer associates, bachelors, masters and even doctorate degrees just in finance. But even then, you can further specialize within specific areas of finance. However, folks managed to live happy, healthy, and whole lives before these fancy degrees came along and will continue to do well without them. Education is definitely important in finances, but a fancy degree is not always necessary. There are plenty of resources that can help you along the way. Hopefully this blog can help navigate through the maze.

Some of the wealthiest family members that I know who left an inheritance for their children and their children’s children only had high school diplomas! So, it it possible to gain financial independence without a fancy degree or certification. Cynthia’s parents only had a nice house, a bit of land, a rental house, some land down the street and about a year’s worth of expenses in the bank. My Aunt Terry passed away fairly early in my Air Force career with a few hundred thousand dollars worth of AT&T and South Western Bell stocks in her retirement portfolio. She had always been a saver and started teaching me about savings when I was young. She was the first person who actually got me thinking about money. All three of these people had a few things in common when it came to finances. They had very modest incomes, lived below their means, had no debt, and used what was left to ensure they always had money to live well into retirement. When they left this broken world, they passed some wealth on to their heirs. Oh yea, one more thing…they all only had a high school diploma and no fancy financial degree. They also tithed 10% and gave more hard earned income to church and were generous to family members or others in need.

It’s all about putting the big rocks first. If you learn the big rocks of finance, you can surely make smart decisions that will align with your financial goals. So, what are those big rocks? The big rocks are what make up the foundation for you to build your financial life upon. With the correct perspective as to what type of rocks you are dealing with, you can look at all of the small decisions you make daily with a different perspective. You’ll look at it and understand how it fits into either moving forward to gain a little ground, moving backwards or away from your direction, or maybe it’s a neutral and insignificant decision that doesn’t really matter much.. But by consistently making small decisions that push you forward, you’ll go far. Rest assured, however, there are no shortcuts.

I’m happy to report that my net worth today is positive. Very comfortably positive that will take me to an early retirement and still leave something for the children’s children. I have funds available for emergencies. If there was a break in income for six months the emergency funds would be available to replace income. I’m also looking towards retirement no later than 59 and a half or sooner (I just turned the big 5-0h). So, if you don’t waste as much time as I did doing what everyone else does, you can be better off and retire even earlier than I do!! Hopefully reading this blog will help you avoid some of the mistakes I made.

Get the Big Rocks right and you’ll be well on your way for financial success. The Big Rocks are assets, liabilities, and net worth. I’ll cover assets next post.

Here’s an old, yet relevant, video on finance. (It’s short for the ADD generation). It lays out one of the most important concepts of financial independence. It shows you how to avoid the biggest mistakes the average american makes and teaches you efficiency in spending money. It’s complicated, but I’m sure this crowd will be able to boil down the complex issues into something useful. Enjoy and let me know your thoughts. Here’s the link: Complex Financial Video.

Paw Paw