Below Your Means Basics: Debt and Savings

Before we get started, if you are months away from foreclosure or other serious financial consequences, this is not the article for you. We do not cover issues like bankruptcy, credit repair, or debt settlement agencies. Consider consulting the assistance of your financial adviser and/or attorney. Our favorite online legal resource is  Nolo’s Bankruptcy Center has plenty of good, free information and they also offer a variety of for-fee products to help those with serious credit and debt problems.

When I was younger I was helping some friends who were newly married with their finances.  I commented that I was impressed with their ability to save.  They quickly added “it’s not that much of an accomplishment when we’re running the credit card up just as fast.”  Fortunately, the statement was an exaggeration, but there was a grain of truth to it – while their savings rate was much higher than the rate they were increasing her consumer debt, the debt was there and the principal was growing.  And because almost all of their savings was tied up in retirement accounts, there wasn’t immediate relief.  I went home and realized I was in a similar situation.  I was saving for the long term but doing nothing to manage my own short and medium term spending.

This kind of problem is very common.  Whether you got in trouble with credit cards (easy to do), were hit by the recession (easy to do), or both, unfortunately it isn’t unusual for people who have respectable incomes and good credit ratings to nevertheless be slowly digging a debt hole that means they will never have financial freedom.

Many people believe (or at least assume) that their spending habits should be directly tied to their incomes.  For this reason, even as people’s incomes increase, their spending increases.  This isn’t necessarily deliberate.  The act of buying a home or moving to larger house, moving into a more expensive neighborhood, having a child, etc. can raise your basic cost of living.  Even without those life changes, it’s easy to see an increase of income as an “improvement” in lifestyle.  This mindset to personal finances often leads to the “payment effect”, where by you become only concerned with what payment plan you can afford.  Unfortunately, this is a vicious cycle that can all too easily end in ruin.

But there’s another way to look at it.  Rather than look at your income, you can focus on your net worth. Your net worth is pretty easy to calculate, and most software programs for tracking your finances can report it very easily.  Your net worth is the sum of all of your assets (the value of your home, your car, your retirement accounts, any investment accounts, your checking and savings accounts) minus your liabilities (your mortgage, car loans, any other loans, and credit card balances).   If the things you own are worth more than what you owe, then you have a positive net worth (sometimes referred to as “in the black”).  If not, then you have a negative net worth (sometimes referred to as “in the red”).

It’s helpful when looking at net worth to pair assets with their related liabilities.  For example, pairing a house with it’s mortgage, or a car with it’s car loan.  Then you can see the effect of a particular purchase on your overall net worth.

Here’s an example of a fictitious family:

Greg and Linda bought a house 2 years ago in preparation to have a child, and Linda is now expecting.  While they put 10% down, the house has lost some value and so their mortgage  is high compared to the value of the house (but they aren’t underwater as they didn’t buy during the peak).  They also just bought a brand new Honda Odyssey minivan.  They are almost done paying off a 2007 Camry that they bought new as well.  They’ve done some saving for retirement and recently opened a 529 account for their baby using a $2,000 gift contributed by the baby’s 4 grandparents.  On the liabilities side, they have 2 credit cards that they use for routine purchases as well as 3 store credit cards they got when furnishing their house.

If you put it into a table you can see the paired assets & liabilities:

Assets Liabilities Impact on Net Worth
Home 200,000 195,000 5,000
2011 Honda Odyssey 32,000 32,000 0
2007 Toyota Camry 11,000 1,500 9,500
His 401(k) 10,000 10,000
Her 401(k) 12,000 12,000
Checking Acct 500 500
Savings Acct 250 250
529 Account 2,000 2,000
VISA Card 5,764 -5,764
MasterCard 8,953 -8,953
Store Credit Card 1 1,572 -1,572
Store Credit Card 2 875 -875
Store Credit Card 3 3,419 -3,419
Student Loans 18,000 -18,000
Totals $267,750 $267,083 $667

Our example couple has a net worth of $667.  The good news is that they are in the black.  The bad news is that they owe about as much on their house as it is worth (they have a high debt to equity ratio), which will make it hard for them to sell their house if they decide to move.  Also, the new minivan will probably depreciate faster than they will pay it off, leaving them underwater on it for a time.  Also, because almost all of their savings is tied up in long term investments (their 401(k) and 529 accounts), they can’t use that money to help reduce the consumer debt they have, which is substantial.  Between their Visa, MasterCard, and store credit cards they owe $20,583, and the interest on that is going to be significant.  Assuming a rate of around 16%, they could be paying upwards of $3,750 in interest each year.

Greg and Linda have the money to make ends meet, although most of their conveniences and luxuries go on the credit card.  So they are making it, and doing just fine from an income perspectiveThe problem is that, from a net worth perspective, they aren’t getting very far. Their credit card debt is rising about as quickly as their savings rate, and while at first they thought it was going to be a temporary increase, they are finding that the maintenance costs of the new home and preparing for their child is changing their spending habits, and not necessarily for the better.  They are looking at their budget and trying to figure out how to cut back, which they’ve done successfully in the past to save up for the down payment on their house.  But for the first time, they are starting to ask themselves net worth questions – do they want to keep two jobs?  Is Greg’s career, which requires some travel, something he wants to keep even as their baby grows?  What about more kids?  Greg and Linda are starting to ask value-based questions about their finances, and realizing the difference between having a high net worth vs. income.

Once you start looking at your financial life through the lens of net worth, you start to see the distinction between what you can afford and what you value. Rather than deciding you should spend X% of your income on a mortgage or car payment, or save only Y% of your income, you can consider how fast you want to grow your net worth and why.  These kinds of decision can help you build a value-based budget and make that budget much easier to stick with.

Next time, we’ll discuss the basics of debt, and how to control it for your own happiness.

Thumbnail Photo: Blocks 1 by Crissy Alright

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3 Responses to “Below Your Means Basics: Debt and Savings”

  1. James D

    This is a great article. My wife and I went through the exercise the other night, and it is pretty eye opening. Mint has a built-in tool to help with this, and even provides reporting to help gauge this over time, which is pretty cool.

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