A while back we heard a nutritionist talk about the balance between exercise and what you eat. She felt that the emphasis for general health, and a stable weight, that the focus should be 20 per cent on exercising and 80 per cent on what you eat. If you were to go for a long run and then feast on fast food, then the result would not be as you would hope. On the flip side, you could go for a moderate walk and eat a healthy, moderate sized meal, you would have a better overall result.
Let’s compare nutrition with your personal finances. To have good financial health you must balance what you make with what you spend. There are many situations where an individual or couple is making good money; however, they are unable to get ahead as they simply spend too much money. On the flipside, I’ve seen people that make a modest income that have accumulated a sizeable nest egg by being prudent with what they are spending.
Leading by example is a great financial lesson
We have all heard the saying, “keeping up with the Joneses.” If someone is always chasing the Joneses, then this does not bring internal contentment. Much of the stuff that people buy ends up in the landfill within months or a few years of the purchase. Many impulsive buying decisions have a negative consequence to good financial decisions.
Before buying anything, it is worth taking a step back, or waiting a couple of days, to see if this is something that you really want or need. If children, see their parents compulsively buying then they are likely to learn similar habits. Leading by example and teaching your children to spend within their means is one of those financial lessons worth passing on.
Whenever possible, talk to your children about marketing and sales tactics used. If you don’t need the item, then it doesn’t matter what the sale price is. Telling your children to wait just a day or two, before doing a compulsive purchase, and think about whether you really need it – most times the answer will be no.
Personally, I’ve told my kids that spending time with people and out in nature is far better than spending time in a shopping mall or shopping online – the best part is you will be physically and financially healthier.
Credit cards can be a nightmare
Over the years we have had numerous discussions with our clients who are having to help their adult children get out of debt. In these cases, credit card debt has accumulated near the maximum levels of the card and the interest costs have become too daunting and unmanageable.
For example, a credit card that has an Annual Percentage Rate (APR) of 18 per cent would have a daily rate of .049315 per cent. If $30,000 was outstanding on the credit card today, the interest cost for the day would be $14.79. Tomorrow the interest would be calculated $30,014.79 x .049315 per cent = $14.80. The interest costs would be approximately $450 per month without paying down the amount owing.
The general rule of thumb that we tell everyone is that if you can not afford to pay off the credit card at the end of the month, you should not do the purchase as the ultimate costs start to skyrocket once interest costs are added on.
Actual costs of the latest and greatest
Let’s use an example of a couple that have a $1-million home and have a mortgage of $750,000. Let us also assume that the interest cost on the mortgage is 5.0 per cent with a 20-year amortization.
Annually, the interest costs alone are approximately $37,500. Any extra funds that are available to pay down the principal will make a huge financial impact and greatly shorten the 20-year amortization.
If you feel that you would like a new vehicle and put $50,000 for an upgrade, instead of paying down the mortgage, this will end up costing you substantially more than $50,000 when you add up the interest and depreciation costs. If the choice was to pay down the mortgage, instead o buying a new car, the interest costs would decline approximately $2,500 annually ($50,000 x 5.0 per cent).
When you buy a new vehicle, it begins depreciating annually at a far greater value than an existing used vehicle. Assuming in 4 years, the vehicle is worth $35,000 then the cost to drive the newer vehicle is approximately $25,000 for this period [(4 x $2,500) + $15,000 depreciation of new vehicle]. Chances are if you continued to drive your older vehicle you would have had some repairs and maintenance but likely nothing near $25,000.
Eating healthy at home
Let’s do a couple of more food and financial health analogies. Every day we can choose to prepare quality meals at home, or we can choose to go out for meals at restaurants. The benefit of making meals at home is twofold – you can make these meals as healthy as you want (both portion size and ingredients), and they typically cost a fraction of what they would be if you chose to go to a restaurant.
The little transactions matter too. I’ve mentioned the latte/coffee factor a few times over the years. If every day you are going out for one or two coffees, you are likely spending $5 to $10 per day. For a fraction of that price, you can make a coffee at home and save a couple of hundred dollars every month. It is the sum of the little things that matter.
This certainly doesn’t apply to those that have extra funds in the bank and doing well financially. For people saving for a big purchase (i.e. education, house, etc.) then choosing to eat at home, and making coffee at home/work helps save extra money. As the old saying goes, crumbs make bread.
Back to budgeting
Controlling spending is perhaps the most important first lesson that all young people can learn. Parents that lead by example are better preparing their children for financial success and contentment. One of my favourite methods for having this with clients is prepare a Total Wealth Plan. When we gather information for a Total Wealth Plan, we will have people estimate how much they spend on necessities, transportation, personal, child/dependent care, shelter costs – principal residence, secondary residence expenses, an other miscellaneous items.
Below are the main categories that gives budgeting a little more clarity. We ask clients to estimate what the annual costs are for each item, if applicable.
- Necessities: Food, clothing, medical, dental, telephone, other.
- Transportation: Vehicle loan/lease payments, gas/oil, repairs, parking, vehicle insurance.
- Personal: Entertainment, restaurant meals, club memberships, sports and lessons, education and tuition, gifts, travel and vacation, other.
- Child/Dependent Care: Childcare/Daycare, children’s activities, child support payments, alimony expenses.
- Shelter Costs – Primary Residence: Property taxes, property insurance, rent, condo fees, housekeeping, yard & house maintenance, renovations, utilities, heat, water, cable, electricity, internet, personal effects insurance, house fund if saving for a house.
- Shelter Cost(s) – Secondary Residence: Property taxes, property insurance, rent, condo fees, housekeeping, yard & house maintenance, renovations, utilities, heat, water, cable, electricity, internet, personal effects insurance.
- Other Miscellaneous: Charitable contributions, pet care expenses, other.
Younger Clients
Most younger clients are not exposed to our services unless they are introduced to us by their parents through householding. We have written many articles of how families that work together can take advantage of householding. Parents that sit down and explain to their children what items cost could provide greater clarity on spending habits.
Learning how to save is more important than learning how to invest when you are younger and do not have a home or have a mortgage outstanding. If owning a home is a priority, then controlling spending is essential to saving enough money to set aside for a required down payment. For those with large mortgages and debt levels, the cumulative interest cost can add up quickly for those that continue to spend rather than being focused on paying down the debt.
Below we have outlined the importance of savings and the compounding effect.
Retired Clients
At the end of the day, what you spend is often more important than what you earn. Our retired clients are often compartmentalizing their funds into different categories, cash flow for the need items, travel and holidays, home renovations, and donations to charities. They have also reached the stage where they are often wanting to dispose of the stuff they have accumulated over the years, especially if they are downsizing to a smaller residence.
Periodically we will ask our clients what they would have done differently knowing what they know now. We often hear people saying that they wished they had not accumulated so much stuff. Instead of buying stuff they really didn’t need, they wished they had saved earlier in life.
The Compounding Effect
Our wealthiest clients saved early in their life and let time do the rest. For those who don’t control their spending in the earlier years, they will not be able take advantage of the benefits of time.
We often refer to this compounding effect as the snowball effect. Visualize yourself as a kid making a snow man. You would start with a small snowball and then begin rolling it on the ground. As it rolls it gets larger. The more you roll it, the more rapidly the growth occurs. The snowball effect can be described as both good and bad.
The bad snowball effect relates to when people get themselves into a bad debt situation and interest costs start accumulating. Examples of high interest debt include: delinquent bills, credit cards, non-favourable business loans, car loans, and other personal loans. Spending beyond your means is a sure way of destroying wealth accumulation. If interest costs and debt are spiralling out of control then it leaves little discretionary cash flow after each pay cheque. In the worst scenarios, net worth is declining every month.
The good snowball effect positively impacts investors who have accumulated significant savings and investments. Below is a table where we have outlined the growth of two different portfolios, one for Jack who has $50,000, and one for Jill who has accumulated $1,000,000. Both portfolios earn eight per cent and are invested for 10 years.
After 10 years, Jack’s net worth would have accumulated to $107,946.25 and his net worth increased $57,946.25.
After 10 years, Jill’s net worth would have accumulated to $2,158,925 and her net worth increased $1,158,925.
The above highlights that the larger the accumulated savings balance, the larger the potential accumulated earnings and the greater the snowball effect of accumulating wealth, especially over time. It is tough to get the full snowball effect until one has saved enough to get the base level of capital.
Although Jack and Jill both made eight percent and invested for ten years, Jill was able to accumulate $1,158,925 of additional wealth, while Jack accumulated $57,946.25. Jill is fully able to take advantage of the snowball effect in a positive way. Essentially, the greater amount saved, the great the snowball effect. The magic of compounding investment returns is magnified when you have accumulated enough savings. Simply put, those who have saved money make significantly more money on that money.
Kevin Greenard CPA CA FMA CFP CIM is a Senior Wealth Advisor and Portfolio Manager, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at timescolonist.com. Call 250.389.2138, email [email protected] or visit .
