Years ago, I had a conversation on wealth building that changed my life. As we approach a new year, I thought to share some of the key lessons I’ve learned of saving that have altered the way I view my own finances. To begin, let’s look at some historic trends.
In 1975, the personal savings rate of the United States hit a peak of 14.6 percent. From 1976 to 2005, the personal savings rate of the country fell to a low of less than 1 percent. Although the savings rate in September of this year was nearly 5 percent, for millions of people, living paycheck to paycheck is a reality. This is partially due to the adoption of consumer credit. As credit cards and consumer loans have developed to become more convenient and accessible, the public has grown its indebtedness. Consumer debt on a per household basis increased from this past year to this year by more than 10 percent. The average household currently carries over $15,000 in credit card debt.
Although the above facts should be a good benchmark, it is even more important that we understand why households carry debt. As a banker, I understand how debt can be used to create leverage, float, convenience, and eventually, even significant wealth. The issue that many face in using credit is that increased credit availability usually translates into increased spending. Rather than using our credit to our advantage, we allow ourselves to be buried in a cycle of financing. To illustrate, let’s talk about a car purchase.
Most people, when purchasing a car, have two basic options. Either we finance the vehicle, or we pay cash. With rates as low as they are now, financing is not necessarily a poor option. Finding a car loan under 5 percent could be a significant advantage, as it may allow you to keep your cash on hand invested in a market that could potentially earn you a higher yield than the rate you would pay. If you have a means of acquiring other assets that pay you a better rate of return, then your opportunity cost (the cost of choosing one option rather than another) would be even higher for paying for your vehicle with cash. Unfortunately, this comparison between financing and a cash purchase doesn’t illustrate the whole issue.
There is a simple rule in microeconomics: As income expands, so do expenses. The same is true with our example. If you finance a vehicle, then you have a car payment. This car payment absorbs your discretionary income on a monthly basis. After the term of the loan, while you have paid off the vehicle, the vehicle has depreciated, and you are left with the prospect of again having to finance another vehicle when your car’s life is up. In theory, you could have a car payment for the rest of your life. If we examine the option of paying cash, then we find a similar problem. Although the vehicle is paid in full, our income will have a tendency to expand to absorb the hole in discretionary spending left by an absence of a car payment, and soon, we will be forced to have saved enough for another vehicle, or choose to finance.
There is a third option that most people fail to see. The concept is called self-funding. Essentially, an individual can find a way to control a potential expansion in his or her discretionary spending by assuming a budgeted car payment (radical, I know). By simply forcing a saved car payment on a monthly basis of both principle and interest (even when you don’t have a car payment) by the end of your car’s life, you will have saved enough to again be in the privileged position to choose the best use for your cash. This, of course, requires you save cash up front for a purchase. Paying yourself an interest rate, however, means that you will increase your overall net worth each month. This basic concept can be used for a small purchase if you are just starting out, but the same principle holds true with million dollar purchases as well. Let’s save, consider our opportunity costs, pay ourselves the interest and move forward with confidence.
Benjamin A. Gochberg lives in Avon.
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