Post #3 – The 2nd and 3rd Most Important Rules of Personal Finance
In my last blog post, “LBYM” The First Rule of Personal Finance, I emphasized the importance of people adopting good financial behavior of “Living Below Your Means” to form the foundation of wealth accumulation. If you do not LBYMs and free up cash for retirement savings or, for that matter, any other financial goal, all the other retirement and investment planning concepts and strategies are useless. In this blog I want to touch on what I believe are the 2nd and 3rd most important rules of personal finance.
The 2nd Rule of Personal Finance – Establish an Emergency Fund
The first step in any retirement savings plan should be to accumulate enough savings to establish an emergency fund. This fund should only be used for true emergencies such as a job loss, a short term disability, or an unexpected large medical bill. It is not to be used to pay off such predictable living expenses as a family vacation or the credit card balance for an extravagant Christmas season. An emergency fund is necessary so you do not dip into your retirement savings account if disaster strikes.
How do you determine the size of your emergency fund? This fund should be equivalent to a minimum of 3 or 4 months living expenses. If you can save more, that is even better, but 3 to 4 months should be the minimum. The monthly amount should be the minimum your family requires to fund the basic living necessities. You should include the cost of servicing any minimum debt payments, but you do not need to include your monthly retirement savings or the government taxes taken out of each check. For example, say you have a monthly gross income of $5,000. In a typical month you contribute 10% in your company retirement plan and you pay about 16% of your monthly check to state and federal taxes (~$800). Let’s assume you also spend about $500 a monthly on non-essential items like eating out or going to movies, etc. This means your net monthly expenses on essential items are about $3,200. Funding 3 to 4 months in an emergency account would mean accumulating about $9,600 to $12,800. These funds should be kept in a very liquid type of account like a money market or regular savings account so they can be withdrawn in case of an emergency.
The 3rd Rule of Personal Finance – Pay Cash for Everything
Since 1980 America has been turned into a credit-based society. Despite some retrenchment the last few years due to the 2008-2009 financial crisis, Americans still depend far too much on credit. Today finance companies have made purchasing almost everything by credit very easy. Americans need to change their credit buying ways if they do not want to end up destitute when they are 65 years old. You should save up the money and pay cash for everything in life. Credit cards should be viewed only as a convenience that you always pay in full every month. If you let yourself get into credit card debt, or any other kind of debt, it seems to get harder and harder to get out of debt. It also goes without saying that being in debt greatly inhibits your ability to save any money for other financial goals.
The single worst personal finance move you can make is to purchase a new car with credit. It may seem impossible to buy a car without credit, but there are many quality used cars available for just a few thousand dollars. You may think that older cars are going to cost a lot in maintenance, and sometimes they do. But the cost of owning (without financing) a 4 or 5 year old used car will never even come close to the cost of owning the same car new with loan payments, the higher insurance premiums, and the depreciation loss. I can tell you from experience, if you buy an older car without financing, you will turbo-charge your retirement savings rate. I currently own a 12-year old Honda with 170,000 miles. I have owned it for 8 years. I keep detailed records of all my living costs (another good personal finance habit) and I have spent a little under $1,000 on maintenance and repairs over 8 years (that’s less than $125/year). My insurance premium is less than $300 per year. Even though, now, I can easily afford to pay cash for a new car, I plan to keep my Honda a few more years. For me, cars only represent reliable transportation.
To finish this blog I must make a comment about purchasing a home. The one exception to using credit is purchasing your home. There are several reasons for this exception. First, the interest paid on a home loan is tax deductible (at least for now). Although homes, over a long period of time, generally maintain or increase in value, as the last few years have demonstrated, over short time spans, this is not always the case. Therefore, your home should not be viewed as an investment. However your home loan, which is being paid down over time, should have an asset backing it in the event you want to sell your home and pay off the loan. In the recent 2008-2009 financial crisis, many people’s home value dropped so much they are now “underwater,” i.e., the value of their home is lower than their mortgage balance. This is unfortunate. This is why you should not buy a home until you can make a significant down payment at the time of purchase. And, most importantly, don’t purchase a home when there are 20 buyers for every home available. When homes regularly receive multiple offers as they did in 2003-2006, this is an obvious sign that it is not the time to buy. Knowing the true value of an asset, whether stocks or real estate, will be one of the most important investment skills you need to learn. I will discuss this important concept in a future blog post.
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I disagree with rule 3, to a point.
I pay everything I buy with credit cards. I hate carrying cash, and carry as little as possible. What I have, though, is discipline over my spending. I never carry a balance, as you mentioned in your post. I will wait and save up for purchases, but, especially for things I am saving for, I do not pay with cash – it is usually cheaper to buy over the internet, and my card has a small rewards program that returns a little over 1% back to me once or twice a year.
As far as cars go, I do agree with you.