Options: What is “Optional” and What is Not When You Have to Cut Expenses?

I have mentioned this several times and even written a post about it specifically. People always say, “I really don’t spend anything,” or “we do not live extravagantly at all” or “I just don’t know why we cannot seem to get ahead, we only spend on things we need.” Bam! There’s the culprit… “things we need.”

I do not want clients to live a monastic life (unless they want to). I do not expect anyone to forsake all earthly delights, but in truth what you perceive as “not an option” may really BE AN OPTION.

When you look at what you spend, there are few things that are NOT AN OPTION, but that list is smaller than you think. After all, an option to one person may not be an option to another. If you ask a billionaire to give up a personal secretary, she may say it’s not an option, yet you and I may not be able to even imagine what it would be like to have a personal secretary. It would be an extravagance.

We all have to make trade-offs in life and if spending less than you earn each month, living consumer debt-free, or paying the IRS (‘tis the season) are your priorities, other things might just have to go.

Here’s a general way I like to look at prioritizing household finances and being financially secure:

  1. Spending less than you earn each month. I’m not kidding, if you do not do this, you will always have revolving debt. Figure out how much you earn and what you need to cut to spend less than you earn each month. Yes, it means less eating out and buying stuff, but it’s worth it.
  2. Pay the IRS! Seriously, folks, these guys are not joking around. If you are in arrears to the IRS, they should be the TOP of the priority list no matter what.
  3. Pay more than the minimums on your revolving debt.
  4. Contribute about 15% of your pre-tax to your retirement account.
  5. Have $3,000 (family of 4) in a Rainy Day Fund for brake jobs, root canals, emergency plane tickets and stuff that happens.
  6. Have 3-6 months of emergency savings - 3-6 times 1 month’s emergency expenses (are about 75% of typical monthly expenses)
  7. EVERYTHING ELSE including, house cleaners, food ordered from special distributors, weekends away, occasional babysitting, celebrations, private school, sports teams, season tickets, camp, renovations, new cars, and all the other “not an option” items.

Here’s what’s interesting about the “everything else” part, too: you may need a new car or camp for the kids, or pizza night every Friday. You may need to plan a wedding, take care of a sick pet or replace an appliance in your kitchen, but when push comes to shove, all of those items are options.

Prioritizing appropriately is where the rubber meets the road in financial planning. I’m suggesting you take a good hard look at your “must-haves” and “not an option” items in the face of some of the items on my list above. Can you do it cheaper? Can you delay the purchase? Can you cut the cost?

Yes, paying the IRS or Rainy Day Savings are not sexy or fun, but it does provide security and peace of mind. Security and peace of mind provide confidence and less anxiety and stress. Calm is sexy

PMI: the Extra Couple Hundred You Pay in Your Mortgage for... What?

What is PMI and why am I paying it? I get this question a lot. PMI (Private Mortgage Insurance) is insurance the bank MAKES you have if you put less than 20% down on your home purchase. Before the 2007, it was common for people to put 0%, 2%, 5% or 10% down on a home purchase, which would have been unheard of when your parents bought their home. They had to put 33% down.

Without boring you with a lot of housing finance history, the big boys at the banks needed more mortgages to carve up and resell in the form of CDOs in the 2000s, and to entice people to take out mortgages, they let people put less (sometimes zero) down. Now, after getting a good thumping in the great recession, banks seem to be back to letting people take out mortgages with almost no money down, which means you should understand PMI.

PMI can vary based on the amount you put down and, of course, the size of the loan. It can be anywhere from 0.3% to 1.15% of the amount of the loan per year. The yearly amount is then divided by 12 (months) and you pay the resulting amount per month on top of your mortgage. But, whatever the amount is, you would rather have that money in your pocket than in some insurer’s hands.

The key about PMI is you do not have to suffer under it forever. PMI will naturally go away when your equity level rises to about 22%. How, you ask? If you put down $100,000 and your home cost was $1million, you put down 10%. After years of paying off interest first and then principal, you will have paid a bunch of interest and at least an additional $120,000 of principal bringing your ownership equity to $220,000 or 22% of the ORIGINAL value of your home when you bought it.

OR (and this is a big OR) your house will have increased in value, and you can ask the bank to cancel your PMI because you effectively own 20% of your home. You can also refinance and NOT have to pay PMI at all. Notice that the threshold if you go ask the bank to cancel it or refinance is 20% and if you have to wait for them, it’s 22%. (These rules are for non-FHA loans, this is a good resource if you have an FHA loan).

Aside from the 2% difference, the BIG DIFFERENCE is that housing prices in many areas of the country are going up faster than you are paying down your mortgage. Thankfully, it does not seem like we’re in a crazy bubble like 2007, but property values are going up.

What do you do? Check Zillow, Trulia, Redfin or whatever real estate site you like and see what your home is worth. I suggest checking several of them. When you think you have a consensus estimate or average, look at your last mortgage statement and see how much is left on your mortgage (principal).

DIVIDE!

If your home seems to be estimated at $500,000 and your principal balance as of your last statement is $378,245, do this: $378,245/500,000. It equals .756 or 76% to you and me. That means in my example, the owner has 24% equity.

If you own over 20% of your home if it were appraised right now due to an increase in property value, you should consider refinancing. You can also call the bank that holds your mortgage and ask them about their process to get PMI waived, but generally, they will not let you use a current appraisal (why should they?). The best way to get rid of it is refinancing.

Now, before you go dialing your mortgage broker, remember, there are points and fees to refinancing and you have to do the math to see if getting rid of your PMI is still worth it, but it is worth looking into and doing the refi math. Next week, I will talk about refi math and why and when you should consider refinancing.

How Much Do You Need in Savings (No, not retirement, we covered that last week)

Everywhere you turn, people are telling you to save more. Save more for college, a rainy day, retirement, emergencies, general savings, for vacations, for gifts, for your heirs. It’s overwhelming especially if you bother to even use the millions of online calculators to help you figure out how much to save. Once you start seeing six figures, you give up...

Okay, kidding aside, what do normal people need to save to have a normal life? Here are some basic rules of thumb. I have to say this: these are general rules of thumb only, every person is different and your specific situation may preclude you from using one of these handy rules of thumb.

First let’s list a few things that would mean you probably need to save MORE than the rules of thumb. It’s not an exhaustive list, there may be other reasons not mentioned here:

If you did not tick ANY of the boxes listed above, the following savings rules of thumb should give you good guidance until you can see a financial planner like myself who will assess all your details and do an analysis specific to your situation.

  1. Have a Rainy Day Fund for car repairs, root canals, home repairs, etc.
    • $1000 if you are single and rent your home
    • $3000-5000 if you have kids and a mortgage ($5000 if you seem to live under a cloud and more than your share of rain falls on your household)
  2. Have Emergency Savings for CATASTROPHES (e.g. job loss, disabling injury/illness, floods)
    • Have 3 – 6 times your MONTHLY EMERGENCY EXPENSES
    • Your monthly emergency expenses are 75-80% of your typical monthly expenses
    • If your household spends $9000/month now, the day you lose your job, you should be able to cut cable, cancel the gym, etc. and get down to about 80% or $7200.
    • If you have good long-term disability, if you are highly employable (e.g. HTML coder) you can have 3 months, otherwise be on the higher end of the range.
    • In our example, I would want the person to have between $21,600-$43,200 saved in cash, money markets or short term CDs/bonds that you can get to within a few days.
    • You cannot keep this money as equity in your beach house or main residence because you cannot liquidate it quickly enough without risk of loss.

Remember, this is the MINIMUM you should have as LIQUID savings, which is in a money market, savings account or an account that you can ACCESS IMMEDIATELY with NO PENALTY OR RISK OF REDEEMING OR WITHDRAWING. Any additional savings can and should be managed with return/growth as the priority. Yes, stocks, beach houses, art... that's for another post.