October 31, 2014

Mail Bag: How To Save Money on $40,000 Per Year

I’m going to walk you through how I’d save money if I were a typical 25 year old with a spouse and one kid on a $40,000 salary.

Joshua,

(Referencing this post, which talked about how a typical family could use $197 per paycheck to end up with $4,300,000 over a lifetime.)

lets look at real life
Mail Bag Joshua Kennon Pen40000 x 0.72= 28800 don’t forget city taxes 28800×0.0225=648 = 28152/12=2346/month
A couple with 1 child will spend
500 for food
300 for gas and electric
400 for car payment
120 for gas for car
900 for home payment,taxes and insurance
75 for car insurance
or a total of 2295

Just where in the heck are they supposed to get 394 a month to invest???????????????

Gary Y.

Hello Gary.

Poverty is generational.  Struggles with money are generational.  You pick up a lot of things in life through osmosis.  It is the reason that a member in the bottom 10% of society, for example, is more likely to drop out, more likely to smoke, more likely to be obese, more likely to have a child out of wedlock, and less likely to read for knowledge than someone who is in the top 10% of society.  During the formative years of your life, you soak up an accent, public behavior, study habits, money habits, relationship patterns … it can all be un-learned later, but it is more difficult.  It is that knowledge that determines, to a significant degree once you are in the lower middle class, how much money you amass.  Years ago, Human Resource departments figured this out when large percentages of certain sub-demographics would not enroll in the 401(k) plan because they hadn’t been exposed to how they work.  (The solution ended up being automatic enrollment for everyone, since people aren’t likely to take the time to opt out of the system.)

Someone who thinks a budget like the one you just sent me is acceptable and isn’t immediately in panic mode grew up with a poverty mentality, currently lives with a poverty mentality, and as a result, is always going to be broke.  The struggles he or she faces are not due to a lack of income, they are due to bad financial decisions.  You can complain about getting ahead if you are supporting a child on a $14,000 annual wage as a low-skill retail worker.  That makes it more difficult to save money.  You cannot complain if you are earning $40,000, which puts you in the top 0.51% of people in the entire world.  That means for every 100,000 people on the planet, you make more money than 99,490 of them.

You are the problem.  Your income is not the problem.

In fact, the budget you sent me was so incomprehensibly bad, I printed your message and put it infront of people – all of whom are financially successful and independent – and said, “Look this over for me.  What are your thoughts?  Let me hear them as they occur to you.”  I wish I had recorded the responses because they would have let you see how truly fiscally sick this kind of allocation is.

But you asked a very specific question.  Where is this money supposed to originate?  How could someone possibly save that cash?

If I woke up in that situation tomorrow – say I were 25, married, with one child and a $40,000 income – my budget would look radically different than yours.  And in 50 years, you would be broke, living on government benefits, convinced that your life were the way it was because you just didn’t make enough, while I would have millions of dollars and be completely self-sufficient.  Don’t believe it?  I’ll walk you through the numbers.  Keep in mind, this isn’t purely academic to me – I lived it.  I never inherited any money.  I wasn’t given any startup capital.  I graduated from high school, moved across the country, and put myself through college.  I know what I’m talking about from experience.

The Shelter I Would Choose

You are in Toledo, Ohio.  It took me a few seconds browsing the real estate listings as of this moment to find a perfectly nice, 4 bedroom, 2 bath Colonial with a two car garage.  You can see the listing for it here.

l19440644-m0x l19440644-m2x l19440644-m5x

The asking price is $119,500 but we could probably get it for $110,000.  With a reasonable down payment, the mortgage payment, property taxes, and insurance would cost $500 per month, not the $900 you budgeted.  That saves us $400 per month, or $4,800 per year.

As a first time homebuyer, I’d take advantage of a little known government program called Mortgage Credit Certificates that will be treated as additional income by the bank, making qualifying for the loan a non-event.  Think of it as the type of program Mitt Romney would take advantage of but only for the poor and middle class.  As long as you live in the home and retain the mortgage, you can get $2,000 in cash taken off your taxes every year.  That is another $167 per month.

So now we’re up to $6,800 per year in surplus cash that I have on this hypothetical $40,000 annual salary that you don’t.

The Transportation Situation I Would Select

With a house secured, I need to get my hands on transportation.  Looking at your budget, you have $7,140 put aside each year for car expenses.  I want you to think about that for a moment.  At this income level, you are allocating 17.85% of your gross pre-tax earnings to automobile expense.  That is insanity.  You have lost your financial mind.  The budget you have submitted in no way reflects responsible household management.  It looks like the affairs of someone who is one or two paychecks away from being broke.  It’s the type of thing someone trapped in the cycle of poverty would do because they don’t know any better and they are repeating the same behavior they learned from their parents.

(Side Note: To break the hypothetical for a moment and put this into perspective so you know I practice what I preach, despite having a real life household income exponentially higher than the scenario we are running, my automobile expenses last year including gasoline, maintenance, and insurance was only $3,768.59, making it not only a fraction on relative terms, but nearly half on absolute terms.  That’s because I don’t allocate a lot of money to cars, and I drive them into the ground until they fall apart.  They are depreciating assets.  The moment you buy one, every day that goes by and every mile that is driven, it loses part of its capital value.  You should not have a significant percentage of either your income or your assets in that type of holding!  If I could get away with it, I would walk, bike, take the bus, or join a carpool, avoiding the car expense altogether, but we’ll imagine that isn’t possible due to the presence of a child in the household in this little scenario.

This obsession with transportation is the embodiment of the problem I wrote about in this article, when I said the single biggest cultural indicator to me that tells you immediately that someone was born into, and will pass on, the cycle of poverty is to look at the percentage of their income and assets they allocate to a car.  I built upon it in an article called The Importance of Frugality in Building Wealth.  I have even broken down my own opportunity cost decisions when buying a car as I considered upgrading my own vehicle last year.)

I’d go to my bank, which is offering car loans for 2.99%, and get a 5-year loan for $11,000 to buy a barely used extremely fuel efficient car, like a Fiat 500.  There are only three of us you said – me, a spouse, and a child – and 34 miles per gallon is about as good as I’m going to get, generating some fairly significant fuel savings, keeping even more cash in my pocket.  (Some men seem to have a problem driving a smaller car to save money, stop compensating for your shortcomings elsewhere.  The price differential in their case could be known as an “insecurity tax”.  You need to put your family’s well-being and your own independence ahead of your short-term misplaced pride.  You need to focus on being financially successful, not looking financially successful.)

New 2012 Fiat 500 in Rosso Brillante

Fiat 500 Saving Money

My payment is $197.61 compared to your $400.00, providing an extra $202.39 per month, or $2,428.68 per year.

You are spending $120 per month on gasoline, or $1,440 per year.  The price of gasoline right now is $3.16 per gallon, so you’re banking on buying 455 gallons in a year, assuming steady gas prices.  That should give the car I bought 13,000 to 16,000 miles on the road, so we’ll call it even and keep it the same.  That seems like a reasonable enough allowance.

At this point, my hypothetical family has an extra $9,228.68 per year in cash than your family, which is $769.06 per month.  We live in a four bedroom Colonial and drive a one year old used, but still practically new, car.

How I’d Handle Other Expenses

For now, I’ll leave your other expense assumptions in place, even though I know I could get them much lower and add a couple thousand more dollars to the household income.  After all, you’re talking to the guy who has a negative cost of milk because we did the math on the system.  At this point, we’ve mastered the French peasant dishes.  The phrase “extreme coupon” would not even begin to describe my approach in this alternate universe.  I’d be using Upromise to get at least $1,000 in extra cash back per year on things I would have had to purchase, anyway.

What I’d Do From This Base

One question that goes unanswered – in this alternate world do I have my own skill set?  If so, I’d use that $9,228.68 in after-tax cash to start a business that required very low capital investments but had very high returns.

One option would be catering.  We know how to throw a party, and we know how to make the food taste better than most people have experienced in their lives.  From perfectly molded cakes to seasonal favorites like corn chowder, I am absolutely certain that within 18 to 24 months, I could build a business from a standing start, with that little capital, and no bank loan, generating at least $50,000 in additional income per year for my family.  I’d then use that money to fund the investments.

Another option would be a form of retail, but I’d have to be careful and focus on a system that let me effectively dip into the vendor’s inventory without typing up my own capital.  Again, I could get to at least $50,000 in profits very quickly from a standing start if it were just me.  Is the kid old enough to work?  If the kid in this scenario can work a computer, I can do it faster.  The free labor would be a huge boost (though I would pay him or her in stock certificates for the help so that he or she got a cut of the profit as an incentive).

Most people have their own skill sets that can be upgraded and used to create cash by giving other people the products and services they desire at a price that generates a profit.  That would be the real key to kickstart the capital accumulation phase.

If my normal skill set is out – and even things that require no startup capital, like writing, which I could do in my sleep – I’d shove the money into high quality, high dividend yielding, fair or undervalued securities.  If I were perfectly mediocre in every way, putting $9,228.68 aside every year for 50 years – we’ll assume I’m 25 in this hypothetical and want to measure my wealth at 75 – would give me $10,741.339.  Adjusting for inflation, that would be the same purchasing power as $1,511,442 today.

For never doing anything else, and never starting any sort of business, never improving my life by getting better employment, never trying to work my way up a self-made system like Edward Jones or Avon, that’s a more than satisfactory result.  My house would have been long paid for, so there is also additional equity there that would have allowed me to save, spend, reinvest, or give even more.

Some Final Thoughts

In the real world, do you think the tooth fairy came down and handed me the capital I used to start everything?  No.  I didn’t buy a car until I was in my early to mid 20’s, opting to walk everywhere or get rides with people.  I shopped at Army Surplus stores to get dirt cheap clothes.  I needed every penny of investment capital I could get my hands on so the money would start working in my place.  Every $1.00 I saved could be employed by an oil stock, for example, and earn me 5.4¢ per year in dividend income.

As long as there are no excessive medical expenses due to a health crisis, if someone in the United States earning $40,000 per year doesn’t retire with at least a seven-figure portfolio, it is because they didn’t know how to manage money.  Period.  There are no exception.  It is basic mathematics.  If you don’t want that, fine, but don’t act like it was because it was impossible.  It wasn’t.  You just didn’t do what was necessary (which isn’t even all that much sacrifice, let’s be honest) to do it.

Bottom line: If you are managing your money like the breakdown you sent me, you’re going to stay poor forever and you’re going to teach your children the same habits of poverty that will trap them in the same cycle.  You are transferring all of your wealth to car, oil, bank, and real estate companies.  You’ve allowed yourself to become a slave, a handful of paychecks away from total ruin.  You are mismanaging your affairs.  It has been a long time since I’ve seen a household budget that poorly run.  I want you to do better.  It doesn’t have to be like this.

  • Dylantherabbit

    That is a nice looking house and big to. Here in the UK where I live it would cost around $350-400k for a house like that, at a minimum, for $110k you would be pushed to find a house like that anywhere in the U.K.

    Great response Joshua.

    • Tyler Phillips

      That’s what I was thinking too.. except I live in Ontario, Canada. I wonder what the rental market is like in Toledo. Maybe I should buy that house and rent it out ;)

      • http://www.joshuakennon.com/ Joshua Kennon

        The real estate values are crazy in some part of the United States. In an area like New York, where the land is rare, prices are sky high. For most of the country, we are around the cheapest home-price-to-average-household-income ratio we’ve ever been as a nation.

        A couple of years ago, you should have seen the real estate in Florida! It was so cheap that $400,000+ houses were going for $100,000+. The state has no income tax so you get to keep more of your money in your pocket. It’s warm all year round. You are right next to the beach. One of the family friends was buying up homes down there from builders who were in trouble, figuring that the rental rates alone would generate double-digit cash returns even if he had to wait ten years to see a large capital gain on the property. Las Vegas was the same way price-wise.

        It was an interesting time. If those prices happened again tomorrow, I’d probably be looking for a vacation house in either Miami or San Diego. The Kansas City area in which I live was almost completely unaffected by the housing bust (which is one of the reasons I chose to move to this particular area after college on the east coast – the prices were very reasonable) so I didn’t truly appreciate how bad it was in the overvalued markets. That and my propensity to be extremely conservative – I live way below my means so I didn’t understand how someone could be so hurt even if their home price dropped by 20% – caused me to miss it. Plus, I was focused on cheap stocks at the time.

        But, yeah, there are still some great deals in the U.S. If you ever do look into rental property, check out the government databases of foreclosed loans. Most people don’t know about them but I’ve seen houses go for 50¢ or less on the dollar because no one was paying attention to the auction dates.

        • Tyler Phillips

          Interesting, thanks. The prices in Las Vegas still seem extremely cheap for newer houses, so I can only imagine what they were a few years ago.

          Would you happen to know where to start looking for these government databases? I tried a few websites so far, but they all seem bogus.

        • http://www.joshuakennon.com/ Joshua Kennon

          You are looking for the United States Department of Housing and Urban Development (HUD). They have a list of the homes or sale in their databases here.

          If you click “From Hud”, for example, you will be taken to this page, where you can search by state or zip code.

          You can also look at the Federal Housing Administration (FHA) foreclosure by state directory, which will take you to the website of each state to see information on the latest foreclosures. You anf ind it here.

          I saw a house in a nice neighborhood in my town that was worth $150,000 go for something like $65,000 or $70,000 (can’t remember exactly) at auction. You have to be selective, but some really good deals show up every once in awhile. I have an older relative that loves buying real estate like this and then fixes the property, rents it out for income, and holds it forever. It’s like value investing, only with tangible property instead of stocks, so there is always some liquidation value.

        • Tyler Phillips

          Thanks very much for the info!

    • http://www.joshuakennon.com/ Joshua Kennon

      You’re definitely correct! The budget would look much different if you lived in an area where population density was high, such as much of the United Kingdom. You’d get a lot less for your money. On the upside, if you lived near a major metropolitan area, the transportation infrastructure might make it unnecessary to own a car, which could offset some of that. It would just depend on the situation.

      You see this problem a lot for people who live in places like New York. It can be a great experience, but you definitely have to make a trade-off decision about what you’re willing to give up (e.g., square footage space) for what you gain (e.g., amazing cultural opportunities, educational facilities, shopping, art galleries, parks, etc.)

  • Alexander Davis

    Joshua,

    One addition you could make to this hypothetical budget is he would likely have a significant tax return if he is paying 28% and has a spouse and child. That return should be included in his calculations assuming he doesn’t blow it like the average american each year.

    This article is so sweet, this has been what I have been doing since I graduated College and moved to LA.

    I have a good job but cost of living is high. I sold my car and easily take the bus to work for 40 dollars a month. I can bike and save 2 dollars a day.

    I cook large dishes that serve up 8 great tupperware meals for about 12 dollars. It could be cheaper but I like eating a lot of chicken.

    I live in a 300 sqft studio and love every minute of it. It takes almost no time to clean and saves on bills.

    I have a significant amount of student debt but it is financed at a weighted average rate of less than 3.5% fixed. I happily pay the minumum as it is offset by my investment accounts.

    I serve in the national guard one weekend per month which brings in extra money and which will net me an portfolio equivalent of about 1mm at 59. This significantly reduces my retirement outlays, so I created a taxable income portfolio that is growing slowly but surely.

    Living in one of the most expensive cities with a large student loan payment each month I can still easily save 15% or more of my cash flow. Including my payments on my cheap debt, I am contributing about 40% of income towards my net worth each month.

    • http://www.joshuakennon.com/ Joshua Kennon

      That is a great point about the tax bracket! Excellent catch.

      Your post made my day. It sounds like you are doing everything right. Most positive outcomes in life are the result of tilting probabilities in your favor for good things to happen and it sounds like you’ve set the board beautifully! I mean it when I say I hope you get everything you ever wanted. You’re already lightyears ahead of everyone else with the mindset you have.

      • Trey Petty

        Joshua, just as an aside, i’m currently in Income taxation (second career). At $40k gross income, the couple would get $11,900 for standard married filing joint deduction plus 3x$3,800 for dependency/personal exemptions. This would bring their taxable income down to $16,700. Their actual federal tax owed would be $1,673. They’d also likely qualify for a child tax credit but we can ignore that for now. That $1,673/40,000 equals an effective tax rate of 4.1825%. Yes, they may have 5% for state and that 2.25% city tax but they’re nowhere near 28%. That level of taxation understanding is another problem with this country. Everyone believes that they are paying their marginal tax rate.

        • http://www.joshuakennon.com/ Joshua Kennon

          Awesome information; thanks for taking the time to post that!

        • TheNessaEmpire

          Yeppers, few know to calculate their effective tax rates. If the
          savings went into a pre-tax retirement account, like a traditional IRA
          or 401k, their taxable income would go even lower. Plus, the typical
          belief of a tax refund as a yearly windfall is frustrating! It’s an
          interest free loan to the IRS or a forced savings plan for those who
          don’t know how to calculate actual withholding rates.

      • Alexander Davis

        I want to thank you for this response.

        I have been studying finance for years but this site really helped me internalize the things I already knew. A lot of my coworkers think it’s strange that I don’t have a car. But I also lived in a plywood hut in Afghanistan for a year. Also in places with no running water and only canned or freeze dried food. I learned that living a simpler lifestyle is totally fine.

        An additional bonus of that experience was feeling financial freedom. I had no expenses and a solid paycheck. I almost never checked my bank account for a year other than setting up a Roth IRA. I made some mediocre investments and then read about indexing. I’ve been doing great ever since.

        My parents are in trouble in retirement. I may send you that story in an email with names changed. But the point is, their situation is frustrating to me because my dad had a very good career and missed the boat on compounding early. Now I am so upset by it that I am determined to retire with a huge margin of safety. Ideally I will be a multimillionaire with an owned home and have low monthly outlays. Allowing for over six figures a year of disposable income. I understand inflation will take a toll, but that’s built into my planning.

        Anyway, thank you for your time in sharing these articles. I understand you could probably find better ROI elsewhere, but I think this site is one of the best for people who are willing to apply their brains.

  • Tony

    Joshua,

    This has got to be one of the most condescending answers to a question I have ever read. Now I realise this blog isn’t meant to help, but rather to lecture people. It’s a time tax on your insecurity, Joshua.

    I worked since I was 14, teaching myself programming and spending every hour I could working remotely for companies. I saved up over $250,000 before I’d finish college. That money works for me now. But I’d be misleading if I said I didn’t get lucky along the way and that I didn’t have a family I could count on to provide for me.

    You claim to be a self-made man. That may well be true. But you have a wealthy family to fall back on, don’t you? (Oh yes, you mention it in every post) Doesn’t that make a world of difference, knowing you can fail and still survive? Some people aren’t that lucky.

    To suggest it’s mathematically impossible not to have a seven-figure retirement account on a $40,000 salary with a family is, quite frankly, ridiculous. There’s nowhere near that amount of certainty in life, and I’m not talking about health issues.

    • http://www.joshuakennon.com/ Joshua Kennon

      A man who will effectively bankrupt his family to drive a car that he cannot afford either has penis envy or self-worth issues. He needs to see a psychologist. There is nothing condescending about it. It’s simply a fact.

      Personally, I have three vices against which I must guard. Insecurity has never been one of them.

      1.) Lack of patience. Almost everything in life has always come easily to me so I forget that it isn’t the case for others and have to remind myself that sometimes they really are trying. I was the kid who didn’t have to practice but would win the music competition; who didn’t have to study and who would ace the exam. It took going away to college to realize that I should always try to treat people as if the roles were reversed because if I were struggling, I would want help. It’s still a struggle to me when I don’t understand how certain things aren’t perfectly evidence but it’s gotten much better as I’ve grown older.

      2.) A propensity to put on weight if I’m not careful because of the amount of time I spend doing work that requires reading or thinking, which by its nature is not physically active, and

      3.) When dealing with people who see the world primarily through emotions, rather than rationality, forgetting to communicate with them in the language they understand. For example, re-writing this article, I could have made precisely the same points in a way that would have been enormously appealing to someone who was mismanaging their own finances, disarming them. Given that I prefer data, and logic, I cut to the heart of the matter too quickly, in a way that sometimes seems cold to others, even though my primary motivation is really to help them so they can live better lives.

      I am not being so direct – which you are incorrectly interpreting as condescending – to try to make him feel bad. I am trying to put it in stark terms that are so clear they cannot be misconstrued: He is, pardon the language, f***ing up his financial life badly. I don’t want him to do that. I want him to have independence. I want him to not have to rely on an employer. I want him to not have to worry about putting food on the table. Why? I have no idea, but I actually care about this stranger who takes the time to read my site because if I were in his situation, I would want someone to step in and help me.

      To be fair, your complete misunderstanding of my family history, my philosophy, and my own motivations is understandable – you’ve read less than 0.004% of the posts on the blog since you found the site and you occasionally show up every 28 days and spend a couple of minutes reading an article about the KRIP portfolio and / or some of the vacation posts. You click only on a few pieces of content that talk about either spending money or investing money, skipping over everything of importance. If I had your reading habits, I’d think I were an asshole, too.

      P.S. Over a 50 year time period, amassing $1,00,000 would require less than $75 a month put into a productive asset generating mediocre rates of return. Your assertion that it is unreasonable for someone making $40,000 a year to reach that level of savings is absurd. There is no luck involved provided there are no medical emergencies suffered or, in a far less likely scenario, a global catastrophic war (even then, there are always intelligent things to do).

    • Alexander Davis

      Tony to be fair, he emailed Joshua asking a question. He got a very detailed answer. If he doesn’t like the price, (free) or isn’t satisfied with the quality (very detailed). He can just go elsewhere. Nobody is forced to read anything. I don’t understand why people get upset about it. He asked for advice, and guess what, he needs it.

    • Eric King

      Tony,

      The problem I have with your statement is that you think the $40k per year is a permanent scenario. Look at what you did with your life. You worked hard and earned the salary for your skill set. I guarantee you, this family can work additional jobs or come up with creative ways to increase their annual salary. A snapshot of a family budget and income is where they are at but it doesn’t mean they are stuck at that point.

      The fact that they have a $400 car payment is totally insane. Who are they trying to impress with that? A $900 mortgage? Why? Can you not live in a house with less square footage? It screams entitlement and that one deserves something. If people can just sacrifice and delay pleasure for a few years or so, they would put themselves in a much better position financially.

  • http://www.joshuakennon.com/ Joshua Kennon

    Amen!

    Somewhere around here, I have a breakdown of the average household income expenditures by demographic and I was shocked to see that when you get to the bottom 20% of society, the purchases of alcohol and tobacco are huge, both relative and absolutely, whereas they are almost non-existent the further up the income and education chain you go. It still doesn’t make any sense to me that the people least able to afford a disposable, addictive product that not only costs a lot of money but also drives up health costs later in life are the ones most likely to desire it.

    Most smokers or heavy drinkers could retire on what they spend on the tobacco and alcohol products alone if they were to put the money aside into good investments.

  • http://www.joshuakennon.com/ Joshua Kennon

    That’s a good point. The problem I have (see vice #3) is that both are true statements. In my mind, there is no emotional loading there. They carry no connotation, either positive or negative, they are simply facts. I understand, and appreciate, that not everyone thinks that way and, thus, it comes across in written form in a manner very different than the intention.

    • Tony

      Point taken. Like you said, it’s probably easy to misinterpret if one only reads a small fraction of the content posted by a person one has never even met before.

      The whole reason I took the time to respond in the first place was that I thought the “evident” arrogance was ruining the message you wanted to transmit. It wasn’t altruism: myself, like many other readers it appears, appreciates you taking the time to write all this stuff (even if I didn’t get to read all of it).

      While we’re on subject, I’m guessing you don’t buy Eldar Shafir’s “psychological poverty trap” theory? Would be a good topic to touch on…

      • http://www.joshuakennon.com/ Joshua Kennon

        I mostly agree with Eldar Sharif but I think his theory is only half the story. The other half is Ruby Payne’s theory.

        That is, there are exceptions to Sharif’s theory (we’ve all met, been related to, or known someone who is just a bum that can’t stick with a job, always does something stupid like steals, or is constantly in trouble with the law), but a significant portion of people are held in true poverty because they are subject to what has been called “the tyranny of the now”. What he misses is what Payne picks up – another significant group of people, sometimes overlapping, held in poverty due to a lack of what is known as “situational knowledge” in education. There are lessons about how money works that you pick up if you come from a middle class or upper class household that would never occur to most people who weren’t exposed to it in childhood.

        I think that is perhaps the reason I find myself so harshly adamant toward the reader’s premise is because there is no poverty here. In a case like this (someone making $40,000), that’s not poverty. Poverty is a single mom working at Wal-Mart for $9.25 an hour with no day care and no health insurance. It’s going to be enormously difficult for her to be thinking about things like investing or retirement saving. In the long-run, even $50 or $100 a month can be enough to make a huge difference, so it’s still not hopeless, but those are the struggles that need assistance programs and community involvement.

        For someone in the situation of the original questioner, with $40,000 per year coming into the bank, all financial stress in life is due to decisions, not a scarcity of capital. All pressure is self-induced, not created by poverty itself. If the single mom has to take on credit card debt to buy her baby formula, that is one thing. But if our guy making $40,000 takes on credit card debt, it is because he is doing a poor job at allocation. Arguably, he could stumble into a cycle that then made him subject to the same forces as Sharif’s theory (bill collectors calling, mortgage providers foreclosing, etc.) In that case, I think the best way to break it is bankruptcy. People are far too emotionally invested in money, instead of seeing as a tool, so they will put it off, harming themselves further instead of using the nuclear option.

  • Gilvus

    As usual, your logic is flawless…though the way it is delivered resembles an attack more than well-meaning advice (which I’m sure was your intention).

    It’s like ordering a steak at a nice restaurant and the waiter throws it at your face. Sure, it may be perfectly cooked and seasoned, but the way it was delivered ruins your entire experience and practically guarantees you’ll never visit again.

    • http://www.facebook.com/joel.willems Joel Willems

      I try to put myself in the position of the advice seeker. My initial reaction was a little upset and then I thought, “I needed a good talking too.” Like a coach yelling at a player to correct an error. If he/she is a good coach it is not out of anger but to get your attention and make the point sink in.

      • Gilvus

        I believe that method only works because the players and the coach want the same thing (for their team to win). It’s different when you are trying to convince an outsider to your way of thinking (or vice versa) – if the exchange becomes confrontational, the “receiving” party goes on the defensive and suddenly it’s “us versus them.”

  • http://www.joshuakennon.com/ Joshua Kennon

    “I think it would help a lot more if Joshua provided some insight on how to dig oneself *out* of such holes, rather than avoid them to begin with. ”

    That is a wonderful suggestion. I’d need to think about it to give it the attention it deserves.

    • Kat

      I for one would really appreciate this. My husband and I are not starting from ground zero — we picked up all those bad habits from our parents and are now trying to unlearn them. It’s a long and painful process, because the mental paradigms and emotional responses need to be reprogrammed in order for the behavioural changes to really stick and become automatic.

      I don’t know any people in my life who are living the way I want to with the financial attitude I want to emulate, so right now that means I’m reading a lot of books and the internet and just surrounding myself with it as much as possible. That’s great for me, since I’m a huge reader, but my husband really isn’t, so the journey’s a lot bumpier for him.

      • http://www.facebook.com/joe.pierson.54 Joe Pierson

        Have a friend whose wife requires a BIG SUV for child protection, so he is kinda stuck with high car payments. And she wants to live close to her parents which is a high price neighborhood. Agreed it is very complicated to get out of this type of situation, if not impossible.

    • msroxanne

      Dave Ramey offers a good 7-step approach to getting out of debt. I used it to become debt free–April 30, 2013 I paid off my last debt–while gathering investing and other life prinicipals to build wealth from this blog.

      • http://www.joshuakennon.com/ Joshua Kennon

        Woo hoo! Congratulations on being debt free!!!! I’m proud of you!

      • Sean

        Congrats. I was already debt free when I stumbled on the Dave Ramsey program, but FPU was interesting and the total money makeover book was interesting.

  • lokgp

    I actually like this type of mail bag question. It tackles the direct questions and problems that are around me. It gives a solution to a problem. Well, only if the one being lectured, or talked to is willing to turn around and set themselves for change. It is very rare for that to happen. But none the less, it offers a straight formula for their success and pursuit of happiness. I just hope more people can listen at the message and remove the noises. Straight advises like this are far better than encouragements that gives you false hope and more wall banging, only to come to the same conclusion yourself. But like I say, people rarely listen. Neither do I. Its a mental barrier that needs crossing and aware of.

  • http://twitter.com/DividendGrowth DividendGrowth

    This person should not be paying so much in taxes. Standard deduction for a couple is almost $12K, plus 3 exemptions – $12K. First 24K is tax free. The remaining funds are taxed at 15%.
    If that person save $500/month in a 401K , they can get a tax-deduction today and possibly even get a match on it form company. If 401K is not available, then you can alwasy put $5K in an IRA, and get a deduction. They can just buy index funds and then they are set for life. If they wanted to learn, dividend stocks would have been best for them.

    The real question is, why is this person unwilling to educate themselves?

  • Alexander Davis

    This is only a first level response.

    True the more debt others carry generally the more benefit to people who carry assets but I imagine your scenario would only exist for a decade or so.

    As investment yields in the US dropped, capital would flow across borders to the most promising areas of the world. Granting them cheaper money and more successful projects. The cost of all goods worldwide would continue to decrease as a result engendering better conditions in real terms even if returns on investments were not as strong.

    Imagine if all the brilliant, and or hardworking people in the world had strong access to capital instead of just those in developed countries. It would be a huge force for global wealth. Big returns are not the only measure of wealth building. If as a society we can drop the prices for almost all goods through efficiency everyone is better off.

    Also, Joshua is an example of temporary spending constraint. He was very careful and disciplined but now I would argue he is quite the consumer! Frugality isn”t eternal. As peoples situations improve, they will spend as well.

    • FratMan

      “He was very careful and disciplined but now I would argue he is quite the consumer!”

      It took me a while for this point to hit home, and even though I had read it before many times, it’s entirely possible that Joshua could be more frugal now spending big money on five-star hotels, colognes, or whatever than he was in his startup days because his income may have grown at a rate far greater than his spending increases.

      Did you read his post awhile back about his Borders investment? One of the things he mentioned about Borders is the fact that the company has high fixed costs, and above that, everything is profit. Well, connecting the dots, our own lives are a lot like that. Once you pay the cell phone bill, health insurance, internet, mortgage, utility bills, and whatever else (and yes, I know mentioned those items in suspect order), everything is quickly profit that drops to the bottom line once you get past that point.

      Charlie Munger, Buffett’s right hand man, always said that saving the first $100,000 is a bitch. There’s so much truth in that. Going from nothing to tens of thousands of dollars in passive income is hard, and most people will die without accomplishing that. But going from $120,000 in annual passive income to $240,000 is a breeze compared to getting to that $120,000 part. That’s the nature of compounding.

      Point being, it could be way off base saying “Joshua is quite the consumer.” He could probably buy the nicest car in the dealership lot, and still be spending a lower percentage of his annual income than when a typical middle-class family goes out for a nice dinner.

      My point? It’s entirely possible that Joshua lives way, way, way below his means compared to the rest of us.

      • Alexander Davis

        I guess the point I was trying to make, is somebody is spending that capital somewhere. If I buy shares to add to my wealth, somebody on the other side of the trade needed the cash to purchase something. The driver of wealth is the efficiency created when people employ the capital to accomplish things. A nation of savers is not inherently bad, as their conditions will improve as they build wealth and others employ their capital to create a more efficient world in which we all have more on absolute terms.

        So I misspoke, I understand your point about the Kennon household not spending a large percentage of it’s income.

  • Chris Falkner

    That was the funnest most informative article I have read in a while. Thanks Joshua

  • Ray

    In many ways, this advice is helpful. In others, not so much, because–as a 25 year old, recently married, graduate student who is trying to plan ahead–I see a number of areas of concern for me and my wife that the article really doesn’t address.

    First, I’ll say that I agree completely about the car payment. $400 a month is outrageous, especially on a $40,000 household income with a child. I’ve had two car loans in my lifetime, and both were around $160. The most recent one was a 2000 Honda Civic with less than 60,000 miles, which I was able to get for $6000. But once you factor in warranty, taxes, registration and paperwork fees, etc. my payment came out to around $160 / mo on a 48 month plan after a $2000 down payment. We are, however, hoping to start doubling our payments soon so we can get that debt out from under us sooner rather than later. Also, I don’t think this is a two-car situation, as this individual shows $75 a month in car insurance. That’s about what my insurance was before adding my wife’s car to the mix–and I have a clean driving record, no accidents, and discounts from my family being with the insurer for a certain number of years. Not to mention it’s a high-deductible, low-frills policy. Now, with two cars, we’re at around $1,400 per year.

    Now for my first major area of disagreement: housing costs. Looking at the house in Toledo the author mentions, I have one immediate reservation. Click on the “nearby schools” tab, and you’ll see that the schools are not very good. Property values–especially in rustbelt cities like Toledo–are extremely variable depending on school district, mostly because the bad schools tend to be REALLY bad in these once major industrial cities that have been brutalized by long-term economic woes. My wife and I are both educators, and we would sacrifice pretty much anything else to make sure that our future kids don’t grow up in an awful school district. That being said, a “good school district” home at that same cost, in a rust belt region like Cleveland, Toledo, Erie, Akron, etc., will probably be 3 br, 1,000 sq ft., and little to no yard. Still, it is not unheard of to buy a modest $100,000 home in a nice part of the midwest. Just not quite as easy as the article suggests. Also important to consider is the fact that most online mortgage calculators seem to underestimate property taxes (especially in areas with good schools) and homeowner’s insurance, which can add another $100-$150 a month to this projected payment.

    Finally, what concerns me most about this sample budget is just how much seems to have been left out. What about allocating money for routine car maintenance (oil changes, tire rotation, etc.)? My wife and I, for example have two cars–a 2000 Honda Civic at 66,000 and a 2004 Hyundai Elantra at 100,000–and could not possibly go with just one since we are both working full time on opposite sides of town. (Public transit isn’t that great around here either.) Even if we’re being frugal and not paying for cable, what about the monthly internet bill? That’s another $50 a month. Factor in health insurance premiums and routine health care costs (an appointment here, a prescription there), of course. Then there’s clothes (we stick to the clearance racks), student loan payments (even on an income-based repayment plan), and the occasional evening out–at an inexpensive restaurant, drinking water, and using coupons–and it seems as though almost all the savings from lowering the car payment and the housing payment have vanished!

    I’m sure that it’s possible for a family of 3 to scrape by paycheck to paycheck on $40,000 a year. My wife and I, combined, make just a little bit more than that. (I’m a graduate student / teaching assistant making peanuts, she’s a special ed teacher just out of college.) We don’t have kids. We have to watch every penny constantly and even we wouldn’t be able to pull out $9,000+ a year to invest. I’m sure we could do much more with what we have, and I wish this level of savings could be possible, but the budget allowing for that kind of savings just doesn’t seem realistic. There are simply too many unavoidable everyday living expenses that seem to be left out of the mix.

  • Adam Yates

    Thank you for articulating this concept well. I will definitely be sending people to this link whenever I hear the excuse that they don’t have any money left over to invest. And this is mostly coming from my friends that have a gross income of at least 50-60k+ a year. I truly believe that compound interest is the 8th wonder of the world.

  • Derek

    Does it seem like Gary is taxed at too high of a rate? Online it shows Gary’s tax bracket would be 3.5% in OH. I live in Illinois where we have a 5% flat tax rate, and a person here earning $40K would be taxed at 23.2% rate (includes federal, state, and payroll taxes). Gary claimed he is being taxed at a 28% rate. Assuming Gary decides not to itemize his tax returns (which might make sense with his child and mortgage), his standard deduction and personal exemption is about $10K, which means he is federally taxed on only the remaining $30K. If I use 3.5% as his state tax (which is slightly higher than what he’d pay given the progressive nature of income tax in Ohio) and 8% as his payroll tax rate then he would pay $4,600 annually to the state and entitlement funds since the entire $40K is taxed by these bodies. He would also owe the federal government $4,046.25 on his $30K of taxable income. This comes out to $8,646.25 Gary will pay in taxes in 2014. This represents only 21.6% of his income. Unless Gary has some strange Ohio taxes that I’ve never heard of, he should take home $2,612.81 in income each month, not the $2,346 he reported. Anyway, my brain hurts now. If anyone can shed some light on this I would appreciate it. Otherwise, I think we just found Gary an extra $266.81/month in income.

  • Sam

    Just stumbled across this article by chance. Good read! I am not familiar with the American market and standards of living as such, as I am from a major metropolitan Australian city. Although I like the look of the house prices over your way.. Someone said that house in the article would cost 400k in GB. Would be 600k+ US in most parts of metro Australia.

    I am just 23, and have a solid salary for my age of around $130,000 AUD (X by .90 and you will reach an approx USD equiv). I have worked very hard to achieve that salary. We have a compulsory retirement saving system over here in Australia called superannuation. 9.25% of a salary must be contributed to a “super fund” administered by fund managers, and can’t be accessed until retirement age.

    Looking at the article, I have definitely made some mistakes. The car being one however I can easily afford it, and I’m a car person; per-se. However there are some leanings I can take overall from your article. Thanks

  • http://proverbsdad.blogspot.com/ Jonathan Boyden

    Joshua,

    Love your site and I am trying to do exactly what you describe. I make $44,700 a year and have a stay at home wife and 3 kids. I am 27 years old. We paid off $37,000 in student loans(stupid i know, but didn’t know anything until after college) in 3 years. We save $950 or so every month and have been living in cheap apartments for 4.5 years (rent $625/month). We put our tax returns into our house savings account and are looking for a house now. We have saved $31,000 for a down payment ($20k from gifts), put 5% into 401k, donate 5% and use money from side jobs to invest on Loyal 3, Computershare and Vanguard. This stuff really works, I read your blog weekly and all the about.com articles. Thanks for sharing knowledge.

    Jonathan @ http://proverbsdad.blogspot.com/

banner