THE neighbor has a white picket fence! And they bought a new 2014 model car that has all the bells and whistles. And their lawn is perfectly manicured. Look at the kids playing about on the front yard (or these days, inside playing XBOX/PS3). Soccer and baseball after school, the mom piles the kids into their new SUV and off they go. You can see a brand-new 60 inch TV in their living room, it lights up the whole neighborhood. All seems to be well and good, isn’t it?
After all, you know Mr. Jones – he’s a contract specialist at the same company you work for. You know he makes about $60,000 a year at the age of 29, which is pretty good in this economy. And that Mrs. Jones works part time to the tune of another $20,000, so they have a combined household income of $80,000. The kids are aged four and one. Which is by any objective standard in the Midwest, not bad – by most standards, they are living the dream.
Don’t buy it for an instant – it’s all a facade. You only have to kick in the door and the whole rotten structure will come crashing down. The Joneses aren’t all that they make it out to be. A lot of that “stuff” is financed – meaning that the putative owner of that property went into a significant amount of debt in order to have that brand-new car right now. And something like 70% of all homes currently have a mortgage on them outstanding, so let’s say Joneses have one on their house as well. And here’s how their monthly budget breaks down.
Their combined gross income is $80,000 – or about $55,000 after Federal, SSI, Medicare, State, county, city (and in some areas) school taxes. Then there’s your 401(k) contribution, which let’s say is $6,000 a year – that leaves us $49,000 a year. Because I hate math, let’s call it $4,000 a month. (It’s actually $4,083.)
That brand-new SUV I talked about in the introduction is financed. If you get a midrange Chevy Tahoe LT – not the top trim level, mind you – the MSRP is over $48,000. That’s not counting the nice wheels, the tinted windows, or the cargo net that every car dealer tries to sell you on. And since few people have $48,000 in the bank to drop on a new vehicle, that new Tahoe is being financed.
According to a quick Bankrate.com calculator, at 4.9% interest over a 72 month loan period, that’s a monthly payment of $771 (or $55,512 on a $48,000 car). And that’s not counting the abysmal resale value that most Chevrolets suffer from, so that car is going to be worth a tiny fraction of its original $48,000 by the time 2018 rolls around due to depreciation.
That house is financed, too. Let’s say it’s worth $200,000, and the Joneses financed 80% of it – and took a $160,000 mortgage at 5% over the next 30 years. Their monthly payment on the house is $859 – without counting mandatory homeowner’s insurance and property taxes (which typically add up to another $400 or so a month), which the bank usually requires you to pay into an escrow account. (And the Joneses will pay $309,240 on a house that they supposedly bought for $200,000).
Go back to the Jones’ personal finances – I said earlier that their take-home pay is $4,000 a month.
Chevy Tahoe payment: $771
House Payment: $859
Home Taxes and Insurance: $400
These three payments alone leave the Joneses with $1,970 a month. Let’s be reasonable and say the Joneses have a second older car that’s been paid off. Out of this $1,970 needs to come gas and insurance for two cars (likely $400 a month or more, since both spouses work and someone has to drive the kids around), groceries (another $400 a month), all utilities such as electricity, heating gas, garbage, water, and internet (another $400 a month). That leaves our Joneses just $770 a month in disposable income.
From that need to come diapers, incidentals, entertainment, dinners at restaurants, fees for the extracurricular activities at school, credit card payments, clothes for when the kids start growing, holidays, and the lawn mower just broke, oh, that’s another $300 for a new push mower.
And it doesn’t include funds for when the water heater breaks, the driveway needs to be paved, a window gets broken, and the appliances explode. It doesn’t include the college fund for the kids. Or if you have six figures of student loan debt, that hasn’t been added yet either. If you get a speeding ticket, that’s not factored in. Or any other hidden taxes or fees, since there’s a good possibility that taxes will go up significantly in the next few years – not just Federal taxes but also local levies and taxes.
All of the last three paragraphs need to come from the $770 a month remainder the Joneses have.
Their finances don’t look so hot anymore. If they’re lucky, they’re breaking even. If not, they’re slowly sinking as they put the balance on credit cards until that debt piles up as well.
You only have to kick in the door and the whole rotten structure comes crashing down.
A financial emergency – the car gets totaled in an accident and the insurer refuses to pay the balance of the loan, the kid gets horridly sick and you have a large deductible or co-pay, a hurricane takes out the roof, or Mr. Jones loses his job due to outsourcing – and the Joneses are in a world of hurt.
Who is the winner in this case? It’s the bank. The bank makes a loan of $160,000 and gets paid back $309,240. The bank makes a loan of $48,000 and gets paid back $55,500. And I haven’t even started talking about student loans, which if federally guaranteed carry up to 7.9% interest, with private lenders going even higher. Credit cards are even more egregious, as many of them carry interest rates as high as 30%.
And if the Joneses ever default on their loans, the bank keeps the money they’ve received so far – and go on to foreclose the home, kick the Joneses out, and sell the house and recoup their money. And in the event they don’t raise enough money from the foreclosure sale, they sue the Joneses and get a deficiency judgment – attaching what remains of the Jones’ wages, cleaning out their checking accounts, and in some states, get warrants to seize and sell personal property such as jewelry and furniture to satisfy that judgment.
There’s a reason why the your house is 3,000 square feet (or less), and the bank’s building is ‘that big.’ Go to any downtown and the skyline is dominated with bank logos on all the high-rises. Consider the photo I used for this article – it is downtown Charlotte, North Carolina. I’ll give you three guesses as to which building is Bank of America’s headquarters, but you’ll only need one.
Realistically Dumping Debt
This brings us to the invariable question – what can we realistically do to keep our debt down (preferably to zero)? After all, the first thing someone will say is “There’s no way you can save $200,000 and pay for the house in cash.”
Yes, you can pay for things with cash. Take for example the Chevy Tahoe financing. You can go out right now and buy a nice used car for $5,000 cash – a 2004 or so Honda Accord, Toyota Camry or something similar – and it will run reliably for another five or six years, easily. And the gasoline and insurance will be far less than they will on a brand-new Tahoe – in fact, those cars are low enough in value that you may consider just maintaining liability on the car.
That said, I’m not telling you to go out and buy a rust bucket that belches blue smoke every time you get going and is held together by duct tape and a prayer – there’s lots of nice, used cars that can be easily had in the $5-6,000 range that will run for at least another five years.
Meanwhile, set aside that $771 every month and put it into savings. That’s $9,252 a year. If you put that money into a save investment such as six year CD’s at the bank, you can get 2.5% or so – and in six years (when the Honda Accord finally does break down), you’ll have $59,419 in the bank. If you’re more aggressive and put the money into a mutual fund averaging an 8% return every year, you’ll have $71,424 at the end of six years.
You can go out and buy that new Tahoe with cash, and still have plenty of money left over. I bet you can haggle the dealer way down from his $48,000 asking price if you show him a big stack of Benjamins and count them out dramatically in front of his face. His eyes will pop out as he says he needs to speak to his manager.
And YOU will have the extra money to spend, in your own pocket – not lining the gold-plated halls of the bank. In fact, that $25,000 or so that you’ve made on not buying the Tahoe up front can go towards a large down payment on the house! The more you’re able to pay down on the mortgage, the more the amount of interest paid drops – dramatically. And that, friends, will save you untold thousands of dollars over a lifetime – the bank won’t be getting as much of your hard-earned money.