Saturday, January 30, 2010

Budgeting: Part 13: The Biggest Mistake

"A man's errors are his portals of discovery."

- James Joyce

In an earlier article in this series, I downplayed the importance of selecting budgeting software, as I believe that bad budgets are mostly caused by bad assumptions and bad numbers - in other words, issues outside the technology realm. I also indicated that I would eventually discuss at length the biggest budgeting mistake people seem to make.

Having now discussed a number of other budgeting errors, the time has finally come to delve into the biggie. Over and over again I see people make this same mistake in their budgeting and in their personal finances in general. This same mistake takes many forms and has many different symptoms. In each case, however, the fundamental mistake is still the same and the corrections are all similar.

In this post, I am simply going to list 12 different examples of this mistake. (I could easily have listed many more.) In the next post, I will discuss the fundamental issues involved, and then in subsequent posts I will work through correcting these examples one by one.

Here are the examples - different symptoms of the same mistake.

  1. Last year you saved $500 every month by transferring the money from your checking account to your savings account or IRA. This year, however, that approach just doesn't seem to be working. There never seems to be enough money in the checking account to transfer. You are puzzled because both your income and your expenses appear to be about the same as last year.
  2. This past year you instituted a no-shopping weekend every other week. You didn't buy any groceries or household products on those weekends. Instead, you simply ate and used only what you had on hand in your house. It sure seemed like you were spending a lot less money, but as you total things up at the end of the year, you are surprised to find that you've spent about the same as the prior year.
  3. Your goal is to pay off an extra $1,000 on your student loan at the end of each month. The payback requires a sustained effort each month, but you feel the sacrifice is worth it to get the debt monster off your back. Near the end of some months, it appears you won't be able to make your goal, but you are determined. During the last week of the month, you usually stop paying for anything with cash, and start using your credit cards for everything. That way you'll have the money on hand to pay extra on the student loan. You also delay some utility bill payments a few days into the next month. Even if you have to pay a small late fee, it's worth it to keep the paybacks on schedule.
  4. Two years ago, you felt like your household finances were completely out of control. That was the year both you and your spouse each bought a new $25,000 car, not to mention a new computer, a new entertainment center, and new carpet throughout the whole house! It was almost reckless, and you used up almost all your savings on those spending binges. But then things changed. Without all that crazy spending on big-ticket items, you managed to save almost $10,000 last year, and you're on track to do it again this year! You congratulate yourself on your self-control, and you feel good that you finally have your act together.
  5. In order to meet your monthly savings goal, you sometimes pay only part of your credit card bill. For example, last month you realized that if you paid off your entire $600 credit card bill, you would not be able to save any money that month. However, your goal is to save $500 per month. Hence, you only pay $100 of your credit card bill and save the other $500. You make a mental note to payoff the whole bill soon. This seems better than not saving money, but you feel uneasy about this approach for some reason.
  6. While reading a magazine article about colleges, you are shocked to find out how much it's going to cost your 3-year-old to attend college in 15 years. The article suggests you should be saving $500 a month for the next 15 years in order to pay for college costs. You look at your budget, but you don't see any way you can come up with any savings. Then an idea strikes. When you bought your $200,000 house about six months ago, your bank gave you a choice of a 15-year mortgage or a 30-year mortgage. You remember that the difference in payments was about $500/month. At the time, you went with the 15-year mortgage because you could afford it and it seemed like a nice idea to pay it off sooner. Now you wish you had that extra $500/month to save for college. So why not switch? You call the bank and find out that for $1,500 you can refinance into the 30-year mortgage. So now with your mortgage payments lowered, you begin to put that $500 into a college savings fund every month. Everything is budgeted properly now, and you think you are quite clever to have thought up this idea.
  7. Your finances seem fine most of the time. However, every once in a while you get clobbered by an unexpected expense, like a huge car repair bill or a furnace replacement. You feel like these unexpected items are killing you! Every time you get a few thousand dollars saved up, another unexpected expense comes along. You feel that you must the unluckiest person in the whole world. If only you could somehow stop these one-time expenses long enough, you could really get somewhere financially.
  8. Your small business seems to be doing well. You have plenty of steady work and you keep meticulous records of all your receipts. For most months, your customer payments (inflows) exceed your expenses for parts, rent, gasoline, telephone and other things (outflows) by $4,000 or $5,000. However, a few months out of each year are ruining things for you. Last month, it was the quarterly tax payment of $3,000. Five months ago, you had to buy a couple of new computers for $3,000, and replace some special construction tools for $5,000. Last year was mostly fine except for July, when you had to buy a new work van for $25,000. You feel that if only you could make every month what you make during the good months, you would be completely satisfied with your business.
  9. You listen to a sales presentation for a new resort condo development in another city. The salesperson assures the audience that these properties are so valuable that the developer will buy the unit back at any time for the next ten years for the purchase price. The loan terms are also attractive at 5% for 30 years and nothing down. The more you consider the offer, the more you feel this is a sure thing. What could possibly go wrong? Since you don't put anything down, and you can always get back at least what you paid, it seems like there is no downside and substantial upside if the condo appreciates. You don't have a lot of money right now, but that's not a problem since you don't have to put anything down. You decide to purchase the condo as an investment and pay as long as you can, at which point you'll either break even selling it back to the developer, or hopefully turn a profit selling it to someone else at a higher price.
  10. Your 15 year old car had a cooling problem that permanently damaged the engine. The shop said it would cost $4,000 to replace the engine and the cooling system. That still seems like a bargain compared to spending $20,000 for a new car. Hence, you decided to go ahead with the repairs. Surprisingly, not all your friends think you did the right thing! You don't understand why people can't clearly see that $4,000 is a much better deal than $20,000.
  11. You observe how much money some of your homeowner friends spend on home repairs and replacements - roofs, siding, gutters, carpet, A/C. Over time it's big bucks! You think to yourself they could be rich if they would stop doing that. You think to yourself that you could live without repairing and replacing most of that stuff. You decide that when you buy a house, you will do things differently. If a pipe breaks and water is gushing everywhere, of course you will fix it. But for other types of things, you will just live with it. You can stand to live with no A/C and old carpet and leaky gutters and so forth. It's not that bad, even if others make fun of your frugality, because you will be laughing all the way to the bank. The extra one or two hundred thousand dollars you won't be spending on home maintenance during your lifetime will pay for early retirement. You'll show 'em.
  12. Your local sports team is doing well and has made the playoffs! Suddenly you think how much fun it would be to actually attend the playoff game. The only problem is that a ticket is $150 and you don't really think you can afford that. So you sit down with your budget to see if you can find some savings. You notice it's the 25th of the month and so far you're under your monthly budget in a few categories. You're $60 under for food, $30 under for gasoline, $40 under for haircuts, and $20 under for household items. You reduce your budgeted amount in each of those categories for this month and then resolve not to buy anything in those categories for the next 5 day. Problem solved. Now you have $150 for the ticket. It didn't turn out to be so difficult after all.

Do any of these scenarios sound familiar to you or someone you know?

Tuesday, January 5, 2010

Budgeting: Part 12: Sins Of Omission

"There is often a sin of omission as well as commission."

- Marcus Aurelius

Often the biggest budgeting errors are simply things that were just plain omitted. Expenses are sometimes forgotten, as we all fail to remember things at times. In other cases, however, the omission is a bit more deliberate. Usually this occurs because the expense is dismissed as too small to be relevant. It is easy to see how this problem arises. The average family starts the yearly budgeting process with a few huge numbers such as:

  • Mortgage = $12,000
  • Taxes = $10,000
  • Groceries = $8,000
  • Gasoline = $3,000
  • Utilities = $3,000

At this point, a small yearly expense of $50 or $100 will seem like noise - too small to worry about, and essentially nothing in the big picture. Based on discussions I've had with friends, people do tend to equate these small expenses with zero and often even declare them to be zero! Occasionally I will push back a little on these sorts of claims, and it makes for a very edgy conversation. Here are some recent examples as best as I can remember them.

S.B.: How's the new car treating you?

Friend #1: Great! It's very comfortable, and we're also really glad not to be spending any money on maintenance for a change.

S.B.: You don't spend anything on maintenance?

Friend #1: Nope!

S.B.: Nothing at all on routine maintenance? No oil changes? Alignments? Don't you have to do some of that just to maintain the warranty?

Friend #1: Yeah, but that stuff isn't much money.

S.B.: Do you know how much?

Friend #1: It's not very much. It's not worth worrying about.

S.B.: Sometimes those routine maintenance items add up to a lot over the course of a year.

Friend #1: I told you - it's not worth worrying about.

Friend #2: Your family goes out to eat a lot.

S.B.: Yeah, I know. It runs us about $250/month, but we enjoy it.

Friend #2: $250! Wow! We never go out to eat. It saves us a lot of money.

S.B.: But weren't you just talking about your kids' Happy Meal toys just a little while ago?

Friend #2: We only go to McDonald's when we are traveling.

S.B.: I see. But don't you also eat out for lunch every day?

Friend #2: Well, that's not my whole family. That's just me.

S.B.: OK. But you're still eating out for lunch, right?

Friend #2: It's not really eating out. That sort of thing is more like a work expense.

S.B.: But it seems like you're still spending money for lunch out regardless of what you call it.

Friend #2: If I didn't go out somewhere, I'd still have to pay for food one way or another, so it's all the same. And besides, it's not very much money because it's just me.

S.B.: Does your wife go out to lunch as well?

Friend #2: Look, wise guy. The point I'm trying to make is that our family doesn't go out to dinner, and that saves us a lot of money compared to your family.

S.B.: I understand. But the point I'm trying to make is that our family sometimes goes out to dinner together. Your family goes out to lunch every day separately. So it seems like the spending would be about the same.

Friend #2: Whatever.

Friend #3: I love digital cameras! Once you buy the camera, there aren't any more costs like the old film cameras.

S.B.: I agree it's a good deal. No more paying for developing shots you don't want. But of course there are still some costs, right?

Friend #3: Not really.

S.B.: Well, the cameras use batteries and that costs money. Or maybe you use rechargeables?

Friend #3: Actually, we don't. We use lithiums because they last really long. We can go a couple of months that way, even if we're taking a couple of pictures every day.

S.B.: So maybe you spend $25 or $30 a year on batteries for it.

Friend #3: Oh, I suppose.

S.B.: Do you ever print some of the photos?

Friend #3: Sometimes. Not too often. Only the good ones.

S.B.: Maybe 5 or 10 a month?

Friend #3: Yeah, maybe something like that.

S.B.: That's about 100 prints a year. So between batteries and prints, you're already up to about $60 or more per year.

Friend #3: But that's still way better than a lot of film development.

S.B.: Definitely. I'm just saying that there are some ongoing costs.

Friend #3: Well, $60 a year is certainly not a lot of money.

The problem with this sort of reasoning is that the average person actually has many different $100 yearly expenses. Unfortunately, the idea that there could be 30 or 40 (or more) of these $100 yearly items seems preposterous to a lot of people I know. ("How many of these $100 expenses could I possibly have? Even if I have 5 of these miscellaneous expenses, that is still only $500 and I'm not going to spend time worrying about that amount of money.") The fact that people are so skeptical about the importance of small expenses is why I advocate tracking everything. It's simply too easy to delude ourselves that we aren't spending significant amounts of money when it occurs through many small, unrelated purchases.

Of course, you don't need to have a separate category for each of these purchases. How finely you want to categorize is largely a matter of taste. However, if you are going to lump a lot of things together under "miscellaneous" or "household" or something like that, then your catch-all category needs to reflect that. I cringe when I see online budgets from bloggers that only have about ten very specific categories and then one final category of "miscellaneous expenses" totaling $300 per year. I'm pretty sure that is totally inaccurate. It's their choice how they account for it, but either they are missing a whole lot of categories, or the miscellaneous bucket is way too low.

So don't be too quick to dismiss small purchases as insignificant compared to your total budget. Try tracking them for a while. You might be surprised at both the frequency and variety of such purchases.