Saturday, November 26, 2011

Budgeting: Part 32: How to Budget for a House

"A man's accomplishments in life are the cumulative effect of his attention to detail."

- John Foster Dulles

Start with Principal and Interest

This is your purchase price spread out over the length of the loan along with the finance cost of delaying the payments from the date of purchase.  For example, if you buy a $200,000 house with a 10% down payment, and you borrow with a 30 year fixed rate mortgage at 4% interest, then your monthly PI (principal + interest) = $859.35.  This is the one part of your housing cost that is constant and predictable, but unfortunately there are many other costs.

Add Taxes and Insurance

Next, you must budget for property taxes and insurance.  The property taxes you pay will depend on where you live and your homeowner insurance costs will depend on a variety of factors.  Using national averages, that $200,000 house will cost you $230/month for property taxes and $65/month for homeowners insurance.  Note that unlike your fixed rate mortgage, your property taxes and insurance will gradually go up over time due to inflation.  The other thing to consider is that you will always have these costs as long as you own the property - even after your mortgage is paid off!  After 30 years, your mortgage will be paid off and you will no longer be paying your $859.35 (principal + interest).  However, if inflation averages 4%/year, then after 30 years, you will still be paying $745.98/month in taxes and $210.82/month in insurance.  Notice that your monthly cost for taxes and insurance may equal (or exceed) your original monthly cost for principal and interest by the time your mortgage is paid off.

Add Repairs and Replacements

Another big (and unpredictable) cost is repairs and replacements.  A house has many things to wear out over time - appliances, roof, siding, driveway, sidewalk, chimney, carpet, plumbing, etc.  All of these items will need to be repaired and eventually replaced.  Even though these costs are large, most people do not budget for them.  I have mentioned many times in this blog that this is a huge budgeting mistake.

If you don't think these costs will be material, just try the following 10 minute exercise.  Go around your house and make a list of all your major appliances: furnace, hot water heater, refrigerator, washer, dryer, water pump, sump pump, oven, whatever.  Then take a quick guess at a realistic lifespan and a replacement cost for each item.  Divide the replacement cost by the number of years and total everything up.  Over time, that's roughly how much you'll spend each year just on appliance replacements.  You can do the same exercise for exterior items (e.g. roof, chimney, gutters, etc) or for plumbing or carpet or most anything.  It is not difficult to see this will be a large number, and that is just replacement costs.  Most people also want to eventually upgrade items such as fixtures, cabinets, windows, and doors.

Finally, there are numerous repairs to be done, and most of us need to be cautious of hubris when considering our skills.  Most people already know (or can easily learn) how to fix a toilet or faucet, paint a wall, repair a light switch, or patch a sidewalk.  These are good skills to have and will save you money.  However, unless you are highly skilled, there will still be many jobs where you will need to pay a professional.  It's unlikely you will handle issues like a main sewer backup, a leak in a second floor roof, or the removal of a large tree growing too close to your house.

Add Furnishings and Landscaping

If you've previously been renting or you've moved to a larger house (or yard), you should expect that you'll probably spend additional money on furnishings or landscaping.  One of the joys of owning a home is being able to do exactly what you want with the house and the yard.  However, this opportunity comes with a cost.  Furniture, pictures, lamps, playsets, shrubs, trees - these all cost significant sums of money.  Only you can decide how much you'll spend, but don't kid yourself - it won't be zero.  For many people, decorating costs will be substantial, if for no other reason than the new owners will want to undo many of the decisions made by the former owners of the property.

Add Risk

Lastly, there is a hidden cost to home ownership: risk.  When you rent, the landlord bears nearly all of the risk.  When you own, the risk becomes yours.  I see at least five specific risks:

1. Borrowing Risk.  When you borrow anything, you agree to pay something back later.  If you borrow a lawnmower from a neighbor, you agree to return it the next day.  When you agree to borrow money via a mortgage, you agree to the payment schedule.  Despite the best of intentions, one can never entirely predict the future, and mortgages are a very long term commitment.

2. Collateral Risk.  Although your homeowner policy will protect you from many things, it won't protect you from everything.  For example, most policies don't cover floods or termite damage.  You might also find undisclosed environmental issues with lead or asbestos.

3. Location Risk.  The general real estate market might do well, but your particular neighborhood - or your particular house - might still have issues.  Your house might decline in value due to foreclosures on your street, increased crime in your neighborhood, the closure of a nearby employment anchor, or the encroachment of a bordering highway.

4. Liquidity Risk.  Even if the property does not decline in value, you may not always be able to sell it in the time frame you desire.  This may limit your future options.  For example, you might not be able to move to another city to take a more desirable job.

5. Diversification Risk.  For many people, the cost of a house is very large compared with their total assets.  This has the effect of concentrating household wealth in one asset. 

Consider the Positives

I don't want this article to come across as entirely negative.  Homeownership has many positive aspects.  There is a certain pride to homeownership that cannot be discounted.  It also provides stability.  If you are owner of the property, you can stay there as long as you like (provided you pay the financing costs and there are no imminent domain issues).  A renter may be forced to move because the landlord has other ideas.  Additionally, if you desire to live in a particular neighborhood, or a particular school district, or even a particular lot, there may simply be no rental available.  Buying may be your only choice if you want to live in that exact location.  Lastly, despite the uncertainties of repairs and other items, ownership may be cheaper than renting if you are disciplined and stay in one location for a long period of time.

Tuesday, November 22, 2011

Budgeting: Part 31: How to Budget for a Wedding

"Perfection is attained not when there is nothing left to add, but when there is nothing left to take away."

- Antoine de Saint-Exupery
The average cost of a wedding is now about $25,000.  Many couples spend significantly more.  Clearly this is a large sum of money and a good candidate for budget scrutiny.  Yet unlike a car purchase, it's not quite so easy to corral wedding expenses into a tight budget.  First of all, most people expect (or at least hope) that their wedding is a once-in-a-lifetime experience, which is worthy of a once-in-a-lifetime expense.  Second, wedding expenses involve a diverse set of emotional items, from childhood dreams to family traditions to societal expectations.

In spite of these difficulties, I believe it's possible to contain these expenses through the appropriate decision making framework.  Like the last article in this series, I'm not going to pretend I have enough background as an expert to give you even a complete overview of the problem.  Instead, I'll try to communicate just one important item to the conversation.

When faced with a difficult budget constraint, the usual response is to agonize over what to add while still ending up under budget: Add catering expenses.  Check.  Add photography expenses.  Check.  Add venue expenses.  Check.  Add catering expenses.  Oops!  Over budget!  Try invitation expenses.  Still over.  Hmmm.  How much is the cake?  OK...this is just not working.  Throw out the whole budget.  It is what it is.

I would like to suggest a different paradigm.  Instead of deciding what to add, decide on what to take away.  In other words, first throw in everything you would ever possibly want in your wedding.  Spare no expense (on paper).  Have it all.  Plan for the ideal.  Then start from that ideal and whittle it down to the reality of your budget number.

This may seem counterintuitive.  Don't we all feel pain when we take things away - even hypothetical things?  Why then would this approach be easier than deciding what to add?  In order to understand why this approach may work well for many people, let me use a familiar example: packing for a trip.

Which is easier: packing to go away for a 2 week vacation, or packing up to go home when you are done?  Clearly the latter is easier for many reasons.  When you are leaving for the trip, there are many uncertainties and many choices.  Should I pack long pants and jackets, or will it be too warm for that?  Should I pack a swimsuit and flip flops, or will it be too cold for that?  Do I need to bring some books, or will there be enough entertainment along the way?  Do I want to take my laptop and stay connected, or do I want to unplug from life on vacation?  Do I need to bring all this over-the-counter medicine in case I get sick, or will there be a drugstore close by anyway?  Can I take this item and still have everything fit in the suitcase?  Should I buy something now to take on the trip so that I don't waste time during the trip looking for it?  Think, think, think - do I have everything I need?

But when it's time to come home, everything is easy.  Simply pack up all the stuff you brought with you and you're done.  Now the amount of time you actually spend putting the items into the suitcases is small and should be about the same whether you are leaving home or returning home.  The difference is that you have to make many decisions before you leave; you don't have to do that when you return.

Further compounding the packing problem is the paradox of choice.  The decisions wouldn't be so difficult if we only had about two suitcases worth of things we needed to fit into one suitcase.  Instead, we need to decide from a whole house full of things we've accumulated and also from literally millions of items we could purchase for the trip.  This overabundance of choices can paralyze our purchasing decisions even with trivial things.  There are now 11 different kinds of Cheerios and the average supermarket now carries about 400 different kinds of shampoo and conditioner.

Many couples I've talked with have said that the wedding planning process was so draining because there were so many choices to make and yet they wanted everything to be perfect.  It's no wonder that people don't want to further complicate the matter by introducing a budget constraint on the wedding.

Hence, my suggestion is to try to separate wedding choices from budget choices to some degree.  Don't agonize over the cost of each item and whether it fits in your total budget as you're trying to investigate individual items.  Instead, mull over each item and then simply list (and rank) your top few choices and their costs.  When you're done with the rough draft, add everything up and look at the total.

Is the total cost too high for your budget?  Well, that's a bummer and you won't be happy that something has to be cut, but at least it will be fairly obvious what you need to do.  For example, maybe you are just slightly over budget.  You can scan your list and see that your second choice for the cake was $200 less than your first choice and you recall that you had a hard time even deciding which was better.  Great.  Choose Plan B for the cake and get on with your life.  On the other hand, maybe you are way over by $4,000.  Again, it will probably be fairly obvious what you need to do.  Many items will have small differences between your possible choices, so there is no point in trying to finesse $100 each out of a half dozen things when that approach clearly won't get you very far.  Find the really big items and see if you can live with a different option to get under budget.

This approach can save you a lot of time, frustration, and confusion.  In addition, you might also find that you are able to get most of what you want and stay under budget because you are more organized and focused.  For example, if you've identified that you are way over the amount you want to spend and the catering bill is the only item where you could possibly make that up, then you can now concentrate your energy on fixing that one problem.  Maybe you need to make a few phone calls to specifically find out if someone can do a sit-down dinner for your party at the cost you need.  Maybe your initial choice for the catering company can work with you to find a lower cost option - maybe a lunch instead of a dinner, or maybe a few less people.  Once you have a clear goal and a clearly defined problem, you can expend some time and energy to meet your budget while minimizing the loss of things that are important to you.  But this is not something you can do very well if you just start making phone calls for all sorts of wedding items with no game plan.  Everything will seem expensive and you will probably end up frustrated.

This paradigm, by the way, is consistent with how I've suggested that people approach all budgeting throughout this series.  Don't pick a budget number until you've first examined your values and finances.  Don't start cutting things until you've actually looked at the total.  (You might already be on target and worried for no reason!)  Don't start choosing which things to cut until you know where the big items are.  And don't start cutting items until you have a clear game plan for choosing the alternatives.

We inadvertently stumbled upon this method during our own wedding planning years ago.  We already had a lot of savings by the time we got married, so we didn't really make much attempt to keep things under control during the planning stage.  But by the time we tallied things up, we were a little surprised (and unhappy) at the grand total.  Rather than starting over, we simply tweaked a lot of little things in the existing plan until we got the money down to a level where we were comfortable.

Lastly, if you're still having trouble motivating yourself not to "go all out" with your wedding expenses, I'd offer two final thoughts:
  • After a certain point, more spending doesn't make a better wedding.  Think back to a few recent weddings you attended.  Don't nitpick, but what were one or two major things you would change?  Typical examples of regrets are: too far away; shouldn't have invited so-and-so; wedding party was late; nasty weather all day.  These are not things that money can change.
  • Money issues are the #1 marital problem on most surveys.  Severe overspending on a wedding can be counterproductive to the whole purpose of getting married.  Why start married life by creating a huge debt for both of you to pay?

Wednesday, November 9, 2011

Budgeting: Part 30: How to Budget for a Baby

"The concept of opportunity cost alluded to above is extremely important in financial management; in fact, some commentators would contend that it is the single most important concept."

- Jim McMenamin, Financial Management

This post is not going to be a general guide to baby related expenses. If you came here looking for an overview, I would recommend one of the following good articles:

Instead, this article will be just a simple warning to prospective parents not to miss what might be one of your biggest expenses, and yet ironically, the one you might totally overlook.

The average person probably estimates baby expenses in one of two ways. They either use information or advice from others, or they look at their own existing spending and attempt to add money for the baby to each category. So with the first method, you might ask a friend how much money they spent on diapers each year, or you might read an article that tells you the average amount of money spent on food or clothes for a child. With the second method, you might go through your budget line by line and add some more to your expected costs for medical care, food, water, clothes, and so forth. These are both reasonable ways of estimating, and I would encourage you to use both methods.

However, there's a hidden expense here that looms large.  In fact, it's possible that this hidden expense may be larger than all the other expenses you considered combined.  The expense: time.

Consider the following thought: Adults have many responsibilities and commitments.  We have demanding jobs and long commutes.  We have houses and cars to maintain.  We have our communities to assist, and the less fortunate to help.  We have friends and business partners to please.  We have our skills and our health and our sanity to maintain.  Most of us also have complicated personal and social relationships.  Some of us may already have older children that require enormous amounts of time, energy, and initiative.  Others may have elderly family members to assist or support.

Now, on top of all of that, enter the new baby -- a totally helpless (and infinitely precious) individual who will require constant attention when he or she is not awake.  It doesn't take a genius to understand that your current busy schedule is on a collision course with your new demands. 

Thus far, I haven't said anything more than the obvious: adults are busy, and babies are a lot of work.  But since we know that time is money, we also know that these new time demands will impact your budget.  Therein lies a subtle financial difficulty that will manifest itself in two distinct ways.

First, the additional demands of your time may have indirect financial costs.  It's not hard to imagine how this plays out.  You might have so little time (or energy) to work overtime hours where you might otherwise earn extra money.  You might also not have time to do certain maintenance or repair jobs, so you will need to pay others to do them.  (e.g. mow the lawn, change the oil, or fix a leaky faucet)  You might cook less and eat out more because you are tired or stressed out or in need of a break.  Many of these scenarios are likely, and they will all increase your budget.

Unfortunately, as this script unfolds, the game plan is often to simply work harder, harder, harder.  The budget will be maintained at all costs, and of course the overwhelming majority of parents are certainly not going to shortchange the child.  Thus, we plod along, attempting to perform all the duties of a new parent while maintaining all the same arrangements as before.

I would suggest that this approach is neither healthy nor realistic.  Notwithstanding the human capacity for hard work, this approach may not be consistent with your values, and so it may set up enormous conflicts within yourself and with others.  This tension brings up the second kind of impact to your budget: shifting priorities.

To use a simple example, suppose it has been a long week.  You are tired.  Your work schedule has been very demanding, and you come home to a new baby that needs constant attention and keeps you up half the night.  Then Saturday afternoon rolls around.  The baby is finally happy for a change!  You would like to play with the baby, maybe even take the child for a stroll in the park.  But the grass is very high and needs mowing.  It's rainy for the next few days and you'll also be at work.  This is possibly your only chance to mow for many days.  But this may also be your only chance to go to the park with a happy baby for the week.

So what do you do?  Do you just grind it out and do it yourself?  Or do you pay the neighbor boy $30 so that you can do what you want for an hour or two?  I hope you appreciate the subtle distinction between lack of time and shifting priorities.  In the first scenario, you simply feel that you have run out of time or energy.  You'd like to cook dinner or mow the lawn or whatever, but you feel that you simply cannot.  There are only so many hours in a day.  There is only so much energy in your body.  In the second scenario, however, you do feel that you are completely able to perform these tasks and save money.  However, you deliberately choose not to do it in order to spend additional time with your child.

Does this mean that you're a better parent every time you choose to spend more money to have more time with your child?  Certainly not.  There is a beautiful Latin phrase everyone should know: est modus in rebus.  Roughly translated, it means "there is a middle ground in all things".  This expression is wise advice for much of life.  In our current context, obviously it's not healthy to maximize dollars completely and ignore the baby, but neither is it healthy to maximize baby time and ignore your own health and employment.  Both extremes are detrimental to you and the child.  As in all things, there is a middle ground, and that middle will be different for different people and different situations.  But in all likelihood, if you've planned your current budget to fit your life without a child, then it will need to shift somewhat to accommodate the child.  In terms of your actual spending, this will happen automatically.  But your budget (a planned estimate of spending) will need to be explicitly changed as well, as a budget divorced from reality is irrelevant.

Can you quantify these expenses in your budget?  I doubt it.  You probably can't say, "I think I'll spend another $1,000 in indirect costs because my time is limited, and another $1,500 in indirect costs because I choose to spend additional time with my child."  However, just because you can't estimate the expenses, doesn't mean they aren't real and probable and significant.  Personally, my advice would be to treat these expenses as a risk that your current budget is inaccurate.  Suppose you saved $5,000 last year.  Great.  Now you are having a child and you've added up all the direct costs and you are pretty sure you will save $2,000 this year.  Treat that number as suspect.  Assume there is a fairly large risk that you will overspend in many categories to compensate for your lost time.  Furthermore, assume you may spend additional amounts of money because your priorities have changed - you would rather spend some additional money to have additional time with your child.

In closing, I want to make sure people don't have the idea that I consider children to be "a burden" because they cost a lot of money, both directly and indirectly.  I surely do not.  Please consider the perspective from which the article was written.  When considering your household budget, don't assume that children have only direct costs like food and medical insurance.  Indirect costs will be significant - recognized or not, quantified or not.  These indirect costs involve paying up for time - both because you need more time and because you want more time.  That is my only point.  My own experience has been that children are more work than I ever expected, and yet far more rewarding than I ever expected!  And that's a tradeoff I am glad to make.