Friday, June 19, 2009

The MONEY Trap and the 1% Rule

The MONEY Trap - How making a lot of money can drive you bankrupt.

From a lot of people reading my blog, I get the usual reactions. "I make good money, so I don't have to worry about saving money," they say, "And $50 here, $100 there, it really isn't worth the hassle."

This blog is not directed at the dirt poor, but rather the impoverished middle class, who are often spending their way to the poorhouse. It is EXACTLY those sort of people who need to conserve their resources (as they are now belatedly finding out) and yes, $50 or $100 is "a lot of money".

Take for example, your typical young Washingtonian. They might have a job making $100,000 a year, which they consider to be a "lot" of money - the mythical "six figure income". When taken against that number, sums of $50 or $100 may seem insignificant - only a fraction of a percentage point.

However, when you consider how large such amounts are compared to disposable income, the picture becomes more focused.

For example, say our Washingtonian makes $100,000 per year. They live in an apartment or home and have a monthly rent or mortgage payment of $2000 per month. Right off the bat, $100,000 a year is reduced to $76,000 a year.

And of course, Federal and State income taxes (and social security, etc.) lop off another 35 percent easily. So now income is reduced to $41,000 per year.

Now, if our friend is playing his cards right, he should be contributing 15% of income to his 401(k) or equivalent program, which means that we now have a disposable income of $26,000 a year.

That works out to $500 a week in disposable cash. And that means $500 per week to buy groceries, make car payments, pay car insurance, pay the light bill, the cable bill, etc.

Suddenly, $100 is a lot of money, when you only have $500 a week to play with. Even $50 or $10 is not chump change anymore.

Of course, these days, making a hundred grand, particularly in Washington, is not hard to do. But even in upper income brackets, the same sort of rules apply. Most folks making more money tend to spend more - on bigger houses, fancier cars, you-name-it. As a result, the amount of income "left over" for daily living expenses can dwindle rapidly.

Cutting some of the big expenses is often a good idea. Owning an appropriately sized home instead of an expensive mini-mansion is one approach to saving money on mortgage payments as well as property taxes and utilitiy bills. But other "big ticket" items aren't so easily shaved off. You can't, for example, cut your tax bill very much. And cutting savings into your 401(k) so you can have Chinese take-out three nights a week is a foolish move.

I fell into this trap with a job I once took. At the the time, they offered me a "six figure" salary, and I thought I was going to be "rich". Of course, I had to drive 20 miles each way to the job, buy lunch at expensive restaurants, and buy new suits for the job. I came home every night, exhausted and unable to plan my finances or make dinner. Yes, we ate a lot of take-out and got fatter.

I realized that the "big paycheck" job was not really making me wealthier, as it also came with a big tax bill and big expenses. Just because I had a large income did not mean I could forego keeping track of spending. Rather, just the opposite was true.

One solution to this problem is to try to look at money in a different light. A person making $100,000 a year might say that $1,000 is not a lot of money, but in reality, it represents 1% of their income. 1% sounds like a small number, but it is not. You only get 100 of those 1%'s in your income. And as we have illustrated, most of those are already spoken for. You can't afford to squander even 1% of your income, because that is the most spendable part you have - the disposable part of your income.

And that 1% ($1000) itself is made up of ten $100 transactions. So "wasting" $100 on something is really a big deal, because you do that a few times, and bada-bing, you reach that 1% level.

I recently sold a bunch of junk on eBay and Craigslist (see my earlier blog entry) and made about $1700. Some folks might argue "well, that's not a lot of money, really". But when you think of it in terms of income, it is one of those one-percent deals, and a one-percent raise in your income is nothing to sneeze at, particularly in this day and age.

SO, get out of the mindset that "you can afford it" and stop squandering money on things like leased cars, cable television, subscription services, eating out five nights a week, and the like. Chances are, if you are a typical middle-class American, you CAN'T afford it, but rather you are mortgaging your future (sometimes literally, with a home equity loan) so you can have Kung Pao Chicken tonight.

Think about it...