Sunday, June 12, 2011

Why $10,000 isn't a lot of money, but $100 is...

Most of us tend to obsess about large sums of money, but trivialize smaller expenses.  This may be the reverse of good financial planning habits.

“Watch the pennies and the dollars will take care of themselves,” Benjamin Franklin supposedly said.  What does this mean, and how does it affect personal finances?

Perhaps today, the value of pennies and dollars make this quote seem meaningless.  Amplify it by a factor of thousands and it starts to make sense.

Consider your typical suburban, middle-class person.  They spend thousands of dollars every month on small transactions of about $100 each.  The Cable TeeVee bill, the cell phone bill, a meal at a restaurant, a trip to the shopping mall for a new outfit, shoes, or a gadget.  All of these sort of activities seem trivial, because they are at or near that magical $100 amount - the amount you can charge to a credit card without cringing.  It is a dangerous amount, as a result.

Now consider the same middle-class schmuck.  He has a $500 deductible collision and comp policy on his car, because "it is worth a lot of money!" and "an accident could be costly!"  So he pays $1500 more a year to insure his used Camry.  But he hasn't checked out the book value on the car lately - and realized that it is worth maybe $10,000 on a good day.

"But $10,000 is a lot of money!" he says, justifying spending more than 1/10th the cost every year to insure this depreciating asset.  He lives in fear of losing a $10,000 car, so he spends more than that to insure it, over time.

The same is true with health care.  I told a friend about my $10,000 deductible Blue Cross policy, and he said, "That's insane!  Suppose you get sick!  Where will you get the $10,000 to pay the deductible?"

I told him "From the same place you get the $10,000 in additional premiums you spend every year to have a $1000 deductible."

You see, there is no health-care Genie, and if you want cradle-to-grave protection, you have to pay for it.  And not surprisingly, if you want "full coverage" you pay full price.

You can pay less for health care, and take a risk you may be healthy for several years (and come out ahead) or pay a lot for health care, avoid the risk of a $10,000 bill one year, but are guaranteed to spend more money over time

(And the joke with health insurance is, if you do get sick, they will jack your rates so high that you will have to go to a $10,000 deductible, just to keep the policy in force.  Why not cut to the chase?)

So, spending $500 a month more on health insurance to get a low deductible seems "reasonable" as $500 is "not a lot of money" but a $10,000 deductible is viewed as a staggering amount.   Never mind that in less than two years, you've paid the difference, in increased premiums - and that for the average healthy person, you will likely have the same out-of-pocket expenses with a $1000 deductible as with a $10,000 one.  Over time, you come out way ahead with the lower deductible, even if you get sick.

And the same is true with car insurance - you spend a little a month, it seems, to get a huge amount of coverage on your car.   But unless you wreck your car once a month, it really isn't such a bargain.  Better off to put that money in the bank, drive more cautiously, and not obsess with what is parked in your driveway.

If what you have parked in your driveway is something you consider a major asset, then your lifestyle priorities are mixed-up.  Investing a lot of money in "things" - particularly movable things - is the path to middle-class poverty.

Looking at $100 transactions as trivial is one sure way to go broke.  Because $100 a month adds up to $1200 a year, which, over 30 years at a moderate rate of return, can be over $150,000.  But no one thinks of their cell phone as costing $150,000.  But if you think about the cost, over your lifetime, that is what it comes to - the cost to your retirement account, to your net worth.  $150,000 is a heck of a lot more than the $10,000 deductible in a health insurance plan or the value of your dented Camry in your driveway.

And yet.... most middle-class people live in fear of that $10,000 expense and will pay hundreds per month to avoid it - incurring a longer-term liability over time.

The reason for this pound-wise, penny-foolish thinking is that most people have what is called a "Job" which is a trap.  The employer pays you in dribbles and drabs over the weeks of the year, and the employee tends to look at money as tiny amounts that can be spent in tiny increments.  They fail to look at the overall costs and expenses of transactions larger than a paycheck.

Everything is looked at in terms of monthly cost.  How much is that new car?  $500 a month!  No, no, it is $20,000.  But the salary slave fails to see that - or that he could buy the same car, lightly used, for $15,000.  But since the term on the used-car loan is shorter, it is still $500 a month - so he buys new, not taking into account the overall transaction costs involved.

One secret to wealth is to break free of the monthly payment mindset and stop squandering hundreds of thousands of dollars, $100 at a time.

Today, Ben Franklin is on the Hundred Dollar Bill - the only "Dead President" who was never a President.  But his reputation for frugality and financial astuteness placed him on the Hundred Dollar Bill.

I think if he was alive today, he would say "Watch the hundred dollar expenses and the $10,000 expenses will take care of themselves."$10,000 isn't a lot of money, but $100 is...  Strange but true!