How much of a house can you afford?

Many experts say that your mortgage payment (principal+interest+tax+insurance) should not be more than 25% of your gross income. If you listen to the likes of Dave Ramsey, that mortgage should be no more than a 15 year fixed rate. But, I was looking at what different salaries could afford (maximum) as a 30 year fixed rate under this plan:

$40,000 salary - $122,000 mortgage ($833/mo)
$60,000 salary - $183,000 mortgage ($1250/mo)
$80,000 salary - $244,000 mortgage ($1667/mo)
$100,000 salary -$305,000 mortgage ($2083/mo)

If you change it to a 15 year fixed as Dave Ramsey suggests:
$40,000 salary - $90,000 mortgage
$60,000 salary - $135,000 mortgage
$80,000 salary - $180,000 mortgage
$100,000 salary - $225,000 mortgage

The assumptions I made were that the interest rate was 6%, taxes at 1%, and I used this calculator which adds in insurance. This assumes also a 20% down mortgage with no PMI. That mortgage calculator incidentally doesn't allow you to go over 28% of your gross, which isn't that much more than the 25% rule. It also allows you to indicate other debts.

"Debts are easy to fix but liability is the nightmare"

I was listening to the US Open and saw a commercial I had seen a million times, but I finally picked up on what one statement was made. The little kid says, "Debts are easy to fix but liability is the nightmare." Wow, I guess it makes sense an insurance agency is trying to sell that. But, I know people who spent over 5 years trying to "fix" their debts...amazing. Check it out about 16 seconds into the commercial.

"One size fits all when its the truth"

Listening to a recent Dave Ramsey podcast, he said "One size fits all when its the truth." I think that is a great statement. As I stated in a recent blog post, I believe that a lot of Dave Ramsey's advice is general. Make no mistake what I mean about this is that a couple of the things he teaches are his opinions and some are based on truth. For example, the truth is borrower is slave to the lender and debt is bad. Therefore, he urges people to get out of debt, avoid debt no matter whether its considered "secured" or not. Ask anyone who has a lot of debt and most of the time they will be frustrated that they so much of their hard work goes to paying debt. If your mortgage is 25% of your income, do you like that every day 25% of your time working is to pay someone else? Probably not. "But I get property out of that." If you have a 30 year mortgage, you haven't even paid off half of the mortgage until 20 years into paying that debt!

When its the truth, like North is North, the temperature, or how much money you have in your bank account...the truth is not relative. However, some of Dave's advice is opinion and not truth. "You must put 15% of your gross in retirement savings." I am not sure what truth that is based on. You must save for retirement, no doubt. If you don't know what you will need, 15% will be a great start. But, I am not sure the 15% should be taken as truth. I will tell you one thing though, if you are just out of college and do 15%, you will live a great life in retirement and thats the truth...

The advice is general, not specific

I Googled recently for Dave Ramsey's credit card study information and found lots of blogs spreading anti-Dave Ramseyisms and I realized that people just don't get it. Dave Ramsey provides general advice which can be applied to everyone. That doesn't mean every piece of advice is the best for everyone, but its good for everyone. For example, someone called in to his show a couple month's ago and asked about 529s. He admitted on the show that not all 529s are bad, but some of them are so its easy to just say avoid them all. Looking into it, I found that some states limit investment choices and charge high fees for their 529s. If you are in a state where you can invest in a mutual fund with a long track record (10-15 years) that has low fees and get a tax deduction for doing so, I believe he would say that is a good choice. But, since not all states and 529 plans are like that, its easier to suggest other investment methods when they exist and also are tax advantaged.

Other areas where I think he gives general advice are the amount to save on retirement and never to use credit cards. The amount to save for retirement he suggests is 15% (once consumer debt is paid off) of your gross income. Advice can't possibly be global like that and perfect for everyone no matter their age, salary, and family situation. So, he gives the best rule of thumb, 15%. You can calculate how much you will need for your particular lifestyle, salary, and age and probably come up with a better figure for yourself. But, if you can't figure it out, 15% of gross will probably work.

Another example is credit cards. Dave says the following:

You’re also paying more. A study by Dunn and Bradstreet showed that the credit card user spends 12 to 18% more when using credit instead of cash. After McDonald’s began taking credit cards, they found that people spent $5 to $7 more per sale.

If someone was disciplined and got a credit card purely for gas purchases making 5% cash back (instead of rewards they will never use)...I doubt they would buy 12-18% more gas just because they are using the credit card or they will buy gas from places with 12-18% higher prices than they would have with using cash or a debit card. The fact is most Americans are not this disciplined. So, a better general rule is to avoid the credit card altogether.

Would Dave agree with that? Not sure, but I believe it :-)

Slightly new focus for our church

Our church, Crossroads Fellowship, sent out an email with a slightly new short term focus which mirrors many of my thoughts and how God is leading me. That is, to help people identify the problems they have with managing their finances and put together a plan to get out of debt and on to a journey of complete financial freedom. Here is what the church sent out today:

If you were unable to worship with us this past Sunday, you can read about our journey with God and how He's leading us in 2008 at www.crossroads.org/pdf/Imagine_Journey_2008.pdf. You can follow along as I walk you through this vision document at www.crossroads.org/audio/Chuck_Imagine_2008.wmv.

If you need help getting out of debt and managing your debt flow our Financial Freedom Ministry provides classes, workshops, resources and budget coaching to help people realize financial freedom. You can discover ways to get out of debt, establish a budget and learn about God's view of money. Take the Crossroads Financial Freedom Personal Assessment at www.crossroads.org/pdf/FF_Personal_Assessment.pdf.

On Saturday, May 17, we are offering a special workshop from 8:30 am - 3:00 pm to help you gain insights that will put you on the path towards financial freedom. Topics include Super Savings, Relating with Money, Dumping Debt and Cash Flow. There will be times when you can meet privately with a budget coach as well as prepare your own action plan for getting out of debt and handling finances God's way. Register online. Cost is $25 per couple and lunch and child care will be provided.

Here are some amazing facts from the charts:

• 70% of Americans live paycheck to paycheck.
• 95% of married couples fight over money and it is the leading cause of divorce.
• Americans spent $1.22 for every $1 they earned in 2007.
• 1 in 6 families may have their homes foreclosed on in 2008.
• 62% of Americans will retire with less than $10,000 income per year.
• Average 28 year old has $66,000 in consumer debt (cars, credit cards and student loans).
• 1 in 7 families is dealing with a debt collector.
• Children today are just as likely to see their parent’s file for bankruptcy as they are for divorce.
• The average household has at LEAST $9,000 in credit card debt.

How much life insurance do you need?

I have written about this very subject in the past, but I was reading the magazine Erie insurance sends us and the Q&A section was this very question. The cynical side of me said, why would you ask an insurance agent how much life insurance you need? Insurance agents are not like brokers, they are not held by law to look out for your best interests. That means they can sell you a $10 million policy if you only need $100k. That does not mean they are all that way, but some are and a second opinion is a good idea. Otherwise, its like asking a car salesman how much you should spend on a car or a Realtor how much you can afford to spend on your home. Sure, some may answer the ways we wish they would. I have a friend who is a Realtor who would be helpful and honest. But, that doesn't mean they all will be. Anyway, the Erie insurance agent answering essentially said, talk to me or use the insurance calculator on erieinsurance.com. So, I decided to check out the insurance calculator there, on the right hand column of this page.

I think its interesting what their defaults are, but the calculator is not bad. I think that you need to carefully read each of the sections and make decisions. I wonder if insurance agents actually take you through all of these or assume the defaults? One example is the private school versus public school. The defaults say that your kids are going to private school. In the end, I actually was told that I was over insured right now. Its better than the one I linked to in the past on Smart Money. In my opinion, its also better than the Zander Insurance calculator, Zander being the company Dave Ramsey suggests you purchase term life insurance from. The Zander Insurance calculator, unlike the other two, asks you how much the person being insured makes per year and how many years the surviving spouse will need that money. The other two, in contrast, ask what the surviving spouse's annual living expenses are minus their annual income, which is more accurately what you need to insure for.

Overall, I would recommend the Erie insurance calculator. But, I would recommend that people carefully fill it out themselves instead of letting an salesman, I mean life insurance agent, do it for them.

Sunk Cost Dilemma -- "Live like no one else today..."

"... So you can live like no one else tomorrow." Is a good quote used often by Dave Ramsey. I am not sure if he originated it, but I do like it. Dave Ramsey is one of the most vocal anti-debt voices out there in the world. What amazes me is that those who are vocally anti-debt like myself, are often those who were on the brink of serious financial disaster at some point. But some who were there get right back in debt.

My new theory is that there are two reactions to being close to financial ruin, fight back and change your ways completely or do just enough to survive another day. Those who fight back are often the ones who change their lifestyle enough to pull out of debt and if it was a serious amount of debt, they did that long enough that they hate debt if for no other reason but because they had to live a very limited lifestyle while getting out of debt. Every financial adviser has a similar blueprint as to how to get out of debt which goes something like this:
1. Establish a budget that minimizes expenses and maximizes debt payments.
2. Save a $1000 emergency fund so you don't pile emergencies on credit cards.
3. Pay off unsecured debts using either the debt snowball (smallest first then put all that money on the next largest) or by paying off the highest interest rates first.

This simple formula can be seen in the Wall Street Journal, Washington Post, New York Times, USA Today, by Financial Advisers like Fidelity Investments, by Dave Ramsey, and through ministries like Crown Financial Ministries. Whats amazing is the difference of what you do afterwards. Do you pay off secured debts or not?

Secured debts are those which have some backing collateral, like a car or a house. The difference between some of the advice and others is whether they suggest you pay off secured debts to eliminate the risk of debt in your life or not. The aggressive financial adviser wants you to start pouring the money into their service and quickly will point out that you can get a higher rate of return (they may quote anywhere from 8-14%) from mutual funds than your interest rate on your secured debt (4-7%), so its not important to dump the extra money into your secured debt. Others, like Dave Ramsey and Crown would point out that this is known as the sunk cost dilemma.

The sunk cost dilemma is an economic principle that points out that people who have already committed to one path (like paying a car loan, student loan, or mortgage) will choose to stay on that path rather than review if this really makes sense. For example, would you borrow against your house to put the money in the stock market? If so, you are a big risk taker, most would not. Well, this is essentially what you are doing with a mortgage if you are putting money into the stock market instead of paying off your house.

Dave Ramsey and Crown would also point out Proverbs 22:7, "The Borrower is slave to the lender."

The bottom line is, "Live like no one else today." Don't fall prey to the sunk cost dilemma. Pay off the secured debts as well. Then, when you have no debt and can pay yourself a lot more, you will "live like no one else tomorrow."

Reset to Realism

I have been listening to the Dave Ramsey podcast for a couple weeks now and I definitely have noticed one consistent theme, which I think I will start calling, resetting to realism. It starts with a caller or individual stating they cannot afford something like paying off debt, doing something they want to do like take a vacation or buy a new car, becoming a stay at home mother, or just even survive. Dave asks them some simple questions about their lifestyle...how much debt do they have, how much is their rent or mortgage, and how much is their car loans or car worth. Invariably, it comes down to one of two major things:
1) Sell your house or car because you can't afford the lifestyle you are living
2) Pick a new job or extra work to get more money into the equation.

Then the real kicker is start living a lifestyle where you budget to live off less than you make AND stick to your budget. Give, Save, then Live.

Its a real epidemic in my generation...that is to live beyond your means. Dave often pleads with people to set a realistic budget based on what they make. But we don't want that realism, do we? Instead, we want what we can't have...and thats why so many people can't afford to do what they want. If you can't pay off your debt, maybe your lifestyle needs changed. If you can't afford that vacation you always wanted, then maybe your house is too expensive for what you make and if the vacations are really important to you, sell the house and live less expensively on a day to day basis while you save for those nice vacations.

Most callers to Dave's program have him give them the same equation. Reset your lifestyle to realism. This may mean driving a less fancy car or having a smaller or more out of the way house. Reset your budget to beneath that which you can afford...afford being that you still have the ability to GIVE and SAVE before the bills and entertainment and all of that is spent. That is what is realistic for your life. Reset those expectations and how you live.

Establishing effective habits

The talk of the gym this week has been the fact that the gym was deserted...the New Year's Resolutionists were gone. One of the other guys at the gym suggested that the saddest thing was that many of them were so close to forming a true habit and that it takes 21 days to establish a habit. I thought that was interesting, only 21 days? That should help people survive a little longer. I found that 21 day claim on Google Answers.

This is useful information. Its useful if you are trying to get in the habit of exercising. Its useful if you are starting your journey to financial peace. But, this begs the question, if you know that something should be a habit 21 days later...do you get discouraged if its still difficult? I wonder..and with my new year's resolutions, I will try this out.

If you need to find some more habits to develop, I suggest the 7 Habits of Highly Effective People. Be Proactive, Begin with the End in mind, First Things First, Think Win Win, Seek First to Understand, Synergize, and Sharpen the Saw. I personally have never figured out how to Begin with the End in mind but put First things First. :-)