Henry Hebeler
If you reach for plastic to pay for many of your purchases, you may find yourself mired in debt -- like many Americans. But the truth is, you can arrange your finances to increase your own bottom line rather than the bottom line of creditors.
Sue, my barber, married a man with a ton of credit card debt -- which she didn't find out about until after they married. Using her barber shears, Sue cut the credit cards in half and put her new husband and herself on a two-meal-a-day diet until they paid off them all off. They got some benefit from the diet as well.
Sue quickly learned something that wealthy people learned long ago. Few people can get an interest rate on their investments that competes with the rate they pay for debts. That means that every dollar used to pay off high-interest debts is a better investment than putting that dollar into savings.
Here's a novel idea: Rather than make monthly payments for years on items purchased with a credit card, you can save for purchases in advance. It's really not a new concept at all, but one that many people have trouble putting into practice.
You can do it, too
Follow these steps to ensure you will have enough money saved when you're ready to draw it.
How to save:
1. Establish a replacement-planninggoal.
2. Calculate your goal.
3. Tax considerations.
4. Practical implementation.
5. How you can do even better.
Establish a replacement-planning goal
The first step is to establish financial goals. These goals should include savings needed for future retirement, but also savings to replace things that will wear out. You've heard that you should use a retirement-planning program for retirement savings, but you seldom hear about replacement planning.
To implement a replacement-planning goal, you can adopt a time-proven method used by competent condominium associations. These organizations have reserves for the eventual replacement of such items as the roof, road, carpeting, painting, appliances, etc. In other words, they save before they buy whenever possible, a strategy that avoids incurring debts or tapping condo owners for whopping assessments to make these repairs.
Calculate your goal
Let's use an example of a $1,000 water heater with a 10-year expected life. The amount you must save each year is $100, that is, $1,000 divided by the 10-year life. If the water heater is three years old, you should put three years times $100, or $300, this year in your reserves.
Understand that you should make this calculation every year, so that if the following year the price of a new water heater becomes $1,050, due to annual inflation of 5 percent, your annual contribution should be $105 and the amount in your reserve after four years should be $420.
If you had invested the $300 at an after-tax return equal to inflation, you should have $315 by the end of year three, so your contribution of $105 at the end of the fourth year would bring the total up to the necessary $420. Although using this strategy helps you combat the effects of inflation on the price of goods and services, you still have to deal with the uncertainty of not knowing exactly how long the item you're planning to replace will actually last. It could be shorter or longer than you plan. If some of your items last longer -- great! You can use part of the reserve to offset other shorter-lived items.
Tax considerations
The theory behind this replacement-reserve calculation is based on getting an after-tax return at least equal to inflation. The after-tax return equals the before-tax return times one minus the tax rate. So if you would get a 5 percent before-tax return and you're in the 25 percent tax bracket, the after-tax return would be almost 4 percent (0.05 x 0.75 = 0.0375). As a practical matter, being a little under or over isn't going to make a lot of difference because you are going to make a new calculation every year.
The savings should not be in tax-deferred retirement accounts such as an IRA or 401(k) unless you are over age 59½ and can make withdrawals without penalties. If you are already retired and must use tax-deferred accounts, increase the amounts in these calculations to account for taxes by dividing the goals by one minus your tax rate. For example, if your tax rate is 25 percent, your annual savings for the water heater would have to be $133 ($100 divided by 0.75 = $133). Your reserve after three years would be $400 ($300 divided by 0.75 = $400).
Unless you specifically establish an account to be used only for replacement reserves, the reserves will be a theoretical part of your total investments. I make this point because most retirement planning programs simply ask you to enter the total of your investments. In fact, you should not enter the amount you have planned for replacement reserves. Doing so will overstate the amount you can spend after you retire.
Practical implementation
These days a young person cannot possibly buy a car for cash unless he has rich and generous parents or buys a cheap wreck and somehow finds ways to keep it running at a low cost. But over your lifetime, it's important to work toward being able to buy an automobile with cash instead of credit because the gains are so large.
To work your way from the position of the very young person to the retired person, you will have to start saving for the next automobile while paying for the first. This may mean that you have to buy a less expensive automobile so you can make the loan payment as well as a partial payment to a savings reserve. You might begin by saving one-third of the calculated annual replacement savings. Then, when purchasing the next automobile, you'll be able to get a loan that's one-third less than the negotiated price of the car.
After you get that next automobile, you should try to save two-thirds of the calculated replacement amount. You can do that because your loan payments will be one-third less, so the net of your payment for the loan and savings deposit will still only be one-third more than you would be paying with a 100 percent loan. By the time you are ready to buy your third automobile, you will be able to pay cash, get a better price and embark on the path to wealth.
How you can do even better
The math assumes that you will keep the car for at least as long as it takes to save the required amount. Of course it would be even better if you keep the car longer. Your reserves for the car will then continue to grow without additional savings. My former boss, T.A. Wilson, then CEO of Boeing, drove his old Chevrolet for many years. That may be because his boss, William M. Allen, drove his old Ford until he retired -- even after the bottom rusted out.
A word of advice: When you go to a dealership to buy a car equipped with cash, start negotiating the price without mentioning that you plan to pay in cash. Often you can get a better price if the dealer assumes he will be able to loan you money since the loan is often the most profitable part of the deal.
For the last 20 years of so of my own career, I only bought secondhand cars for our family's use. I now have enough reserve savings so that I buy new cars, but I keep them a number of years longer than I originally intended. It's a great feeling to be retired and not have to worry about where the money will come from to pay for the next car or to replace my roof.
Henry "Bud" Hebeler is author of "Getting Started in a Financially Secure Retirement" and founder of www.analyzenow.com.
