Today I continue down the list provided in 10 Dirt Simple Rules of Money Management, where I provided 10 rules to follow to basically ensure a great financial future. (Note, you can find all of the posts in this series by choosing Dirt Simple from the category list in the right sidebar.) Today we cover the second rule:
2. Before you buy something to “save you money,” figure out how long it will take to recoup your costs.
There are always people telling us about all of the money we’ll save by buying their product. Before you take the plunge and buy into something, however, you should spend a little bit of time doing a simple analysis to figure out how long it will take for you to make your money back and then actually start saving money. By doing so, you might find that some ideas make a lot of sense, while others are really not that much of a bargain after all.
When approaching this kind of analysis, you should start out simple with gross assumptions, just to see if the numbers are close or tilted far one way or another. If you do so and the results are really convincing, like it would take you 40 years to make your money back, there is not a reason to continue. If things are close, however, like you estimate that it will take you three years to make your money back but you will probably only own the thing for 2 1/2 years, then you should improve your assumptions and try again. This would be referred to as “sharpening the pencil” in engineering and accounting circles.
For example, let’s say you are looking at refinancing your home and you see that you can cut your interest rate by 1/2 of a percent. Is this a good deal? What is a simple analysis that you could do to estimate the amount of time required to make your money back (your break-even time)?
Well, if you have a $200,000 loan, saving 1/2% per year would save you (1/2% * $200,000) plus a little more. As a first estimate, just assume you save (1/2% * $200,000) = $1000 per year. Looking on the internet, you might find that closing costs for such a loan would be somewhere between $2000 and $4000. You might just pick $3000 as a first-cut estimate. Your time to break even would be:
$3000/($1000 per year) = 3 years.
So, if you are planning to be in your home for 15 years, this would be a no-brainer. After about 3 or 4 years, you would have made the money back that you had paid in closing costs and you would be saving a thousand dollars per year after that. If you were only planning to be in your home for a year, you would obviously lose money and should just stick it out with your current mortgage. If you were planning to be in your home for four years, you would be right ont he line and would need to improve your analysis. You could improve your analysis by using an online calculator to calculate your payments and to get better information on closing costs, since it could go either way.
You can also do the same sort of analysis if you’re looking at doing something to earn more money. For example, let’s say that you are looking at going to a technical school and get a drafting degree. The school costs roughly $15,000 per year and it would take you two years to get the degree. You are currently making $10 per hour and think you could make $20 per hour as a draftsman from a brief internet search.
The cost of the education would be: (2 years) * ($15,000 per year) = $30,000. If you needed to take out loans to go to school, double the estimated costs to $60,000. If you needed to leave your job to go to school, add ($10/hour)*(2000 hours/year)*(2 years) = $40,000. So, you education would cost you about $100,000 if you took out loans and went full time.
Once you finished the degree and found a job, you would make ($10/hour)*(2000 hours/year) = $20,000 more per year that you were making before you went back to school. Based on these numbers, it would take you $100,000/$20,000 = five years to make back your money. If you are looking at a 20 year career, this would be a great move since you would make around $300,000 more than you would have without the degree. If you were planning to work for a few years and then stay home to raise children, however, you might want to think about waiting until the kids were out of the home to get the degree since it might be more attractive to employers.
I can guarantee that on certain purchases you will almost never break even. These include:
1. Buying a time share, or even a vacation home. You may think that you’ll get a “free vacation” each year after you make these purchases, but you’ll find that the payback will take forever and little costs you haven’t considered will keep you in the red.
2. Going to an elite college, especially on loans. With very few exceptions, such as becoming a partner in a law firm that only hires people who go to Princeton, you will never make the additional money back that you pay for an elite private school versus just going to your local state school.
3. Buying an electric car or even a hybrid car. You really won’t save that much money in gas, especially when compared to a comparable diesel car, and you won’t make enough to overcome the higher price tag before you’re looking at an expensive battery replacement.
4. Any sort of home improvement. You’ll only get maybe 75% of your money back on even the best projects, such as a kitchen or bathroom upgrade, and it will all disappear in five or ten years as your upgrades become dated.
So what about cases where you will never break even, or at least not break even during a time frame that matters? In these cases, you should look at it as a purchase and treat it the same way you would treat any other luxury. If you have a couple million dollars in the bank, you can afford to send a child or two to Harvard so they can proudly wear a maroon sweatshirt the rest of their lives. If you are willing to eat in most lunches and save up the cash, you can buy a Prius to make all of your eco-elite friends jealous. Just realize that you are spending money and not saving money. You are buying a liability, not acquiring an asset, and people who do well financially acquire more assets than liabilities. Like many other things, it’s about balance.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.