I recently read a book called The Latte Factor by David Bach. It is an effective story that demonstrates how small decisions and financial habits can compound over years and years to result in a large financial nest egg. I do recommend the book, and have noticed the financial benefit of making my own coffee at pennies on the dollar compared to Starbucks (for just as good taste). However, I found the book left out the fact that the difference between financial independence and a lifetime of financial quicksand that must be dug out of constantly actually starts with only a few major decisions. These decisions are akin to the original bearings of the compass on your financial journey: they seem small at first, but over time the destinations end up being very far apart. Avoiding these financial mistakes at the beginning of your financial independence journey will fast track your progress and have much more of an effect than the everyday decision of whether to make your own coffee or order it to-go.
Mistake #1: Buying or Renting More House Than Is Needed
In 1973, the median new single family house was 1,525 square feet and the average family household sheltered 3.01 people. In 2018, the same respective metrics were 2,435 square feet and 2.53 people, a 60% increase in median home size combined with a 16% decrease in average occupancy (all according to Census data). Furthermore, a UCLA study from 2012 showed that on average we only use around 40% of our actual dwelling area, as illustrated by the heat map below:
Why are we buying bigger houses when our families tend to be getting smaller? I can hypothesize about certain things like keeping up the Joneses or the fact that we’re buying more “stuff” and need more room to fit everything, but those reasons are difficult to prove and are different for everyone. What I do know is that buying (or renting) 150% more house than you actually need is a giant load of empty calories in what is likely the largest line item in most people’s budgets. From a financial perspective, renting unused space for renters and homeowners’ heating, cooling, cleaning and maintaining of unused space is a massive drain on your monthly cash flow, not even considering the extra time wasted to maintain this space. Additionally, home buyers will have to pay extra up-front in a down payment and every month that they have a mortgage for the space (30 years in many cases), so the cost of having too much space can be long-lasting.
While watching the HGTV show Caribbean Life the other night (in which people from mainland North America house hunt in the Caribbean) we noticed many couples that had kids already out of the nest were wanting to buy houses with extra bedrooms “just in case” they came in town to visit. Would these people ever consider booking a hotel room for the entire year just in case their kids came down? No. But although the price for booking a hotel room would probably be higher than the equivalent marginal price of an extra bedroom, having “just in case” rooms is essentially the same in principle to booking those rooms. “Just in case” is dangerous when it comes to the amount of housing bought or rented due not only to the scenario just mentioned, but also “just in case” items that are bought and will need to be stored somewhere. “Just in case” items and scenarios are very easy to justify, but are almost never worth the amount of money spent per occasion in which they are actually used.
I’m not necessarily advocating to get rid of everything and move into a tiny house. On the contrary, we have been looking at potential houses that are larger to fit the needs of a larger family down the road. But we are looking for houses in which we believe we would use the maximum amount of the house daily rather than focusing on events that would occur sporadically (like the “just in case” scenarios mentioned). We want to make sure that our home purchase price and utility bill costs go toward things we will actually use and not wasted space. We want our time to be used cleaning and maintaining the space in which we make great memories, not the unused areas the just collect dust. Along with being easier to maintain and not being tempted to fill unused space with “stuff”, we would get the most value out of our home expenses and have more money leftover to buy our freedom and things we enjoy.
Mistake #2: Buying a Brand New Car
I’ve never bought a brand new car, and knowing what I know now it will definitely be staying that way. It turns out that car dealerships hold out on you when you buy a new car, even after all the negotiations and debt you may take out to buy a car from them. What do they hold out from you? They don’t let you take around ten percent of the purchase price of the car in cash, put it on the ground, soak it in gasoline and light it on fire. What do they let you do instead? Drive the car off the lot.
From a financial perspective, the loss incurred is exactly the same. Furthermore, it is estimated that a new car loses 20% to 30% of its value after one year and around half its value after three years. Many people go into debt for the privilege of paying for this excess cost that has no intrinsic value as illustrated by the sharp decline in resale value immediately after purchase and beyond, further hurting their budget and big picture net worth. In economics, “deflation” (opposite of inflation) is defined as a decrease in the general price level of goods and services. Deflation is thought of as bad for the economy as a whole because of the theory that if people know the price for an item will lower in the future, they will hold out and buy the item at a future date, causing a slowdown to the economy in the present. This idea clearly didn’t seem to take hold in the car-buying business, save for those savvy folks that intuitively know the deflationary characteristics of a new car and wait for the price to lower in the future.
At the end of the day, a car is made to transport a person or people from Start A to Destination B. There are obviously other safety features, technologies, and sport utility that go into the experience of driving and riding in a car; but how efficiently, effectively and for the longest period a car can get from A to B should be the main factors to consider when looking at buying a car (in my opinion). While technology upgrades to things like safety features, engine performance and fuel efficiency occur in every new iteration of car model, I will bet you that these features will never improve 100% over the course of a three year period. However, when you buy a new car that loses half its value over a three year period, that is exactly what you are paying for. Therefore, would it make sense to get pretty amazing technology that is only three years old for half the price of an incrementally “better car”? You would have to decide for yourself, but for me I will gladly take the cost savings.
Mistake #3: Making No Effort to Lower Smaller, Recurring Expenses
According to many polls, the US Congress has enjoyed a very low approval rating ranging from 10% – 15%. This held true in 2014, where 96.4% of the incumbent Representatives and Senators were re-elected. What gives?
This to me is an example of “drift”, a phenomenon that we all experience at some point in our lives. It commonly occurs when we settle into certain habits and routines, achieving a certain level of comfort. We stop being challenged as much, and life isn’t amazing but it’s not that bad either. We might have an okay job that we’ve grown bored of but it would be way too much of a hassle and too risky to look for something else. We just drift through life and let life happen to us, rather than taking chances and pushing ourselves to our limits.
I notice this idea occurring a lot with the small to mid-range financial expenses that people incur, specifically around insurance and utilities. I see many people who went with an insurance company because they received a good rate the one time they shopped around years ago and have not shopped around since even though other companies could save them hundreds of dollars. I see people still paying for expensive cable when they can still get everything they want to watch for a fraction of the price of a cable bill. I see people paying far more than they should for a cell phone plan when they can get more than enough of the minutes, texts and data they need on lesser known carriers that run on the exact same network as bigger named providers.
While it does take a little bit of effort, the small amount of time it takes to routinely shop around for these expenses is more than worth it. If the idea of calling around overwhelms you, you can try Trim, which uses robots (that sound exactly like normal people) to call for you and negotiate on your behalf and don’t make any money from you unless they successfully save you money on your bills. You will gain the benefit of being in control of your finances and add to your net worth with everything you save along the way.
Deciding to give up on a coffee for one day will save you about five dollars. You could also opt for a smaller house, say one that’s 1500 square feet instead of a 2000 square foot house that had 500 square feet you would barely use. Let’s say the 2000 square foot house cost $400,000 and you saved $100,000 by buying the 1500 square foot house for $300,000. Not taking into account the savings in interest, maintenance and utilities, this one decision had the same financial power of 20,000 “do I or do I not get coffee today” questions. While it is always important to be mindful of your daily spending, these big decisions will be the biggest determining factor of your financial success in the long run.