By Etelka Lehoczky
In their 2003 book The Two-Income Trap, Harvard law professor Elizabeth Warren and her daughter, personal-finance expert Amelia Warren Tyagi, examined bankruptcy records to uncover the biggest risk to Americans’ financial welfare. The problem, they found, is that too many of us haven’t built up enough of a cushion to see us through bad times. As a result, many of us are often just a health crisis or a job loss away from financial disaster. Now, in All Your Worth: The Ultimate Lifetime Money Plan, they offer practical advice for anyone whose income simply doesn’t leave enough for saving. You’ll be glad to hear it doesn’t involve cutting out your morning latte.
Q: Experts usually say that if you feel strapped, cut back on unnecessary expenses. But you encourage people to indulge up to a point. Why?
TYAGI: The old belief was that the only reason people get into trouble is because they spend too much on stupid stuff. That just isn’t true. There certainly are people who fritter money away on little things, but in The Two-Income Trap, we found that the typical family today spends less on the little things than their parents did. They spend less on food, even when you account for eating out, and less on clothing. But they’re spending a lot more on basics like housing, cars, preschool for the kids, child care and health care.
WARREN: Anyone who is budgeted to the edge and feels there’s no money for fun does not have a lifetime money plan. All of life becomes cheating and feeling deprived and anxious. No one can live like that.
Q: So you argue for setting aside 30% of your income for fun. Isn’t that a lot?
WARREN: The worst advice I’ve ever read is “cut out the lattes to pay off your debt.” You can cut out all the lattes, but unless you’re floating a boat in them, it won’t be enough to pay the interest on your debt.
TYAGI: The key is to make dollar cuts before you spend time on penny cuts.
Q: But small stuff can add up, can’t it?
TYAGI: Yes, so you need to give yourself an overall budget, put that amount of cash in your wallet–once a week, say–and don’t pull out the plastic. Cash lets you relax because you have freedom to buy what you want and know what you can afford.
Q: What’s wrong with using credit cards if you pay your balance every month?
TYAGI: Researchers have found that when people use plastic rather than cash, they spend more. When you use cash, you know exactly what you’re spending.
WARREN: Cash is the key to confidence. It lets you track your spending as you go, so you don’t have to second-guess yourself or be surprised at the end of the month.
Q: Besides 30% for “wants,” your Balanced Money Formula recommends budgeting 50% for “must-haves” and 20% for savings . Why is it important to get the must-haves down to 50%?
WARREN: It’s sustainable, and it’s safe. If you lose your job you’ll more easily get by on one income or an unemployment check. If you face a disability–as one in four people will before they reach retirement age–you’re more likely to be able to survive on a disability check.
Q: I thought that’s what an emergency fund was for. If you’re saving a lot, can’t you go above 50% on fixed expenses?
TYAGI: We agree it’s a good idea to have six months’ worth of expenses in liquid savings. And with that savings, a little flexibility in the other categories is fine. But the reality is that most Americans not only aren’t saving, they’re carrying a whole lot of credit-card debt to boot. So we suggest building in a little extra slack.
Q: To many people, getting fixed expenses below 50% without overhauling their lifestyle sounds impossible.
TYAGI: There are lots of relatively easy cuts that nobody ever thinks about.
WARREN: A big one is insurance. Most people are paying way too much. If you spend an afternoon shopping for car insurance and homeowners insurance, you may be able to free up hundreds of dollars a month. Get at least five quotes and ask your current insurer to beat them.
TYAGI: Sometimes you can get a big discount by buying all your insurance from one company. There are also discounts for nonsmokers, for installing burglar alarms and smoke detectors, or for reaching the age of 55 or 65.
Q: What else?
TYAGI: Get a flexible spending account if your employer offers one. You pay medical expenses tax-free, which is like a 30% discount on all medical bills.
WARREN: And there are lots of ways to save on medical insurance. If your company offers several plans, the lowest-cost plan may be the best value. It’s amazing how many people will pay an extra $50 a paycheck just to go to a dermatologist who’s 20 minutes closer to home.
TYAGI: Also, get rid of insurance you don’t need. This includes credit-card loss and identity-theft protection, mortgage insurance and accidental-death insurance.
Q: You point to several other areas where we don’t comparison shop enough.
TYAGI: Car loans is one: These days, car makers earn more on financing than on selling cars. So don’t just take the dealer’s rate. Check banks and credit unions.
WARREN: If you haven’t checked your mortgage rate in the past year, it’s worth shopping. A difference of half a percentage point can mean tens of thousands of dollars over time. Get at least five quotes and play brokers off one another. And be sure to shop all the pieces, not just the interest rate. Shop for points, fees and closing costs as well.
Q: Why devote 20% of income to savings?
WARREN: We want to make sure you’ll have enough to retire–which experts say requires saving 10% of take-home pay–plus enough for your dreams beyond retirement, like paying off your home, buying a cabin by the lake, helping your kids through college.
TYAGI: We also include paying off debt in this category. That’s a kind of savings too, because if you have money in the bank and aren’t paying off credit-card debt, you’re fooling yourself. You’re installing smoke detectors in the hallway while there’s a grease fire in your kitchen.
Q: But everyone has some debt. Is it really the financial equivalent of a grease fire?
WARREN: With debt for a home, car or education, at least you have something valuable once you pay it off. Other kinds of debt steal from the future.
Q: Besides avoiding bad debt, what’s the most important step for your future?
TYAGI: The key is to take stock and get in balance. That’s not a gimmick, it’s a lifelong plan. It’s “get rich slow.”
Money magazine, 2005
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