Monday, February 9, 2009

Financial Slavery

Visa has a booklet of financial advice available online called Practical Money Skills: A Guide to help you manage your money. It contains a fair bit of very basic, but useful information. The advice on how to allocate your income is consistent with other sources of financial rules of thumb, but it struck me how useless this advice is for anyone who wants to develop some financial independence.

The first page of content after the mandatory giant pictures of smiling families contains the following chart in large font:

Guideline for after-tax expenses:
30%: shelter
10%: fixed expenses
10%: loan payments
10%: personal spending
10%: savings

Presumably, the missing 30% is income taxes. On the surface, these percentages seem sensible enough. The truth is that staying within these guidelines will work fine if your goal is to be like everyone else and trudge off to work each day for most of the rest of your life to a job you will come to hate but can’t afford to leave.

If you’re hoping for more out of life, you’ll want to aim for something better than Visa’s percentages. The first thing to observe is that the guidelines have you saving and borrowing at the same time. A certain amount of this can be unavoidable, but it serves the interests of banks nicely. Banks make much of their money from the interest rate spread between savings and loans. Customers who have both are profitable and low-risk for banks.

To see how the guidelines don’t do much to get people ahead, let’s consider a hypothetical young couple, the Smiths, who have a modest combined income of $75,000 per year. The monthly spending guidelines for the Smiths are then

$1875: shelter
$625: fixed expenses
$625: loan payments
$625: personal spending
$625: savings

The Smiths rent a nice house for $1875/month and manage to save $625/month. They make the following debt payments each month:

$450 - Line of credit balance $15,000
$175 - Credit cards total balance $8750
Total debt: $23,750

So, they are matching the guidelines exactly. Suppose that the Smiths get a combination of raises that increases their income by $5000/year for the next 5 years, and that they continue to follow the guidelines exactly. After 5 years, their combined income is $100,000. Their new monthly spending breakdown is

$2500: shelter
$833: fixed expenses
$833: loan payments
$833: personal spending
$833: savings

They rent a nicer house now, still save 10% of their income, and their debt payments are now

$600 - Line of credit balance $20,000
$233 - Credit cards total balance $11,650
Total debt: $31,650

If the Smiths’ savings grew at 7% per year, their total savings after 5 years works out to $50,030. This is more than their total debt which puts them in a better position than many people. But the Smiths have made little progress toward enough financial independence to make some different choices.

If the Smiths want to buy their own home, their savings could make a down payment, but they would still have $31,650 in consumer debt, and they’d have nothing left saved for retirement. They can’t afford to have one of them quit working to stay home with children. If they are unhappy with their jobs, they can’t afford pay cuts while they ramp up in a new career.

The fundamental problem is that constructing a lifestyle that consumes almost all of your income locks you into a rut. During a 5-year period where the Smiths’ total income was $425,000, their financial situation improved by only a small amount. The job that you love at first may not seem so exciting 5 years from now.

The truth is that to have enough financial independence to make choices later in life, you need to eliminate consumer debt and save more than 10% of your income. Some debt is very difficult to avoid, such as a mortgage or student loans. However, car loans and credit card debt are almost always completely avoidable.

We tend to look to others to see what is normal. Unfortunately, “normal” for most people is to be indebted enough that they are locked into a path in life. If you want more out of life, aim much higher than Visa’s income breakdown guidelines. Debt takes away choices.


  1. Ah, yes, why hold savings while paying back debt? Debt expenses will be higher than savings income, unless someone can constantly ride these 0% transfer deals.

    I didn't really pick up on their income allocation bias, and I agree with your assertion. Pay debt first and then build savings (beyond an emergency fund, that is). Or, as you mention, avoid the debt altogether.

    I used to read those financial family profiles they have in MoneySense, and it always puzzled me to see people with $50k in debt and $12k in savings, and some money in RSPs (though RSPs could make sense if their company has an employee match). I guess I'll have to agree with your assessment, people want to be like everyone else.

  2. Do you have any thoughts on the psychology of debt? I would think a lot of people would be averse to going into debt.

    However, I can also imagine that once one has debt, it might be easier to go further into debt versus someone who is debt free.

  3. Gene: Your theory seems plausible, but I don't have any added insight. One thing I do know is that people who lived through the great depression are usually _very_ conservative with money (based on the limited sample of older people I've known).