The word “millionaire” used to evoke a world of extravagant wealth. But, these days, it’s nothing special, as everyone needs to save at least $1 million for retirement.
And that money shouldn’t be spent in retirement, but instead lived on through income-producing investments such as dividend stocks, bonds and real estate. What’s important is how much income you can generate with that nest egg to keep you (and your spouse or partner) living comfortably for an indefinite period.
As a result, you’ll need to begin planning early and have a realistic understanding of what it means to be financially secure.
Among several thoughtful Father’s Day presents from beloved family members was the book “The Millionaire Next Door” by Thomas J. Stanley and William D. Danko. The book, which I just finished, was first published in 1996, but Stanley wrote a long preface for the 2010 edition. Even though the book was written before the credit crisis, its ideas are current.
The main idea
The book defines the “millionaire next door” as someone who doesn’t look the part. He or she makes no ostentatious display of wealth. There’s no fancy car, no $5,000 watch, no McMansion. This wealthy person lives in a regular middle-class or lower-middle-class neighborhood.
According to statistics backing the book, “more than 80% [of U.S. millionaires] are ordinary people who have accumulated their wealth in one generation.”
And the most important factor in building that wealth has been what’s called underconsumption.
Are you living in the most expensive home you can afford? Are you driving the nicest car you can afford? If so, even if you’re earning a lot of money, there’s a good chance you are what the authors call a UAW, or “under accumulator of wealth.” Homes and cars are two of the main items that can keep you from accumulating wealth, but there are many others, of course.
The book cites several examples of people who were interviewed by the authors, so more insight could be gained into successful wealth-building strategies, as well as less successful strategies and non-strategies.
It’s fascinating that people at all income levels live “paycheck to paycheck.” In one case study, the authors cited cultural factors as a major reason why a successful salesman was so focused on “being a lot better off than his parents.” The man came from a lower-middle-class family and had gone to a high school with students from families with different social and economic backgrounds.
He was amazed at the fancy cars being driven by some of the students, while he had no car and his parents had an old vehicle.
So, to him, being “a lot better off” meant achieving enough career success to enable him to own “a nice home in an upscale neighborhood, fine clothes for everyone in the family, classy cars, club memberships and items purchased in the best stores.”
That’s all well and good, but those material items won’t build financial security. This man and his wife are likely to be carrying so much debt that they cannot save enough money to withstand an emergency, such as the loss of a job. A high debt load, relative to income, means they will always be living in a house of cards. They will suffer from stress, owing to insecurity. That can lead to poor health, a shaky retirement, and even the humiliating possibility that the couple will be forced to rely on their children for financial assistance when they retire.
The authors go into great detail through several positive and negative case studies, identifying many areas of risk and opportunity for people who wish to build wealth.
Taxes and deferred taxes
In one of the case studies, the authors described a woman with a high salary and a combined marginal income tax rate of 59.5%. That isn’t a very good circumstance for wealth building, so the authors discuss tax-avoidance strategies of the wealthy.
But no matter your salary level, it’s possible that you are “leaving money on the table,” while paying too much to the tax man during your working years. If you work for a company or organization with a 401(k) or similar tax-deferred retirement plan, chances are your employer makes matching contributions. For example, if the employer matches up to 5%, it means that if you contribute 5% of your pretax salary to your retirement account, the employer will also put in 5%. Boom — you just realized a 100% gain on your investment during the first year, and set aside the equivalent of 10% of your salary.
It’s not enough — 20% total savings per year is more like it — but it’s a start, and if you don’t make a contribution of at least the maximum match, you’re simply losing a lot of money. Over time, you should also work to maximize the annual 401(k) contribution. The basic limit for your own contributions is $18,000 a year (for 2015), with an additional $5,500 allowed when you reach the age of 50.
Those amounts may seem outrageously high, but if you start early and build up your contributions slowly, you can get there. Yes, it will hurt, but if it doesn’t hurt, you can be pretty sure you’ll be left high and dry some day.
Getting back to cars and houses
People let their emotions affect which cars they buy. Have you ever heard someone say they simply “just want a new car”?
I myself own a nine-year-old car with nearly 180,000 miles on it. The car has had no repairs, except for two airbag recalls. Just maintenance, including tires, front brakes and spark plugs. A salesperson from the dealer called me this week to ask if I would be interested in “updating to a new model.” I said: “You’re a victim of the manufacturer’s success in making such a good product.” So that’s it. A new car might be a better status symbol, but it would be so much more expensive than driving the old car, which is in fine condition.
I recently read an article written by Earl Stuart, who runs a Toyota dealership in Lake Park, Fla., discussing how salespeople ”flip” potential buyers into taking out a lease. According to Stuart, if you get a good price for a car and buy it, the dealer typically makes a profit of $1,000, while the salesperson makes a $200 commission. But if you go for the lease, the dealer eventually may realize a $15,000 profit, and the salesperson could earn a commission as high as $3,000.
Potential buyers scared away by high monthly loan payments may find leases attractive, because they’ll be shelling out less each month. But the problem with the lease is that at the end of the term, you give the car back to the dealer and are left with nothing. You’re starting all over again, whereas if you had suffered through a car loan, you might then drive the car for another five years, or longer, with no monthly loan payments.
Charles Passy spent two days working as a car salesman for Stuart last year and wrote about how it made him a smarter car buyer, and later followed up with 10 things car dealers won’t tell you.
With cars out of the way, what about homes? Memories can be short, but a homeowner who lived through the credit crisis of 2008 knows you can’t rely on home values to increase every year. You also can’t plan “just to live here for five years and then sell,” because it won’t be so easy if values decline.
But your choice of home could make a huge difference in your long-term financial health. If you resist the temptation of buying a “status symbol,” and go for something less expensive that you can easily afford, you will then have the option of going with a 15-year fixed-rate mortgage loan rather than a 30-year loan. Not only will pay off the loan 15 years earlier, you will save oodles of money.
The authors of “The Millionaire Next Door” didn’t focus on the ins and outs of mortgage financing, although they did dig deeply into what motivates people to overspend on homes. But comparing the costs between a 15-year and a 30-year mortgage can illustrate just how much money you might be throwing away if you either buy “too much house” or assume that you must spend 30 years paying off a home loan.
Here’s an easy example for a person who buys a $350,000 house with a 20% down payment. The borrower puts down 20%, or $70,000, and borrows $280,000. Based on on Thursday, the average rate for a 30-year fixed mortgage loan is 4.03% and the rate for a 15-year loan is 3.13%.
The monthly principal and interest payment for the 30-year loan is $1,342. The total interest paid over the life of the loan will be $202,978.
For the 15-year loan, the monthly principal and interest payment is a much higher $1,951. But the total interest paid over the life of the loan will be just $71,213, for a savings of $131,765, not to mention having the monkey off your back 15 years earlier. That’s a lot of money, and when you consider the time value of money, when it is invested, your benefit from “buying less house,” tightening your belt and going with a 15-year loan will probably be much higher.
These loan-payment examples exclude two very important items: Taxes and insurance. Depending on where you live, homeowners insurance can be very expensive, if you face special certain hazards, such as hurricanes. If the home is in a FEMA-determined special flood hazard area, the bank will also require you to carry flood insurance. In some states, if property values are rising, your property taxes may come in much higher than you expect, and higher than your real estate agent and even your lender told you to expect.
These items are usually escrowed, that is, added to the monthly loan payment, and they can make your new home unaffordable. You need to check with local insurance agents on prices before you buy, and also personally visit the county tax collector’s office to obtain a proper estimate of how high your property taxes will be. Then add all these items up and divide by 12, to see how much more you’ll be paying each month.
The purpose of the example above is to make you consider “going smaller” to save tremendously over the long term, and possibly delay your first heart attack.
Other topics covered by Stanley and Danko
The authors shared the results of numerous studies, which involved surveying participants. All sorts of psychological aspects of spending and saving are covered, as well as most aspects of personal finance, including estate planning, and various forms of employment, even factoring in gender.
Here’s a telling quote: “Are you surprised to learn that some millionaires shop at Penney’s? Perhaps even more surprising, 30.4% of the respondents who are millionaires hold J.C. Penney credit cards.
Stanley and Danko also discussed which professions or businesses were most likely to help people become financially secure, and the philosophy of investing, rather than simply spending, or helping someone by “giving.” They also pointed out the fascinating tendency for millionaires to focus on investing in income-producing properties, while de-emphasizing stock investments.
If you have already achieved financial security, congratulations. But you certainly know someone who could benefit from the book. Give it to them as a present.
Written by Philip van Doorn of MarketWatch