Sunday, May 20, 2007

Spend Below Your Means

Have you got your financial plan? If no, you may want to refer to earlier post to read about it. If yes, you are now ready to take action.

What do you think is the first step? Many people would think that by increasing their income, their wealth will automatically increase. Unfortunately, increasing income is only one side of the wealth equation. There are people who earn $2,000 a month and are broke and there are those who earn $20,000 and are still broke. The reason is simple. When we don't manage the money we earn, our expenses will always rise to our level of income, wiping out any surplus we have. Or worse, we start to spend on credit lured by easy repayment schemes.

Henceforth, managing your spending is one contributing factor to increasing your wealth. The number one trait that you must possess is to be FRUGAL and live well BELOW your means. Once spending is reduced, your saving will increase and correspondingly your wealth will increase too.

In that case, how am I going to own a house and buy a car? Well, taking a consumer debt would be unavoidable. However, you must avoid taking on too much for too long a period.

Use the following ratios to measure if you have taken too much debt.
  • Total Debt / Total Asset Ratio. This measures one's ability to pay one's debt. It should not be more than 50%
  • Mortgage Debt / Total Annual Income Ratio. This measures one's solvency and ability to pay one's debt. Advisable limit is 5 times for those below age 30; 3 to 4 times for those age 30 to 40; 2 to 3 times for those age 40 to 50; 1 time for those age above 50.
  • Debt Service Ratio. i.e. total debt repayment / total annual take home income. This measures how much income is needed to repay your debt. A ratio of > 50% is considered excessive. A ratio of <>
In addition, you must avoid taking on a debt for too long a period. In other words, you must reduce your debt as soon as possible. Why? This is because a 5% -6% interest rate, which may seem small, can compound to a huge amount of money over an extended period of time. You will find yourself paying thousands of dollars in instalment payments every month just to see that the principal sum you owe go down by only a couple of hundred dollars.

For example, let's say you bought a $500k Apartment and took a $400k mortgage at 6% stretched over 30 years. If you just pay the minimum instalment payment (using PMT formula in Excel, it is $2,386.27) every month, how much do you think you would pay for in interest eventually? The answer is $459k ($2,386.27*360 - $400k) in interest to the bank. That is like buying two apartments and giving one to the bank!.

That is all for now!. Be sure to look out for more tips.

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