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In 1972, the average family had only one spouse working, but even with just that one paycheck, they only spent 54% of their income on fixed expenses, that is expenses that had to be paid each month, like the mortgage, insurance, basic food, any car loans, etc. By 2005, the average family had both spouses working, yet they spent a whopping 75% of their income on fixed expenses[17].

Why is this critically important?

Because it makes the average family today much more financially vulnerable. In the past if something went wrong, such as a job loss or illness, the 1972 family only had 54% of income going to fixed expenses that they couldn't quickly or easily cut back. The other 46% was discretionary. It was spending on things like eating out, movies, fashion clothing, and vacations, that could immediately be cut back.

In many cases, unemployment insurance paid over 55% of one's previous income[18], so from that alone many families could get by because they only had to cover fixed expenses of 54% until another job was found. They could weather the job loss without having to resort to debt, which can spiral out of control and ruin a family. In addition, in 1972 there was typically only the husband working[19], so there was a spouse in reserve who could go into the workforce to make up for a lot of the lost income.

Thus, a generation ago, a family could much better weather setbacks like a job loss, because:

  1. Only 54% of income was going to fixed expenses, so they could cut back their spending by 46% immediately to weather a crisis without having to resort to debt that they might never be able to pay. By contrast, the average family of 2005 has a whopping 75% of its income going towards fixed expenses like the mortgage, insurance, and car payments[20] that cannot be quickly or easily cut. All that they can cut back immediately (or anytime soon) to cope with the crisis is a mere 25% of their expenses. They can eat all the generic macaroni and cheese, and drink all the grocery store coffee they want, and not spend a penny on clothing and entertainment, but all it will do is cut their expenses by 25%, at most, and that's not usually enough to weather the loss of a spouse's income without having to eat up savings or take on debt.
  2. The typical family of today doesn't have a spouse in reserve. They don't have the option of sending the wife into the workforce to help cushion the blow of the husband‘s job loss, because the wife is already in the workforce. And even with that income, they were still spending 75% of their earnings on fixed expenses, expenses again, like the mortgage, that cannot quickly or easily be cut back.

So you can see it's much harder for the modern family to weather something going wrong without depleting savings and/or resorting to debt which can spiral out of control. In addition, not only is the modern family less capable of coping with a crisis, unfortunately today crises are much more likely to happen. I've already given many statistics, but there are more you should know (Don't worry; I'll get to ways to defend against these things, and prosper, but first it's important to really understand how things have changed over the last generation.):

First, having two instead or one spouses in the labor force alone would be enough to approximately double the family's chances of a layoff, but over the last generation each individual's chance of losing his or her job increased substantially. Harvard Professor Elizabeth Warren cites a study in her book, “The Two Income Trap”, which found that over the last generation the probability of an involuntary job loss increased by 28%[21].

And it's not just that the risk of losing a job has increased substantially. An even bigger risk has increased even more – the risk of only being able to find a new job that pays much less, or one that doesn't have health or dental insurance. Yale Professor Jacob Hacker in his book, “The Great Risk Shift” found that the probability of a 50% or greater loss in family income over a year increased from 7% in 1970 to 17% in 2002[22].

In addition, as I noted earlier, over the last generation the probability of losing your health insurance has skyrocketed. Experts calculate that an individual is now 49% more likely to be without health insurance than a generation ago[23]. Shockingly, one-third of the U.S. population under the age of 65 spent at least some time without health insurance in 2006 or 2007[24]. And even with health insurance, families are much more at risk than before because the amounts that they have to pay, the deductibles and co-pays, have skyrocketed, and increasingly insurance companies are finding reasons not to cover illnesses or treatments at all, or limiting the amounts that they will pay to much less than the cost[25].

Please now click here to read a New York Times article about this. After you finish, please hit your Back button return to this text and continue reading (maybe after a snack; remember, you are, of course, totally free to take this course on whatever schedule is most convenient for you).

Welcome back. After reading that article you can really see why the number of families declaring bankruptcy in the wake of a serious illness multiplied more than twenty fold between 1978 and 2003[26].

And it's not just medical care; over 100 million Americans don't have dental insurance, and the average dental procedure rose 25% between 1996 and 2004, even adjusting for inflation. In the 2003-2004 period, 27% of children and 29% of adults had untreated cavities[27]. This can eventually lead to root canals costing thousands of dollars, or the loss of teeth, and serious infections.

Again, I know all of this sounds depressing, but please bear with me. I want to make sure you understand how much things have changed over the last generation, and how the old prescriptions from your parents or grandparents of, “Eat out less”, “Clip coupons”, “Eat less steak and more hamburger” are not nearly enough. Today the big fixed expenses like housing and health care dwarf these things. They have skyrocketed over the last generation and must be addressed smartly and effectively. In addition, today you can get into trouble that it was impossible for your parents or grandparents to get into. Just as one example: they could never get a mortgage on a home that cost many times their annual income, because bank regulations prevented it. But after years of ever more deregulation, families can now take out mortgage on a home costing even ten times their annual income, something unimaginable a generation ago.

Now, I am foreshadowing here; later we'll talk more about how the old personal finance prescriptions are not good enough today, and what the new prescriptions are, but for now, please bear with me while I finish up my description of the harsh changes that have occurred. It's necessary that you understand them so you can protect yourself against them, and see why the advice I will be giving to you makes sense, and will allow you to build wealth and live well.

O.K., so let's continue with the changes. One of the biggest is in retirement. A generation ago most jobs came with defined-benefit pensions, a dependable fixed payment that you knew you would get for sure in retirement[28]. The company offering the pension could go bankrupt, but even then, the U.S. government guaranteed payment of all or a substantial portion of the pension (In 2009, up to $54,000 per year[29] is guaranteed by the Pension Benefit Guaranty Corporation of the federal government[30], and the limit is increased annually for inflation.)

In 2005, however, only 11% of private employers offer a defined-benefit pension[31]. The vast majority of Americans instead have 401(k)s – or nothing. While 401(k)s can allow you to save a large amount of money for retirement, they are riskier. And they require much more personal finance knowledge to manage well and to avoid making devastating mistakes. You have to know how to invest money in a well diversified mutual fund, because it is up to you to decide how your 401(k) money is invested.

Many people don't have the knowledge to do this, and end up unknowingly investing their retirement money in a very risky way. For example, it is all too common for people to be completely undiversified, having 100% of their retirement savings in just a single stock, the stock of the company they work for. Ask the former Enron employees who lost their life savings how that worked out. When Enron collapsed, the company stock became worthless, and people saw their retirement savings disappear.

With a traditional pension, if the company you work for goes bankrupt, the government will back you up, making the pension payments for you up to $54,000 per year (in 2009; the limit increases each year for inflation[32]), but if you have a 401(k), and the investments you put the money in go bankrupt, you get nothing. There's no government guarantee.

Again, there's a lot more risk today, and a lot less government guarantees, protections, and safety nets. So knowing personal finance is a lot more important than it was in your parents‘ or grandparents‘ time, and personal finance today is very different.

Another area which requires far more expertise today, and is far riskier, is borrowing. Let's start with mortgages. A generation ago, mortgages, and banking, were highly regulated[33]. As a result, it was impossible to charge more than a very moderate interest rate. Sub-prime mortgage interest rates like we see today of 10%, 15%, or more above the inflation rate, were unimaginable back then. And regulation also prevented the kind of enormous fees that we see today, in some cases over 20% of the amount borrowed.

Because banks were not able to charge high interest rates or fees like today, they were only willing to loan out money if they were very sure it would be paid back. Thus, a family typically could only purchase a home that was 2 to 3 times their annual income. As a result, mortgage payments were far lower: The home's price was much lower relative to the family's income, only about 2 to 3 times annual income, the interest rate relative to inflation was lower, or much lower, and, on top of that, families typically put down 20%[34], which lowered the amount borrowed and the mortgage payment even further. Moreover, there was no private mortgage insurance or any of the other new fees of today tacked on to the monthly payment. And almost all mortgages were at a fixed interest rate, so there was no risk from an increase in rates.

As Harvard Professor Elizabeth Warren put it in her book, “All Your Worth: The Ultimate Lifetime Money Plan” (which I think is by far the best personal finance book available today):

Remember how we told you on the very first page of this book that the rules have changed? This is one of those rules. Back when your parents were young, it was pretty reliable that if they held regular jobs and lived regular lives, their money was pretty much in balance. Why? Because your parents just couldn't spend all that much on their basic monthly bills. If they earned a middle class income, the odds were good they could afford a middle class home without much stretching – and they could buy that home on Dad's salary alone. Your folks didn't have to hire a whiz-bang accountant to figure out what they could afford. All they had to do was walk down to the local bank to apply for a mortgage. If your parents tried to buy a home that cost more than they could manage, the bank just wouldn't lend the money. Mom and Dad and their friends didn't have to worry too much about getting in trouble because it just wasn't possible to take on a mortgage that was more than they could afford.

The same held true in other areas. If your dad wanted to buy a car that was more than he could afford, he couldn't get the car loan...As a result, in those days it was really, really rare to spend too much on basic monthly bills. Why? It's not because your parents generation was smarter or thriftier or “more in touch with what matters”. No, things were different in your parents' day because the rules were different. Your parents lived in a time when the government strictly regulated the banking industry. The amount of interest a bank could charge was tightly limited, so banks had to be very careful to lend money only to people who could comfortably pay them back. As a result, in your parents' generation there were no “zero-down” mortgages. Almost no one was “house poor”, spending too much on a home or apartment. There were no offers on TV to “cash out” your home equity. No one had a car payment the size of Texas, and car leases hadn't even been invented.[35]

As Harvard Professor Warren noted, lending used to be highly regulated, and that included credit card lending. A generation ago most families didn't have even have a credit card[36], and the main reason for this is that credit card interest rates and fees were strictly limited, so a credit card issuer would only provide a card to the safest risks, and even then, with much lower balance limits than we see today.

Currently, there are, in fact, no legal limits on credit card interest rates. Although technically some states do have credit card interest rate limits, those limits are not binding on a credit card issuer whose headquarters is another state. Thus, credit card companies headquarter in states which have no limits, like South Dakota and Delaware. They are then able to issue credit cards in any state with no legal limit on the interest they can charge[37].

Moreover, the fine print in credit card contracts allows the provider to double or even triple your interest rate overnight, with no advanced warning. Please read more about this now in the New York Times article, “The Plastic Trap: Soaring Interest Compounds Credit Card Pain for Millions”[38], by clicking here. Then, please hit your Back button to return to this text and continue reading.

Welcome back. That was pretty shocking wasn't it? Unfortunately, lending gets even more extreme. While the highest credit card rates are currently in the 30s, the effective annual rates charged by payday lenders can exceed 1,000% per year. A $500 loan from a payday lender can end up costing over $5,000 in fees and interest if kept going for a year. This would have been unthinkable a generation ago, but today it's perfectly legal. Deregulation has allowed for whole new fringe economy of auto title loan, rent-to-own, check cashing, payday loan, and pawn shops that charge interest and fees ranging from the outrageous to the astronomical.

For the most part this fringe economy preys on those who are poorer and less educated, but more and more members of the middle class are becoming ensnared, partly due to increasing desperation with today's epidemic of financial distress, and partly because these operations more and more use deceptive advertising to pose as mainstream. They should be avoided at all costs. For those interested in learning more, I recommend University of Houston Professor Howard Karger's excellent book, “Shortchanged: Life and Debt in the Fringe Economy”.

Another form of lending, a very important one, that has become far more dangerous and expensive over the last generation is student loans. A generation ago most college students graduated with no student loans at all, and did not work during the school year either. As the Center for Economic and Policy Research report, “Student Debt: Bigger and Bigger”, notes, “...back in 1981, a student could work full-time all summer at a minimum wage job and earn about two-thirds of his annual college costs, leaving less than $2,000 (in inflation adjusted 2004 dollars) that he needed to pull together from grants, loans, working during the school year, or his parents.[39]

Yet by 2004, almost two-thirds (66.4%) of students at four-year colleges and universities had student loan debt[40], and the average amount owed by graduating seniors more than doubled just from 1993 to 2004, from $9,250 to $19,200 – a 108% increase (58% after accounting for inflation)[41]. Also in 2004, 5.4% of graduating seniors had more than $40,000 in student loan debt, an 18 fold increase from 1993, even adjusting for inflation[42]. Students attending graduate or professional school can accumulate over $100,000 in student loan debt today.

Even with all of this debt being taken on, college students are at the same time working unprecedented hours to be able to pay for their education. In 2002, 46% of all full-time students worked at least 25 hours per week, and 20% worked at least 40 hours per week[43]2½ times the percentage that did so in 1987[44].

Studies have shown working more than 15 hours per week lowers grades and decreases the probability of graduating. In part due to this, graduation rates have fallen. ACT's 2008 figures show only 40.3% of 4-year college students graduated after 5 years[45].

All of this, obviously, is very serious. A college degree on average means over $1.2 million in increased income over a lifetime[46], and a great increase in the odds of having medical and dental insurance. Obtaining a college degree, or vocational degree, or Microsoft certification, or any increase in skills is an important way to increase your income and benefits. There are affordable and smart ways to do this, even very part time, which we will discuss later, but for now let's continue with student loans.

Not only are students having to take out far more loan debt today, the loans have become much more complicated. There is much more that it's important to know, and not just for college students, but for anyone who in the future will have children or grandchildren reaching college age. The knowledge you learn about student loans in this course could really help your loved ones, as unfortunately, it's unlikely an 18 year old will know these things.

Now, what things am I referring to? We'll have a whole section on student loans later, but for now it's important to know that since 1998 it is impossible to discharge government student loans in bankruptcy (with extremely rare hardship exceptions), and since 2005 it is impossible even to discharge fully private student loans in bankruptcy (again with extremely rare hardship exceptions).

Government student loans are, however, very safe. They have many protections (if you know about them). The biggest is you can request an income based payment plan where your payments will never be more than 15% of your disposable income. Specifically, you only pay 15% of any income over 150% of the poverty level[47].

For a family of 4 with an income of $60,000 per year, that would mean a payment of just 7.1% of their income. With a $100,000 income, it would still be just 10.0% of income. And, any debt remaining after 25 years, the government forgives[48]. Moreover, interest rates on government student loans are capped at a very low level.

So these loans are very safe and certainly should be taken out if necessary to obtain an education, and in order to keep a student's work hours under 15 per week. Otherwise there is too much of a risk to grades and graduating from working too much and studying too little.

But Private student loans are a totally different story. They are the most dangerous type of debt and should never be taken out under any circumstance. They cannot be discharged in bankruptcy if they spiral out of control (except, as noted, with extremely rare hardship exceptions), and they certainly can spiral out of control, because they have none of the protections of government student loans: There are no income based payment plans, no deferments or forbearances, and no low caps on the interest rates, which can easily go into the double digits. Moreover these loans can contain very dangerous provisions buried in the fine print in legalize. There is no circumstance where they should be taken out (If you already have private student loans, I will give you advice for dealing with them, and paying them down to zero as fast as possible, in the student loans section).

Wrapping this section up, as I've made abundantly clear, the world is much riskier today (if you are interested in reading more on this, I recommend the book, “The Great Risk Shift”, by Yale Professor Jacob Hacker. Things are more likely to go wrong, and when they do, the average family is far less equipped to handle it. Fixed expenses that cannot be cut back in the short run, like the mortgage, car payments, insurance, etc. now comprise 75% of the typical family's earnings, up from just 54% a generation ago. So today's family only has 25% in discretionary spending that can be cut back to weather a crisis. In addition, with both spouses working, there is no reserve spouse to go into the workforce to bring in extra income during setbacks and crises. As well, there is no stay at home spouse to take care of a sick child, or parent, so an earner has to miss work, or hire expensive outside help. This is not to say both spouses shouldn't work, it is just to say that this is an important change over the last generation, and so modern personal finance must take it into account. And the most important way to do this is not to overcommit to fixed costs.

So, clearly things are very different today than they were in your parents and grandparents time. As a result their advice will not be good enough, and much of it won't even apply. So what should be done? What is good personal finance today? Well, let's start with the most fundamental and important thing.

« Introduction | Fixed Expenses Under 50% of After-Tax Pay »


[17] Warren, Elizabeth (2007) "The New Economics of the Middle Class: Why Making Ends Meet Has Gotten Harder" Testimony Before U.S. Senate Finance Committee; page 9

[18] OECD Unemployment insurance data

[19] Warren, Elizabeth (2007) "The New Economics of the Middle Class: Why Making Ends Meet Has Gotten Harder" Testimony Before U.S. Senate Finance Committee; page 3

[20] Warren, Elizabeth (2007) "The New Economics of the Middle Class: Why Making Ends Meet Has Gotten Harder" Testimony Before U.S. Senate Finance Committee; page , Figure 4

[21] Warren & Warren Tyagi (2003) The Two Income Trap; page 82

[22] Hacker, Jacob S. (2005) The Great Risk Shift; page 31, Figure 1.4

[23] Warren & Warren Tyagi (2003) The Two Income Trap; page 88

[24] "Facts About Health Care - Health Insurance Coverage" (National Coalition on Health Care n.d.)

[25] Abelson and Freudenheim (2008) "Even the Insured Feel the Strain of Health Costs". New York Times, May 4, 2008; http://www.nytimes.com/2008/05/04/business/04insure.html?_r=2

[26] Warren & Warren Tyagi (2003) The Two Income Trap; page 84, endnote 43

[27] Berenson, Alex (2007) "Boom Times for Dentists, but Not for Teeth" New York Times, October 11, 2007; http://www.nytimes.com/2007/10/11/business/11decay.html

[28] Seburn, Patrick W. (1991) "Evolution of Employer-Provided Defined Benefit Pensions" Monthly Labor Review, December 1991, pages 16-23; available online at http:/www.bls.gov/opub/mlr/1991/12/art3full.pdf

[29] See "Maximum Monthly Guarantee" tables at the Pension Benefit Guaranty Corporation's http://www.pbgc.gov/workers-retirees/benefits-information/content/page789.html#2008

[30] The Pension Benefit Guaranty Corporation is not funded by general taxes. It is funded through insurance premiums paid by employers that offer defined-benefit pensions, and are thus protected by, the PBGC.

[31] Wirtz, Ronald A. (2006) "Covet Thy Neighbor‘s Pension?" FedGazette; Federal Reserve Bank of Minneapolis, May, 2006. Available online at http://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=1353

[32] The Pension Benefit Guaranty Corporation is not funded by general taxes. It is funded through insurance premiums paid by employers that offer defined-benefit pensions, and are thus protected by, the PBGC.

[33] Warren & Warren Tyagi (2003) The Two Income Trap; page 128

[34] Warren & Warren Tyagi (2003) The Two Income Trap; page 127

[35] Warren & Warren Tyagi (2005) All Your Worth; pages 16-17

[36] Warren & Warren Tyagi (2003) The Two Income Trap; page 112

[37] Warren & Warren Tyagi (2003) The Two Income Trap; page 128

[38] McGeehan, Patrick (2004) "Soaring Interest Compounds Credit Card Pain for Millions" New York Times; http://www.nytimes.com/2004/11/21/business/21cards-web.html

[39] Boushey, Heather (2005) "Student Debt: Bigger and Bigger" Center for Economic and Policy Research Briefing Paper, September 2005, page 2

[40] Project On Student Debt: "Quick Facts about Student Debt" http://projectonstudentdebt.org/files/File/Debt_Facts_and_Sources.pdf

[41] Ibid

[42] Ibid

[43] King and Bannon (2002) "At What Cost? The Price That Working Students Pay For A College Education" The State PIRGs‘ Higher Education Project. http://www.pirg.org/highered/atwhatcost4_16_02.pdf

[44] Eight percent of full-time college students were employed full time in 1987: Lipke, David J. ( 2000) "Work Study" American Demographics, October 2000, page 9

[45] ACT 2008 "Retention / Completion Summary Tables", page 4 http://www.act.org/research/policymakers/pdf/retain_trends.pdf

[46] Kratowitz, Mark (2007) "The Financial Value of a Higher Education" NSFAA Journal of Student Financial Aid; page 20, Table 1 http://www.nasfaa.org/Annualpubs/Journal/Vol37N1/Kantrowitz.PDF

[47] You can find information about Income Based Repayment Plans at : http://www.ibrinfo.org/

[48] Table at: http://www.ibrinfo.org/what.vp.html

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