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Maybe those lousy 2% raises are better than I thought
Old 11-05-2014, 02:47 AM   #1
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Maybe those lousy 2% raises are better than I thought

Over the last several years, I always managed to beat my annual savings targets, despite slowly increasing cost of living (aka inflation) and mostly quite modest pay raises. I wondered why that was the case, so I modeled an example in MS Excel to study this.

All figures in this example are completely fictitious. Say, a household has
- an annual net income of 50,000$.
- They pay 15,000$ towards their mortgage.
- Other expenses total 20,000$,
- leaving 15,000$ for savings/investments.

Now let's assume an inflation rate of 2%, so next year, that household will spend 20,400$, while the mortgage payments remain at 15,000$. I will also assume a salary increase of 2% net, just enough to compensate inflation. My assumption was that this would basically not change our household's economic situation at all. Turns out that is wrong: With a new income of 51,000$ (50,000$ + 2%), expenses of 20,400$ (20,000$ + 2%) and the mortgage payments still at 15,000$, they now have 51,000-20,400-15,000=15,600$ to save/invest, or 4% more. Of course those 15,600$ now are worth only 15,600$/1.02=15,294$ in last year's dollars, but it's still a 1.96% real increase.

The reason for that effect is obviously that the mortgage rate does not increase with inflation. Now, this is probably all very obvious for everyone but me, but I must admit that I was quite surprised.

For my planning spreadsheet, this means that I can budget an increase in my saving rate even if my pay raises only keep up with inflation. Nice.
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Old 11-05-2014, 05:46 AM   #2
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Originally Posted by RISP View Post
Over the last several years, I always managed to beat my annual savings targets, despite slowly increasing cost of living (aka inflation) and mostly quite modest pay raises. I wondered why that was the case, so I modeled an example in MS Excel to study this.

All figures in this example are completely fictitious. Say, a household has
- an annual net income of 50,000$.
- They pay 15,000$ towards their mortgage.
- Other expenses total 20,000$,
- leaving 15,000$ for savings/investments.

Now let's assume an inflation rate of 2%, so next year, that household will spend 20,400$, while the mortgage payments remain at 15,000$. I will also assume a salary increase of 2% net, just enough to compensate inflation. My assumption was that this would basically not change our household's economic situation at all. Turns out that is wrong: With a new income of 51,000$ (50,000$ + 2%), expenses of 20,400$ (20,000$ + 2%) and the mortgage payments still at 15,000$, they now have 51,000-20,400-15,000=15,600$ to save/invest, or 4% more. Of course those 15,600$ now are worth only 15,600$/1.02=15,294$ in last year's dollars, but it's still a 1.96% real increase.

The reason for that effect is obviously that the mortgage rate does not increase with inflation. Now, this is probably all very obvious for everyone but me, but I must admit that I was quite surprised.

For my planning spreadsheet, this means that I can budget an increase in my saving rate even if my pay raises only keep up with inflation. Nice.
So, the lesson is to lock in non-inflating costs wherever possible. Although, as your math shows, this is working around the edges. The real savings comes from other LBYM actions.

BTW, I want to live where this couple lives, in "tax free" land.
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Old 11-05-2014, 06:34 AM   #3
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Yes, the mortgage principal and interest does not change during the duration of the loan. You may be able to drop PMI somewhere along the line, too.

A complete look at personal finance would have to include R.E. taxes if you have any. I know where I live the R.E. taxes are now $1K+ per month. Twenty years ago they were half that amount. So the taxes have come to eclipse the entire total payment from the past. That is not an issue for some, but you do need to look at other costs which do rise at the rate of inflation and then some.

How about home insurance? It's not a major item, but combined with the utilities it adds up to real money each month.

Coincidentally, I had 2% raises each year for 8 years. I never pulled a check with the last raise. I'm glad I max'd the 401 and catchup each month for 7 years. I have another pillar for retirement.
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Old 11-05-2014, 08:53 AM   #4
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This is how I really was able to get myself in the position that I am in (retiring in mere days!)

Around 10 years ago, I figured out that I was living pretty good on my wages and decided that any COLA/promotion $$$ would immediately go to work for me instead of consuming more crap. Of course, when my DW came along and became quite successful in her RE business, I was able to stash even MORE $$$ and it became quite addictive. And today, I am still living on (actually a little less) the amount that I was making over 10 years ago. The only *real* regret with leaving is that I have an effective savings rate of almost 70%...and watching my nest egg grow as fast as it has..well...but that's OK. As long as I continue to live as I do now, I will only spend my pension income (and save some of that too!!!) and my nest egg will continue to grow.

On another...sorta same...note, I came across a calculator that can be used to compare COLA without COLA. I am sure this can be done with Excel, but well..I'm not a fan of Excel. This calculator is pretty basic and simple, it will show how much a monthly income increases over time with and without COLA.

COLA versus Fixed Pension Calculator
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Old 11-05-2014, 09:11 AM   #5
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Unfortunately for us, food inflation and kids activities inflation easily trumps savings provided by fixed rate on my mortgage.
But if your expenses only grew with inflation your calculations seem right on the mark.
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Old 11-05-2014, 09:31 AM   #6
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Said another way, mortgages are repaid with inflated money. Over the long term the US inflation rate has averaged 3.something%. That means a mortgage at a 3.something% rate has about $0 cost, and that's without taking into account tax and other benefits.
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Old 11-05-2014, 10:47 AM   #7
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Economists would point out that inflation is artificially high, at lrast in the short term, because as the price of one good rises, you will substitute away from it in order to maximize value. Your expenses wont increase at the rate of inflation as a result. This is the argument for remodeling SS. I haven't heard a economist argue against it yet.


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Old 11-05-2014, 12:26 PM   #8
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Economists would point out that inflation is artificially high, at lrast in the short term, because as the price of one good rises, you will substitute away from it in order to maximize value. Your expenses wont increase at the rate of inflation as a result. This is the argument for remodeling SS. I haven't heard a economist argue against it yet.
Beef, chicken are pork are all $1 per unit. Beef goes up to $1.50 per unit, so you switch to chicken, your second favorite. Meanwhile, pork goes up to $1.25, but you don't notice. Then chicken goes up to $1.50 and you switch to pork, which is 25% more than it was before.

I'd say the "substitute away from it in order to maximize value" thing only sort of works sometimes.
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Old 11-05-2014, 12:40 PM   #9
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Beef, chicken are pork are all $1 per unit. Beef goes up to $1.50 per unit, so you switch to chicken, your second favorite. Meanwhile, pork goes up to $1.25, but you don't notice. Then chicken goes up to $1.50 and you switch to pork, which is 25% more than it was before.

I'd say the "substitute away from it in order to maximize value" thing only sort of works sometimes.
Or you become a vegetarian. But then the price of vegetables goes up....Meanwhile, back at the ranch, if enough people stop buying expensive beef, the price may fall. Supply and demand.
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Old 11-05-2014, 12:49 PM   #10
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We rent, so all of our expenses are inflation-sensitive. But our living expenses represent only about 20% of gross income. So even though we live in an area where rent inflation is usually steep, a modest increase in income allows us to easily absorb such inflation and keep our savings rate up. LBYM is the key.
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Old 11-05-2014, 01:52 PM   #11
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The reason for that effect is obviously that the mortgage rate does not increase with inflation. Now, this is probably all very obvious for everyone but me, but I must admit that I was quite surprised.
This is one of the principal reasons why a home mortgage may be a good long term investment. Effectively, you freeze the cost of the home for the term of the mortgage. If that term is 25-30 years, even if the housing market crashes a couple of times, the underlying secular trend will lead to a rise in the numerical value of your home. If interest rates are low when you buy the home and you can lock them in for the entire amortization period*, the interest you pay on the purchase price will be more than compensated for by inflation. Of course, locking in high interest rates is not such a good idea. If interest rates are high when you purchase, it pays to refinance as they fall, and to put spare cash towards the principal.

As an example, a cousin purchased a home in 1969 for the equivalent of $10,000, with a 25 year mortgage term. By the time the mortgage was paid off in 1994, the monthly payments were small change compared to earnings, and the house was worth more than $200K. It's now worth about $600K.

* in the US, the term of the mortgage is the same as the amortization period. In Canada, the term is usually five years or less and nowadays the maximum amortization period is 25 years. At the end of the term the remaining principal is remortgaged at then current rates (unless you pay it off).

This reminds me of a cautionary tale I recently heard about a Canadian couple who purchased a new home with a mortgage of 80% of the purchase price, a 25 year amortization period and a 5 year term. During the 5 year term they retired. They also ran into major health problems with significant ancillary expenses. They missed two mortgage payments. When the term expired, the financial institution refused to renew their mortgage, on the grounds that (a) they had defaulted on payments; (b) they could not show employment income. The financial institution demanded repayment of the remaining principal. Property values in their area had gone down, and the couple was now underwater. Facing foreclosure, they walked away from the property. Moral of the story: don't take on a large mortgage heading into retirement.
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Old 11-06-2014, 01:57 AM   #12
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BTW, I want to live where this couple lives, in "tax free" land.
I did write "annual net income" and "salary increase of 2% net", didn't I?
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Old 11-06-2014, 06:09 AM   #13
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I did write "annual net income" and "salary increase of 2% net", didn't I?
Yep, you did; missed that.

Well crap! I was ready to move in next door to them to eliminate my tax bill.
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