Debt – Instant Gratification vs Long Term Wealth Creation

The Free Dictionary defines debt as an “obligation or liability to pay or render something to someone else”.  In the context of Personal Finance I have a different definition of debt which is that it is a “decision to consume now without the necessary wealth to pay for that consumption.  Should interest be charged on that consumption and opportunity cost considered then the consumption now will likely be smaller than would have been possible should the wealth have first been created.”

If this was the official definition of debt it would then be obvious to people that by using debt you are likely getting less now than you could have had later in exchange for taking instant gratification today.  This therefore affects your opportunity to create wealth.  I do not believe that the majority of people appreciate this when they go into debt to buy something.  My definition also tells you this is for 2 reasons:

1.    Interest charges.  Buy it now without the means to pay for it up front and the end result is that each loan repayment being made to repay the debt is going to include a principle portion, which will eventually cover the original purchase price, plus an interest charge.  If you instead chose to save what would have been the regular repayment amount until you have saved up enough to pay cash then two phenomenon occur:

• You will save the amount needed for the purchase faster than the equivalent loan will be repaid because what would have been the interest portion is adding to your savings. 
• If you saved until what would have been the last loan repayment day then you will end up with more cash than the original purchase price, again because of the interest portion.

2.    Opportunity Cost.  This is rarely if ever discussed when people discuss debt but it should be considered as its effect can be considerable.  If you don’t make the purchase or defer the purchase then the money you would have used to fund the debt repayment can be invested to generate a return for you elsewhere.

It’s important to note that these statements are based on the assumption that the purchase does not rise in price at a rate higher than the interest charge.  If this was the case then you would also have to include the opportunity cost (including considering the risk of that other opportunity) of deploying the debt repayment s elsewhere.  If after this calculation the price was still rising at a faster rate then the debt may actually help with wealth creation while also giving instant gratification.

Has the UK Already Had Its House Price Crash?

Every month I run an analysis which looks at the Affordability and Value of UK Property.  This analysis uses the Nationwide House Price Index which measures the price of a standard house priced in Pound Sterling (£’s). 

In the current world we live there is one big problem with this Index and in fact all the other UK House Price Indices.  All of them are priced in Pound Sterling which is not a fixed peg in the ground for many reasons some of which include:

• We live in a globalised world however only 0.9% of the World’s population use the £ as their currency;
• The UK Government, Bank of England, Banks and many other vested interests have done everything in their power to keep asset prices in the UK high at the expense of just about everything else.  They’ve been relatively successful so far using methods such £375 billion of Quantitative Easing, 0.5% Official Bank Rates and the Funding for Lending Scheme.  This has allowed inflation to run a little at the expense of an official remit and led to negative real interest rates which among other things has resulted in Sterling falling in value against the currencies that 99.1% of the world use; and
• The UK for all its problems is compared to the rest of the World a very attractive place to live and unlike a lot of countries actually has a Rule of Law.  It’s not perfect but as a person who has travelled the world for my work I ask where is.  This means a lot of people want to migrate and live here.

My first chart reminds us of the price of housing priced in Sterling.  If you’re a UK resident earning in Sterling, saving in Sterling and investing in Sterling this is what you’ll see.  Since the peak prices in nominal terms have fallen 12.8%.  Hardly a House Price Crash, more a small adjustment.

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What about Prices measured in the most widely held Reserve Currency, the US Dollar?  Measured in this currency we see UK house prices down 33.7%.

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UK Average Weekly Earnings – February 2013 Update

Over the past couple of weeks the mainstream media seem to finally have discovered that in real inflation adjusted terms average earnings are falling and that this is putting a squeeze on household finances.  They’re a little behind the curve given we’ve been talking about it here since April 2010 with the last regular update here.  This doesn’t really surprise me given that the Press today rarely published any investigative journalism instead choosing to publish whatever press release a political party or corporation is trying to push that day.  I guess it keeps running costs down but I digress...  Let’s not follow the same path and instead run some analysis to understand what is really going on.

Let’s firstly look at the nominal data. The Office for National Statistics reports that the Average Weekly Earnings for:

• The Whole Economy including bonuses and allowing for seasonal adjustment is £472.  This is stagnant against last month and up £6 (1.3%) year on year.
• The Private Sector earns less than the average Whole Economy at £468 per week.  Private Sector Earnings have also gone nowhere since last month and are also up £6 (1.3%) year on year.
• The Public Sector earns more than the Private Sector at £489 per week and is also doing better when it comes to securing pay rises.  Month on month we see an increase of £1 (0.2%) and year on year an increase of £10 (2.1%).  Given that we are supposedly living in times of austerity, albeit a version where the government spends more than they did in the prior year, I’m amazed that the Public Sector is seeing year on year increases that are more than 50% higher than that of the Private Sector.

Unfortunately, while we were seeing those nominal annual increases of 1.3%, 1.3% and 2.1% respectively inflation according to the Retail Prices Index (RPI) was 3.1% during the same period.  This means that whether you are working in the Private or Public Sector it is likely you are taking a real terms pay cut. I know I am.  At my company’s last pay review I received a grand total increase of £0.  Meanwhile I know that essential items that I buy are increasing in price.  I’m continuing to learn frugal habits but I’m also sure that prices rising combined with stagnant earnings is putting pressure on my savings rate which at last check was only 55% of gross earnings against a target of 60%.  I’m working hard to find spending savings to get that back on track but given I’ve been at it since 2007 there is not a lot more to find. 

The long term erosion of spending power can be best seen with a couple of charts.  The first chart takes the RPI and Average Weekly Earnings and then converts them into an Index that starts in 2000 with a value of 100.  Whenever the gap between Earnings and the RPI is increasing earnings power is increasing.  The chart shows this stopped happening around 2008 meaning we have been seeing spending power erosion since then.  Today the spending power of the whole economy is back to levels last seen in May 2001.

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Blogging for Money

Retirement Investing Today had humble 2009 beginnings when I began writing with a free .blogspot.com domain.  Since then I believe the site has grown into a unique fact based data source covering both the general economy and personal finance ultimately aimed at helping you maximise your wealth creation and for those that choose the path early retirement.  I don’t say that because I’m arrogant but because the non-emotional fact based data tells me this is so.  This includes the site now having a Google PageRank of 3, a mozRank of 4.46, an Alexa ranking which puts the site in the top 12,500 sites read by people located in Great Britain according to Alexa and finally because readership continues to rise rapidly with visits up 32% in the last month alone.

Retirement Investing Today is also meeting the Objectives personally set which includes:

1. Holding myself accountable.  By publishing my philosophy, strategy and progress measured against these I have to stay the course and can’t stray from the path.  This reduces the risk of my failing to achieve early retirement.
2. Continuous learning about economics and personal finance.  To be able to publish unique up to date content regularly I am “forced” to continually data mine and expand my knowledge base.
3. Share what I have learnt over the years, including my mistakes, so that you can conduct your own research and learn about unfamiliar topics which might affect your wealth creation.  The emails and comments I receive tell me this is occurring.
4. The reciprocal of point 3 which is to gain information from you that force me to go off and do more research about a topic I clearly don’t know enough about.  I can definitely confirm that this is occurring.

To achieve the site you see and meet my objectives I typically invest 12 to 15 hours per week.  This covers data analysis, writing the posts, publishing the posts and keeping the site free from the continual spam attacks which you hopefully don’t see.  My daily commute plus day job currently then fills around 60 hours per week.  The two combined leave me with little time for further published content if I am to keep my current day job pace (which is necessary as it forms part of the Save Hard portion of my philosophy) and also allow some time to spend with my family.

Which brings me to the point of this post – Blogging for Money.  I already earn a very small amount of revenue which covers the costs of running the site but it’s not enough to give me a “salary” of any description.  It doesn’t cost you the reader anything but is achieved via:

• Adsense.  If you click on any of the AdChoices in the right hand side bar I receive a small amount of revenue.
• Amazon.  If you click on any of the links within The Books That Helped Me tab below the main site banner and then go on to buy something with Amazon I receive a small amount of revenue.
• Sponsored Posts.  I post a very occasional Sponsored Post which has been written by a Freelance Writer working with an Agency.  Unlike most sites I clearly label these as a Sponsored Post so that you the reader know what you are looking at.

Why Using Your ISA Allowance Every Year Is So Important

We are now less than 2 months away from a new tax year in the UK.  With that new tax year comes a new ISA (Individual Savings Account) allowance.  The Investing Wisely portion of my Low Charge Strategy requires me to continually work at minimising the tax paid to HM Revenue & Customs  which is partly achieved by maximising my ISA contributions and coming as close to the full ISA allowance every year as possible. 

Before we review why maximising contributions and preferably using the full ISA allowance is so important let’s first review the basics of ISA’s:

• An ISA is nothing more than a wrapper that surrounds purchased assets such as cash and shares.  Its primary purchase is to shield you from taxation.
• There are two types of ISA.  The first is a Cash ISA where you can contribute up to £5,640 in the current 2012/13 financial year.  In the 2013/14 financial year the allowance will rise to £5,760.  The second is a Stocks and Shares (S&S) ISA into which you can contribute £11,280 less any contribution made into a Cash ISA this financial year.  In 2013/14 the S&S ISA allowance will rise to £11,520.
• Contribute refers to the total amount of money you can pay into the accounts each year.  For example it is allowable to contribute £11,280 into a S&S ISA and then withdraw £3,000.  What isn’t allowed is to then add that £3,000 back into the ISA within the same tax year.
• Current government policy is that the annual ISA subscription limit will be increased annually by the Consumer Prices Index (CPI). The increased limit will then be rounded to enable punters to make regular monthly payments in round terms. If the CPI is negative then limit will not be reduced but will be left unchanged.
• Any savings in a Cash ISA can be converted to a S&S ISA but you can’t convert a S&S ISA into a Cash ISA.
• You don’t pay any tax on interest received with a Cash ISA.
• You don’t pay any tax on dividends received within a S&S ISA.  If you’re a 20% (basic rate) tax payer then in theory the ISA offers no advantage because 20% tax payers don’t pay tax on dividends.  If you’re a 40% (higher rate) or 45% (additional rate) tax payer then you get a big advantage because if you’re saving outside of an ISA your effective tax rate on dividends are 25% and 30.55% respectively after allowing for the dividend tax credit.  ISA’s therefore offer higher and additional rate tax payers a significant advantage however I also believe that basic rate taxpayers should also take advantage.  The reason is because you never know when you will be a higher rate taxpayer plus you also never know when government will start to apply tax to dividends received by basic rate taxpayers. 
• You don’t pay Capital Gains Tax within a S&S ISA.  If you’re outside of the ISA wrapper then UK taxpayers receive an Annual Exempt Amount (£10,600 in 2012/13) however after this then you’re up for tax at 18% or 28% depending on your taxable income.  So ISA’s save basic rate, higher rate and additional rate taxpayer’s tax.  You may think that you can invest outside of an ISA and keep capital gains tax within your annual exempt amount by controlling when you sell but remember corporate events outside of your control like takeovers and share swaps can trigger capital gains tax events.  Within the ISA you have nothing to worry about.
• A time advantage is that you don’t need to keep records for tax reasons and because you can ignore anything within an ISA for tax reasons then filling in your annual tax return is greatly simplified. 
• It is a use it or lose it allowance.  So if you only contribute £10,000 to a S&S ISA this year then that’s it. You never get another chance to contribute that £1,280 of unused allowance.  It is lost forever. 

The last point is critical and shouldn’t be underestimated.  It is a mistake I have made and which is now impossible to rectify.  I was naive and for a number of years never even considered ISA’s.  Then when I did eventually understand a little about them I thought I’m just a basic rate taxpayer so they won’t help me.  Roll on a few years and hard work resulting in a few promotions plus bracket creep (inflation pushing income into higher tax brackets) has resulted in me becoming a higher rate taxpayer.  It’s a mistake that is now impossible to rectify because I can’t roll back the clock.  The vast majority of my savings will be used for my Early Retirement (some will be used to buy a home when value returns) meaning that I will possibly be paying for that mistake for the rest of my life.