The other day I talked about how a modest lifestyle eases the road to financial independence, and how I was reluctant to spending a lot of money on a new car. That’s because of my nemesis, Fixed Monthly Expenses.

All of us have this monkey…or gorilla…or King Kong…on our backs. Your fixed monthly expenses define how much money you have to make each month to avoid going into debt. (Or taking money out of savings, which is the same thing.) The lower that bar, the easier it is to support yourself, and put money back for retirement, your kids’ college, and luxuries. Fixed Monthly Expenses, and their evil cousin Debt, are two of the biggest things that keep us chained to that paycheck.

To a certain extent, there’s no getting around fixed expenses. Most of us have to pay for housing (at least property taxes, even if you own your house free and clear), utilities, phone (landline or cell, or both), food, and various car-related expenses (gas, maintenance, and insurance at a minimum). You may also have bills for TV, Internet, medication, etc. There is a wide variation in most of those categories, though. Housing could be a few hundred dollars a month for a tiny apartment in a humble neighborhood or several thousand a month for something more impressive in size, location, or both. Likewise, food could account for a few dollars a week for rice, beans, and potatoes, or a few hundred for dining out every night. One person’s car payment might easily be higher than another person’s house payment.

Enjoyable as these material possessions are, the things you own weigh you down. The things you’re still paying for in particular, but all of them add their fractional burden. Your furniture may be payed for, but you still need a place to put it and if you move, it has to be moved with you or disposed of.

The real killers, though, are the toys that bring monthly payments with them. Your house and car. You need them, and they bring you pleasure, but they’re also your boss. You’re working for them.

I mean that literally. Let’s say you have a car payment of $500 a month, and you make $25 an hour. You probably only take home about $20 of that $25 so you have to work 25 hours a month just to pay for that car. Add another $150 for insurance and $100 for gas (I’m not even going to get into maintenance costs) and you’re up to 37.5 hours that you’re working for that car. Nearly a full work week. Every month.

Try running those numbers on your mortgage for an even grimmer picture.

There is something you can do to ease the pain, though.

With nearly any product you can plot cost and functionality on a graph, if you’re the sort of person who likes to graph things. If you do, you will often notice that at a certain point you start paying a lot more for very small improvements in functionality. A computer, for example, might give you a 5% boost in performance, but at a 30% price premium over the next cheapest model. It’s the same with cars, houses, etc. At the cheap end of the scale relatively small amounts of money will buy you a lot more function. At the expensive end of the scale, the opposite is typically true.

The key to managing these expenses without your quality of life suffering, is to find the sweet spot where you are getting the most of what matters to you for the least amount of money.

To illustrate, I’ll go back to my looming new car purchase. My requirements are a reliable vehicle with a back seat, fuel efficient, and reasonably fun to drive. It would be nice if it were not horribly ugly. A compact four-door sedan from a quality maker is the target I have selected to meet these criteria.

The most economical (on the surface, at least) way of obtaining this vehicle would be to trade the old Miata straight across for a sedan of similar vintage. That would get me into the right type of vehicle with no significant outlay of cash. It would also, most likely, set me up for a lot of downtime and maintenance expenses. My car is my livelihood; if I can’t go out on service calls, I don’t make money and my kid doesn’t eat. My car has to run.

By sliding the scale up to later model used cars you increase the reliability, but also the price. Many people advocate buying a very recent model used car as a way to get a reliable vehicle without eating the depreciation of buying new. I am unconvinced by these arguments. A solid late-model used car is going to cost nearly as much as a new one. If you are financing (and most of us are) remember that you will be paying a higher interest rate on a used car, which reduces the difference even more. Add in the two or three years of probably hard use and unknown maintenance the used car has had and buying new looks even better.

(My personal take on it is that you’ll do pretty well either buying a late-model used car, or buying new, if you keep the car a long time. It’s the people who are constantly buying, and never getting out from under that car payment, who are taking it up the ass.)

So, barring finding an exceptional deal on a suitable used car, I’m looking at something new. Pure financial sense would have me looking at the low end of the market; sedans in the $10,000 range. The problem with this is that, in my entirely biased opinion, they all suck. Oh, some of them are serviceable enough vehicles and even the more dubious ones will probably give at least a few years of good service. But I like to keep my cars a long time. The Miata is nearly 10 years old and I’d probably keep it at least a couple more if it weren’t for this whole ‘backseat/baby carseat’ thing. Cars in that market segment are built and marketed as ‘entry level’ cars. The manufacturers expect that whoever buys them will fairly quickly trade up to something nicer. They aren’t designed for anyone to live with them for a long time. So, upmarket I go.

Looking over what’s out on the market, I decided that $25,000 is the upper limit of what I’m willing to spend on a new car. You can buy a helluva good car for that much money, and for me, at this time, anything more would be wretched excess.

Now, here’s the tricky part. Having settled on my upper limit, I didn’t start looking at $25k cars. That’s the most I can stand to spend. $15k would be better, so that’s where I started looking, trying to find the cheapest car that I thought I could live with for eight or ten years. What I found is that there’s a pretty good selection of reliable, fun to drive, and fairly well equipped cars right around $18,000. Okay, they’re not as nice as a 3-Series BMW, but the Bummer isn’t twice as good. Mostly what the BMW gives you for your thirty four thousand George Washingtons is the right to say you don’t drive a Civic. There are real advantages in performance, of course (though not in reliability) but mostly what a car over $25,000 is buying these days is bragging rights.

I’ve got a wife and kid to support; bragging rights are an expensive option that I can’t afford. Not that I really give a damn about impressing the neighbors anyway.

Not everyone can afford a new car, of course–there was certainly a time in my life when the best I could do was scrape together some cash and see what I could get–but if that’s the case then how you spend your money is even more important. The same process works for houses, computers, TVs; pretty much any significant purchase. You’re probably not going to be happy with the low end for very long, and the high end is probably overkill. Set your budget before you start looking, and look from the bottom up. Don’t go looking at the most expensive TVs on the shelf first; they’re going to look great and you’ll want one. Start with the cheapest ones and work your way up till you find something you can live with. If the cheapest item you can live with is still over your budget, well, learn to live without for a while.

I’ve spent a lot of time on this decision making process because it is an important part of living within your means, and if you don’t live within your means you’re never going to save any money, and if you don’t save you’re never going to be financially independent (and you’re going to have various other problems as well, but that’s another subject). One of the most common ways people get into financial trouble is by buying too much. Too much house, too much car, too much stuff and then their income takes a hit and all of a sudden they can’t pay for it anymore.

Buy to fit your budget, and your happiness, not to fit what other people are going to say about it. If you’re happy driving a Civic, why should you care if your BMW-driving friend isn’t impressed? Your car hauls you around just as well, and you’ve now got $20,000 that he doesn’t. And let me tell you, a pile of cash is very soothing.

Keep those monthly payments down, keep your debt down, and you may be amazed at how much money you can put in the bank. Soon we will talk about what to do with that money.

Fixed expenses are only one of the things crushing your financial independence. The other big weight is, as you might guess, variable monthly expenses.

Some of what I call fixed expenses can actually vary quite a bit from month to month (mainly utility bills), but you know that bill is going to be there every month, and you probably have a pretty good idea what it’s going to be. Variable expenses aren’t necessarily there every month. You’re always going to have an electric bill, but you aren’t going to buy a big screen TV every month (at least I hope not).

Some variable expenses are unavoidable, like home or car repairs, or medical bills. They certainly need to be taken care of when they come up, but you can’t really budget for them. The other variable expenses are entirely under your control. These are the things you buy every month, because you want, or need, or ‘need’ them. Video games, DVDs, books, electronic gadgets (guys), that cool looking pair of shoes (ladies), a spontaneous weekend out of town, and so on and so forth. These things won’t usually break your finances as badly as a poorly chosen mortgage or car payment, but they add up, and they add up in a particularly nasty way.

Most of these random expenses end up on your credit card, which is a very, very bad place for them to be. There are two problems with credit cards. First, when you use a credit card you tend to spend more. It hurts more if you have to pull cash out of your pocket to buy something, and once you run out of cash you can’t buy anymore. Credit card purchases are harder to keep track of while you’re making them (Quick, how much have you charged on your card in the last four weeks?) and you can easily charge beyond your ability to pay.

Second, credit cards are designed to keep on paying. The interest rates are brutal and the minimum payment is negligible. If you only pay the minimum it will take you a long time, and a lot of interest payments, before you get that card payed off…if you’re not charging anything on it anymore. If you’re only making the minimum payments and still charging on the card, may God have mercy on your soul, because the credit card company will have none.

I’ll use one of my own bills as an example. A couple months ago my statement showed a $1696.11 balance. That was a bit more than usual because of some Christmas purchases, but not excessively so. That card has an 18.24% interest rate and the minimum payment was $25.

If I only made the minimum payment, I would be charged about $25.40 interest. You can see that it would take a very long time to pay off this balance by making only the minimum payments.

In this case, I paid off the balance immediately, as I nearly always do, and instead of being perpetually in debt, losing another twenty five bucks a month in interest payments, the bank sent me $32.49 for that month.

There is a subtle poison at work with credit cards too. People sometimes begin to think of their available credit as an asset, like a savings account. “I’ve got $2000 left on my card!” It’s not; it’s a measure of how deeply you can get yourself into debt. If the credit card were a lake, think of the credit limit as the depth. How far do you want to sink?

Credit cards can be useful. The ability to spend over what you can actually pay can be useful sometimes in an emergency. You can consolidate many small bills into one big one (rather than writing five checks for groceries, put the groceries on the credit card and write one check). A record of your purchases can be handy. But it is a very dangerous tool that ends up hurting most people. The average American family carries something like $9000 in credit card debt. That works out to about $135 a month just in interest. Over $32,000 in twenty years, assuming the balance stays steady. That’s a very significant drain on anyone’s finances.

There is a very simple way to keep all these expenses under control, though. There’s no need to live like a monk, never spending your money, pinching every penny. Buy the things you want; enjoy yourself. That’s what life is all about. Just do one thing.

Pay off your credit card every month. Never carry a balance into a new billing cycle. If you can do that, you might end up spending more than you should on comic books and porn every month, but the expenses won’t turn into debt that becomes a major burden on your finances.

If you’re clever you will also get a rebate card, which gives you a trickle of cash back to help offset some of your spending. You might also, after having to grit your teeth and write a smacking great check to the bank, decide to rein in your spending a little.

Your credit cards are an enemy that must be slain every month. But if you don’t slay them, they will grow stronger each month and eventually strangle you. Kill them early and often.

Are you doing well right now? Making money hand-over-fist? Living large? Think the good times are going to last forever?

Maybe they will. But then, maybe not. The foreclosure lists are full of people who thought the money would never stop coming.

The most important thing you can do to get through financial hard times is to save up a reserve of cash when times are good. It might mean missing a vacation or waiting to buy that new home theater system, but when you’re laid off and wondering how you’re going to make the next mortgage payment, you’ll be damn glad to have a few thousand in the bank. That reserve buys you time to get your income flowing again, without losing your house or credit rating, or accumulating debt that will drag on you for months or years to come.

The experts say that you should have enough cash on hand to cover six month’s worth of expenses. That’s a lot of money; $30-40,000 for many middle class families. I think that may be excessive (though if you have the resources, and you want to do that, by all means, go ahead) but some sort of reserve is invaluable. I cannot emphasize that strongly enough: It is absolutely imperative for your financial health and freedom that you maintain a cash reserve.

If you’re making money now and don’t have any ready savings (I’m assuming that you have some retirement savings, something in your company’s 401k at a minimum, but that’s not something you can access in an emergency and you don’t want to anyway.) start accumulating some, before your luck runs out. Don’t aim at tens of thousands of dollars right away. That goal will seem unattainable and you’ll be going cold turkey on some other spending you’re used to. Start small. Figure up how much you spend on groceries in a month and make that number your savings goal. (Use a savings account; you want to mentally separate this money from the contents of your checking account.) If your finances are currently in good shape you should be able to do that in a month or two. Now aim for having one mortgage payment in the bank. And so on.

Depending on how much disposable income you have (income after basic expenses), it may take anywhere from a few months to a year or two, but eventually you’ll have enough cash in the bank to live on for a month without bringing in a dime of outside income. Congratulations. You’ve bought yourself a huge chunk of financial freedom and peace of mind. That reserve won’t just save your butt if you’re axed from work. That’s what will pay off your credit card after you had to charge those home repairs. Or car repairs. Or that trip to the emergency room. What it is, in other words, is a buffer between you and debt. It’s a cash airbag that will hopefully keep you from being hurt by a shock to your finances. It is one of your most precious assets and should be guarded accordingly.

One thing that you will quickly notice about your growing savings account is that your bank doesn’t think much of it. The first time you look at your statement and realize that the $5,000 you have in your money market account has netted you 83 CENTS in interest, you will be quite justified in saying, “What the fuck is up with that?”

Now that you’ve got a satisfying reserve saved up, it’s time to vary the theme a little. The interest paid by most banks on savings accounts right now is negligible. You might be tempted to just keep the money in your checking account, for simplicity, but don’t do it. The separation you get by keeping your reserve in its own account is worth much more than the minor hassle of tracking two accounts. If you just keep it in checking what you’re going to do is spend it and that is what, in technical terms, we call bad.

So what you want to do is keep the savings/money market account, but only keep a portion of your cash reserve there. A thousand or two, maybe; just enough to smooth out the bumps in cash flow and deal with any minor emergencies. The rest should be placed in a higher-yield, but still readily accessible account. A CD won’t do; you don’t want your reserve locked up for that long. Any other sort of investment is even worse. What’s left?

Fortunately, the Internet has brought us the online high yield savings account. Head over to Bankrate.com and check out the various offerings from ING Direct, HSBC, and others. Pick one that you like and move most of your cash reserve there. Now, instead of 83 cents your five grand will bring you in twenty bucks or more each month. The only drawback is that to get at that money you have to have it transfered to your local account, which can take a few days. That’s why you still want to keep a grand or two in what I call the ready reserve.

What you are developing here is financial defense in depth. You have a ready reserve of modest size, with just enough cash to meet immediate and minor emergencies. That buys you time to tap into the larger reserve, which in the meantime is generating noticeable amounts of money for you. Together, they buy you time to get back on your feet in the event of a financial hardship, without going into debt or ruining your credit (or worse, going hungry).

There are some further variations we can add to this basic theme, but that’s enough to get you started. If you don’t have a reserve now, get saving. Even a little money in the bank can be very soothing, and a healthy savings account will help you sleep at night when the chill wind finally blows and you find yourself facing a pile of bills and no other way to pay them.

I see that the mortgagepocalypse continues apace. Perhaps it’s easy for me to point fingers, burdened with only a sensible mortgage and in a housing market that isn’t in free fall, but I feel little sympathy for either the home owners who are losing their houses or the bankers who are losing their jobs. (Though I admit I do feel more sympathy for the former than the latter.) They have combined to create a fairly major economic disaster that is going to put a drag on the whole US economy and which will probably take five years to recover from.

The whole mess was easily preventable; people just had to not act like dumbasses. But history tells us that that is too much to expect. For anyone not familiar with how we got into this mess, it breaks down like this.

The mortgage companies figured out a way to make a pile of money selling loans to people who couldn’t actually afford to buy a house. They pushed these interest-only adjustable-rate mortgages to overly optimistic people who wanted a house but who didn’t have any, you know, money. Then, and this is key, the lender sold most of those loans to other financial institutions. The people making the loan, in other words, were not the people trying to collect on it. They had no incentive to make sure that the borrower would actually be able to make the payments. They just took their cut and dumped it on someone else. Like most businessmen, they were short-sighted, focusing only on the quarterly bottom line.

The home buyers thought they finally had a chance to buy their own house. With home values rising, they could make relatively small interest-only payments on their mortgage–never reducing the amount they owed–and still build equity. If they wanted, they could sell the house at a profit.

Here’s an example. A few years ago we sold our old house. Nearly all of the offers we got for it were identical. The prospective buyer wanted to pay about $5000 over our asking prices, but wanted us to pay the closing costs. This was just a way of rolling the closing costs into the loan (further increasing their payments). They were trying to buy a house without money. That was when I realized just how badly the mortgage industry had stepped in it.

These are people who were not able to save up enough money to buy a house through more traditional loan programs. Either their income was too small, or their financial management too poor. Neither of those things changed for the better after they became home owners. Now an unfortunate number of them realized too late just how expensive it can be to own a house, and that they couldn’t make their payments (particularly as property taxes and interest rates climbed and their payments went up accordingly) and the number of homes being foreclosed on began to climb dramatically.

The glut of houses on the market began to drive prices down, putting even more pressure on the marginal home owners–not to mention builders, and the finance companies. (Here’s a secret for you: Your mortgage company doesn’t want your house. They want your money.) More foreclosures. Lather, rinse, repeat.

The later Robert Heinlein once said, talking about writers, “We’re professional gamblers. Make sure your house is paid for and your car is paid for. Don’t go into debt.” Today that isn’t just true of writers, or even the other self-employed. Just about everyone is a professional gambler these days. You never know when your company may hit some hard times and start laying people off, or merge with another company, or relocate, or offshore your job, or just decide to dump a bunch of people off the payroll to make the quarterly bottom line look better so the executives can get bigger bonuses. Your income may drop to nothing at any time.

People have been gambling with their houses. They bet that home values would keep going up forever, and interest rates would stay low. They lost, and continue to lose. The bankers bet right alongside them and the rest of the country is going to have to pay the price, one way or another, because these two bunches of overly-optimistic dumbasses never thought about the implications of what they were doing.

Buying something you can’t afford is bad enough. Buying something you can’t even start to pay for is just pure folly.