Running in Circles

The average two-income family today earns 75% more (adjusted for inflation) than a one-income family earned a generation ago. Nonetheless, today's two-income family has significantly less discretionary income once the basic bills — mortgage, health care, education and so on — are met. And thanks to the proliferation of credit cards, the average household today carries 100 times more debt (adjusted for inflation) than their parents' generation did.

That debt has become an enormous burden. Consider this: In 2004, more Americans filed for bankruptcy than graduated from college, suffered heart attacks or were diagnosed with cancer. The single best risk factor for bankruptcy? Having a child.

Today's working-hard-but-carrying-more-debt reality calls for new rules about handling money, says Elizabeth Warren, a professor of bankruptcy law at Harvard, and her daughter, financial consultant Amelia Warren Tyagi. Their new book, "All Your Worth" (Free Press, 2005), offers a formula that the authors say will help today's families manage their money for a lifetime. We recently asked them to share their thoughts on how to play today's money game.

SmartMoney.com: You have been studying the financial problems of middle-class Americans for more than 20 years. What has changed the most over this time?

Elizabeth Warren: More people are worried about money than at any time since the Great Depression. Families are divorcing over money, they're fighting over money; 51% of Americans just responded to a survey saying money is the most sensitive topic in the household.

Families need tools to cope with a rapidly changing world. That's what we're trying to give them. When I started doing this work 25 years ago, there were some people in financial trouble, but their numbers were small, and they usually were people who had been hit by extraordinary crises. Today people see their neighbors, folks in their own families, crumbling financially and they worry about their own safety.

Amelia Warren Tyagi: Another big shift I see is that Americans are more and more on their own. The safety net that was there for their parents just isn't there for us. We have to figure out our own health care, our own retirement, our own child care. We're on our own, and the only way to deal with that is to get smarter.

EW: A generation ago it wasn't possible to overspend on a home. When your mom and dad wanted to buy a house, they had to sit down with a banker who carefully examined their income and their savings, to make sure that they would have no difficulty paying off that mortgage. Today, a young family buying its first home has to fend off those real estate agents and mortgage brokers who tell them they can afford to spend two and three times more than they really can afford. The same changes have taken place with credit cards. A generation ago the people who got credit cards were those who could show that they could repay their debt. Today, small children, large animals and a few inanimate objects have been approved for credit cards.

SM: You base your book "All Your Worth" on the premise that the rules of successful money management have changed. So what are the new rules?

AWT: The first new rule of money is that you cannot take it for granted the way your parents could. You can't assume that just because you're working hard and you're not going crazy that it's all going to work out.

EW: The second rule is that [to manage your money wisely], you have to take care of the basics first. No one is going to develop a financial plan based on cutting out the lattes and using double coupons. That's a little like moving into a house that's falling down and the first thing you do is change the curtains. We believe that at the heart of a meaningful financial plan is balance. It's a principle that works up and down the income ladder.

AWT: You balance your money in three categories. You start with the must-haves: These are things like your mortgage or your rent, your insurance, your car payments, the stuff you have to pay month in and month out, no matter what. The second category is your wants: This is the stuff that's just for fun because life should be about more than boiled vegetables. This is for a bikini wax or a car wax, a great new sweater, a new set of speakers. And the third category is about saving for your future.

SM: How do you prioritize those three categories?

AWT: We don't just prioritize, we actually give some numbers. And think of these numbers as the center of the bull's eye, to let you know what you're aiming for. You may not be able to get here tomorrow or the next day, but it's good to know over a lifetime what works for most people most of the time. Start with the must-haves and aim for 50% of your take-home pay. Then it's 30% for your wants, and 20% for your savings. And if you're carrying debt, that 20% goes toward paying down your debt first.

SM: How easy would it be for people to adjust to and stick to this formula?

EW: A big part of the book is helping families get there. We step-by-step diagnose where they're at and then help them bring their money in balance. Not everyone will have the same set of problems. We've counseled people who were way over on their must-haves and quite frankly, weren't spending enough money on fun. We've also counseled people who had their must-haves well under control, but who are out of control on the fun stuff.

SM: In your book, you wrote that even if people are doing everything right, the system is against them. Credit card companies keep increasing interest rates, there's a new bankruptcy law that will prevent many people from filing for bankruptcy...

AWT: That's true: It is a tougher world financially and the deck is stacked against people. No doubt about it. It is harder to live a middle-class life on a middle-class salary. And at the same time, everybody can make steps to make it better.

EW: That really is the philosophy of this book. No, it's not fair, but fair isn't what counts here. I've been very active in this bankruptcy debate, and I have pressed Congress as hard as I humanly know how about how this bankruptcy bill presses down on hardworking families while it lets credit card companies and millionaires walk free. I think it's not fair. But I might as well shout to the wind. Families need to help themselves today. And we're trying to give them the tools to do that.