In mathematics we learn to solve problems by factoring the problem into its smallest parts. By so doing the solution becomes obvious. This technique can also be applied when making personal financial decisions.
Too often individuals and families feel overwhelmed with their personal financial situations. “Overwhelmed” means that they can’t seem to get rid of their debt, they feel like they are living paycheck to paycheck, and are worried about their financial future, such as retirement. And these concerns are complicated by differing emotions. Fundamental to solving this large problem is to “factor” it down into its smallest parts, as you would do in order to solve a mathematical problem. To do this, you must understand the factors that make up the issues surrounding money problems. One of the most important is the way you spend money and from within the way you spend money, you can factor spending down into three even smaller elements that you must take into consideration. These three factors always come into play when a decision to buy something is made by you or by someone else, and whether for a consumable good or to invest in something:
- Utility: Do I need or just want this item or service. Do I like the color, quantity, taste, size, power, dependability, performance, etc. of this item? Does it meet my risk tolerance, liquidity needs, and support my long-term goals?
- Availability: Do I have the money sufficient to pay for this item or investment? Do I have cash in my pocket, can I write a check, or should I use my credit card? Will the bank give me a loan?
- Affordability: Can I “afford” this item, or this investment? Does it fit into my long-range goals? What impact will this purchase or investment have on my financial future? What is the opportunity cost?
The first thing I want to emphasize here is that Availability is not to be confused with Affordability. They are not the same thing! Many spending decisions are made because it is assumed that when you have some method for purchasing an item, such as a credit card or cash in hand and can pay in full, or more commonly pay monthly, then you can “afford” the expenditure. Money in hand or access to the money sufficient to satisfy the vendor does not necessarily mean that you can afford something — the item is available to you, yes, but not necessarily affordable to you.
The way to know whether you can afford something is by asking the following very critical question:
Does the expenditure strengthen my long term financial goals?
Let me be a bit practical here. I am not talking about everyday expenditures for groceries, gas for the car, or utilities. I am talking about single expenditures in the amount of $200 or more. Certainly houses, cars, vacations, investments, paying tuition for your children, toys, etc. are all expenditures that can adversely affect your long-terms goals. However, if you don’t have long-term goals, what does it matter? How will you ever know if you can actually afford the expense? Thus, it is imperative that to make wise spending decisions you need to have long-range goals.
To get really clear about the kind of long-range goals you want to make, consider these conservative numbers on a credit card expense at a modest 5% interest rate:
- $200/month at 5% interest for 60 months = $13,601
- $200/month at 5% interest for 120 months = $31,056
- $200/month at 5% interest for 240 months = $82,207
- $200/month at 5% interest for 360 months = $166,451
Another way to look at your spending is to realize that to consume $200 in the form of credit card debt or a long-term loan is to ultimately squander $166,451. Purchasing something in this way and for this length of time would be a spending decision that you cannot afford! This little example should help enlighten you about what you really ought to be considering as your long-term spending decisions and long-range plans.
For more information on how to make better spending decisions contact Alan 801-292-1099, firstname.lastname@example.org.