Questions to Ask Before Taking on New Debt.
As a Certified Financial Planner, I am often called on to help people out of money jams. And the majority of those money jams are a result of poor major purchase decisions. Too big a house, too expensive a car, college loans that are unaffordable.
In truth, our consumer centered society is very good at separating people from their money. And the most powerful weapon in the arsenal of marketers and salespeople is credit. When you go to shop for a car, it is rare that the salesman will talk in terms of actual price – they will prefer to discuss payments. They know that few people are going to part with $40,000 to buy a new car. Yet, the same buyer may pay that much and more to purchase a vehicle for $625 per month over 6 years at 4% for a total of $45,000 out of pocket!
Intuitively we may see that this makes no sense. Why are we willing to spend $45,000 for the car AND the interest if we weren’t willing to spend $40,000 on the car in the first place? Marketers know the answer. They understand that the mental calculation most people make to justify $625 per month is much different from the calculation used to part with $40,000.
When considering whether to spend $40,000 on a car, a buyer is going to consider all the alternative uses of $40,000. He could pay off debt. Use it as a down payment for a condo. Supercharge the college or retirement fund. Enjoy a lifetime of nice vacations. When looking at all the alternative uses for such a large sum of money, it becomes increasingly likely that the shopper will walk over to the used car department (or just try to squeeze another year out of the old clunker). It is easy for any individual to order priorities for how to spend or save $40,000 – and this purchase may not come out on top. Marketers realize this, which is why they are trained to discuss monthly payments rather than purchase prices!
The same buyer looks at a decision to spend $625 per month much differently. “I make lots more than that. I should be able to swing it. It’s not that much money.” This is the line of thinking the salesman is relying on – and it is absolutely the WRONG way to think about a major purchase. When dealing with a smaller number, most people will do a less thorough analysis, and won’t fully consider or even understand the impact the decision may have on their future well being. As a result, people will frequently spend more on cars, homes, and other big ticket items than they can really afford, and then wonder why they are so financially stressed.
The best approach to avoiding such problems is just not to borrow money for anything other than a home purchase. But I run into resistance with that recommendation, so absent the cash only approach, let's consider how to give $625 the same attention that the $40,000 would receive.
Here is the mental process that a prudent buyer should be going through before taking on a major financial commitment, using the new car example above to illustrate.
- Have I been saving $625 per month? If yes, am I willing to reduce my savings by that much every month? If not, then I will clearly need to give something up to make these payments every month.
- What am I willing to sacrifice EVERY MONTH to make these payments?
- I can’t sacrifice paying rent, utilities, insurance, and other essentials.
- I can’t really cut back that much on food and medical expenses, so those items are out.
- I can’t (or shouldn’t) cut back on payments on my other debts.
- It would be foolish to cut back on retirement savings, or contributions to the kids college funds.
- So how much do I currently spend on DISCRETIONARY items like eating out, entertainment, hobbies, vacations, clothing, cleaning or grass cutting services, etc.
- Am I willing or able to reduce those discretionary expenses by $625 per month every month in order to make this purchase?
- If I am not willing to cut back on these items to free up $625 each month, then I shouldn’t make the purchase.
The truth is, most people have no clue how they spend their money, and so are unable to complete this analysis. They are more likely to spring forward on faith and hope and make the purchase without actually knowing where the money will come from, or what other wants or needs will be left unmet in the future. Trust me on this - the marketers know this is your weakness and they WILL use it against you.
Maintaining a detailed budget and spending plan is the only way you can make a completely rational purchase decision. It is the only way you can accurately answer the question “Can I afford this?” A consumer who maintains a good cash flow budget will fully understand the future impact of this new $625 commitment. She will look ahead and know that she will have to find another $625 every month for an expense that wasn’t there before. She will know this means less to spend on other priorities, which may be of even greater importance. If and when she does decide to make the purchase, she is far less likely to experience buyer’s remorse or financial stress.
There is quite simply no more important financial practice you can develop in life than to learn how to budget and control your monthly cash flow. It will put you back in charge of your money and change your relationship with money (and your loved ones as well!) for the better.