Whenever you face a financial decision, what question do you ask yourself? If that question is, Can I afford this today?; you are asking the wrong question. The impact of financial decisions carries far beyond the moment they are made. A debt will affect you for the term of the loan. The decision to retire will affect you for the rest of your life. Even the purchase of a couch can have an impact on your finances for weeks or months into the future.
What is the right question to ask?
So what is the right question? It depends on the circumstances. The proper question for a 60-month car finance purchase is, Can I afford the monthly payment for the next five years? A decision to retire requires the question: Will I be able to afford to live on my retirement income and accumulated assets, taking inflation and increased health costs into account, for the next 20 to 30 years? The appropriate question for non-essential everyday expenditures such as eating out, going to the movies, or the purchase of a clothing accessory is, Can I afford this and still make my essential expenditures for the balance of the month, including any unanticipated expenses such as medical co-pays and repairs on vehicles or appliances?
You take change into consideration when you ask the right question
If you are honest, asking the right question forces you to think about the future. In thinking about the future, you must account for change, and not just any change; you must account for what might go wrong. How have circumstances changed in your life over the last year, three years, five years? Has your cost of living increased? Have you been laid off or had your hours cut? Have you experienced health problems that kept you from working? Have you experienced periods when there was a reduction or interruption of income? Have you had to pay medical deductibles and/or co-pays, auto insurance deductibles, auto repair expenses, appliance repair or replacement expenses, or repair expenses to your house?
Account for change in the future with savings
How do you account for what might go wrong in the future? You do it with savings. You need cash in reserve to handle expenses that exceed your monthly take-home pay and to cope with reductions or interruptions in income. If you don’t have savings, your answer to the purchase question is always “no”; you cannot afford to purchase anything that is not an essential expense such as food, rent, utilities, fuel, insurance, maintenance drugs, and any payments on debt. If you don’t have at least three to six months of living expense in an emergency fund to replace reduced or lost income, the answer to the purchase question is “no”; you cannot afford to purchase anything that is not an essential expense.
At a minimum, you need enough short-term savings to cover insurance deductibles and out-of-pocket expenses, a major repair to the automobile, and the replacement of a major appliance along with a separate emergency fund equal to three to six months of living expenses. Without this short-term cash on hand, you cannot account for the future, and therefore, cannot afford to purchase other than essentials.
Retirement requires accounting for change over a 20 to 30-year period of time. How do you know how inflation will affect your cost of living over two to three decades? Can you accurately predict your state of health and the costs of health care during that period of time? The truth is you can only make intelligent guesses about the future. The answer to dealing with an unpredictable future is to have a hefty cushion of retirement savings and let it grow, untouched, during the first decade of retirement. You can do this if you live on less than your retirement income during the early years of retirement.
What about the good things that could happen in the future?
Does accounting for what can go wrong in the future sound negative and pessimistic? What about the good things that can happen: a raise, a better paying job, or a bonus? True, the future may hold good fortune for you. The thing is, you cannot count on it. If you want to get out of debt and stay out of debt, it is absolutely necessary to account for what could go wrong in the future. If you don’t ask the right question and fail to account for the future, the future will not be kind to your finances, and you will be forced to take on debt to deal with unfavorable changes. On the other hand, when you ask the right question and account for the future, our experience has been, more often than not, that the future turns out to be bright.
K. C. Knouse is the author of True Prosperity: Your Guide to a Cash-Based Lifestyle, Double-Dome Publications, 224 pages