Wednesday, May 28, 2014

'Afford' vs. 'Can pay for'

Many people are afraid to say it, or can't find words for it, or assume that people implicitly understand this concept. It is absolutely the underlying principle necessary for financial responsibility, and for your personal financial well-being. 

And it is this:

Just because you have the money to pay for something, does not mean that you can afford it! 

Image from website; the 2014 Ford Focus costs around $20k

This is less than half the price of a typical new compact car like the Ford Focus, Hyundai Elantra, Toyota Corolla, and so on--but it would leave Bob with money in savings, even after all the associated hidden costs like taxes, tags, title, registration, insurance, and gas. Yet this used Accord will still be a reliable, relatively nice car: possibly nicer than the brand-new compact car would have been--but without the major depreciation hit! 

For example: Suppose Bob has $25,000 in savings, and buys a brand-new compact car for $20,000, and then drives it all over the place and spends $5000 a year in gas. How will Bob pay for the car insurance for the upcoming year? For his taxes? His food? 

Will it be from his wages in the upcoming year? 

NO! If Bob doesn't have the money currently in his possession, he can't count on it! What if he's fired or quits? What if the company he works for goes out of business? 

And if something bad happens to the vehicle--like if Bob is in an accident, or his car is stolen--how much will the car insurance will pay? [Answer: even if the car is only a few months old, the insurance will pay what the car is currently worth, not what Bob originally paid.] So Bob is hit with a significant monetary loss, despite having faithfully paid his insurance premiums!

There are so many expenses associated with life, that it is a foolish move for Bob to spend 4/5 of his savings on a new car, even though he has the money on hand to pay for it now

And if Bob chooses to finance the car in order to maintain most of his current savings, he'll be paying a lot more than $20,000 due to the interest rates! This is a well-documented phenomenon, and I'm not going to explain it again. A quick web search on how interest works will give you more information than you probably wanted to know!

A much better option for Bob would be to purchase a 5-10 year old used car, with good reliability (the annual Consumer Reports magazine edition for used cars is the go-to source for reliability data). A 2006 Honda Accord can go for less than $10,000, according to Kelley Blue Book. (Of course, this price depends on mileage, condition, options, etc.) 

This example demonstrates the Millionaire Mindset, and how saving money really works. People who are financially responsible realize that being able to afford something is more than simply having the money available to purchase it right now. 

Aside from really big-ticket items like cars and houses and college educations, I recommend only telling yourself that you can truly afford something if you can pay for it now, AND have enough money left over to replace it! This ensures that you can truly afford the item, and that you won't be left in despair if disaster strikes and the item is broken beyond repair. 

What if you're going for one of those big-ticket purchases? My answer would be to ensure that you have some money immediately available for repairs, so that you're not caught flat-footed if something goes wrong. 

To make sure I'm clear here, this post is directed at making you a more responsible consumer. If you're making investments, this risk-averse advice is probably not the best approach. But the purpose of this blog is to give you the tools and the mindset to make you a better steward of your money. There are lots of other resources whose goal is to make you a wealthy investor, but sometimes getting rich does not make you financially sound (see the stories of many lottery winners for examples of this). 

Happy saving!