Thursday, September 8, 2011

Expenditure Traps

A bizarre thing happens when our  income increases - expenditure seems to increase in almost exact correlation. If you are doing exactly what you want where you want this could make some sense, after all you can't take the money with you to your grave. However, if like me you are a wannabe escaper from a hum drum existence you can not let this happen.

You should be looking to drive a wedge between them - look to decrease your monthly out goings whilst you income increases. This is not easy but it is definitely possible and in this article I will discuss pitfalls to avoid and habits to adopt.

Networth vs Cashflow

Forget net worth as an objective and focus on positive cash flow - more specifically aim to be generating, robust free cash every month. If you are earning $2000 net but your out goings are $2000 you have zero free cash flow being generated. Again, this may be fine but if you are wanting to escape your current life style to something new then this is a problem.

In this example, the problem is not that the income is too small or that the expenditure is too large but their size in relation to each other. If your overheads are really cut back to the bone and they still run at $2000 then clearly the focus has to be on generating more income to achieve a differential. BUT when you do start generating extra income do not do the following;

Try to upgrade into a bigger flat/house
Take on more debt - mortgage or otherwise
Treat yourself to a nicer car
Start buying designer cloths

This all seems obvious but we are all human and experience the thrill of thinking now we're doing better we could afford this and that. Try to enjoy the feeling of having chunks of cash left over every month that accumulate in your account. It will make you fell stronger, more robust, less insecure and less fearful of exploring new avenues and starting to think what you really want to do with your life. If you think "Well, we can now get the bigger house that's up the street and its a good investment" stop and say do I really need it, does it have the potential to radically change my life. 

I enjoy climbing and mountaineering and often day to day living creates similar sensations. For most of us there are years of uphill struggle mixed with elation, excitement but also fear. Fear can paralyse us both on the mountain and behind closed doors in our homes. We start feeling everything is going to unravel and we will fall down. This is a real and rational fear and you should not ignore it but aim to beat it. Financial robustness goes a long way to beating much of those fears. Being careful with money goes some way to keeping the fear out of your household. In my opinion, you should avoid any type of credit other than a mortgage. If you can avoid a mortgage then even better but you will be in a minority. Cars are financial killers and if you buy on finance you often pay interest but you are normally buying more car than you should so and are getting killed on deprecation. Just paying $10,000 for a car is probably going to cost you $2000 this year on depreciation alone. If you have two of those in your household they stealthily suck a lot of money away from you.

Nice cars and houses are great but my point is aim to get them on your terms when your are sufficiently robust they do not dictate your life. Lets say you are earning $150,000, lucky you, and have a bit of cash and you stretch and borrow enough to buy a $1m home that you've always dreamt of. DON'T. Great income and good savings should create a robust household but as soon as you use these to stretch to the house you are instantly on the back the cliff edge. Worst case next month you lose your income and all your savings are locked up in the house which you lose a few weeks later. You've gone from being well off to poor in weeks - really unforgivable. An alternative which I urge you to consider is to say we will buy a more modest house, say $200,000, have little or no mortgage payments to make each month. Keep a modest car or two with no finance, and all that's got to come out of your $12000 gross a month is hundreds rather than thousands of dollars a month. Therefore, every month your income continues you build up your reserves. If you lose your income next month you can take in a lodger or mow lawns until you find another IT director role or start another business. Not great but you keep your family in your home and you have a platform to get your income back up.

All of this sounds obvious but houses are a financial trap because they are seen as an investment when so often they are extravagance. What the credit crunch showed us was that there were vast numbers of people who were comparatively wealthy one month and the next they had absolutely nothing. They were earning enough and had saved enough to get lured into a seemingly low risk financial decision which turned out to be ruinous.

The reality is that a great deal of expenditure is driven by what our neighbours/family/friends  will think of us and assess our level of success. Whilst arguably this does matter to some degree we should make sure it does not nobble us at the beginning of a race that is decades long and ultimately is with only ourselves. I know I have heard stories of couples with kids achieving a level of success, and then buying a property far grander than they need for them and two kids. Then business/jobs don't go to plan and they loose pretty much everything. For a short period of time peers chat away about how well they are doing, but the children are often effected for life by the experience of seeing their parents lose everything.

In my opinion, if you are doing well at the moment then good on you. Just please, please resist collecting houses, cars etc to communicate to others how well you are doing until those purchases are zero threat to your robustness.

For more frugality-based articles, visit http://www.controlyourcash.com

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