Tag Archives: Savings

Opportunity Costs

When it comes to getting the most value for your money, it makes sense to measure the opportunity costs linked to where your money is being dispensed.  Opportunity costs are based on a theory from microeconomics.  It is based on making decisions that provide the best value for your money.

Many economic theories are just theories to the average person.  They are discussed in the classroom or in the financial media, but the average individual investor does not receive too much practical application from most of these theories.  They can be discussed, but not really applied to everyday life.  The theory of opportunity costs does not fall into the category of academic mumbo-jumbo.   It can easily be applied to the management of your personal finances.  Paying attention to opportunity costs can totally change how you think about money.

Total Cost

What do you think about before you buy something?  Most people only look at the direct cost.  When most people decide to buy something, they just look in their wallet to see if they have enough money to pay for it.  Some people don’t think at all and make the purchase with credit and just take on more debt to make the purchase. 

The only time people tend to give any serious thought to what they are buying is when they are making major purchases.  A good example of this is when someone decides to purchase a house.  The potential home buyer will have their credit score checked, shop for the best interest rate, analyze how much they can afford in monthly payments, as well as many other considerations. 

This type of thinking is not the most prudent form of financial management.  Managing the finances around major purchases is important.  Getting the big purchases right can make or break your financial situation. 

Death from 1,000 cuts

The lesser financial decisions are also important.  Not thinking about day-to-day spending can equally jeopardize a financial plan.  The little costs add up quickly if a person is not mindful about their spending.  They are like death from 1,000 cuts.

It is easy for small amounts of spending to get out of control.  A couple of lunches out per week can add up to $100.  Watching a movie at the cinema with snacks can cost $25 per person.  Taking your kids to an indoor water park on the weekends can add up to hundreds of dollars.  Without being mindful, the wasted spend can add up quickly and so do the wasted opportunities for that money to be put to use in a more prudent way.

When money is spent without thought, that is a sure way to not get the most value for the energy that you are exerting to earn it.  To be successful with your personal finances, a consumer needs to be intentional.  Otherwise, they are missing out on maximizing the opportunities that are available.   

Always run the numbers

When making a financial decision, opportunity costs are based on weighing the pros and cons of how money is utilized.  An example would be when you decide to buy a new car.  When you establish the budget do you decide on buying a $30,000 car or a $20,000 car?  If you decide on the $20,000 car, the additional $10,000 that you decided not to spend can be used to pay off debt or to be added to savings?  Buying the $30,000 car would have $10,000 in wasted opportunity costs.

Being mindful of opportunity costs is a great way to maximize the value of your money.  If you are trying to reach financial independence, getting the most bang for your buck needs to be front and center whenever you must spend money.  By always evaluating the opportunity cost of a purchase helps to develop a savers mindset.

Investing

Tracking opportunity costs also have a role when it comes to managing investments.  There is an opportunity cost involved with being too conservative with your selection of investments.  If an investor kept all their savings in a money market account from 2007 until 2017, they would have earned less than 1%.  If that investor put their money in an S&P 500 index fund, they would have earned almost 10% during that same time period.  If an investor was not comfortable investing 100% in equities and wanted to invest in a more moderate allocation, they would have still earned 7.3% in the Vanguard Star Fund (VGSTX) that has an allocation of 60% in stocks and 40% in bonds.

Conclusion

If reaching financial independence is your goal, measuring the opportunity costs of all your purchases will help you get there.  After you start to practice measuring the opportunity cost of every financial transaction for some time, it becomes like second nature.  It is useful no matter where you are in the journey toward financial independence.  If you are new to this way of life and working on paying off debt, it will help to curb your spending.  If you are in the saving and investing phase, being mindful of opportunity costs will help you to free up more money to be used to build wealth.  If you are entering retirement, keeping track of opportunity costs will help you to spend less and preserve your wealth.

Whenever I must spend money, I think about the opportunity cost tied to that purchase.  I credit that thought process as helping to establish a high savings rate.  It is a fun mental game to play.  By being aware of how I am spending my money, it helps me to not miss out on all the better opportunities that are available for my money.

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Debt: Reaching Step Zero

The first step in correcting a problem is to admit that there is a problem.  Prior to admitting that there is a problem, there is another step.  That is when a person reaches their breaking point and cannot go on living the way that they are living.  That is often referred to as step zero.  Step zero is when a person says to themselves “this crap has to stop”.  It is the breaking point.  It is the point where a person becomes willing to take corrective action.  They become willing to try a different approach of living because of a psychic change.

Have you reached the point where you realized that your way of managing money is not working?  Are you spending more than you earn?  Does all of your earnings go towards paying bills?  Do you have creditors calling you who want to be paid?  Do you have to borrow money when an emergency occurs?  Do you find yourself spending money that you do not have in order to keep up with your friends, neighbors, or relatives?  Do you feel broke even though you work hard and earn a good income?  Do you contribute any money to your retirement savings accounts?

Have you reached step zero? Do you want to change how you manage your finances?  Do you want to take control of your life?  Do you want to break away from the bondage of debt?  Are you at a point where you are totally dissatisfied with how you are living because of debt?

The good news is that there is hope.  It can get better.  It is all up to you.  It is based on your willingness to change.

Now that you have admitted that your way of managing your finances does not work, how should you start the mending process?

Measuring the Damage

Start by measuring the damage that you created.  Before you can move forward, do an analysis of what you owe.  My favorite tool to assess debt is the debt-to-income ratio.

To calculate your Debt-to-Income Ratio, see the formula below:

Debt-to-Income Ratio = Monthly Debt Payments/Monthly Income x 100

Example: $1000 in Monthly Debt Payments/$3000 in Monthly Income x 100 = DTI of 33%

What is considered a bad DTI Ratio?

If your DTI Ratio is higher than 36%, you are in the danger zone.  The higher your DTI Ratio is, the less money you have to cover your living expenses.  A healthy DTI Ratio is less than 16%.

Where to Start

After you know your DTI Ratio, it is time to start paying down that debt.  Start with paying off all of your bad debt.  Pay off all of your payday loans, credit cards, and auto loans.  Next, start to pay down your student loans, mortgage, and business loans if they exist.

Stop the Bleeding

Stop buying stuff you do not need on credit.  Identify what you need and only pay cash for those needs.  A few examples of needs are food, clothing, medical supplies, transportation costs, and housing expenses. Wants are fancy cell phones, cable TV, designer clothes, eating at restaurants, or any other expense that is not required to live.

Income

If you are part of a dual-income household, learn to live off of one salary.  Use the higher of the two salaries to pay for all of the household living expenses.  Use the lower of the two salaries to pay down debt.  After your debt is paid off, you can start to focus on saving money.

Get a second job.  Find a side gig to earn money to pay down debt.  If you spend your free time working, you will be less likely to spend money on stuff you do not need.

Create a budget.  A budget is a plan that allows you to break down where your earnings will be allocated based on a percentage.  For example, 25% for housing, 11% for transportation, 20% to pay off bad debts.  Once you have a budget established, all you need to do is follow it.

Recreation

Even though you have debt, you still have to live your life and have fun.  Find ways to enjoy what your local community has to offer.  Instead of going to high priced movies or amusement parks, go to local parks or free museums.  Instead of going to a high priced gym, exercise outside by walking.  Instead of going on a luxurious vacation, take a staycation.

Guilt & Shame

There is no use in feeling bad about having debt.  You have identified the problem.  Now is the time to move ahead and to make positive changes.  Having ill feelings is not a solution.

Focus on the positive and on everything that is possible once your debt is under control.  Try to take small steps and to monitor your progress.  Don’t strive for perfection.  If you have a slip, don’t beat yourself up.  Pick yourself back up and keep striving for progress.

Conclusion

Debt is similar to hiking.  Once you walk 5 miles into the woods, you have to walk 5 miles to get out.  Now that you have decided that a change is needed, it is up to you.  At this point, there is no use in looking for someone or something to blame for your debt.  You cannot change the past.  You can just pick up what is left and apply a solution.  If you learn from the situation, it was not a waste.  As you move forward, you can also use it to help other people who are struggling with their own financial issues.

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