How many times have you heard one or more of the following comments in the last month?
- “The situation was beyond my control”
- “No one could have planned for this”
- “How was I to know?” or “No one told me…”
When I hear these statements, I can’t help but question the validity of them. It is far too easy to say and then believe that when hard times hit there was no way you could have been prepared and it is, undoubtedly, a great way to absolve yourself of any blame.
Everyday, things happen in your life that are random and unplanned. Shouldn’t that fact alone be enough to tell you that there will always be surprises and that not all of them will be positive? While, none of us have any way of telling what is around any corner, shouldn’t we all instinctively know that we should be prepared for the unexpected or unforeseen, whatever it turns out to be? Who is most responsible for what occurs or doesn’t occur in your life?
There are virtually no limits on the number of actions you can take to ensure that you are prepared for whatever occurs in your life, but for our purposes, let’s stick to the steps that you can take to be financially prepared for life’s journey. Even limiting the discussion to the topic of financial preparedness is broad based. So, lets drill all the way down to what I believe is at the core of every financial decision and the basis for which people will either experience financial freedom or financial indebtedness.
I think the foundation of every financial decision is set by the answer to this question, “Is this a financial need or a financial want?” and a complete understanding of the importance of the answer.
Let’s start by defining what a need really is. There are essentially three basic human needs...food, shelter, and clothing. For the purpose of this exercise, I am going to add two more, transportation and education, because they are so essential to the pursuit of your dreams and the quality of your life.
Your financial objectives begin by satisfying these five needs. How you go about doing that will go a long way toward determining how much debt you will incur and how much financial freedom you will obtain.
When you address these financial needs, the first thing that you want to do is to make sure that you do not end up confusing any of these needs with a want. It is safe to say that you would like to live in a new house, drive a cool car, eat at the best restaurants, and go to the best schools, however, your financial wherewithal will determine to what degree you are able to meet your needs and at what point you can convert a need into a want.
Financial freedom is derived from having the ability to make your own choices about how you spend your money and you are only able to make these choices if you actually have it to spend. In other words, if you have committed all of your income to meeting your debts each month, then you will not be free to make any additional choices unless you find a way to earn more money. Amidst the uncertainty of today’s economic environment, that is a pretty tall task; so, you need to make sure that the choices you make in addressing your actual financial needs are sound and that they leave you with some money left over each paycheck.
One way to prioritize your financial needs is to rank them in order of importance and then assign the portion of your income that reflects that importance. For most of you, your home and your transportation are going to comprise the biggest pieces of your expenses. To illustrate, I am going to use round numbers, but if you are applying this thought process to your own situation, simply use the percentage guidelines provided.
For example, let’s say that you earn a total of $1,300 per month and that you have $1,000 in take home pay after taxes. You will probably be able to devote a maximum of 40% or $400 to your housing expense. You will likely want to spend more in order to get a bigger place with more amenities, but doing so will likely cause you to overextend and/or have to make sacrifices before you address your other needs. To further clarify, this 40% needs to cover your rent at a minimum. If you are a homeowner or want to become one, this number needs to cover your mortgage payment and any insurance and real estate taxes that may apply.
By prioritizing your housing expense, you will now have a clearer picture of what is available to cover your remaining financial needs. Generally speaking, you should do your best to limit your debt payments to no more than 50% of your total pay. With $400 already committed to housing, you are left with $250 for your essential monthly needs. If you are in need of a car or you have a car payment, those costs will account for the majority of your remaining $250. Remember that your car budget must include the car insurance payment as well.
It is certainly possible that you live in an area where public transportation is a viable option. You may even be able to ride your bike to work. If these options exist for you, your transportation costs may comprise a much smaller piece of your financial needs.
Obviously, there will be a lot of variance in each individual situation. Some of you have higher education costs, but have very little need to purchase new clothing. Some of you may be out of school, but perhaps going out on your own and purchasing food and clothes with your own money for the first time.
The value in the exercise is found in addressing those five needs and doing so within the confines of approximately 65% of your take home pay or 50% of your total pay. Using this example, you may wonder how the additional $350 of monthly income affects your needs and wants equation.
By not obligating 35% of your take home pay toward debt, you will afford yourself a couple of luxuries; the largest, of which, is the freedom of choice. Keep in mind that you have not accounted for all of your bills. As one example, you will still need to pay your utilities out of the 35% that you have left, but you have given yourself some flexibility and left yourself with some options. Now, each month, you have the option of saving a few dollars or splurging on a nice dinner. If something unforeseen comes up, you’re prepared. More importantly, with your first set of financial goals in place and solidly based on your needs, you can start on your next set of financial goals based on your wants.
As is the case with everything, your ability to effectively separate your needs from your wants will require self-discipline on your part. You cannot allow yourself to fall into the trap of…I needed transportation so I had to get that new car. No, transportation is the need; the new car is the want. Wants are a derivative of needs, but they are still wants. Housing is a need; a large house on a beautifully landscaped lot is a want. Food is a need. Steak is a want. A suit may even be a need depending on your job. A designer suit is a want.
It is possible to meet your needs and achieve your wants, but only if you first separate them and then apply the reality of your finances to the equation. If you keep those two steps in mind regardless of whether times are good or bad and you maintain the equation regardless of how much money you make, you will put yourself in position to meet your financial needs and obtain your financial wants. You are destined for a future that is fueled by financial freedom or one that stagnates because of financial obligation. The choice is yours.
This article is part of Scott Arney's educational series, entitled The Serial Decision Maker.