Part 1 stated the problem: We’ve lost our understanding of what “afford” means. This second part addresses how to determine whether you can afford something.
You might define afford as “have enough money to pay for”. It can also, and more importantly, be defined as “being able to do something without risk of adverse consequences”. That’s what I mean when I talk about being able to afford something – buying something (both needs and wants) shouldn’t put you under financial stress.
Just because you can make the monthly minimum payments on a purchase, have room on your credit card or have the money in the bank equal to the cost does not mean it’s affordable to you. “Affording” things in this way will land you in a state of financial, mental or emotional stress.
On Black Friday 2013, I bought a top-of-the-line carbon fiber road bike on sale for just over $2,000. I was proud of myself for taking advantage of a 50% off Black Friday bargain; this was before I had guidelines in place for large purchases. I nearly maxed out my credit card and brought the bike home that day. While I had room on my credit card for the purchase, by no means could I actually afford it. I took nearly a year to pay off that credit card balance using the strategies I now teach. Remember: credit cards should be used for small expenses and the balance should be paid off each month.
Compare that with how I paid for my wife’s engagement ring four years later. I saved up for ten months while living in a duplex I owned (which reduced my monthly rent almost to zero) so that I could pay cash for the ring.1 I created a new savings account outside of my regular bank where each month I transferred the money specific to this purchase. 2 When I tracked my Net Worth each month, I excluded the ring savings account. As far I was concerned, that money was already spent. When I eventually bought the ring and proposed to my wife, I could enjoy the moment without stressing afterward about the cost (and focus my attention on the stress of planning the wedding).
It’s easy to see now I could afford the engagement ring, but couldn’t afford the road bike. It’s counterintuitive, because the engagement ring cost substantially more than the bike. My approach of monthly budgeting, a separate bank account, and tracking my net worth (coupled with my hard-learned lesson from the road bike) enabled me to position myself better financially the second time around.
So how can you determine in the moment whether you can afford a fancy dinner, large purchase, vacation, car etc.? Here’s a checklist to help you determine what you can afford.
Note: You’ll determine what you can afford for small, recurring purchases by setting up your monthly budget. This checklist is for larger purchases. Correct answers in GREEN.
Purchase Affordability Checklist:
- Do you have a monthly budget set up? YES If not, start with a Net Worth Budget. Does your budget build in a cushion for unexpected expenses? YES
- Do you have an emergency fund saved up? YES Will this purchase force you to dip into your emergency fund? NO
- Have you consistently paid off your credit card balance each month? YES If making this purchase with a credit card, will you still be able to pay off the full balance when due? YES
- If you have not been able to pay off your balance, set up a plan to get back on track.
- Remember: if you pay off the balance each month, you do not accumulate or pay any interest. You only pay interest if you have a balance that you do not pay off timely.
- Are you paying off other interest-bearing debt like an auto/student loan? YES Have you been at risk of being unable to make any payments, including mortgage/rent? NO
- If these loans have high-interest rates, consider refinancing them.
- Always make at least the minimum payment on any loans/credit cards.
- Is your income secure? YES
- When your employment situation is frustrating it can be tempting to lean on “retail therapy” to refocus your attention. If there’s risk to your job security you should be cautious about making large purchases.
- Are you investing enough? YES
- This should also be part of your budgeting process, but your circumstances might have changed since you made your budget.
- Can/have you pushed off the purchase a month (or longer), just to be sure you can afford it and really want it? YES
- I really mean this. Try to push purchases off. Make sure you really want them.
- This isn’t always feasible. If you’re buying a suitcase for travel next week then you really can’t wait a month (as long as you can afford it). Though, a side note here: do not spend money on fancy luggage – it gets destroyed once checked – you can find a great piece of luggage at a discount store (think: Nordstrom Rack, not Nordstrom).
It used to shock my wife that I would walk into a store and make a large purchase (seemingly) quickly. She didn’t realize at the them that I’d been thinking about and saving for the purchase for months. I didn’t, and don’t, have to think about the cost again after making a purchase, and now you won’t have to either. Following this checklist, you can feel confident about large purchases.
Reach out to me with any specific questions. Looking for more? Check out my recent article on how to dress well without breaking the bank.