Thursday, January 4, 2007

The Financial Golden Rule

I probably should have started with this, but it's better said late than never.

This is the rule upon which good personal financial management is built. Following this rule helps get the rest of your financial house in line.

If you can't afford it, don't buy it.

With a few exceptions, which are really variations on this rule, you should never borrow money to buy stuff. Stuff is not as important as running water. Stuff is not as important as being able to pay your hospital bills if something happens.

If you have to ask yourself whether you should buy a new toy or pay your electricity bill, you should put that toy down. You can't afford it. You should not buy it. If you have a credit card maxed out you need to stop buying non-essential things. Because you can't afford them.

The exceptions to this Financial Golden Rule come in the form of large-item loans: Home mortgages, car loans. Getting a loan to buy a yacht you think you'll use every weekend does not count. If you can afford it, go ahead. If you can't, don't.

The Large-Item Loan
The sad fact of life is that most people in developed areas need a vehicle to get around. Many metropolitan areas are not safe to walk in, the distances are too great to make walking or biking feasible, and public transportation does not meet the everyday needs of a lot of people. So, a car becomes a necessary purchase. Housing is a basic necessity for life. If you are considering a loan to purchase either of these items, the variation on the Financial Golden Rule comes into play: If you can't afford the monthly payments, you can't afford it. And if you can't afford it, don't buy it. Not everyone can afford to pay cash for a car or a house. They can afford to put a, relatively, small amount of money towards the item each month. This is the purpose of a loan. Money now for small repayments plus interest over time.

If you can afford to pay $1200 a month in home loan payments and you have a choice between a home that would cause you to pay $1150 a month and a home that would cause you to pay $1500, you should buy the first home. You can afford $1150 a month. You shouldn't even consider the $1500. What are you going to do about the $300 you can't afford? Get another loan somewhere? It is the height of idiocy to put yourself into debt to pay off debt(the exception being shifting debt to a lower interest rate or more stable program). What about just paying the $1200 you can afford and ignoring the $300? Well, even if your lender allows you to get away with that, you're just hurting yourself in the long run. That's $300 a month that's not going towards paying off principal. That's principal that's still gathering interest. That's principal you're going to have to find a way to pay off when your loan comes due. Let's say the lender does allow you to only pay $1200 a month instead of $1500, but they're going to apply the $1200 a month you send them backwards so that they put $300 to the first month's bill and then apply the rest to the current month's bill. Here's how it would go for the first year.
Month 1: $1200
Month 2: $300(to month 1)/$900(to month 2)
Month 3: $600(to month2)/$600(to month 3)
Month 4:$900(to month 3)/$300(to month 4)
Month 5:$1200(to month 4)/$0 (to month 5)
Month 6:$1200(to month 5)/$0(to month 6)
Month 7:$300(to month 5)/$900(to month 6)
Month 8:$600(to month 6)/$600(to month 7)
Month 9:$900(to month 7)/$300(to month 8)
Month 10:$1200(to month 8)/$0(to month 9)
Month 11:$1200(to month 9)/$0(to month 10)
Month 12:$300(to month 9)/$900 (to month 10)
Not the kind of situation you want to be in.

Remember: If you can't afford it, don't buy it.

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