The Best Way to Avoid the Worst Financial Problems
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Yarn Sculpture by Jackie Brewer, photo by Philip Brewer Simple living should be about enjoying the good stuff. So, rather than go into a bunch of things you can do to head off possible problems, I'm going to give you just one tool for avoiding bad stuff. Happily, it's a tool so powerful that you just about don't need any others. Then we can get back to putting our focus on living large.
I can give it to you in once sentence: Keep the cost structure of your household flexible. That is, arrange your life so that you can react to a fall in your income by reducing your expenses.
Now, I just wrote a post that recommended the opposite — taking advantage of the sorts of deals you can get when you're willing to make a commitment — so I'm not trying to say that making a long-term commitment is automatically a bad idea. It's often a good idea. Just don't automatically take advantage of every opportunity to save money that way. Be strategic.
The cost structure of most people's household is terribly inflexible. They have debts, leases, and service contracts that require fixed dollar payments that don't vary with their income. This is so common that most people don't even imagine that there are other alternatives, but it's entirely possible to avoid doing so. As soon as you start being strategic about those commitments, you start building flexibility into your household cost structure — flexibility that can save your finances when your income takes a hit.
Only make long-term deals where you're buying something that you're determined to have for the long term. A home often falls into this category. I'm not so sure about a cell phone.
Only make a limited number of long-term deals. Since some things are only available with a contract of some sort, and some things are much, much cheaper if you make a long-term deal, sometimes you don't have much choice. Those have to be long-term deals. So in cases where you can get just as good (or almost as good) a deal without one, refrain from making a commitment.
Only make long-term deals where you're buying something that you could still afford, even if your income fell. Many people buy the most home they can afford. If you instead buy a house that's well within your means, your household cost structure is a little more flexible.
Here's a brief personal example. My cell phone battery recently quit holding a charge. I looked into getting a new phone, but I also priced a new battery. Getting the new smart phone that I wanted would entail not only a 2-year contract but also increasing my bill by at least $30 a month (for data service). By buying a $7 battery instead, I've kept the cost structure of my household a little more flexible. (It was an easier decision for me than for most people because although I'd like a smart phone, the phone I've got now is running software that I helped write, so I've got a personal attachment to it that most people wouldn't feel.)
It's not bad to have fixed costs; you can often get a better deal if you're willing to commit to an expense for a period of time. But each additional fixed cost makes your household budget a little less flexible. If you can keep the cost structure of your household flexible, you'll be okay even if something bad happens financially. And, once you've got that flexibility in place, you can quit worrying about money and put your focus on living large.
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Philip,
Good point here. I think everyone should do a minimum fixed cost calculation. That is what is the minimum monthly payment that you would have to come up with just to subsist. Include rent, mortgage, minimum utilities, taxes, transportation, basic food, etc. Add it all up and that's how much you need just to get by, so if the income went down, you would need to come up with this.
Take your unemployment and other guaranteed income and then calculate your gap. Now compare that to your emergency fund. If you are going to burn through your emergency fund in less than 6 months, you need a lot more savings.
The interesting thing about this Recession is that things like Cable or Cell phone service that people used to consider must haves are starting to get discarded or at least heavily downgraded.
I really think this is key to the difference between "then" and "now." In my childhood, few had credit cards (it was a big deal when my father got one for his business). I think for most the only monthly expense was the mortgage.
Paying off my house early eliminated the biggest fixed expense we had. I have never regretted it, even several years ago,when the financial press derided such decisions (b/c "you could always take money out of your house...").
I would also add:
Don't put bills on automatic payments.
Many ongoing expenses such as utilities, Internet, etc. give you the option to have your bill automatically deducted from your bank account. I did this for a few of them a couple years ago. One or two is OK but you can quickly get into losing control of your bank account. I budget and know my upcoming expenses but still would be surprised when money would appear to be missing.
It can also be a huge hassle to get these things off automatic payment.
Not having automatic payments means you also have the flexibility to delay a payment one month if you have an emergency and need the money.
This is why I created my 2010 budget and really analyzed items line by line. I learned so much from doing this. I actually have a savings plan. Budgeting forced me to look at things differently. I had to eliminate a good amount of expenses, but it was worth it.