Friday, February 18, 2011

The first rule of personal finance

The spending problem.

John Doe needs to spend money. He is a typical human. He has living expenses. Assuming that (unlike in our last post)  John Doe isn't living in his parents house, there are three ways he can find money to spend.

1. Debt. John Doe can just live off of his credit cards. This probably won't work for very long. The credit card companies will expect John to pay interest every month for the amount that he owes them. They will also expect him to pay back some of the loan every month. He can try borrowing from one lender to pay back the other but his will not work for very long.

2. Savings.  If John has some money he inherited sitting in a bank account or under his mattress, he can use that money for his spending needs. This isn't a much better solution then debt. Unless John has inherited a very large amount of money or unless he has a very short life expectancy, he will outlive his savings. There is one way that John can make the most of his savings, he can reduce spending.

"Reduce spending" is the second half of the first rule of personal finance. We haven't said out the complete rule yet. The important thing to remember is that:

The slower one's spending rate, the longer he will be able to live on a fixed amount of money

Even if John reduces his spending, it will only slow down the inevitable. Eventually he will outlive his savings and will have to find another source of spending money. This brings us to the third way John can find money. It will be familiar to all of you from my previous post.

3. Earnings. John can get a job, earn money and spend the money he earns. This is a great way for John to find spending money. The big downside here is that he has to work, but that's life. It's important to note that John will only be able to rely on his earnings for spending money if he is not spending money at a greater rate then he is earning money. This bring us to something very close to the first rule of personal finance:

Don't spend more than you earn.

Well that's short, but not exact enough. Let's say it a little bit differently.

Don't let your spending rate go higher than your earnings rate.

This is still not the "the rule". The problem is that if John lives by the minimum that this rule requires then he will not be saving any of his earnings. He will be spending all of it. Saving earnings is important to a lot of people and it is the only way one can possibly hope to increase their wealth. 

Another problem is that the rule, as stated above does not take into account that most people's spending rates fluctuate, there will be occasional spikes in spending rates. For example, lets say we define the spending and earning rates as amounts of money per month. (Looking at the monthly rates is very helpful for most people, as most people get paid by the month and pay there bills monthly). If one were to buy a home this month  then his  spending rate for the month of February will probably greatly exceed his regular spending rate. He probably will not be able to compensate for this spike in spending by trying to earn more money in the month of February. Spikes in spending usually have to be saved for over time, (sometimes they can be borrowed for but that's not always a good idea). Typical examples of spending spikes include: Home purchases, auto purchases, college etc. The best way to deal with these spikes is to save money for them beforehand.

Another problem is that earning rates are also not usually steady. They usually go down considerably when one becomes too old to work. It's a good idea to save money in anticipation of this decrease in earnings rates. This is called saving for retirement.

There is only one way to save money. This brings us to the first form of the first rule of personal finance.

Earn money at a faster rate than your spending rate. 

That's the first form of the rule. The rule does not say what the difference in rates should be. For that we need the second form of the rule which is:

The greater ones earnings to spending ratio, the faster he will save money.

The two best things that one can do to increase his earnings to spending ratio is to earn more money and reduce spending. This is the key to saving money, but it's important to remember the following. If your earnings rate is not higher than your spending rate, then you are either not earning enough or spending too much or both, and you probably need to make some life style changes.

No comments:

Post a Comment