There is a big difference between having the money to buy something and being able to afford it. In most cases just because we have the funds to be able to purchase something it doesn’t mean we should buy it. When we are young our pay cheque enters our account and leaves just as quickly. We think we can buy items because the money is available through the tap of a card. The majority of the everyday millionaires live well below their means and refrain from buying luxury items. Everyday millionaires are often able to afford luxury items but don’t because their foundational values are frugality, saving and investing to build wealth.
There are a few questions we have to ask ourselves before understanding whether or not we can afford an item. First, am I sacrificing any amount of money from my other financial goals to be able to purchase this item? Unless the item is a need or of other significant importance it can be added to our financial plan and saved towards before purchasing.
Secondly, is this item a depreciating asset/what is the value of this item to me? The first question is fairly straight forward but the second question can be a bit difficult to answer. There are a number of factors to look at when addressing the second question. What type of item are you purchasing? Is it a nondurable/perishable good or a durable good? Many times if the item we want to purchase is a perishable good like fast food or a meal at a restaurant the price is not justified by the product/service. As a consumer we have to understand the total product concept that we are buying into. When we purchase a meal at a restaurant we are buying more than just the meal itself. You are also buying into the excitement leading up to the meal, the atmosphere, service during the meal and often the ability to be able to connect with a group of people. We still have the question whether the total product justifies the price of the experience. This can be determined on a case-by-case basis.
If the item is a durable good we can examine the cost over a period of time. The more we use an item the more spread out the initial cost of the purchase is. A pair of jeans that we spent $100 on and wear everyday has cost us $0.27 a day for the first year and it goes down from there. This looks pretty good in comparison to a pair of jeans we pay $100 for and wear a couple times a year. Let’s say we wear this second pair of jeans on 5 separate occasions throughout the year, we have spent $20 a day to wear those jeans. Not good. That is not to mention the clothing that we have purchased but not worn. This means we have spent our hard earned money to be able to hold a piece of clothing in our possession without using it. The ROI isn’t looking to good on that purchase. This example helps to illustrate the importance of the second question and the value we can draw out of an item for each dollar we spend on it.
Our ability to access funds makes it easier to spend more money. Part of the issue is credit cards and spending money that isn’t ours which I have spoken about previously (The Pros and Cons of Credit Cards). The other issue is that banks often over qualify us for loans. We get access to money but we can neither afford or have an understanding of the ramifications associated with it. This has been known to cause moral dilemmas for employees at banks as they are asked to meet quotas on the amount of credit cards they sell and money they have to loan out. When we receive a student loan or get a credit the average person doesn’t fully understand how to properly use the funds we gain access to. We tend to spend the money and worry about it later which leads to us paying more fees or interest than necessary. It is important to fully understand the contractual agreement you are signing up for before entering the loanable funds market. Banks receive the majority of their income from the deposits of customers but they also receive a lot of their income from the fees we pay on overdraft charges, credit card fees and interest. Banks borrow short and lend long. The banks generate funds by accepting deposits on short notice and the banks lend funds over a long duration in order to be able to collect interest. Banks also have many depositors and loan money to few. This makes for a smoothly operating financial system where money stays in rotation. As much as we rely on banks they are a for profit business. As the banks customers we have to educate ourselves and take care of ourselves first.
By separating our ability to be able to purchase something from our ability to afford it we can make better everyday decisions. This will allow us to better stick to our financial goals and set us down the right path in our relationship with money.
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The Rich College Student 