How should I pay for this?
Life brings several opportunities to spend money and for most of us this requires a choice on how we are going to pay for what we buy. There are really only two options, borrow or use cash. The choice you make for each type of spending will be a major factor in your long term financial success.
How would you categorize the different types of spending?
Basically there are four types of spending opportunities that we all encounter: Everyday living expenses, occasional short term expenses, long term expenses and major purchases.
Why is it important to look at expenses differently?
Each requires a different method of payment and choosing the wrong method can lead to a financial crisis. For example, paying for everyday living expenses with credit typically leads to a personal debt crisis.
What are examples of everyday living expenses and how should they be handled?
These would be your monthly expenses to live besides transportation and housing, so this includes food, entertainment, monthly prescriptions, utilities…anything that is needed as part of everyday living. All of these expenses should always be on a cash basis meaning they should come from your monthly income.
What are examples of short term occasional expenses?
These are expenses that occur every year but not every month. Examples include gifts, holiday shopping, car, renters or auto insurance. The preferred method of paying is to save in advance so these expenses don’t have to come out of your monthly income all at once.
Buying a car or a house would be consider long term, are there others?
The other common long term expenses would be student loans and any home improvement project that is over $20,000. All of these types of expenses are going to have to be financed. The most important component is to borrow only what you need and try to have some of the funds saved or in the case of college obtain scholarships or have work/study that offsets some of the cost.
The last category is major purchases, what is included here?
Major purchases are those expenses that are over $1,000 and include furniture, electronics, and vacations. All items that are usually discretionary in nature although there can be a few required purchases like car repairs or a new water heater.
Some of these expenses are emergency fund expenses, what about the rest?
Yes, car repairs or water heater purchases should come from your emergency fund, the rest should be paid with funds from savings for these types of purchases. Using credit for furniture or vacation is a very poor choice financially because the interest expense is typically very high on these types of purchases.
Is there a general rule to follow when spending?
It is always good to think in terms of appreciating or depreciating assets. Try to pay for cash for depreciating purchases like vacations, furniture and finance appreciating assets like a home or college education. The one exception, the auto, simply because the cost of new auto is extremely high.