We all know that there are different personality types out there when it comes to money. Some of us enjoy personal finance, others are bored to tears by it. Some of us are savers, others are spenders. For that latter group, there are even bigger risks than might meet the eye!
What I mean is that when it comes to making smart purchasing decisions than simply controlling expenses. Sure, we should make sure that income exceeds expenses, and that the more we save for retirement and old age, the better off we will be. But if we want to increase net worth, it’s important to think about how time and spending can be interrelated.
To illustrate this, let’s use an example of a hard working, responsible person out there. Let’s assume this person makes $75,000 per year and saves $15,000 after all expenses, including taxes. Saving 20% of gross income, not bad!
Let’s say she then wanted take a mini-vacation with friends, and spend $1,000. No big deal? Well, I think the impact of spending extra money might be greater than this person might realize.
Keeping in mind the income and savings of this person, let’s look at 3 things to consider before spending money.
The Time Value of Money
By this, let’s first consider the notion that a dollar today is worth more than a dollar tomorrow. Due to inflation, the purchasing power of a given amount of money will go down over time. Remember when a $1 could buy more than a gallon of gas? Maybe I’m getting old, but I distinctly recall paying 89 cents per gallon back in the 1990’s. I still remember the sign outside that gas station.
What would that 89 cents buy today? As of this writing, less than 25% of a gallon of gas. It’s not just gas that’s gone up, as we know. Food, education, clothing – you name it, it’s gone up in price. The cost of living increases over time.
Rather than spending the money, what if we saved it instead? We could actually keep pace with inflation, or if we invest well, actually see our money increase! Unquestionably, rate of return matters.
Back to the person we brought up earlier. If she saved that $100 instead of spending it, and invested it well, it could be worth more in the future. Let’s say she invests it and earns a rate of return that’s 4% more than inflation, after taxes. After 20 years, that $1,000 would be worth over $2,000 in today’s purchasing power.
Thus, spending $1,000 might really be like spending $2,000.
Hours Worked to Afford It
One of the things we can think about it is the hours worked to afford a purchase. We’ve talked about this before, and we can revisit the concept with this example.
We already said this woman earned $75,000 per year. If we assume a standard 2000 hours of work annually, that comes out to $37.50 per hour. Let’s say that after taxes, this comes out to $25.00 per hour. In this situation, that $1000 mini-vacation with friends ended up costing 40 hours of work. That’s one entire week at work, just for a vacation!
Hourly Savings Rate
Back to our friend and her vacation. If we go beyond how long she had to work for this, let’s consider that what she really had available to spend was her savings. Meaning, after all of her expenses, she had that $15,000 of savings we alluded to earlier. That $1000 mini-vacation ended up being 1/15 of year annual savings!
She would have to work almost 3.5 weeks to earn $1,000 in savings! Just imagine if she only saved $3,000 per year instead. That would be 4 months of work to save that $1,000 she wanted to spend on a vacation!
Bottom Line – when spending money on purely discretionary purchases, let’s keep in mind how hard we really have to work for it and what it can become if we invested it instead. That doesn’t mean we shouldn’t ever splurge of course, but it’s important to think of the real value of our money and our time.
My Questions for You
Do you ever think about these factors when making bigger or discretionary purchases?
Which of the three factors makes the biggest impression on you?
For me it is the time-value of money definitely. I’m always wary of recurring expenses, might seem small, but they tend to add up. Cut cable and put it towards your mortgage and you cut a few years and bucket load of money on your mortgage. When you do the math, it is almost magical!
It really can be eye-opening when the math is done, I agree.
Not really a dollar to me but it gas cost way way lesser than what it is today. And while the price of daily commodities skyrockets, the salary seems to be crawling. That’s why we need to adjust and take care of our moeny well.
Always good to take good care of our money, and not take it for granted.
Some good points made by everyone here, i’d say we need to learn how to respect money a bit more, and i’m guilty of it more than anyone. A lot of places now have a salary freeze, but whilst the cost of goods and services increases it just means we’re getting poorer and poorer. Something definately needs to be done.
Good points, with no salary increases we are certainly not getting richer!
I always like to think about how long it took me to earn that item. Is working for 2 hours worth it for this dress?
Michelle – in most cases, probably not when it comes to clothes! Especially when thinking about the hourly savings rate, and how much of what would otherwise be savings is being spent.
I have to admit, I don’t think about these factors. One thing though: I think you need also to take into account the rising cost of whatever it is you’re not buying today and deciding to save the cost instead. If you’re going to buy that thing or experience sooner or later, it’ll likely cost more later. So that price rise will offset some or all of the growth in the money you saved by not buying it earlier. Does that make sense?
Kurt – I get what you’re saying. Not buying something today could come back to get you later when you ultimately buy it anyway. What I’m referring to would be more along the lines of incremental purchases. For those, where you wouldn’t buy it anyway, the costs can really add up in many ways!
I find myself doing at least one these things all the time when we’re spending money. Now that we run our own business I know exactly what it’ll take to make that money back. I remember when gas was that cheap in the 90’s, what I would spend to put gas in my car then would only get me a few gallons today. 😉
John – I can see how running your own business could help with the understanding of what it takes to make the money that was spent. And yes, what we spent back then wouldn’t go far today in terms of gas. Even factoring inflation into the picture, we’re still spending a lot these days.
One thing I would add to this list is the opportunity cost… If I make this purchase what am I going to miss out on?
Agreed. My post prior to this illustrated a good (I think) example of this, where someone could get a whole lot of other options in lieu of paying nearly $6 for 8 oz of juice.
You basically hit the nail on the head with these examples. One will usually spend their money differently if they had to earn it compared to if it was given to them. This is something that parents should instill in their children very early on in life. Long story short, you are doing your children no favors if you are always giving them high dollar items without making them work for it. They will carry that over into adulthood when they leave the house.
Good point Zimmy, and one that I hope to work on as a parent. We all need to prepare the next generation to be able to survive, not just get luxuries at any time automatically, since that’s not how the real world works.
I remember when gas (or petrol here in the UK) was so cheap in comparison to today. Then all the strikes happened, noone could get into their gas station and it was an absolute nightmare. This was an example of how people are sturggling to cope with these economic imbalances.
Sure is more expensive here in the US as well.
I’ve really grown to like the idea of associating a purchase with hours worked. When I was younger and making minimum wage I used to figure out how many hours it would take to buy that really nice sweater I wanted. Instead I guess I should have been thinking I just spent x number of hours of my life to buy that sweater (which I no longer wore after about 1 year). These are great examples, thanks for the sharing.
When you think about how long it took to save that money used to buy a sweater, it makes it even more eye-opening! Thanks for stopping by.
Time value of money, absolutely agree with.
In terms of the “how long to afford it” rationale, I think it makes more sense to look at how long will the enjoyment last or what memories can be made? Let’s say on that vacation, someone got married and she was there to witness the proposal (or some other amazingly important life event). I say the return on that money far outweighs the cost or time it took to make.
For me, time value of money. I once had someone tell me that if you save .50 cents when deciding not to buy a sode and invest it. It would turn into some big chuck of money when I retired. That always stuck with me and it helps me make smart money decisions occassionally.
I also like to think about how long it takes me to earn what I want to buy. I find it gives me a good way to compare different things I want to buy and keep a handle on my finances.