2 Things You Must Know Before Making a Major Spending Decision

by Keith Whelan on 1 November 2013 5 comments

Most would agree that successfully managing your finances is near the top of the list of important things to do in life. In fact, for most Americans only two other things, family and health, are more important. But how do you define success? (See also: Defining What Financial Success Means to You)

Without a clear and measurable definition of financial success, like Alice in Wonderland you risk falling through the looking glass and losing your way. Or as George Harrison paraphrased the book's author: "If you don't know where you're going, any road will take you there."

So, what should your financial goal be? And what's the best road to get you there?

Financial Independence, Not Wealth, Is the Goal

It's best to start with the goal and work backwards, so let's begin there.

Most personal finance advice focuses almost exclusively on only one thing: increasing your wealth, or net worth. But what good is wealth if it doesn't pay the bills? Yes, you want to accumulate wealth, but some sources of wealth actually increase debt and drain your monthly income.

It's that monthly income that pays the bills, and if you have enough of it from sources other than salary, you will be… financially independent. That is the goal: financial independence; and it's measured by cash flow. Wealth does play an important role, but it's a supporting role. You want to accumulate the types of wealth that generate cash flow, and avoid or minimize those that don't. (See also: How Cash Flow Allocation Helps You Retire)

The Two Rules of the Road You Must Follow

OK, we've defined the destination. That's half the battle. Now, what's the best road to get you there?

There are actually many roads — many ways — to achieve financial independence. The key to success is to avoid the detours and dead ends that can delay your trip. To help you avoid the wrong roads and make more positive choices, you just need to follow two rules of the road. Before making any important investment or major spending decision, ask yourself two questions.

1. Will This Item Appreciate, or Grow in Value?

Appreciation is the "wealth" question. Does the asset increase or decrease in value over time?

2. Will It Generate Positive or Negative Cash Flow?

The other question is, of course, the cash flow question. Will I spend more on the purchase than the income it generates?

You need to consider the impacts on both your wealth and your cash flow to make a fully informed purchase decision.

Where the Rubber Meets the Road

Here's where the rules actually help you make decisions. Just asking these two questions will allow you to prioritize every investment.

  • Best: It BOTH appreciates AND generates cash flow (rental properties, stocks that pay dividends, business ownership).

  • 2nd Best: It EITHER appreciates OR generates cash flow but not both (savings accounts, CDs, bonds, a primary home).

  • Worst: It NEITHER appreciates NOR generates cash flow (cars, boats, furniture).

Your strategy? Avoid, or at least minimize, the "Worst" investment decisions. Also, keep the "2nd Best" items in check. And, when possible, take advantage of opportunities to invest in "Best" items.

Cars Are Among the Worst

For example, a car purchase slows your progress on the path to financial independence because it's money spent on something that loses value and creates a negative cash flow in the form of a monthly loan or lease payment. Still, most people need a car. That's fair, but don't buy a costly one. Pay it off quickly to eliminate the negative cash flow; that will free up money you can use to pay off other debts (which frees up more cash flow), or to make a "Best" investment. (See also: Guide to Buying a Used Car)

A House Is 2nd Best

Another example, this time from the "2nd Best" category, is a house.

On the surface you might think a house is a good investment. In fact, a primary residence often accounts for the majority of a household's wealth, and over the long term it even appreciates in value. But that's looking at it in terms of wealth only. What about cash flow? Truth is, a house can be a real cash flow killer, suffocating your ability to pay off other debts or to make "Best" investments… especially if you buy a house that's too big, or if you keep pouring cash into repairs or improvements. (See also: 9 Costly Things New Homeowners Don’t Prep For)

So a poor house purchase decision can slow your progress to a crawl on the financial freedom highway.

What about a rental property? That's a different story, for if you make a good multifamily purchase it could appreciate in value and also generate positive cash flow. You win on both measures, and the additional cash flow will supplement your traditional retirement savings sources.

When You Come to a Fork in the Road…

Spending money involves making choices. In fact, the first choice is to spend or not to spend. Every decision has consequences, both in terms of wealth creation and cash flow gains or losses.

It's the negative impacts that pose the greatest threat, because they carry an opportunity cost —  a lost opportunity to grow your wealth or improve your cash flow. Even small everyday purchases trickle away cash flow and, taken together, they can add up to an annoying negative income stream. But the big purchases, like a car or a home, are the ones to really watch out for. Poor decisions on these big items can create large, ongoing negative cash flows.

So when making an important investment decision keep your destination —  financial independence — in mind. If you follow the rules of the road and consider the impacts to both your wealth accumulation and to your cash flow, you're bound to avoid the detours and arrive at your destination years ahead of schedule.

What rules do you rely on to help guide your spending decisions?

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Guest's picture

When you consider "does it generate cash flow" do you always consider this as a stand-alone.

For example, say you rent for $1000 a month.
Then, you buy a house, where on the mortgage you pay $500 per month in interest and $300 per month in capital repayment.

Therefore, the house will appreciate in value, and its relative cash flow (compared to the alternatives) is positive. Does this still only fall in the second category?

Guest's picture
Keith

Good question. They key issue is whether the asset can generate positive cash flow, if not now then in the future. An apartment can't, and neither can a single family home that you live in because even after paying off the mortgage there are monthly negative cash flows in the form of real estate taxes and homeowners insurance.

A rental property has the POTENTIAL to generate positive cash flow. In some rare instances a multi-family can generate positive cash flow from rents, even with a mortgage, but much more often you need to pay off the mortgage to get to positive cash flow. And some properties still can't get there even after paying off the mortgage, so it all depends on doing the numbers in advance to select a property that will "work."

Guest's picture

An interesting article, but I disagree with its argumentation. You cannot equate "good" with buying assets and "bad" with discretionary spending. Both types of expenditure are required in order to lead a fulfilled and happy life. In addition, you also consider a house as an asset, which is an assumption that does not correspond with reality. Houses often go down in price if the area loses attractiveness or population. A well-written article, but I do not share its views.

Guest's picture
Keith

Thanks for your feedback Josh. I agree that all types of expenditures are necessary.

Keep in mind that these classifications are intended to help with evaluating the consequences of major spending decisions...the big ones that have greatest impact on your ability to get ahead financially. In particular they can be used to avoid making a major expenditure mistake - one that creates a large ongoing negative cash flow. Because that prevents you from having the cash to pay down other debts quickly or to make investments that move you closer to financial independence.

I also agree that a house can depreciate. We've seen that during the current recession. Over the long run homes do tend to appreciate, and in general stocks also tend to increase in value but there are no guarantees. These categories provide initial direction and a way to prioritize opportunities generally. When you are making a decision on a specific major expenditure it's then important to run the numbers in advance - in particular the cash flow projections. For even if the asset doesn't appreciate or fluctuates in value over a period of time, if it generates positive cash flow you're increasing your financial independence.

Guest's picture

The decision between saving and spending is a major one.Should one spend on a home paying off most of the salary for the EMI at the cost of contingency funds needed for a medical emergency .Should one purchase a car which is a luxury rather than a necessity?Financial planning calls for these major decisions to be made.