2 Things You Must Know Before Making a Major Spending Decision
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?