Why are some people always strapped for cash while others have money in the bank and are maxing out their retirement investments? It's not just about how much money they earn; it's also about the spending decisions they make.
As a financial counselor and former caseworker who assisted families in financial crisis, I've seen all kinds of poor financial decision making. After assisting hundreds of families, I can share the top four decisions families made that led to financial crisis. Learn from their mistakes and avoid their financial woes.
1. Taking out a new car loan
If you live in an area without public transportation, you may need a car to get around. However, you don't need a brand-new car. One of the biggest money mistakes I saw families make was getting saddled with a large loan for a new vehicle.
Many financial advisors recommend that you spend no more than 20% of your income on transportation costs. Most clients in crisis I assisted had auto loans for new vehicles, and usually their auto payments were over $400 per month. By the time the client paid the auto loan, insurance, and gas, the total cost for the vehicle often exceeded 50% of their monthly income.
It's no wonder that it didn't take long for those clients to fall behind on auto or rent payments or start running up large credit card balances to make ends meet. Unfortunately, by then they were so upside-down on their auto loans that they couldn't get rid of the car without ending up with no vehicle and still owing thousands of dollars on the loan.
Don't succumb to pressure from auto dealers or the Joneses down the street. Keep your total auto expenses limited to 20% or less of your income, even if that means picking a modest used car. Be happy with the knowledge that your neighbor's fancy SUV is depreciating by the minute, and the extra funds you saved when purchasing your used car are accruing nicely in your retirement account.
2. Funding your lifestyle with credit
Another common problem I saw as a caseworker was families drowning in debt. Frequently, families had thousands (or tens of thousands) of dollars in credit card debt. Many families also had furniture payments or payment plans for electronics or appliances.
When I asked clients what they had purchased with the credit card, they often had no definite answer. The credit card statements we reviewed revealed that they were funding their lifestyle on credit. The charges usually included restaurant bills, movie tickets and other entertainment purchases, or charges for shopping trips. These families were living beyond their means, and the interest payments were costing them big-time.
When we talked about the new furniture, electronics, or appliances purchased on credit, clients said they needed these items. When I asked whether they had considered purchasing these items used or waiting until they had savings or more income, most said they hadn't.
Remember that your home doesn't have to look like something from HGTV -- at least not until you have the money on hand to make it TV-worthy. Look for used items, raid your parents' attic, or just live with an empty room for a while. Most people can't afford to furnish an entire home all at once. Save up and add furniture and decor when you can afford it.
Credit cards are convenient, but they shouldn't be used to fund your lifestyle. If you realize you don't have much to show for that large credit card balance and you can't pay it off in full each month, consider using cash. Studies show that you spend less when you have to hand over cold hard cash at the register. If you don't have the cash, stay out of restaurants and the mall.
3. Not having any savings
All the families I assisted had one thing in common: They had no emergency savings to cover unexpected expenses. Frequently, the grants provided to families I worked with were as low as $150 to pay an electric bill. Even an expense of $150 was enough to cause a financial crisis for these families -- and they're far from being alone. According to a recent Bankrate survey, only 41% of Americans have savings to pay for an emergency expense.
For many families, an emergency expense causes even more debt. If an electric bill goes unpaid and the power is disconnected, late charges and reconnect fees are added to the original bill. A family with no savings may resort to using credit cards to pay the bill. Others use payday loans or auto title lenders, which can be financially ruinous. The interest charges for credit card balances or other quick cash lenders lead to even more debt.
The solution? Make establishing an emergency fund an immediate priority. Start by saving $500 as quickly as you can, and then keep saving until you have four to six months' worth of living expenses saved.
4. Not using a spending plan
Each family that requested assistance had to develop an income and expense statement for the month. When I would review these statements, some expenses were very precise, like that large $466 auto payment and the accompanying $152 for auto insurance. Families could also identify the amounts they paid for rent, utility bills, and regular consumer loan payments.
However, most families had little idea what they spent in other categories, and that was the problem that led to financial crisis. A family of six submitting food expenses of $100 for the month always sent up a red flag. When we would review bank and credit card statements to make the expenses more precise, we would frequently find that the client's actual spending would be two or three times more than what the client thought they were spending.
It's important to keep track of expenses and categorize spending. You may be surprised at how much you spend dining out or how much you actually spend each month on music or game purchases. These budget leaks can add up to hundreds of bucks each month, which could instead be funding your emergency fund or retirement savings account.
The financial decisions we make can make the difference between comfort and crisis. Start by developing a spending plan and living within your means. This may mean holding off on new vehicle or furniture purchases, but the older stuff can work just as well without breaking your budget. Build up savings so that when the unexpected happens, you're prepared to cover it.