An interesting discussion at Five Cent Nickel (courtesy of a post by Matt Jabs), my most recent post on Untemplater, and a couple of comments around the personal finance space have all had a common thread lately–dealing appropriately and responsibly with future income.
It’s not a topic that’s thought about often, because we are naturally trained to believe that the status quo will continue or things will get better. No one wants to think the opposite.
Two Approaches
There are basically two ways you can deal with income. Which one you choose determines a good chunk of your financial life.
- Relying on future income for today’s purchases. This usually means buying on some sort of credit, either through loans or credit cards, and usually without the financial emergency backbone to react if income falls or disappears.
- Relying on past income for today’s purchases. This means saving for purchases before they are made, usually paying cash or a cash equivalent, or utilizing effective debt methods (0% financing, etc.) with the savings to back them up.
Let’s examine some of the perspectives that come into play when evaluating these two side by side.
Necessity vs. Options
There’s a big difference in planning for future income and relying on it. The latter assumes, perhaps incorrectly, that future income levels will be the same or higher than today’s levels.
That’s a pretty gutsy assumption in any kind of economic environment, but especially during the current one. With so many jobs on the line, many people can lose work unexpectedly. By definition, they never saw it coming.
TC questioned this philosophy on Untemplater by asking how to deal with a car loan and massive student debt while not relying on future income. TC’s debt repayment plan assumed increasing income over the next few years to be successful.
I think that’s a good example of preparing for the worst and planning for the best, and of how planning is different from “relying on.” If TC’s income falls at any time during the next few years, his aggressive debt repayment plan may suffer, but he shouldn’t fall behind on anything as a result.
The same goes for income goals or any other forward-thinking income projection that will motivate you to do more and do it better. None of that hurts you, until you apply that future reality to your current spending.
A Faulty Argument
DL’s comment on Five Cent Nickel brings up the argument that some people may see true value in financing something because of the time factor–getting to enjoy it sooner.
But the argument that paying a little bit “extra” is worth having something sooner doesn’t consider whether you’ll have the income to support that purchase in the future. DL correctly points out that an emergency fund would have to be increased to cover these additional payments.
This is a common pitfall of people who fall into the debt trap–thinking that we need things “now” and that everything is an “emergency,” as well as a big desire for things we want to have. Meanwhile, all it takes it a few years, or sometimes even months, to get ahead of the curve and live off past income.
Time-Value Argument
There is one glaring instance where what seems like a good approach falls apart. And I don’t think buying a TV on store credit is one of those instances…
The time-value-of-money viewpoint looks at the risks of financing something versus the benefits it provides. Perhaps the best example of this is financing education.
In many cases, it would be unpractical and even unwise to save enough money to finance your higher education–an education that by its very nature promises to increase your earning power, and ability to enter the very career or field that is supposed to provide your income.
The time-value approach might indicate that it could take, let’s say, 5 years to save for college while working a low-end job after high school. By financing college, that repayment period will decrease due to increased income.
Are you still taking a risk? Of course. As many current graduates are quickly finding out, their assumptions about future income are proving to be false as the floor fell out of their job market. And the reality is, many college graduates are consolidating loans and spreading repayment over 10-20 year periods.
Is that risk worth re-considering your plans? Well, do you want to wait 10-20 years to go to college? It’s sort of a catch-22 situation, but ultimately a balance and a decision has to be made based on your personal situation.
A Better Way
The argument about college (or home purchases, or any other big-ticket items) aside, there is a better way to approach your everyday spending. You can buy into the future, or you can choose to buy into the past. The principle is simple:
Unless the time-value argument holds true, make purchasing decisions with money that’s already earned.
It’s All About Perspective
This is one of those never-ending questions in personal finance, because it all depends on how you look at it. It is not always a financial decision–the numbers may be so close for either alternative that it’s a wash. But more often than not, the psychological effects of spending ahead (stress, worry, anger, etc.) are worse.
I want to hear your perspective. How do you deal with future income? What are your mistakes of the past? What would you suggest to the younger generation considering college costs and shaky job prospects?
Photo by Refracted Moments
Fiscal Fizzle 
We are definitely in the “rely on past income for today” camp. We have had inconsistent commission-based income and whenever we knew a good-sized check was possible, we would start planning what to do with the money. But we would never spend it until the cash was physically in our account.
Regarding the “time value of money issue”, I think there are only 2 possible scenarios where it makes sense to take on some debt:
1) purchasing a home
2) paying for higher education
As you said, a lot will depend on your particular situation. But the best course of action might be a balance where instead of working for 5 years to save for your entire education, you work for 2 or 3 and finance the rest. It depends on your own comfort level, the type of job you can get now, the type of income you can expect in your chosen field, and the job market upon graduation.
With regard to taking on a mortgage, it’s important to buy a home that you can comfortably afford. Again, maybe wait a year or 2 and save up a larger down payment. Contingency plans are a must as well. What will you do if things don’t quite go as you planned?
Sorry for the lengthy comment, but this post really made me think!
.-= 2 Cents´s last post: Book Review: All Your Worth =-.
That’s very true–most people opt for the balanced approach (whether they work through it or have their parents help out), and finance the rest. Both my wife and I are in that camp.
I agree on the home point, even though it’s as big (or an even bigger) gamble than student loans, because you’re literally talking about the roof over your head. A responsible home purchase with adequate emergency savings is really important.
Glad to have made you think! Don’t ever hesitate to write as much as you want. 🙂
This is a winner! Me thinks it needs to go on the side bar o’ stellar posts.
What strikes me about the time-value approach is how many studies have demonstrated that folks who have the ability to delay gratification end up far more successful in life. The “I want it NOW!” debt-incurring idiocy (yeah, I said it) is the playground of folks who just don’t do as well in life–across the board (finances, personal relationships, etc.)– as their “I’ll save for it” peers. That knowledge alone has stopped me more than once from making an absurd purchase on debt (why do we keep calling it credit?).
I’m with 2 cents above–home and education. Lots of folks, myself included, place automobiles in the same category by taking out loans. Miiiistaaaake! Won’t be making that blunder again.
.-= ConsciouslyFrugal´s last post: Tuesday’s Tip: Free Birthday Goodies =-.
Ditto on the car thing. When I was in my late teens and very ecstatic about having bought my first car, a very wise 40-something guy told me “A car is a hole in your pocket.” I didn’t really get it until a decade or so later, but he was so right!
.-= 2 Cents´s last post: Book Review: All Your Worth =-.
You bring up awesome points about delayed gratification, and I hope you’ve seen the famous “marshmallow experiment” with little kids!
Cars are definitely a really large purchase, but I think it’s a reachable goal for many just by waiting and saving a few years (getting “ahead of the curve,” so to speak).
Of course the main point of my FCN post was missed because I happened to bring up education as an example… but with the exception of really high paying careers that take enormous amounts of schooling, a lot of degrees can be paid for with saved money and/or money that is earned while in school.
I only wish I would have had this perspective when I was in college… now I have 10 years experience in a career that college prepared me very little for. I would have been MUCH better off simply starting off in the industry and working my way up.
I suppose it is worth mentioning that students SHOULD NOT go to college unless they know PRECISELY what they want to learn while there… otherwise I’m afraid your risk of wasting your education dollars increases greatly.
.-= Matt Jabs´s last post: When Does Compound Interest Kick-in? =-.
I can’t agree with your last assertion, Matt. I don’t know one single soul who is actually using their undergraduate degree at this point in time, but not one of us could have landed the gigs we have without that coveted piece of paper, even though our degrees had absolutely nothing to do with the careers we’ve built.
Also, I’ve hired and managed many folks over the years and have had battles more than once with HR, because I wanted to hire someone without a college degree who had ample experience in the field. Over and over I found myself turning away qualified folks, because HR policies would not allow us to hire people without a college degree (yes, even when we advertised positions with the caveat that experience could substitute for a lack o’ degree). This has happened at more than one company, and I doubt it is terribly uncommon.
I would suggest that folks get a degree in virtually anything (unless you are going into a particular vocation that requires a specialized degree at the undergraduate level), find a field they’re interested in and enter at the highest level possible. Jumping from one major to another, if it results in adding an extra year or two of tuition, isn’t a smart move, but there’s no need to know precisely what you want to study.
Interesting point–I would tend to agree that a diploma opens a lot of doors, and not only in your chosen field. But I also second Matt’s point that a diploma is reachable with savings, especially if you take advantage of state and local schools.
As an aside, I am in the exact career that college prepared me for (architecture), and I can tell you that it prepared me very little. So that tells me that even knowing exactly what I wanted to do didn’t help. Not to mention that a diploma is a legal requirement in the US to practice…
All really interesting points to ponder!
Oh, I also agree that you can afford school with savings if you’re not going Ivy. Lord knows you could when I went–the state school was only $65 per credit hour! (No, I’m not that old.) Someday, I’ll find a way to explain why I have student loan debt. *cough*stupidity*cough*
I’m in the ‘rely on the past’ camp. My wife and I have used the “pay cash only” method before. If we can’t pay cash, we don’t buy it. In today’s job market, this strategy is EVEN MORE NECESSARY. Good post.
.-= Ken´s last post: Making Retirement Days Your Best Days =-.
Today’s job market is probably THE most important reason for this approach. Even people with steady jobs and no warning of any change are being laid off to save companies a few salary dollars.
For my wife and I this was the key idea that turned our finances around, we had always banked on future income. Not in a large way even, just a small one, next months paychecks pay off this months bills on the credit card (except rent, even with that craziness we had limits!), it was a very stressful prospect, we worried about “what if’s” more than we should have, it took up a lot of emotional space and made us make some wacky financial decisions.
Just flipping that around, going lean for a few months so we could always live on past income changed everything, loads less stress, a lot less hang ups and it sort of kicked off a series of wiser financial decisions.
We lapsed on Christmas this year and when there was a brief moving around of how I was paid it brought all that stress and crazy back in! I can’t believe we used to live like that all the time.
I think a good rule of thumb for taking on things like student loans and homes and such that are extremely difficult to pay from the past is to ask yourself what paying those things off would look like from your “zero” the reasonable worst-case estimation of where you’d be if it falls through for a while. When we had to take a small loan out for a car, it wasn’t based on our finances now, we based it on what would happen if we had to move in with a friend or relative and work a low hourly wage again. It helped keep our spending in check and kept us with a reasonable car payment.
Kevin,
The baseline approach you’re talking about it really good–it’s an exercise that we often go through by re-working out current budget to reflect the worst-case scenario (protecting) as well as a goal scenario (planning).
It also helps to play with income shifts (what happens if income goes down 10%, up 10%, etc.>?)