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.
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.
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