If you are looking for ways to improve your finances in the new year, the Internet is full of recommendations for setting a budget, cutting out that coffee run, and other tips for nickel and diming your way to financial freedom.
While these all sound like great advice, the truth is that if you focus your efforts on housing, transportation, and “other expenses” such as insurance, which account for more than half of average household spending, you will not need to sweat the small stuff. The thousands you save in the long run will by far make up for the little splurges you have throughout the year. (That’s not to say that you should splurge every day – a cumulative small expense can quickly become a big expense. But, an extra $10, $20, or even $50 here or there does not matter in the grand scheme of things.)
Housing: when renting makes more sense than buying. If 2016 is your year to swap out your monthly rent for a mortgage, realize it is not an even trade. Included in your rent check is the luxury of having a landlord who will replace the broken water heater, fix faulty appliances, and maintain the exterior of your home. If you allocate the same monthly fee to your mortgage, understand that you will need extra funds to take care of all of these things yourself. Aside from home maintenance, there’s homeowners insurance, property taxes, and related costs like possibly commuting from a further distance. It is easy to fall in love with the perfect dream house – just make sure you have considered how these extras affect your bottom line.
Also consider the transaction costs of buying and selling a home – the commission you pay to the real estate agents, plus the various fees, taxes, and dizzying array of other closing costs. These can easily add up to tens of thousands of dollars every time you buy and sell your home. Buying a home for the long run distributes these costs over time and makes home ownership more sensible, but if you think you will move again in the “near” future (within, say, 5 years or so), you are probably better off continuing to rent instead of paying these steep transaction costs multiple times.
Transportation: be practical when buying a car. First, ask yourself if you really need a car. You may get by with a combination of mass transportation, car sharing, biking, and walking – alternatives that are clearly working for a growing number of Americans. If you still decide to purchase a car, you will need to decide on what particular make and model of a car that you want, as well as if you want to buy it new, used, or lease it.
To keep things straight, focus on apples to apples comparisons. Do not, for example, look at a used car as a necessarily cheaper alternative to the new car version of the same model. Though the used car has a lower purchase price, it also will have higher maintenance costs and will not last as long. Leases can be even more deceptive because they appear to give you the chance to “buy” a new car at a much lower upfront cost than buying it outright. Lease agreements, however, can be notoriously complicated and expose you to many unexpected costs.
My personal preference is to purchase a new, moderately priced, high-quality car I can keep for many years. This strategy appears to offer the lowest annual combination of maintenance costs, taxes, insurance payments, and fees. It also minimizes the number of times in your life that you have to go through the hassle of buying a car (watch the car buying scene in the movie Fargo for a classic example of this experience).
If you have to borrow money to buy the car, then separate the search for the best purchase price from the search for the best financing deal, as this will make comparison shopping much easier (if the dealer is offering subsidized financing, then use this as negotiating leverage to lower the purchase price in lieu of the subsidized financing). And, just as with the car purchase decision, be sure to do an apples-to-apples comparison of financing offers (e.g., do not be misled into thinking that the lower monthly payment on a five-year loan is necessarily cheaper than the higher monthly payment on a four-year loan).
Insurance: don't overinsure or underinsure. “Would you like to buy insurance on that purchase?” This question seems to accompany virtually everything we buy, and it can appear to be incomprehensively difficult to decide when to buy the insurance and when to decline it. The good news is that there is a simple rule to follow when buying insurance on anything: Do not buy it unless the loss of it would be catastrophic.
Luckily, the list of truly catastrophic losses for many people can be blissfully short: your health, your ability to work, your home, and general lawsuit liability (usually associated with your car). Be sure that you are adequately insured against these losses.
But what about life insurance? Well, if you have loved ones who are financially dependent on you, then you absolutely should buy enough term life insurance—avoid whole life insurance—to replace the funds they depend on for the length of time they will need them. But if you do not have financially dependent loved ones, then you do not need it (one exception can be for people who expect to have financially dependent loved ones in the future and want to avoid the risk of not being able to get the life insurance in the future due to health problems).
As for everything else, such as your computer, television, phone, vacation trips, etc., skip the (likely overpriced) insurance policies and self-insure whenever possible. It can be a daunting goal, but if you can save enough in a cash fund to repair or replace these items if they break or are destroyed, you can pocket those high insurance premiums. On the other hand, until you have the means to self-insure, do not eliminate your insurance coverages if not having them would cause you financial hardship (though if you have to buy an insurance policy to replace or repair a consumer product, then that may indicate that the item is an overly extravagant purchase).
If you make smart decisions about these big expenses, you will have the freedom to indulge in the small things. It is time consuming – and unhealthy – to be hyper focused on a monthly budget. Instead, focus your energy on getting the big things right and then treat yourself to a Grande Caffe Latte.
Allan Eberhart is a professor of finance at Georgetown University’s McDonough School of Business who specializes in personal wealth management. He also is the director of the school’s Master of Science in Finance program.
