Do You Understand Your Tradeoffs?

No one is without limits. We don’t have an unlimited supply of money, time or any other resource. Some are lucky enough to have a lot of money, time and other stuff, but even they have to make choices. Life is a series of tradeoffs. We give up something to get another.

The problem is that tradeoffs are not always obvious. In our world, where we generally have plenty, we may feel like we really aren’t giving anything up with our choices. Really, what are we giving up when we decide, on the spur of the moment, to go out for lunch? Or will an extra $20 per month to get the latest iPhone with our cell phone plan make any difference? In isolation, no they won’t. Just like that doughnut, on its own, won’t make us gain weight. But if we don’t have a plan, our spending, like calories, adds up, and before long our remaining choices are very limited.

As part of my research for my book, I’ve been talking with people about their financial decisions and how they think about money. One thing that I’ve heard often is “I don’t like to think about money”. Folks seem to be reasonably comfortable as long as they can pay their bills each month. They may be a little concerned if they aren’t saving for their kids college or they haven’t set much aside for retirement. But they figure those issues will sort themselves out. Unfortunately, without a plan, these things do sort themselves out. Only it’s in a way that paints you into a corner.

I was recently talking with a young couple who were very frustrated with their finances. They felt, between the two of them, they made decent money. Yet they couldn’t manage to save for a down payment on a house. Every month was a juggling act to pay the bills and avoid adding to their debt load. Over the years they had accumulated a good chunk of debt in just this way – by spending just a bit more than they brought home. While they tracked their spending, they didn’t have a plan for it.

By now, their debt payments represented a large part of their monthly spending. This kind of spending isn’t flexible. You can’t choose to not pay it, so as debt builds it crowds out other uses for your money. In this case, it was crowding out their ability to save for a house. It was time to make some tradeoffs. In order to save for a down payment, they needed to create some flexibility in their monthly spending. They needed to reduce their debt.

If they could make extra payments on their debt, they could quickly bring down the principle that they owed. Bringing down the principle reduces the interest, and together the two shorten the time it takes to pay off a loan. If they focused on making extra payments on one loan, it could be paid off in short order. Then the money they were paying on that loan, both the required monthly payment and the extra payment, could be put toward the next loan for an even bigger impact on the balance. Before long, they could be out of debt.

But how could they make extra payments if they were barely squeaking by as it was? Because they didn’t have a plan for their spending, they didn’t understand the tradeoffs they were already making. For example, they had the premium cable package, and they ate out several times per month. There were other areas where they could reduce spending without too much pain as well. They didn’t understand that they were trading watching sports broadcast live for saving for a down payment on a house. Or that eating out, as much fun as it is, was keeping them on the financial edge. If they wanted to achieve their dream of owning their own home, they had to reduce their spending, and their only choice was where to do it.

Now, there was no reason they had to get rid of cable or stop going out to eat all together. Nor did they have to cut back permanently.  If they could give up those premium cable channels and eat out less often for just a couple of years, the debt could be eliminated. By making a plan for how they would spend their money, they could raise enough to make extra payments on their debt, and once that was gone, the money they were using to make debt payments could go to raising a down payment for a house. With the debt gone, they would once again have choices.

When you understand the tradeoffs you are making, you are better able to make the decisions that allow you to meet your goals. Once you start looking at tradeoffs, its hard to ignore them. I’m confident that our couple will be better able to plan their spending and make the tradeoffs that are best for them for the rest of their lives if they can make these changes now.

Image courtesy of krishna arts at FreeDigitalPhotos.net

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