Monday, April 19, 2010

Luxury Threshold: When to Spend and When to Save

People are always wondering how to become more frugal. But people think it is easy to suddenly cut back to a lifestyle of living below the margins. No, it is not easy in some cases. Especially when it comes to vices. But nonetheless, I will set up a plan for those who are trying to save up their first couple of grand and set up a plan for those who are already there but would like to sock away more cash.

Now there is a lot that can be said about wanting to take control of your finances. There is often good and bad advice about managing debt. First off, there is no magic bullet, cure-all, fix-all program. If you are leveraged up to your eyeballs in debt, it would  probably be a good idea to see a professional financial counselor who is FINRA certified or see a CPA that works on debt management. You can obtain some pertainent information, but you will seriously need someone that will legally be on "your side" and knows loop holes in the mortgage/taxation system(s).

For the rest of you, I present my luxury calculator. I should probably patent this formula, but it is probably worthless anyways. Here is how I calculate luxury ratio.

I take my cost of item/total liquid assets on hand. Just to simplify things we will use a $10 item and divide it by $15000. Here the total is .0006667... The rule of them to all luxury is one type of luxury per month. So in order to meet that luxury threshold I just set a random percentile. I will use .0075 since I have strict standards. People can set the numbers to whatever percentile they choose, but try not  to go past .05 mainly because when starting out it becomes a burden to recoup losses so you want to get into the habit of saving money. Starting out I did .10 or 10% of my overall balance until I was able to build it up and then the amount naturally becomes smaller. The smaller the number, the more freedom you have to make purchases on stuff you do not  need. Remember, you need to take into account your liabilites as well. And yes, mortgages are liabilites.

Going back to the .0006667, another thing that needs to be accounted for is that when you spend money, this number will compund itself. So it does not mean that $130 is my monthly threshold, it means that after continual consumption the amount will amortize itself and probably be around $110 or $120. In case if anyone was wondering food is my selected luxury usually. However, the exception to the rule is the amount does not amortize for an item is $1300. If something is that much already, the best way of handling it is to spread out the amount over a 10 month duration into the budget. The reason being is that it is counted as a big ticket item and can be re-earned over the course of a few months. Doing this will cut you out from luxuries for 10 months so be careful or you will lose out!