The most important financial rule

There is one fundamental rule to get ahead financially. It’s not new, or surprising, and is well known by everyone, but not everyone abides by it.

The rule is simply: Spend less than you have. On a pay cycle basis that would be “spend less than you earn”.

Following that rule should generally keep you happy. Breaking it may keep you unhappy, indefinitely. The common example used is of Mister Micawber from Charles Dickens’ David Copperfield, who famously observed in Chapter 12:

Annual income twenty pounds, annual expenditure nineteen, nineteen and six, result happiness.

Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

Sometimes this can be harder to achieve in practice.

For example, what do you do when something comes up that you “need” to pay for? For example it may be to attend a close relative’s funeral or to replace a broken washing machine. Dipping into savings is one way or getting a temporary loan (for example from the bank) or by extending your mortgage. Or you might be able to do some extra work for someone or sell something on TradeMe or see if a relative will lend you the money temporarily.

If these aren’t options for you then you may be tempted to go to a payday lender. This is the worst option. These lenders charge astronomical interest rates as well as additional charges for late repayment. These lenders should be avoided at all costs.

Jamie’s brother was killed in a car accident up country. Jamie didn’t have enough money to fly there or enough for the petrol and the ferry but he was upset and needed to head home. He calculated that the ferry would cost $320 plus he’d need around $200 for petrol. He would be able to stay at a friend’s place in Wellington and could stay at the family home up North. In the meantime though he needed around $520. He had $120 but still needed $400. His next payday was only a few days away but he knew he’d need at least a little spending money on the way.

He checked on line and found a payday lender who could lend him the money that day. And it was cheaper than the other payday lenders. The sign up process was quick and easy and a few hours later he had the $500 in his bank account. He had had to pay a $64 loan establishment fee and an account set up fee of $24, which were added to the loan, giving a total loan of $588. He knew the interest rate was 365% but at 1% a day that didn’t seem too bad. He agreed to repay it in 8 weeks. That gave a total loan of $917 and he felt confident that he could repay that amount at around $230 per payday for the next 4 paydays. Jamie would say he lived on next to nothing for those weeks and at several points almost defaulted on the payments. But, knowing that that would just increase the costs he held out on spending on anything other than the bare essentials but he still says it was a very tough period. All up his $500 loan cost him $917, almost double the amount he borrowed. Asked if he would do anything differently again he said he would have sold something on TradeMe and borrowed the rest off a mate or two. The cost of the payday lender way outweighed the benefit from using that type of lender.

But in all cases, prevention is better. The way to avoid these situations is to establish an emergency fund or buffer. The amount may be $200, $500, $1,000 or $10,000 depending on your financial situation and the things you might need the funds for. Yes, it may take a while to build up an emergency fund or buffer but it will reduce your stress levels immeasurably to know that there is some money stashed away if needed urgently.

Remember, before using it, that it is only for emergencies and that it will take a while to rebuild, so use it with caution.

If you want to avoid these situations, or frequently find yourself in a situation where you are running out of money, then look at ways to increase your income on a more regular or permanent basis. These might be to apply for promotion at your work or somewhere else, take on a second, part time job, take in a boarder, or look at selling things on the internet or at local farmer’s markets or fairs, for example, things you own and no longer use, or things you can make or grow. With the additional income, make sure you set aside your emergency fund or buffer before you start spending the increased funds.

The information in this blog does not purport to be financial advice and no reliance should be placed on it. It is of a general nature only based on my experience as a Chartered Accountant in practice and specific advice should be sought for your particular situation.