How to determine what you can afford

One of the most common pieces of financial advice is to make and stick to a budget. But what does that mean exactly? It’s easy to know if you can or cannot afford that purchase at the grocery store simply by looking in your wallet. But how do you know if you can handle big-ticket items like a car or a plasma TV? Knowing how to budget can mean the difference between early retirement and working until you’re old and gray. In fact, it’s the most important part of planning your financial future. Here are some tips on how to determine what you can and cannot afford.

If you can’t pay for a car in five years, you can’t afford it
Technically, you can keep debt going forever, especially credit-card debt. But doing so means that you could end up paying more in interest than the amount you borrowed in the first place. While there’s no absolute rule for how long you should take to pay off a loan, it is best to pay it off as quickly as possible, especially if it’s an item that depreciates over time. Why? Well, since you end up paying more for longer loans, you’ll get hurt even worse if you extend a loan on something that’s losing money, like a car. A car — unlike your house, which goes up in value — decreases the minute you buy it, so the longer the loan, the more money you’ll lose.

Your mortgage payments shouldn’t be more than 30% of your income
You hear a lot of guys give you advice like: “Don’t bite off more house than you can chew.” But what does that mean exactly? A standard rule of thumb is to make sure your mortgage payments don’t exceed 30% of your income after you pay the tax man. While that sounds easy enough, you must watch out for two things.

First, you need to build a cushion because your income will vary from year to year (and sometimes emergencies happen). But, more importantly, you must be prepared for possible jumps in your mortgage payments. If you signed up for a variable loan or a negative amortization mortgage, you could see your payments increase significantly. So when you budget, make sure to calculate the highest payment for the life of the loan, and not just the monthly payments you’ll make in the first year. Don’t forget to factor in savings, outstanding debts and other important variables. After all your monthly expenses, you should have 10% of your income left for savings.

Savings are the most important part of your budget, because a budget that doesn’t leave you money left over at the end of the month isn’t a budget at all — it’s a recipe for disaster. Most financial advisors like to get their clients to save 10% of their income. But remember: That’s a minimum. You can always save more. The problem is that most guys save what’s left, which usually means they save nothing at all. When trying to figure out if you can afford a big-ticket item, don’t forget to take that 10% off the top for savings.

Take outstanding debts into account
If you ignore your outstanding debts simply because you don’t need to pay them right away, you’ll just dig a deeper hole. Always include them in your budget and choose monthly amounts that pay off the whole debt in five years or less (excluding homes). Remember: A monthly budget isn’t just about putting you in the black at the end of every month; it’s the strategic tool you’ll use to make your financial position better and better as the years go by.

Factor in income instability
Nothing lasts forever, least of all jobs in a rapidly changing economy. While you can hope that your six-figure income will last for years, the truth is that you might lose your job and find yourself having to take a pay cut. If you’ve budgeted for that possibility, you should be able to take the hit in stride. If not, you may find yourself with expenses that you can’t possibly afford to pay. So what’s the lesson? Assume your income won’t always be there and avoid a budget that puts you right on the edge. In other words, don’t make purchases you’re not certain you’ll be able to pay off in the future.

Budget before you buy
Looking at your income relative to your expenses and declaring that to be your budget isn’t the way to go. Making a budget means starting from zero, factoring in what you need to buy, looking for places to save, and then finding out what you can afford to buy. In other words, don’t work backward, and don’t let your purchases dictate your budget.

Know your limits
In life, knowing your limits will keep you in the clear. When it comes to managing your money, the best policy is always to play it safe. Stretch for the things you need, like a home or an emergency, but don’t overextend for the things you only want, like a new car or a vacation. If you know what you can spend, you’ll not only save money, you’ll also save yourself aggravation.  

By: Michael Estrin