Three P’s of Money – What’s Our Purpose?
The final pillar of the Three P’s of Money, what is our purpose? We started out by breaking down different segments of the dollar so we can identify the true effects of our financial decisions. This category is about giving our dollar a purpose. When we make a financial decision, we often have a justification for why we spent it or used it. Here we aren’t going to try to justify how we used the dollar, but we are going to create a purpose for it. When you purposefully use or spend money there should be an intended financial benefit from it. Throughout our lives, we are bombarded with significant financial decisions with very little guidance. You start off by opening a checking or savings account, then you get offered credit cards, maybe take out student loans, get a mortgage, or expense a major project using financing. In general, many people know the costs of these decisions, but they don’t know the effects or the why.
Spending money is very easy. It comes in and then it goes out. Hopefully, there is some leftover for you to save and begin funding your future needs! When you have discretionary income or extra savings there are decisions that can optimize the use of that money or carry an adverse effect. Let’s take the idea of a major home renovation to replace your roof & siding. A job like this can easily cost $50,000. Now ideally, you would have $50,000 saved or accessible that you pay for the job directly and that’s what the job cost you, $50,000. What if there are financing options available? What if you save $50,000 seems like it will take 10 years and some of this work is more of a necessity than just wanting it done? When you are faced with these decisions a best practice is to assign a purpose to your dollar.
There are typically three ways to pay for a major expense. One, have the money saved and pay for it directly. Two, have a portion saved and finance the rest. Three, finance the entire project. This is where the water can get muddy without understanding the purpose of your dollar. When you pay for something directly there is no additional cost to your capital. Paying for something directly can also carry savings because vendors and contractors sometimes offer discounts for paying upfront and in full. When you borrow the money there is going to be some level of interest charged on what you borrow. By understanding WHY you are borrowing the money we can evaluate what the optimal decision is. When interest rates are low, borrowing money can be a very powerful tool… for the right purpose. Let’s say you have that $50,000 saved but instead of paying for the job directly you can finance the project at 3%. So now you’ll be able to keep your $50,000 and have an affordable monthly payment. The purpose behind the $50,000 that you are keeping instead of financing should be to create value. If you can invest that money and earn 5% a year, you are now creating a 2% profit for yourself. That is known as arbitrage. If you financed the full $50,000 and then spent what you had saved, well now you no longer have an asset that’s working for you. You’re just spending money and costing yourself more over time.
Understanding how investing money vs borrowing money is a big part of financial literacy. Going back to our previous example, what if you could finance the project but the interest rate is high. If you finance a project at a high-interest rate, 6% or higher, then finding ways to create arbitrage without taking a significant risk can be difficult. An example of bad debt is when you don’t have enough saved and acquire this major expense that is now a monthly payment. This is where the scales of your personal balance sheet become imbalanced because all you’ve done is get into debt. On the other hand, what if you can finance the project at 0% interest? That is my favorite debt and should be taken advantage of whenever available as long as the strategy has the right purpose.
There are millions of different examples of how identifying the purpose behind your dollar can have positive or negative outcomes. There are always best practices and fundamentals that should always be practiced but the bigger decisions should carry a little more consideration. I thought of the Three P’s of Money to help begin tackling some basic financial literacy and introduce some critical thinking around the dollar. Hopefully, these thoughts and ideas may spark a new way of tackling some of your everyday financial decisions!