Consider if it's really worth buying that expensive new car. What about the impact it will have on your future wealth?
When you want to buy something, you have two options with how you can finance the purchase. You can use your existing savings, or if you don’t have enough, or are not prepared to use them, you can borrow the money instead.
And if you do end up borrowing the funds, who do you think you are entering into a loan agreement with?
The majority, of people would say, it’s the bank or the credit union or whoever agreed to give them the money in the first place, and of course they are correct. But there are those who look at it differently - me being one of them - who argue that the agreement isn’t really between you and a financial institution at all, they are just a by-product of the purchase.
Yes, you got the money from them, but you are really borrowing money from yourself, your future self to be exact. Let me explain further.
I met a girl last week, who had just signed a lease agreement to buy a new car. The rate was 8%, and the loan repayments were €468 per month. She didn’t have enough cash to fund the purchase, so financed it through her bank.
She did have enough money to buy a second-hand car though and could have bought one with cash for about €8,000 but chose not to.
She didn’t think much about the transaction or what implications it could have for her in the future. She was young, and it was hard to see beyond the next five years not to mind the next 30, so she couldn’t see how a car repayment of €468 per month would have any impact on her income or quality of life when she was older.
However, what her present self was doing by making those payments to a car finance company, was taking away a possible €957,125 from her future 65-year old self, because that is what she would have accumulated if she diverted the €468 car repayment to her pension instead.
The 30-year-old was taking €38,285 per year away from the 65-year-old, because that’s what €957,125 would pay her each year at 65.
I am assuming of course that she would have continued to make those repayments for the next 35 years, and she may not, and if she did they may not be as big as they are now.
And I don’t know whether this girl would still have had a great financial future if she continued making car loan repayments or if she saved the money instead. It’s hard to look into the future and predict what things will be like. But what I do know, is that she is giving herself a much better chance of a secure and comfortable future if she did.
Without a doubt though, the choices we make today will shape what our future life will become and what options we are giving ourselves. And this applies to many other areas of our lives, like our health, our career, our relationship with family etc.
When it comes to any sort of decision making, there is always an internal tug of war, between our present and future selves. Our present self wants that short term fix of immediate gratification and in fairness we can’t help it, because we are wired that way, but living in the now can be a dangerous strategy. Ideally, what we want to achieve is a happy medium where our present and future self coexist in a way that satisfies both.
And doing something with an eye to the future doesn’t have to mean you make big sacrifices and end up miserable today either. That girl can still buy a nice car, and enjoy it, and save for the future as well.
But what you have got to consider and be aware of, is that whenever you are tempted to enter into an agreement that locks away part of what you earn each month, take a step back and think about what you are doing. Think about whether that money will impact your future quality of life. Will it hinder it, or will it have no impact? At least once you know the potential outcomes, you can then decide.
A number of behavioural economists have been looking at this area to see what could influence and help people from making decisions that allow them to enjoy the present whilst setting themselves up for success in the future.
Daniel Goldstein, is one of them, and he outlined in an excellent TED talk in December 2011, how things like commitment devices i.e. locking away your credit card until you pay off what you owe, setting up a budget and sticking to it, help keep you accountable and on track.
Goldstein’s research has discovered that visualisation tactics help as well, where computer programs help people see the impact current decisions will make on their future self. It shows a person’s face ageing with various degrees of happiness based on their financial security. Another program shows images of different types of living accommodation you can secure based on different levels of income in retirement. Looking into the future and seeing what that might look like, influences people’s behaviour in the present.
I encounter people all the time close to, or in retirement who tell me the reason they are struggling isn’t specifically because of difficult economic periods, they’re struggling because of the money they blew which was available and surplus to requirements in good times, but rather than save some for when they were older, they spent it on their present selves.
So from a financial perspective knowing the difference between your present and future self is important.
Liam Croke is MD of Harmonics Financial Ltd,
based in Plassey. He can be contacted at firstname.lastname@example.org or www.harmonics.ie