Using the Rule of 5 When Buying Things

Getting ahead financially, or even managing your budget can be a difficult task. But it is never impossible if you at least think about it. Sometimes one of the ways to do that is by having unique ways to force yourself to not only think about what you spend but force yourself to think about ways to save.

All too often, part of the problem is a lack of forward thinking, or the, "I want it now," mentality. What can especially get us into trouble is relying too heavily on credit, and not thinking about what the real cost of things are when they are financed.

We all know about the value of compound interest on assets. But compound interest applied to liabilities can devastate us.

For a lot of people who carry large amounts of debt, they tend to think of their debts as manageable so long as they can make the payments. The reality is that if you cannot afford to pay the debts off tomorrow immediately, you cannot afford to carry the debt.

If debt is used responsibly, it can be a useful tool with some additional rules applied. For example, if the cost of the interest on any loan is less than the amount of interest you are earning on cash in savings or investments, the debt is "affordable." If the cost of the interest on the debt is greater than the amount of interest you are earning on any cash or investments, it is better to use the cash instead of incurring the debt.

The rule, however, creates a caveat. But it is one that works to your advantage.

The Rule of 5 is a very simple concept, and one that can be applied, and even probably should be applied to nearly every purchase you make, with some exceptions—such as real estate, for example.

The idea is to accumulate money before you spend it rather than to simply earn it and then spend it as it comes in. You may see a pair of shoes you want, for example and think, "I have $50 right now to buy them, and so therefore I can afford them."

The reality is that you cannot actually afford them. Even if you have the cash right now in your hands to buy them.

Applying the Rule of 5 means that before you can rightfully claim to be able to afford that pair of shoes, you need to have at least $250 of available cash on hand that is expendable—in other words, not tied to any other commitments.

It makes you stop and think about your money before you hand over your hard-earned cash. It's posing a very simple question. "Can I afford to buy 5 pairs of these shoes?" If the answer is no, you wait until you can before you actually make the purchase.

Not only does it avoid spending money today, but it also forces you to save additional money and to think about your reward for having the money differently. Instead of having nothing left after your purchase, you have the joy of knowing that you have $200 left. On top of that, you can now apply that to other future things you may want to buy.

Although the Rule of 5 can seem impractical when it comes to certain purchases, I think it is essential. It gives us a peak into what we are actually doing to set ourselves back financially. Something we rarely pay attention to, which ultimately gets us into all sorts of financial problems.

"Can I afford this car?" you might ask. "Can I buy 5 of them?" is the better question. Even if you decide to take on a loan, it doesn't mean you can afford it. 

"But if I want a reliable car, and I have to pay at least $30,000 for one that is reliable, who has $150,000 lying around to justify it?"

The answer is, "Most people don't have that kind of money lying around because they have never considered the Rule of 5 in regard to anything else. Especially when it comes to the small things."

We are all well aware of the age-old adage that good things come to those who wait. It is rarely applied to reality when it comes to most people. Even if you applied the Rule of 5 on a smaller scale, the rule could still work.

For example, say you can afford a car payment that is $600 a month. You aren't going to be able to afford $3,000 a month. But you can afford $120 a month. So, when you decide to buy a car, you find one that will only cost you one-fifth of the payment you can make.

How about considering applying this rule in your favor? You effectively make the $600 payment after you buy the car and have a payment of $120, but instead of paying $600 each month to a loan originator, you pay $480 to yourself and put it into savings or investments.

If the loan term is for 5-years, at the end of that term you'd have effectively saved $28,800 which can be applied to whatever future assessment of a vehicle you can afford would be. It is either used as a hefty down payment on something, or it is reapplied to the rule of 5 and divided into a 5th over the course of another 60 months giving you an additional $96 of monthly spending power, meaning now you can afford a payment of $216 per month when added to the $120 per month you could reasonably afford to pay before based on the Rule of 5.

Of course, applying this rule does not mean that what you are ultimately trying to do is to be able to necessarily buy more things. It simply means that if something happens tomorrow that negates your ability to afford things in the longer term, you are able to at least cover everything in the short term.

If you suddenly lose your job, you can still pay for what you have, and if you have applied the rule appropriately to everything you buy over time, you probably have something to fall back on as well to cover the necessary day to day expenses until you can find a replacement job.

The idea is to simply think about your money in terms of its intrinsic value and apply that value in order to get the most out of your money over the long haul.

There is nothing more comforting than knowing that if your income fell to zero tomorrow, you could still afford to pay off every single debt you have five times before you've actually run out of money. More importantly, the Rule of 5 forces you to think about your money more carefully before you pull out your wallet.

| "If you are digging a hole, it is best to bring a ladder with you along with your shovel, because ultimately you are going to want to have a way to climb back up to the surface." |

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Thinking In Terms of a Paycheck Is Part of the Problem

Especially when it comes to living at a time many of us have not experienced in our lifetimes, a period of high inflation where every dollar we earn has less buying power and must be carefully thought out before we spend any of it, there is still something I think that holds us back when it comes to financially getting ahead.

A paycheck.

That may seem like a silly thing to say considering a paycheck is of course, a means to an end. We can't really get anywhere without one. But it is how we think about our paychecks which happens to be the very thing that holds us back.

When it comes to income, it's the one thing most people consider as the source to having more money. If they could just earn a little more, ask the boss for a pay raise or find a better paying job, or find secondary or tertiary incomes like second jobs or side gigs, they'd fare better financially.

But the art of having money is not in simply earning it. The art is building wealth from what we earn. In other words, the more you keep and save the better off you are. 

Building wealth is not really so much about earning more as it is about making every dollar we have go farther, and letting our dollars endure the labors rather than us to produce more income. That means taking on some level of risk such as investing.

There is a difference between earning money and creating money. And once the mindset changes to understand that it makes a world of difference. It changes one's entire perspective about money and wealth building and creation.

When you work for a paycheck what you are really doing is simply chasing your tail. You earn some money, you spend it, and then you have to go out and earn some more. But you never really get anywhere. The cycle just repeats over and over again.

Richard Kiyosaki from Rich Dad, Poor Dad called it akin to being on a treadmill, being constantly in motion, but ending up exactly where you started.

The key is to find ways to make what you earn more valuable over time. What's a dollar worth if you spend it? Zero. But if you invest it a dollar could be worth $1.08. And with compounding, over a longer period of time that dollar could be worth $5.

This doesn't mean don't seek a higher paying job and earn more if you can. It doesn't mean don't ask for that pay raise. It doesn't even mean stop working. It simply means, don't think of that extra earned income as something to spend more with. Think of it in terms of something to build wealth from.

If you can get a pay raise through a better job or from your current one, pretend like you never got it and put the money to work for you.

A paycheck can be both a crutch and an opportunity. It just depends on how you think about it. It can either provide a level of comfort knowing if you just keep working, the paychecks will continue to come. Or it can offer you an incentive to put more of your money to work so that your paychecks become less and less necessary over time as an absolute means to pay for things.

As I have always said, paychecks are essentially worthless if all they do is maintain the status quo.

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