A friend recently questioned the value of buying a home near San Francisco, where he works - not because he can't afford it, but because he isn't sure if it made sense for the lifestyle he aspired to have. "I like knowing that I can just pick up and move if I want. Owning a home locks you down," he explained. In that brief moment, my friend had pretty much calculated the value of that potential purchase by looking beyond the financial requirements to the personal rewards - a too-important variable we sometimes forget to include.
In my new book, Psych Yourself Rich, I spend some time discussing how to measure the value or worthiness of our financial choices - from buying a home to purchasing a car to paying for a graduate degree. Here are four questions we should consider before making the leap.
1. Do I Have the Money?
This is the first and most obvious question - if you don't have the means to make a purchase, you can just skip the rest of this exercise. Affordability comes down to having either enough cash or a way to finance the purchase, like a loan. Take buying a car: If you are financing it for three years with a $300-a-month car loan that is just 10% of your take-home pay, that's pretty affordable. On the other hand: If you need to put the entire cost of your wedding on a credit card and carry the balance month to month, that means you can't really afford it.
2. What's the Trade-off?
Just because you have the money doesn't mean you should or would want to buy it. Just about every purchase has an "opportunity cost" - at least one alternative path that you have to abandon. Let's say putting down $40,000 toward a new home means depleting most of your rainy-day savings, leaving you with a weak security blanket in the event of a layoff or other financial emergency. That's a pretty steep trade-off. Will it still be worth it, knowing you could be in a big financial bind if you lose your job?
Or let's say putting that $300 a month towards a new car means having to cook more during the week than eating out with friends, or delaying the purchase of (gasp) an iPad. How badly do you want that new car now?
3. What Are the Benefits?
I call this "measuring utility." Few purchases can actually boost happiness, but imagine how this purchase could possibly improve your life. What conveniences might it bring? What's the emotional upside? Unlike renting, for example, owning a home gives you the authority to do as you wish with the property. Want to paint the walls red or add an extra room? It's your call, assuming you have no board members or zoning issues to deal with. The benefit to getting a graduate degree may be a salary raise in the next few years - or it may be the prestige of those extra letters after your name.
Keep in mind: determining the "benefit" of a purchase can be tricky. Studies show that when we pay more for something (whether a fancy degree or a $300 pair of shoes), it makes us feel better, and we therefore think that we got a better item (or service). Researchers at California Institute for Technology found that when people tasted two identical wines, they thought the one with the higher price tag was more delicious. Busted!
4. What Are the Risks?
Sometimes, risks go beyond opportunity cost - as for my friend, who worries about the lack of flexibility that comes with buying a home. What are the risks - and how well prepared are you to manage them? In my friend's case, although selling a home takes time (and could force a financial loss), he might instead decide he'd rent out the home in he wanted to move. In that case, buying in a rent-friendly neighborhood could increase the odds of finding a suitable renter.
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