Thursday, December 15, 2011

Budgeting: Part 34: How to Budget for a Vacation

"A vacation is what you take when you can no longer take what you've been taking."

- Earl Wilson

Let's talk about vacation!!!

This Post is Not About Cheap Travel Deals

First of all, let's make sure we've understood the title of this post.  This article is not about how to save money on your vacation.  (The world doesn't really need yet another 200 word blog post that repeats the same "10 Ways To Save Money" bullets from every other article.)  This post is about how to plan ahead for vacation costs, how to work a vacation into your budget, and how to stick to the vacation budget that you've set. Indirectly, of course, you may save money by sticking to your budget and not spending more than you intended.

Why Vacation as an Example?

Any expense could be used as an example of how to do these things, but I've chosen vacation expenses for some specific reasons.  Anyone can budget for something small and predictable like a $39/month cable bill.  In order to make the post realistic, I wanted to deal with something more difficult by choosing an expense that was large and irregular, yet completely discretionary.  I also wanted an expense I could relate to because I didn't want this to be a theoretical exercise.

Why I Can Relate to Vacation Expenses

I've mentioned before that I'm not really into "things". In fact, it's often hard for me to relate to many of the spending temptations that other people face.  I'm the sort of person who can go to the mall all evening with credit cards in pocket and not buy anything.  In fact, if I had to wander around the mall all week long, I really doubt I'd buy much of anything.  This doesn't make me better than anyone else - it's just the way I'm wired inside.

I do, however, crave experiences.  I like to try new things and go to new places.  Furthermore, my entire family is also infected with this openness disease.  I'm sure you can see where I'm going with this.  From a spending standpoint, being at a mall or a big box store is not a place of weakness for me.  On the other hand, vacation is a time and a place where my spending can easily get completely out of control.  First of all, I have the time to do things.  Second, I'm all geared up to do new things.  Third, newness begets newness, and when you are in new surroundings with new possibilities and new people, it all starts to snowball.  Fourth, since I've often traveled a great distance, there is the high probability that this may be my only shot to do all that this location has to offer.  In short, the most difficult category for me to budget is vacation.

Start Planning for Vacation Early

The best thing you can do to ensure the success of your budgeting for vacation is to start early.  Even if your vacation is in the middle of the summer, try to give a rough estimate at the beginning of the year.  It shouldn't be that difficult to estimate the major expenses of your trip, such as airline and hotel costs.

If your vacation occurs near the beginning or end of the year, you may need to drag another budget year into the picture. For instance, if you want to take a ski trip in January of next year, you shouldn't wait until Jan 1 to start budgeting for it.

Budgeting as a Yearly Process

We budget on a yearly basis, so if we expect to take the same sort of vacation as the previous year, then we simply carry over the figures from last year.  If the vacation cost is materially more because we are going somewhere special, then we recognize many months in advance that we'll need to make adjustments to our budget.  If you know six months in advance that you anticipate spending, for example, $2,000 more than last year on vacation expenses, then you will probably have time to make the necessary adjustments.  Maybe you need to work overtime hours, or maybe you need to cut back on your spending in other categories.

Cutting Back Before Vacation

A long while ago, I wrote an entire article about how to make budget choices, and here is a quick summary of the mechanics of it.
  1. Order all your spending from most valuable to least valuable to you.
  2. Include any savings goal in this list as if it were a spending item.
  3. Whenever you need to cut spending, pick from the bottom of the list.
  4. If you add new spending, prioritize the new item into your list.  If you need to cut something else to make room for the new spending, then again, choose from the bottom of the list.
The main idea is to frame spending decisions always in context and never in isolation.  I present the steps above mainly as a formal description of this paradigm.  You don't have to follow it rigidly to achieve results.  Many people intuitively follow these same steps to cut spending, but it's useful to formalize the idea in case you feel stuck or overwhelmed.

For example, suppose you really, really want to go somewhere or do something expensive on vacation this year.  Suppose it will cost $2,000 more than your normal vacation budget.  Start at the bottom of your prioritized spending list.  If this vacation is so important to you, it should be a lot more important than the spending item at the bottom of the list.  Good.  Then you are going to trade off that bottom item for part of your vacation.  Start working your way up the list.  For each item, you need to decide whether it is more important than this special vacation.  If the vacation is more important, then trade off the item and keep going.  I know it is hard!  We all want the vacation and the other item, too!  But you have to choose: vacation or item X; vacation or item Y.  Eventually, you will either find enough stuff to cut, or you will find that your special vacation is just not worth the cost to you.  Either way, you should feel good that you have spent your money in the way that is most valuable to you.  For the money that you currently have, you've done the best you could do.

Cutting Back After Vacation

I also find that despite my conservative budgeting and my best intentions, we often overspend on vacation once we get to our destination.  Given what I detailed above about my personal preferences, it's not too difficult to see how that happens.  However, we've also found that we can still make up that difference after vacation is over.  You can cut back in the months immediately following your vacation.

But you might need to ask yourself whether this is truly a realistic strategy for you.  It's one thing to avoid consumption now because you really want to take a nice vacation in a few months.  However, once the vacation is over, it's an entirely different kind of discipline to avoid consumption just to balance out the vacation you've already taken.

No Silver Bullet

At this point you might be saying to yourself, "Doesn't this article have more to offer than just cutting back in other areas?"  Unfortunately, there is no budgeting silver bullet.  I don't have any magic to offer you.  There are a few creative tweaks such as high return investments and financial autopilot, but generally speaking, you've got to make hard choices.  If you want to spend more in one area, you've got to cut back on others, or you have to earn more income.

Other articles may offer a canned list of items to cut, but is that really helpful?  These lists often contain many items that I currently don't even spend any money on.  In other cases, the list may contain the items that I personally value the most.  No thank you.  I'd prefer to make my own list, and cut the items where I'm currently spending a material amount of money, but value least.

The Importance of Saving

If your budget is accurate, it will explain your financial situation in personal terms:

Income - Expenses = Savings (or Borrowings)

Is this number positive (saving) or negative (borrowing)?  I don't encourage routine borrowing (i.e. negative savings), but only you can decide how much saving is enough.  Treat this number with respect; don't just say "whatever".  You have long term financial dreams and goals, and your savings is your progress toward those dreams.  You may not care about savings in some abstract sense, but you certainly care about these goals.  For some people, it's financial independence or early retirement.  For other people, it's the dream of sending your kids to college or paying off your home or starting a business.  And for another crowd, it's the idea of being able to help others less fortunate, to make a difference in the world.  Everyone has dreams of this sort, and that's why the bar needs to be placed very high in regards to savings.  Don't settle for paycheck to paycheck living.

If you are already saving a large amount of money, then some moderate amount of overspending is not going to break you.  If you're already saving $10,000 a year, and you now overspend your budget by $2,000 this year, you won't go broke.  $8,000 is still a lot of savings.  The problem is one of long term resolve.  It's easy to think $8,000 is almost $10,000 and $6,000 is almost $8,000 and so forth, until you eventually find yourself saving very little.  If you decide to cut back your savings, make sure you've really thought things through.  Does your decreased savings really fit with your life goals?

The Benefits of Organization

If your budget is complete and accurate and organized, the choices will be clear.  The decisions may still be difficult in the sense that you have to give up something.  But the decisions will be straightforward in the sense that the choices will be clear within minutes - probably seconds.  You won't have to wonder about how much to cut, where to find the savings, and which things you value most.  It will all be organized for you and ready for you to make your decisions.

And organized or not, you will still have to make these decisions!  But without a good budget, your decision making may be poor.  For example, you may guess your spending is low, overspend on vacation, and find yourself in debt.  Or you may think there is no way you can afford a trip to Europe and stay home, when in fact, with a little organization and a little discipline, you could be enjoying London or Paris.

Net Worth vs Cash Flow

Thus far, I've assumed that you have a budget similar to mine, but this is probably not the case.  Our family is very fortunate in that we can focus on net worth because: (a) I have a steady, well-paying job, (b) we save 40% of our income, and (c) we have a bill paying system that emphasizes net worth.  However, many people are not so fortunate.  This means that you will also need to focus on cash flow.

This means that in the months before your vacation you will need to save up additional cash in order to be able to pay the vacation bill when it comes due.  This is not inconsistent with the many articles I've written about the dangers of cash flow myopia.  Cash flow is actually very important.  Obviously you need to have money available to pay your bills and your debts on time.  I just don't feel that cash flow gives you a very good idea of wealth accumulation or true savings.  Net worth and cash flow are two different things, and each must be used only for its intended purpose.

Saturday, December 3, 2011

Budgeting: Part 33: How to Budget for a Car

"Middle Age - When you want to see how long your car will last instead of how fast it will go."

- Unknown

I'm going to build this article around Edmunds Total Cost to Own (TCO) Calculator.  This is an online tool that calculates the total cost of ownership of a vehicle.  Edmunds also has a background article on vehicle costs and another article that details the assumptions that go into the calculations.  I have no affiliation whatsoever with Edmunds.  I just like the tool and find it useful.

The Major Vehicle Costs

There is no tool that can just blindly give you a prediction of your actual vehicle costs.  However, the Edmunds tool is reasonably transparent about what it's doing, so it's still a good starting point to discuss vehicle costs.  In addition to your initial cost to purchase (which includes the purchase price, shipping, and sales tax), the tool correctly identifies the following eight types of ongoing costs:

  • Depreciation
  • Interest
  • Taxes/Fees
  • Insurance
  • Fuel
  • Maintenance
  • Repairs
  • Tax Credits

Some Finer Details About Vehicle Costs

This tool has been featured on many other blogs and I've sifted through many of the reader comments in preparation for this article.  I'm going to work through the most common complaints as a way of discussing some of the finer points of vehicle costs.  Some complaints seem quite valid to me; others do not.
  • "The tool doesn't include older models."  In my opinion, this criticism is totally valid.  The tool will only accept model years 6 years old or newer.  Now you could actually cobble together a lot of this information manually from other parts of the Edmunds web site.  For example, you could look up the mpg of older cars to calculate the fuel costs, and you could look up the resale value of different model years to approximate the depreciation cost.  However, the tool is automating the process of looking up all that information and performing the calculations for newer cars.  It doesn't seem like there's any reason it couldn't be made to work for older cars.
  • "Depreciation isn't a real cost."  Well, what more can I say about this?  Claiming it doesn't exist doesn't make it so.  You can read my thoughts on this topic in a previous article about depreciation.
  • "I didn't like the assumptions."  The tool had to use something as a base case.  At least they break out the different costs separately and clearly spell out the assumptions.  It does, however, seem like they might have allowed you to tweak the assumptions.  For example, it could have let you enter the number of miles you expect to drive (to better calculate fuel costs) or your age and state (to better calculate insurance costs).  As it stands, you'll have to manually adjust for things like that.
  • "My experience with the cost of repairs was not the same."  A lot of people seemed to think that if the tool told them that the average cost of repairs for their vehicle was $500/year, and they only spent $100 last year, then the tool was "wrong" or "useless".  It is not a crystal ball.  In fact, the tool wasn't even intended to be predictive.  It was designed to facilitate comparing different models.

    For some car models, there are literally millions of these vehicles on the road.  The calculated cost is intended to be the average.  Obviously for any given year, many cars will be way over or way under the average.  Furthermore, large repairs are infrequent and irregular.  The same car may be way under the average for several years and then be way over one year because of a major repair.  The average may turn out to be way off for your vehicle, and yet the average is still your best guess.

    Personally, I roll over unspent repair money into the next year because it seems to me it's more likely that things will average out over time.  It's also a more conservative approach.  In other words, if I budget $400/year for repairs but only spend $100 on repairs this year, then I budget $700 for repairs next year.  (If you followed your budget last year, you'll have that extra $300 you didn't spend on repairs, right?)

    You may be interested in knowing how Edmunds determines the average cost of repairs.  They use the cost of a bumper-to-bumper warranty for the vehicle in question.  This makes sense because it leverages the findings of a whole industry that examines these costs.  Insurance companies are not in the charity business.  They make sure that the cost of these warranties covers the cost of repairs.  Edmunds then subtracts the overhead and profit of the insurance company to arrive at the average cost of repairs.  Note that this is very similar to the method I suggested in a previous article about unexpected costs.  In fact, if you want to make your repair costs almost entirely predictable, you can simply purchase one of these warranties for your vehicle.
  • "Depreciation doesn't matter because I paid cash and I'm never going to sell the car."  You can certainly account for your car purchase by simply expensing the full price in the year you bought the car and then using zero for every year after that.  But I've warned about this approach many times because it's way too easy to frame things badly.  We then imagine our costs are low and our savings are high, only to be blindsided by the next vehicle purchase.

    Ironically, it's just the opposite scenario where depreciation might not need to be explicitly calculated.  For example, if you plan to buy a car with a 5-year loan and sell it after 5 years, then your monthly payments are actually a rough approximation of your depreciation.  Why?  By spreading out equal payments over 5 years, you're essentially accounting for a 5 year complete depreciation of your car.  In fact, if the finance rate was 0% and the loan term was the same as the life of the vehicle, then your monthly payments would be exactly the same as straight-line depreciation costs.  Now usually there are some finance costs, the car is still worth something after the loan is paid off, and depreciation is not linear.  Still, monthly payments do give you a similar view of the ongoing costs just to keep the vehicle.  Depreciation costs are just more precise.