Tuesday, March 17, 2009

The Financial Thermostat

Here is a concept that may need to be discussed based on some responses I saw regarding paying off mortgage and credit card debt. It's called the financial thermostat.

Think about the thermostat in your home that controls your furnace and air conditioner. We set the upper limit for a certain temperature. If the heat in the house gets to that temperature, the air conditioner turns on and cools us down. We set the lower limit to a certain temperature. If the heat in the house gets to that temperature, the furnace kicks on and warms us up. We are kept in a nice comfortable range.

The same happens to us in our financial life. We get used to a certain amount of debt and certain amount of savings.

Let's say we have a debt tolerance of $10,000 not including our mortgage. If we go out and finance a car or charge up a vacation to Disneyland, we start to get a little 'hot' and uncomfortable. Our debt is now above our comfort range and we work a little harder trying to get the debt down to where we like it. In terms of the financial thermostat, our air conditioner turns on. However, we start paying off our debt and get down to $10,000 and suddenly paying more toward debt isn't so urgent anymore. As a matter of fact, if we get below $10K, we might feel free to charge a little more to the credit cards because we're still in a comfortable range.

The same happens with our savings. If we're used to seeing $1,000 in the savings account, not including 401k investments, we don't worry much. Then an emergency strikes and we have to withdraw some of that money. We start to get antsy and work a little harder to get that money back into the savings account. In terms of the financial thermostat, our furnace kicks in. But let's say the savings account gets higher than we're used to. Let's say we get a windfall and suddenly have $2,000 in the savings account. Now $1000 is mentally burning a hole in our pocket and we're looking for ways to spend it. Our thermostat is saying that we don't need an extra $1000 in savings.

One the keys to personal finance, is examining where our financial thermostat is set. Many people are perfectly comfortable having thousands of dollars of debt and ZERO savings. Their furnace and air conditioning never kicks on. That can lead to a rather uncomfortable existence.

The next step is to consciously reset our thermostat. For instance, we can decide that we want to feel really uncomfortable with any credit card debt. As we pay down that debt we have to be aware that we're going to be getting signals that it is okay to NOT carry out our plan. Our old financial thermostat setting is going to want us to loosen up. We'll have to live debt free for a couple of years before we get used to the new thermostat setting. The same thing happens in our house. If we consciously decide we're going to set the furnace at 68 degrees F instead of the old 74 degrees F, then 68 degrees or even 70 or 72 is going to feel awfully cold for a while.

This is one of the reasons why paying off credit card debt with a mortgage refinance or home equity loan doesn't work. When we do that we haven't reset our financial thermostat. We're actually UNcomfortable with zero credit card debt and subconsciously give ourselves permission to charge up the credit again. And this is why so many people have a hard time saving even an emergency fund. Having that money 'just sitting there' makes them uncomfortable. We have to consciously reset the financial thermostat for savings to the new, higher level.