We can take small steps to create a margin of safety for personal finances. The term, “margin of safety,” is an engineering concept used to describe the ability of a system to withstand loads that are greater than expected.
For example, let’s say a bridge is required to support 5,000 tons. Do we build it to withstand 5,001 tons? I would not want to drive over that bridge! What if we have a day with much heavier traffic? What if the bridge starts to weaken over time much faster than anticipated? To account for this, we build the bridge to support 20,000 tons. Now we have a margin of safety.
A margin of safety is important in many areas of everyday life. Having a “cushion” helps people deal with unforeseen problems and deal with life’s inevitable challenges. If it takes me 30 minutes on a day with “normal” traffic to get to work, I might leave 50 minutes ahead of time “just in case.”
There are many ways we can apply this strategy to our personal finances to increase our financial margin of safety.
• Live below your means. People who spend less than they earn have a nice cash cushion to weather unexpected financial storms. Not only do they have greater income than expenses, but they likely have accumulated some savings by living frugally and setting aside some of their extra cash. Those who are able to live on 60 percent to 80 percent of their income can handle more financial stress than others who cannot.
• Build adequate emergency funds. An adequate emergency reserve provides a margin of safety against unexpected events such as accidents and unemployment. Financial experts recommend setting aside three to six months expenses. Notice I said expenses, not income. Many households do not come anywhere near this amount, however, so today is a good day to start building an emergency fund. Any savings is better than none. Remember, the bigger the cushion, the more chaos you can handle.
• Pay off debt. Debt is an albatross around personal finances. The sooner it is paid off the more “wiggle room” people have to handle life events. Aim to pay off outstanding credit card debt in a year or less.
The PowerPay debt reduction program from Utah State University Extension (see https://powerpay.org) can create an accelerated debt repayment plan. Also aim to make a final mortgage payment before retirement.
• Purchase adequate insurance. Sometimes negative life events are so costly that, even with savings, people cannot afford to pay for them out of pocket. Examples are cancer diagnosis or the inability to work for two years due to disability from a severe auto accident.
This is where insurance comes in because the risk of loss is transferred to a third party (insurance company) in exchange for payment of a premium.
• Arrange contingency options. Examples include a line of credit for small business owners to bridge gaps in their irregular cash flow, reverse mortgages as a financial planning tool (e.g., to delay the receipt of Social Security benefits so they will be larger), and current estate planning documents (e.g., a will and advanced directive documents such as living will and durable power of attorney for health care).
Take action today to build your financial margin of safety.
For more financial advice or information, contact Susan Cosgrove, Financial Management Area Extension Agent, at 601-635-7011.
