July 2017
Barbara O’Neill, Ph.D., CFP®
Extension Specialist in Financial Resource Management
Rutgers Cooperative Extension
This article describes small steps that people can take to create a margin of safety for their personal finances. According to author and productivity expert, James Clear, the term “margin of safety” is an engineering concept that is used to describe the ability of a system to withstand loads that are greater than expected. For example, imagine that someone is building a bridge and the maximum weight for a commercial truck carrying a full load is around 80,000 pounds. An engineer on the project will build a bridge that can safely carry vehicles weighing far more than the maximum weight, just to be safe. That additional capacity is known as the margin of safety.
A margin of safety is crucial, not only in the world of construction, but also in many areas of everyday life. Having a “cushion” helps people deal with unforeseen problems and deal with life's inevitable challenges. An example is shoveling a wide swath of snow from your driveway in case there's even more snow coming from a new storm. The way that people schedule their time is another example of margin. For example, if it takes 30 minutes on a day with “normal” traffic to get to work, you might leave 50 minutes ahead of time “just in case.”
As Clear notes, a healthy margin of safety improves the odds that you will arrive on time: “If everything has to go perfectly for you to be on time, then you're not going to be on time very often.” When there are delays, a margin of safety provides extra time to handle the chaos. When you arrive early, you can use the extra time to talk to coworkers, get some exercise, check email/social media messages, or do whatever else you want to do.
The “margin of safety” concept can also be applied to how people handle their personal finances. Below are five strategies to increase your financial margin of safety:
- Live Below Your Means - People who spend less than they earn have a nice cash cushion to weather unexpected events. Not only do they have positive cash flow (income greater 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, say, 60% to 80% of their income can handle more financial stress than others who can't.
- Build Adequate Emergency Reserves - An adequate emergency fund provides a margin of safety against unexpected events such as accidents and unemployment. Financial experts recommend setting aside three to six months expenses (e.g. $6,000 to $12,000 with monthly expenses of $2,000). Many households don't come anywhere near this amount, however, so today is a good day to start building emergency reserves. Any savings is better than none. Clear notes, “the bigger the buffer, 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 include a 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).
Want to take small steps to improve your personal finances? Take action today to build your financial margin of safety. Every small step makes a difference.