It shouldn’t take a masters degree in finance to understand how to relate with money. I think we often bury our heads in the sand when something seems too difficult to comprehend. We hear phrases like dividends and algorithms and other big fancy financial terms and we just give up.
Sometimes it seems the only way to get ahead with money is to actually work in the financial sector itself.
That’s why I try to keep this simple. Anyone should be able to make wise decisions with their money and be able to get ahead financially. But if I spend all of my time motivating and inspiring you to get better with money, yet fail to provide instructions then I’m pretty much worthless as a finance writer.
You may have heard the phrase “Break Even Analysis” before. And because it’s not something you deal with on a regular basis you probably didn’t take the time to learn about it. At least that’s how I was. But this little tool proves quite powerful when making financial decisions.
Sometimes in an effort to save money we go with what appears on the surface to be the cheapest option. Although this may not always be the best decision we can make.
Here’s an example of how to do a break even analysis.
If you had the option between full coverage auto insurance for your $8,000 car at $200/month or liability insurance coverage for $50/month and you’re trying to save money it may seem like a great deal to save the $150/month.
This is a great time to use a break even analysis. Ultimately we’re trying to find out what it takes for our savings to “break even.” That is, just to get back to zero.
The risk you have in cutting your full coverage insurance to liability insurance is that if you cause an accident, you’ll be responsible for fixing your own vehicle. According to the IIHS, the average repair bill in an accident is $4,000.
So to do a break even analysis in this situation we divide $4,000 by the $150/month savings you get from cutting your insurance. We find that it will take 27 months of safe driving on your part just to get to a break even point. And that’s just in an average accident. What if you total the car? $8,000 divided by the $150/month savings = 53 months (4.5 years!) without causing an accident.
In this situation saving the $150/month by dropping your full coverage insurance sounds and looks like a great idea. But if you make it 56 months and then total your car, your savings is only $450, and then you have to pay your deductible. If you make it 28 months and then cause a minor accident you’ve only saved $150 and still have to pay your deductible.
It’s probably not worth the risk.
Anytime you have to make a financial decision between 2 options, find a way to apply a break even analysis. It helps bring clarity to what otherwise could be a difficult decision.
What are some other ways you could use this financial tool? Tell me in the comments below.