Michael on July 22nd, 2008
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That’s the question I asked myself when I finished reading through this week’s Carnival of Personal Finance to determine which one article is most worth sharing with you. (In addition, of course, to my own article about the endless correspondence I received related to the economic stimulus.)

Well, here it is: the best (completely subjective) article of the week from the carnival: Consumption Smoothing and You: Save While the Saving’s Good by FivecentNickel. Nickel discusses the concept of saving more while you can afford to while spending more when you need to. Consumption smoothing, in my mind, is something that happens automatically to those who save at all (but it’s good there’s a name to describe it).

You: Automatically?

Yes. People who save aggressively from an early age learn that once they have kids it’s nearly impossible to save as much as they did earlier in their lives. (Note: Personal experience: kids are expensive, even if you’re cheap. Even if you focus on the free stuff. After all, a family of four eats about twice what a married couple eats. Plus, if your child likes organic strawberries – look out!)

On the other hand, if you didn’t save when you were younger, consumption smoothing really won’t apply to you. Instead, you’re more likely to simply struggle to save your whole life as you slowly realize that, despite a growing income, your needs increase even faster.

Net: consumption smoothing works great – so long as you save when you can most afford to. For most people (even those with student loans), that means when they first start out in the “real world.”

Your take?

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2 Comments to “What the heck is consumption smoothing?”

  1. M. Contreras says:

    I’m interested in your last sentence: “For most people (even those with student loans), that means when they first start out in the “real world.”

    Having completed by first year in “The Real Wold”, as a rule, I put at least 10% of every paycheck into my ING savings account. However, I occasionally get a large check every quarter or so. I can’t decide if I should pay off my highest rate student loan first or save more.

  2. Michael says:

    The point I’m making in my last sentence is that many people incorrectly feel that saving will come easier later in life when the student loans are paid off. I believe that to be inaccurate because life’s natural expenses (wedding, kids, bigger home, higher taxes, higher utilities) will creep up even if you are very careful.

    To your question about selecting what to do with your excess funds, be it to save more or to pay off debt, know that you’re asking a great question. Too many people never struggle with what to do in your situation because they never feel like they have extra funds in the first place.

    First, make sure you have an emergency fund of 3-6 months of living expenses. So, if you have accomplished that goal, that comes first. If you have, then the choice between saving more in a high-interest savings account vs. paying off student debt is a classic trade-off in interest rates. Which is paying higher? Both are guaranteed returns. But remember, you can’t take out student loans again if you have an emergency, so make sure that’s taken care of first.

    Of course, this requires making several other assumptions, including that you have no other expensive (credit card) debt and are already maxing out your match at your workplace retirement plan.

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