In many aspects of personal finance, you have a choice of whether to protect yourself with a safety margin or with some form of insurance. This won’t make much sense until we look at some examples.
Many homeowners worry that interest rates will rise and make their payments unaffordable. This can make long mortgage terms with fixed interest rates seem more attractive. However, long-term fixed rates are higher than variable interest rates. As Jim Somerville explains in this post, the extra interest is a form of insurance against future interest rate increases.
Suppose that your bank says that you can get a mortgage for up to $300,000. If you get a mortgage this big, then you may need to lock it in for a long term because a spike in interest rates might ruin you. But, if you get a smaller house with a $200,000 mortgage, you’ll have a margin of safety that makes it possible to save interest costs by taking a variable-rate mortgage.
If mortgage rates remain steady, then the interest savings go into your pocket making your financial life better. The safety margin makes you essentially self-insured.
When you retire, you’ll have to live off your savings (plus any pension income you might have). It can be tempting to go for high returns when investing your money during retirement, but the variability of returns can be scary.
There are two basic ways of dealing with this problem. One is to reduce the risk by investing in short-term government bonds or by using stock options to lower downside risk. This approach is essentially a form of insurance. You expect to get lower returns, but they will be more predictable.
The second solution is to use a safety margin. You may be expecting stock returns of 6% above inflation, but you choose a lifestyle that requires returns of only 4% above inflation. If you actually get the higher returns, then you can increase your spending later on.
What Insurance is for
Insurance is a way to reduce risk. But, costs can be high. It always makes sense to see whether you can get the financial protection you need with a safety margin rather than insurance.
Almost all of us need insurance to protect ourselves against the possibility of a million-dollar settlement over a car accident. You would have to be wealthy to be able to handle this with a safety margin.
But, choosing the deductible on your car insurance is a different story. With some modest cash savings as a safety margin, you could afford to take a small chance with a $500 deductible rather than a $50 deductible. Over time the savings on your car insurance premiums would add up.