Personal Finance is a plan on how to manage your money and finances. Most people go through life living from paycheck to paycheck. They buy things they want on their credit card, and they have no idea if they can even pay for them. The concept of financial planning is about taking control of your money and having a plan for how you earn, spend and save it to reach all the goals you want to reach in life. It's about taking control of your finances. Financial planning involves setting goals for your money throughout your life like retirement or saving for a house. It is about planning for the unforeseen events so they will not wipe out your savings or cause financial hardship.
When it comes to financial planning, the budget is the heart of the whole process. This is about knowing what you own and what you owe. It's about all the money you have coming in and all the money that is going out. When it comes to a budget, your income is a fixed amount. It's very hard to change how much you earn without changing jobs, getting a promotion or starting a side job. When it comes to budgeting, the first input is your income. If you are a family, then it would be the income of people who contribute to the household. There are ways to help improve income if you find you can't make ends meet, but most of the time, the problems are in over spending. The first column of your budget should list all your sources of income.
The next step is to figure out everything you are spending money on. When I first started, I just spent 3 months recording everything I spent money on and organized them into categories. Some things are necessities like housing, food, clothing and transportation, but other things are discretionary like going to movies, eating out or online shopping. I would first break up all expenses into necessities and discretionary spending. Then I would break out other categories. My housing would include rent or mortgage, utilities, and insurance. For my car, I have Tags and Registration, Inspections, Maintenance, Gas and Insurance. The first step is just to follow the money and figure out where it is going and then categorize it into necessities and discretionary. What you don't want to do during your period or recording your expenses is to change your behavior. I know some people will have a tendency to cut back when they are actively recording their spending. You want to get an accurate picture of your spending so make sure you do all the normal things you would do while following your expenses. Then break them down into other important categories for what is needed the most like food, housing, clothing and transportation to work. Then divide them into necessities, discretionary and savings.
Once you know what you are earning and spending, you can sit down and figure out if it balances out. There are some guidelines for balancing a budget like the 50/30/20 rule. This states 50% of your money should be dedicated to needs, 30% should go to discretionary spending and 20% should be saved for all your future goals. When I first did my budget, I was actually shocked at how much money I spent on some things like going out to eat for lunch. I was able to save large amounts in my budget by changing a few habits. I had like 10 online subscriptions when I was using only 2. There will always be ways to save money. One of them is using a grocery list. So much shopping at the grocery store is impulse buying. I never enter a store without a list of what I want. I also include a few planned snacks. I even limit how much I can spend on those snacks so I tend to buy what is on sale.
When it comes to budgeting, you don't have to go to the extreme. The budget is a plan and you might need to adjust it as you go along and learn. Maybe you budgeted not enough for gas to drive to work. Maybe you still spend too much on eating out. The budget isn't about forcing yourself to be disciplined as it should be a guide to help you make better decisions. Too many people make a budget, they can't stick to it so they just give up and stop. Treat the budget as a tool and an asset to help you make better financial decisions. If you just can't live without that coffee every morning, then find something else where you can save money for it. Sometimes the budget is about compromising some of the things you can live without for the things you really want. The budget is about helping you prioritize what your money gets spent on so you can achieve all the goals you have both short term and long term. The budget has to provide for day to day living while planning for long term financial goals like saving for a house or retirement. Most people will want something like a new phone, and they will just go out and buy it. They will worry about how they will pay for it later. The person who plans financially will plan for how they will pay for something before they ever go out and buy it.
One useful method for people who are new to budgeting is using the Envelope method of budgeting. This is where you create an envelope marked on the front for each spending category in your budget. You will end up with an envelope for rent, electric, water, groceries, entertainment, and any other categories. You put the money in each envelope for the allocated amount of money in the budget. Then you use only the money in that envelope for that expense. This helps you understand the consequences of going over budget in a category. If you budgeted $100 for clothing and spent $75 on new shoes, but now you want a jacket that is another $100, you would only have $25 in the clothing envelope for your budget. You could take money from another envelope, but then you might end up short somewhere else at the end of the month. You definitely would not want to take from necessities like rent. Not unless you want to get evicted. You would not want to take from gas if you have to drive to work. You might take from groceries and cut back on eating for the month. Using the envelope method can help you control the budget better for beginners. It can also help you understand the consequences of the spending decisions you make.
The goal of budgeting is to create a space for savings. You can never get out of debt or build savings for future goals if you have no money dedicated in the budget for savings. Many people who budget only account for the income and expenses and don't plan at all for the future. At first, you might have too many expenses to have any savings. The best way to carve out some savings is to cut back on some things or pick up a side job for a short time. Unless you can find a way to end up with more income than expenses at the end of each month, you will always be treading water. One of the ways I did this was to forgo discretionary spending for a while to get the extra money to pay down debts and create some room for savings. I call it a discretionary spending holiday.
Once you are able to start saving, there will be priorities for what you should use that money toward. You don't want to jump right into investing. The first thing you will need is an emergency fund. We will talk about this in the next section. Then you want to use all that extra savings to pay down debt. We will cover debt payment strategies in a later section. Only after you have an emergency fund and all bad debt eliminated should you look at savings and investing. There is nothing gained if you make 5% on a Certificate of Deposit or 10% on an investment if you are paying 20% on your credit card debt. You are actually losing money in that situation.
The next step as part of budgeting is to take account of what you own and what you owe. This is about your assets and debts. Maybe you already own a home. That is an asset. Maybe you have a ton of credit card debt. That is a debt that we will learn to fix later. There is a difference between good debt that is used to finance assets and bad debt which is credit cards. There is a set of guides that show the assets and debts of different classes of wealth. Rich people tend to have many assets that produce extra income while having little debt. People in the lowest income tend to have a ton of debt and no assets. The goal of financial planning is get out of that bad debt and get into assets that grow value or earn income. Good assets will appreciate in value like homes, land and even collectables. Good assets can produce income like rental properties, bonds or dividend stocks. The key to financial planning is to make money work for you instead of working for your money.
The emergency fund is the most important thing you can ever do to improve your financial security and piece of mind. This is a shock absorber for your financial life. Too many people get into budgeting and saving just to be derailed by an unforeseen event like their car breaks down. There are always going to be unforeseen events in life that impact your financial plan. The only way to protect from them is to have a plan to handle those events. The emergency fund does exactly that. This is a fund of cash that is easy to access, but far enough away to avoid impulse spending. It acts like a shock absorber for any unforeseen events. The typical rule is you should have at least 3 months and preferred 6 months worth of your monthly expenses in the emergency fund. That way, if you lose your job, you can continue to pay your bills for 6 months until you find a new one. If you are just getting started and have a lot of debt to pay down, you can get away with 1 month for an emergency fund until you pay down your debts. That gives you some cushion while allowing you to address the most immediate problem of debt.
I tend to use a savings account at a local bank with no online access for my Emergency fund. It's close enough that I can go and get it should I have an emergency, but lacks enough access that I can't spend it impulsively. I actually have to drive to the bank to withdraw it. You should never touch your emergency fund unless you have an unplanned event. If I want a new laptop, I will budget savings for a new one. If mine suddenly breaks, I will buy one from my emergency fund then budget savings to replace that amount until the emergency fund is fully restored. An emergency fund is for unplanned emergency expenses. It's not for discretionary expenses. You should always plan for any expense like a new phone or a vacation.
Setting goals financially is about figuring out what you want over the long term and building a plan to reach those goals. The first major goal all people should have is retirement. Buying a house, paying for college or buying a car will also be big financial goals that need planning. Budgeting is about figuring out how to pay for all the things we need today while saving money to pay for all the things we will need later in life. Setting some goals will help us with our budget. Every goal we set for the long term, needs to be paid for in the short term. When setting these goals, they typically use the Acronym SMART to help us define those goals.
The SMART acronym stands for Specific, Measurable, Achievable, Realistic and Time Sensitive. You want to define the goal you are setting to make sure you know exactly how much money you need to reach that goal. You also need to make the goal one that is realistically achievable with your financial means.
Maybe I want to save for retirement. That is great, but how much do I actually need? That is where I need to get specific. I need to figure out how much money I need to maintain my lifestyle in retirement. That way I can figure out how much I have to budget to reach that goal. I might think I want to save $10 million for retirement. If I only make $100,000 a year, that probably is not realistic or achievable. If I make $100,000 a year, then I only really need to save $2 million for retirement invested at 5% return to sustain my lifestyle. That would make $2 million specific, measurable, achievable, realistic and time sensitive as I will have to reach it by the time I am 65 or 70 years old. Now you can sit down and use an investment calculator to see exactly how much you must budget each month to reach that goal. If you are 25 years old and make $100,000 a year, you need $2 million in 40 years. That would come out to about $4,600 per year you need. That is less than 5% of your income you would have to save starting at 25 just to reach that goal.
If I were saving for a house, what kind of house? Do I want a million dollar home or do I want a $250,000 house? When setting a goal, you need to come up with a specific amount of money you need to reach that goal. When it comes to a house, you need to reach a down payment which is usually 20% of the purchase price. If you make $100,000 a year, then a million dollar home is probably way out of your price range. It would not be Achievable or Realistic. Saving for a downpayment on a $500,000 house would be very realistic. At 20% down payment, you would need $100,000 for the down payment. To reach that goal, you would have to save about $700 per month for 10 years. That is another 8.5% of your annual income.
If you are saving 20% of your income toward those long term goals, we already planned for retirement and a house in 10 years using just about 15% of that 20%. This is how financial planning along with using SMART goals can help us achieve all the important things in life. Another goal might be education that most people will have to plan for. Typically this is done in the form of student loans that are paid back after the student graduates.
Savings and Investing
What is the difference between savings and investing? Savings is designed for short term money that needs to stay liquid or ready to be used. Your emergency fund should always be savings as you could need it at any minute. Investments are hard to liquidate and can take time to get out of even if they are available for sale at the time. Sometimes the market is down, and you might not want to sell at a loss. It can take a few days for the sale to clear to get access to cash. The rule of thumb is any money that will be needed within the next few years should be in liquid accounts like savings or money market accounts. If you don’t need that money in the next few years, you can invest that money for a better rate of return. This works for those long term goals like retirement, a house, a car or education.
How much you need to save depends on your long term goals. I use the 50/30/20 rule which dedicates 20% of income to savings. At the beginning, this money will probably go toward paying down debt. Over time, I actually have much lower discretionary spending as I spend time doing free activities like learning on Youtube or taking walks with the dog. That gives me more money to direct to savings and investing.
The rule here is to pay yourself first. That means you should take the money you dedicate for those future goals and pay them first. Many people will automate their savings to ensure it gets paid first. If you have an employer with a 401k or IRA plan, you can contribute to that automatically from pretax income which is a win/win. Contributions from pretax income lower your income you pay taxes on while going into a tax free account to earn interest. I have my monthly contributions automated for several of my investments. It can be very difficult for some people to save money. By automating their savings and investing, they take it out of their hands. This can be very helpful.
There are different ways to save. You can use a simple savings account. Some of these online savings can have a higher level of interest. You just have to be sure they are reputable before trusting them with your money. You can use other accounts like a money market account which tends to give higher rates, but requires you to have higher balances. You can even use Certificates of Deposit that are short term investments. These are your most liquid investments that give you quick access to your cash in an emergency. The normal CD will be 6 months or a year, but some of them now offer no penalty withdrawal.
You can even use some short term bonds or treasuries that last less than a year up to 2 years. This works best for shorter term goals that don’t need to be kept in cash like saving for a down payment on a car or house. They tend to offer higher rates than the liquid accounts, but have short maturities for short term goals.
Long term investments move into the Bonds and Stocks which are designed to be held for the long term. Many of these investments can be volatile over the short term and make poor short term investments. They do have the highest returns for your money you wont need for 5 years or more. Any money you need within 5 years should be put in liquid investments while anything over 5 years can go into longer term investments like stocks. Some of the longer term goals that might be good for investing are saving for education. Most people pay for their education with student loans then pay for it after they have a good job, but if you are saving for your children’s education, you might want to invest that money. If you are saving for that downpayment for a house, you might invest that money into some more less risky investments. Retirement is the top reason people invest.
What is the difference between Credit and Debt? Credit is the amount of money you are able to borrow based on your ability to repay the money you borrow. This is often calculated based on your Credit Score. The higher your credit score, the more likely you are to repay the money you borrow. This means creditors will be willing to lend you more money. This is called your credit limit. This is the total amount of money you can borrow based on things like your income, expenses and credit score. Debt is the amount of money you owe based on what you have already borrowed against that credit limit. This is often called the Credit Utilization rate. Let us assume you have a credit limit that says you can borrow a max of $10,000 dollars based on your income, expenses and credit score. Now, we will assume you have one credit card with $2,500 and another $1,000 in credit card debt. The credit utilization ratio would be $2,500 plus $1,000 or $3,500 of your credit limit is used out of the $10,000. That means you have a credit utilization of 35%. A good credit utilization ratio is 30%. When you go beyond 30% it begins to impact your credit score. Knowing how to manage debt well is an important part of financial planning.
Credit is the ability to buy products and services now and pay for them over time. Using credit negatively impacts your ability to save. Every time you spend money on credit you are spending your future earnings which lowers your ability to save. You have to budget to pay back that money you borrow plus any interest on the principal. This can make credit costly. How much you pay to use credit is impacted by your credit score. There are three credit bureaus which keep a history of our credit report. They are TansUnion, Equifax and Experian. Each of these companies keeps a record of your entire credit history. You are entitled to get an annual copy of these reports from each of these bureaus each year. The data in these reports can vary from bureau to bureau. Some of them might even have errors. Your FICO score is a number that represents your total credit score and takes the information from the credit bureaus and translates into an easy to use number. The statistics for your credit score says that 35% of your score comes from your payment history. This is your history of paying your bills on time. Then 30% of the score is how much debt you have borrowed. The length of your credit history accounts for 15% of the score. People with short credit histories will naturally have a lower score. The types of credit you use also accounts for about 10% of the score. The last 10% is the number of inquiries there are for your credit score. All of these things go into a formula that translates them into the overall FICO score. The FICO score can range from 300 to 850. The 300 - 579 range is called Poor credit. Fair credit ranges from 580 to 669. Good credit ranges from 670 to 739. Very Good credit ranges from 740 to 799. Excellent credit ranges from 800 to 850. The amount of interest you will have to pay on any loan or credit card is determined by your credit score. Those with below average credit scores will have to pay higher rates while those with high credit scores will get discounts on rates.
There are two types of credit with secured and unsecured credit. When you use secured credit, you have to put up an asset as collateral. You actually borrow the money against that asset. This can be your car for a car loan or your house for a home loan. If you fail to make your payments on a collateralized loan, the borrower can take that asset as repayment of the loan. We saw the impacts of this in mass during the 2008 housing crash. Banks foreclosed on loans that borrowers could no longer afford to pay. Unsecured credit does not require you to pledge collateral. Instead, the amount of money you can borrow is based on your credit worthiness. This will often be things like credit cards.
When it comes to debt, there are two kinds of debt: bad debt and good debt. The average return of the stock market is 8% return per year over the long term. It will have its big up years and big down years, but it averages 8% per year over the long term. Any debt that has an interest rate of less than 8% is considered good debt. This tends to be a mortgage or a business loan. These are good debts as the money you pay for that debt goes to build equity in something that has value. As long as your home's value is worth more than your mortgage, it is a good investment. Borrowing money to build or start a business can be good debt which will build equity in that business. The business should eventually become income producing.
Bad debt is any debt that has higher than 8% interest rates. This is mainly credit cards which can have rates upward of 15% to 30% depending on your credit score. You will never get anywhere if you invest at 8% and pay 15% on your credit cards. Other forms of bad debt can be a car. The minute you drive a car off the lot, it loses a significant amount of its value. That makes it worth less than you owe on it. You will end up paying a high interest rate on it too. Student loans can have higher interest and sometimes fall into bad debt, but they have some rules on them that make them less of a problem then other debts. They have income protections on them that can allow you to pay less if you don't make enough income. Some people will refinance student loans to get cheaper rates.
When it comes to bad debt, we want to focus on eliminating those credit cards which have the highest rates. There is a right way to use credit cards and a wrong way. Most people are using them the wrong way. They use them to borrow money instead of as a tool. Using a credit card for planned purchases that are in your budget and paying them off in full at the end of the month is a good use of credit cards. You can often earn rewards or bonuses on those cards for spending money you already budgeted. A person who uses credit cards well makes them work for them. They don't pay any interest and they get something out of it in the form of rewards.
There are two really good strategies for paying down credit card debt that I used when I first got started. They are the snowball and avalanche methods. With both methods, you make a list of all your credit cards along with the balance on each and the interest rate. As you dedicate money into savings, it goes to paying down those credit cards. With the snowball method, you start by putting all your excess money into the card with the lowest balance while maintaining the minimum payment on all the other cards. Once that card is paid off, you move to the next card with all the money you can until it is paid off. This method is used the most as it gives 2 bonuses. First is the quick sense of accomplishment when the first card is paid off. The second benefit is the money you were paying for that card now goes to help pay off the rest of the cards. For the avalanche method, you pick the card with the highest interest rate and focus on that one first until it's paid off while maintaining the minimum payment on the rest of the cards. This can take longer and might take more discipline to get it paid off. Targeting the highest rate card actually saves you more money in the longer term. Regardless of which method you chose, the goal is to wipe out all that credit card debt and then learn to use them correctly. Paying down that debt means nothing if you don't budget and enact some discipline to prevent racking those balances back up. Many of those places you see online that are designed to help you consolidate your credit cards into low interest loans to pay down your credit cards, but they don't actually help fix the underlying cause of the spend impulse. People end up using them to pay off their credit cards then they go out and max them out again. Then they end up with a consolidation loan and still have maxed out credit card debt.
Good debt is lowest interest rate debt that goes toward the purchase of assets like education. An education can be one of the best investments a person can make. It allows you to improve your lifetime earnings. The average person only has about 40 years to make as much money as they can during their income earning years. If you make $100,000 for 40 years, that is a gross earnings of $4 million. By investing in education, a person can increase their earnings. Even if you spend $50,000 on a career or degree, you can increase your earnings potential for a lifetime. Even if your income increases to $125,000 per year, you improve your lifetime earnings to $5 million dollars which is more than the $50,000 you invested in it.
Most people know that a mortgage is considered good debt. This allows you to buy a house which you can live in. It is also an investment as an asset since it will gain value over time. In most cases the interest you pay on a mortgage is tax deductible. It is a very good type of debt that has many benefits for you. If you spend 30 years paying off a mortgage, you could decide to sell after retirement and downsize to save money while having more money in retirement from the sales of the asset.
The final use of good debt is to start or expand a business. If you have your own business, taking out debt to expand or improve that business is considered good debt. This can be used to hire more employees or attract more sales. Investing in your own business can improve you total income which makes it an asset.
Risk management in personal finance is about protecting yourself if something goes wrong. This comes in the form of insurance. There are some obvious places in life where insurance is important, but there might be some you might not have thought about. Having homeowner's or renter's insurance will protect your residence from fire or disaster. Especially if you live in a rental property linked to other rental properties like an apartment. You can often have the negligence of someone else cost you in a fire. Car insurance is important and law in many states. This isn’t so much about the damage done to your car as it is about protecting yourself from a lawsuit if you are found at fault in an accident. Property damage and medical expenses alone can be enough to bankrupt the average person. One of the most important is health insurance. The vast majority of bankruptcies in the US come from medical expenses. In this day and age medical insurance is the most important insurance you can have to protect your financial wealth. Those might seem like the obvious types of insurance. The next would be disability insurance. This might not be something you consider, but it can happen to anyone at any time. If you or your family depend on your income, then you should protect it in case of disability. This is even more important if you work in a higher risk job where injury can occur. The final type of insurance would be life insurance. If you are young and single with no one depending on your income, then life insurance might not be a thing you need. If you are married, with a mortgage and bills along with kids, you have many people who depend on you to provide income for them. Life insurance is considered income replacement insurance if the worst case happens. The rule is you should have enough life insurance to cover any debts you have plus 5 years worth of your wages to keep your family financially safe.
Retirement planning comes down to two factors. The first is figuring out how much you need to retire and maintain your current lifestyle or any lifestyle you wish to achieve in retirement. As long as it's within the realm of possibility for your income as we discussed in achievable and realistic goals. Once you know your goal, you can figure out how much per month you need to contribute to reach that goal. The average annual return of the market is between 8% and 10%. It has increased over recent years as markets have done much better under Fed stimulus. I would be conservative and stick with the long term 8% average. With a simple amount needed, the return rate and the amount of years you have until retirement, you can plug those numbers into any one of the countless retirement calculators on the internet and find what you need to contribute each month. When it comes to retirement planning, you want a tax free account. They tend to have limitations against withdrawals before retirement, but they compound interest free.
Where should you put that money? The first choice should be an employer 401k or equivalent. There are some government employee programs that are like 401k, but they call them a different number. In a 401k, the magic lies in the employer matching. The rules for matching can vary for every employer, but the key thing to remember is it's free money. If you put in $200 and the employer puts in another $200, that is free money. You are doubling your money right off the bat even before you start compounding that return rate tax free. Compounding in a tax free account is one of the most powerful ways to build long term wealth.
The second best option is using an IRA. These tend to come in traditional and Roth IRA's. The difference between them is how taxes are handled. The traditional IRA allows you to put money in tax free, but you pay taxes on the money as you withdraw it in retirement. The Roth IRA gets money put in from after tax income, but then you don't have to pay taxes when you withdraw it. The IRA's have a max contribution limit for how much you can put in annually. I think it's currently $7,000 per single person and $14,000 per couple. That doesn't seem like much, but $7,000 per year for 40 years compounded 8% annually is around $1.8 million in retirement. That is not a bad amount. At the $14,000 limit for a couple, you would reach close to $3.6 million over 40 years.
* I am not a Financial Advisor. This is just My Strategy. Please refer to your financial advisor before making any investing decisions.