Let's face it, we need to know how to manage our money effectively. Sometimes, with all the noise in the world, it is hard to know where to start. Some feel the pressures to get the latest and greatest, some feel as if they need to save everything, and some are in between. Personal Finance is at it's core a relationship with yourself that is to be managed to keep yourself accountable, prepared, and provide a safety net for when the good times are not so good. When in doubt, keep it simple!
This article briefly touches on major aspects of personal finance you must know, including:
Cash Flow
Assets vs. Liabilities
Budgeting
Developing a Margin of Safety (Your first Emergency Fund)
Paying Down Debt
Saving for Goals
We also share some interesting bonus topics that we'll be making future articles on, so stay tuned!
Cash Flow
Cash flow is extremely important - if you are currently in a position where you are living paycheck-to-paycheck, you surely know this. One of the biggest impacts on your personal financial situation is you Net Cash Flow.
Net Cash Flow = Cash In Each Month - Cash Out Each Month
Net Cash Flow >= 0
We want Net Cash Flow to be positive or worst case, zero. To properly calculate net cash flow, consider your income, your taxes, expenses, rent or mortgage, credit card debt, car payments, and extra savings towards retirement, a goal, or other savings.
Some aspects of cash flow can be considered an asset-type cash flow, and some considered a liability-type cash flow. Keep in mind that these are not true assets and liabilities, but this is just for arguements sake to show that some elements of cash flow do help build wealth, and some do not.
If you find yourself in a situation where your cash flow is negative, there are a few options:
Decrease your spending - eliminate any unnecessary spending (easiest)
Increase your income (can be tricky, but not impossible)
Shrink your fixed, necessary expenses (moving, renting less expensive place, etc, saving on utilities, smaller phone or internet plans)
Pay off your debt - this will help you keep more of what you make later on
Reallocate savings to minimize your risk - there are ways you can prioritize your savings to make sure you are safe if an unexpected expense comes along. More on this later.
While this list is not exaustive, it is easy to see what comes in and out each month by looking at your bank statements, and evaluating what is necessary vs what is a luxury. While we can't get rid of every luxury, practically speaking, we can be measured and diligent when it comes to what we allow ourselves to spend.
Assets vs. Liabilities
Assets and liabilities can be a confusing topic - but think of it this way. If you were to lose your job today, and had to pay something off, or keep making payments to keep that item, that is a Liability. If you have something that increases your net worth, and you could go out and trade with someone (and do not have to keep paying into it), that is an Asset.
Our goal is to maximize our total net worth over time, while still maintaining a reasonable quality of life. We all need to make sacrifices, but by taking small steps, we can achieve financial security and eventually financial freedom.
Net Worth = Total Assets - Total Liabilities
Lets dive into Assets. Assets are things that increase your net worth. Anything you own and have completely paid off are assets. Any cash you have sitting around is an asset, because it can be used to pay off liabilities or otherwise be used, now or in the future. The equity you have in your home is an asset, as well as any equity in a vehicle, company, small business, or investments and retirement accounts.
Liabilities are things that you must pay off - any outstanding debt for a mortgage, interest payments on a credit card or unpaid bills, car loans, child support, etc - are all liabilities. They detract from your overall net worth.
Sticky Points:
Be careful to not assume that just because you have a car or a house that it is fully considered an asset. Homes and Cars have regular maintenance and payments required, not to mention property taxes on homes, and insurance required. These subtract from your cash flow, and many times high interest loans actually fail to build equity as much as an alternative, such as renting a home/apartment or buying a less expensive car with cash.
Many homes and cars are liabilities since money is usually borrowed, and regular payments must be made to the bank - or they will take the house/car back. In the case of a fully paid off home - you have built equity in the home (i.e. you fully own the home, and can sell it at will and retain all the proceeds from the sale minus any fees). Homes and cars have a high standard of regular maintena which detracts from cash flow. But, equity can still be built, even if there is a tradeoff with current cash flow vs your goals and needs. Sometimes. minimizing total liabilities is not the smartest move, since liabilities can help generate assets. However, this balance must be thought through and an individual must know their plan of action.
Everyone's personal situation is different - simple calculations will help you determine what the right course of action is regarding your wealth building plan and your cash flow month to month. A careful balance of short term and long term planning is necessary to craft an individual financial plan.
The End Goal:
Net Cash Flow >= 0
Maximize Net Worth = Maximizing (Total Assets - Total Liabilities)
Budgeting
Budgeting is the cornerstone to financial freedom, because it allows you to see what your money is getting you, and how your money is harming you.
To create a good budget:
Define your needs (expenses that cannot change)
Define your wants (expenses that you must limit yourself, and can be eliminated if needed)
Define your goals (things you need or want to save for), and prioritize your goals
Understand your taxes. Make youre you are witholding appropriate amounts from your paycheck through your employer or yourself to cover tax liabilities.
Make sure you have positive Net Cash Flow
Staying consistent
The most important part of a budget is staying consistent and holding yourself accountable. Measuring where you fall short or succeed each month relative to your budget allows you to keep tabs on your progress and make necessary changes where needed. Staying honest and continually recommiting to follow your budget allows you to develop discipline to manage greater amounts of money over time, and the ability to reap the rewards of financial security as you follow your personal plan.
Each month, sit down and review your spending and saving with respect to your budget plan. And, halfway through each month, do a quick check to ensure you are on track and see if you need to make a small change before the month is over.
Remember - what gets measured, get managed!
Example Budget
Below is an example budget for a two income household, each making roughly 50-55k a year. Read the comments to understand each line. Remember - all situations are different, and you must create your own budget to understand your financial goals.
Remember, if you have any uncommon or single expenses that may occur, be sure to put them in your budget for each month.
Yearly numbers are just 12x Monthly numbers, so this budget should be reviewed each month and modified if you have an upcoming large expense that does not fit a category. Use this to be sure you have the savings to cover the expense.
Be sure to factor in all savings and deductions form employers.
We recommend to maintain a 5% Net Cash Flow each month (5% of take home pay left over), to provide for unexpected budget overages.
This money can be used to provide padding in your checking account if unused, or to save more on a month-to-month basis.
Your No-Nonsense Saving Guide
Margin of Safety
When it comes to saving money, one of the key concepts to understand is the Margin of Safety. This is the buffer you create between your income and expenses to protect yourself in case of unexpected financial emergencies. By maintaining a healthy Margin of Safety, you can navigate through challenging times without falling into debt or financial distress.
Create a margin of safety through a few "first lines of defense" for specific areas. This doesn't have to be done all at once, but in some clear steps we will outline:
Emergency Fund (General fund to cover job loss, major health issues, large home repairs, car accidents, etc). Generally should cover 3 - 6 Months of critical expenses, if not more depending on your situational risk.
Insurance - health, life, home, car, and umbrella insurance are all ways that you can reduce your risk if something significant happens. While these all cost a hefty penny nowadays, you have the choice to get coverage you need based on your current risk level and savings.
Car Savings - to cover unexpected car repairs, or save for a new vehicle. This can help cover vehicle replacement in the case of an accident, in addition to vehicle insurance.
Home Maintenance Fund - if you own a home, to cover unexpected home repairs as well as fund potential improvements to enhance value.
Roth IRA investments - a more general investment fund that you can invest your money in well placed S&P-500 index funds for extra money that you may need in > 5 year time horizons. You can remove funds up to the amount you added from Roth IRA accounts. Disclaimer: Do not put critical funds (funds that may be needed within 5 years) into an investment account like this, as market volatility can quickly erase your safety margin.
Risk vs Reward
Another crucial aspect to consider is the balance between risk and reward. While it's important to invest and grow your wealth, it's equally essential to assess the risks involved. Understanding the trade-offs between risk and potential returns can help you make informed decisions about where to allocate your savings.
Example: A couple is expecting a baby in 6 months and has recently moved into a new house, and the husband has just started a new job. The wife is likely to spend time at home to raise the newborn until they are able to work a situation to have her return to work. The home needs some non-critical improvements, but none that influence the safety of the home. They just used most of their savings to buy the home.
The risks involved here include a need for future cash flow (a baby on the way is fairly expensive) as well as a lack of current cash, as the couple used the majority of their savings on the purchse of the house. Since the husband just started a new job, his job is likely secure if the company is not a in a volatile sector. and is in good financial standing.
Due to the lack of current cash, they would be wise to save up for a basic emergency fund prior to commiting to home renovations. Establishing a helathy emergency fund to cover any expenses during a more critical time after the baby is born, will reduce the risk the couple takes on when their expenses go up more. After a fund is established, cash flow can then be slowly reallocated in steps towards home renovation savings.
Risks and rewards try to balance cash flow and savings (essentially an financial moat). If cash flow is positive and net worth is positive (savings are positive) then financial risk is lower. However, if either are lacking, attention may be needed in the lacking area.
Different jobs, family situations, or financial situations require differenct levels of allocation. Some require more cash flow than savings due to higher expenses in the near term. Others require long term savings and cash-on-hand to finance a goal or build up a nest egg for the future. Each individual is different.
Building your first emergency fund
Building your first emergency fund is a significant milestone on your journey to financial security. This fund acts as a safety net, providing you with a financial cushion in case of job loss, medical emergencies, or unexpected expenses. Aim to save at least three to six months' worth of living expenses in this fund to ensure you're prepared for any unforeseen circumstances.
Building a good emergency fund occurs in multiple steps. To provide immediate security, ensure you have established at minimum, a $1,000 starter fund for unexpected expenses. If you need to pause other savings temporarily to do so, that is okay - as long as you are making required payments otherwise. Then, begin slowly saving for progressively larger amounts as you simultaneously work to pay down other debts (credit cards, etc) that hold you back.
A simple $1,000 fund will start you with the peace of mind that you can cover small expenses while working towards other goals. Without a small margin of safety, even a small expense can severely set you back.
$1,000 Emergency Fund
1 Month's Salary
3 Month's Salary
6 Month's Salary
Additional savings are situationally depended based on future needs and risks.
Cutting the fluff
To optimize your savings, it's essential to cut out unnecessary expenses and focus on essentials. By identifying areas where you can reduce spending, you can free up more money to put towards your savings goals. This could involve meal planning, cutting back on subscription services, or finding more cost-effective alternatives for your regular expenses.
Fluff can come from the following:
Unneeded trips to the coffee shop at work
Extra gas used driving around
Subscriptions and credit card fees that you forgot about
Extra unneeded food or clothes that are not necessary
High insurance rates - you can likely reduce rates by shopping around!
Paying down debt
One of the most effective ways to improve your financial health is by paying down debt. High-interest debt can eat into your savings and limit your financial freedom. Prioritize paying off debts with the highest interest rates first, such as credit card debt or personal loans, to reduce the amount of interest you pay over time.
After establishing a $1,000 emergency fund, use the extra cash flow used to create that fund to pay down credit card debt each month. By paying this debt off, you will pay less in interest and eventually remove the debt.
After removing the debt, work hard to spend less than usual and ensure you never let a debt payment lapse - doing so will just incurr more interest payments!
After eliminating your debt, switch gears to saving up for a larger emergency fund - one goal at a time.
Building your nest egg
As you work towards financial stability, building your nest egg should be a top priority. This involves saving for retirement and long-term financial security. Consider opening a retirement account like a 401(k) or IRA and contribute regularly to take advantage of compound interest and tax benefits.
After you have a sizable emergency fund established, consider reallocating cash flow to other savings. Roth and Traditional 401(k)/403(b) accounts through an employer or an IRA are great choices to stash away and invest savings - something that can compound and significantly increase in size over the years! Depending on your income level now and what you expect your income to be when you retire, you may elect one type of savings over another.
Another article will come soon to decipher between Roth and Traditional retirement accounts, but long story short, if you expect your tax rate to be higher than currentlywhen you retire, stash money in a Roth type account. In Roth accounts, post-tax money is deposited, and you are not taxed on gains or the money taken out during retirement.
Saving for goals
Lastly, saving for specific goals can help you stay motivated and focused on your financial objectives. Whether it's saving for a down payment on a house, a dream vacation, or your children's education, setting clear savings goals can give you a sense of direction and purpose in your financial journey.
After you have a good emergency fund, have gotten a handle on your budget and expenses, and are stashing money for retirement, start saving for your other goals you desire. Be sure to also try to increase your income simultaneously to generate the cash flow needed to support your long term dreams.
Steps
Create a budget and identify areas to reduce unnecessary spending, and reallocate money to save
Establish a basic $1,000 emergency fund by reducing spending and saving any extra cash you have.
Work to keep your expenses low and pay of your credit card debt, one month at a time. Reducing interest-bearing debt will reduce your money lost.
Save 1-Month's Expenses in your emergency fund by staying diligent with your budget and finding ways to increase income or reduce spending
Start Saving for other important areas while still building your emergency fund to 3-Month's Expenses.
Save 3-6 Month's expenses in your emergency fund and begin to contribute to retirement accounts or investing accounts to build your net worth.
Bonus
But I don’t have enough to save?
Most people, if necessary should be able to find ways to reduce their spending or increase their income when necessary to create extra cashflow to save. While it can be uncomfortable, even saving $100 a month can help you get the momentum to save up your first $1,000 emergency fund. Slow and steady progress and measuring your progress day in and day out is the key to successfully working on your financial goals.
To Rent or to Buy? What is best?
While this is a topic for another article, I figured I would touch on it briefly. Renting or buying is a very complex decision, but in reality comes down to your personal goals/needs for your family as well as the financial burden it may place on you.
Renting is generally the cheapest option in most areas. With renting, you do not have responsibility over excessive maintenance, there is flexibility in where you can live, and you don't require significant cash up front. However, for large families, this is largely impractical.
To buy a home you need both down payment for the home, as well as enough cash to cover closing costs - feed by the lender or behind-the-scenes workers who appraise the home and process your loan. Monthly payments include not only the mortgage, but property taxes and homeownders insurance as well. Once these are factored in, the comparison between renting and buying can be a no brainer. However, this is dependent on interest rates, location, and other external factors. You can easily buy a home in a bad area for the price of renting in a good area - but those are the tradeoffs between your personal goals and financial ability. More to come in another article!
[Disclaimer: Nothing in this article constitutes investment advice. All personal financial situations are different and research must be performed prior to taking any investment or financial action. Readers shall hold harmless theCatholicJourney.com from any actions taken forth from this article.]
Comments