The Basics of Personal Finance
A Basic Guide to Financial Planning
This basic guide to financial planning is an outline of the major things you need to focus on for financial success. You will need to do some additional research for this guide to be truly helpful, but I hope it will lead you down the right path. As I add more information to this website, I will link those articles here so you can learn more about the specific topics that interest you.
1. Determine your values, goals, and priorities.
Before you start focusing on numbers and investments, you need to determine your values, goals, and priorities. What is important to you? What kind of lifestyle do you desire? How much will it cost? What sacrifices are you willing to make? What goals are non-negotiable? The answers to these questions can drastically affect how you implement the rest of this advice. Because this advice is written in a generalized format, I cannot address every possible situation or set of goals. You must think through this yourself and figure out how it affects the steps you need to take.
Although it sounds quite simple, this is often the number one hurdle for most people trying to achieve financial freedom. It is essential you understand that you cannot build wealth if you do not spend less money than you earn. You must make a commitment to save your money. If you have difficulty in this area, creating a budget can help you develop a picture of where your money is going and where you might be able to cut expenses.
Frugality is not a bad word and does not mean you have to live at an extreme. It simply means you are careful with your money, avoid being wasteful, prudently save for the future, and comparison shop when making major purchases. Starting these habits may require changing your current mindset about money, but once they are in place you will be on track for financial success.
The second part of spending less than you earn is how much money you make. If you are spending more than you earn, one way to fix the problem is to earn more. While that’s not often an option, it is a possibility. Also, if you can earn more but keep your spending the same (below your previous earnings), you can build wealth even faster. So earning more money is just as important as spending less.
For more information on spending less than you earn, consider reading:
Three Financial Formulas You Need to Know and Understand
Why a Budget Is Good (or Spending Plan if That Makes You Feel Better)
Ways to Create a Budget and Track Your Spending
3. Build an emergency fund with 3-6 months worth of living expenses.
Life is unpredictable – you never know when you might need some extra money for a car repair, hospital bills, a major item you forgot to budget for, or unemployment. By building an emergency fund you can be prepared for whatever may come your way. You should focus on building an emergency fund of at least 3-6 months worth of your living expenses (rent, food, utilities, auto expenses, debt, bills, and other necessities). If you cannot calculate your living expenses, then go for 3-6 months worth of your take-home pay.
It is important to earn a high interest rate on these savings so your money can keep up with inflation. You can search for a savings account with a competitive interest rate on www.bankrate.com.
If you have credit card or other high interest rate debt, you may want to scale back your emergency fund goal to $1,000 until you get those debts paid off. After you have eliminated those debts, come back to this step and increase your emergency fund to 3-6 months worth of living expenses.
4. Pay off your credit cards and any other high interest rate debt.
Credit cards and high interest rate consumer debt (non-mortgage debt) do not build wealth! If you carry a balance on your credit cards from month to month or have any high interest rate debt (>8-9% APR), then your top priority needs to be to pay off that debt as soon as possible. Try to find ways to cut your expenses and put that extra money towards paying off your debt.
Once you pay off one debt, use the payments you were making there to pay off your other debts. You can tackle your debts by going after the highest interest rate first or the smallest balance first. Getting rid of the higher interest rate debt first is the best way to go if you just look at the numbers, but eliminating several small debts early on can give you the psychological boost you need to achieve your goal of eliminating all your debt.
Being free from debt will make saving easier and provide substantial peace of mind. Although mortgage debt is not necessarily bad, no one has ever regretted owning their home free and clear.
5. Make sure you have enough insurance – not too much, not too little.
Adequate insurance coverage can protect you from financial disaster. A car accident, disability, or fire in your home can be devastating if you do not have the appropriate insurance in place. At a minimum, you will need auto insurance (if you have a car), health insurance, homeowner’s or renter’s insurance, and disability insurance. You may also need life insurance if you have any dependents.
Health and disability insurance are often provided by or through your employer. These are much easier to get through work as a group policy than on your own as an individual policy, though you usually will not have much flexibility in choosing how much coverage you get.
You can often cut costs by having your auto insurance and homeowner’s or renter’s insurance with the same company. Be sure to shop around for the best deal. If you are not sure how much insurance coverage you need, try to do some research online for help or get a referral for a trusted insurance broker from someone you know well. An insurance agent is tied to a single company, while an insurance broker can shop around on your behalf to find the best deal with the best company.
6. Get your estate documents drafted and signed.
The most basic estate documents include a Will, a Durable Power of Attorney, and an Advance Medical Directive. These documents make sure your wishes are fulfilled after you pass away or in case you are incapacitated.
Wills direct how your property will be dispersed when you pass away. Powers of Attorney allow a person of your choice to carry on your financial affairs and protect your property while you are incapacitated. Finally, Advance Medical Directives allow you to approve or decline certain types of medical care and appoint a person to make decisions on your behalf.
All of these documents are important in ensuring that your wishes are fully met if you are incapacitated. Although these documents can cost a few to several hundred dollars, they are quite important and worth the cost. Try to obtain a referral for a trusted estate attorney from someone you know well.
7. Own a home if you want to and it makes sense for you.
Although there are some situations where renting makes sense, you are more likely to build wealth and have a stable financial situation if you own a home. Do not listen to all the “gurus” who tell you to buy the most house you can get. Only buy as much house as you can afford and make sure it suits your needs.
There are plenty of online calculators to help you figure out the true cost of owning a home. You can try www.dinkytown.net for these types of calculators. Be sure to shop around for the best mortgage rate you can find. Do not get sucked into the lowest payment option, as these “fancy” mortgages may have hidden costs and drawbacks you may not be aware of. Stick to the traditional 15 year or 30 year mortgage, preferably the 15 year mortgage if you can afford the payment. Save up for a 20% down payment so you can avoid paying for private mortgage insurance (PMI).
Also, do your homework before making an offer on a home and make sure you visit several different homes in your price range before making a choice. A realtor may be able to help you if you do not have the time to search on your own, but doing the homework yourself and buying directly from the owner may allow you to negotiate a lower cost.
8. Save for retirement.
Most people have a goal to stop working sometime down the road. Establishing enough retirement savings can take a long time, but prudent savings and investing can keep you from being dependent on your loved ones or the government during retirement. If your employer offers a match for your retirement contributions, make sure you do whatever it takes to get the maximum available match. It is free money! If you are young, you may want to look at also contributing to a Roth IRA.
You are going to need to save quite a bit to reach retirement by age 65 or 70. If you are in your twenties, you should be setting aside at least 10-15% of your desired income in retirement. If you are just starting in your thirties, you will want to set aside 15-25%. And if you are just starting to save in your forties, you will want to set aside at least 30-40%. You can see that starting early really makes it a lot easier to save for retirement. If you are late in the game, do not despair! The best time to start saving is right now!!!
Choosing the proper investments for your retirement savings can be difficult. If you have little investment knowledge and little desire to gain more, your best option may be a Target Date Retirement Mutual Fund. You select these funds based on the year you are going to retire.
Vanguard, Fidelity, and T. Rowe Price all offer low fee Target Date Retirement Funds. By putting your money in one of these Target Date Retirement Mutual Funds and forgetting about it, you can keep yourself from making costly mistakes while your portfolio is managed by professionals who rebalance and choose diversified investments for you. There is a better way to invest for retirement, but this is the easiest choice by far.
9. Plan and save for your other goals.
Depending on your personal situation and life goals, you may need to plan and save for other items not addressed above. This could range from education for your children or grandchildren to a beach home for your retirement. Because there is an infinite number of possible goals, I cannot discuss every single one in this short post. Think through the what, why, when, how much, and how of your goals. Then do what it takes to reach them!
10. Consider using a fee-only financial planner if you need help.
It can be daunting to tackle all the aspects of your financial situation on your own. There will be some things that interest you and others you can barely understand. If you run into problems while trying to plan or figure something out, you may want to hire a fee-only financial planner.
You must be very careful when doing this because there are many people out there who do not have your best interests at heart. You should comparison shop before going with a financial planner. Money Magazine has a good article on what you need to consider before hiring financial help.
Two good resources for finding fee-only financial planners are The National Association of Personal Financial Advisors and The Garrett Planning Network. Both sites have a search feature for fee-only advisors in your area. The Garrett Planning Network focuses on hourly fee-only planners, while The National Association of Personal Financial Advisors includes all types of fee-only financial planners.
Finally, just because a fee-only financial planner is not listed on one of these websites does not mean he or she is not qualified or trustworthy. Just be sure to thoroughly question the planner on his or her experience, objectivity, and compensation methods before signing a contract.
For more information on hiring a financial planner, consider reading:
Ripped Off: Can You Trust Your Financial Adviser?