If you followed us for a while, then you know a financial plan increases your chances of financial success. If you don’t have a financial plan, let’s start your financial plan today.
Just as there are three steps to land that hottie you have your eye on (flirt, buy them drinks and then make your move), there are three steps to score a better financial future and maybe even more hotties (budget, save and invest). These are the foundation of a financial plan. We will elaborate on each of these.
Budget Is Not a Four Letter Word
The first steps to create a financial plan is to create a budget. A budget is not a four letter word. Really, it’s six. Many people have a negative perception of a budget, but budgets actually liberate you. Without one, we humans, especially those with a propensity for the material, have a tendency to spend more money than we should.
Without a budget, governments cannot function (hmmmm . . . makes you wonder). Without a budget, businesses cannot function (hmmmm . . . makes you wonder some more). Without a budget many, many of us, including governments and businesses, get in over their head with debt.
With the best credit card annual percentage rate (a.k.a. APR) at 10 percent, most people with debt will not achieve financial goals beyond earning pre-sale access to Cher’s latest farewell tour. While her show will no doubt be the experience of a lifetime, Cher’s tickets will take many a lifetime to pay off when bought on credit.
Too many of us spend more money than we make. We do this by living on credit cards and other loans, always owing someone something like J. Wellington Wimpy. Of course, you are not going to eat a hamburger before you go to Cher’s show, but like Wimpy you may see her today and then pay for it tomorrow and the next day and you may still be paying it off when her next farewell tour comes around. That delay in payment will cost you a lot of money.
A budget lets you know what you can do and when without interest payments. A budget does not say you cannot see Cher. It simply tells you how to plan so she does not cost you 20 percent more than she should. That leaves 20 percent to put towards your Cher costume or, better yet, your retirement plan.
There are two basic steps to create a budget.
The first step is to calculate your personal monthly profit. First, calculate your monthly net-income, which is your income minus taxes and other deductions such as healthcare, life insurance, etc. Then, from this number, subtract your monthly expenses, both recurring and fluctuating. Recurring expenses include auto-loan payments and internet service that cost the same each month. Fluctuating expenses include heat, water and groceries with costs that vary each month.
The second step is to review your personal expenses. If your monthly expenses exceed your monthly income so that you don’t have a monthly profit, you must cut your monthly expenses. By this we mean cut non-essential expenses, such as dining out, cable and magazine subscriptions. If your monthly expenses grossly exceed your monthly income, you may need to sell your car or downsize your home.
How much of your monthly income should you spend? The simple answer is that you should spend less money than you make. This requires planning ahead and having patience. You can certainly go to Cher’s show, but in order to go without carrying a credit card balance for the next few years, you must save first.
A great app to download to your smart phone or tablet is Mint.com’s personal finance app. This free app categorizes your spending and has tools to help you track and stay on target to reach your personal finance goals. More information can be found at www.mint.com.
Save for Security
The foundation of a solid financial plan is an emergency savings account. Many people don’t like the word “emergency” because it suggests something ominous. We call it a “insurance” account instead.
The benefit of an insurance account is just as the name implies. It provides you with insurance. Standard advice is to save between three to six months worth of living expenses in a separate, not easily accessible, savings account. The easiest way to calculate your range is to multiply your total monthly expenses from above by three and six.
If you have been too much like Wimpy and have credit card debt, first save $500 to $1,000 for your insurance account and then pay off your credit cards before you fully fund your security account. Rates for savings accounts are considerably lower than the APR you likely pay to carry credit card debt from month-to-month. If you pay off your credit card debt first, you save money in the long run because you reduce your future expenses when you eliminate interest charges.
The reason an insurance account is important is because, just like Cher, you cannot turn back time and erase past mistakes, financial or otherwise. A security account reduces the risk you will acquire new or additional debt should anything nefarious happen to you.
Get Ahead with Investments
The final step to a financial plan is about growth. Investments make your money work harder for you than you work for your money. Investments are imperative for a successful financial plan. Robert Kiyosaki, the author of Rich Dad/Poor Dad, defines true wealth as having your investment income exceed your living expenses. All too often, our living expenses exceed our investment and earned income.
Consider this example. Say you bought a new Audi RS5 in 2011 for about $70,000. The millisecond you drove that new car off the dealer lot, it depreciated in value about 10 percent, or about $7,000. After you owned that not-so-new car for three years, it depreciated in value over 40 percent, or almost $28,000.
What would have happened if you invested your $70,000 rather than buy a new car? The average annual return of the S&P 500 over the last three years was about 16 percent. If you invested your $70,000 in an S&P ETF (Exchange Trade Fund) in 2011 and never touched it, it would have appreciated about $39,000 and total over $108,000 today.
We are not suggesting that you drive a car that won’t get you to Cher’s show. We simply want you to consider your opportunity costs when you spend money.
We are often asked the question, “How much money should I invest?” The best answer is to “invest as much money as you can.” Now that you want to smack us and yell, “Snap out of it!” we’ll get more specific.
There are many formulas to calculate how much you should invest. One formula suggests you save 10 percent of your monthly income. Another suggests you invest the percentage of your monthly income based on your decade of life. Save 20 percent in your twenties. Save 30 percent in your thirties and so forth.
There is the 50/30/20 rule that suggests you spend 50 percent of your monthly income on essentials, such as housing and food, 30 percent on non-essentials, such as your phone bill and social life, and then invest the remaining 20 percent.
We suggest that you spend less than you earn and invest more than you think you can.
In summary, a quality financial plan includes 3 key steps. Start your financial plan or amend an existing plan today. If you’re new to investing, here are our 10 Steps to Simple Investing.
1. Create a budget to bring your current expenses below your income
2. Create a security account to protect yourself
3. Develop a plan to invest