Financial literacy is a must for everyone. Even if ones traditional education is minimal, there is still a chance of financial success. How?
By opting to be financially literate. Financial literacy teaches one – how to manage money.
It’s importance is high, and that is why in 2003, United States Senate declared April as “National Financial Literacy Month”.
Money Management & Global Crisis
The need for more financial literacy became highlighted after the global financial crisis of 2007-2008.
It’s true that excessive use of subprime mortgage was the cause of this crisis.
But had people been more financially-aware, this crisis could have been avoided.
World’s Financial Literacy Data
[Interesting: Check world’s financial literacy data compilation]
Americans can afford debt more than majority in the world. Why? Because here the earning power is higher. Hence, debt is available easily to people. But what if the paycheck gets spent more wisely (instead of on debt)? So what? It’ll improve ones personal finance and create wealth.
How to do it? Let’s discuss more…
- Step #1: Getting the basics right
- Step #2. Watch spendings, & then save
- Step #3. See Future
- Step #4. Control New Debt
- Step #5. No Overspending
- Step #6. Start Investing
- Step #7. Credit Worthiness
- Step #8. Be Insured
- Step #9. Investment Management
- Step #10. Income Management
How to manage your money?
There are several steps that one has to take in the overall management of ones money. In financial terms we call it ‘personal finance management’. But what’s really managed in these “steps” will be discussed here in this blog post.
Step #1. Getting the basics right…
- Be Organised: This is the most basic step. Most people loose track of their money because its all messed up. To start with, one needs to get organised with two things: (1) Tax payments, & (b) bill payments. All bills has either a monthly, quarterly or annual cycles. Just begin with paying all bills on time. Open the calendar on your mobile phone and put a reminder. That’s it, this will do. Read: Become financially organised.
- Be Debt Sensitive: Become aware of your debts. Even if you think, you remember it all, open your excel sheet and try to list down all. Include your student loan, auto loan, mortgage, credit card debt etc. Now, note against each line item their interest rates. Finally, sort the list in order of their interest rate. What next? Start prepaying the costlier debt first. Bigger purpose should be to become debt free asap. Read: Why to become debt free.
- Be Net worth Aware: This gives a clarity about whether ones finances are on track or not. What is net worth? Total of all assets minus total of all debts. Young people will start with negative net worth. It’s understandable. So how to go about it? First bring it to zero, then make it grow. A simple net worth tracking can do wonders to this goal. But how many in America are aware of their net worth trend? Not many. To stand out, estimate your net worth today. Read: Track your net worth.
For a beginner even these three To-Do’s may be overwhelming. But it must start here. Practice this for 3 months and then take the next step. Do not be in hurry of jumping steps. Idea is not to be fast, but to be thorough.
Step #2. Watch spendings, & then save
This is another big step towards a strong personal finance management. In step #1 what we did will shape our foundation. In step #2 we will pour concrete into it. Perhaps, these two step are so huge that it covers 40% of money management a common man will ever need in life.
- Budget: Cliche, right? But it is essential. One should not take the next step without accomplishing this. Why? Because budgeting expenses will give clarity about ones spending habits. It will also put limits on those activities which is causing overspending. People in America overspend. Period. Hence this step is a must. Read: 50-30-20 Rule of Budgeting.
- Track Expense: Go easy, open a mobile app start budgeting and tracking expenses. Budgeting alone will mean nothing. Recording expense is mandatory. This can be easily done using an app. At the end of the month, compare how money was spent compared to the budget.
- Use Prepaid Cards: If you tend to overspend, stop using credit cards. Opt for a better option of making payments using a ‘prepaid debit card’. Even better – switch to cash. You will be surprised how much less you have spent just because you went prepaid (or cash). Try it to experience it. Read: Why not to use credit card.
- Emergency Fund: In step #1, key was “paying-off loans”. Here, it is building emergency fund. These two actions alone has powers to transform lives. Building a sufficiently big emergency fund is important. How big? Multiply your monthly expense by six. If ones monthly expense is $5,000, size of emergency fund must be $30,000 (minimum). Read: About emergency fund.
Step#1 and Step #2 can continue together. This may be overwhelming for many, why? Because these steps are like new practice for people. Hence, it is critical to execute them for at least three months, before including the next step #3.
Step #3. See Future
By the time you’ve reached this step, you are already paying off your debts and building an emergency fund. This is a point where one can start looking at future. How to do it? By goal setting. Why to see future? Because it will give a direction and purpose to life.
- Financial Goals: On an average, a typical American can have financial goals like: annual vacations, retirement account, buying car, being debt free, buying a home, having children, wedding etc. These are just examples. Think deeply and prepare a unique list for yourself. Allot a number ($) to each of these goals, and set a time frame. Read: How to deal with tough financial goals.
- Estimate Cost: Each goal has a cost. Suppose you want to buy a home after 5 years from today. This will cost in two ways: (a) down payment, and (b) monthly mortgage payments. Read: About goal based investing.
A successful goal setting is one which is not only elaborate but also detailed. Listing out all future financial goals will be the first requirement. Spend time thinking about it. Once the list is ready, do the maths and calculate all costs attached to each goal.
Step #4. Control New Debt
After completing step #3, the next logical step seems ‘investments’, right? But we are not going there still. Why? Because if we continue piling up new debts, diverting money for investing will not be as useful. So, we must first control debt? How to do it? Be critical about the following:
- Debt Dependency: Debt on its own is not bad. People must use debt as a leverage, not for overspending. How to use debt for leverage? A rule of thumb is, not to be more than 50% dependent on loans to buy a thing. Example: if you want to buy a $50,000 car, fund the purchase by paying $25,000 from your savings (down payment). The balance $25,000 can be bank financed (auto loan). Read: How to identify debt trap.
- Affordability: Suppose you have decided to buy a $50,000 car, and you also have a $25,000 for the down payment. This way the estimated monthly payment will be $454, for an auto loan of $25,000 (@3.39% for 6 years). Make sure that you can afford to pay $454 consistently. Check your budget, and ensure that your current saving is enough to pay for the auto loan. Read: How to stop overspending.
These two observations will help you gauge new debt in a perspective. You will exactly know when you can buy, and if you can afford it. These two clarities can help one to substantially kill the temptation of accumulating new debt. Moreover, it will also enhance the understanding of affordability.
Step #5. No Overspending
Overspending happens only when it is ‘triggered’. What triggers it? Our urge to spend instantly. How to curb this urge? By keeping a check. When we create a budget and track expenses, it is to prevent overspending. But this alone is often not sufficient. One must do more.
- Budget for Luxury: Even if we try not to do miscellaneous shopping, it happens. No matter how much we try, we will slip into a dinning-out spree once in a while. Important is to understand ones pattern (…when it gets out of hand), and then budget for it. No need to ignore – better is to deal with it. But put a check. How? Do not allow yourself to spend more than 20% of your paycheck on luxury. Read: How much to spend on a car purchase?
- Shopping List: Never go shopping without a list. Even when you are going casual shopping, don’t go without it. Family members can sit together for five minutes and prepare a list. Idea is, to approach a store with a clear objective of what you want to buy. This way, random buying can be eliminated. Read: Where people spend money?
- Go Cash: When you are on a casual shopping spree, make sure you do it with cash. Fix a budget, go to the ATM and withdraw the dollars. Do not fall for the offers of the credit card. If you like earning reward points, use credit cards for paying monthly bills, grocery, etc. But casual shopping must be financed using cash. Read: Why credit card offer rewards?
In step #3, we talked about ‘goal fixing’. The next step #4, talked learnt about ‘new debt control’. In step #5, we saw how not to overspend money. Together, these three steps has prepared us to handle investments.
Step #6. Start Investing
For a common American, investment is easy. Why? Because variety of mutual funds are there to take care of ones investment needs. There is another reason why mutual funds are better for small and medium investor. This allows investments to operate on autopilot. Few things to remember about investments:
- Requirement: If you have reached here, you must have already done the requirement analysis in step #3 (estimating cost). What is its utility? Suppose you have two goals. Both the goal ask you to invest $5,000 and $10,000 per month respectively. But your current affordability is only $7,000. How to go about it? Proportionately distribute the money for both the goals. In this case $7,000 will split as $2,350 for goal one, and $4,650 for goal two. Read: The best investment strategy.
- Increments: One may start small, but the contributions must increase with time. What should be the increment criteria? Every time there is a hike in paycheck (income), there should be a proportional increase in the contribution too. Following this simple rule can do the trick. Read: How to invest money?
- Tax Bill: As a beginner, one must start investing in those options which can also reduce the tax bill. At a given point of time, one must utilise maximum tax breaks possible – through investments. There are two benefits here: (1) Often tax-efficient investments are safer, (2) they can gradually mould the person to handle riskier investment (like equity etc). Read: About income tax planning.
- 401(k) & IRA: If one is below 50, the maximum contribution to 401(k) is $15,000 per annum – try to match it. If it is not possible, minimum contribution must be capped at 15% of gross salary. Similarly for IRA, maximum contribution is capped at $6,000 per annum. Make sure to contribute at least 6.5% of gross income to IRA. Read: About retirement planning.
- Start Early: The best time to start investing and saving tax is from the first day in job. Imagine yourself as a 21 year old man, who will invest $500 a month for next 40 years (@5% increment each year). What will be the corpus after 40 years? $3.2 Million dollars (returns @8% p.a.). Longer the money stays invested, bigger will be its final volume. Read: About early retirement.
Investing is an essential step of the overall management of ones personal finance. But here the outcome is also dependent on ones decisions. More informed will be the decisions, bigger will be the success.
Step #7. Credit Worthiness
When a person needs debt, credit worthiness will come into play. If you have not heard of FICO scores, you might know about it when you’ll apply for a car loan. Though one must always try to remain debt free – but it is not bad to be aware of ones ‘credit worthiness’. It will come handy in times of need (debt emergency). Moreover, ‘managing credit worthiness’ can support the cause of ‘money management’ – how? Because in this process, people are obliged to follow wise money habits.
- Credit Limit: Suppose you have a credit card whose credit limit is $10,000. What is a credit limit? In simple language, this is the maximum value of purchases you can make using your card. But, here comes the caution. Using credit cards for amount more than 10% of credit limit, raises a red flag. A person who consistently use the credit card for values below 10% of credit limit will have a stellar credit worthiness. Read: Habits of people with high credit score.
- Monthly Payments: Never miss your monthly payments on any loan bills. Let it me mortgage, student loan, personal loan, auto loan or a credit card bill. Make sure that the payments go through as scheduled. Over a period of time, such timely-bill-payments can build a strong credit worthiness. Read: How to use credit card?
- Check Bounce: Suppose I’ve paid someone using my checkbook (say $10,000). But my checking account has only $9,500 as balance. In this case, when the bearer of check will try to withdraw money, the check will bounce due to insufficient balance. Such check bounces can badly damage ones credit ratings. It must be avoided in all circumstances.
- Check Report: One must check credit report at least once a year. One free report can be downloaded every 12 months. Where to get the credit report from? There are three credit bureaus in USA: Equifax, Experian, and TransUnion. Why these companies offer credit reports for free? Because according to “The Fair Credit Reporting Act (FCRA)”, they are bound to provide it to every American upon request. Read: Improve credit score without debt.
There are two credit scoring templates in America, FICO and Vantage. Both these companies gives a credit rating in scale of 300 and 850. The higher is the credit score, the better. A credit score of above 720 is excellent. Generally speaking, a credit score above 700 can easily fetch one a credit card, or a personal loan.
Step #8. Be Insured
No matter how well managed are ones personal finance, but in case of unforeseen happenings, it is easy to get caught unprepared. This is what is called as emergencies. Road accident, loss of life, damage to property etc are few extreme examples. How to deal with it?
In step #2, we have built an emergency fund. But this is not enough. It will only take care of minor emergencies. For others, one needs insurance.
- Life Insurance: This is essential for everyone in the family. But to get the main earning members insured for life is more important. In America there are two main types of life insurance: (a) Term insurance, and (b) whole life. People generally go for the basics whole life policy. On an average, if one purchase a life insurance policy of $100,000 at 30 years of age, monthly premium will be $720 ($585 for women). Read: About term insurance plans.
- Own Policy: People who are in job, get a life cover from their companies. But this policy is often not big enough. Moreover, if the job is switched, the policy will cease to exist. So better is to buy a life insurance by self, which continues – no matter where ever one works. Read: How to use life insurance money.
- Health Insurance: Health care in America is very expensive. Hence, it is better to get oneself sufficiently insured for even general medical needs. At least the hospitalisation expense should be covered under the health plan. Getting every family member covered under a health insurance plan should be the goal. The cost of insurance for a family of four is about $1,200 per month. Read: Buying medical cover in 40s.
- Renters Insurance: If you are living on rent, then this insurance will be required. Generally, the home owner’s insurance only covers the damage to the property. But loss of furniture, clothes, gadgets, etc are not covered. These can be covered under ‘renters insurance’ policy. If one is living in an apartment, $50,000 cover will be enough. But a home would require a $100,000 cover. These days, landlords insist on their tenants to having a renters policy in place within the first month of occupation.
Insurance is a cost. Their returns are not evident till one faces an emergency. Hence, it is easy to see people ignoring insurance. But ignorance is a mistake. Make sure to include the cost of insurance in your budget. It’s worth it.
Step #9. Investment Management
In step #6 we saw how to put our investments on autopilot. This way one can continue investing money without a miss. But occasionally the portfolio must be reviewed. What to review in the investment portfolio? Two main things:
- Asset Balance: Mainly there are two types of asset in ones investment portfolio: Equity and Debt. A person in 20s will have different proportion of equity-debt in portfolio than a 40 years old. Equity = 100 – your age. If you are 45 years of age, weight of equity in your portfolio cannot be more than 55%. So, periodic review of portfolio for its asset balance is necessary. Reviewing ones portfolio every 12 months should be enough. Read: How to build asset?
- Expense Ratio: Over long term, low expense ratio of mutual fund can make a big difference. One goal of periodic review, should be to check if the expense ratio of the fund is trending up or down. A stable or downward trend is what’s desirable. Read: Use sharpe ratio to buy mutual funds.
Checking ones brokerage account once a while is not bad. It is also true that one must not ‘overdo’ it. A person who watches ones portfolio too closely, will often make hasty investment decisions.
Step #10. Income Management
No personal finance discussion can end without the mention of ‘income’. Income is the root of all money management talks. Why? Because no wealth can be built in absence of income. If one is in job, the main source of income is your employer. If one is self employed, the source of income will be customers, subscribers etc. Managing ones employer, customer, subscribers is a challenge, which one cannot afford to loose. How to do it?
- Job: Every employee has deliverables. Some deliverables are long term, and some has shorter durations (like daily). As an employee, one must manage both the deliverables. But in the hurry-worry of office life, it is easy to loose track of the deliverables. Hence, periodic review with the boss and colleagues will do the trick. If one can keep rendering the deliverables efficiently, income management will be mostly in place. What more needs to be done? Relations management. Read: About salary dependency.
- Business: No matter how small or big is the business, the basic traits of doing it remains the same. Focus must be on (a) requirement, (b) quality, (c) and quantity. If one can add a bit of (d) “innovation” in these three parameters, winner is on the card. These four parameters has potential to skyrocket ones income. Read: Build business to become rich.
- Passive Income: No matter how high is ones active income, if ones passive income is small, the person is not rich. Diverting a good part of savings to accumulate passive income sources is a necessity. Investment portfolio heavy in income generating asset is great. Why? Because it has capacity to replace active income. Read: The concept of passive income.
In the process of income management, it is essential to keep a balance between “growth” in active income and passive income. At all points of time, ones passive income must not be below 30% of active income. If this is not the case, it means, passive income needs serious attention.
Personal Finance & Money Management
When we talk about money management, the first thing that comes to mind is budgeting. But our personal finance consists of an array of things. Budgeting only takes care of our spending patterns. Other aspects which needs work has been explained in the above steps.
What is personal finance management? It is handling of a combination of all these 10 parameters (all-together). It sounds tedious, right? Yes it is, and that is why it is necessary to split the whole process into ten manageable steps.
Managing money is not about savings and investment alone. It requires a more holistic view of ones personal finance. The same has been detailed in this article. Hence, the activity of money management becomes tedious. People who can afford, offloads this responsibility to their money manager. But for majority it needs to be done by self. What are the benefits of a sound money management?
- Cash Flow: It will enhance the quality of cash flow. What is a high quality cash flow? When majority income is coming from passive income sources. Initially. the cash flow requirements will be managed using active income. Then a stage will come when the passive income will be big enough. This is a stage of financial freedom. A good money management can lead to it. Read: Generate monthly income.
- Net worth: At the end of the day, all what matters is cash flow and individuals net worth. Purchase of investments, insurance will ensure the sustainability of ones ‘ever growing net worth‘. Read: Networth Calculator.
- Quality of life: Why we care about money management at all? To take care of our ‘needs of life’. Peoples needs are dependent on their standard of living. If one can ‘effortlessly’ maintain a desired standard of living, it is a sign of leading a quality life. Only efficient management of ones personal finance can lead to it. Read: Manage money like wise men.
One of the simplest form of personal finance management is ensuring enough cash in ones checking account. It is easier said than done. But this simple understanding can pave the path for a more inclusive money management in years to come. Here is a simple representation of managing checking account by a beginner.