The term “personal finance” refers to how you manage your money and plan for your future. All of your financial decisions and activities have an effect on your financial health. It’s always important to consider what we should be doing—in general—to help improve our financial health and habits. Here we discuss five broad personal finance rules that can help get you on track to achieving whatever your financial goals may be.
- “Personal finance” is too often an intimidating term that causes people to avoid planning, which can lead to bad decisions and poor outcomes.
- Take the time to budget your income vs. expenses, so you can spend within your means and manage lifestyle expectations.
- Successful financial planning entails being mindful of spending regardless of your income level or of what you want but don’t need.
- By saving early, you capture more potential of compounding – investment growth on prior investment growth.
- Always prioritize creating an emergency fund; you never know when something will come up.
1. Do the Math—Net Worth and Personal Budgets
Money comes in, money goes out. For many people this is about as deep as their understanding gets when it comes to personal finances. Rather than ignoring your finances and leaving them to chance, a bit of number crunching can help you evaluate your current financial health and determine how to reach your short- and long-term financial goals.
Calculating Net Worth
As a starting point, it is important to calculate your net worth—the difference between what you own and what you owe. To calculate your net worth, start by making a list of your assets (what you own) and your liabilities (what you owe). Then, subtract the liabilities from the assets to arrive at your net-worth figure.
Your net worth represents where you are financially at that moment, and it is normal for the figure to fluctuate over time. Calculating your net worth one time can be helpful, but the real value comes from making this calculation on a regular basis (at least yearly). Tracking your net worth over time allows you to evaluate your progress, highlight your successes, and identify areas requiring improvement.
Net Worth by Age
Net worth is highly dependent on age. It’s common for younger investors to have low or negative net worth when they start their careers, while older individuals further in their careers have much higher net worth.
Calculating a Personal Budget
Equally important is developing a personal budget or spending plan. Created on a monthly or an annual basis, a personal budget is an important financial tool because it can help you plan for future costs, reduce unnecessary spend, save for future goals, and prioritize where you put your money.
There are numerous approaches to creating a personal budget, but all involve making projections for income and expenses. The income and expense categories you include in your budget will depend on your situation and can change over time. Common income categories include:
- Child support
- Disability benefits
- Interest and dividends
- Rents and royalties
- Retirement income
- Social security
General expense categories include:
- Debt payments (car loan, student loan, credit card)
- Education (tuition, daycare, books, supplies)
- Entertainment and recreation (sports, hobbies, books, movies, DVDs, concerts, streaming services)
- Food (groceries, dining out)
- Giving (birthdays, holidays, charitable contributions)
- Housing (mortgage or rent, maintenance)
- Insurance (health, home/renters, auto, life)
- Medical/Health Care (doctors, dentists, prescription medications, other known expenses)
- Personal (clothing, hair care, gym, professional dues)
- Savings (retirement, education, emergency fund, specific goals such as a vacation)
- Special occasions (weddings, anniversaries, graduation, bar/bat mitzvah)
- Transportation (gas, taxis, subway, tolls, parking)
- Utilities (phone, electric, water, gas, cell, cable, internet)
A budget is only useful if it is followed. After you prepare a personal budget, track your income and spending across categories. Then, refine your budget based on what actually happened.
Once you’ve made the appropriate projections, subtract your expenses from your income. If you have money left over, you have a surplus, and you can decide how to spend, save, or invest the money. If your expenses exceed your income, however, you will have to adjust your budget by increasing your income (adding more hours at work or picking up a second job) or by reducing your expenses.
2. Recognize and Manage Lifestyle Inflation
Most individuals will spend more money if they have more money to spend. As people advance in their careers and earn higher salaries, there tends to be a corresponding increase in spending, a phenomenon known as “lifestyle inflation.”
Even though you might be able to pay your bills, lifestyle inflation can be damaging in the long run because it limits your ability to build wealth. Every extra dollar you spend now means less money later and during retirement, and higher disposable income today doesn’t guarantee higher income in the future.
As your professional and personal situation evolves over time, some increases in spending are natural. You might need to upgrade your wardrobe to dress appropriately for a new position, or, as your family grows, you might need a house with more bedrooms. With more responsibilities at work, you might find that it makes sense to hire someone to mow the lawn or clean the house, freeing up time to spend with family and friends and improving your quality of life.
As you enter into different phases of life, re-evaluate your personal budget to have it reflect the right conditions in your life. When preparing a list of your expenses, evaluate which costs are truly needed and which you can go without.
TIP: A helpful scenario is to consider what changes you were to receive a pay cut at work. If your income were to be cut 20%, how would that impact your spending or saving?
3. Recognize Needs vs. Wants—and Spend Mindfully
It’s in your best interest to be mindful of the difference between “needs” and “wants”. Needs are things you have to have in order to survive: food, shelter, healthcare, transportation, a reasonable amount of clothing. It’s also important to set aside money each month for savings, although that is much more contingent on your other needs being met first.
Conversely, wants are things you would like to have but don’t require for survival. These costs may be engrained in our daily lives, so they may feel like needs. Whether it’s a streaming subscription that isn’t necessary for survival or skipping a morning treat that is now part of your daily routine, wants are items that are non-essential.
This line between “wants” and “needs” is blurred for essentials when there is no defined level of either. A car is a good example. Depending on your city’s public transportation, you might be able to make the case that a car is a “want”. However, for the many of us that consider it a “need”, what type of car is appropriate? What is an appropriate balance between a higher car payment and a nicer vehicle?
Your needs should get top priority in your personal budget. Only after your needs have been met should you allocate any discretionary income toward wants. Again, if you do have money left over each week or each month after paying for the things you really need, you don’t have to spend it all.
TIP: Saving money for the future is a need as long as your current physical needs (food, shelter, transportation) are met. In addition, some may argue that obtaining a retirement contribution match by your employer is a high priority.
4. Start Saving Early
It’s often said that it’s never too late to start saving for retirement. That may be true (technically), but the sooner you start, the better off you’ll likely be during your retirement years. This is because of the power of compounding
Compounding involves the reinvestment of earnings, and it is most successful over time. The longer earnings are reinvested, the greater the value of the investment, and the larger the earnings will (hypothetically) be.
The Power of Compounding
Realizing its power to create wealth, Einstein referred to compounding as “the eighth wonder of the world”.
To illustrate the importance of starting early, assume you want to save $1,000,000 by the time you turn 60, and you expect to earn 5% interest each year.
- If you start saving when you are 20 years old, you would have to contribute $655 a month—a total of $314,544 over 40 years—to be a millionaire by the time you hit 60.
- If you start saving when you are 40 years old, you would have to contribute $2,433 a month—a total of $583,894 over 20 years.
- If you start saving when you are 50 years old, you would have to contribute $6,440 each month —a total of $772,786 over 10 years.
The sooner you start, the easier it is to reach your long-term financial goals. You will need to save less each month and contribute less overall, to reach the same goal in the future.
5. Build and Maintain an Emergency Fund
An emergency fund is just what the name implies: money that has been set aside for emergency purposes. The fund is intended to help you pay for things that wouldn’t normally be included in your personal budget. This includes unexpected expenses such as car repairs or an emergency trip to the dentist. It can also help you pay your regular expenses if your income is interrupted
Although the traditional guideline is to save three to six months’ worth of living expenses in an emergency fund, the unfortunate reality is that this amount would often fall short of what many people would need to cover a big expense or weather a loss in income. In today’s uncertain economic environment, most people should aim for saving at least six months’ worth of living expenses—more if possible.
Keep in mind that establishing an emergency backup is an ongoing mission. Odds are that as soon as it is funded, you will need it for something. Instead of being dejected about this, be glad that you were financially prepared and start the process of building the fund again.
How Do I Calculate My Net Worth?
To calculate your net worth, make a list of everything you own and the value of each item. Then, make a list of all of your debts (like credit card loans, car loans, or student loans). The difference between these two lists is your net worth. It represents the amount of money you could have if you sold everything you own and paid off your obligations.
How Do I Create a Budget?
To create a budget, start by listing all of your income streams and how much you bring in each month. Then, make a list of everything you spend money and those amounts. Be mindful that some months may be different than others, so it may be helpful to create a monthly budget for the entire year.
The difference between what you bring in and what you spend is your household net savings. You can choose to spend this money on non-essentials or can save it for emergencies or retirement.
What Is Compound Interest?
Compound interest in interest revenue earned off previously earned interest revenue. Compounding occurs when you grow money on top of the money you’ve already grown in the past. By saving money at an earlier age, your money is more likely to grow faster due to compounding.
How Much Money Should I Save Each Month?
Your top priority each month is to pay for your essentials – worry about costs like shelter, food, and transportation first. After your needs have been met, it’s often advised to try and save at least 10% of your take-home income. However, just because you have the money doesn’t mean you should spend it. If you’re able to save more now, you’ll have greater earning potential in the future.
How Big Should My Emergency Fund Be?
Everyone’s emergency fund will be different. It’s often advised to have six months of expenses saved in case of emergency. This amount is often adjusted in consideration of your profession and your fixed expenses.
The Bottom Line
Personal finance rules can be excellent tools for achieving financial success. However, It’s important to consider the big picture and build habits that help you make better financial choices, leading to better financial health.
This article was written by Jean Folger and published on Investopedia.com on June 29, 2022.
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